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Business associations Section 2b: Firms – internal relationships Prof. Amitai Aviram Aviram@illinois.edu University of Illinois College of Law Copyright © Amitai Aviram. All Rights Reserved F14D
Firms: internal relationships Models of firm governance Direct control Management by consensus (collective decision-making) Works well when SHs have: – Low cost to act collectively – Equal access to info/expertise – Similar business interests Good governance when it works well, but when it doesnt it - – May be impossible (deadlock) or very inefficient (meeting of 1M SHs) – Creates a majoritarian agency problem (C vs. MSHs) Delegated control Management by authority (central decision-making body) Needed if SHs have: – High cost to act collectively – Unequal access to info/expertise – Differing business interests Managerial agency problem (BoD & officers vs. SHs) – If firm has a controlling SH, managerial agency problem is mitigated, but a majoritarian agency problem is created © Amitai Aviram. All rights reserved. 2
Firms: internal relationships Overview of Section 2b 1.Direct control – Rights of a beneficiary under direct control – Dysfunctions of direct control 2.Delegated control 3.Intervention solutions 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 3
Direct control Economic rights of a partner in a GP Economic rights – Right to a share of firms profits, if theyre distributed: Each partner is entitled to an equal share of the partnership profits… [and losses] [RUPA §401(b)] – Right to a share of firms assets upon dissolution: Each partner is entitled to a settlement of all partnership accounts upon winding up the partnership business. [RUPA §807(b)] – Right to alienate economic rights: The only transferable interest of a partner in the partnership is the partners share of the profits and losses of the partnership and the partners right to receive distributions. [RUPA §502] © Amitai Aviram. All rights reserved. 4
Direct control Control rights of a partner in a GP Control rights – Right to participate in collective management: Each partner has equal rights in the management and conduct of the partnership business. [RUPA §401(f)] A partner is not entitled to renumeration for services performed for the partnership [except in winding up the partnership]. [RUPA §401(h)] So why bother managing the partnership? – Right & power to act (unilaterally) on firms behalf: Each partner is an agent of the partnership [RUPA §301(1)]. Actual authority determined by RUPA §401(j). RUPA §401(j) – Ordinary course of business majority – Outside the ordinary course of business unanimous – Amendment to the partnership agreement unanimous Example: Ralph, Sarah & Tom are partners in a law firm – Partnership agreement silent about dividing profits between them – They vote 2-1 to add a section to the agreement that divides profits: 40% R, 40% S, 20% T. Is the new section valid? – They also vote 2-1 not to accept any employment law cases. Is this valid? © Amitai Aviram. All rights reserved. 5
Direct control Control rights of a partner in a GP RUPA 401(j) addresses the relationship between the partners (actual authority). What about third parties? – RUPA §301(1): …An act of a partner… for apparently carrying on in the ordinary course the partnership business… binds the partnership, unless the partner had no authority to act for the partnership in the particular matter and the person with whom he was dealing knew or had received a notification that the partner lacked authority. – RUPA §301(2): An act of a partner which is not apparently for carrying on in the ordinary course the partnership business… binds the partnership only if the act was authorized by the other partners. In other words: – Ordinary course of business Partnership liable if either theres actual authority or T doesnt know/have notice that A lacked authority – Outside the ordinary course of business Actual authority required This is the same rule as in agency: partnership liable if partner acted with either actual or apparent authority – Actual authority: RUPA § 401(j) – Apparent authority: RUPA assumes a reasonable T would believe that a partner has authority to act in the ordinary course of partnership business, and doesnt have authority to act outside the ordinary course of business © Amitai Aviram. All rights reserved. 6
Direct control Control rights of a partner in a GP Limiting partners apparent authority – Hypo: Abe lacks common sense. His partners Becky & Charlie are concerned that he will bind the partnership to third parties in half-baked transactions. – What can they do? [Note RUPA §303] Power regarding transfer of real property All other powers © Amitai Aviram. All rights reserved. 7
Direct control Dysfunctions of direct control a)Inefficiency: – Direct control is efficient when SHs have: Low cost to act collectively Equal access to info/expertise Similar business interests – The more SHs a firm has, the greater the cost of acting collectively – Large & changing SH group increases likelihood SHs will have different interests – SHs with small stakes in the firm likely to be rationally apathetic, lacking incentive to know firms business & participate in the firms management (each SH has little power to change things & little to gain from changing things) Inefficiency is addressed by governing through delegated control © Amitai Aviram. All rights reserved. 8
Direct control Dysfunctions of direct control b)Deadlock: SHs veto each other – E.g., 50/50 split with neither side having a majority), causing the firm to be unable to act Deadlock is addressed via: – [Most frequent solution] Shift towards delegated control via SH agreements & voting trusts (which require parties to vote in a particular way or based on a predetermined process) – Suit for breach of fiduciary duty » Discussed in Section 2b3 (intervention solutions) – Dissolution (liquidating the firm) or dissociation (buying out one group of SHs) » Discussed in Section 2b4 (exit solutions) © Amitai Aviram. All rights reserved. 9
Direct control Dysfunctions of direct control c)Oppression: Controller exploits minority SHs – By managing firm in a way that shifts value to controller at minoritys expense, or that pressures minority to sell their shares to controller at a low price – Example: Bob owns 60% of Acme Corp, while Jack owns the remaining 40%. Bob is Acmes general manager. Jack doesnt work at Acme. Acmes BoD consists of Bob, Bobs wife & Jack. How can Bob oppress Jack? Oppression is addressed via: – Suit for breach of fiduciary duty » Discussed in Section 2b3 (intervention solutions) – Dissolution or dissociation » Discussed in Section 2b4 (exit solutions) © Amitai Aviram. All rights reserved. 10
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control – Rights of a beneficiary under delegated control – Actors for the corporation – Authority 3.Intervention solutions 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 11
Delegated control Economic rights of SHs in a corporation Economic rights – Right to a share of firms profits, if theyre distributed (i.e., if dividends are declared by BoD) – Right to a share of firms residual assets upon dissolution (i.e., if both BoD & SHs approve dissolution, or if court orders dissolution) – Right to alienate economic rights (and also control rights) Almost identical to economic rights under direct control (except that corporate law allows selling control rights together with economic rights, whereas partnership law does not allow unilaterally selling control rights) © Amitai Aviram. All rights reserved. 12
Delegated control Control rights of SHs in a corporation Control rights – Right to participate in collective management (as a SH meeting), but only for the following acts: Electing & removing directors [DGCL 211(b), 141(k); MBCA 8.03(c), 8.08] Amending charter & bylaws [DGCL 242, 109(a); MBCA 10.03, 10.20] Approving mergers & major asset sales [DGCL 251,271; MBCA 11.04,12.02] Approving dissolution of the corporation Approving corps independent auditor Adopting precatory (nonbinding) resolutions – No right or power to act unilaterally on firms behalf Why are SH control rights so limited? – When direct control is inefficient, firms use delegated control (delegate control to body that can efficiently exercise direct control: low cost to act collectively, equal access to info/expertise, similar business interests) Can this body be an agent of the SHs? (A acts on behalf of B & subject to Bs control) Corporate organs act on behalf of B but not subject to Bs control – Need other mechanisms besides Bs control to mitigate agency problem © Amitai Aviram. All rights reserved. 13
Actors for the corporation Types of actors Agents (act on behalf of firm & subject to its control) – Including officers, who do the day-to-day management Organs (act on behalf of firm, but not subject to its control) – BoD: has one/more of following functions Advisory: Directors add value through their advice, prestige & contacts Executive: Directors add value through managing the company Supervisory: Directors add value through their supervision of the officers Representative: Directors monitor company on behalf of stakeholders that they represent (e.g., particular SH, labor union, government), adding value by creating trust between corporation & stakeholder; representative function can be combined with other functions (often supervisory) – BoD committee: part of the board; acts on behalf of the entire board – SH meeting: considered an organ in some jurisdictions, but has very limited role in US law Controlling SHs (no right to act on behalf of firm, but control firms organs) – Will be addressed in the BA2 course (Section 3a2) © Amitai Aviram. All rights reserved. 14
Officers are a sub-class of a firms agents – I.e., all officers are corps agents, but not all corps agents are officers – Agency law governs all agents relations with corp & 3rd parties What distinguishes officers from other agents is: – (Actual) authority of the office is determined by law, bylaws or BoD The office is also a circumstance affecting their apparent authority Officer may hold multiple offices – Unclear whether officers benefit (like directors) from the Business Judgment Rule (BJR), an SoR that replaces the agency SoR For this course, use agency SoR for officers – Some laws impose duties/liabilities specifically on officers E.g., securities laws, environmental laws, service of process © Amitai Aviram. All rights reserved. 15 Actors for the corporation Agents: Officers vs. other agents
Actors for the corporation Agents: Common officers Chief executive officer (CEO) – #1 officer in the hierarchy Chairperson of the BoD – Administers BoDs activities – If Chairperson is affiliated with management, firm sometimes also has lead director Chief operating officer (COO) – Responsible for firms day-to-day business operations Chief financial officer (CFO) – Responsible for accounting & financial operations Treasurer – Same as CFO, or subordinate responsible for managing firms cashflow Secretary – Keeps minutes of BoD/SH meetings & authenticates corporate records President – Head of a business unit (or entire firm, overlapping COO or CEO) © Amitai Aviram. All rights reserved. 16
Actors for the corporation Organs: The Board of Directors Size [DGCL §141(b) / MBCA §8.03] – BoD consists of 1 or more natural persons – BoD size specified in / fixed in accordance with charter or bylaws Term in office – By default, directors are elected in each annual meeting (i.e., they serve a term of 1 year, renewable) [MBCA §8.03(c)] – Exception: charter may create a staggered board, dividing directors into 2 or 3 groups; one group elected each year [DGCL §141(d); MBCA §8.06] Removal [DGCL §141(k) / MBCA §8.08] – Directors may be removed by SHs for cause – Directors may be removed by SHs without cause, if charter does not say otherwise (MBCA) or if firm does not have staggered board (DGCL) – BoD may not remove a director Filling vacancies [DGCL §223 / MBCA §8.10] – SHs or BoD may fill vacancies in the BoD Meetings – Board of a typical public company meets 8 times a year; compensation & audit committees typically meet another 6-9 times a year © Amitai Aviram. All rights reserved. 17
Actors for the corporation Organs: Status of individual directors BoD is a corporate organ, individual directors are not – Individual directors have no authority to act for the corporation, unless they are granted authority by the board to act as a BoD committee (which may consist of a single director) – Likewise, the SH meeting is an organ, individual SHs are not Directors (and the board) are not the firms agents as such – We discussed this in sub-section 1a2; same goes for SHs & the SH meeting Directors individually owe FD to the firm – This is derived from their status as directors, not as agents – So, when we (figuratively) say X sued the board, we really mean that X sued each of the directors on the board – Why cant X (literally) sue the board? © Amitai Aviram. All rights reserved. 18
Actors for the corporation Organs: BoD committees Appointing committee members [Steigerwald (IL 1956)] – Committee must consist only of directors Otherwise, BoD majority can delegate authority to someone unelected by SHs – Members must be selected by the board (directors cant delegate nomination to someone else, such as the CEO) Common BoD committees – Executive committee: Manages day-to-day operations/decisions – Nominating committee: Picks the directors that BoD recommends to SHs – Compensation committee: Negotiates/approves officer/director compensation – Audit committee: Oversight of financial reporting & disclosure (sometimes also oversees regulatory compliance & risk management) – Risk committee: Oversees institutions risk management practices – Ad hoc committees Above committees are typical standing (permanent) committees; BoD may also create ad hoc (temporary, single-issue) committees When create an ad hoc committee rather than using a standing committee? © Amitai Aviram. All rights reserved. 19
Actors for the corporation Organs: How corporate organs act Corporate organs act by approving resolutions, in one of two ways: – Written consent BoD or BoD committee may act by written consent if consent is unanimous [DGCL §141(f)] SHs may act by written consent if consent is signed by holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted [DGCL §228] – Many corporations have a provision in their charter that eliminates SHs ability to act by written consent – MBCA default requires unanimity [MBCA §7.04] – Meeting: three elements to a valid meeting a)Call (authority to call meeting + notice requirement) b)Quorum c)Vote © Amitai Aviram. All rights reserved. 20
Actors for the corporation Organs: How corporate organs act a)Call – Authority to call a meeting BoD/committee: Charter, bylaws or BoD resolution may schedule regular (e.g., monthly, annually) meetings and may create a procedure for calling special meetings (e.g., chair may call special meeting); BoD resolution may call a special meeting (e.g., at end of previous BoD meeting, or by written consent) SH meeting: Annual SH meeting – as stated in bylaws [DGCL §211(b)], and court may order a meeting, if none was called for 13 months [§211(c)]; special SH meeting: BoD resolution + as stated in bylaws/AoI [§211(d)] – Did the call provide sufficient information & advance notice? BoD/committee: No notice requirement, but abuse may breach FD – In contrast, MBCA §8.22(b) creates a default 2-day notice of date, time & place of meeting, but not of meetings purpose SH meeting: notice must be given no less than 10 days or more than 60 days before the meeting; notice must be in writing and specify place, date & time of meeting, means of remote communications [DGCL §222] © Amitai Aviram. All rights reserved. 21
Actors for the corporation Organs: How corporate organs act b)Quorum – BoD/committee: by default, majority of total # of directors; may be modified by charter/bylaws upwards or downwards, but no less than [DGCL §141(b)] Presence via teleconference [DGCL §141(i)]: BoD meetings & BoD committee meetings may be held via conference telephone or other communications equipment by means of which all persons participating in the meeting can hear each other Presence via proxy is not allowed – SH meeting: by default, majority of shares entitled to vote; charter/bylaws can opt out of default, but never less than [DGCL §216(1)] Presence via proxy is allowed © Amitai Aviram. All rights reserved. 22
Actors for the corporation Organs: How corporate organs act c)Vote – BoD/committee: Vote of majority of directors present at a meeting constitutes the act of the BoD (unless charter/bylaws require supermajority) [DGCL §141(b)] – SH meeting: varies depending on the type of vote Default standard: majority of shares present [DGCL 216(2)] – Bylaw amendments – Precatory SH resolutions Majority of disinterested shares present – Ratifying breach of FD [DGCL 144(a)(2)] Majority of shares entitled to vote – Mergers [DGCL 251(c)] – Sale of all or substantially all of Cs assets [DGCL 271] – Charter amendments [DGCL 242(b)] Plurality of shares present – Electing directors [DGCL 216(3)] © Amitai Aviram. All rights reserved. 23
Authority Corporations authority (ultra vires) Ultra vires (Latin for beyond its powers) is a (mostly obsolete) doctrine regarding the corporations powers – History & erosion of ultra vires doctrine Doctrine of ultra vires originally stated that an act of the corporation that was not specifically authorized in the charter was void, meaning that it did not bind the corporation or third parties and could not be ratified by SHs Doctrine steadily eroded through creation of exceptions, liberal interpretation of implied powers & expansion of statutorily specified powers (e.g., DGCL §122) Eventually, statutes allowed corporations to state that they had the power to conduct or promote any lawful business or purposes (DGCL §101(b) & 102(a)(3); engaging in any lawful business: MBCA §3.01(a)) – Ultra vires occurs when firm acts in violation of its charter E.g., in SEPTA v. Volgenau [Del. Ch. 2012], firm merged & gave different consideration to some SHs, when charter stated that all SHs will receive equal consideration in a merger DGCL 124/MBCA 3.04 allows raising ultra vires claims only in: – Suits by state Attorney General to dissolve corp or enjoin ultra vires act – Suits by SHs to enjoin the ultra vires act – Suits by corporation (itself or derivatively by SHs) against the actor for damages from ultra vires act DGCL §124 limits ultra vires challenges to authority, but the same action may also breach FD, and §124 doesnt limit such suits [Volgenau] © Amitai Aviram. All rights reserved. 24
Authority Organs authority A firms actor can have authority in three ways – Grant of authority by law – Grant of authority by agreement (in charter/bylaws/valid SH agreement) – Grant of authority by approval (unilateral behavior of/attributed to B, either before As act (prior consent) or after (ratification)) © Amitai Aviram. All rights reserved. 25
Authority Authority of the BoD BoDs authority granted by law – DGCL §141(a): The business and affairs of [a corporation] shall be managed by or under the direction of a board of directors… BoDs authority granted by agreement & approval – Usually irrelevant because under DGCL §141(a) BoD already has authority to take any act the firm can take BoDs power to grant other actors authority by approval – BoD may delegate management authority and tasks to officers or other agents of the corporation, but may not delegate authority that law, charter or bylaws specifically assign to the BoD [DGCL §141(a) / MBCA §8.01(b)] For this reason, directors cannot vote by proxy in a BoD meeting – BoD may delegate to a BoD committee authority that was specifically assigned to BoD, with exceptions (see next slide) [DGCL §141(c) / MBCA §8.25(e)] – If authority is delegated BoD maintains oversight responsibility, but BoD can rely in good faith on agents/committees/experts reports [DGCL §141(e) / MBCA §8.30(f)] © Amitai Aviram. All rights reserved. 26
Authority Authority of a BoD committee BoD committee authority granted by law: not relevant in this course BoD committee authority granted by agreement: check charter/bylaws BoD committee authority granted by approval [DGCL §141(c)] – BoD may designate committees, each consisting of 1 or more directors – Committee may receive, in BoD resolution or bylaws, any powers or authority of the BoD except: Approving, adopting or recommending to SHs any matter that is subject to SH approval (other than election/removal of directors) Adopting, amending or repealing a bylaw – Different exceptions in MBCA §8.25: approving distributions; filling board vacancies © Amitai Aviram. All rights reserved. 27
Authority Authority of the SH meeting SH meetings authority usually limited to the following: – Exclusive to SHs Electing directors Ratifying selection of corporations independent auditor Precatory (non-binding) SH resolutions – Jointly with BoD Charter amendments Mergers / sale of all or substantially all of the firms assets Dissolution of the firm Ratification of certain unauthorized corporate actions (DGCL §204) – Either SHs or BoD Bylaw amendments Ratifying breach of fiduciary duty © Amitai Aviram. All rights reserved. 28
Authority Authority of officers & other agents All agents (including officers) have actual authority as determined by agency law – A reasonably believes that s/he is authorized; and – This reasonable belief is traceable to manifestations by P (i.e., an authorized corporate actor) Officers & actual authority – Relevant manifestations by P include a grant of authority by law or by agreement (in the charter or bylaws) – Like any other agent, officers may also have actual authority derived from other manifestations of the corporation (e.g., delegation of authority from the board) © Amitai Aviram. All rights reserved. 29
Authority Authority: Assumptions for exam On the exam, you may assume that the corporations discussed in the fact pattern have the following terms in their constitutional documents, unless 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. 30
Authority Section 2b mini-case (authority) Acmes 5 directors are alumni of the Univ. of Chicago – They decide to have the corporation donate $5M to the U of C – Alice, a SH of Acme & a Yale alum, demands that half the donation go to Yale – Bob, another SH, wants to enjoin the donation & make Acme distribute the money as dividends – Acmes directors point to: DGCL §122(9) (or MBCA §3.02(13)) DGCL §141(a) (or MBCA §8.01(b)) Does the board have authority for the decision to donate? Is this enough for summary judgment in favor of the BoD? © Amitai Aviram. All rights reserved. 31
Authority Section 2b mini-case (authority) Pressed for time, Carla – – Sends an e-mail to all other directors, explaining the deal in great detail & attaching the proposed agreement E-mail requests prompt reply as to directors vote on the deal – Calls Alan and asks him to come over to her office the following day at 5pm to discuss the deal The following day, Alan comes to Carlas office – Carla shows Alan an e-mail she received from Barb, who says that she is in favor of the deal & explains her reasons – Alan is in favor as well; explains his reasons. Carla agrees. – Carla & Alan sign a document stating their approval, to which Carla attaches Barbs e-mail Is the approval valid? If the approval was procedurally valid, is that the end of the inquiry? © Amitai Aviram. All rights reserved. 32
Delegated control Governance solutions © Amitai Aviram. All rights reserved. 33 Bonding Align As payoffs with Bs payoffsPerformance-based compensation Joint ownership Intervention Have someone determine if As behavior was appropriate Regulation Contracts Fiduciary duty SH litigation procedure Voice Intervention by B: Allow B unilaterally to act on behalf of the firm or to force A to behave in a certain way Approval SH voting procedure Exit Allow B unilaterally to end her relationship & receive her share of the value produced by the relationship Termination Dissociation Alienation
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions – Duty – SoR – Application – BJR – Application – Entire fairness – FD in private firms 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 34
Intervention solutions Internal analysis frameworks Authority – Authority granted by law, agreement or approval For agents: is A an agent (Rest. 1.01) & does A have actual authority (Rest. 2.01)? For organs: is A an organ & does a law, agreement or approval grant A authority? – If authority is granted by approval, use the approval framework For agents, Rest. 2.01 test is used for the unambiguous element of the approval framework – Authority may have a procedural aspect (require particular process for A to act) – Authority is irrelevant when an inaction is challenged Fiduciary duty – Duty (does A owe B a fiduciary duty?) – Identify potential legal flaws in As behavior & determine SoR for each flaw For agents: always agency SoR For organs in BA1: BJR or entire fairness For organs in BA2: BJR, entire fairness or enhanced scrutiny – Application of SoR to each potential flaw – Approval (if behavior of/attributable to B waives FD breach) © Amitai Aviram. All rights reserved. 35
Intervention solutions How organ & agent analyses differ An organ is less able than an agent to rely on B for cover – Approval is more limited (approval by SHs is more limited than approval by P) – Why do we limit organs ability to rely on voice solutions (SH approval)? B faces more burdens to challenge an organs act than an agents act – Higher standards for proving negligence & self-dealing Negligence: gross negligence, not ordinary negligence Self-dealing: fairness, not automatic breach – Default SoR for organs (BJR) defers to As discretion more than agency SoR But other SoRs – enhanced scrutiny & entire fairness – sometimes apply – Why do we increase obstacles to Bs challenges? Organs behavior may violate DoL even without proof of self-dealing – Organ FD analysis has a bad faith category (in addition to negligence & self-dealing) – Why create an additional category (bad faith) for organs? © Amitai Aviram. All rights reserved. 36
Illegality – Actor intentionally violates the law (including fraud) Corporate waste – Act is so one-sided (against the firm) that no business person of ordinary, sound judgment could conclude that the firm has received adequate consideration – Corporate waste is occasionally referred to as: Irrational acts Act motivated by an improper purpose (a purpose other than Bs welfare or As self-interest) Conscious disregard of duty – A intentionally fails to respond to a known duty or exhibits a conscious disregard of a known duty (i.e., knowingly refuses to do her job) Failure to disclose – Under some circumstances A has a duty to disclose information to other actors Intervention solutions Bad faith (actions/inactions) © Amitai Aviram. All rights reserved. 37
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions – Duty – SoR – Application – BJR – Application – Entire fairness – FD in private firms 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 38
Duty Existence of a fiduciary duty Directors – Each director owes a FD to the firm (and to its SHs) – Exculpation: Under DGCL §102(b)(7), a firm can have a clause in its charter that eliminates or limits directors personal liability for monetary damages for breach of FD, except: Self-dealing & bad faith (acts/omissions not in good faith, involving intentional misconduct or knowing violation of the law, and acts/omissions where director derived improper personal benefit) Unlawful dividend payment/stock repurchase – So, if a firm has this clause, a challenge based on unintentional negligence that requests a remedy of damages (as opposed to an injunction) will fail Officers – The law is not clear as to whether officers are agents or organs – For this course, treat officers as agents Agents – Agents owe a FD to the principal (we already discussed that in sub-section 1a3) SHs – SHs do not owe a FD to the firm or to other SHs – Exception: SH may owe FD in exercising control of the corporation This exception is discussed in BA2; for BA1, treat SHs as never owing a FD © Amitai Aviram. All rights reserved. 39
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions – Duty – SoR – Application – BJR – Application – Entire fairness – FD in private firms 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 40
SoR Who decides whether As act was in Bs interest? Judicial discretion [entire fairness SoR] – Breach if court thinks action was unfair to B – Drawback of relying on judicial discretion? – Entire fairness SoR applies when an organ is self-dealing (also applies when controller is self-dealing, but this isnt part of BA1 material) Actors discretion [BJR SoR] – No FD breach unless A fails to use discretion (no decision/arbitrary decision) or acts in bad faith (i.e., knows shes acting unfairly to B) – Drawback of relying on As discretion? – BJR is the default SoR for organ behavior (acts/inactions) Beneficiarys discretion [agency SoR] – FD breach unless B approves As act – Agency SoR limits both judicial discretion & deference to A – court must find a FD breach if A is negligent or self-deals (unless B approves) – Drawback of relying on Bs discretion? – Agency SoR applies to all agent behavior (acts/inactions) © Amitai Aviram. All rights reserved. 41
Delegated control requires giving A broad authority to act (impractical to rely on Bs approval), so courts avoid second-guessing A (i.e., defer to As judgment) Example: To hire T to work for B, A offers her twice the normal salary. Can T rely on As offer, or does he need to talk to B? – In agency (e.g., A is an officer): possibly no apparent authority (cf. Lind) – So, T may need to get approval for the offer from B (the corporation) – But who speaks for the corporation? If the board is subject to same rules as an agent, then an offer from the board may lack authority as well – So, T needs to get approval for the offer from someone else (SHs?) – But we use delegated control precisely because SH approval is likely to be inefficient, expensive & uninformed Conclusion: when direct control is an impractical governance system (as is typically in firms using delegated control), we need SoRs that de-emphasize Bs discretion: BJR or entire fairness SoR Why not use agency SoR for organs? © Amitai Aviram. All rights reserved. 42
SoR Entire fairness Entire fairness SoR applies if A has CoI with respect to the challenged behavior, or received an unauthorized benefit from the fiduciary position Collective actors (e.g., BoD, BoD committee) – A collective actor has CoI if 50% or more of its members have CoI – Example: BoD, composed of 5 directors, votes 5-0 to hire Ann If 2 directors have CoI & 3 dont, decision benefits from BJR If 3 directors have CoI & 2 dont, BJR is rebutted – Trick example: Acme has 100 SHs, each owning one share In SH meeting, they vote to approve a merger with Ajax 52 SHs have CoI. Is the act tainted with CoI? Constructive CoI (based on Cinerama v. Technicolor [Del. 1995]) – An actor or member of an actor who does not directly have CoI regarding an act, may nonetheless be considered as having CoI if: Someone with a CoI controls or dominates A – Test for control/domination in Beam v. Stewart Someone with a CoI failed to disclose their interest to A, and a reasonable A would regard the undisclosed interest as significant to evaluating the act © Amitai Aviram. All rights reserved. 43
SoR Conflict of interest: Beam v. Stewart [Del. 2004] Beam, a SH of Martha Stewart Living Omnimedia (MSO) sues Martha Stewart, alleging Stewart breached FD by committing insider trading & mishandling subsequent media attention Standing issue: Stewart owes FD to MSO, not to Beam directly – Delaware law requires that Beam ask MSOs BoD to sue Beam (make a demand on the board), unless Beam can show reasonable doubt that a majority of MSOs BoD is independent (show demand futility) Beam did not make a demand, so her suit must be dismissed unless her allegations show demand futility Even though this case doesnt look at a BoD decision, it simulates whether it would have deferred to a BoD decision not to sue Stewart – If court wouldnt have deferred, then its OK for beam not to have asked BoD to sue © Amitai Aviram. All rights reserved. 44
SoR Conflict of interest: Beam MSO has six directors: Stewart, Patrick, Martinez, Moore, Seligman, Ubben Chancery Court finds Stewart & Patrick not independent Beam abandons claim that Ubben lacks independence – Stewart, Patrick, Martinez, Moore, Seligman, Ubben – How many additional directors does Beam need to prove lack independence? © Amitai Aviram. All rights reserved. 45
SoR Conflict of interest: Beam Test for control/domination Court: To create a reasonable doubt as to an outside directors independence, a plaintiff must plead facts that would support the inference that… the non-interested director would be more willing to risk his or her reputation than risk the relationship with the interested director. © Amitai Aviram. All rights reserved. 46
SoR Conflict of interest: Beam Martinez – Chairman of the Federal Reserve Bank of Chicago – Director in four prominent companies – Executive & director of major corporations since 1990 (14yrs) – Why do these factors affect independence? Evidence of lack of independence? – Recruited to MSO BoD by Beers, a close friend of Stewart – Worked for Sears, which bought many MSO products – Patrick said Martinez is an old friend to both me & [Stewart] – Do these facts create a reasonable doubt re independence? © Amitai Aviram. All rights reserved. 47
SoR Conflict of interest: Beam Moore – Fewer positions of fiduciary responsibility than Martinez Evidence of lack of independence? – Moore & Stewart were invited to a reception for the wedding of the daughter of Stewarts lawyer – Fortune magazine published an article that focused on the close friendship among Moore, Stewart and Beers – When Beers resigned as MSO director, Moore replaced her Court: Close call, but not enough for reasonable doubt – …[F]riendship must be accompanied by substantially more… – Rejects the structural bias argument © Amitai Aviram. All rights reserved. 48
SoR Conflict of interest: Beam Seligman Evidence of lack of independence? – Seligman, while a director for JWS (a publisher), contacted JWSs CEO about an unflattering biography of Stewart, that was slated for publication Beam claims that this shows Seligman preferred protecting Stewart over FD to MSO & JWS – Court finds that this does not create reasonable doubt about independence. Why? Outcome in Beam v. Stewart – Stewart, Patrick, Martinez, Moore, Seligman, Ubben – 4 of 6 directors were independent © Amitai Aviram. All rights reserved. 49
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions – Duty – SoR – Application – BJR – Application – Entire fairness – FD in private firms 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 50
Application - BJR Overview of the BJR SoR When BJR is the applicable SoR, application of the SoR takes 2 steps: – Does court defer to As discretion? When BJR does not apply (because of one of these exceptions or because entire fairness SoR applies), it is said that BJR was rebutted (BJR is seen as a presumption of As integrity) – Applying judicial discretion, did As behavior breach FD? Step 1 (BJR rebutted?): court defers to A (no FD breach), unless – – A didnt make a business judgment (inaction or negligent act) – A didnt act in good faith pursuit of a legitimate corporate interest Step 2 (FD breached?): Once BJR is rebutted, FD is breached – – If legal flaw was negligence, FD is breached if act was grossly negligent – If legal flaw was a bad faith action, FD is automatically breached – If legal flaw was a bad faith inaction, certain tests for whether FD was breached © Amitai Aviram. All rights reserved. 51
Application - BJR Negligence: BJR rebutted? If challenge is to an allegedly negligent inaction, BJR is automatically rebutted (no business judgment to defer to) – FD breached if inaction was grossly negligent (see later slide) Negligent act – is BJR rebutted? – Identify necessary expertise & information, taking into account the importance of the challenged act to corporation/SHs – Did actor acquire necessary expertise & information? Reliance on actors own knowledge/expertise Reliance on advisors (DGCL §141(e)) – Expertise – Independence – No abdication of decision © Amitai Aviram. All rights reserved. 52
SH sues BoD for approving the sale of the corporation for $55/share Duty: yes, defendants owe FD as directors SoR: VG may have CoI, but other directors dont, so no self-dealing (BJR applies) Application (possible flaws: negligence) – Bad faith: No illegality or corporate waste – Lack of business judgment? Necessary expertise & information (this is a very important decision) – Legal analysis of merger agreement; valuation of the company; knowledge on how to best auction the company Did actor acquire necessary expertise & information? – Reliance on actors own knowledge/expertise – Reliance on advisors (Romans/VG) » Expertise? (Romans did not do a valuation; but VG has law degree) » Independence? (VG was nearing retirement) » No abdication of decision? (Hardly any deliberation; BoD not proactive) – Conclusion: BJR rebutted due to lack of business judgment (BoD lacked the required info & expertise given the importance of the decision); once BJR is rebutted, court applies its own judgment to the challenged act (see next slide) Application - BJR Negligence (Example: Van Gorkom) © Amitai Aviram. All rights reserved. 53
Application - BJR Negligence: FD breached? If BJR rebutted, DoC is breached if actor was grossly negligent – McPadden v. Sidhu (Del.Ch. 2008):gross negligence is conduct that constitutes reckless indifference or actions that are without the bounds of reason – MBCA does not use the term gross negligence and its language suggests an (ordinary) negligence standard (MBCA §8.31(a)(2)(ii)(B) & (iv)), but MBCA commentary considers directors subjective state (similar to gross negligence) When an action (but not an inaction) is allegedly grossly negligent, if BJR is rebutted then the action was grossly negligent (DoC breached) – When an inaction is allegedly negligent, BJR automatically rebutted, so you now need to analyze whether inaction was grossly negligent (otherwise the inaction doesnt breach DoC) © Amitai Aviram. All rights reserved. 54
Application - BJR Bad faith actions BJR rebutted & actor breached FD if: – Illegality: actor knowingly violates the law (including fraud) – Corporate waste: transaction is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration Alternative test: A knowingly pursues a purpose other than SH welfare or As self-interest © Amitai Aviram. All rights reserved. 55
Application - BJR Dodge v. Ford Motor Co. [Mich. 1919] The superficial story FMC cuts dividends to: – Afford to reduce car prices – Double employee salaries – Build the River Rouge plant Dodge brothers, who own 10% of FMC, sue to enjoin construction of plant & require FMC to issue special dividends – No self-dealing is alleged Superficially, this seems like a dispute between FMCs BoD (Ford) & some of FMCs SHs (Dodge brothers) about what FMC should do with its profits – Court: FMC must issue special dividends; can continue with construction plans – Did the court get the law wrong? Even if court agrees with Dodge, doesnt BJR require it to defer to BoD? © Amitai Aviram. All rights reserved. 56
Application - BJR Dodge: Fords cross-examination Henry Ford John F. Dodge & Horace E. Dodge © Amitai Aviram. All rights reserved. 57
Application - BJR Dodge: Fords cross-examination Counsel for Dodge: Do you still think that those profits were awful profits? Ford: Well, I guess I do, yes. D: And for that reason you were not satisfied to continue to make such awful profits? F: We dont seem to be able to keep the profits down. [One more slide…] © Amitai Aviram. All rights reserved. 58
Application - BJR Dodge: Fords cross-examination D: … Are you trying to keep them down? What is the Ford Motor Company organized for except profits, will you tell me, Mr. Ford? F: Organized to do as much good as we can, everywhere, for everybody concerned… And incidentally to make money. D: Incidentally make money? F: Yes, sir. [End] © Amitai Aviram. All rights reserved. 59
Application - BJR Dodge: What is really going on? Interpretation of holding: The purpose of the corporation is to maximize SH wealth; BoD has discretion over the means to achieve this purpose, but cannot change the purpose Modified story – SHs (Dodge) argue that SHs are best served by reducing expenses & distributing FMCs profits as dividends – BoD (Ford) cares about the welfare of employees & customers (wages/prices) at the expense of SHs (dividends) – BJR rebutted due to bad faith (corporate waste); court need not defer to BoD But the court still seems to be getting the law wrong… – Corporate waste test: transaction is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration – Can Ford argue for any benefit (to FMC & ultimately to SHs) from reducing the price of cars? Doubling employee salaries? Building the River Rouge plant? © Amitai Aviram. All rights reserved. 60
Application - BJR Dodge: What is really going on? Now Fords position looks odd – Why doesnt Ford tell the court these justifications? And now the Dodge brothers position looks odd. If Fords plans create value for SHs, why do the Dodge brothers object? Modified, modified story – Courts apply the corporate waste test very narrowly in determining if a BoD has an improper purpose; almost any argument for a SH benefit from As challenged behavior suffices to establish a proper purpose – But the Dodge brothers allege that Ford had an improper purpose, and Ford agrees, so the court is forced to accept that position and find corporate waste that rebuts the BJR and breaches FD – therefore dividends are enjoined – But the court understands the real situation: Ford is acting in the interest of FMC SHs, while the Dodge brothers are not. So the court does not enjoin construction of the plant – FMC can easily finance this (and Fords other plans) by borrowing money © Amitai Aviram. All rights reserved. 61
Application - BJR Bad faith inactions BJR always rebutted (inaction); FD is breached when: – Failure to disclose Actor must disclose to other actors (e.g., BoD, BoD committee, SHs) all material info reasonably required for them to act on behalf of corp E.g.: since SHs elect the directors, BoD would act in bad faith if it failed to provide SHs all material info is has relevant to deciding whether to elect the proposed candidates MBCA duty of disclosure (MBCA 8.30(c); use this for Delaware law as well): duty to disclose info that is material to the discharge of another actors decision-making or oversight functions, unless disclosure violates a superior duty (imposed by law, confidentiality agreement, ethics rule, etc.) When info isnt related to facilitating another actors acts, failure to disclose may still breach FD if it qualifies as a bad faith disregard of duty – Conscious disregard of duty: Stone v. Ritter test © Amitai Aviram. All rights reserved. 62
Application - BJR Bad faith: disregard of duty Stone v. Ritter [Del. 2006]: AmSouth employees violated federal Bank Secrecy Act & anti-money-laundering regulations – Failed to notify govt when they suspected a transaction involved funds derived from an illegal Ponzy scheme – Bank pays $50M to govt to settle charges No evidence that BoD had notice of employees illegal acts – If BoD knew employees were violating the law, whats the analysis? Plaintiffs allege that BoD failed to implement appropriate compliance system, and failed to use existing system to monitor and ensure compliance – Thus, BoD allegedly showed conscious disregard for duties (in Delaware, this is known as violating Caremark duties) – Why not frame this as a negligence allegation? © Amitai Aviram. All rights reserved. 63
Application - BJR Bad faith: disregard of duty Court: two alternative prongs for liability – Directors utterly failed to implement any reporting or information system or controls – Having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention AmSouth BoD had implemented several compliance mechanisms, and used them to monitor compliance – Evidence of non-compliance doesnt prove lack of a system or insufficient monitoring © Amitai Aviram. All rights reserved. 64
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions – Duty – SoR – Application – BJR – Application – Entire fairness – FD in private firms 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 65
Application - Entire fairness The fairness test Hypo based on Bayer v. Beran [NY 1944] – Celanese Corp. of America (CCA) makes clothes made of Celanese, which is a synthetic fiber that CCA brands as a sophisticated choice – Celanese Corp. has 4 directors on BoD: Anna (the CEO), Barry, Chuck & Dave Barry is CCAs Chief Financial Officer Chuck is the General Counsel of a large industrial company (unaffiliated with CCA) Dave is the Chief Marketing Officer of a luxury handbag company (unaffiliated with CCA) & a childhood friend of Anna – Anna negotiates a contract to hire Edgar (her husband), a famous opera singer, to sing in CCA radio commercials She is advised by Frank, a media consultant who is often hired to advise CCAs management Following Franks advice, Edgar is paid same as CCA paid the previous person who starred in their radio ads (a famous public intellectual) – BoD approves the contract Anna didnt tell the other directors that Edgar is her husband, but Barry & Dave know that he is (Chuck does not) SH sues BoD, claiming that the decision to hire Tennyson breached directors FD What SoR applies to this challenge? – Could CCA hire Edgar without exposing the decision to the entire fairness test? – Note: Oracle [Del.Ch. 2003] suggests that when a decision is delegated to an ad-hoc (specially-created) BoD committee, the standard for independence is higher than in Beam (so, e.g., social connections could suffice to create a CoI) © Amitai Aviram. All rights reserved. 66
Application - Entire fairness The fairness test Application of the entire fairness SoR: was the challenged behavior in Bs interest (i.e., wealth-maximizing for the SHs)? Detailed fairness test for acts – Was undertaking the act (e.g. hiring CEOs spouse) in the firms interest? – Were the terms of act (e.g., employment contract) similar to what firm would have received in an arms length transaction? Fair process (for determining price/other terms) – indirect assessment Fair price (valuation/comparison) – direct assessment of the terms – Conduct the fairness test for the hypo in the previous slide Detailed test for usurping a business opportunity (Guth v. Loft test: no single factor is dispositive; court balances all factors) – Was the firm financially able to take the opportunity? – Was the opportunity is in the firms line of business? – Did the firm have an interest or expectancy in the opportunity? – By embracing the opportunity, would the actor create a conflict between his/her self-interest and that of the firm? © Amitai Aviram. All rights reserved. 67
Intervention solutions Summary of FD analysis FD analysis: SoR & Application stages Neg. actNeg. inactionBad faith actBad faith inactionSelf-dealing SoR BJR Test for self- dealing (apply entire fairness) App. (BJR rebutted?) Van Gorkom testAutomatic (for inaction) Tests for illegality & corp. waste Automatic (for inaction) Fairness test App. (FD breached?) Gross negligence (almost automatic) Gross negligence Automatic breach if BJR rebutted Tests for disregard of duty (Stone) & failure to disclose © Amitai Aviram. All rights reserved. 68 FD analysis: types of legal flaws NegligenceSelf-dealingBad faith Negligent act Neg. inaction CoI Unauthorized benefit from fid. position Illegality Corporate waste Disregard of duty Failure to disclose
Fiduciary duty Section 2b mini-case (FD) Challenged decision: Acme donates $5M to the University of Chicago Authority: analyzed earlier Fiduciary Duty – Duty: The 5 defendants are directors & therefore owe FD to Acme Legal flaws: (1) lack of business judgment; (2) corporate waste; (3) CoI If suit is for damages & Acme has a DGCL 102(b)(7) exculpatory clause, no need to further analyze the lack of business judgment flaw – SoR Lack of business judgment & corporate waste – BJR CoI: Beam test to see if 50% of BoD is conflicted; if so, this flaw is analyzed under entire fairness SoR; otherwise, no FD breach by this flaw – Application BJR – Lack of business judgment: Van Gorkom test to see if BJR rebutted » If so, breach if decision was grossly negligent – Bad faith (corporate waste test) – if BJR rebutted, automatic FD breach Entire fairness – Was donating to a university in firms interest? (Likely yes & ALI principles allow donations of reasonable amounts anyway) – Was process that led to choosing Chicago & determining terms of donation fair & were the terms themselves similar to those in arms length donations? – Approval: If SH purported to waive FD breach, check if it was a valid approval © Amitai Aviram. All rights reserved. 69
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions – Duty – SoR – Application – BJR – Application – Entire fairness – FD in private firms 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 70
FD in private firms Broader FD in private firms Wilkes v. Springside Nursing Home [Mass. 1976]: Wilkes, Riche, Quinn & Connor own Springside Nursing Home – When SNH accumulates cash, they distribute equal weekly stipends Wilkes isolated – Ill-will develops between Wilkes & Quinn; Riche & Connor support Quinn – In the next BoD meeting the stipends were replaced with salaries, and Wilkes was fired (so he didnt receive a salary) Wilkes sues, alleging RQC breached FD as SHs – Is this oppression? (Are RQC diverting the firms value to them at Wilkes expense?) Court quotes Donahue v. Rodd Electrotype, in which the court analogized FD in close corporations to partnerships – In a partnership, by default all partners share control & cant be fired – No such protection to SHs in a corporation © Amitai Aviram. All rights reserved. 71
FD in private firms Broader FD in private firms The Wilkes court creates a new rule – SHs in a close corporation owe each other a duty of strict good faith: – If controllers act is challenged by a MSH, controller must show a legitimate business objective for its action – If such business objective has been demonstrated, MSH must show that controller could have accomplished the business objective in a manner that was less harmful to MSHs interests Wilkes placed initial burden of proof regarding biz justification on the defendant; some jurisdictions place BoP on plaintiff: – Nelson v. Martin [Tenn. 1997] – Court places BoP on plaintiff to show lack of business justification – Also, Nelson court states that if defendants were protecting the interests of the company, the presence of spite or ill will would not render them or the corporation liable © Amitai Aviram. All rights reserved. 72
FD in private firms FD & SH agreements Courts are less likely to view as a breach of FD actions that are in accordance with an employment/SH agreement to which plaintiff is a party Blank v. Chelmsford OB/GYN, P.C. [Mass. 1995]: Doctors employment terminated in accordance with employment agreement. Shares in the corporation were redeemed in accordance with stock repurchase agreement. – Court: Donahue does not apply when all SHs in advance enter into agreements regarding employment & share repurchase © Amitai Aviram. All rights reserved. 73
FD in private firms Delaware law Under Delaware law, controllers owe MSHs a FD when exercising control (in any corporation, not just close corporations) – This will be discussed in Section 3a2 (controllers) Nixon v. Blackwell (Del. 1993): FD in close corporations same as in any Delaware corporation – Court refuses to create a different FD standard for private firms – Justification: if direct control & restricted alienation increase risk of oppression, a person entering a minority position in a private firm has several options to protect herself by provisions in the charter, bylaws or SH agreement (e.g., buyout provisions, voting trusts) Members of Delaware LLCs may waive FD entirely, though by default (if nothing is said about FD in the LLC constitutional documents) the law assumes that the parties owe FD © Amitai Aviram. All rights reserved. 74
Intervention solutions Practice questions: Take 1 Alex and his wife Betty compose the BoD of a bank – Fraud by their son Charles (an employee of the bank) causes the bank to lose $1B – Alex & Betty knew Charles always tried to get away with bad behavior, but didnt suspect he was committing fraud – BoD had no procedures to monitor employee fraud SHs sue BoD for failing to prevent the loss – Authority – FD Duty SoR Application Approval: not suggested by the facts here © Amitai Aviram. All rights reserved. 75
Intervention solutions Practice questions: Take 2 Add active decision – Alex & Betty know Charles is committing fraud – In the next BoD meeting they consider whether to fire him and decide not to, because they believe Charles skill in attracting clients offsets the expected harm to the bank from his fraud Charles fraud causes the bank a $1B loss; SHs sue BoD for the decision to keep Charles – Authority – FD Duty SoR Application Approval: not suggested by the facts here © Amitai Aviram. All rights reserved. 76
Intervention solutions Practice questions: Take 3 Remove illegality & CoI – No fraud; Charles is simply absent-minded & maintains sloppy records – Failing to maintain good records in itself is not illegal – Charles is not related to Alex & Betty – Alex & Betty know that Charles maintains sloppy records, but decide to keep him because they believe his skill in attracting clients offsets the cost of his sloppiness Sloppy records cause company to lose a $1B lawsuit; SHs sue BoD for the decision to keep Charles – Authority – FD Duty SoR Application Approval: not suggested by the facts here © Amitai Aviram. All rights reserved. 77
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions 4.Voice solutions 5.Exit solutions © Amitai Aviram. All rights reserved. 78
Types of approval – Prior consent: B grants A authority or waives FD breach before A acts – Ratification: B grants A authority or waives FD breach after A acts Approval gives emphasis to the beneficiarys discretion – Approval is more restricted for organ acts than for agent acts. Why? Elements (same as agency, except as explained in following slides) 1.Appropriate approver 2.As behavior can be approved – Attributed to beneficiary – Appropriate scope 3.Appropriate approval – Unambiguous – Informed – Timely (relevant only for ratification, not for prior consent) Approval Elements © Amitai Aviram. All rights reserved. 79
In the context of firms, appropriate approvers are: – The beneficiary Firm is beneficiary, but cant approve (someone has to approve on its behalf) – A person who has authority to approve on behalf of the beneficiary BoD – BoD can approve behavior of corporate actors (based on its plenary authority under DGCL §141(a) & on DGCL §144, 204) – As with agency law, BoD cant approve its own acts & cant approve acts regarding to which BoD has CoI (e.g., no approval of controlling SHs behavior) SH meeting – SH meeting can approve transactions suffering from self-dealing (DGCL §144) » Not clear if SH meeting can approve other behavior of corporate actors; even if it lacks authority to approve, approval may be construed as waiving a SHs right to sue for the legal flaw that was purportedly approved – When approving, vote must be specifically designated as a ratification, and SH meeting can only approve acts that dont require a SH vote to become legally effective [Gantler v. Stephens (Del. 2009)] Approval Appropriate approver © Amitai Aviram. All rights reserved. 80
Approval Act can be approved Same as agency, except for public policy reasons preventing B from approving (part of attributed to beneficiary element): – Void acts (cant be ratified) Lack of corporation authority (ultra vires) – But unanimous SH ratification insulates BoD from future SH challenge Bad faith actions (illegal acts & corporate waste) Probably also conscious disregard of duty – Voidable acts (can be ratified): lack of actor authority, negligence, self-dealing & failure to disclose © Amitai Aviram. All rights reserved. 81
Same as agency, except for some details regarding ambiguity – Implied approval is interpreted from the approvers behavior, rather than expressly framed as an approval (same as agency) E.g.: ratification implied by unambiguous acquiescence Implied approval by BoD is possible if it is unambiguous, but implied approval by SHs is probably impossible (inherently ambiguous) – Express approval is framed as an approval To be unambiguous, express approval must comply with formal procedures for call, quorum & vote There are specific statutory rules for the process of approval of a transaction flawed by self-dealing or lack of authority (see next slide) Approval Appropriate approval © Amitai Aviram. All rights reserved. 82
Approval Appropriate approval Approval procedure – Lack of authority: DGCL §204 (approval by BoD & in some situations also by the SH meeting) (effective April 1, 2014) – Transactions in which a director/officer has CoI: DGCL §144(a), either: Approval by a majority of disinterested directors (even if disinterested directors do not compose a quorum) Approval in good faith by vote of the shareholders (in Fliegler the court said this requires a vote of the majority of disinterested SH) – Any other act: no statutory authorization for approval, but approval is possible under BoDs plenary powers (DGCL §144(a)) Follows the normal process for BoD acts (written consent or call/quorum/vote) Hypo – Hypo: Acmes board consists of A, B, C, D & E. They vote to ratify a contract between Acme & As wife (B, C & D do not have CoI). Only A, B and C show up for the vote. Do they have a quorum? [Note DGCL §141(b), §144 (b)] – A, B & C all vote in favor of the contract. Was it approved? [Note §141(b), §144(a)(1)] © Amitai Aviram. All rights reserved. 83
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions 4.Voice solutions 5.Exit solutions – Alienability – Dissociation – Termination (dissolution) © Amitai Aviram. All rights reserved. 84
Exit solutions Types of exit solutions Exit solutions allow B unilaterally to leave the firm & receive her share of the firms value – Alienability: allow B unilaterally (without requiring consent of firm/other Bs) to sell interest in the firm to third parties Allows for the firms longevity & maintains firms goodwill, but no guarantee business ownership remains in acceptable hands – Dissociation: allow B to unilaterally sell interest in the firm back to the firm/other Bs (at the interests fair price) Allows for the firms longevity, maintains firms goodwill & keeps business ownership in acceptable hands, but requires that: (1) parties agree on the fair price; (2) firm/remaining Bs are able to pay; (3) firm is viable to the remaining Bs without the dissociating B – Termination (dissolution): allow a SH to unilaterally cause the firm to terminate, liquidate its assets & divide the proceeds but allows restrictions on alienability, but sacrifices firms longevity & may lose firms goodwill (value of the live business - value of the dead business) Public firms favor alienability over dissolution/dissociation Private firms favor dissolution/dissociation over alienability – Why? (Compare to marriage) © Amitai Aviram. All rights reserved. 85
Alienability Rules on alienability in corporate law Transferable shares – By default, SH can sell shares without restriction – Restrictions on alienating SH rights separately from shares (e.g., selling right to vote without selling shares) Perpetual existence – By default, a corporation exists indefinitely Restrictive dissolution – Individual SH has no right/power to dissolve – Dissolution if majority of both BoD & SHs vote in favor, or (in rare cases) by judicial or administrative order Capital lock-in (SH cant withdraw equity capital, giving corporation financial stability, but at expense of lost accountability) When corp issues new shares, SH pays corp (say, $10) for shares When SH wants to cash out, she cant force corp to buy back her shares; instead, SH can sell shares to T (corp keeps the $10) – Exception 1: if shares were specifically made redeemable – Exception 2: corp may choose to repurchase the shares © Amitai Aviram. All rights reserved. 86
Alienability Rules on alienability in partnership law April, a partner in a three-partner law firm, wants to cash out Can she (unilaterally) sell a 1/3 share of the partnership assets (e.g., 1/3 of the furniture) to Brian? – RUPA §501 Can she (unilaterally) sell her control rights in the partnership to Brian? Her economic rights? – RUPA §401(i), 502, 503(a)(3) © Amitai Aviram. All rights reserved. 87
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions 4.Voice solutions 5.Exit solutions – Alienability – Dissociation Dissociation Buyout agreements Relationship between dissociation & buyout agreements – Termination (dissolution) © Amitai Aviram. All rights reserved. 88
Dissociation Dissociation in corporations & partnerships Dissociation allows B to unilaterally sell interest in the firm back to the firm/other Bs (at the interests fair price) By default, corporations have capital lock-in (no dissociation) – But a corporation can issue shares that are redeemable at the SHs option – Also, SHs can create a buyout agreement in which they agree on situations in which one party may force other parties to buy her shares In RUPA partnerships, each partner has a power to dissociate (this is mandatory, not just default rule) – RUPA §602(a): A partner has the power to dissociate at any time, rightfully or wrongfully, by express will… – Departing partner generally remains liable on pre-dissociation partnership obligations unless released by creditors [RUPA §703] – If the partnership agreement prohibits or limits dissociation (e.g., requires partner to remain a partner for X years, or give X days advance notice), a dissociation contrary to the agreement is called wrongful dissociation – it creates a dissociation, but former partner is liable for breach of contract © Amitai Aviram. All rights reserved. 89
Dissociation Implied terms may limit dissociation Ann & Becky are partners in building & operating a cafeteria Ann supervises construction & operates the cafeteria (service partner); Becky puts up the money – Partnership agreement states Becky is to be repaid $30K in 1 st year of operation & $60K/yr. thereafter, until her investment is fully repaid Original estimate of building costs: $300K – When building costs reach $600K, Becky refuses to put up more money; sues for dissociation Can Becky dissociate? – Can Ann make an argument that Becky wrongfully dissociated? © Amitai Aviram. All rights reserved. 90
Dissociation Statutory dissociation under RUPA By act of a dissociating partner [RUPA §601(1)] – By right: if the partnership is at will – Wrongful dissociation [RUPA §602(b)] By terms of partnership agreement [RUPA §601(2)-(3)] By unanimous vote of all other partners [RUPA §601(4)] – Limited to specified circumstances By court order [RUPA §601(5)] By operation of law [RUPA §601(6)-(10)] – E.g., due to death, bankruptcy, unlawfulness © Amitai Aviram. All rights reserved. 91
Buyout agreements Some key considerations 1.Who buys the equity interest? – Third parties No buyout agreement; just avoid share transfer restrictions Limited value if market is very thin (few buyers/sellers) Undesirable business partners Difficult when firm must have share transfer restrictions (e.g., Del. statutory close corp.) – Remaining SHs Raises problems with liquidity of SHs Can be used opportunistically to extract benefits – Or else SH will cash out, forcing the other SHs into insolvency – The firm Raises problems with firms liquidity (can be used opportunistically) – Life insurance One of the most commonly implemented exit arrangements in close corporations is triggered upon a SHs death. Why? Life insurance both helps with financing the buyout, and avoids arguments over valuation (since its clear the deceased SHs estate would sell the shares, it would push for high valuation) © Amitai Aviram. All rights reserved. 92
Buyout agreements Some key considerations 2.Triggering event: what has to happen to allow a SH (or the firm) to force a buy-out? – Check relevant statutes for mandatory/default right to dissociate, and make sure to cover all situations that allow dissolution/dissociation under the applicable statute 3.Price for which equity interest is bought-out – Parties may determine value periodically by agreement Parties often neglect to do so As interests diverge, parties may disagree – Parties may hire an appraiser May be difficult to agree ex-post on the identity of appraiser Appraiser may over time develop a closer connection to one party © Amitai Aviram. All rights reserved. 93
Buyout agreements Some key considerations (price) Parties may set a formula – Often a multiplier of annual cash flow or earnings – Example Acme is a close corporation that owns a shopping mall; annual profit: $500K A similarly-situated company is publicly held, with 2M shares outstanding, trading at $5 a share (market cap: $10M) & an annual profit of $1M (so price/earnings ratio: 10) – If Acme has the same P/E ratio, it should be worth $5M ($500K x 10) – Acmes buyout agreement can either specify the multiplier, or require checking the multiplier at time of buy-out Parties may use book value – Book value is the price of the assets when purchased, reduced over the years for wear & tear (depreciation) – Depreciation may not reflect real value (e.g., antique that appreciated in value; car that lost much value in 1 st year) © Amitai Aviram. All rights reserved. 94
Buyout agreements Some key considerations (price) Strategic process – E.g., You cut, I choose: One party names a price, the other decides whether it will buy from the other, or sell to the other, at that price – Works well if both parties have sufficient cash & info – Example: Banks A & B jointly own Acme, a home financing joint venture Bank A (much larger than Bank B) owns 75% of the shares; Bank B owns 25% – As a result of antitrust enforcement, banks required to break up the joint venture; charter had a buyout clause that implements you cut, I choose Bank A decides on a price per share (any price it wants) Bank B then chooses whether to sell its interest to Bank A at that price, or buy Bank As shares at that price – Assume that both banks have no financial constraints Would Bank A decide on price thats higher or lower than Acmes perceived value? – Now assume Bank A expects Bank B to have liquidity problems Bank B has less money & has to pay for 3 times the # of shares Does A expect that B will buy or sell? Would A decide on price thats higher or lower than the perceived value of Acme? © Amitai Aviram. All rights reserved. 95
Relationship between dissociation & buyout Haley v. Talcott [Del. 2004] Matt Haley Greg Talcott Matt & Greg Real Estate, LLC Redfin Seafood Grill Owns 100% Employment Agreement 50% Bank Personal Guarantee Loan/ Mortgage © Amitai Aviram. All rights reserved. 96
Relationship between dissociation & buyout Haley v. Talcott Talcott owns Delaware Seafood (aka Redfin Seafood Grill), a restaurant operated by Haley Haleys employment contract gives him a bonus of 50% of the restaurants profits, after the loan from Talcott was repaid – Why pay Talcotts loan first? Is this a partnership? – What do the parties do to avoid framing this as a partnership? How is Haley vulnerable to misappropriation? – Firing Haley What does Haley do to protect himself? – Siphoning the profits out of the company How can Talcott siphon money out of the Redfin Grill? What does Haley do to protect himself? © Amitai Aviram. All rights reserved. 97
Relationship between dissociation & buyout Haley v. Talcott Haley exercises the option; owns 50% of Matt & Greg Real Estate, LLC – LLC purchases the property, financing it through a mortgage from County Bank Both Haley & Talcott sign personal guarantees for the mortgage – Redfin Grill leases the property from the LLC for $6,000/month – enough to pay the mortgage but probably below market rent Relationship deteriorates – Haley expects to receive equity interest in the Redfin Grill – Talcott refuses, and eventually sends Haley a letter purporting to accept Haleys resignation & forbidding Haley from entering the premises of the Redfin Grill – What right does Talcott have if Haley resigns? © Amitai Aviram. All rights reserved. 98
Relationship between dissociation & buyout Haley v. Talcott LLC Agreement has an exit mechanism – If a member elects to quit the LLC, the other member may elect to purchase the departing members interest for fair market value. – If other member does not elect to purchase, LLC is dissolved Why does Haley want to dissolve rather than exercise the contractual exit mechanism? – How does Haley respond to Talcotts letter? Whats Delaware laws general attitude regarding judicial dissolution when a contractual exit mechanism exists? – How does it rule in this case? © Amitai Aviram. All rights reserved. 99
Firms: internal relationships Overview of Section 2b 1.Direct control 2.Delegated control 3.Intervention solutions 4.Voice solutions 5.Exit solutions – Alienability – Dissociation – Termination (dissolution) Forced dissolution Statutory dissolution Process of dissolution © Amitai Aviram. All rights reserved. 100
Dissolution Types of dissolution Voluntary dissolution: firm acts to dissolve itself – Corporation: BoD & SH vote (DGCL §275; MBCA §14.02) – Partnership: by unanimous vote of partners Forced dissolution: dissolution by unilateral action of any SH – Corporation: individual SH has no right/power to dissolve – Partnership: yes, by default (RUPA); yes, mandatory (UPA) Statutory dissolution: court/govt forces firm to dissolve – Administrative (DGCL §284; MBCA §14.20) – Judicial: Individual SH/partner can petition court to dissolve in some cases (MBCA §14.30; RUPA 801(5),(6)) © Amitai Aviram. All rights reserved. 101
Dissolution Delaware corporations Voluntary: BoD vote + SH vote + Filing [DGCL §275] Forced: no unilateral right for SH to dissolve Statutory – Administrative: Delaware AG may sue to revoke a corporate charter for abuse, misuse or nonuse of its corporate powers, privileges or franchises [DGCL §284] – Judicial: No right of dissolution for oppression Nixon v. Blackwell (Del. 1993): Court-imposed buy-outs are inappropriate because contractual protection is available to MSHs Whats the disadvantage of this approach? – I.e., if parties can contract for dissolution, why should a court dissolve the corporation in situations not covered by an agreement? © Amitai Aviram. All rights reserved. 102
Forced dissolution The tradeoff Forced dissolution can be made easier or harder Liberal – Forced dissolution allowed (mandatory in UPA partnerships; default in RUPA partnerships) – Judicial dissolution if MSHs interests are frustrated (Stuparich) – Judicial dissolution if MSHs are oppressed (MBCA §14.30(2)(ii)) – Judicial dissolution only due to fraud/abuse (DGCL §284) – Only voluntary dissolution allowed (majority vote) Restrictive Liberal dissolution sacrifices longevity and gives MSHs some leverage On the other hand, it prevents/mitigates oppression © Amitai Aviram. All rights reserved. 103
Forced dissolution UPA Three triggers for dissolution: – By act of one or more partners [UPA §31(1)-(2)]; e.g.: At the termination of the partnerships term or particular undertaking, or, if it has none, at the will of any partner Wrongful dissolution: In contravention of the agreement between the partners, by the express will of any partner at any time – By operation of law [UPA §31(3)-(5)] Due to death or bankruptcy of a partner, or due to bankruptcy or unlawfulness of the partnership – By court order [UPA §31(6); §32] © Amitai Aviram. All rights reserved. 104
Forced dissolution Continuing operations (UPA) Archie, Beatrice & Chris are partners – Partnership agreement states that partnership will last for 10 years & that no partner may dissolve it before that time Nonetheless, after only two years Archie announces that he is dissolving the partnership – Can he do this? Beatrice & Chris now cease to be partners of each other, even though they desire to remain partners – Can they do anything to continue the partnership? Note UPA § 38(2)(b) © Amitai Aviram. All rights reserved. 105
Forced dissolution RUPA By voluntary dissociation of a partner, if the partnership is a partnership at will [§801(1)] By dissociation of a partner through operation of law, if within 90 days at least half of the remaining partners want to dissolve the partnership [§801(2)(i)] By the unanimous vote of all the partners [§801(2)(ii)] By the terms of the partnership agreement [§801(2)(iii)-(3)] By operation of law due to unlawfulness, but there are 90 days to cure the illegality [§801(4)] By court order [§801(5)-(6)] – Partners suit: Economic purpose frustrated; not reasonably practicable to carry on the partnership business – Transferees suit: if equitable and possible under the terms of the partnership agreement © Amitai Aviram. All rights reserved. 106
Forced dissolution RUPA vs. UPA Hypo: Anita is a partner in a law firm – Partnership agreement silent regarding partnerships duration & right to dissociate or dissolve – Anita informs the other partners she is dissociating from the law firm What happens to the partnership? – Note RUPA §601(1), 801(1) Can the partnership agreement opt out of this outcome? – Note RUPA §103(b)(6)-(8) Conclusion: Is a partners ability to dissolve different in RUPA than UPA? © Amitai Aviram. All rights reserved. 107
Statutory dissolution MBCA MBCA §14.30(2) – Dissolution may be ordered when: – Corporation is deadlocked BoD is deadlocked; SH are unable to break deadlock; and Irreparable injury or paralysis of the corporation will result from the deadlock. – Shareholders are deadlocked SH are evenly divided SH fail to elect successor directors in (at least) two consecutive annual meetings – BoD or controller acts illegally, oppressively or fraudulently – Corporate assets are being misapplied or wasted © Amitai Aviram. All rights reserved. 108
North Carolina allows dissolution when it is reasonably necessary for the protection of the rights and interests of the complaining [SH] Meiselman: To dissolve a close corporation, sufficient to show that MSHs reasonable expectations are frustrated – MSH doesnt need to demonstrate oppressive/fraudulent conduct by controller To be reasonable, expectations must - – be reasonable under the circumstances – be/reasonably should be known to controller – be central to MSHs decision to join the venture Meiselman: In a close corporation it is a reasonable expectation to participate in the management of the business or be employed by it – But this is limited to expectations embodied in understandings, express or implied, among the participants © Amitai Aviram. All rights reserved. 109 Statutory dissolution Meiselman v. Meiselman [NC 1983]
Statutory dissolution Stuparich [Cal. App. 2000] Siblings Malcolm Jr., Candi & Ann owned equal amounts of HFMs non-voting shares, but Malcolm owned majority of the voting shares – HFM had a profitable mobile home park & an unprofitable furniture business – Malcolm, his wife & son worked in HFM (no claim of excessive salaries); Candi & Ann didnt – Candi & Ann wanted to separate the two parts of the business; Malcolm didnt After their mothers shares are distributed, C&A expect to gain control of the corporation, and call for a SH meeting to vote – They discover that their father (Malcolm Sr.) clandestinely sold his shares to Malcolm Jr. for a low price (Malcolm Jr. now has 51.56% of voting shares) – C&A ask Malcolm to buy them out; Malcolm refuses At a family event at the home of the Malcolm Sr., Malcolm & Candi had an altercation that resulted in physical injuries to Candi – Fight may have been over the sisters unsuccessful attempt to impose an involuntary conservatorship on their father © Amitai Aviram. All rights reserved. 110
Statutory dissolution Stuparich v. Harbor Furniture Mfg. The sisters sue for dissolution – CA statute states that in close corporations (<35 SH) dissolution may be granted if it is reasonably necessary for the protection of the rights or interests of the complaining [SH] (similar to NC statute in Meiselman) What are the sisters frustrated expectations? – Working for the company Under Meiselman, is fact that sisters didnt work at HFM grounds for dissolution? – Disagreement about HFMs strategy What principle can Jr. cite to justify his decision not to sell the furniture business? Would the sisters argument be stronger if they wanted to keep the furniture business & Malcolm Jr. wanted to sell it? – Expectation to control the company Does court recognize a reasonable expectation of the sisters to control the firm? – Acrimony & violence between SHs Does court allow dissolution of the corporation due to the violent incident between Malcolm Jr. & Cindi? © Amitai Aviram. All rights reserved. 111
Process of dissolution Hypo Archie, Beatrice and Chris are partners in a grocery store – On January 1, they vote unanimously to dissolve the partnership – On January 2, Archie sells bread that is in the grocery store to customers & Beatrice orders more bread from a bakery Chris claims that these transactions do not bind the partnership, because it has dissolved and so it no longer exists as a legal entity Is he right? – Note RUPA § 802(a), 804 What effect does dissolution have? Why? © Amitai Aviram. All rights reserved. 112
Process of dissolution Terminology Winding-up – Liquidating the partnerships assets/business – Settling the partnerships debts/obligations – Dividing between the partners the remaining assets/money Termination: The partnership ceases to exist Dissolution: The process that begins with winding-up & ends in the termination of the partnership © Amitai Aviram. All rights reserved. 113
Process of dissolution Division of profits & losses RUPA provides default rules on division of profits/loss Division of profits – Default rule: Profits divided equally between partners [ RUPA §401(b) ] – What if one partner contributed 90% of capital? Equal distribution – What if one partner contributed 90% of work? Equal distribution Division of losses – Default rule: Losses divided the same way as profits. [RUPA §401(b)] Partnership agreement can change this default – E.g., there need not be symmetry between division of profits and losses © Amitai Aviram. All rights reserved. 114
Process of dissolution Capital account Capital account: A running balance reflecting each partners ownership equity (see RUPA §401(a)) Begins with the initial contribution – Not limited to money (also labor, assets & anything else partners agree on) Share of the profits is added Share of losses & draws (distributions) is subtracted Example – April contributed $5,000 to ABC law firm in return for a 1/3 interest in the partnership – Firm ended 1 st year with a $3,000 loss (so Aprils share of the loss was $1,000) – In 2 nd year firm made a $9,000 profit (Aprils share of that was $3,000) – At end of 2 nd year, the partners made a draw of $4,500 (April received $1,500) – Aprils capital account at end of 2 nd year is: 5,000 - 1,000 + 3,000 – 1,500 = $5,500 © Amitai Aviram. All rights reserved. 115
Process of dissolution Dissolution as an incentive Most firms are worth more alive (as an operating business) than dead (assets sold separately) – For that reason, even in dissolution the business is often sold in one piece – Even if sold in one piece, some of firms value will be lost because - Dissolution forces to sell now, which weakens the sellers bargaining position Outsiders arent sure if firm has skeletons in its closet, so they discount the price to account for risk of negative surprises – What is the likely outcome if a court orders dissolution due to frustrated expectations/oppression? Judicial dissolution serves as an alternative to buy-out agreements, but also as an incentive to form buyout agreements – Analogy: parent threatens to take away a toy if siblings cant agree how to share it © Amitai Aviram. All rights reserved. 116
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