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Business Organizations Lectures

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1 Business Organizations 2010-2011 Lectures
Partnerships, Corporations And the variants PROF. BRUCE MCCANN LECTURE 14 REVIEW

2 What are we talking about?
Two Umbrella Types of Entities: Limited personal liability for owners Limited partnership Limited Liability Company Corporation No protection from personal liability: General partnership Sole proprietorship What is meant by limited liability? Point out there are sub-categories, but these are the ones we will be focussed on. The full list is in the text at p. 35. As with many law school subjects, the structures and rules that have evolved make sense when you give some thought to the problems those structures and rules were intended to solve. Let’s start with a simple business and see if you cannot anticipate what kinds of problems we may need to address: Joe’s Horseshoeing Business Joe starts business shoeing horses. Working out of the barn on his property. Joe has an anvil, a forge, technical know-how, a wagon and a horse to pull it. Joe is paid $10 for each hoof he shoes, payable after the work is done. Joe can shoe 4 horses a day, earning $160. Joe gets two orders for next Saturday, each with 4 horses. He can’t be two places at once, but his nephew Sal can shoe horses. Joe has to provide the horseshoes, and they cost $2.50 each,or $10 per horse. What are Joe’s options: Turn away the extra business Let Sal contact the owner and make arrangements that exclude Joe, or Pay Sal to shoe horses for him, giving him less than $10/shoe But there are two problems with that: The Joe has to buy the horseshoes in advance, so he needs to have money before he gets paid. What if Sal either runs into a dead beat or does a bad job such that the owner doesn’t pay? State law says you have to pay your workers regardless of whether you have been paid So, Joe could enter into a deal with Sal so that Sal shares the risk in some way. What form could that take? He could make a deal with Sal to get a percentage of the profit that was made by the two of them What percentage% Joe has the tools Joe has the credit to buy the materials Joe is the “rainmaker” Or, Sal could put money in equal to the value of these things in return for larger percentage. Let’s assume Joe and Sal join forces as “Joe and Sal’s” horseshoing. They are now able to shoe 8 horses a day. They made a deal that Joe would provide the horseshoes and drum up business and he would get 2/3 of the profit. However, they are finding that there are many different sizes of horses out there. So they often arrive on the job to shoe a horse only to find they don’t have the right horse shoe. They then have to stop everything and ride to town and get the right horseshoe which takes all day. This happens at least once a week, meaning they lose about 20% of their time. While they are thinking of ways to deal with that problem, Sal is on a job in Cotati when he drops a horseshoe on the foot of the owner. The owner is now suing Joe because Sal has no money. In the meantime, Joe decides that the answer to his problem with wasted time is to have keep an inventory of many horseshoes available so that he always has a shoe that fits. Joe resolves to find some way to do business where he doesn’t face personal liability everytime something goes wrong. Unable to afford to buy such an inventory, he goes to the bank. The bank won’t lend him money because of the lawsuit and because the business does not have a long enough history of making a profit. The bank might go along if Joe puts up all his personal assets as collateral, but Joe doesn’t want to make things worse if things go wrong. At dinner, his Aunt Emma tells Joe she has some money put away that she might be willing to invest in his business, but she doesn’t know anything about horseshoes, doesn’t want to work at the business, and doesn’t want to worry about anyone coming after her other assets if the business doesn’t pay someone or hurts someone. THESE ARE THE FUNDAMENTAL PROBLEMS THAT ARE ADDRESSED BY THE STRUCTURES THAT WE WILL BE STUDYING IN THIS COURSE. All of the entities we will examine, all of the relationships, were designed to allow businesses to grow and move forward without the problems Joe faced. The choice of structure will depend in large part on which of Joe’s concerns looms largest in your situation. If you simply need a way to divide profits and labor, a partnership may be fine. If you need “passive” investors, those who don’t want to have anything to do with the business except share in profits, an LLC or corporation is the answer. If you need to do all that and shield your owners from liability also, a LLC or LP works. Review lecture Corps Prof. McCann

3 Some Basic Terms Partnership
Two or more persons (and by “person” we also mean other entities) Share power Share profits Share losses Partnership reports its profits and losses to the partners who each take their percentage on their own tax return (pass through) Partnership itself is not taxed Each partner personally liable Dissolves on death of partner or other No formal registration required with State Joint venture is subspecies: a partnership formed to do a single project. Review lecture Corps Prof. McCann

4 Corporation One or more owners
No personal liability (assuming formalities met) Registered with Secretary of State Managed by its Board of Directors who are elected by the owners Board names officers who run day-to-day operations Separate existence from its owners (perpetual life) Pays taxes Distributes profits via dividends to owners Under “Pays taxes,” note the S corp distinction Review lecture Corps Prof. McCann

5 PARTNERSHIP Entity v aggregate, etc

6 Aggregation vs Entity Theories
Commonlaw (Aggregation) Partners held undivided but separate interests in property Partnership was not an entity distinct from its partners Withdrawing partner entitled to piece of each asset as is her estate Unanimous consent to admit new partner Partnership meant one exact constellation of partners. Any change resulted in dissolution. What is meant by limited liability? Point out there are sub-categories, but these are the ones we will be focused on. The full list is in the text at p. 35. As with many law school subjects, the structures and rules that have evolved make sense when you give some thought to the problems those structures and rules were intended to solve. Let’s start with a simple business and see if you cannot anticipate what kinds of problems we may need to address: Joe’s Horseshoeing Business Joe starts business shoeing horses. Working out of the barn on his property. Joe has an anvil, a forge, technical know-how, a wagon and a horse to pull it. Joe is paid $10 for each hoof he shoes, payable after the work is done. Joe can shoe 4 horses a day, earning $160. Joe gets two orders for next Saturday, each with 4 horses. He can’t be two places at once, but his nephew Sal can shoe horses. Joe has to provide the horseshoes, and they cost $2.50 each,or $10 per horse. What are Joe’s options: Turn away the extra business Let Sal contact the owner and make arrangements that exclude Joe, or Pay Sal to shoe horses for him, giving him less than $10/shoe But there are two problems with that: The Joe has to buy the horseshoes in advance, so he needs to have money before he gets paid. What if Sal either runs into a dead beat or does a bad job such that the owner doesn’t pay? State law says you have to pay your workers regardless of whether you have been paid So, Joe could enter into a deal with Sal so that Sal shares the risk in some way. What form could that take? He could make a deal with Sal to get a percentage of the profit that was made by the two of them What percentage% Joe has the tools Joe has the credit to buy the materials Joe is the “rainmaker” Or, Sal could put money in equal to the value of these things in return for larger percentage. Let’s assume Joe and Sal join forces as “Joe and Sal’s” horseshoing. They are now able to shoe 8 horses a day. They made a deal that Joe would provide the horseshoes and drum up business and he would get 2/3 of the profit. However, they are finding that there are many different sizes of horses out there. So they often arrive on the job to shoe a horse only to find they don’t have the right horse shoe. They then have to stop everything and ride to town and get the right horseshoe which takes all day. This happens at least once a week, meaning they lose about 20% of their time. While they are thinking of ways to deal with that problem, Sal is on a job in Cotati when he drops a horseshoe on the foot of the owner. The owner is now suing Joe because Sal has no money. In the meantime, Joe decides that the answer to his problem with wasted time is to have keep an inventory of many horseshoes available so that he always has a shoe that fits. Joe resolves to find some way to do business where he doesn’t face personal liability everytime something goes wrong. Unable to afford to buy such an inventory, he goes to the bank. The bank won’t lend him money because of the lawsuit and because the business does not have a long enough history of making a profit. The bank might go along if Joe puts up all his personal assets as collateral, but Joe doesn’t want to make things worse if things go wrong. At dinner, his Aunt Emma tells Joe she has some money put away that she might be willing to invest in his business, but she doesn’t know anything about horseshoes, doesn’t want to work at the business, and doesn’t want to worry about anyone coming after her other assets if the business doesn’t pay someone or hurts someone. THESE ARE THE FUNDAMENTAL PROBLEMS THAT ARE ADDRESSED BY THE STRUCTURES THAT WE WILL BE STUDYING IN THIS COURSE. All of the entities we will examine, all of the relationships, were designed to allow businesses to grow and move forward without the problems Joe faced. The choice of structure will depend in large part on which of Joe’s concerns looms largest in your situation. If you simply need a way to divide profits and labor, a partnership may be fine. If you need “passive” investors, those who don’t want to have anything to do with the business except share in profits, an LLC or corporation is the answer. If you need to do all that and shield your owners from liability also, a LLC or LP works. Review lecture Corps Prof. McCann

7 Aggregation or Entity Theories
Under Uniform Partnership Act, 1997 Partnership is an entity distinct from the partners Withdrawing partner has no interest in partnership assets but only right to receive pro rata share of the value of assets Entity may continue on despite withdrawal or death of partner Review lecture Corps Prof. McCann

8 Under Entity Theory CAL. CORP. CODE § : California Code - Section 16502 The only transferable interest of a partner in the partnership is the partner's share of the profits and losses of the partnership and the partner's right to receive distributions. The interest is personal property. Review lecture Corps Prof. McCann

9 Under UPA, Modern P/S a Hybrid
Still an aggregation of partners in sense that: Each partner individually (jointly and severally) liable for debts Pass through entity, invisible to taxing authorities – each partner pays on her own income from the partnership Review lecture Corps Prof. McCann

10 Formation CAL. CORP. CODE § 16202 :
(a)Except as otherwise provided in subdivision (b), the association of two or more persons to carry on as coowners a business for profit forms a partnership, whether or not the persons intend to form a partnership. (Emphasis added.) * * * Review lecture Corps Prof. McCann

11 Establishing a Partnership
Majority: Intent is key, as evidenced by conduct and circumstances. Minority: Requires finding all of the following: 1. A community of interest in the venture 2. An agreement to share profits 3. An agreement to share losses 4. A mutual right of control or management Review lecture Corps Prof. McCann

12 RECAP OF PARTNER LIABILITY
Restatement of Agency A Principal is liable for torts of employee if they are committed within the course and scope of employment “Course and scope” requires that there be some intent in the mind of the agent to serve the purposes of the principal Uniform Partnership Act Partnership is liable if partner is carrying on in the usual way the business of the partnership and has actual or apparent authority NO REQUIREMENT that the partner is motivated to benefit the partnership What is meant by limited liability? Point out there are sub-categories, but these are the ones we will be focused on. The full list is in the text at p. 35. As with many law school subjects, the structures and rules that have evolved make sense when you give some thought to the problems those structures and rules were intended to solve. Let’s start with a simple business and see if you cannot anticipate what kinds of problems we may need to address: Joe’s Horseshoeing Business Joe starts business shoeing horses. Working out of the barn on his property. Joe has an anvil, a forge, technical know-how, a wagon and a horse to pull it. Joe is paid $10 for each hoof he shoes, payable after the work is done. Joe can shoe 4 horses a day, earning $160. Joe gets two orders for next Saturday, each with 4 horses. He can’t be two places at once, but his nephew Sal can shoe horses. Joe has to provide the horseshoes, and they cost $2.50 each,or $10 per horse. What are Joe’s options: Turn away the extra business Let Sal contact the owner and make arrangements that exclude Joe, or Pay Sal to shoe horses for him, giving him less than $10/shoe But there are two problems with that: The Joe has to buy the horseshoes in advance, so he needs to have money before he gets paid. What if Sal either runs into a dead beat or does a bad job such that the owner doesn’t pay? State law says you have to pay your workers regardless of whether you have been paid So, Joe could enter into a deal with Sal so that Sal shares the risk in some way. What form could that take? He could make a deal with Sal to get a percentage of the profit that was made by the two of them What percentage% Joe has the tools Joe has the credit to buy the materials Joe is the “rainmaker” Or, Sal could put money in equal to the value of these things in return for larger percentage. Let’s assume Joe and Sal join forces as “Joe and Sal’s” horseshoing. They are now able to shoe 8 horses a day. They made a deal that Joe would provide the horseshoes and drum up business and he would get 2/3 of the profit. However, they are finding that there are many different sizes of horses out there. So they often arrive on the job to shoe a horse only to find they don’t have the right horse shoe. They then have to stop everything and ride to town and get the right horseshoe which takes all day. This happens at least once a week, meaning they lose about 20% of their time. While they are thinking of ways to deal with that problem, Sal is on a job in Cotati when he drops a horseshoe on the foot of the owner. The owner is now suing Joe because Sal has no money. In the meantime, Joe decides that the answer to his problem with wasted time is to have keep an inventory of many horseshoes available so that he always has a shoe that fits. Joe resolves to find some way to do business where he doesn’t face personal liability everytime something goes wrong. Unable to afford to buy such an inventory, he goes to the bank. The bank won’t lend him money because of the lawsuit and because the business does not have a long enough history of making a profit. The bank might go along if Joe puts up all his personal assets as collateral, but Joe doesn’t want to make things worse if things go wrong. At dinner, his Aunt Emma tells Joe she has some money put away that she might be willing to invest in his business, but she doesn’t know anything about horseshoes, doesn’t want to work at the business, and doesn’t want to worry about anyone coming after her other assets if the business doesn’t pay someone or hurts someone. THESE ARE THE FUNDAMENTAL PROBLEMS THAT ARE ADDRESSED BY THE STRUCTURES THAT WE WILL BE STUDYING IN THIS COURSE. All of the entities we will examine, all of the relationships, were designed to allow businesses to grow and move forward without the problems Joe faced. The choice of structure will depend in large part on which of Joe’s concerns looms largest in your situation. If you simply need a way to divide profits and labor, a partnership may be fine. If you need “passive” investors, those who don’t want to have anything to do with the business except share in profits, an LLC or corporation is the answer. If you need to do all that and shield your owners from liability also, a LLC or LP works. Review lecture Corps Prof. McCann

13 “The Usual Way” American Rule: partner must be acting consistently with the way that particular partnership operates. English Rule: partner must be acting as do others in that type of business, whether or not usual for that particular partnership. UPA follows English Rule interpretation Review lecture Corps Prof. McCann

14 California Corporations Code Section 16404 [Excerpt]
The fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care set forth [below] A partner's duty of loyalty to the partnership and the other partners includes all of the following: ***(3) To refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership. A partner shall discharge the duties to the partnership and the other partners under this chapter or under the partnership agreement and exercise any rights consistently with the obligation of good faith and fair dealing. A partner does not violate a duty or obligation under this chapter or under the partnership agreement merely because the partner' s conduct furthers the partner's own interest Review lecture Corps Prof. McCann

15 The End Game of a Partnership
Dissolution (or Dissociation) An event triggers the end of the partnership Winding Up The affairs of the partnership are concluded Assets liquidated or earmarked for distribution Taxes paid Creditors paid Partners are paid Termination All affairs are wound up Review lecture Corps Prof. McCann

16 Dissociating Partner Within Rights Under Agreement
Share as per agreement or per UPA Price if all assets sold as of date of dissociation at greater of liquidation value or going concern value, with interest In Violation of Agreement or Wrongful Same less Value of Goodwill (discretionary) Offsets for damage caused by wrongful dissociation Any other amounts owed by departing partner Review lecture Corps Prof. McCann

17 LIMITED PARTNERSHIPS Form allows limited liability to limited partners provided they do not manage 1976 ULPA provided “safe harbor” if acts of limited confined to such things as: Consulting with general partner re partnership affairs Requesting or attending meeting of partners Voting on matter relating to business affairs if subject of vote is one allowing approval or disapproval of limiteds Serving as agent or employee of LP Review lecture Corps Prof. McCann

18 liMITED Liability Companies
LLC liMITED Liability Companies

19 California Corporations Code Section 17153
The fiduciary duties a manager owes to the limited liability company and to its members are those of a partner to a partnership and to the partners of the partnership. Review lecture Corps Prof. McCann

20 California Corporations Code Section 17001
(z) "Membership interest" means a member's rights in the limited liability company, collectively, including the member's economic interest, any right to vote or participate in management, and any right to information concerning the business and affairs of the limited liability company provided by this title. Review lecture Corps Prof. McCann

21 California Corporations Code Section 17001
(n) "Economic interest" means a person's right to share in the income, gains, losses, deductions, credit, or similar items of, and to receive distributions from, the limited liability company, but does not include any other rights of a member, including, without limitation, the right to vote or to participate in management, or, except as provided in Section 17106, any right to information concerning the business and affairs of the limited liability company. Review lecture Corps Prof. McCann

22 LLC Re-Cap Creature of Contract
Variation between states as to what the operating agreement can do with respect to: Eliminating fiduciary duties, namely Duty of Care Duty of Loyalty California, for example, Cannot entirely eliminate duty of loyalty in operating agreement But can specify certain acts which will not constitute breach if not “manifestly unreasonable.” Review lecture Corps Prof. McCann

23 Duty of Loyalty Duty to account for property or profit or benefit derived by the member from LLC property. Duty not to appropriate an LLC opportunity Duty to avoid conflicts of interest Duty to refrain from competing Acts in violation require consent of the members. Review lecture Corps Prof. McCann

24 Duty of Care Duty to refrain from grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law. Agreement cannot unreasonably reduce this duty of care. Review lecture Corps Prof. McCann

25 CORPORATIONS The rest of the story

26 Promoters and Pre-incorporation Liability
Liability that of promoters until corporation adopts pre-incorporation agreements and other party agrees to novation, replacing promoter with corporation Contract language indicating promoter not to be personally liable may exonerate promoter Review lecture Corps Prof. McCann

27 Overview of Corporate Structure
Shareholders Directors President Secretary Treasurer Review lecture Corps Prof. McCann

28 Incorporation Process Review
Review lecture Corps Prof. McCann

29 Incorporation Process Review
Articles filed By laws prepared First meeting held of shareholders Elect Directors Make subchapter S election Directors meeting Adopt pre-existing agreements Appoint officers Authorize issuance of stock Authorize banking relationships Review lecture Corps Prof. McCann

30 The Debt-Equity Relationship
Control Liquidity (Debt) Review lecture Corps Prof. McCann

31 Why Capitalize with Debt?
You can keep (i.e., leverage) the cash you have. You retain ownership (control) of the business Interest payments are tax-deductible Generally easier to sell debt because you don’t have to convince someone that the company will grow, only have to convince them that they’ll get paid back (and they get paid first). Lender is first in line to get paid if must liquidate assets Have a good return on investment (ROI) Review lecture Corps Prof. McCann

32 Advantages of Selling Equity
Motivate buyer to pull for the success of the company Doesn’t use precious cash No obligation to re-pay Can “print” more when needed Review lecture Corps Prof. McCann

33 Disadvantages of Selling Equity
Usually requires giving up at least some control Allows “camel’s nose under the tent” Dividends are not deductible from corporate tax Review lecture Corps Prof. McCann

34 Status of Shares Validly Issued Fully Paid Non-assessable
Board has authorized and Dept of Corporations has issued authorization Fully Paid All consideration has been received Non-assessable The holder of the shares has no obligation to honor any assessments against the shares Review lecture Corps Prof. McCann

35 Common Stock Required to be issued Usually carries voting power
May or may not have “par” value First in line in terms of control, last in line in terms of getting paid on liquidation Review lecture Corps Prof. McCann

36 Preferred Stock Preference given as to Dividends
Liquidation of the company’s assets May also allow certain rights if the dividends are not paid (such as electing a number of directors) Review lecture Corps Prof. McCann

37 Capital Contribution Issues
Watered Stock Shareholder liable to creditors to extent stock has not been paid for Measured by difference between share’s value and what was (was not) paid Comes up where: Did not pay par for the stock or Value of the consideration given was overstated Review lecture Corps Prof. McCann

38 THE PLAYERS, REVISITED SHAREHOLDERS Elect directors
Usually must ratify certain acts of directors Resolution to dissolve Resolution to merge with another entity Resolution to sell principal assets Resolution to change corporate purpose Resolution to amend by-laws or charter Review lecture Corps Prof. McCann

39 VOTING Statutory (or Regular) Voting Cumulative Voting
One vote per share, each directorship voted on independently i.e., Jim has 500 shares, there are 3 directorships up for election. Jim can vote his 500 shares for each of the 3, but cannot accumulate his “1500” votes and put all on one directorship. Cumulative Voting One vote per share multiplied by the number of directorships up for election. Total number of votes can be allocated as shareholder wishes i.e., Jim can cast all 1500 votes for one director. Review lecture Corps Prof. McCann

40 “Closely Held” vs Statutory Close Corporation
Any corporation can be held by a small number of shareholders. One shareholder is not uncommon. A “closely held” corporation is a term with no particular legal significance other than to mean: Few shareholders Most of whom participate in management No general market for the stock (because of limitations on control and liquidity) and Some limitations on transfer of the stock Courts now widely allow shareholders to control management via controlling director’s powers. Review lecture Corps Prof. McCann

41 Statutory Close Corporation
Specifically so-identified in Articles Limited as to number of shareholders possible, usually 30 or 35. Stock certificates must bear “legend” detailing that there are restrictions on transfer Prohibited from making a public offering If adhere to rules, statutes allow exemption from claims regarding improper limits on directors’ powers Delaware allows shareholders to manage directly without a board of directors. Review lecture Corps Prof. McCann

42 Pricing the Shares Three usual approaches: Book Value
What do the accounts show the shares are worth if you divide the number of outstanding shares into the number you get when you subtract the liabilities from the assets? Liquidation Value What would you get if you closed the doors, sold all the assets, paid all the debts, and divided the money up? Cash Flow or Earnings What would an investor be willing to pay today to own a company that generates the profits your company generates? Review lecture Corps Prof. McCann

43 Recording the Corporate History
All States Require Minutes be Maintained Calif Corps Code 314 The original or a copy in writing or in any other form capable of being converted into clearly legible tangible form of the bylaws or of the minutes of any incorporators', shareholders', directors', committee or other meeting or of any resolution adopted by the board or a committee thereof, or shareholders, certified to be a true copy by a person purporting to be the secretary or an assistant secretary of the corporation, is prima facie evidence of the adoption of such bylaws or resolution or of the due holding of such meeting and of the matters stated therein. Review lecture Corps Prof. McCann

44 By Laws Must conform to the Articles Must conform to the law
e.g., by-law prohibiting any transfer of interest would be unenforceable Review lecture Corps Prof. McCann

45 California Corps Code 204 The articles of incorporation may set forth: (a) Any or all of the following provisions, which shall not be effective unless expressly provided in the articles: * * * (5) A provision requiring, for any or all corporate actions … the vote of a larger proportion or of all of the shares of any class or series, or the vote or quorum for taking action of a larger proportion or of all of the directors, than is otherwise required by this division. Review lecture Corps Prof. McCann

46 Calif. Corporations Code Section 603(d)
(d) Notwithstanding subdivision (a), directors may not be elected by written consent except by unanimous written consent of all shares entitled to vote for the election of directors; provided that the shareholders may elect a director to fill a vacancy, other than a vacancy created by removal, by the written consent of a majority of the outstanding shares entitled to vote. Review lecture Corps Prof. McCann

47 Postscript on Consents
Model Act now allows electronic or other consents without unanimity and without notice to all shareholders if: Articles of Incorporation provide for passage by majority vote, and The action is approved by consents signed, even electronically, by a majority of eligible voters By default, Directors are to be elected by “plurality” (rather than cumulative vote or majority vote) True both under Model Act and Delaware law BUT, bylaws may provide for majority or other constraint Review lecture Corps Prof. McCann

48 Pillsbury v Honeywell Shareholders Rights
Right to review corporate records is not unlimited Must be for “a proper purpose germane to his interest as a stockholder” Del. Code, Title 8, § 220. “Proper purpose” means a concern relating to “investment return” BUT investment return can include shareholder motivated by desire to take control of the corporation Review lecture Corps Prof. McCann

49 Who Has the Power to Act for Shareholder?
Shareholder “of record” Proxy Assignee (Pledgee) if assignment or pledge so allows Review lecture Corps Prof. McCann

50 The Powers and Duties of the Board
It is a Board, not a gathering of Generals No director has any power acting alone Their only power derives from decisions they make acting as a Board and which are recorded in the minutes of the corporation Power of directors is “original and undelegated.” Their powers are not granted by others but originate with their election to the Board. Directors’ power comes from the state, if anywhere. The relation of directors to shareholders is that of trustee to beneficiaries. Review lecture Corps Prof. McCann

51 The Powers and Duties of the Board
May Delegate Some of Its Duties Where large board, usual to allow for subcommittees to operate with relative autonomy “Executive Committee” is common device, organized to handle decisions or required resolutions (such as approval of significant contract) when full board cannot be readily convened. In Public Corporations, Usually See “Inside” and “Outside” Directors Inside: are also officers of corporation Outside: are recruited from other corporations, public service, etc. Review lecture Corps Prof. McCann

52 The Powers and Duties of the Board
Key Functions: Provide advice and counsel Instill discipline in the decision-making of the corporation Oversee crises Monitor the conduct of Management Review lecture Corps Prof. McCann

53 REMOVAL OF DIRECTORS Tension between treatment of shareholders who are also directors They want security against removal And treatment of directors who are not shareholders Shareholders do not want to have any impediment to voting such directors out. RULE: Under Model Act statutes, cannot deny shareholders right to remove with or without cause. May require supermajority to remove shareholder-director without cause, however. Review lecture Corps Prof. McCann

54 Tools for Dealing with Deadlock or Misconduct
Judicial Dissolution Buyout of dissenting shareholder Appointment of custodial director or manager Arbitration provision in bylaws or other contract Review lecture Corps Prof. McCann

55 Under Model Act, requires Writing Setting out provisions
VOTING TRUSTS Under Model Act, requires Writing Setting out provisions 10 yr limit (can be extended by some or all) Delivery to corporation’s principal office Review lecture Corps Prof. McCann

56 POOLING AGREEMENTS Widely used to “pool” smaller stock holdings into a unit having power to influence Board or corporate actions Generally provide for process to “pre-vote” an issue put to the shareholders, then cast all shares in pool for winner of the internal vote. Agreements are contracts and enforced as such Equitable relief now available via statute Previously courts could only remedy breach by damages Review lecture Corps Prof. McCann

57 Shareholder Agreements
Liberally construed in closely held corporations BUT, under Model Act, Must be included in writing filed with the corporation Must be unanimously approved by all shareholders at time of creation Must be included in articles or bylaws or in a separate writing BUT Cannot eliminate fiduciary duties of officers and directors, Are not binding on creditors or third parties Are not binding on shareholders without knowledge Review lecture Corps Prof. McCann

58 GALLER V GALLER Held: Shareholder agreement not violative of public policy unless Violates an express statement of policy or Is “manifestly injurious” to public welfare and Where corrupt or dangerous tendency clearly appears on face of agreement or is part of a corrupt scheme and disguised to conceal true nature of the transaction Review lecture Corps Prof. McCann

59 Sea-Land Rule Corporate entity will be disregarded and veil of limited liability pierced if: There is a unity of interest and ownership such that the separateness of the personalities of the entity and the individual (or other entity) no longer exists; Circumstances must be such that adherence to the fiction of separateness would SANCTION A FRAUD PROMOTE INJUSTICE Review lecture Corps Prof. McCann

60 Sea-Land Rule – “Promote Injustice?”
Means more than that a creditor will go unpaid. There must be a wrong beyond creditor’s inability to correct, e.g., Unjust enrichment to person or entity who looted corporation Scheme to move assets to one entity and liabilities to another Must be sufficient to “merit the evocation” of the court’s equitable powers. Review lecture Corps Prof. McCann

61 Piercing Based on Agency Analysis
Where person uses a corporation as a shield to pursue the person’s interests and activities, effectively same conduct as if used any other agent: Therefore, liability imposed on principal via respondeat superior No matter if agent’s wrongdoing arises in contract or tort Review lecture Corps Prof. McCann

62 Declaring Dividends Highlights the tension between creditors and shareholders CREDITORS do not want money taken out of the corporation until they have been paid SHAREHOLDERS like dividends because (a) represents a return on investment that is no longer subject to market forces; (b) declaring a dividend signals optimism about the future and often drives the share price higher. Review lecture Corps Prof. McCann

63 Basic Policy Objective: Protect the Creditor
Limit so that dividends can only be paid from “surplus” after sufficient capital held in reserve to pay debts. Review lecture Corps Prof. McCann

64 Solely Within Authority of Directors
Holders of common shares have no vested right to a dividend Some preferred shares carry right to a dividend and enforcement power (such as right to name directors) if required dividend is not paid to preferred shareholders Courts will not interfere with directors’ decision to declare or withhold dividend absent showing of fraud, bad faith or abuse of discretion by directors BUT once a dividend is declared, shareholders may enforce in court Review lecture Corps Prof. McCann

65 TYPES OF SURPLUS Capital surplus Earned surplus Reduction surplus
Excess portion of price received by corporation for its stock after subtracting the par value Plus any amount directors deem necessary (sometimes required by creditors) Earned surplus Earning of the company from operations after subtracting liabilities and net of capital accounts Reduction surplus The amount directors vote to take out of Stated Capital (e.g., by reducing par or because augmented from capital surplus and now unwinding Revaluation surplus The amount of previously unrealized appreciation directors choose to recognize (and which moves into earned surplus) Review lecture Corps Prof. McCann

66 Stock Dividends Issue additional shares in lieu of cash. Reasons:
Don’t want to spend the cash but want to appease shareholders Want to increase voting rights of pro-board shareholders in case of takeover bid Need to issue more shares to make an offering work and must issue stock dividends to keep voting rights intact Drives down stock price somewhat (because more shares over which ratios operate, such as “earnings per share”) Review lecture Corps Prof. McCann

67 Directors’ Duty of Care
Francis v United Jersey Bank: Director is fiduciary of the corporation and its shareholders And in the context of the business of the corporation, may be a fiduciary to its creditors Where there is constructive or actual trust Director must “discharge duties in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions” Review lecture Corps Prof. McCann

68 Francis v United Jersey Bank
Where director breaches duty, personally liable if negligence was a proximate cause of a loss to the creditor or shareholder or corporation Plaintiff has burden of showing loss would have been avoided if defendant had performed her duties Analysis includes determination of “reasonable steps” director should have taken BUT causation will be inferred where reasonable to conclude particular result from a failure to act and that result has occurred. Review lecture Corps Prof. McCann

69 Caremark Director liability can be grounded on several theories:
Liability following poor decision by board because decision was negligent and ill advised Liability based on failure to act where due diligence would prevent the loss BUT, “absent cause for suspicion there is no duty…to install and operate a system of corporate espionage to ferret out wrongdoing that they have no reason to suspect exists.” Review lecture Corps Prof. McCann

70 Caremark cont’d There must be a system in place adequate to assure the board that appropriate information will come to its attention in a timely manner Failure to insist upon and maintain such a system may render a director liable Review lecture Corps Prof. McCann

71 Caremark cont’d Plaintiffs must show: Director knew or
Should have known were violations of law Took no steps to prevent or remedy Failure proximately caused the loss Review lecture Corps Prof. McCann

72 The Rule Absent fraud, illegality or conflict of interest, a director who acts in good faith is not personally liable for mere errors of judgment short of CLEAR AND GROSS NEGLIGENCE Shlensky v Wrigley 237 N.E. 2d 776 (Ill. 1968) Unless director(s) had an interest in the subject of the decision or Unless decision constitutes illegal conduct (e.g., decision to pay a bribe) Review lecture Corps Prof. McCann

73 ALI Version No liability for a business judgment reached in good faith provided: 1. Director or officer was disinterested 2. Director or officer was informed as to the subject of the decision to a degree the director or officer reasonably believes appropriate; and 3. Rationally believes decision is in the best interests of the corporation Review lecture Corps Prof. McCann

74 SMITH V VAN GORKOM "Informed" within meaning of "due care" means board reviewed all material information reasonably available Liability under Business Judgment Rule arises only where there is a showing of gross negligence, meaning something more careless than ordinary negligence. E.g., failure to even read a report which was itself deficient Review lecture Corps Prof. McCann

75 Delaware Gen Corp Law Sec. 141
(e) A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of such member's duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporation's officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other person's professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation. Review lecture Corps Prof. McCann

76 Shareholder Ratification
Shareholders may ratify acts of even interested directors PROVIDED shareholders are “fully informed” Burden is on directors to establish shareholders were fully informed Review lecture Corps Prof. McCann

77 Model Act SECTION 8.30. GENERAL STANDARDS FOR DIRECTORS
(a) A director shall discharge his (sic) duties as a director, including his (sic) duties as a member of a committee: (1) in good faith; (2) with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner he (sic) reasonably believes to be in the best interests of the corporation. (b) In discharging his (sic) duties a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by: (1) one or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters presented; (2) legal counsel, public accountants, or other persons as to matters the director reasonably believes are within the person's professional or expert competence; or (3) a committee of the board of directors of which he (sic) is not a member if the director reasonably believes the committee merits confidence. (c) A director is not acting in good faith if he (sic) has knowledge concerning the matter in question that makes reliance otherwise permitted by subsection (b) unwarranted. (d) A director is not liable for any action taken as a director, or any failure to take any action, if he (sic) performed the duties of his (sic) office in compliance with this section. Review lecture Corps Prof. McCann

78 Calif. Corp Code Sec. 309 (a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances. (b) In performing the duties of a director, a director shall be entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by [officers, consultants, etc]. (c) A person who performs the duties of a director in accordance with subdivisions (a) and (b) shall have no liability based upon any alleged failure to discharge the person's obligations as a director. In addition, the liability of a director for monetary damages may be eliminated or limited in a corporation's articles to the extent provided in paragraph (10) of subdivision (a) of Section 204. Review lecture Corps Prof. McCann

79 The Duty of Loyalty and the BJR
The Business Judgment Rule only shields directors where there is no conflict of interest. Where a potential conflict of interest exists, burden is on directors to demonstrate decision is fair and reasonable to the corporation. Review lecture Corps Prof. McCann

80 What is “Fair and Reasonable”?
An objective test. There must be procedural fairness There must be substantive fairness The transaction must be reasonable in the overall context of the objectives of the corporation As measured against transactions with unrelated parties As measured against strategic goals – i.e., not only must the terms be fair, but the transaction itself has to be one the corporation would have pursued even were the other party not affiliated As measured at the time of the decision Review lecture Corps Prof. McCann

81 Safe Harbor for the Interested Director/Officer
Delaware provides: No transaction void or voidable just because interested director or officer participated if: a. All material facts regarding the conflict of interest were disclosed to the board or shareholders who nonetheless approved the transaction in good faith; or b. The transaction was intrinsically fair to the corporation at the time it was approved. NOTE: Regardless of board or shareholder approval, many states require fairness test be satisfied Review lecture Corps Prof. McCann

82 Split As to Application of Safe Harbor Rules
Majority: Burden is on shareholders to prove board action unfair so long as BJR criteria met Shifting burden to shareholders to show unfair provided one of the safe harbor tests is met (i.e., board need not also show intrinsic fairness) Burden of proof on board to demonstrate intrinsic fairness (Minority) Review lecture Corps Prof. McCann

83 Interplay with BJR Benihana:
If fully informed disinterested directors approve the transaction, the burden shifts to the shareholders to show decision does not satisfy the Business Judgment Rule (i.e. , that the process followed in reaching the decision was flawed, regardless of the merits of the decision) Effect is to insulate the decision from judicial review for fairness Review lecture Corps Prof. McCann

84 Alternative Attacks on the Transaction
Waste Fraud Exceeding Authority Breach of Loyalty action against the interested director Review lecture Corps Prof. McCann

85 The Emerging Duty of Good Faith
Walt Disney: The decision of the compensation committee will be sheltered by the BJR if they acted with due care (i.e., were not grossly negligent) and if they were not acting in BAD FAITH. BAD FAITH can be Subjective: motivated by an actual intent to do harm, or Unintentional but grossly negligent QUESTION: If the board is grossly negligent for duty of care purposes, are they then automatically acting in bad faith? ANSWER: No, gross negligence alone does not constitute bad faith. (Otherwise, exculpation statutes meaningless.) Review lecture Corps Prof. McCann

86 What is Bad Faith for Purposes of Liability?
Intentional dereliction of duty or a conscious disregard for one’s responsibilities Deliberate inattention and inaction in the face of a duty to act. Review lecture Corps Prof. McCann

87 A Taste of Waste Board is guilty of corporate waste only if
Transaction is so one-sided that no business person of ordinary sound judgment would have concluded that the corporation has received adequate consideration Review lecture Corps Prof. McCann

88 Compensation as Waste If compensation decision concerns non-insider (i.e., not a director), directors alone decide if adequate consideration is received by corporation If for insider, directors have burden of showing fair to corporation and in good faith – BJR does not apply (because self-interest exception)…UNLESS Full disclosure and subsequent ratification by disinterested directors or by the shareholders In which case, BJR again protects the directors Review lecture Corps Prof. McCann

89 The Evolving Good Faith Standard
Not an independent basis for director liability A subset of the Duty of Loyalty Caremark remains the standard insofar as duty to monitor Review lecture Corps Prof. McCann

90 The Duty of Good Faith and Compensation
“Spring Loaded” Options: options granted to employees at a time directors reasonably believe value is going to rise in near future as a result of non-public information “Bullet Dodging” Options: options timed to be issued right after stock is going to drop as the result of information not yet made public Review lecture Corps Prof. McCann

91 Option Grants and the BJR
Tyson I: The BJR does not protect directors who grant spring-loaded or bullet-dodging options if plaintiff pleads and proves: Options were issued per shareholder approved employee compensation plan and When they approved the options the directors possessed material non-public information that would impact share price and Issued the options with the intent to circumvent restrictions in the shareholder-approved plan Review lecture Corps Prof. McCann

92 The Corporate Opportunity Doctrine
Corporate fiduciary may not take an opportunity for herself if: 1. The Corporation is financially able to exploit the opportunity 2. The opportunity is within the Corporation’s line of business 3. The Corporation has an interest or expectancy in the opportunity, and 4. By taking the opportunity the fiduciary will be placed in a position inimicable to her duties to the Corporation Review lecture Corps Prof. McCann

93 The Corporate Opportunity Doctrine
Corporate fiduciary may take an opportunity for herself if: 1. The opportunity is presented to the fiduciary as an individual and not in her corporate capacity 2. The opportunity is not essential to the Corporation 3. The Corporation has no interest or expectancy in the opportunity, and 4. The fiduciary has not wrongfully used Corporate resources in pursuing or exploiting the opportunity Review lecture Corps Prof. McCann

94 The Line of Business Test
Guth v Loft: Fiduciary cannot take opportunity for herself if A. The corporation is financially able to exploit it B. It is “in the line of the corporation’s business” C. It is of “practical advantage” to the corporation D. The corporation has an interest in the opportunity and E. If the fiduciary were to take the opportunity she would be brought into “conflict” with the interests of the corporation Review lecture Corps Prof. McCann

95 The A.L.I. Test Fiduciary may not take advantage of a corporate opportunity unless: A. The fiduciary first offers it to the corporation and discloses the conflict of interest. B. The corporation rejects the opportunity and C. Either the rejection is fair to the corporation or D. The decision to reject satisfies the BJR or E. The rejection is authorized in advance following disclosure by disinterested shareholders and does not constitute waste. Review lecture Corps Prof. McCann

96 ALI Test Continued: What is a corporate opportunity?
A business opportunity presented initially by someone who believes it is being presented to the corporation. An opportunity developed using corporate information or property Any opportunity which a senior executive knows is closely related to the corporation’s current or projected business activities Review lecture Corps Prof. McCann

97 Duties of Controlling Shareholders
A dominant shareholder owes a fiduciary duty to the corporation to conform its actions to the “intrinsic fairness” doctrine. Such a shareholder bears burden of proving transaction was objectively fair. BUT only comes into play when self-dealing is involved, where parent is on both sides of transaction with subsidiary and receives benefit from the transaction that minority shareholders of subsidiary do not. Review lecture Corps Prof. McCann

98 Intrinsic Fairness vs BJR
Absent showing transaction benefited dominant s/h and not minority, standard is BJR Example: declaring dividend which equally applies to minority s/h not unfair regardless of disparity in number of shares held If transaction satisfies BJR re methodology, will be upheld unless Improper motive and Amounted to waste Review lecture Corps Prof. McCann

99 Duty of Majority in Sale of Controlling Interest
Feldmann Where majority shareholder received premium for controlling interest in steel operation during period of market shortage, held liable to minority shareholders, individually, for premium received. Burden on defendant majority s/h to demonstrate acted in best interest of corporation (and minority) Extra value derived from market conditions equivalent to business opportunity belonging to the corporation generally Dissent: Majority always carries power of control of directors and there is no fiduciary duty not to sell your stock Modern trend Review lecture Corps Prof. McCann

100 ALI Standard So long as sale of control does not generate premium to the seller because buyer intends to exploit its power over minority shareholders, sale is not breach of any fiduciary duty. Review lecture Corps Prof. McCann

101 Dual Directors Director serving on boards of both selling and buying corporations owes identical duty of loyalty to each corporation and must act with utmost good faith and candor Review lecture Corps Prof. McCann

102 Fairness Analysis involves both Fairness of the process (fair dealing)
Includes duty of candor Includes transparency as to access to corporate information Fairness of the price Considering all relevant factors- including future value likely Review lecture Corps Prof. McCann

103 Statutory “Short Form” Mergers
Expedited process whereby corporation can retire minority interests for cash. Issue: Must transaction pass “fairness” test beyond fair price? Held: No, to so require would frustrate purpose of statutes. Exclusive remedy of minority is appraisal. BUT duty of full disclosure of all facts relevant to price remains Review lecture Corps Prof. McCann

104 Burden of Proof Initially, proponents of transaction have burden to establish “entire fairness” Where an independent committee is empanelled to evaluate and negotiate the transaction, burden shifts to opponents PROVIDED committee exercises true bargaining power independent of majority shareholder(s) Review lecture Corps Prof. McCann

105 How Can Control of a Corporation Change?
Voluntarily 1. It can sell all of its assets. Alternatively, it can swap its assets for stock in another company. 2. It can sell all of its stock. Alternatively, it can swap its stock for the stock of another company, leaving the other company holding all of its stock. 3. It can formally merge with another company. Review lecture Corps Prof. McCann

106 Why Prefer One Approach to Another?
Purchase of Assets Simpler Leaves corporate liabilities as the problem of the shareholders of the corporation Tax benefits of asset purchases simpler Purchase of Stock Broader range of rights usually acquired (e.g., brand, employees) Inherit business contracts, BUT also all liabilities Review lecture Corps Prof. McCann

107 De Facto Merger Despite the characterization given to the transaction by the parties, a transaction which has, in practical effect, the characteristics of a merger. The combination of two corporations The virtual extinction of one of them in its previous form with respect to Asset value or type Stock value Nature of its business Management Control And the stock of the acquiring corporation going to the shareholders of the disappearing corporation Review lecture Corps Prof. McCann

108 Other Responses California
Denominates a general classification termed “reorganizations” A. Merger B. Exchange (one corp gets 50% or more of stock of another in exchange for its own shares) C. Sale of Assets Reorganization (assets for cash or stock) Majority of Shareholders of both corporations must approve A and C. Majority of acquiring corp shareholders must approve B reorganization. Where Shareholder approval required, shareholders generally have appraisal rights if they dissent. Review lecture Corps Prof. McCann

109 Anatomy of a Takeover Predator buys small percentage of stock of Prey
Predator makes tender offer to shareholders of record, often “two tiered,” One price will be paid until Predator has acquired majority interest (“first tier”). Predator will take control of board of directors. Second, often lower, price will be paid to those who don’t sell in the first tier. “Mopping Up.” Review lecture Corps Prof. McCann

110 Directors and Tender Offers
The “Enhanced Business Judgment Rule” Directors must determine if takeover proposal is in the best interests of the corporation and its shareholders. If they act to repel the takeover, their decision are shielded by the BJR if Directors first establish that they had reasonable grounds for believing that the takeover posed a danger to corporate policy and effectiveness. Burden is satisfied by showing “good faith” and “reasonable investigation” Review lecture Corps Prof. McCann

111 Enhanced BJR The “Enhanced Business Judgment Rule”
Directors must determine if takeover proposal is in the best interests of the corporation and its shareholders. If they act to repel the takeover, their decision are shielded by the BJR if Directors first establish that they had reasonable grounds for believing that the takeover posed a danger to corporate policy and effectiveness. Burden is satisfied by showing “good faith” and “reasonable investigation” Review lecture Corps Prof. McCann

112 Unocal Is offer in the best interests of the corporation?
If contend it is not, the board must show: Offer is threat to corporate policy or effectiveness Via evidence of investigation The defensive response is “proportional” to the threat. Review lecture Corps Prof. McCann

113 Paramount v Time Even an “all cash” sale can be a threat where sale will defeat corporate strategic alliance of potentially greater benefit So long as response does not preclude future offer for the combined alliance. Review lecture Corps Prof. McCann

114 Revlon Once board takes steps to sell the corporation (or where sale inevitable) duty of board is to maximize the price. Defensive measures are “moot”. Triggered at least two ways: When corporation initiates active bidding process to sell itself or When a corporation seeks to reorganize in such a way that it involves a clear break-up of the company Review lecture Corps Prof. McCann

115 Stalking Horse The initial bidder with whom the debtor negotiates a purchase agreement is called the "stalking horse" bidder. The term is an old hunting term referring to either a real horse or an image of a horse (typically some type of screen) behind which a hunter would hide to conceal himself from, and get closer to, his prey. Review lecture Corps Prof. McCann

116 DGCL Section Mergers Board of each corporation must first adopt resolution approving merger agreement. Agreement shall set forth terms of the merger, mode of bringing into effect, manner of converting shares. The agreement shall then be submitted to the shareholders of each corporation for vote on no less than 20 days notice. Merger is not effective until requisite number of shares approve it. Review lecture Corps Prof. McCann

117 Omnicare Refinements to Unocal
Where defensive measures are invoked to protect a merger agreement, Unocal proportionality test is applied as follows: 1. Court must first determine if the measures are preclusive or coercive. If either, measures are illegal. 2. If measures pass that threshold test, then the Board must establish their measures were within a “range of reasonable responses.” Review lecture Corps Prof. McCann

118 LYONDELL Revlon duties do not arise simply because a company is “in play.” The duty to obtain best price arises only when the company itself embarks on a transaction that will result in a change of control. Either on its own initiative or In response to an unsolicited offer Review lecture Corps Prof. McCann

119 Shareholder Derivative Litigation
An action by shareholders to remedy an alleged wrong to the corporation. A wrong by the directors or controlling shareholders or A wrong by a third party, such as a supplier The action is “founded on a right of action existing in the corporation itself, and in which the corporation itself is the appropriate plaintiff.” Daily Income Fund, Inc. v. Fox 464 US 523, 528 (1984) Review lecture Corps Prof. McCann

120 Shareholder Derivative Litigation
Two actions in one: A. A suit to compel the corporation to sue and B. A suit by the corporation (asserted by the shareholder –plaintiffs) against those liable to it Review lecture Corps Prof. McCann

121 Shareholder Derivative Litigation
In addition to demand requirement, shareholders filing derivative action must first post a bond to pay the defendants’ costs if the plaintiffs lose or abandon the litigation (in certain states); establish they are “adequate representatives” of the shareholder s in general and counsel is able to prosecute the action Review lecture Corps Prof. McCann

122 Direct vs. Derivative Claim Direct Derivative
Δs conpired to deplete corporate assets Δs diverted corporate assets Δs paid dividends to only certain shareholders in class Δs conduct caused share value to decline Δs diluted minority shares for benefit of majority s/h Δs refused to allow inspection of corporate records Δs prevented shareholder from voting Δs proposed action is ultra vires Δs wrongfully failing to dissolve the corporation Δs are acting fraudulently Review lecture Corps Prof. McCann

123 Demand Futility Demand requirement waived if “futile”
Test is whether there is a reasonable doubt that The directors are disinterested and independent (as to the action proposed by the plaintiff) and The transaction being challenged was the product of the valid exercise of business judgment Review lecture Corps Prof. McCann

124 The Corporate Response
BJR shields directors as to 1. Their response to the demand 2. Decision to dismiss the derivative suit 3. If suit is directed against them, the directors have the BJR shield as a defense. PROVIDED: 1. Directors are disinterested as to any decision in question 2. The directors have not been grossly negligent with respect to their duty to inform themselves regarding the decisions(s) Review lecture Corps Prof. McCann

125 Approaches to Demand Futility
Model Act: Absent a showing of irreparable harm if demand is required, a demand must always be made before a derivative action can be pursued. “Universal Demand.” New York: Demand required unless plaintiff shows: 1. Majority of board are not disinterested as to the transaction 2. Board did not inform themselves as to the transaction; or 3. Transaction is so egregious could not have resulted from sound business judgment. Review lecture Corps Prof. McCann

126 The Rise of the ILC Review lecture Corps Prof. McCann
Corp Gets Named in Shareholder Derivative Action (SDA) Board Votes to Create Independent Litigation Committee (ILC) Board Expands Itself to Add Members and appoints only new board members to be the ILC Corporation seeks Stay of SDA proceedings in court to “investigate” the merits of the SDA ILC “investigates” and reports back to the board that the SDA is not in “best interests of the corporation” Corp files motion to dismiss the SDA and/or for summary judgment along with report. Review lecture Corps Prof. McCann

127 The “Structural Problem” of the ILC
The “Independent Litigation Committee” Who appointed them? What will the appointees be doing once the ILC disbands? Whose Country Club do they belong to? Plaintiffs or defendants? How do they feel about rabble-rousing shareholders? “There but for the grace of God go I.” Review lecture Corps Prof. McCann

128 Zapata In balancing corporation’s right to avoid being hi-jacked by fringe shareholders with shareholders right to protect themselves from directors’ failure to act, In deciding corporation’s motion to dismiss derivative suit, court test the motion as follows: First, was board (committee) independent and acting in good faith? If no, motion shall be denied. If passes that test, court may still test the decision applying the court’s own “business judgment” if court suspects corporation’s interests so require Review lecture Corps Prof. McCann

129 The Limited Aronson test re demand futility is operative
Complaint must allege with particularity facts raising reasonable doubt that Directors had financial interest or Directors were motivated by desire to remain in power (entrenchment) or Directors were dominated or controlled by person interested in the transaction Test as to director’s independence is subjective: Did that particular director lack independence under the circumstances? Review lecture Corps Prof. McCann

130 Other Approaches Other jurisdictions apply slightly different tests to board motions to dismiss derivative suits: North Carolina: burden is on board to establish transactions giving rise to the derivative suit were “just and reasonable” to the corporation New Jersey: In rejecting demand or moving to dismiss a derivative claim, board must show Members independent Were acting in good faith with due care Decision is reasonable Model Act: Court will grant motion of board to dismiss only after court conducts “reasonable inquiry” and concludes derivative action is not in the corporation’s best interests Review lecture Corps Prof. McCann

131 Protecting Directors and Officers
Three principal approaches: 1. Buy “D&O” insurance 2. Provide “contractual indemnification” through agreements with directors and officers 3. Exculpate directors through available statutes and/or by-laws Review lecture Corps Prof. McCann

132 Permissive Indemnification
Delaware: Corporation may indemnify where director sued “by reason of the fact” he or she was a director. Heffernan says policy of exculpation requires expansive interpretation of “by reason of the fact.” Model Act: Indemnification authorized if director acting in good faith and in best interests of corporation, even if her conduct didn’t satisfy duty of care. Articles/By-laws may expand or limit this duty to indemnify Review lecture Corps Prof. McCann

133 Waltuch Corporation may agree to broader indemnification rights for its directors and officers than are provided by statute, but Those rights cannot be inconsistent with the statutory scheme Review lecture Corps Prof. McCann

134 Insurance Issues A corporation can often use D&O (“Directors and Officers”) coverage to indemnify risks that the corporation itself could not indemnify. Insurance Coverage can be broader than statutory limits of indemnification allowed the corporation itself. BUT Public policy forbids indemnifying against criminal conduct, willful conduct or fraudulent conduct Review lecture Corps Prof. McCann

135 D&O Policies Typically provide:
1. “Company Reimbursement” – compensates company for monies it expends for mandatory indemnification expenses. (Side B) 2. “Directors and Officers Liability” – covers losses incurred by the directors and officers and not reimbursed by the company for statutory or other reasons. (Side A) 3. “Entity Coverage” – insures for the company’s direct liability to the plaintiff. (Side C) Review lecture Corps Prof. McCann

136 What is a Security? "Security" means any note; stock; treasury stock; membership in an incorporated or unincorporated association; bond; debenture; evidence of indebtedness; certificate of interest or participation in any profit-sharing agreement; collateral trust certificate; preorganization certificate or subscription; transferable share; investment contract; viatical settlement contract or a fractionalized or pooled interest therein; life settlement contract or a fractionalized or pooled interest therein; voting trust certificate; certificate of deposit for a security; interest in a limited liability company and any class or series of those interests (including any fractional or other interest in that interest…; certificate of interest or participation in an oil, gas or mining title or lease or in payments out of production under that title or lease; put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof); or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency; any beneficial interest or other security issued in connection with a funded employees' pension, profit sharing, stock bonus, or similar benefit plan; or, in general, any interest or instrument commonly known as a "security"; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. All of the foregoing are securities whether or not evidenced by a written document. "Security" does not include: (1) any beneficial interest in any voluntary inter vivos trust which is not created for the purpose of carrying on any business or solely for the purpose of voting, or (2) any beneficial interest in any testamentary trust, or (3) any insurance or endowment policy or annuity contract under which an insurance company admitted in this state promises to pay a sum of money (whether or not based upon the investment performance of a segregated fund) either in a lump sum or periodically for life or some other specified period, or (4) any franchise subject to registration under the Franchise Investment Law (Division 5 (commencing with Section 31000)), or exempted from registration by Section or Calif. Corporations Code Sec Review lecture Corps Prof. McCann

137 Sarbanes-Oxley Section 302 of the Act mandates a set of internal procedures designed to ensure accurate financial disclosure. The signing officers must certify that they are “responsible for establishing and maintaining internal controls” and “have designed such internal controls to ensure that material information relating to the company and its consolidated subsidiaries is made known to such officers Under Section 404 of the Act, management is required to produce an “internal control report” as part of each annual Exchange Act report. See 15 U.S.C. § 7262. The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.” 15 U.S.C. § 7262(a). The report must also “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting. Section 802(a) of the SOX, 18 U.S.C. § 1519 states: “ Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both. Review lecture Corps Prof. McCann

138 SEC Rule 14(a) Rule 14a-9 -- False or Misleading Statements
No solicitation subject to this regulation shall be made by means of any proxy statement, form of proxy, notice of meeting or other communication, written or oral, containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, or which omits to state any material fact necessary in order to make the statements therein not false or misleading or necessary to correct any statement in any earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading. Review lecture Corps Prof. McCann

139 Virginia Bankshares v Sandberg
1. Because of the weight given director opinions by shareholders, statements of opinion (“we recommend it because it is a fair price”) which are misleading will support 14a action. 2. But, before liability will lie, the proxy solicitation must be an “essential link” to the corporate action giving rise to the damage to the plaintiff. 3. Where proxy solicitation is superfluous, no liability will lie. Review lecture Corps Prof. McCann

140 Shareholder’s Rights to Solicit Proxies
SEC v Transamerica Proxy Rule x-14A-7 requires management to present a shareholder proposal if Shareholder gives reasonable notice to management Proposal is “proper subject” for action by shareholders Review lecture Corps Prof. McCann

141 Fradkin v Ernst FRADKIN V ERNST
ISSUE: Must a plaintiff prove scienter to prevail on a 14(a) misleading proxy solicitation claim? HOLDING AND REASONING: No. Where issuer is the defendant, general principles of tort law apply. Negligence will suffice. No need to prove evil intent or recklessness. DISTINGUISHED first party from third party defendants, finding scienter required as to third parties (such as accountants assisting in preparation of proxy statement) because statutory intent is to prevent corporate officers from profiting from their own deception. No direct benefit to the accountant. Review lecture Corps Prof. McCann

142 Shareholder Proxies 14(a)-8
If I have complied with the procedural requirements, on what other bases may a company rely to exclude my proposal? Improper under state law: If the proposal is not a proper subject for action by shareholders under the laws of the jurisdiction of the company's organization; Violation of law: If the proposal would, if implemented, cause the company to violate any state, federal, or foreign law to which it is subject; Violation of proxy rules: If the proposal or supporting statement is contrary to any of the Commission's proxy rules, including Rule 14a-9, which prohibits materially false or misleading statements in proxy soliciting materials; Personal grievance; special interest: If the proposal relates to the redress of a personal claim or grievance against the company or any other person, or if it is designed to result in a benefit to you, or to further a personal interest, which is not shared by the other shareholders at large; Relevance: If the proposal relates to operations which account for less than 5 percent of the company's total assets at the end of its most recent fiscal year, and for less than 5 percent of its net earning sand gross sales for its most recent fiscal year, and is not otherwise significantly related to the company's business; Absence of power/authority: If the company would lack the power or authority to implement the proposal; Review lecture Corps Prof. McCann

143 14(a)-8 (Contid) Management functions: If the proposal deals with a matter relating to the company's ordinary business operations; Relates to election: If the proposal relates to a nomination or an election for membership on the company's board of directors or analogous governing body or a procedure for such nomination or election; Conflicts with company's proposal: If the proposal directly conflicts with one of the company's own proposals to be submitted to shareholders at the same meeting. Substantially implemented: If the company has already substantially implemented the proposal; Duplication: If the proposal substantially duplicates another proposal previously submitted to the company by another proponent that will be included in the company's proxy materials for the same meeting; Review lecture Corps Prof. McCann

144 The Elements Material misrepresentation or nondisclosure Scienter
A connection between the misrepresentation and the purchase or sale of a security Reliance Economic Loss Loss Causation (a “causal relationship” between the misrep and the loss Review lecture Corps Prof. McCann

145 And more Resubmissions: If the proposal deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company's proxy materials within the preceding 5 calendar years, a company may exclude it from its proxy materials for any meeting held within 3 calendar years of the last time it was included if the proposal received: Less than 3% of the vote if proposed once within the preceding 5 calendar years; Less than 6% of the vote on its last submission to shareholders if proposed twice previously within the preceding 5 calendar years; or Less than 10% of the vote on its last submission to shareholders if proposed three times or more previously within the preceding 5 calendar years; and Specific amount of dividends: If the proposal relates to specific amounts of cash or stock dividends. Review lecture Corps Prof. McCann

146 And more Resubmissions: If the proposal deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company's proxy materials within the preceding 5 calendar years, a company may exclude it from its proxy materials for any meeting held within 3 calendar years of the last time it was included if the proposal received: Less than 3% of the vote if proposed once within the preceding 5 calendar years; Less than 6% of the vote on its last submission to shareholders if proposed twice previously within the preceding 5 calendar years; or Less than 10% of the vote on its last submission to shareholders if proposed three times or more previously within the preceding 5 calendar years; and Specific amount of dividends: If the proposal relates to specific amounts of cash or stock dividends. Review lecture Corps Prof. McCann

147 10b-5 "Rule 10b-5: Employment of Manipulative and Deceptive Practices": It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." Review lecture Corps Prof. McCann

148 The Essence of 10b-5 Persons (insiders or not)
Having material information not known to the investing public (or others with whom the person is dealing) Must disclose it prior to transacting or Must abstain from transaction until it is disclosed Review lecture Corps Prof. McCann

149 Material Information to which a reasonable investor would attach importance in determining her choice of action regarding a transaction A balancing: How likely is it that the fact will actually come to fruition (i.e., a merger; and How significant will be the impact of the event in the totality of the company’s operations? Review lecture Corps Prof. McCann

150 The Elements Material misrepresentation or nondisclosure Scienter
A connection between the misrepresentation and the purchase or sale of a security Reliance Economic Loss Loss Causation (a “causal relationship” between the misrep and the loss Review lecture Corps Prof. McCann

151 Sub-Issues in 10b-5 Cases Fault
Simple negligence is insufficient to suport an action for civil damages. There must be an intent to deceive, defraud or manipulate. Ernst and Ernst v Hochfelder Recklessness will suffice to establish requisite scienter. Review lecture Corps Prof. McCann

152 Sub-Issues in 10b-5 Cases Who Is Subject to 10b-5 Constraint?
Absent a relationship between a purchaser of stock and the seller, there is no duty to disclose information acquired by the purchaser under 10(b). However, that relationship can be found to exist where purchaser works for, say, printer employed by seller. (Misappropriation) Duty likewise where purchaser is insider or fiduciary of seller But, SEC can find violation if anyone was owed a duty by the purchaser, even if a particular plaintiff cannot succeed. Materia (SEC prosecution against printer’s employee). Review lecture Corps Prof. McCann

153 Sub-Issues in 10b-5 Cases Tippees/ Aiders and Abettors
Where insider who made disclosure did so without violating fiduciary duty, a tippee who passes the disclosure on is not liable under 10(b)-5 Dirks v SEC: Source of information was insider who disclosed it in the process of trying to investigate wrongdoing. Test: Did the insider personally gain? Review lecture Corps Prof. McCann

154 The Elements Material misrepresentation or nondisclosure Scienter
A connection between the misrepresentation and the purchase or sale of a security Reliance Economic Loss Loss Causation (a “causal relationship” between the misrep and the loss Review lecture Corps Prof. McCann

155 Loss Causation and Damages
Fact price is inflated (“fraud on market” test) is not sufficient to prove the misrepresentation caused the loss. At the moment of purchase the stock is worth what was paid, so no loss. The inflated price may, but may not, lead to the later loss when the stock is sold for a lower price. Dura Pharmaceuticals, Inc. v. Broudo (reversing 9th circuit test that plaintiff sufficiently alleged causation between the loss and the misrepresentation for 10(b)-5 purposes by alleging the price paid was inflated) Review lecture Corps Prof. McCann

156 Calculation of Damages
Disgorgement Measure: Plaintiff may recover post-purchase decline in value up to reasonable time after purchase, limited by the total gain enjoyed by the tippee as a result of trading on the inside information. Where multiple plaintiffs, recover pro rata from the tippee. Subsequently, Sec. 20A provided for treble damages and other disincentives in SEC prosecutions. Review lecture Corps Prof. McCann

157 Other Statutes Sarbanes-Oxley Act of 2002
Creates criminal violation for executing or attempting to execute a fraud in connection with any security; Or to obtain by fraud any money or property in connection with purchase or sale of security Review lecture Corps Prof. McCann

158 Sec. 16 of the Exchange Act a. Directors, officers, and principal stockholders required to file Every person who is directly or indirectly the beneficial owner of more than 10 percent of any class of any equity security …or who is a director or an officer of the issuer of such security, shall file the statements …[with]… the amount of all equity securities of such issuer of which the filing person is the beneficial owner; and…shall indicate …at the date of filing, any such changes in such ownership, and such purchases and sales of the security[.] Review lecture Corps Prof. McCann

159 Sec. 16 of the Exchange Act b. For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale…within any period of less than six months, unless such security …was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer Review lecture Corps Prof. McCann

160 Smolowe v Delendo Must each sale unfairly use inside information before it is subject to Sec. 16? No. All transactions in the 6 month period covered. Disgorgement is of difference between highest sale and lowest purchase, times number of shares bought or sold. Purpose to sweep in all conceivable profits. Review lecture Corps Prof. McCann

161 Smolowe v Delendo The Real World
Date Buy/Sell Shares Price Net Profit (Loss) 1/1 Buy 100 $115 Sell $93 ($2,200) 1/3 $90 $95 1/5 $97 $700 1/6 $105 1/7 $108 $300 1/8 $1,000 Total $800 Review lecture Corps Prof. McCann

162 Smolowe v Delendo Under 16b
Date Buy/Sell Shares Price Net Profit (Loss) 1/1 Buy 100 $115 Sell $93 1/3 $90 Match with $115 sale = $2500 profit $95 Match with $108 sale = $1300 profit 1/5 $97 1/6 $105 No other buys matched with sells generate gains. 1/7 $108 1/8 Total $3,800 profit Review lecture Corps Prof. McCann

163 The Universe of Defendants
16b Means What It Says: Only directors, officers or beneficial owners of 10% of the stock are potential defendants. Ownership measured immediately prior to the transaction (i.e., was the shareholder a 10% owner when he entered into the transaction in question?) So, “step transaction” to reduce ownership to less than 10% will shield sale of remaining interest. Review lecture Corps Prof. McCann


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