Business associations Chapter 3: Internal governance (corporate governance) Prof. Amitai Aviram University of Illinois College of Law.

Business associations Chapter 3: Internal governance (corporate governance) Prof. Amitai Aviram Aviram@illinois.edu University of Illinois College of Law Copyright © Amitai Aviram. All Rights Reserved F15D

Internal governance Governance solutions © Amitai Aviram. All rights reserved. 2 Bonding: Align a party’s welfare with the group’s collective welfare Morality/identity Performance-based compensation Joint ownership Intervention: Have government enforce appropriate behavior by whomever acts for the group Private ordering Public paternalism Private paternalism Voice: Allow a party unilaterally to express dissent in a manner that may affect the group’s behavior Approval Protest Exit: Allow a party unilaterally to end her association with the group without losing her share of the value produced by the group Termination Dissociation Alienation

Internal governance Overview of Chapter 3 a.Internal governance in agency 1)Challenging an actor’s behavior Authority Governance solutions in agency law 2)Intervention: Fiduciary duty 3)Voice: Approval 4)Exit: Termination b.Intervention solutions c.Voice solutions d.Exit solutions e.Customizing the firm © Amitai Aviram. All rights reserved. 3

Challenging an actor’s behavior Two frameworks: authority & fiduciary duty An actor (A) is someone who acts on behalf of another; that other person is called the beneficiary (B) – In an agency relationship, agent is the actor & principal is the beneficiary B gets two distinct challenges vs. A’s behavior (acts & omissions) – Authority: A did not have the right to do the particular act on B’s behalf – Fiduciary duty: A’s behavior had an improper purpose (wasn’t in B’s interest) – Why go beyond authority? – What’s the downside of FDs? A’s act lacks authority if A was not granted authority by either: – law – agreement between B&A – B’s unilateral approval A’s behavior breaches FD if it suffers from any of these flaws: – Negligence – Self-dealing – Bad faith © Amitai Aviram. All rights reserved. 4

Challenging an actor’s behavior Authority analysis framework Test for actual authority (in agency) [Rest. § 2.01/3.01] 1.Manifestations by P that are perceived by A 2.These manifestation cause A to reasonably believe that A is authorized to act in a certain way on behalf of P A can be granted authority (legal power to act on B’s behalf): – by law (for agents, use actual authority test, with the relevant law as P’s manifestation) – by agreement between B&A (for agents, use actual authority test, with the agreement as P’s manifestation) – by B’s unilateral approval (for agents, use approval test explained later in this section, applying the actual authority test for the “unambiguous” element) Rest. 2.02(1): A has actual authority for acts that are “necessary or incidental” to achieving the principal’s objectives – Practical tip: if you find there’s actual authority for act Z under Rest. 2.01, you can use Rest. 2.02(1) to expand actual authority to other acts that are “necessary or incidental” to act Z © Amitai Aviram. All rights reserved. 5

Challenging an actor’s behavior (Actual) authority vs. apparent authority Authority (of an actor) is the legal power of A to bind P – When A has actual authority, A has the right to bind P, so P is bound to T by A’s act, and also P cannot sue A for his act (even if P is unhappy about A’s act) – When A has only apparent authority (but not actual authority), A has the power, but not the right, to bind P: P is bound to T by A’s act, but P can sue A for acting without (actual authority) Regarding a specific act of A: 1.Manifestations by P that are perceived by A/T 2.These manifestation cause A/T to reasonably believe that A is authorized to act in a certain way on behalf of P Actual authority [P»A] [Rest. § 2.01] – E.g., dean tells professor to teach class Apparent authority [P»T] [Rest. § 2.03] – Why do we need apparent authority? (D id you hear the dean tell me I teach BA?) Actual authority is relevant for both internal & external governance; apparent authority is relevant only for external governance © Amitai Aviram. All rights reserved. 6

Challenging an actor’s behavior Governance solutions in agency law © Amitai Aviram. All rights reserved. 7 Bonding: Align a party’s welfare with the group’s collective welfare Morality/identity Performance-based compensation Joint ownership Intervention: Have government enforce appropriate behavior by whomever acts for the group Private ordering Public paternalism Private paternalism (FD) Voice: Allow a party unilaterally to express dissent in a manner that may affect the group’s behavior Approval Protest Exit: Allow a party unilaterally to end her association with the group without losing her share of the value produced by the group Termination Dissociation Alienation

Internal governance Overview of Chapter 3 a.Internal governance in agency 1.Challenging an actor’s behavior 2.Intervention: Fiduciary duty a)Agency SoR: Negligence b)Agency SoR: Self-dealing 1)Conflict of interest 2)Unauthorized benefit from fiduciary position 3.Voice: Approval 4.Exit: Termination b.Intervention solutions c.Voice solutions d.Exit solutions e.Customizing the firm © Amitai Aviram. All rights reserved. 8

Intervention: Fiduciary duty What is a fiduciary duty? FD is a duty that requires an actor to act in the interest of the beneficiary, beyond what is required of A by contract FD apply in a variety of contexts; in this course we cover FD owed by: – Agents (acting on behalf of B & subject to B’s control) – in this section – Organs (acting on behalf of B, but not subject to B’s control) – in section 2b – Controlling shareholders (Bs who control the firm’s organs) – in section 3a FD analysis framework 1.Flaws: identify potential flaws in A’s behavior 2.Duty: is A required to act in B’s interest? Agent owes principal a FD: “Agency is the fiduciary relationship…” (Rest. §1.01) So for an agent, establish duty by showing that A is an agent of P under Rest. §1.01 3.Standard of review (“SoR”): who decides whether A’s act was in B’s interest? For each flaw, determine appropriate SoR (for agents, always use agency SoR) 4.Application (of SoR to the potential flaws) 5.[Approval (if behavior by/attributable to B waived FD breach)] © Amitai Aviram. All rights reserved. 9

Intervention: Fiduciary duty Flaws in an actor’s behavior Negligence (breach of A’s duty of care (“DoC”)) – Action/inaction in which A doesn’t employ sufficient effort/care Self-dealing (breach of A’s duty of loyalty (“DoL”)) – Conflict of (self-)interest & duty (“CoI”) – Unauthorized benefit from fiduciary position Bad faith (breach of A’s DoL) – A acts disloyally/fails to act loyally (i.e., behavior against B’s interest), without evidence of self-dealing This is a category designed to give judges extra discretion to condemn A’s behavior even when there is no evidence of self-dealing The bad faith category does not exist in agency SoR (DoL breached only if there is self-dealing) This category exists for organs – will be discussed in Section 2b3 © Amitai Aviram. All rights reserved. 10 Relevant for agents

Intervention: Fiduciary duty Application (Agency SoR): Negligence Negligent act – Penny, owner of Penny’s Pizza, tells her agent Amos hire someone to deliver pizza to customers’ homes – Amos interviews the candidates & hires Dave, but does not do a background check and therefore doesn’t discover that Dave was fired from previous jobs for assaulting customers – Dave later assaults a customer Negligent inaction – Penny tells Amos hire someone to deliver pizza to customers’ homes – Amos forgets to hire someone; pizzas don’t get delivered Rest. 8.08: Test for A’s negligent behavior (act or inaction) – Did A act with care, competence & diligence normally exercised by agents in similar circumstances? – Special skills/knowledge A has/claims to have are considered in analysis © Amitai Aviram. All rights reserved. 11

Conflict of interest occurs when A faces a conflict between his self- interest & his duty to act in P’s interests, in matters connected with the agency relationship (Rest. 8.01, 8.03-8.04) – Conflicted actor transaction: Agent Ann hires her brother Tom to work for P – Usurping business opportunity: A is an employee of P’s auto repair business; T asks A to repair her car; A does this on his own (not for P) Unauthorized benefit from fiduciary position: A obtains an unauthorized benefit by use or by reason of his fiduciary position or of opportunity, knowledge or access to property resulting from it – Benefit by reason of fiduciary position (Rest. 8.02) – Using P’s property (Rest. 8.05(1)) – Using P’s confidential information (Rest. 8.05(2)) – Usurping P’s business opportunity (Rest. 8.04) – overlaps with CoI Intervention: Fiduciary duty Application (Agency SoR): Self-dealing © Amitai Aviram. All rights reserved. 12

Intervention: Fiduciary duty Self-dealing: overlap between the two prongs Conflict of interest Unauthorized benefit from fiduciary position E.g., Usurping business opportunities (Rash) CoI without proof of benefit Benefit without proof of CoI (e.g., Reading) © Amitai Aviram. All rights reserved. 13

Intervention: Fiduciary duty Conflict of interest: Rash [CA10, 2007] Facts – Rash hired to manage the Tulsa, OK division of JVIC’s oil refinery & power plant maintenance business – Rash owned TIPS (a scaffolding business); JVIC had its own scaffolding business – Rash often selected TIPS as subcontractor for JVIC-Tulsa’s contracts (paying over $1M between 2001-04) – Does Rash have a CoI? Did he have personal interest in his behavior that conflicts with JVIC’s interest? Did the CoI occur in a matter connected with the agency relationship? Is a conflicted actor transaction always bad? – Hypo: Ann is the CEO of Orange & Blue Taxi Corp, a taxi company. One of O&B’s cabs breaks down. – Ann’s brother Tom is a car mechanic. Is there an advantage to the company in having Tom fix the cab (rather than go to another mechanic)? © Amitai Aviram. All rights reserved. 14

Intervention: Fiduciary duty Conflict of interest: permissible CoI Agency law allows P to approve A’s conflicted behavior (Rest. §8.06) – Without approval, an agent’s self-dealing violates FD Approval – Rash claims that JVIC’s president, Joe Vardell, told him that “he had no problem with Rash forming a business which might contract with JVIC”. – Why does this defense fail? Fairness – Assume court finds that TIPS was the best & cheapest firm to do scaffolding jobs for JVIC-Tulsa. This is not a defense in agency law. Why? Discretion to determine P’s interest P’s control of A – When directors self-deal, but the deal is fair to B, they do not breach their FD. Why are directors treated differently from agents? SH apathy SH rivalry © Amitai Aviram. All rights reserved. 15

Intervention: Fiduciary duty Unauthorized benefit from fiduciary position Hypo: Angie works at Patty’s restaurant. Patty said Angie would be paid an hourly wage. Nothing was mentioned about tips. After serving a large & demanding group, she gives the bill to Tom, who pays for the group Tom pay the bill, then hands Angie a $50 bill and says “This is for you, not your boss. I know we were a fussy group, and you had the patience of a saint.” Does Angie have to give the $50 to Patty? Did A receive a benefit? Was the benefit unauthorized? Was the benefit derived in connection with A’s position/actions on behalf of P? © Amitai Aviram. All rights reserved. 16

Intervention: Fiduciary duty Unauthorized benefit from fiduciary position Reading [UK, 1948]: British soldier in Egypt escorted, while in uniform, a smuggler’s trucks through Cairo – Presence of a British soldier causes police not to inspect the trucks – Soldier receives £20,000 for the escort (roughly $1M in today’s $US) – UK government confiscates the money; Reading sues to get it back Did Reading breach his FD? – Unauthorized benefit from fiduciary position? Did A receive a benefit? Yes – £20,000 Was the benefit unauthorized? Yes – Reading did not ask for authorization Was benefit derived in connection with A’s position or actions on behalf of P? – Conflict of interest? Did A have personal interest in A’s behavior that conflicts with P’s interest? – UK had no interest in the “business opportunity” of smuggling; maybe a general interest that soldiers do not violate local (Egyptian) law? Did the CoI occur in a matter connected with the agency relationship? – Reading didn‘t act on behalf of the British government in dealing with the smugglers; probably a connection through use of his position as soldier © Amitai Aviram. All rights reserved. 17

Intervention: Fiduciary duty Unauthorized benefit from fiduciary position Reading: the disgorgement remedy – How was the Crown harmed by Reading’s acts? – Remedy imposed: disgorgement of the £20,000 (doesn’t reflect the harm to P) – Disgorgement is available as a remedy for self-dealing – Why do we have this remedy? Hypo – “Mark Owen” is the pseudonym of a soldier in the special forces unit that killed Osama Bin Laden – After retiring from the military, he wrote a book describing his experience in that operation – Does the U.S. Army have a right to the book royalties under agency law? Did A receive a benefit? Yes – book royalties Was the benefit unauthorized? Yes – no authorization sought Was benefit derived in connection with A’s position or actions on behalf of P? © Amitai Aviram. All rights reserved. 18

Intervention: Fiduciary duty Application (Agency SoR): Summary Negligence: FD breached if reasonable actor would have exercised more care/effort (Rest. 8.08) – Did A act with care, competence & diligence normally exercised by agents in similar circumstances? – Special skills/knowledge A has/claims to have are considered in analysis Self-dealing: FD breached if A has CoI or if A received an unauthorized benefit from the fiduciary position – Conflict of interest Did A have personal interest in A’s behavior that conflicts with P’s interest? Did the CoI occur in a matter connected with the agency relationship? – Unauthorized benefit from fiduciary position Did A receive a benefit? Was the benefit unauthorized? Was the benefit derived in connection with the agent’s position or actions on behalf of the principal? © Amitai Aviram. All rights reserved. 19

Internal governance Overview of Chapter 3 a.Internal governance in agency 1.Challenging an actor’s behavior 2.Intervention: Fiduciary duty 3.Voice: Approval 4.Exit: Termination b.Intervention solutions c.Voice solutions d.Exit solutions e.Customizing the firm © Amitai Aviram. All rights reserved. 20

Voice: Approval General principles of approval Approval is behavior by (or attributed to) B, that cures a legal flaw in A’s behavior – If approval takes place before A’s behavior, it is called prior consent – If approval takes place after A’s behavior, it is called ratification Revoking approval – Valid ratification can’t be revoked (i.e., once ratified, act can’t be un-ratified) – Prior consent can’t be revoked after the act takes place; whether it can be revoked before the act takes place depends on the agency agreement (by default, yes) Rights of “fourth parties” (parties other than P, A & T) – Prior consent doesn’t diminish rights of persons not parties to the transaction, as a general matter of contract law – Ratification doesn’t diminish pre-ratification rights of persons not parties to the transaction, under Rest. § 4.02(2)(c) E.g., A is P’s financial manager. Without actual/apparent authority, A gives T an option to purchase P’s Google shares for $50K. P then agrees to sell the shares to S for $40K. When T tells P he wants to exercise the option, P ratifies A’s agreement with T. S can enforce his contract to buy the shares for $40K (but P is also liable to T for damages for breach of contract, because he ratified) © Amitai Aviram. All rights reserved. 21

Voice: Approval Elements of approval © Amitai Aviram. All rights reserved. 22 1.Appropriate approver Identity (B or person w/authority to approve & no CoI) Attributability (A’s behavior is attributable to B) Capacity 2.Appropriate approval Unambiguous Informed Timely Appropriate scope Elements in blue must always be discussed; other elements should be discussed if fact pattern suggests they are an issue

Voice: Approval Appropriate approver (identity) Appropriate approvers are: – The beneficiary (person on whose behalf A acted or purported to act) – Person who has authority to approve on behalf of B & doesn’t have CoI with B regarding the behavior that is approved Authority to approve: may be assumed if person has authority to conduct on behalf of the beneficiary the same behavior that is subject to approval (unless specifically prohibited from approving or delegating that behavior) – Example 1: Suppose Amy’s unauthorized purchase of Blackacre was ratified not by Paul but by Alex (another agent of Paul). Alex is an appropriate approver if Paul authorized him to buy property at $210K (or to ratify such deals) – Example 2: if Paul authorized Alex to buy property at $210K, but specifically prohibited him from delegating the purchase to others, the authority to approve is not assumed (since if he approved Amy’s act it would amount to a delegation of his authority to Amy) No CoI with beneficiary – E.g., In example 1 above, if Alex gets a commission if the sale goes through but not if it doesn’t, he can’t approve the transaction – Rule means that approver (other than beneficiary) can’t approve his own acts © Amitai Aviram. All rights reserved. 23

Voice: Approval Appropriate approver (attributability & capacity) Actor’s behavior is attributable to beneficiary – A must have acted or purported to act on B’s behalf [Rest. 4.03] E.g., if Amy bought Blackacre for someone other than Paul (such as for herself), Paul can’t ratify – B must exist at the time of the act [Rest. 4.04] E.g., if Amy bought Blackacre for PaulCo, a corporation that she is about to form (but hasn’t yet formed), PaulCo isn’t bound by the deal (P couldn’t create manifestations of authority) & can’t ratify it (PaulCo didn’t exist when Amy signed deal to buy Blackacre) – No public policy reasons to prevent B from approving This limitation has significance for organs’ actions; will be addressed in Section 2b4 (Firms: internal governance – voice solutions) Approver must have legal capacity at time of approval [Rest. 4.04] © Amitai Aviram. All rights reserved. 24

Voice: Approval Appropriate approval (unambiguous) Rest. 4.01(2) – B approves an act by: – Manifesting assent that the act shall affect B’s legal relations; or – Conduct that justifies a reasonable assumption that B consents E.g., B knowingly accepts the benefits of A’s act, even if B manifests disagreement to accepting the act’s legal consequences Approval requires objective or externally observable indication that B consents to A’s act Related to ambiguity, Rest. 4.02(2)(b) makes ratification ineffective in favor of A if B ratifies to avoid a loss – So, if B ratifies to avoid a loss, B is liable to T, but A may be liable to B – E.g., A is B’s financial manager. A lends B’s money to T without actual/apparent authority. T becomes insolvent & B files a claim in T’s bankruptcy proceeding. Filing the claim doesn’t release A from liability for exceeding actual authority. – Not relevant for prior consent (if B gave prior consent, she wasn’t “trapped” into approving by the threat of a loss) © Amitai Aviram. All rights reserved. 25

Voice: Approval Appropriate approval (informed) Approval is valid only with “knowledge of [all] material facts involved in the original act” [Rest. 4.06, 8.06(1)(a)(ii)] – Unless B was aware of such lack of knowledge – Probably “all material facts” refers only to those facts A is aware of (since there are always some uncertainties that neither A nor B know of) – Material facts: Facts that a reasonable person would consider relevant to the decision whether to approve Related to this, Rest. 4.02(2)(a) says ratification is ineffective in favor of a person who causes it by misrepresentation or other conduct that would make a contract voidable (duress, undue influence) – E.g., A buys car for B from T without actual or apparent authority. T persuades B to ratify by falsely telling him car has a new engine. B not bound to T. © Amitai Aviram. All rights reserved. 26

Voice: Approval Appropriate approval (timely) Ratification ineffective if “circumstances that would cause the ratification to have adverse and inequitable effects on the rights of [T]” occurred [Rest. § 4.05] – T withdraws from the transaction B hires A to identify houses B might want to purchase. A sees that T is asking for a very low price for his house, so she buys the house from T on B’s behalf with no actual or apparent authority. T learns there was no authority & notifies B he withdraws from the transaction. B then ratifies. Ratification is ineffective. – Material change of circumstances that makes it inequitable to bind T E.g., A sells B’s house without actual or apparent authority. B’s house then burns down. B cannot ratify the sale. – Ratification after rights have crystallized (ratification timed so that T is deprived of a right or subjected to liability) E.g., T gives B an option to buy stock, which expires on May 3 rd. Without actual or apparent authority, A purports to exercise the option on B’s behalf on May 2 nd. B ratifies on May 4 th. T is not bound by the ratification. Prior consent is always timely © Amitai Aviram. All rights reserved. 27

Voice: Approval Appropriate approval (appropriate scope) Ratification (but not prior consent) must encompass “the entirety of an act, contract or other single transaction” [Rest. § 4.07] Approval of self-dealing (ratification/prior consent) must address a specific act/transaction or acts/transactions of a specified type that could reasonably be expected to occur in the ordinary course of the agency [Rest. 8.06(1)(b)] Approval of authority cannot exceed the authority the approver has © Amitai Aviram. All rights reserved. 28

Internal governance Overview of Chapter 3 a.Internal governance in agency 1.Challenging an actor’s behavior 2.Intervention: Fiduciary duty 3.Voice: Approval 4.Exit: Termination b.Intervention solutions c.Voice solutions d.Exit solutions e.Customizing the firm © Amitai Aviram. All rights reserved. 29

Exit: Termination Causes of termination [Rest. § 3.06] Terminating actual authority – Agreement between P & A – Law (“the occurrence of circumstances specified by statute”) – Changed circumstances (“the occurrence of circumstances on the basis of which [A] should reasonably conclude that [P] no longer would assent to [A’s] taking action on [P’s] behalf.”) – A’s or P’s death/cessation of existence/suspension of powers – P’s loss of capacity – P’s and A’s power to terminate © Amitai Aviram. All rights reserved. 30

Exit: Termination Death [Rest. 3.07] A’s death/cessation of existence/suspension of powers → Terminates actual authority P’s death/cessation of existence/suspension of powers → Terminates actual authority: – Immediately (except as provided by law) – if P is not an individual – Only when A has notice of P’s death – if P is an individual – Termination effective vs. T if T has notice of P’s death (even if A doesn’t know) © Amitai Aviram. All rights reserved. 31

Exit: Termination P’s loss of capacity [Rest. 3.08] P’s loss of capacity terminates actual authority: – Immediately – if P is not an individual – Only when A has notice of P’s permanent/adjudicated loss of capacity – if P is an individual – Termination effective vs. T if T has notice of P’s permanent/adjudicated loss of capacity (even if A doesn’t know) P can agree in writing that actual authority will become effective upon P’s loss of capacity, or not be revoked by loss of capacity – Why allow this exception with loss of capacity? © Amitai Aviram. All rights reserved. 32

Exit: Termination Power to terminate [Rest. 3.10] Regardless of any agreement between P&A, actual authority is terminated if: – A renounces authority by manifestation to P; or – P revokes authority by manifestation to A Authority is terminated when the other party has notice If an agreement between P&A does not allow termination of the agency (or specifies a term beyond the time the agency was terminated), the agency is still terminated, but the terminating party might be liable for breach of contract © Amitai Aviram. All rights reserved. 33

Exit: Termination Terminating apparent authority [Rest. 3.11] Termination of actual authority does not end any apparent authority held by the agent – Why is there a separate rule for terminating apparent authority? Apparent authority ends when it is no longer reasonable for T to believe that the agent continues to act with actual authority Hypo: Supermarket tells one of its cashiers that she’s fired – Is actual authority terminated? – How can it terminate the cashier’s apparent authority? © Amitai Aviram. All rights reserved. 34

Exit: Termination Terminating apparent authority Now, supermarket fires a manager responsible for purchases of produce – If the manager now orders another shipment of produce on the supermarket’s behalf, must the supermarket pay? – How can it terminate the manager’s apparent authority? © Amitai Aviram. All rights reserved. 35

Agent’s duties to P Summary of the analysis frameworks First, confirm you’re using the right frameworks – Identify the “players” (use framework only if beneficiary is suing actor) – Identify the challenged act(s) – Identify scope of challenge (authority, FD, or both) Authority (Rest. 8.07, 8.09) – Does A have (actual) authority? [Granted by law, agreement or approval] Fiduciary duty a)Flaws (identify potential flaws in A’s act) b)Duty (for agents: is A an agent of B?) c)SoR (for agents: agency SoR) d)Application (of SoR to potential legal flaws in A’s act) Negligence (Rest. 8.08) Self-dealing: CoI/benefit from fiduciary position (Rest. 8.01-8.05) e)[Approval (if relevant to the facts)] Appropriate approver (identity, attributability, capacity) Appropriate approval (unambiguous, informed, timely, appropriate scope) © Amitai Aviram. All rights reserved. 36

P’s duties to A Contractual duties P’s duties to A are contractual in nature (Rest. 8.13, 8.14(1)) In addition to express terms of the agreement between P & A, P is liable to A for: – Implied terms (Rest. 8.13) – Breach of duty to deal in good faith (Rest. 8.15) – Default terms re indemnification (Rest. 8.14(2)) Implied terms – Terms that a reasonable person would infer from the express language of the agreement © Amitai Aviram. All rights reserved. 37

P’s duties to A Duty of good faith & fair dealing Duty to deal fairly and in good faith (Rest. 8.15) – Protects agreed common purpose & A’s justified expectations Common application (1): frustrating A’s justified expectations – P must avoid unreasonable conduct that harms A, when: Contract lacks specific language governing the issue; and Conduct frustrates purposes reflected in contract’s express language – E.g., Prof agrees with RA that he will get an extra $100 if he shows up at prof’s office at 8am. Prof later changes mind, locks office doors so RA can’t enter office at 8am. Common application (2): duty to warn – P breaches duty if P fails to provide A with info about unreasonable risks involved in the agency, if risk is foreseeable to P & A is unlikely to become aware of risk on his own – Risks include physical harm, pecuniary loss, and possibly also harm to business reputation & reasonable self-respect E.g., P sends A to sign up investors for an investment that P knows (but A doesn’t know) is a Ponzi scheme. When A is implicated in the Ponzi scheme, his business reputation is tarnished and he cannot get another job. P may be liable to A for the harm suffered by A. © Amitai Aviram. All rights reserved. 38

P’s duties to A Duty to indemnify Indemnifying agents – default rule (Rest. 8.14(2)) – When the agent makes a payment within the scope of the agent's actual authority, or that is beneficial to the principal, unless the agent acts officiously in making the payment – Officious (“voluntary”) payments are ones in which the agent has a reasonable opportunity to receive P’s authorization, but makes a payment without seeking authorization – When the agent suffers a loss that fairly should be borne by the principal in light of their relationship While this is vague, a duty to indemnify typically arises when A’s loss is: – In connection with the agency relationship; and – Not a result of A's own negligence, illegal acts, or other wrongful conduct © Amitai Aviram. All rights reserved. 39

P’s duties to A Review: epilogue to “No good deed…” The buyer of Ann’s book turned out to be Tom. When Tom received the book, he noticed that it’s the exact same copy he saw at SPL (he did not know that the seller was the volunteer he spoke with at the sale). He went to Patrick to inquire how the book ended up sold online, and only then realized that Ann was the person who priced the book (at what seemed to be) prohibitively high, then took the book for herself. Outraged, he told Patrick that he was going to go to Ann’s home and shoot her. Patrick tried to discourage Tom from doing so, but Tom stormed out of the library. Two days later, Tom rang the doorbell at Ann’s home. When she opened the door, Tom shot Ann and ran away. Fortunately, Ann only suffered a minor injury from the shot, but medical expenses amounted to $5,000. SPL sued Ann for her pricing and purchase of the book. Ann counter-claimed against SPL for $5,000 in medical expenses. Discuss Ann’s counter-claim. © Amitai Aviram. All rights reserved. 40

Internal governance Overview of Chapter 3 a.Internal governance in agency b.Intervention solutions – Flaws & duty – SoR – Application – Entire fairness – Application – BJR – Aiding & abetting FD breach – FD in private firms c.Voice solutions d.Exit solutions e.Customizing the firm © Amitai Aviram. All rights reserved. 41

Intervention solutions Fiduciary duty framework 1.Flaws (identify potential flaws in A’s behavior) 2.Duty (is A required to act in B’s interest?) 3.Standard of review (who decides whether A’s act was in B’s interest?) – For each flaw, determine the appropriate SoR For agents: always agency SoR For organs: BJR (default), entire fairness (self-dealing) or enhanced scrutiny 4.Application of SoR to each potential flaw 5.[Approval (if behavior of/attributable to B consents to FD breach)] © Amitai Aviram. All rights reserved. 42 Types of legal flaws NegligenceSelf-dealingBad faith Negligent act Negligent inaction CoI Unauthorized benefit Illegality Corporate waste Disregard of duty Failure to disclose

Intervention solutions Overview: how organ & agent analyses differ An organ operates in an environment in which Bs are assumed to be unable to effectively govern collectively Therefore, B has a smaller role in policing A, and judicial discretion is expanded to compensate for that – Approval by SHs is more limited than approval by P (out of concern that the organ would manipulate B to get legal cover) – Standards for proving FD breach for organs allow more judicial discretion Higher standard for negligence (gross negligence, not ordinary negligence) Higher standard in self-dealing: fairness, not automatic breach Default SoR for organs (BJR) defers to A’s discretion more than agency SoR When self-dealing is a concern, other SoRs apply (enhanced scrutiny & entire fairness), which shift discretion to the judge 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) – Again, this increases judicial discretion to compensate for the smaller role of B in policing A © Amitai Aviram. All rights reserved. 43

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 B’s welfare or A’s 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 – When failure to disclose is entirely merged in another flaw (i.e., only impact of failure to disclose is facilitating the other flaw), analyze only the other flaw E.g., A hires A’s spouse to work for B, without disclosing the CoI to B: analyze this only as self-dealing, not a second time as failure to disclose Intervention solutions Flaws: bad faith (actions/inactions) © Amitai Aviram. All rights reserved. 45

Intervention solutions 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 – There are conflicting authorities as to whether officers are agents or organs – For this course, treat officers as agents Agents – Agents owe a FD to the principal 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 M&A; for BA, treat SHs as never owing a FD © Amitai Aviram. All rights reserved. 46

SoR Who decides whether A’s act was in B’s interest? Agency SoR: emphasis on beneficiary’s discretion – FD breach unless B approves A’s 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) – Agency SoR applies to all agent behavior (acts/inactions) – Drawback of relying on B’s discretion? BJR SoR: emphasis on actor’s discretion – No FD breach unless A fails to use discretion (no decision/arbitrary decision) or acts in bad faith (i.e., knows she’s acting unfairly to B) – Drawback of relying on A’s discretion? – BJR is the default SoR for organ behavior (acts/inactions) Entire fairness SoR: emphasis on judicial discretion – Entire fairness SoR applies when an organ is self-dealing (also applies when controller is self-dealing, but this isn’t part of the material for this course) – Breach if court thinks action was unfair to B – Drawback of relying on judicial discretion? © Amitai Aviram. All rights reserved. 48

SoR When does entire fairness apply? Entire fairness SoR applies if A was self-dealing – I.e., A is conflicted with respect to the challenged behavior or received an unauthorized benefit from the fiduciary position (latter is typically an inaction anyway) A collective actor (e.g., BoD, BoD committee) has CoI if 50% or more of its members have CoI – Example: BoD, composed of 4 directors, votes 4-0 to hire Ann If 1 director has CoI & 3 don’t, decision benefits from BJR If 2 directors have CoI & 2 don’t, BJR is rebutted A (an actor or member of a collective actor) is conflicted if: – A has a personal interest in A’s behavior that conflicted with B’s interest, and the conflict occurs in a matter connected with the fiduciary relationship – Another member of the collective actor who is conflicted fails to disclose their interest to A despite a duty to do so (the duty exists if the interest is material; i.e., a reasonable A would regard the undisclosed interest as significant to deciding on the act) – Someone with a CoI controls or dominates A Test for control/domination in Beam v. Stewart: is the non-interested director would be more willing to risk his or her reputation than risk the relationship with the conflicted director? © Amitai Aviram. All rights reserved. 49

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 MSO’s BoD to sue Beam (“make a demand on the board”), unless Beam can show reasonable doubt that a majority of MSO’s 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 doesn’t look at a BoD decision, it “simulates” whether it would have deferred to a BoD decision not to sue Stewart – If court wouldn’t have deferred, then it’s OK for beam not to have asked BoD to sue © Amitai Aviram. All rights reserved. 50

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? Test for control/domination: “To create a reasonable doubt as to an outside director’s 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. 51

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. 52

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 Stewart’s 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. 53

SoR Conflict of interest: Beam Seligman Evidence of lack of independence? – Seligman, while a director for JWS (a publisher), contacted JWS’s 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 doesn’t create reasonable doubt about independence. Seligman’s behavior may demonstrate loyalty to MSO & JWS Outcome in Beam v. Stewart – Stewart, Patrick, Martinez, Moore, Seligman, Ubben – 4 of 6 directors were independent © Amitai Aviram. All rights reserved. 54

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 CCA’s 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 CCA’s management Following Frank’s 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 didn’t 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 Edgar 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. 56

Application - Entire fairness The fairness test General test: was the challenged behavior in B’s interest (i.e., wealth- maximizing for the SHs)? Detailed fairness test for acts – Was undertaking the act (e.g. hiring CEO’s spouse) in the firm’s interest? – Were the terms of act (e.g., employment contract) similar to what firm would have received in an arm’s length transaction? Fair process (for determining price/other terms) – indirect assessment Fair price (valuation/comparison) – direct assessment of the terms – In re Nine Systems Corp. (Del.Ch. 2014): if process is grossly unfair, decision is unfair even if the price is fair (possible remedy: shifting attorney’s fees & costs) Detailed fairness test for usurpation of business opportunities (Guth v. Loft test: no single factor is dispositive; court balances all factors) Was B financially able to take the opportunity? Was the opportunity is in B’s line of business? Did B have an interest or expectancy in the opportunity? By embracing the opportunity, would A create a conflict between his/her self- interest and that of B? Conduct the fairness test for the hypo in the previous slide © Amitai Aviram. All rights reserved. 57

Application - BJR Overview of the BJR SoR BJR is a rebuttable presumption that A’s behavior was in B’s interest; when BJR doesn’t apply, it is said that “BJR was rebutted” – Rebutting the presumption doesn’t always mean FD was breached When BJR is the applicable SoR, application of the SoR takes 2 steps: – Does court defer to A’s discretion? – Applying judicial discretion, did A’s behavior breach FD? Step 1 (BJR rebutted?): Court defers to A (no FD breach), unless – – A didn’t make a business judgment (inaction or negligent act) – A didn’t 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. 59

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 time constraints & the importance of the challenged act to B – Did actor acquire necessary expertise & information? Reliance on actor’s own knowledge/expertise Reliance on advisors (DGCL §141(e)) – Expertise – Independence – No abdication of decision © Amitai Aviram. All rights reserved. 60

SH sues BoD for approving the sale of the corporation for $55/share Flaws: negligence (no illegality, corporate waste or self-dealing) Duty: yes, defendants owe FD as directors SoR: CEO may have CoI, but other directors don’t, so no self-dealing (BJR applies) Application (flaw: negligence) – Necessary expertise & information (very important decision; no time constraint) 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 actor’s own knowledge/expertise Reliance on advisors (Romans/Van Gorkom) – Expertise? (Romans did not do a valuation; Van Gorkom has law degree) – Independence? (Van Gorkom 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. 61

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 director’s 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 doesn’t breach DoC) © Amitai Aviram. All rights reserved. 62

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 A’s self-interest © Amitai Aviram. All rights reserved. 63

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 FMC’s BoD (Ford) & some of FMC’s 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, doesn’t BJR require it to defer to BoD? © Amitai Aviram. All rights reserved. 64

Application - BJR Dodge: Ford’s 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 don’t seem to be able to keep the profits down. [One more slide…] © Amitai Aviram. All rights reserved. 66

Application - BJR Dodge: Ford’s 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. 67

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 FMC’s 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. 68

Application - BJR Dodge: What is really going on? Now Ford’s position looks odd – Why doesn’t Ford tell the court these justifications? And now the Dodge brothers’ position looks odd. If Ford’s 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 A’s 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 Ford’s other plans) by borrowing money © Amitai Aviram. All rights reserved. 69

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 actor’s decision-making or oversight functions, unless disclosure violates a superior duty (imposed by law, confidentiality agreement, ethics rule, etc.) When info isn’t 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. 70

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 gov’t when they suspected a transaction involved funds derived from an illegal Ponzy scheme – Bank pays $50M to gov’t to settle charges No evidence that BoD had notice of employees’ illegal acts – If BoD knew employees were violating the law, what’s 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. 71

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 doesn’t prove lack of a system or insufficient monitoring © Amitai Aviram. All rights reserved. 72

Intervention solutions Summary of FD analysis FD analysis: SoR & Application stages Neg. actNeg. inactionBad faith actBad faith inactionSelf-dealing SoR BJR 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. 73 FD analysis: types of legal flaws NegligenceSelf-dealingBad faith Negligent act Neg. inaction Conflict of interest Unauthorized benefit Illegality Corporate waste Disregard of duty Failure to disclose

Aiding & abetting FD breach FD & third parties Third party as plaintiff? – T can’t sue A (or B) for breach of FD, since FD is owed to B, not to T Rest. §7.02: A’s breach of duty to P does not make A liable to T – Exception: public benefit corporation laws in some states allow “benefit enforcement proceedings” against directors & officers (the equivalent of SH challenges to corporate actions) to be brought by SHs, directors, 10%+ SHs in the parent firm of the benefit company, and any other persons specified in the PBC’s charter or bylaws Third party as defendant? – FD is owed by A, not by T, so P has no claim against T for breach of FD – P has a claim against T for aiding & abetting a breach of FD if P can prove: 1.Existence of a fiduciary relationship (duty stage in our FD analysis framework); 2.Breach of the fiduciary's duty (SoR & application stages in our framework); 3.Knowing participation in that breach by T; and 4.Damages proximately caused by the breach – Elements 1&2 use our FD analysis framework; we now discuss element 3: knowing participation © Amitai Aviram. All rights reserved. 75

Aiding & abetting FD breach Morgan v. Cash [Del. Ch. 2010] Corp can have multiple classes of stock w/different rights – E.g.: Acme has 1,000 common shares & 1,000 preferred shares that each have a $1,000 liquidation preference and participate in any remaining liquidation value). Acme dissolves. – How much will each SH get if Acme’s assets are worth: $500K? $5M? Voyence has common & preferred shares – Voyence agrees to be acquired by EMC for an amount that is below the liquidation preference (i.e., common SHs get nothing) – 4 of 5 directors represent preferred SHs; 5 th director (CEO Nash) is married to a partner in a firm that owns preferred shares SH (and employee) Mary Morgan sues – – BoD for accepting this offer (claiming BoD should have held out for a better offer that gave common SHs some consideration) – EMC for aiding & abetting BoD’s breach EMC moves to dismiss for failure to state a claim © Amitai Aviram. All rights reserved. 76

Aiding & abetting FD breach Morgan v. Cash Knowing participation: Malpiede v. Townson [Del. 2001] – T's acquisition of favorable terms through arm's-length negotiations is not knowing participation – T knowingly participates if T attempts to create or exploit conflicts of interest in A, or where T and A conspire in or agree to the FD breach – Conflicting authorities as to whether T can knowingly participate in a breach of DoC (i.e., when A doesn’t intentionally breach FD) Morgan’s arguments: 1.EMC's offer of employment to Nash & Fortenberry induced them to support EMC's lowered offer price EMC has legitimate incentive to retain Voyence’s management to maintain Voyence’s value Offers were similar to what N&F were already receiving No evidence N&F influenced BoD decision to accept offer (BoD asked N&F to leave room during their deliberations) Susan Nash (CEO) Donald Fortenberry (CFO) © Amitai Aviram. All rights reserved. 77

Aiding & abetting FD breach Morgan v. Cash Morgan’s arguments: 2.EMC knew Voyence directors were designees of preferred SHs & exploited CoI between directors & common SHs Court: To knowingly participate, third party needs to either – – Buy off BoD in a side deal (no evidence EMC conspired w/BoD) – Actively exploit BoD conflicts to detriment of SHs (no conflict here, since pref SHs would have wanted higher offer) » Safe harbor: tough negotiating in arm’s length bargaining isn’t aiding & abetting (not relevant here, since there’s no conflict) H. Berry Cash (director)Dennis Gorman (BoD chairman)Skip Glass (director)Terry Rock (director)Susan Nash (director) © Amitai Aviram. All rights reserved. 78

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 didn’t receive a salary) Wilkes sues, alleging RQC breached FD as SHs – Are RQC diverting the firm’s 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 partners share control & control rights can’t be taken away from them – No such protection to SHs in a corporation © Amitai Aviram. All rights reserved. 80

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 controller’s 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 business 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 © Amitai Aviram. All rights reserved. 81

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]: Doctor’s 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. 82

FD in private firms Delaware law 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) Is Delaware that different? – Under Delaware law, controllers owe MSHs a FD when exercising control (in any corporation, not just close corporations) [discussed in the M&A course] – In a case like Wilkes, if Wilkes could demonstrate that controlling SHs had a CoI in firing him (get a higher share of the profits because their salaries are really dividends), then firing Wilkes would be reviewed under entire fairness (perhaps similar to Wilkes’ review of business objective) – However, members of Delaware LLCs may waive FD entirely. By default (if nothing is said in the LLC constitutional documents), parties do owe FD © Amitai Aviram. All rights reserved. 83

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 beneficiary’s discretion – Approval is more restricted for organ acts than for agent acts. Why? Elements (same as agency, except elements in blue, explained in following slides) 1.Appropriate approver – Identity – Attributability – Capacity 2.Appropriate approval – Unambiguous – Informed – Timely – Appropriate scope Approval Elements © Amitai Aviram. All rights reserved. 85

In the context of an organ’s behavior, appropriate approvers are: – The beneficiary Firm is beneficiary, but can’t 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 can’t approve its own acts & can’t approve acts regarding to which BoD has CoI (e.g., no approval of controlling SH’s behavior) SH meeting – SH meeting can cure directors’/officers’ self-dealing by approval (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 SH’s 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 don’t require a SH vote to become legally effective [Gantler v. Stephens (Del. 2009)] Approval Appropriate approver (identity) © Amitai Aviram. All rights reserved. 86

Approval Appropriate approver (attributability) Same as agency, except for public policy reasons preventing B from approving: – Void acts (can’t 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. 87

Implied approval is interpreted from the approver’s 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 (unambiguous) © Amitai Aviram. All rights reserved. 88

Approval Appropriate approval (unambiguous) 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 BoD’s plenary powers (DGCL §141(a)) Follows the normal process for BoD acts (written consent or call/quorum/vote) Hypo – Hypo: Acme’s board consists of A, B, C, D & E. They vote to ratify a contract between Acme & A’s husband (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. 89

Internal governance Overview of Chapter 3 a.Internal governance in agency b.Intervention solutions c.Voice solutions d.Exit solutions – Alienability – Dissociation – Termination (dissolution) e.Customizing the firm © Amitai Aviram. All rights reserved. 90

Exit solutions Types of exit solutions Exit solutions allow B unilaterally to leave the firm & receive her share of the firm’s value – Alienability: allow B unilaterally (without requiring consent of firm/other Bs) to sell interest in the firm to third parties Allows for the firm’s longevity & maintains firm’s 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 interest’s fair price) Allows for the firm’s longevity, maintains firm’s 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 firm’s longevity & may lose firm’s 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. 91

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 can’t 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 can’t 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. 92

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. 93

Internal governance Overview of Chapter 3 a.Internal governance in agency b.Intervention solutions c.Voice solutions d.Exit solutions – Alienability – Dissociation Dissociation Buyout agreements Relationship between dissociation & buyout agreements – Termination (dissolution) e.Customizing the firm © Amitai Aviram. All rights reserved. 94

Dissociation Dissociation in corporations & partnerships Dissociation allows B to unilaterally sell interest in the firm back to the firm/other Bs (at the interest’s fair price) By default, corporations have “capital lock-in” (no dissociation) – But a corporation can issue shares that are redeemable at the SH’s 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. 95

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. 96

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. 97

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 firm’s liquidity (can be used opportunistically) – Life insurance One of the most commonly implemented exit arrangements in close corporations is triggered upon a SH’s death. Why? Life insurance both helps with financing the buyout, and avoids arguments over valuation (since it’s clear the deceased SH’s estate would sell the shares, it would push for high valuation) © Amitai Aviram. All rights reserved. 98

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. 99

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) – Acme’s 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. 100

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 A’s shares at that price – Assume that both banks have no financial constraints Would Bank A decide on price that’s higher or lower than Acme’s 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 that’s higher or lower than the perceived value of Acme? © Amitai Aviram. All rights reserved. 101

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. 102

Relationship between dissociation & buyout Haley v. Talcott Talcott owns Delaware Seafood (aka Redfin Seafood Grill), a restaurant operated by Haley Haley’s employment contract gives him a “bonus” of 50% of the restaurant’s profits, after the loan from Talcott was repaid – Why pay Talcott’s 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. 103

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 Haley’s resignation & forbidding Haley from entering the premises of the Redfin Grill – What right does Talcott have if Haley resigns? © Amitai Aviram. All rights reserved. 104

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 member’s 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 Talcott’s letter? What’s Delaware law’s general attitude regarding judicial dissolution when a contractual exit mechanism exists? – How does it rule in this case? © Amitai Aviram. All rights reserved. 105

Internal governance Overview of Chapter 3 a.Internal governance in agency b.Intervention solutions c.Voice solutions d.Exit solutions – Alienability – Dissociation – Termination (dissolution) Forced dissolution Statutory dissolution Process of dissolution e.Customizing the firm © Amitai Aviram. All rights reserved. 106

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/gov’t 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. 107

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 What’s 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. 108

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. 109

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 partnership’s 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. 110

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. 111

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)] – Partner’s suit: Economic purpose frustrated; not reasonably practicable to carry on the partnership business – Transferee’s suit: if equitable and possible under the terms of the partnership agreement © Amitai Aviram. All rights reserved. 112

Forced dissolution RUPA vs. UPA Hypo: Anita is a partner in a law firm – Partnership agreement silent regarding partnership’s 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 partner’s ability to dissolve different in RUPA than UPA? © Amitai Aviram. All rights reserved. 113

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. 114

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 doesn’t 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 MSH’s 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. 115 Statutory dissolution Meiselman v. Meiselman [NC 1983]

Statutory dissolution Stuparich [Cal. App. 2000] Siblings Malcolm Jr., Candi & Ann owned equal amounts of HFM’s 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 didn’t – Candi & Ann wanted to separate the two parts of the business; Malcolm didn’t After their mother’s 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. 116

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 didn’t work at HFM grounds for dissolution? – Disagreement about HFM’s 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. 117

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. 118

Process of dissolution Terminology Winding-up – Liquidating the partnership’s assets/business – Settling the partnership’s 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. 119

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. 120

Process of dissolution Capital account Capital account: A running balance reflecting each partner’s 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 April’s share of the loss was $1,000) – In 2 nd year firm made a $9,000 profit (April’s share of that was $3,000) – At end of 2 nd year, the partners made a draw of $4,500 (April received $1,500) – April’s capital account at end of 2 nd year is: 5,000 - 1,000 + 3,000 – 1,500 = $5,500 © Amitai Aviram. All rights reserved. 121

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 firm’s value will be lost because - Dissolution forces to sell now, which weakens the seller’s bargaining position Outsiders aren’t 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 can’t agree how to share it © Amitai Aviram. All rights reserved. 122

Internal governance Overview of Chapter 3 a.Internal governance in agency b.Intervention solutions c.Voice solutions d.Exit solutions e.Customizing the firm – Customizing via SH agreements – Customizing via constitutional documents © Amitai Aviram. All rights reserved. 123

Customizing the firm Customizing in public & private firms Rules governing a firm can be derived from the law or from contracts created by the stakeholders Public firms derive more rules from laws and fewer from contracts compared to private firms – More mandatory laws (that contracts cannot modify) – Opting out of defaults is done by manipulating the firm’s institutions (e.g., rights attached to shares, or to firm offices) rather than manipulating individual SHs’ rights Example: X wants double the voting rights of other SHs Private firm (e.g., partnership): partnership agreement provides that X has double voting rights Public firm: charter creates Class B shares with double voting rights as Class A shares; X receives Class B shares © Amitai Aviram. All rights reserved. 124

Customizing via SH agreements Why is agreement enforcement a major issue? SHs in a close corporation sign a SH agreement obligating them to vote in favor of a specified slate of directors – Directors favor expanding into the widget market Some SHs renege on the agreement; vote for directors who refuse to expand into widgets – As a result, Acme does not expand into widgets Other SHs sue for breach of the agreement – What are the damages? How easy is it to prove them? – How can you make the agreement easier to enforce? © Amitai Aviram. All rights reserved. 125

Customizing via SH agreements 1. Voting trust Title of shares transferred to a trust Agreement forming the trust gives trustee power to vote the shares Disadvantages? Statutory restrictions – Publicity: some states require the voting trust to be made public (e.g., DGCL §218), or to submit to the firm information on participating SHs (e.g., MBCA §7.30), which makes this info accessible to MSHs through SH inspection rights – Duration: some states limit the duration of voting trusts (MBCA used to have a 10-year limit, but no longer does) © Amitai Aviram. All rights reserved. 126

Customizing via SH agreements 2. Contractual enforcement a)Specific performance – DGCL §218(c) allows voting agreements, implicitly allows a remedy of specific performance – MBCA §7.31(b) states that voting agreements are specifically enforceable – Court may refuse to enforce due to oppression / violation of other SHs’ rights b)Irrevocable Proxies – Proxies usually revocable; can be made irrevocable if attached to an interest [MBCA §7.22(d)] – Being a party to a voting agreement is considered an interest [MBCA §7.22(d)(5)] – So, the proxy tends to be an enforcement mechanism that is ancillary to a voting agreement c)Is the SH agreement valid? – If it constrains discretion that isn’t subject to FDs (e.g., appointing directors) Voting agreements generally permissible [DGCL §218(c); MBCA §7.31] – If it constrains discretion that is subject to FDs (e.g., appointing officers) Does it impermissibly constrain BoD’s discretion? [McQuade/Clark] © Amitai Aviram. All rights reserved. 127

Customizing via SH agreements McQuade v. Stoneham [NY 1934] Stoneham owned a majority of the stock of the NY Giants McGraw (the Giants’ manager) & McQuade (a city magistrate) bought a small amount of stock from Stoneham The three signed a SH agreement – Agreed to do their best to elect each other as directors & appoint each other officers at specified salaries McQuade lost Stoneham’s favor & was fired – McQuade sues for specific performance Court: – BoD must exercise independent business judgment on behalf of all SHs – If directors agree in advance to constrain BoD’s judgment, SH will not receive the benefits of their independence – Therefore, agreement is void as against public policy Protection in the SH agreement didn’t save McQuade – How can he protect himself from being fired? © Amitai Aviram. All rights reserved. 128

Customizing via SH agreements McQuade v. Stoneham McQuade seems to offer a bright line rule ValidVoid But the rule is not so bright Constrain SH judgment Constrain director/officer judgment © Amitai Aviram. All rights reserved. 129

Customizing via SH agreements Clark v. Dodge [NY 1936] Clark knows a valuable secret formula. Dodge contributes money. They form two drug companies. Clark and Dodge sign an agreement: – Clark agrees to disclose his secret formula – Dodge agrees to invest the required money – Clark receives 25% of profits (salary & dividends) – Dodge would vote, both as SH & director, to assure that Clark would be a director & General Manager as long as his performance was faithful, efficient and competent – Why does Clark need the agreement? Why does Dodge? Clark discloses secret formula. Dodge eventually fires Clark. – Clark sues. Dodge claims SH agreement is void. – Apply the reasoning in McQuade to this case © Amitai Aviram. All rights reserved. 130

Customizing via SH agreements Clark v. Dodge Clark court: MSHs aren’t harmed by a commitment to keep someone as an officer “as long as he is faithful, efficient and competent” – I.e., SH agreements are valid if SH merely agree to do as directors what they could do validly anyway This contradicts the holding in McQuade – Also, SHs may be harmed by an obligation not to fire without cause (e.g., downsizing; better/cheaper candidate) Clark court: McQuade was designed to protect MSHs who were not parties to the agreement – In Clark, all SHs are parties to the SH agreement Clark creates an exception to McQuade when all SHs are parties to the SH agreement How can Dodge avoid the SH agreement (reach McQuade outcome)? © Amitai Aviram. All rights reserved. 131

Customizing via SH agreements “Homemade McQuade” Preempting the “Homemade McQuade” – The company can prevent a “Homemade McQuade” by creating constructive knowledge of the agreement – including the agreement in the charter or printing a reference to the agreement on all stock certificates Another obstacle for Homemade McQuades – Galler v. Galler – In Galler, the court held that a SH agreement is valid even if not all SHs are parties to it, if: The corporation is closely-held The terms are reasonable (i.e., MSH should not object) The MSH does not object © Amitai Aviram. All rights reserved. 133

Customizing via SH agreements Caselaw summary McQuade: SH can commit to how they vote as SH, but cannot constrain their judgment (or others on their behalf) as directors Clark: SHs can constrain their judgment as directors, if all SH are parties to the SH agreement Galler: SHs can constrain their judgment as directors even when some SHs aren’t parties to SH agreement, if terms of agreement are reasonable and fair to those SHs (& those SHs don’t complain) © Amitai Aviram. All rights reserved. 134

Customizing via constitutional docs Limits on bylaws Boilermakers Local 154 Retirement Fund v. Chevron Corp. [Del.Ch. 2013] – Chevron & FedEx BoDs amend bylaws to add a “forum selection bylaw”, which requires that derivative suits, fiduciary duty suits, DGCL suits and internal affairs suits involving the company will be adjudicated in Delaware courts. – The bylaw addresses venue (which court) not applicable law. What law would apply to fiduciary duty suits, internal affairs suits, etc. & why? Plaintiff SHs sue to invalidate the bylaws, claiming: – Bylaw does not have valid subject matter – Bylaw is not binding on SHs because BoD, not SHs, amended the bylaw – Bylaw should be invalidated because there are many circumstances in which it can be abused © Amitai Aviram. All rights reserved. 135

Customizing via constitutional docs Limits on bylaws Valid subject matter – DGCL 109(a): bylaws may address any subject “not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees.” 1.Bylaws are subordinate to the law & charter So, anything that the law says should be in the charter (e.g., number of authorized shares, rights of shares) is not valid bylaw subject matter 2.Valid subject matter includes Business/affairs of firm Rights/powers of firm, SHs, directors, officers & employees 3.Bylaws dictate process, not substantive decisions Court: “[B]ylaws typically do not contain substantive mandates, but direct how the corporation, the board, and its stockholders may take certain actions.” © Amitai Aviram. All rights reserved. 136

Customizing via constitutional docs Limits on bylaws Effect of BoD-adopted bylaws – By law, SHs have the right to amend bylaws; BoD may amend bylaws only if the firm’s charter allows it – The charters of Chevron and FedEx allowed the BoD to amend bylaws – Court: Delaware law does not follow the “vested rights doctrine”, which prohibits a BoD from modifying bylaws in a way that diminishes SH rights without SH consent – Any SH who bought shares in the company knew of the authority BoD had to amend bylaws, had consented to being governed by the bylaws as may be amended by the BoD – SHs can always repeal a BoD-amended bylaw they don’t like Potential for abuse – In an earlier case (CA, Inc. v. AFSCME Emps. Pension Plan [Del.2008]), the court said a bylaw is not valid because there are many potential situations in which it would mandate actions that would violate directors’ FD – Chevron court clarifies that CA was a unique case & doesn’t represent Del. law – Bylaw is not invalidated because it can be abused; if a particular act abuses the bylaw, that act can be challenged © Amitai Aviram. All rights reserved. 137

Customizing via constitutional docs Stock specifications Delaware – DGCL §102(a)(4) allows corporations not to issue any stock (charter needs to state this & either specify conditions of membership or that these conditions are in the bylaws) – DGCL §151(a): “Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any and all of which classes… may have such voting powers, full or limited, or no voting powers, and such [economic rights]… as shall be stated… in the certificate of incorporation… or in [a BoD resolution] pursuant to authority expressly vested in it by its [charter].” – DGCL §151(b) allows the issuance of redeemable shares as long as after redemption there are still shares with full voting powers – DGCL §151(e) allows the issuance of convertible shares MBCA – MBCA §6.01(b) – “Minimum requirements”: At least one class of shares with unlimited voting rights At least one class of shares with a residual claim (i.e., the right to receive the net assets of the corporation upon dissolution) – doesn’t have to be the class with unlimited voting rights – MBCA §6.01(c) – Authorizes non-voting stock, convertible stock, and other characteristics of stock © Amitai Aviram. All rights reserved. 138

Customizing via constitutional docs Stock specifications Authorized shares: Maximum # of shares corporation can have – BoD has authority to issue shares, up to the authorized number (DGCL §161) – What purpose do authorized shares serve? (Note: number of authorized shares must be specified in charter; changes to charter require both BoD & SH vote) Outstanding shares: # of shares corp issued (& not repurchased) Authorized but unissued shares: Shares that are authorized but have not been issued by the firm (or were issued & repurchased) – Example: Acme’s charter says it has 1,000 authorized shares. Acme’s BoD issues 200 shares to investors. Acme now has 1,000 authorized shares, 200 outstanding shares, 800 authorized but unissued shares Treasury shares (DGCL): shares that have been issued in the past, but later repurchased by the issuing corporation – Example: Acme Corp. now repurchases 50 of its 200 outstanding shares. After purchase, it has 1,000 authorized shares, 150 outstanding shares, 50 treasury shares, 800 authorized but unissued shares – MBCA classifies treasury shares as authorized but unissued shares (MBCA §6.31(a)) I.e., Acme has 1,000 authorized shares, 150 outstanding shares, 850 authorized but unissued shares © Amitai Aviram. All rights reserved. 139

Customizing via constitutional docs Policy on customizing control rights Hypo 1: Acme Corp. has only one class of stock. SHs are entitled to dividends (if BoD authorizes dividend distribution) & to Acme’s net assets upon dissolution, but not entitled to vote – Is this permitted by MBCA §6.01? – Are there any risks to this capital structure? Hypo 2: Acme has instead two classes of stock – Class A shares are the same as in the above hypo (entitled to dividends & net assets upon dissolution, but not entitled to vote) – Class B shareholders have the same rights as Class A, except that each Class B share also has one vote – Is this permitted by MBCA §6.01? – Are there any risks to this capital structure? © Amitai Aviram. All rights reserved. 140

Customizing via constitutional docs Policy on customizing control rights Can the market protect itself? – Abe is offered Acme non-voting shares; economic value of 1 Acme share is $10 – Abe thinks Acme’s directors are a bunch of thieves Abe estimates that they will “steal” $10M ($1/share) Abe agrees to buy a share for $9 ($10-$1 stolen) – If SH can assess the decrease in share value caused by the inability to keep BoD accountable, then there’s no harm from non-voting shares SH pay a price proportionate to their (limited) rights Companies who want to raise capital more cheaply can give voting rights to SH & receive a higher price per share – Can SH assess the harm from an unaccountable BoD? Does FD suffice? – Suppose that there is no way to assess the discount for lacking the ability to keep the BoD accountable. Nonetheless, a BoD action that is not in SHs’ interest violates directors’ FD. – Isn’t it enough to give SHs right to sue BoD for breach of FD? © Amitai Aviram. All rights reserved. 141

Customizing via constitutional docs Policy on customizing control rights If we can’t trust the market to protect itself & we can’t trust FD to protect nonvoting SHs, why not prohibit nonvoting shares? – Can still bypass with “supervoting” shares E.g., 1 class A share has 1 vote; 1 class B share has 1M votes – So why not require each share to have equal voting power (“1 share, 1 vote”)? Equal voting power: SEC’s attempt – In 1988, the SEC adopted Rule 19c-4, prohibiting any stock exchange or mutual securities association from listing any stock of a corporation that takes any action to the effect of nullifying, restricting or disparately reducing the per share voting rights of existing common SH. – The Business Roundtable v. SEC (D.C. Cir., 1990): Court vacates the rule on the ground that it exceeds SEC’s authority SEC instead informally pressures stock exchanges to adopt similar requirements in their listing rules But does an equal voting power rule solve the problem? © Amitai Aviram. All rights reserved. 142

Customizing via constitutional docs Policy on customizing control rights Hypo based on Stroh v. Blackhawk Holding Corp. [Ill. 1971]: Chris forms Blackhawk Corp., with two classes of shares: – Class A – “Normal shares” Chris buys 50,000 shares for $2/share (firm receives $100K) – Class B – Voting rights, but no econ rights (no rights to dividends or assets in dissolution) Chris buys 500K such shares for 0.1¢/share (firm receives $500) Blackhawk sells to public 500K Class A shares at $4/share (firm receives $2M) Do Blackhawk’s shares offer equal voting power? Yes (was required by the Illinois constitution at the time) Does this prevent a split between control & economic rights? No © Amitai Aviram. All rights reserved. 143 BuyerShares AcquiredCostVotesEconomic Rights Chris50K Class A$100K (~4.8%) 50K (~4.8%) 50K (~9%) Chris500K Class B$500 (~0%) 500K (~47.6%) 0 (0%) Public500K Class A$2M (~95.2%) 500K (~47.6%) 500K (~91%) Total$2,100,5001,050,000550,000

Customizing via constitutional docs Addressing SH right misappropriation Problem of “watered stocks”: Acme worth $100, has 10 shares outstanding – How much is each share of Acme worth? – Acme’s BoD issues 10 new shares to Jill for $2/share ($20 total) – What is Acme worth now? – How many shares does Acme have now? – How much is one Acme share worth now? – Value of Jill’s shares? Value of other SHs shares? Legal solutions to the misappropriation 1.Limit the number of shares that BoD is allowed to issue without authorization from the existing shareholders Authorized shares: maximum number of shares that the firm can have Charter must specify the number of shares the corporation is authorized to issue (their number can only be changed by changing the charter) Both MBCA [§1.40(2)] & DGCL [§161] use this concept 2.Set a minimum price for the shares Par value is the minimum price for which a share can be issued (doesn’t affect the price share is sold by the SH to a new SH) E.g., Acme has 1M common shares, with a par value of $1. If Acme issues a new share to Sarah, it must receive consideration of no less than $1. Sarah, however, is free to sell the share at any price (or give it as a gift). DGCL uses this concept [DGCL §153(a)]; MBCA does not © Amitai Aviram. All rights reserved. 144

Customizing via constitutional docs Addressing creditor right misappropriation Problem of siphoning assets to SHs: Acme has 10 shares outstanding, $100 in assets, no debt – Acme issues $50 of one-year bonds, bearing 10% interest Acme’s net assets are now $150; it will need to pay $55 in 1 year A year later, Acme lost $70; it has $80 in assets ($150-70) How much are the bondholders entitled to? – Before bonds mature, Acme declares $8/share dividend SHs receive 100% of Acme’s assets ($80); bondholders receive nothing – Instead of dividend, Acme repurchases 8 of its shares at $10 each 80% of SHs receive 100% of Acme’s assets; bondholders & 20% of SHs receive nothing Legal solutions to the misappropriation 1.Contractual approach: bond agreement can create limits on dividends/repurchases or state that if certain financial ratios indicate firm approaches insolvency, firm must pay debt immediately 2.DGCL approach: specify a minimum amount of assets that dividends cannot compromise (“legal capital”) 3.MBCA approach: prohibit a dividend that causes insolvency © Amitai Aviram. All rights reserved. 145

Customizing the firm Review Controller Cass is creating a firm, and wants to own 60% of the control rights & 20% of the economic rights Methods 1-2 are suitable for private firms – Customizing via arrangements between SHs – Assume only other SH is minority SH Mary Methods 3-5 are suitable for public firms – Customizing via constitutional documents (share specifications) – Assume other SHs constantly change (“the public”) © Amitai Aviram. All rights reserved. 146

Customizing the firm Review: Method 1 (voting trust) 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80 Mary forms a trust with Cass as the trustee, and transfers to the trust legal title to 40 shares – Mary is the beneficial owner of the fruits of this trust (e.g., dividends), but Cass (as trustee) gets to vote them at his discretion Mary – 40 Trust – 40 Cass – 20 Control: 60% (20+40) Dividends: 80% (40+40) © Amitai Aviram. All rights reserved. 147

Customizing the firm Review: Method 2 (voting agreement) 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80 Cass & Mary sign a voting agreement (AKA vote pooling agreement) in which Mary promises to vote 40 of her shares as Cass instructs – Some voting agreements have a designated arbitrator would decide how to vote if parties disagree – To ensure that the agreement is specifically enforceable, Mary may give Cass an irrevocable proxy to vote a 40 of Mary’s shares Why does Cass need an irrevocable proxy? MBCA §7.22: Proxies are ordinarily revocable at the will of the SH, but a SH can give an irrevocable proxy. Usually, the proxy must be coupled with an interest. Acceptable interests include: – Proxy holder is a pledgee – Proxy holder has purchased/agreed to purchase the shares – Proxy holder is a creditor of the corporation who required the irrevocable proxy in order to extend it credit – Proxy holder is an employee of the corporation who required the irrevocable proxy in his employment contract – Proxy holder is a party to a voting agreement Proxy irrevocable only as long as proxy holder has an interest in firm © Amitai Aviram. All rights reserved. 148

Customizing the firm Review: Method 3 (dual-class; 1 share, 1 vote) As in Stroh – Class A shares have one vote per share, full economic rights – Class B shares have one vote per share, no economic rights Assuming firm plans to issue 2M A-shares to raise money – C buys, for a symbolic price (0.1¢) 2M B-shares – C also buys 20% of A-shares (400K shares) – Public buys remaining 80% of A-shares (1.6M shares) – Result: C has 60% of control rights (2.4M out of 4M votes) & 20% of economic rights (400K out of 2M A shares) © Amitai Aviram. All rights reserved. 149

Customizing the firm Review: Method 4 (dual-class; voting/non-voting) If non-voting common shares are permissible: – Class A shares are non-voting, full economic rights – Class B are voting, no economic rights C buys 20% of A-shares – Remaining A-shares sold to the public – Result: C has 20% of the economic rights C buys 60% of B-shares – Remaining B-shares sold to other investors who want to buy control rights and who are acceptable to the controller (typically, such investor would also buy A-shares to get economic rights, and will insist on sharing control rights via SH agreement with C) – Result: C has 60% of control rights © Amitai Aviram. All rights reserved. 150

Customizing the firm Review: Method 5 (class-specific rights) Design share classes as follows: – Class A shareholders (as a group) appoint 2 of the 5 directors & receive 80% of the economic rights – Class B shareholders appoint 3 directors & receive 20% of the economic rights Controller buys only Class B shares & issues to the public only Class A shares – Results: Controller has 60% of control rights (appoints 3 of the 5 directors), and receives 20% of the economic rights Example: “Golden shares” © Amitai Aviram. All rights reserved. 151

Business associations Chapter 3: Internal governance (corporate governance) Prof. Amitai Aviram University of Illinois College of Law.

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Business associations Chapter 3: Internal governance (corporate governance) Prof. Amitai Aviram University of Illinois College of Law.

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Presentation on theme: "Business associations Chapter 3: Internal governance (corporate governance) Prof. Amitai Aviram University of Illinois College of Law."— Presentation transcript:

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