I. What is a Corporation?.......................................... 1 II. Promoters...................................................... 4 III. Limited Liability............................................. 7 IV. Business Judgment Rule........................................ 10 V. Duty of Care................................................... 12 VI. Duty of Loyalty............................................... 15 A. Interested Party Transactions.................................15 B. Corporate Opportunities.......................................17 C. Controlling Shareholders......................................18 D. Executive Compensation........................................19 VII. Shareholder Litigation....................................... 22 VIII. Control Issues.............................................. 29 A. Shareholder Voting............................................29 B. Precatory Proposals...........................................31 C. Shareholder Inspection Rights.................................32 D. Control in Closely Held Firms.................................32 E. Duties to Shareholders........................................34 F. Abuse of Control..............................................34 G. Transfer of Control...........................................34 I. What is a Corporation? One definition - The most common form of business organization Chartered by state Given many legal rights as entity separate from its owners - Characterized by Limited liability of its owners Issuance of shares of easily transferrable stock Existence as a going concern - Process of becoming corporation is called incorporation Gives company separate legal standing from its owners
Transcript
I. What is a Corporation?........................................................................................................................1
II. Promoters...........................................................................................................................................4
III. Limited Liability..................................................................................................................................7
IV. Business Judgment Rule..................................................................................................................10
V. Duty of Care..................................................................................................................................... 12
VI. Duty of Loyalty................................................................................................................................ 15
A. Interested Party Transactions.......................................................................................................15
B. Corporate Opportunities...............................................................................................................17
C. Controlling Shareholders...............................................................................................................18
D. Executive Compensation...............................................................................................................19
VII. Shareholder Litigation....................................................................................................................22
VIII. Control Issues................................................................................................................................29
A. Shareholder Voting.......................................................................................................................29
B. Precatory Proposals.......................................................................................................................31
C. Shareholder Inspection Rights.......................................................................................................32
D. Control in Closely Held Firms........................................................................................................32
E. Duties to Shareholders..................................................................................................................34
F. Abuse of Control............................................................................................................................34
G. Transfer of Control........................................................................................................................34
I. What is a Corporation? One definition
- The most common form of business organization Chartered by state Given many legal rights as entity separate from its owners
- Characterized by Limited liability of its owners Issuance of shares of easily transferrable stock Existence as a going concern
- Process of becoming corporation is called incorporation Gives company separate legal standing from its owners Protects owners from being personally liable if company is sued (limited liability)
Provides companies w more flexible way to manage - Together, they make corporation uniquely attractive
For organizing productive activity- But they also generate tensions
That lend a distinctively corporation character to agency problems Most business are not corporations
Corporations are where the money is- $16.5t receipts from corporations- $1.5t receipts from partnerships- $1t receipts from proprietorships
Owners of corporations- Public aka publicly held
Characterized by public secondary market Shares of the company are listed for trade
- Close aka closely held Characterized by absence of secondary market for its stock Often relatively small number of shareholders who actively manage firm May display many characteristics of partnerships
Types of corporations- Professional corporations
Examples = physicians, lawyers Increasingly use LLPs or LLCs
- Non-profit corporations None of surplus revenue (profit) may be distributed to shareholders (members) Often have members rather than shareholders Examples = charities, churches
- Quasi-governmental corporations Examples = Fannie Mae, Freddie Mac
- Government corporations Examples = universities, hospitals
MBCA- Model act – suggested corporate law- Adopted by 35 states- NY, CA, DE have own code- Yearly revisions
Characteristics of business organizations
Sole P. Gen. Part. LLC S-Corp Corp.
Formation No filing No filing Filing Filing Filing
Duration Any Dissolvable Statute Perpetual Perpetual
Taxation Personal Pass through Pass through Pass through Corporate tax
Cost of form. None None Fee Fee Fee
Raising equity
Personal From partners Can sell interests
Stock Stock
Transferable? No No Possibly Yes, with consent
Freely
Six core characteristics of corporations- Formal creation (DGCL §101(a))- Legal personality (DGCL §106)
Body corporation Sue or be sued Shield assets of entity form creditors of owners
- Limited liability (MBCA §6.22(b)) Shareholder not personally liable for acts of debts of corp Unless through own acts/conduct becomes liable
- Separation of ownership & control (DGCL §141) Managed under direction of board of directors
- Transferable shares (DGCL §122) Issue notes, bonds, other obligations
- Infinite duration (DGCL §122(1)) Benefits of corporation form
- Eliminates messy problems from personal liability Reduces need to monitor agents (managers) Enlists creditors to monitor managers (creditors bear downside) Reduces need to monitor other shareholders Makes shares fungible – increases liquidity, lowers cost of capital Facilitates diversification – without LL, minimize exposure by holding one corp only
- Allows investors to enter and exit the firm – just need to buy or sell shares Permits takeovers – disciplines management Allows exit without disrupting business
- Prevents minority investors from trying to hold up firm by threatening to dissolve it- Makes it easier for 3rd parties who contract w firm to know who they are dealing with
- Improves decision making through command and control structure Choosing a state for incorporation
- Paul v. Virginia (US 1869) State may not exclude foreign corporation engaged in interstate commerce
- Delaware’s dominance More than 300k companies incorporated in DE
60% of Fortune 500 50% of NYSE companies
Enabling statutes Standard form contract to reduce bargaining costs Transaction costs lower for default rules
No minimum capital requirements Only need one incorporator
Corporation can be incorporator Favorable franchise tax in comparison to other states Favorable taxation for companies doing business outside of DE
No corporation income tax No sales tax, personal property tax, or intangible property tax for corps No taxation on shares of stock held by non-residents No inheritance tax upon non-residents holders
Corporation may keep all books/records outside of DE May have principal place of business/address outside of DE
Highly competent judiciary in corporate law Extensive and detailed case law on the subject
Federal law- Disclosure & procedure
Substantive law can be “secreted in interstices of procedure” More and more substance, though
- Securities laws Blue Sky Laws
Merit review Securities Act of 1933, Exchange Act of 1934
Disclosure and fraud- Sarbanes-Oxley- Creeping federalization of corporate law
II. Promoters Incorporators (§101)
- Any person – singly or jointly w others – may incorporate or organize a corporation- By filing a certificate of incorporation with the Division of Corporations in Department of State
Power of incorporators (§107)- Incorporator will manage affairs until directors are elected at first annual meeting
If ppl who will serve as directors have not been named yet- May do whatever necessary and proper to perfect organization of corporation
Including adoption of original bylaws or corporation and election of directors Promoters and corporate entities
- Third-party sales A & B are strangers A buys Blackacre for $125k and quickly sells to B for $200k Does B have cause of action?
Potential cause of action for fraud If B asked A how much he paid and he said $200k
- Principal-agent sales #1 A buys Blackacre for $125k A if B’s agent for land investments B doesn’t know about A’s transaction and inquires about Blackacre B hires A to represent her in purchasing Blackacre A sells land to B for $200k Does B have cause of action?
Agent who makes a profit in connection w transactions conducted by him or on behalf of principal is under duty to give such profit to the principal
- Principal-agent sales #2 Same facts as above, but buyer is corporation wholly owned by B What result?
Corp has same rights as B in above B has no rights
- Promoter sales A & B are strangers A buys Blackacre for $125k and contemplates selling to B for use in residential development Option 1
A creates X Corp (so A is promoter) X sells all shares to B for $200k and B becomes president A sells Blackacre to X for $200k Board (made up of B’s family) approves transaction What result?
o A is fiduciary of X so X can recovero A has legal obligations to refrain from dealing w corporation at arm’s length
Option 2 A sells Blackacre to B for $200k B forms X Corp. B contributes Blackacre to X corp in exchange for all shares What result?
o Neither B nor X has cause of action unless agent of Bo Form > Substance
Option 3 A forms X Corp. and contributes $200k in cash for all shares of stock A appointed president and director of X – A’s husband and son are other two directors A sells Blackacre to X for $200k – transaction approved by board A then sells all shares of X to B for $200k A ends up w $200k of B’s money B owns all shares of corporation that owns Blackacre What result?
o A can’t cheat himself so no liability
o If part of a plan, though, then maybe liability The Body Corporate (§106)
- Upon filing certificate of incorporation with Secretary of State Incorporators who signed certificate and assigns constitute body corporate By name set forth in certificate Subject to dissolution of other termination of its existence
General principles- Promoters
Owe fiduciary duty to firms they form May owe fiduciary duty to new shareholders
If part of plan at outset to bring in shareholders- Opportunism
Central concern of corporate law Worried about it from the beginning
- Form > Substance Sometimes equity matters Example
Acquire wants to buy Target but doesn’t want shareholder approval Acquire can just put all its assets in a shell corporation And then use the shell to purchase Target
Pre-incorporation transaction by promoter- Once charter filed, does corporation become party?
Not automatically Principal generally may ratify unauthorized K of agent Corporate rule – may not ratify but may adopt
- Once charter filed, is Promoter liable if corporation breaches K? Absent agreement to contrary, remains liable even if corp adopts K Can opt out with K terms Equitable relief possible as well
- If charter not filed, is Promoter liable on K? Absent agreement, remains liable
De facto corporation- If P thought he was dealing with de jure corporation, defective corp irrelevant- Requirements
Good faith effort to incorporate Legal right to incorporate Business carried on as though it were corporation
- Statutory response 1950 MBCA attempted to do away with de facto corps 1984 MBCA bring back common law rule bc of court resistance
Corporation by estoppel- If P thought dealing with corp and would earn windfall if now able to argue against corp, defective corp
irrelevant - Requirements
Person dealing though it was corp whole time Would earn windfall if not able to argue that it is not a corp
- Only used when articles of incorporation not filed- No requirement of misrepresentation, reliance, change of position
III. Limited Liability Limited liability (MBCA §6.22(b))
- Shareholder of corporation is not personally liable for acts or debts of corporation- But may become personally liable based on his own acts/conduct
Dark side of limited liability- Externalities
Allows ppl to avoid some social costs of their activities- Encourages excessive risk-taking- Funding
Conflicting incentive of lenders and shareholders Alter-ego doctrine (Walkovsvky)
- Where shareholder uses control of corp to further own (rather than corp’s) interest Liable for corporation’s acts and debts on principal-agent theory
- Control factors Commingling of funds Undercapitalization Disregard for corporate formalities
Shareholder meets Board meetings Minutes of minutes Separate books Issue stock Appoint a board Adopt charter or by-laws
Does undercapitalization matter?- Having such little capital that corp can’t meet liabilities- Initial undercapitalization v. draining assets
Few states have mandatory min – those that do are nominal Draining may support veil piercing, though
- Too subjective How much capital do you need to safeguard? What liabilities are certain to arise? What will role of undercapitalization have on juries?
- Ex ante planning will be less certain Legitimate reasons for using multiple corporations
- Reduce monitoring costs for lenders- Tracking stocks- More efficient management- Comply w different legal regimes- Tax reasons
Generic Questions- Is it improper to incorporate your business for purpose of avoiding personal liability?
NO- Is it improper to split single business into multiple to limit liability of each part?
NO Veil piercing
- Possible legal rules Misused Unfair result Undercapitalization Controlling/dominating shareholders Small firms (closely held)
- Does veil piercing induce internalization of risks? Doesn’t have to do with policy questions at issue Doesn’t help sort out which risks should be internalized v. externalized Doesn’t promote populist notions of economic democracy
- Court’s decline to pierce in 90% of cases where formalities are observed Special rule for small firms?
- Shareholder characteristics Few in number Actively involved in firm management Not well-diversified
- Creditor characteristics Few in number Low enforcement & monitoring costs Small equity cushion
- Line-drawing problem Where would limited liability kick in How many shareholders
- Investor choice Off the rack rules – one size does not fit all
- Penalty default Force parties to bargain
Avoiding liability- Personal liability (of you)
Just respect corporate formalities Take out minimum insurance
- Enterprise liability (of your other corps) Need separate books and bank accounts for each corp Careful accounting for supplies, etc.
Policy options – what should we do?- Raise mandatory insurance levels- Require tort-prone companies to post large bond- Let loss fall on victim- Pierce corporate veil (pro-rata liability)
Ex ante bargaining re limited liability
Transaction cost matrix- Contract creditor in public corporation
Shareholders Limited liability since they are residual owners Prefer riskier projects w bigger upside bc they don’t share downside of risk Power very limited to direct investments – difficult to externalize costs of risky ventures
Creditors Prefer unlimited liability Creditors are cheaper monitors of corporate investments Accept role as monitor w limited liability regime in return for prior claim on corp’s assets
- Contract creditor in close corporation Shareholders
Much more likely to be in control – increased risk of externalizing costs Creditors
Face low monitoring and collection costs bc small number of shareholders Often require shareholder/manager to execute personal liability agreements
- Tort creditor in public corporation Concession theory in bunk
Corporate law is set of standard form Ks designed to facilitate private ordering Externalities are real problem Pro-rata tort liability would have many problems
- Tort creditor in close corporation Hardest case to justify limited liability default Shareholders in control and have bargaining power Piercing available (but also for K creditors)
Veil-piercing test- New York (Lowendahl)
Corporate shareholder domination of corp Corporate wrongdoing that proximately caused creditor injury
Lack of corporate formalities Commingling of funds and assets Under-capitalization Movement of funds back & forth
Failing to pierce would either sanction fraud or promote injustice Tax fraud Use of corporation funds for personal benefit
Public corporationClose corporation
Contract creditor
Tort creditor
(1) Very costly
(2) Low cost
(3) Impossible
(4) Impossible
- Contract creditors (Laya, Kinney Shoe) Unity of ownership
Such that separate personalities of corp and individual shareholder no longer exist Inequitable result occurs if acts were treated as those of corp alone
And veil is not pierced D still might prevail by showing assumption of risk by creditor
Who should have known of undercapitalization through investigation Enterprise liability and parent-sub corps (In re Silicone Implants)
- Separate corps facilitates offloading of externalities Operate high-risk activities with asset-less corp
- Best test for veil piercing here Focus on whether corp is offloading like this
Reverse veil piercing- Allows shareholders to disregard corp’s separate identity- Courts split 50-50
Outsider reverse piercing- Allows creditor of shareholder to disregard corp’s separate identity- Unsecured creditors who relied on corporate assets disadvantaged (same w other shareholders)
IV. Business Judgment Rule Duty of Care v. Business Judgment Rule (Dodge)
- Duty of care Common law
Officers and directors owe shareholders duty of careo Requires directors to exercise that degree of skill, diligence, careo That reasonably prudent person would exercise under ccs
MBCA §8.30(a) Each member of board, when discharging duties of director, shall
o Act in good faith; ando In manner the D reasonably believes to be in corp’s best interests
Generally Tells directors not to be negligent
- Business judgment rule Two prerequisites
Duty of loyalty (no self-dealing) Duty of care
Generally BJR shields directors from liability for making mistakes Insulates directors from negligence liability – liability only for fraud or self-dealing
In performing duties of director in best interests of corp, may consider the interests of Corp’s employees Corp’s customers Corp’s suppliers Corp’s creditors Economy of region, state, nation Impact on community environment
long-term and short terms interest of corp and shareholders- Most states have these
Few are mandatory Evaluating charity decision under BJR
- What do you need to know as atty? Applicable statute? Limits in charter or by-laws? Approval from board? Board informed? Board interested in transaction? How much is $ for corp? Was it pet charity? Was it reasonable relative to profits? What was business purpose?
Business judgment rule- Shlensky
Directors’ decision is final and not subject to judicial review Absent fraud, illegality, or self-dealing
Carte blanche to make decisions that might turn out badly No discretion to make selfish decisions Directors immune from claims of negligence
If well informed and careful about decisions Traditional justification
Courts not business experts, so litigation is imperfect way to review business But, court not experts on lots of things it rules on
Other justifications Designed to protect decisions not in interest of non-shareholder constituencies Encouraging optimal risk taking Hindsight bias Review may disrupt board as team-based decision maker Shareholders better off to let management make decisions w/out their vote
o BJR does this w/out cutting off shareholder action for egregious caseso Tradeoff bt accountability and discretiono Judicial review threatens board’s authority
- Kamin BJR insulates Board from suit on merits
Absent fraud, dishonesty, or nonfeasance Court will not substitute its opinion for Board’s opinion
Dividend questions exclusively business judgment decision Strong abstention version of BJR
- ALI §4.01(c) D who makes business judgment in good faith fulfills the duty under this section if the D
Is not interested in the subject of business judgment Is informed on subject of business judgment to extent that D believes appropriate Rationally believes that the business judgment is in the best interests of corp
- Chancellor Allen BJR provides that where D is independent and disinterested, not liability for corp loss Unless no person could possibly authorize such a transaction if he was attempting to meet duty
Two ways to think about BJR- As standard of liability (this wins in the end)
No liability for negligence Instead liability based on
Gross negligence Fraud
Illegal conduct Self-dealing
- As an abstention doctrine Court will not review substance of board decisions Preconditions
No fraud No illegality No self-dealing
Court will examine decision-making process To extent to which Board made informed deicison
V. Duty of Care Standards
- Graham Ds must use care which ordinarily careful and prudent men would use in similar ccs
- ALI §4.01(a) D has duty to corp to perform D’s functions
In good faith In manner that he reasonably believes to be in best interests of corp, and With care that ordinarily prudent person would reasonably be expected to exercise in like
position under similar ccs- Van Gorkom
Gross negligence If D is grossly negligent, not protected under BJR Board must provide some credible, contemporary evidence that it knew what it was doing If not, board member can be held personally liable
Procedural due care perquisite to invoking BJR Major transaction w final period consequences Evidence that board has abrogated decision making authority
Ds who fail to act in informed and deliberate manner will not get BJR protection- Technicolor
First ask whether P can show evidence or breach of loyalty, good faith, or due care If P fails, BJR attaches Rule acts as both procedural guide and substantive rule of law
- Cinerama, Weinberger Entire fairness test
Process board followed Quality of decision board reached Disclosures made to shareholders
Appraisal proceedings Allow for fishing expedition Always allows discovery, which can then yield procedural irregularities
- Eisner No substantive due care
Due care in decision making context is procedural due care only Expert reliance (DGCL §141(e)
Ds fully protected in relying in good faith on reports made by officers BJR can be rebutted if P shows that Ds breached fiduciary duty of care or loyalty or bad faith
Burden shifts to D to show the challenged transaction was entirely fair Bad faith standard
Conduct motivated by subjective bad faith (intent to do harm) Intentional dereliction of duty (conscious disregard for responsibilities) Not gross negligence
- McMullin NJR operates as both procedural guide and substantive rule of law P can survive MTD phase
- Francis BJR has no application where Ds have failed to exercise business judgment P still has to prove that Ds breached duty of care No violation when not on notice – free bite rule
- Caremark Test of liability = lack of good faith by sustained/systematic failure of D to exercise reasonable
oversight Makes board service by qualified persons more likely while still acting as stimulus of good faith
- Operative rule (Parnes) Presumptive validity of business judgment is rebutted only when decision is so far beyond
bounds of reasonable judgment that it seems inexplicable on any ground other than bad faith- MBCA §8.31(a)(2)(iv)
D not liable for any decision or failure to act unless P shows conduct result of Sustained failure of D to devote attention to ongoing oversight of business; or Failure to devote timely attn when particular facts and ccs of significant concern
materialize that would alert reasonably attentive D of need Framework for D&O liability
- Business judgment rule (RMBCA §8.31(a)(2)) Presumes that duty of care standard has been met
- Waiver of liability (DGCL §102(b)(7)) Corps can eliminate D&O liability for duty of care violations Self-insurance for gross negligence
- Indemnification (DGCL §145) May indemnify for D&O actions in good faith And for those not provided but still in good faith
- D&O Insurance (DGCL §145(g)) Corp may buy insurance whether or not they have power to indemnify such person
- Reimbursement of legal expenses (DGCL §145(c)) Even if not in good faith, success in legal action requires indemnification for legal bills
Theory of Board power- Authority-based decision making is essential for public corps
Large number of constituencies w different access to info Diverse constituencies w conflicting interests Intractable collective action problems
- Tension by authority & accountability vis-à-vis boards and managers Agency costs only eliminated by eliminating authority Market constraints important Power to hold account is power to decide
- Choosing authority raises issues of accountability Who’s watching the watcher?
- BJR prevents shifts locus of decision making from boards to judges Shareholders would bargain for BJR Hindsight bias would discourage risks Inference w internal governance Judicial decision making not subject to market discipline
Damages (Technicolor)- Cede I
Action for rescission and damages can proceed in parallel- Cede intermezzo
Absent proof of D self-interest, must prove that D negligence caused injury
Must introduce sufficient evidence form which responsible estimation of damage can be made- Cede II
Gross negligence in process is sufficient to shift burden to directors Requires Ds prove that transaction was entirely fair
- Cede III Gross negligence doesn’t mean substance of deal was unfair There can be gross negligence in entirely fair transaction
Books & Records (Eisner, DGCL §220)- Stockholder can inspect corporation’s books and records for any proper purpose
If corp refuses, shareholder can get order to compel from Chancery court- What is proper purpose?
Investigate mismanagement – no fishing expeditions though Share valuation Proxy contexts
- What is improper purpose? Proprietary business info Strike suits Serve other business interest Pursue political, social goals
Duty to be informed (Francis)- Obligation of basic knowledge and supervision
Continuing obligation to keep informed about activities of corp General monitoring – not detailed inspection of day-to-day activities
- Read and understand financial statements D should acquire at least rudimentary understanding of business of corp Not required to audit books – just maintain familiarity w financial status by reg review
- Must object to misconduct – if necessary, resign- Who are duties owed to?
Shareholder Creditors (sometimes)
Duty to monitor - Allis-Chalmers
Absent cause for suspicion, not duty on Ds to ferret out wrongdoing which they have no reason to suspect exists
- Caremark Duty of care requires board to monitor important aspects of firm
Legally, board itself required only to authorize most significant corp actso But ordinary business decisions can vitally affect welfare of corp
Growing role of criminal law with safe harbors for compliance programso Powerful incentive for corporations to detect violation thru these programs
D’s obligation includes duty to attempt in good faith to assure that corp info and reporting exists
o Must be system that board deems adequate- Martha Stewart
No duty to monitor personal behavior Regardless of someone’s importance to corp, person is not the corp Monitoring of personal affairs is neither legitimate or personal
- Sarbanes-Oxley Need internal control reports validated by officers Can go to jail for 30 yrs or have $5m in fines or both All firms are “biters” re accounting and financial reporting
VI. Duty of Loyalty Duty of loyalty
- Ds owe firm duty of constant and unqualified fidelity- No judicial deference for self-dealing transactions
Both negligence and self-dealing are forms of shirking that are costly to firm Preventing self-dealing doesn’t inhibit effective board function
Duty of care violations involve whole board Duty of loyalty involves limited number of board members
Self-dealing is evidence or dysfunctional team – courts less concerned Duty of loyalty violations harder to detect Large potential gains justify higher level of deterrence Great moral culpability – stricter than morals of marketplace
A. Interested Party Transactions Common law rule
- Transactions w Ds per se voidable by firm w/out regard to fairness or approval D of corp can’t deal with corp which he represents Prevents mutually beneficial bargains from being struck
Firm can always walk away if deal goes bad- Interested party transactions NOT permitted
Common law rule liberalized to allow transaction under certain ccs (Globe Woolen)- But D still subject to duty of constant and unqualified fidelity- Interested party transactions okay if
Ratification by fully informed and disinterested majority of board Fairness to corp
Structural bias theory (Bayer)- Assumed all members of board are sympathetic to one another and cannot be relied on to make unbiased
judgments on culpability of other Ds- Not how courts normally look at directors
Independence of directors- Independent unless he
Was employed by firm in last 3 years Has an immediate relative was employed by firm as executive office in last 3 years Has a business relationship w firm Is a partner, controlling shareholder, or executive officer of company that does biz w firm
- Every firm must have At least 3 independent directors Audit committee comprised solely of independent directors
Must all be financially literate One must be expert in accounting and finance
Modern test (DGCL §144)- Conflicted interest transaction not void/voidable solely bc of D’s conflict as long as the transaction was
Approved fully by majority of disinterested Ds after disclosure; or Approved by good faith vote of shareholders following disclosure; or
Burden on D to show fairness If vote, then burden on P to show terms so unequal that deal is gift or waste of corp assets
Fair to corporation at time it is authorized by board or shareholders D must show
o Terms of deal within range of fair (fair process)o Corp wouldn’t get materially better deal if details were disclosed (fair outcome)
Hallmarks of fair transactiono Within range of terns that parties bargaining at arm’s length might reacho Defects in disclosure still highly relevant
Book value v. market value- Book value
Acquisition cost minus depreciation Value reported on firm balance sheets
- Market value Replacement cost Price of a thing is what it will fetch
- Accounting rules BV appropriate where no liquid market MV appropriate where liquid trading market Mark to market occasionally required for certain assets
Piercing-like inquiry re fairness (Lewis)- Inquiry
Did Ds respect separateness? Did Ds do arm’s length analysis?
- Burden shifting BJR w burden on P presupposes that Ds have no conflict of interest When interested, burden shifts to Ds to show that transaction was fair
Shareholder ratification- Entire atmosphere changed when formally approved by shareholders (Gottlieb)
If ratified Director conflict
o P must show waste Controlling shareholder conflict
o P must how deal not entirely fair If not ratified
D has to show fair deal- Competing approaches
Standard of review (burden of proof) DGCL §144 RMBCA §8.61 ALI §5.02
Shareholders ratify Waste (P). But see Wheelabrator (EF, if
controller)
Waste (P) Waste (P)
- Big picture Ratification of duty of care problem kills the claim Ratification of director conflict shifts burden of proof but keeps standard at waste Ratification of dominating shareholder conflict shift burden but lowers standard to fairness
- Hierarchy considering Ability of courts to police (their perception) Ability of shareholders to recognize (court’s perception) Seriousness of problems (court’s perception)
Black letter law- Absent conflict of interest
P has burden of proof and will likely lose under BJR- If unratified conflict of interest
Directors have burden of showing the challenged transaction was fair/reasonable- If conflicted party transaction is ratified (by either disinterested shareholders or directors)
For director ratification P has burden of proof and must overcome powerful BJR
For shareholder ratification of director conflict P must show waste
For shareholder ratification of controlling shareholder conflict P must show not entirely fair
B. Corporate Opportunities Corporate opportunity doctrine
- Purpose? Deter taking new business prospects that belong to the corp
- Covered persons? Officers and directors of the corp Dominant shareholders who take active role in firm management
- Why can’t parties just bargain? Socially wasteful costs
Guth test- Line of business- Prior expectancy or interest in opporuntiry- How opportunity discovered
Broz test- Factors
Financially able? Same line of business? Expectancy or interest in opportunity? Does it create conflict of interest?
- Absence of one factor not enough- If D believes that corp not entitled to take opportunity based on a factor
D may take opportunity for himself- Board presentation
Disclosure Not a prerequisite to show opportunity to board But if D does so and board rejects, then safe harbor
Costs Reduces incentives to invest in info/opportunities Risk of litigation if minority shareholders
Other relevant factors- Were there prior negotiations w firm about the opportunity?- Did the D conceal the opportunity?- Did the D use corporate fund to pursue opportunity?- Will opportunity involve competition w firm or otherwise thwart a business purpose?- Did corp have substantial need that opportunity would have satisfied?- Did corp have necessary technical, HR, other resources to exploit opportunity?- Is the D an insider?
Defenses for alleged opportunity usurpers- Capacity
Relevant to whether it was corp opportunity Directors & officers
o Corporate opportunity if learned while in corporate capacity
Officerso Corporate opportunity if within line of business
- Financial or technical inability Problem with this defense
Management helps raise money for firm – moral hazard problem Management can loan it to firm if it has money Seems like firms have to be virtually bankrupt for this to be relevant
- Refusal to deal (Energy Resources Corp) Must be disclosed to prevent opportunism Creates post-hoc evidence problems
- Process (best defense) Disclosure and ratification
C. Controlling Shareholders Common law rule
- Shareholders entitled to vote shares w/out regard to interests of other shareholders (Haldeman)- Shareholders qua shareholders are still allowed to act selfishly in deciding how to vote shares
Shareholders v. investors- Directors
Elected to serve interests of shareholders/firm as whole- Shareholders
Just invest to make money Voting control
- In most cases, voting control gives power to elect board- Potential to constrain thru agency law
Board is agent of shareholder; shareholder is principal Controlling shareholder can be derivatively liable for misconduct of agents
Controlling Shareholder definitions- Securities law
Presumption at 10%- ALI §1.10(b)
Presumption at 25%- Delaware
> 50% or exercises control in decision making Controlling shareholder, then Ds must show entire fairness Not controlling shareholder, then P must show waste
- Better definition No bright line rule for who is controlling shareholder Just whether board lacks independence
Parent subsidiary situations (Sinclair Oil)- Standards of review
BJR Intrinsic fairness
Use when parent has rec’d benefit to exclusion and at expense of minority shareholders of subsidiary
Limited to self-dealing Capital structure situations (Zahn)
- Directors/controlling shareholders have same fiduciary relationship to corporation Need to exercise independent judgment in changing classes of stocks Can’t just do it arbitrarily to put windfall on certain type
- Rule Firm should redeem class As
Bs are most junior-class of securities (biggest risk bearers) When fiduciary duties conflict, Ds should protect interests of investors bearing most risk
Arbitrary to extend but clear rule and parties can contract around it Corporate finance
- Complex capital structures allow firms to offer mixes of risk and return- Facilitates raising capital- Control follow risk
Summary – controlling shareholders- Fiduciary duties run to minority shareholders- If self-dealing, burden shifts to Ds to show entire fairness
D. Executive Compensation Legal basis
- CEO and director pay set by directors DGCL §122(5)
Ds appoint officers and agents and provide suitable compensation DGCL §122(15)
Ds establish and carry out pension, profit sharing, stock option, stock purchase, stock bonus, retirement, benefit, incentive, and compensation plan
- Directors typically delegate compensation decision to compensation committee Composed of entirely independent directors (NYSE & NASDAQ rules) Committee hires compensation consultant to make recommendations
Types of pay- Salary
Fixed cash payment set at beginning of year or contract (usually 3-5 yrs)- Bonus
Addt cash payment if performance (financial or non-financial) exceeds target level Subjective element too
- Stock options Right to buy shares at fixed price Vesting and lifespan restrictions
- Performance units Stock granted if performance exceeds target over 3-5 years
- Restricted stock Stock grant with vesting tied to specific employee term
- Perks Club membership Company cars Purchased homes, Company jet
- Contractual agreements Severance agreements Golden parachutes Post-retirement consulting contracts
- Benefits Life insurance Health insurance Regular pensions SERPS Employee stock ownership plans
Alleged problems with pay- Managerial power
CEO picks board and board sets pay
- Amounts CEOs make lots of money, but so do celebrities
- Disparity CEOs make more than secretaries, but what should ratio be?
- Pay not linked w performance Some CEOs paid a lot even shareholders don’t do well
Growth of CEO pay- Total CEO compensation (salary + bonus + option value + long term incentives)
$9b in 2005- CEO compensation is
.09& of sales .07% of market capitalization 1.22% of net income
Compensation research- Top decile firms in pay outperform industries by 50%- Bottom decile underperform by 25%- Linage with firm size and market value- Technology allows returns to labor across greater asset base
Mechanisms to constrain pay- Disclosure
Shaming won’t work Involuntary disclosures won’t work
Leads to greater pay for performance Ceilings becomes floors
o Change of controlo Golden parachutes
- Ban specific practices Loans Backdating
- Improve governance- Caps
Pay in other ways Go private Jurisdictional competition
Conclusions- “Problem” is that managers paid like owners and owners doing very well
We can pay managers like something else, but what?- Contracts seem as efficient as we can expect
But there can still be learning- There are rotten apples
Prosecution of laws and internal governance improvements can help- Transparency and deterrence has own costs- Ultimately a political question
Want boards to be able to be on the next Jack Welch Qualified Immunity for Directors (Disney)
- BJR protects director decisions Even when info and decision making process not so tidy to meet best practices
- Is this qualified immunity? Option terminology
- Types Call option
Right to buy share at specified price (strike price Put option
Right to sell a share at specified price- Terms
At the money option Strike price = current market price
In the money option Strike price < current market price
Out of the money option Strike price > current market price
- Shenanigans Backdating
Date options in past when price was lower Spring-loading
Delay release of positive information to times after option issues; or Time grant of option right before release of positive information
Bullet-dodging Delay grant of options until after bad news released; or Delay release of bad news until right after grant of options
Fraud through misleading disclosure - Type 1
Shareholder must approve stock option plans Under tax regulation and stock exchange listing standard
When soliciting shareholder approval, corps tell shareholders strike price = market price On day issued
Backdating options breaks that promise Constitutes securities fraud
- Type 2 Public corps must disclose issuance of options
As part of ongoing periodic disclosure obligation By falsely claiming that option was issued on earlier date, company breaks promise
Constitutes securities fraud again- Desimone
Board can permit issuance of back-dated options But can’t permit these grants at less than market price Corp can’t do something it knows is illegal to pursue profit
But what about UPS double-parking? Investment Advisors/Managers
- §36 of Investment Company Act Imposes fiduciary duty on investment advisors in connection w their receipt of fees Claims of excessive fees to be brought to SEC by shareholders
- Gartenberg Fees need to be so disproportionately large as to constitute breach of fiduciary duty To be guilty, manager must charge fee so disproportionately large that it
Bears no reasonable relationship to services rendered; and Could not have been product of arm’s length negotiations
Factors Cost to advisor-manager in providing services Nature and quality of service Extent to which advisor realizes economies of scale as fund grows larger Volume of order being processed by manager
Market test Fees paid to other fund advisors NOT dispositive Bc insufficient competition in advisor marketplace – boards don’t fire advisors
- Jones Test is whether advisor acted as honest fiduciary
Fiduciaries not limited to ordinary fees Can charge as much as market will bear
Fiduciaries must disclose fees, though These fees are like corporate pay Signals the end of substantive fiduciary duties
At least at federal level
VII. Shareholder Litigation Public markets
- Benfits Most liquid and cheapest capital Encourages greater innovation in economy
Allows entrepreneurs to cash out but keep firms independent Public paydays attract human capital
Incentive compensation Public disclosure and transparency leads to greater accountability Democratization of capitalism
- Costs Federal regulatory burden
SOX SEC disclosure rules
Transparency and loss of privacy Greater volatility Leads to short-term focus Pressure distracts from operational focus
Shareholders Press Plaintiffs’ lawyers
Risk of shareholder suits Purpose of shareholder litigation
- Tension bt accountability and authority Balance heavily tilted towards authority
Soviet-style elections for directors BJR Duty of care barely enforceable Interested-party transaction allowed
- Shareholders need to constrain Opportunism, self-dealing behavior Illegal actions Utterly irrational behavior
Derivative v. Direct- Derivative suits
Brought by Shareholder on corp’s behalf (suit in equity to compel firm to sue)
Cause of action Belongs to corp as entity
Arises from Injury done to corp as entity
Lawsuit in equity to compel corporation to sue third party Typical suits
Mismanagement Executive compensation Waste
Remedy Money to corp
- Direct suits Brought by
Shareholder in his or her own name Cause of action
Belongs to shareholder in his or her individual capacity Arises from
Injury directly to shareholder and not shared by corp Typical suits
Oppression of minority shareholders Dividends Mergers
Direct suit test Injury to shareholder that is not derivative of prior injury to corp entity; or Breach of contractual duty owed to shareholder independent of any right of corp
Remedy Non-monetary
Derivative suit basics- Problems
Why can’t shareholder just due whenever injured directly or indirectly? Burdensome litigation – too many suits But solution is class actions
Who should run the derivative litigation? Ds run firm so should have control of litigation But when Ds are sued for breach of fiduciary duty Thus don’t trust Ds to be unbiased Again, board authority v. accountability
- Civil procedure Rule 23.1
Complaint shall allege o P was shareholder at time of transaction; ando The action P desires from directors w/ particularity; ando Reasons for P’s failure to obtain the action
- Statistics Number of suits
175 in 2003 60% involve accounting (mostly revenue recognition) 33% include allegation of insider trading
Average settlement $23m – up 20% from 2002 6 suits for > $100m
Probability of being sued over 5 yr period 10% chance of being named in at least one suit
Institutional shareholders Lead plaintiff in 30% of cases – up 3% from 1996
Outcomes 38% settled w/ financial recovery (most for only pennies per share) 38% settled w/o financial recovery 23% dismissed/failed 1% verdict for P
Strike suits- Potential for abuse
Suits are brought not to redress real wrongs, but to realize upon their nuisance value
- Settlement incentives Firms settle to avoid discovery, embarrassment, and bad PR Lawyers settle to get guaranteed fee
Expense statutes- Make unsuccessful plaintiffs reimburse firm for reasonable legal expenses
Applies to shareholders w < $50k- Few states have them- Purpose
Deter frivolous litigation Create shareholder liability for other side’s legal fees
- Do they work? Apply only to derivative suits
Careful pleading and weak-minded judges can help evade Can avoid by forum-shopping Impact can be diminished
Can bank together w other shareholders to satisfy minimum Other mechanisms exist
Sanctions for frivolous suits Board ability to terminate non-meritorious litigation
Demand requirement- Basics
Most states requires P demand firm sue alleged wrongdoers Demand must
o Identify wrongdoerso Describe basis of wrongful acts and harm caused to corpo Request remedial relief
Does not have to be formal complaint Shows that Ds manage business and affairs of corp
If demand required, failure to make demand is procedural bar to suit Purpose of demand
Exhaustion of intra-corporate remedies serves ADR procedure to avoid litigation If beneficial to corp, corp can control If demand wrongfully refused, shareholder can control Collapses relevant judicial inquiry to demand stage to conserve resources
- When is demand excused? Business judgment rule
Reviewing demand decision, board gets protection of BJR P usually loses Generally no discovery on these cases
Grimes (DE) Excuse based on facts supporting reasonable doubt that board is capable of making
independent decision (if the following met, no BJR)o Majority of board has financial or familial interest excluding the suit; oro Majority of board incapable of acting independently bc of domination/control; or
But, rejection of structural bias theory – don’t presume insiders biasedo Underlying transaction is not valid exercise of business judgment
Gross negligence standard applied to decision making process (Brehm) Rales test
Excused if facts create reasonable doubt that board COULD HAVE properly exercised independent and disinterested business judgment in responding to demand
Applies in three caseso Where majority of board that made challenged transaction replaced by
disinterested and independent board members
o Where board didn’t make decisiono Where challenged decision made in good faith by board of different corp
Marx (NY) Complaint must allege with particularity
o Majority of Ds interest in self-dealing trans (or controlled by self-interested D); oro Ds didn’t fully inform selves about challenged trans to extent appropriate; oro Trans so egregious on face that it could not have been product of good BJ
If demand made, concede that it is required and not excused Consequences of not making demand trivial – if required just slight delay while you
make demand Thus, well advised Ps almost never made demand
- What happens if excused but board doesn’t want suit? Corp may move to dismiss
If suit not in best interests of corp Usually firm sets of special committee to make recommendation
o Inquiry is whether board in fact acted independently, disinterestedly, or with due care in response of demand
Creates problemso Potential immunity for some self-interested transactionso Disinterested and independent board can refuse demand where does not involve
fraud, illegality, or self-dealing on part of majority of boardo No discovery
If demand required, almost always get to wrongful refusal review Standard is reasonable doubt as to whether BJR applies to decision to refuse demand
Derivative litigation decision tree
Direct or Derivative?Dir
ectπ sues
Demand futility
π suesSLC Cases
DemandrequiredDemand
excused
Derivative
Special litigation committees (SLCs)- Auerbach (NY)
Deferential rule BJR applies to SLC recommendations
Inquiry permissible into two aspects of SLC Disinterest and independence
o P has burden Adequacy and appropriateness or procedures by which decision made
o D might have to make some showing here- Zapata (DE)
STEP 1 - Inquire into good faith and independence of SLC Bases supporting SLC’s recommendation D has burden of proving
o Independenceo Good faitho Reasonable investigation
Objective and thorough Submit written recommendation
Limited opportunity for discoveryo For both sides
More strict than Auerbacho Looks at both process and substance of processo Written recommendations need to support decision to dismiss
Justification = structural bias theoryo Independent SLC not really independent bc
Appointed by rest of board Social influences of rest of board Want to be reappointed Want Ds in their firms to be deferential
STEP 2 - If first step passed, court may (but need not) go on to apply its own business judgment On issue of whether suit should be dismissed Safety valve
o Intended to catch cases where SLC complied w letter but not spirit of law Consider corp’s interest in having suit dismissed along with matters of law/policy Factors
o Cost of litigation v. (likely recoverable damages x probability of liability) If C > DxL, then dismiss
Demand Made?
Demand Refused?
Marx; Grimes
Analysis BOD sues
NoYes
No
YesRefusal wrongful?
Stop; no suit
π sues
YesNo
C includes atty fees, out of pocket expenses, time spent by execso When recovery will be small, consider costs of distraction and lost business
- Oracle Independence test
Turns on whether D is – for any substantial reason – incapable of making decision with only the best interests of the corp in mind
o Focus on impartiality and objectivity SLC has burden of proving its own independence
Unlike demand-excusal context where board is presumed independent DE derivative suit decision tree (w/ SLC)
MBCA alternative- Demand required (§7.42)
Demand required in all cases Shareholder cannot bring suit for 90 days unless
Irreparable injury or Board refusal
- Demand review (§7.44) If disinterested/independent Ds are quorum, board can review In all cases, independent Ds may vote by majority to appoint committee of indy Ds to review Board review must be in good faith after reasonable investigation
Demand can be refused if board concludes that proceeding not in best interests of corp If board that votes is majority independent
Burden of inquiry into independence/adequacy of investigation is on P If board not majority independent
Burden of inquiry on D Does not authorize review by court of reasonableness of determination made by board/committee
Firm can indemnify if person acted in good faith Makes charter provision unenforceable if no good faith
- §145(b) Corp may not reimburse D for liability in derivative suit that he loses unless court approval
- §145(c) Corp must reimburse D for expense in successful suit Indemnification not limited to good faith
Reimbursement of proxy fights- Rosenfeld
General When directors act in good faith in a contest over policy
o They have right to incur reasonable/proper expenses for Solicitation of proxies and Defense of corporate policies
Specifics Corporation may not reimburse either party unless dispute is of Qs of corporate policy Corp may only reimburse reasonable expenses Corp may reimburse incumbents if
o They win; oro They lose
Corp may reimburse insurgents only ifo They win ando Shareholders ratify payment
Problems Distinction bt policy and personnel largely charade Reasonableness – burden should be on Ds Obvious and intractable asymmetry in payment
o Bias in favor of management – disincentive to mounting as insurgency Decision tree analysis
Assumptions:
Dissident owns 15% of shares
G = gain to the corporation from the contest
50% likelihood of winning if insurgent spends $5M
No chance of winning if insurgent spends less; and corporation will spend $5M opposing
Anti Takeover Defenses- Dual class recapitalizations
Payoff
Run ProxyContest?
Win?Yes
No
Yes
No50%
50%15% x (G - $10M)
$5M + (15% x $5M)
0
Firm asks shareholders to approve votes w/ super voting powers Class A stock – existing common stock Class B stock – distributed pro rata to shareholders
o Nontransferableo Convertible to class A shareso Super voting rights (10 votes per share)
Most public shareholders convert to class A Bc they want shares to be transferrable Leaves most voting power to management
Problems Management conflict of interest
- DGCL §160(c) Prohibits corps form voting stock ownership if issuing company is majority shareholder in corp Most applicable to parent-sub relationships
VIII. Control Issues
A. Shareholder Voting Why we give shareholders right to vote
- Makes most sense in closely held firm Information asymmetries are lower Managers are owners
- What about large public corps? Facilitates takeovers
Disciplines management Prevents dilution of rights
Basic feature of voting system- Shareholders vote on 3 kinds of matters
Election of Ds Organic or fundamental changes
Mergers Sales of assets Corporate dissolutions Charter amendments
Shareholder resolutions- Registered shares
Each share has holder of record, which facilitates getting in touch w beneficial holder- Proxy system
If you can’t attend shareholder meeting, you can still vote by finding rep (proxy) Who goes to meeting on your behalf
- State law mandatory rules All state statutes require annual meeting for election of Ds Quorum requirements
- State law default rules All state statutes permit special meetings and action by written consent
- State v. federal law State law governs substance
Federal law governs procedures Voting patterns
- State laws are enabling statutes Alterable by contract
- Patterns of choice are clear One share, one vote Only shares possess vote Cumulative voting is rate Nonvoting stock is rare Shareholder rarely chose managers
Usually chose board who selects managers No special elections Ds not typically recalled from office Shareholders vote by proxy Incumbent slate is elected Issues decided by majority of votes cast
- Limits No vote selling Proxies are revocable up until time of voting Voting required for certain fundamental transactions
Voting apathy- Individual investors
Only informed when benefits > costs Benefits
o Nearly all holder have very small stake in firm o No evidence that corporate governance reforms have impact on performance
Costso Proxy statements long and complex
- Institutional investors Growing role in proxy fights and governance – taking voting more seriously
Costs reduced by outsources to intermediaries Still very little monitoring
More monitoring good? Pros
o Repeat players w large holdingso If not them monitoring, then who?
Conso May limit development of new bizo May lead to other corp governance problemso Undermines board-centric view of firmo Who is watching the institutional monitors?
Board action re votes (Peerless Systems)- Two possibility for standard of review
If board acted w primary purpose of interfering w shareholder franchise Then board must demonstrate compelling justification for actions
If can’t meet primary purpose test Then BJR for Ds’ actions
- Side lessons Non-confidential nature of proxy voting
Allows selective solicitation of voters Management control over process
Not only does management draft proxy But can play fast and loose w voting process
Proxy system- Separation of ownership and control
Fear of managers capitalizing on agency costs Diffuse, uninformed, disinterested shareholders
To keep themselves in office By seizing control of the proxy machinery
- 1934 Act §14(a) Unlawful to use any mean of interstate commerce to solicit any proxy in respect of any security
In contravention of SEC rules/regs necessary in public interest/shareholder protection Key components
General disclosure provisions Disclosure requirement for rival groups General antifraud provision Shareholder communications provision – placing proposal in proxy
- Levin Decision to continue present management rests entirely w stockholders
Director performance irrelevant Disclosure is key foundation for proxy process
Amount spent should not be excessive- Shareholder meetings
Uncontested meetings Managers can charge firm for proxies to get quorum Can charge firm for cost of informing shareholders on issues
Contested meetings Managers may also charge firm for proxies to get quorum
SEC rules- §13(d)
> 5% holders must register w SEC- §13(f)
Institutional investors must register all holdings w SEC- §14(a)(8)
Following are exempt from having to be included in proxy Public statements about how one going to vote Public advertisement asking to vote one way or other Communication w less than 10 persons Communications w someone w whom shareholder has biz relationship
Proxy advisors Proxy card
- Required disclosures Firm must send shareholders annual report Must file preliminary proxy card w SEC 10 days before solicitation Director and executive compensation Biographical material about D, including personal misconduct
B. Precatory Proposals Proposal requirements
- Any shareholder can being as long as Has >$2,000 invested and Has held stock for at least one year
Can aggregate for amount of time- Resolutions must be couched as non-binding- Shareholder can submit only one proposal per year- Limited to 500 word
Outcomes- Proposals never “win” – never get majority of votes- Stunning victory is 10% of vote
Grounds for excluding (14a-8(i))- (1) it is not proper subject for shareholders
Choosing the CEO- (2) it is illegal
Firm should bribe senators- (3) it violates proxy rules
Misleading proposals- (4) it concerns personal grievance or benefit
Austin – labor union and employment practices (not resolved)- (5) it relate to operations which account for < 5% of its net earnings and gross sales AND if not
otherwise significantly related to issuer’s businesso Lovenheim
Not limited to economically significant issues Matters of ethical and social significance can be included
- (6) it is beyond power of firm to effectuate- (7) it relates to firm’s ordinary business operations
Dole – pension fund wants health study (fine since just study)- (8) it relates to an election for membership on company’s board of directors
AIG – process needs to deal w election of removal of directors to be excluded- (12) It was submitted in past and didn’t get support
Must get 3-10% of votes to include in next year Method of excluding
- Firm sends “no action” letter to SEC- If firm loses, always acquiesces- If shareholder loses, can go to DC Cir.
Employment practices proposals- SEC 1992
Bright line rule banning all employment related proposals Under ordinary business exception
- Cracker Barrel No action letter excludes all proposals regarding affirmative action
- SEC 1998 Employment related proposals that raise significant social policy issues can be okay Case by case approach
Day to day stuff like hiring, firing = ordinary business Affirmative action = social policy
C. Shareholder Inspection Rights Shareholder lists
- NY statute Can get lists if
You are shareholder of record for at least 6 mos if not >5% holder It’s for purpose which is in interest of business of foreign corp
- Anaconda Whenever corp faces situation having potential substantial effect on its wellbeing/value
Shareholders are necessarily affected and biz of corp is involved under NY statute- DGCL §220(b)
Requesting shareholder must submit demand asserting proper purpose Something reasonably related to such person’s interest as stockholder
If request for shareholder list, burden on corp to show improper
If request for other records, burden on shareholder to show proper- Pillsbury
Not proper purpose when Impressing opinion favoring reordering of priorities If it was about money and not just moral, it would proper
- Sadler Law should be liberally construed in favor of stockholder DE doesn’t require firm to compile NOBO list Firm has to produce on what is (or should be) in its possession
D. Control in Closely Held Firms Shareholder agreements
- Ringling (DE 1947) Generally enforceable Shareholders can contractually bind selves as shareholders
- McQuade ALL agmts among shareholders binding actions of Ds are void
Stockholders may NOT (by agmt amongst selves) control D in exercise of judgment vested in D
D may not (by agmt as stockholder) abrogate their independent judgment- Clark
Voting agreements to constrain Ds okay if no minority shareholders Shareholder agmts binding if unanimous
- Galler If not unanimous vote, three factors re enforceability
Close corporationo No market for shares – more than just investor – human capitalo Shareholders often directors
No objection from minority shareholders Agreement reasonableness
- Ramos Voting agmts can limit shareholder power
Even if end result is (indirect) constraint on D discretion Vote pooling agmts valid even if firm isn’t statutorily close corporation
You can agree about how you’ll vote as shareholders You can NOT agree about how you’ll vote as directors
o Can evade this by penalizing D votes Why voting agreement Ks necessary?
- Generally Investors/entrepreneurs will NOT agree to form new firm and leave out details of who runs Rather, they insists on deciding crucial details in advance of investment Voting agreement one way to solve this problem
- Buy/sell agreement as rider to shareholder agmt – sometimes required for close corp Cross-Purchase Agmt
Withdrawing owner agrees to sell interest to remaining officers Suited for small biz w few owners
Entity-Purchase Agmt Withdrawing owner agrees to sell interest to entity Which then retires ownership interest
Hybrid Agmt Withdrawing owner must first offer ownership interest to entity If entity declines/unable to purchase, then shares must be offered to other owners
- Setting the price
Right of first refusal Bargain in good faith Valuation formula Book value of assets
o Appraiser Coase theorem
- Private ordering will result in efficient renegotiation or contractual obligation Modern state law
- IBCA §7.70 Generally authorizes voting agmts among shareholders Doesn’t apply to statutorily close corps SCCs can replace board governance w shareholder governance
- IBCA §7.71(b) Shareholder agmt is effective against shareholder not party to K as long as
Shareholder had actual knowledge of agmt when became holder Agmt is conspicuously noticed on certificate of incorporation
- MBCA §7.32(b) Must be unanimous vote Limited to 10 yrs in duration Must be conspicuously noticed on stock Any purchaser without notice entitled to rescission
E. Duties to Shareholders Wilkes
- Fiduciary duties of partnerships apply to corps as well- Modified Donahue test
Shareholders in close corp owe each other a duty of strict good faith If challenged by minority shareholder, controlling group must show
Legit business objective for its action Minority shareholders can nevertheless prevail if can show that
Same purpose could have been achieved in less harmful manner- Court offers intermediate level of fiduciary duty – between partners and BJR
Muddy like this limits clarity and incentives to contract on terms Nixon
- Wilkes is wrong- Holder who buys stock in closely held corp can make BJ whether to buy minority position- Parties can contract for protection and should do so – the court shouldn’t do this if no K
Ingle- Minority shareholder in close corp who contractually agrees to repurchase of his shares upon term- Acquires no right from corp or majority shareholders against at-will discharge
F. Abuse of Control Smith
- Key Q is whether one has control – not size of holdings 25% holder has duty to other holders in close corp under 80% majority rule Can’t act out of personal greed and spite
Jordan- Minority shareholder in close corp must be told about merger at earlier stage than in public corp- Shareholder incidental to employment so seems like at-will should trump
G. Transfer of Control Zetlin
- No duty to share control premium w minority shareholders
- Absent looting of corp assets, conversion of corp opportunity, fraud, bad faith Controlling shareholder free to sell controlling interest at premium price
- Majority can sell control block at a premium Minority shareholders have no automatic tag-along rights
- Any other rule would require tender offer in all cases Too radical of a rule for judges to make
Perlman- When sale necessarily results in sacrifice of obvious business opportunities and consequently unusual
profit to fiduciary who caused sacrifice He should account for his gains
Corporate opportunity transfer- DE
Show that benefit appropriate to the exclusion of detriment of minority- MBCA
Financial interest of D likely to influence judgment
