Law of Business Organization.docx

Introduction to the Law of Business Organization Class Introduction to the Law of Business Organization What are should be the goals for any body of rules designed to govern cooperative economic relations How can the legal system assist people in cooperative economic action How important is economic efficiency as a social value and how do we define or conceive of it What forces social technological other drive the evolution of this body of law Reading Chapter Allen Kraakman Subramanian Chapter INTRODUCTION TO THE LAW OF ENTERPRISE ORGANIZATION Law of enterprise organization A useful menu of standard forms Relations are essentially contractual but some mandatory features A property dimension third party effects Law of agency simplest form of business organization The general partnership simplest form of jointly owned business firm Corporate form most stable complex and socially important form of business organization This course not only describe the rules of enterprise law but also attempt to evaluate them This introductory chapter Efficiency as a standard Relationship between efficiency and fairness Outline of the modern learning on the economics of the firm transaction cost theory and agency cost theory Efficiency and the Social Significance of Enterprise Organization Wealth Creation and the Corporate Form of Organization Corporate law deals with the control over vast aggregations of wealth and power Dominance of corporate form throughout the world What Do We Mean by Efficiency Economic efficiency is the principal standard by which this law should be evaluated throughout this course grapple with the question whether a given rule of law or principle or practice is likely to be efficient Pareto Efficiency Only efficient if resources are distributed in such a way that no reallocation of resources can make at least one person better off without making at least one person worse off In reality at least one person gets worse off problem of externalities Pareto efficiency is poorly suited to evaluating or criticizing the law of enterprise organization Kaldor-Hicks Efficiency Rule is efficient if at least one party would gain from it after all those who suffered a loss as a result of the transaction or policy were fully compensated not actual payment but potential improvement Limitations but advantage compare costs and benefits when this course speaks of efficiency it has Kaldor-Hicks efficiency in mind Law from Inside and Out Shared Meanings and Skepticism Viewing law from interior perspective of legal actor v from external perspective of a social scientist The Outside and the Inside Perspective social scientist rooted in practical need to produce good society in changing world Perspective legal actor rooted in history authority and consistency Today legal education and scholarship combine the interior and exterior perspectives Fairness and Efficiency Efficiency should be at the core of organizational law but courts rarely use the efficiency concept How can we expect the legal system to even approximate a normative ideal of Kaldor-Hicks efficiency Short answer In corporation law fairness is generally fairness to SHs SHs interests are increasing total corporate wealth Kaldor-Hicks efficient state Development of the Modern Theory of the Firm In business law a lawyer who fails to understand the economics of a problem usually fails to find a satisfactory solution to the problem Eighteenth century Adam Smith problem firms require managers that are less diligent than owners Until s the internal organization and function of firms were largely ignored Ronald Coase s Insight Firms exist because of transaction costs Some transactions can be accomplished more cheaply in firms than on markets Transaction Cost Theory Two areas of ongoing research Transaction Cost Theory Firm is a set of transactions cost-reducing relationships Agency Cost Theory Agency Cost Theory Jensen Meckling Takes up Adam Smith s observations that firms require managers that are less diligent than owners Basic insight of agency approach to the extent the incentives of an agent differ from the incentives of the principal a potential cost will arise an agency cost Agents are maximizers of their own interests rather than the interest of their principals At the margin managers will fail to optimize firm value PROBLEM Three general sources of agency costs Monitoring costs Bonding costs Residual costs In which relationships Managers v investors owners Majority SHs v minority SHs Firm v other parties with whom it transacts Corporation is most important form of business organization it reduces transaction costs but risk of agency costs so a principal aim of corporation law is the reduction of agency costs of all sorts Class The Law of Agency Class The Earliest Building Blocks of Economic Organizations Law of Contract and Agency Formation of agency relation Authority of agents Termination of agency Principal s liabilities to third parties for agents acts - Contracts by agents beyond express powers - Tortious Acts by agents Reading Chapter AKS Review Restatement of Agency in Statutory Supplement Class Conclusion on Law of Agency Introduction to Partnerships Liability of Agent to Principal Fiduciary Duties Liability of Principal to Agent Reading same as Class Here concentrate on three aspects that have greatest relevance to corporation law Formation and termination Liability Principal s relationship to third parties for agents acts Liability of Agent to Principal Fiduciary duties Liability of Principal to Agent Contractual a Formation R A three elements Consensual relationship both agent and principal must agree but consent may be implicit Jenson Farms different forms of granted authority special agents general agent disclosed undisclosed partially disclosed Principal has right to control agent Different levels e g Employment control details e g Independent contractor control less extensive Agent acts on principal s behalf b Termination Principal can revoke and agent can renounce at any time In no event will an agency continue over the objection of one of the parties If a set term is fixed termination by one party can give rise to a claim for damages for breach of contract only monetary damages no specific enforcement Principal s relationship to third parties Liability in contract Actual authority a reasonable agent would infer from the conduct of principal Incidental authority ordinarily done in connection with facilitating the authorized act Apparent authority a reasonable third party would infer from conduct of principal R A White v Thomas What is reasonable third party Third party has some obligation to inquire about an agent s scope of authority Inherent authority inherent power not conferred on agents by principals but represents consequences imposed on principals by the law R A A R A comment b R A Gallant Nature of inherent authority Agency by Estoppel If i failure to act when knowledge and ii an opportunity to act arise plus iii reasonable change in position on the part of the third person R A Agency by Ratification Accepting benefits under an unauthorized contract R A Liability in tort Only a particular kind of agency relationship the employer-employee relationship not independent contractors ordinarily triggers vicarious liability for all torts committed within the agent s scope of employment R A Humble Hoover Examples of distinction between employee and independent contractor facts are important Duties that agent owes to principal Agent is a fiduciary of her principal Numerous specific duties Three categories of general duties see also p Duty of obedience obey principal s commands Duty of loyalty in good faith advance purposes of principal not for personal benefit R A - Tarnowski v Resop No self dealing all profits made by agent in capacity as agent must go to principal Recovery of profits and damages by principal if agent breaches duty of loyalty Duty of care as a reasonable person would act Trust resembles agency Trustee has power to affect interests of beneficiary Trust differs from agency Trustee is not ordinarily subject to control of beneficiary In Re Gleeson No self dealing all profits made by trustee in capacity as trustee must go to beneficiary Chapter acting through others the law of agency Introduction to Agency What is agency One person extends the range of her own activity by engaging another to act for her and be subject to her control Business law not only contract law also property and agency law Many basic problems of corporation law are prefigured in law of agency core problems are similar Here concentrate on three aspects that have greatest relevance to corporation law Formation and termination Principal s relationship to third parties Duties that agent owes to principal Agency Formation Agency Termination and Principal s Liability Formation Definition of Agency R A Consensual Both principal and agent have to consent Principal can define or delimit the granted authority in any way she pleases Possibilities special agent general agent disclosed undisclosed partially disclosed Principal s right to control agency is essential aspect may vary substantially E g Employee servant right to control details E g Independent contractor rights of control are significantly less extensive Termination Principal can revoke and agent can renounce at any time In no event will an agency continue over the objection of one of the parties If a set term is fixed termination by one party can give rise to a claim for damages for breach of contract only monetary damages no specific enforcement Questions Parties Conception Does Not Control Agency relations may be implied even when parties have not explicitly agreed to an agency relationship Why might courts be particularly concerned about debtor-creditor contracts JENSON FARMS CO v CARGILL INC N W d Minn Facts - Warren operated as a grain elevator purchasing grain from local farmers - - Cargill financed Warren In several stages financing became larger In the same time Cargill s control over Warrens business and finance grew as well examples indications see book p - in order to monitor financing - Cargill found out that Warren s financial statements had been deliberately falsified Cargill refused additional financing Warren owed million to Cargill - Warren defaulted on contracts made with plaintiffs for the sale of grain Warren owed million to plaintiffs Procedural history - Plaintiffs sought recovery of million They brought action against Warren and Cargill They alleged that Cargill was jointly liable for Warren s indebtedness as it had acted as principal for Warren - Jury trial in favor of plaintiffs - This appeal affirms Issue s Became Cargill by its course of dealing with Warren liable as a principal on contracts made by Warren with plaintiffs Even though Warren and Cargill didn t explicitly agree on an agency relationship Applicable Rule s of Law R A and Definition of agency Holding s Yes The Court s Order Affirms judgment jury trial Reasoning - In order to create an agency there must be an agreement but not necessarily a contract between the parties An agreement may result in the creation of an agency relationship although the parties did not call it an agency and did not intend the legal consequences of the relation to follow - Existence of agency may be proved by circumstantial evidence which shows a course of dealing between two parties prove of consent and control - This deal is markedly different from an ordinary bank financing Cargill s reason for financing was not interest on loan but to establish source of market grain for its business Criticism Control alone is not enough for agency see C QUESTION ON JENSON FARMS CO v CARGILL INC See C Liability in Contract Actual and Apparent Authority Actual authority a reasonable agent would infer from the conduct of principal Incidental authority ordinarily done in connection with facilitating the authorized act Apparent authority a reasonable third party would infer from conduct of principal R A Apparent authority What is reasonable third party WHITE v THOMAS LEXIS Ark App Facts - White appellant gave Simpson authority to bid in his behalf up to on an entire -acre farm except for the three acres on which a house sat - Stanley and Mary Thomas appellees bought the three-acre tract on which the house sat Simpson bought the -acre balance of the land for - Simpson sold to the Thomasses forty-five acres of the land she just purchased She did not have actual authority to do so but told the Thomasses that she had a power of attorney for the sale - White closed the deal for the -acre purchase but repudiated Simpson s action of selling the forty-five acres to the Thomasses Procedural history - The Thomasses began action seeking specific performance of the contract - Trial court concluded that contract was valid and binding and ordered specific performance and release of property by bank from its mortgage lien Issue s Simpson did not have express actual nor implied incidental authority to resell part of land Did she have apparent authority to do so Holding s No The Court s Order Reversed order of specific performance and release of property by bank from its mortgage lien Reasoning Indeed appellees were sufficiently concerned about Simpson s authority to contract to sell White s property that they specifically asked her whether she was so authorized Appellees made no attempt to contact White concerning Simpson s authority and did not even demand to see the alleged written power of attorney under which Simpson claimed to be acting Instead they close to rely solely upon an admitted agent s own declarations as to her authority While the declarations of an alleged agent may be used to corroborate other evidence of the scope of the agency neither agency nor the extent of the agent s authority can be shown solely by his own declarations or actions in the absence of the party to be affected Questions Comments and Speculations What is reasonable third party Third party has some obligation to inquire about an agent s scope of authority Inherent Authority Inherent authority inherent power not conferred on agents by principals but represents consequences imposed on principals by the law Ratio protection of third party harmed by or dealing with agent Easiest to understand in context of an undisclosed principal transaction E g see p Problem third party cannot invoke apparent authority since she did not even know of the existence of the principal R A A traditional approach i as long as a general agent would ordinarily have the power to enter such contract and ii the third party does not know that matters stands differently in this case Concept of inherent authority no longer included in R A R A comment b and R A Agency by estoppels and restitution Same result for the particular case of an undisclosed principal Is that true Which approach do you prefer better Nature of inherent authority GALLANT INS CO v ISAAC N E d Ind App Facts - T-Harris is an independent insurance agent Its authority includes the power to bind Gallant Insurance Company Appellant on different aspects of insurance policies No written agreement describes their relation but the Record indicates Gallant became bound at time and date when T-Harris i faxed or called Gallant and ii received premiums - Isaac s Appellee insurance would expire on Dec On Dec she went to T-Harris to renew her policy for a new car Employee of T-Harris told Isaac that agency was closed but she would immediately bind coverage and asked Isaac to come back on Dec to complete the paperwork and pay the down payment On Dec another employee sent a fax to Gallant to request new policy and stated that effective date of change was Dec - On Dec Isaac collided with other car in which Davis Appellee was a passenger - Later on Gallant renewed Isaac s insurance policy with effective starting date of Dec Procedural history - Gallant brought compliant for summary judgment that would state that policy was not in force It insists that T-Harris did not have authority to bind Gallant in a manner contrary to what its policy states - Trial court granted summary judgment in favor of Defendants-Appellees Issue - Neither an actual nor apparent authority theory applies - Did T-Harris have authority to act as Gallant s agent under an inherent authority theory Holding Yes The Court s Order Affirms summary judgment Reasoning - Inherent power is power of agent that is derived not from authority apparent or estoppels but from the agency relation itself Ratio protection of third party harmed by or dealing with agent - Double test Act must be act which usually accompanies or is incidental to such authorized transactions and third party must have reasonably believed that agent had authority to conduct the act in question based at agent s direct and indirect manifestations Questions Comments and Speculations Is this combination of incidental and apparent authority No apparent authority is based on actions or statements of principal not of agent QUESTIONS ON WHITE AND GALLANT Agency by Estoppel If i failure to act when knowledge and ii an opportunity to act arise plus iii reasonable change in position on the part of the third person R A Agency by Ratification Accepting benefits under an unauthorized contract R A Liability in Tort Only a particular kind of agency relationship the employer-employee relationship not independent contractors ordinarily triggers vicarious liability for all torts committed within the agent s scope of employment R A Distinction between employee and independent contractor HUMBLE OIL REFINING CO v MARTIN Tex S W d Facts - Schneider operated gas station owned by Humble at the time of accident - Love left her car at that gas station - Car rolled off the premises and hit Martin and his three daughters - Jury established acts of negligence by Schneider is no longer at discussion here Issue Is Schneider an independent contractor or an employee of Humble If Schneider is an employee Humble would be liable for torts committed by Schneider Holding Schneider is employee Reasoning - Factual circumstances that Schneider is an employee p - Distinction with The Texas Company v Wheat factual circumstances were different Distinction between employee and independent contractor HOOVER v SUN OIL CO A d Del Facts - Barone operated service station owned by Sun Oil Company Smilyk was employee of Barone - Fire started at rear of plaintiff s car allegedly caused by the negligence of Smilyk Procedural history Plaintiff sued Smilyk Barone and Sun Issue s Is Barone an independent contractor or an employee of Sun Holding s Barone is an independent contractor Reasoning - Factual circumstances that Barone is an independent contractor p - - Distinction with other case factual circumstances were different QUESTIONS ON HUMBLE OIL AND SUN OIL As a policy matter who should be held liable for torts of franchisees Both franchisor has more money and franchisee has better control over negligent acts The Governance of Agency The Agent s Duties The Nature of the Agent s Fiduciary Relationship Agent is a fiduciary of her principal Legal power over property held by the fiduciary agent is held for the sole purpose of advancing the purposes of the principal Fiduciary is bound to exercise her good-faith judgment in an effort to pursue under future circumstances the purposes established at the time of creation of the relationship Numerous specific duties Three categories of general duties see also p Duty of obedience obey principal s commands Duty of loyalty in good faith advance purposes of principal not for personal benefit Duty of care as a reasonable person would act Further discussed in partnership and corporate context Point here Why assume duties the form that they do What remedy if duty is breached How should duty differ according to specific fiduciary relationship The Agent s Duty of Loyalty to the Principal QUESTIONS ON RESTATEMENT THIRD AGENCY - Why should self-dealing transactions that are not disclosed be voidable automatically under No self dealing all profits made by agent in capacity as agent must go to principal Recovery of profits and damages by principal if agent breaches duty of loyalty TARNOWSKI v RESOP N W d Minn Facts - Plaintiff principal asked defendant agent to investigate and negotiate for a purchase of a route of coin-operated music machines Relying upon defendant s advice plaintiff purchased such a business from the sellers - Defendant made only a superficial investigation and adopted false representations of the seller and passed them on to plaintiff False representations about gross net income number of locations age of machines Defendant also received a secret commission from sellers - Plaintiff rescinded the sale but sellers refused - Plaintiff brought suit against sellers and won Procedural history - This action plaintiff brought action against defendant seeks to recover secret commission defendant received and damages for - Jury verdict in favor of plaintiff - Here on appeal Issue s Can principal recover profits made by his agent even though he rescinds act of agent and he obtained recovery from third party sellers Can principal recover damages listed on p of his agent who has breached his trust even if principal was successful in rescission against third parties Applicable Rule s of Law Holding s Yes Yes The Court s Order Reasoning Universally recognized principle All profits made by agent in course of agency belong to principal Also fruits of violation of agent s duty Also if principal upon discovering a fraud has rescinded the contract and recovered his input Yes General rule R A comment p Rule also applies to attorney s fees if directly traceable to the harm caused by defendant s wrongful act QUESTIONS ON TARNOWSKI v RESOP If only damages is only restitution it doesn t take into account the missed business opportunity profits The Trustee s Duty to Trust Beneficiaries Trust resembles agency Trustee has power to affect interests of beneficiary Trust differs from agency Trustee is not ordinarily subject to control of beneficiary R of Trusts No self dealing all profits made by trustee in capacity as trustee must go to beneficiary IN RE GLEESON N E d Ill App Facts - Gleeson settlor owned among other properties acres of land - Colbrook trustee was appointed as trustee under the will The residuary estate including acres of land was devised to him in trust for the benefit of Gleeson s children beneficiaries - After Gleeson s death Colbrook leased the acres of land to himself and a partner the self-dealing Special circumstances the deal was ok arm s length full disclosure however Colbrook did not make effort to look for other tenant Issue Was this self dealing allowed If not Colbrook s actions farming the land were actions as a trustee in other words the profits of farming the land belong to trust not to Colbrook himself Applicable Rule s of Law General principle of equity trustee cannot deal in his individual capacity with the trust property Holding No Reasoning Colbrook did not make effort to look for other tenant Colbrook should have decided whether to continue as a tenant or to act as trustee He chooses trustee so he could not deal with himself Comments Coolbrook behaved fine but liability because of self-dealing Class Law of Partnership Class Law of Partnership What is it legally What are economic reasons that we observe evolution of partnership form Formation Default Powers of Partners contractual flexibility of form Authority of partners how is the Partnership bound Tenancy in Partnership UPA Section Liability of partners to third parties Liability of partners among themselves Reading pp - AKS Stat Supp Uniform Partnership Act to section Class Law of Partnership Partnership Dissolution New Forms growth of limited liability Reading pp - AKS Stat Supp UPA sections - rev UPA - Tenancy in partnership Unlimited personal liability for partners Chapter the problem of joint ownership the law of partnership Introduction to Partnership Compare with agency law With respect to third parties closely follows agency law With respect to relation among partners UPA RUPA Important difference tenancy in partnership of partnership property Primary agency problem Not between agent and owner But potential conflicts among the joint owners Why Have Joint Ownership Cheaper way to raise capital Co-ownership creates problems of its own but it can also resolve contracting problems Story of the formation of a partnership driven by the need for capital WILLIAM KLEIN JOHN C COFFEE THE NEED TO ASSEMBLE AT-RISK CAPITAL Business Organization and Finance - th ed Two possibilities of raising capital Borrowing money fixed interest rate but interest rate will be higher if risk higher Investment share in risks and profits in exchange investor wants control QUESTIONS ON THE KLEIN-COFFEE EXCERPT Roots of modern-day partnerships ancient Rome HENRY HANSMANN REINIER KRAAKMAN RICHARD SQUIRE LAW AND THE RISE OF THE FIRM Harv L Rev Four structures that allowed for joint ownership of business organization focus on asset partitioning or entity shielding The Partnership The Family The Peculium The Tradable Limited Partnership The Agency Conflict Among Co-Owners Three fundamental Agency problems Conflict between agents and principals agency in general Conflict between principals and third parties agency in general Conflict between controlling and minority co-owners specific partnership Illustration MEINHARD v SALMON N E N Y Facts - Meinhard plaintiff and Salmon defendant entered into a joint venture - Defendant entered into a lease for the premises of the Bristol Hotel on th Avenue for a term of years He planned to change it into shops and offices at a cost of Plaintiff and defendant entered into a joint venture to finance the operation Plaintiff had to pay half of the money requisite to reconstruct alter manage and operate the property Defendant had to pay plaintiff of the net profits for the first five years for the years thereafter Defendant had the sole power to manage lease underlet and operate the building Each party had to bear the losses equally The operation resulted in a rich return - After the end of the lease defendant entered into a new lease covering not only the Bristol premises but also other premises owned by the new owner The lease was granted to Midpoint Realty Company owned and controlled by defendant The lessee had the obligation to replace the existing buildings after seven years with a new building to cost Rental was to old lease was only Defendant personally guaranteed the performance He didn t involve plaintiff in the new lease - Plaintiff asked that the new lease be held in trust as an asset of the joint venture and to share the obligations Defendant refused Procedural History Referee attributed of whole lease to plaintiff based on pro rata of Bristol premises Appellate division attributed of whole lease to plaintiff Case is now on appeal by defendant Applicable Rule s of Law Joint venturers like copartners owe to one another while the enterprise continues the duty of the finest loyalty Not honesty alone but the punctilio of an honor the most sensitive Holding s While it lowered the plaintiff's award to the court held that Salmon as the managing partner owed Meinhard as the investing partner a fiduciary duty and that this included a duty to inform Meinhard of the new leasing opportunity Reasoning - Joint venturers owe each other the highest duty of loyalty Not honesty alone but the punctilio of an honor the most sensitive and Salmon as managing partner has assumed a responsibility by which Meinhard must rely on him to manage the partnership - The court further held that Salmon was an agent for the joint venture and when Salmon agreed to the new business opportunity which was made available to Salmon only because he held that position with relation to the joint venture Salmon carried the joint venture into the new lease with him Questions Comments and Speculations - This decision extended the duties of partnership far beyond duties under a contract It determined that in such a relationship loyalty must be undivided and unselfish and that a breach of fiduciary duty can occur by something less than fraud or intentional bad faith - Today Partners contract about corporate opportunity doctrine If no contract corporate opportunity is specification of duty of loyalty he has fiduciary duty to share with others Dissent A three-judge dissent written by Judge Andrews contended that any duty following from the partnership ended at the end of the twenty year period because the partnership was created to manage the building for the twenty year term the dissent felt that deals involving events to occur after the expiration of that term were of no matter to the partnership QUESTIONS ON MEINHARD Joint venturers owe each other the highest duty of loyalty Not honesty alone but the punctilio of an honor the most sensitive one party may not appropriate to his own use a renewal of a lease though its term is to begin at the expiration of the partnership A partner though he may not renew a lease may purchase the reversion if he acts openly and fairly Partnership Formation Implied partnership VOHLAND v SWEET N E d Ind App Facts - Sweet plaintiff started working as an hourly employee in a nursery operated by Charles Vohland father of plaintiff - After Charles Vohland retired Sweet s status changed he was to receive of net profits of the enterprise after all of the expenses were paid - Sweet s income tax stated he was a self-employed salesman at the nursery money paid to Sweet was listed as commissions in Vohland s income tax return Vohland handled all financial books and made most of the sales Vohland alone took up loans Sweet managed the physical aspects of the nursery - Sweet tries to dissolve partnership and get his share of business wind-up sell assets and distribute proceeds Issue s Is Sweet a partner by inference Applicable Rule s of Law Principles governing establishment of partnerships p Central factor division of profits Contribution of capital is not required Parties can be partners even if they expressly stipulated otherwise it is their behavior that matters Holding s Yes a partnership may be implied even by contribution of sweat equity The Court of Appeals held that evidence that plaintiff received a share of nursery's profits presents a prima facie case UPA to support a finding that a partnership existed and that plaintiff had a interest in inventory of the nursery and bare assertion unsupported by authority that neither of alleged partners in nursery had any interest whatever in nursery stock planted on leased land did not comply with appellate rule requiring citation of authority and cogent argument thus waiving such issue Questions Comments and Speculations - Note The more inventory Sweet provides the less he gets paid Unless Sweet were a co-owner he would have a perverse incentive to keep inventory low so as to keep his profits higher Thus Sweet believed he had a stake in the business - Note If Vohland had faced bankruptcy court likely would not have found that Vohland sincerely believed that Sweet was a partner QUESTION AND NOTE ON VOHLAND v SWEET Sharing of gross return is not sharing in risks Relations with Third Parties Three principal issues Who is a partner When can existing or retiring partner escape liability for a partnership obligation How are claims to an individual partner s personal assets to be balanced against the claims of nonpartnership creditors of that person Who Is a Partner PROFESSOR BRUDNEY S UPA PROBLEMS Consider UPA - and Third-Party Claims Against Departing Partners Uncomfortable situation of departing partner still liable but no longer control UPA and release of liability in two situations Policy balance between Third-Party Claims Against Partnership Property Tenancy in partnership Partners cannot transfer partnership property but do have transferable interest in the profits arising from the use of partnership property and the right to receive partnership distribution UPA and RUPA and Claims of Partnership Creditors to Partner s Individual Property Partnership Assets Individual Assets Partnership Creditors Individual Creditors See chart p QUESTION Partnership Governance and Issues of Authority NATIONAL BISCUIT CO v STROUD N C Facts - Stroud and Freeman entered into a general partnership to sell groceries Nothing in the agreement limits Freeman s authority with respect to the ordinary business of the partnership - Stroud advised plaintiff that he personally would not be responsible for any additional bread sold by plaintiff to the partnership - At the request of Freeman plaintiff sold bread to partnership Issue s - Are the partnership and Stroud bound by the purchase of bread - Can one partner limit the authority of the other partner Holding s - YES UPA Freeman has equal rights in the management and the conduct of the partnership business - Activities within the scope of business should not be limited save by the expressed will of the majority half of partners is not majority QUESTIONS ON NABISCO Termination Dissolution and Dissociation Accounting for Partnership s Financial Status and Performance Balance Sheet Income Statement Capital Account QUESTIONS ON THE SAMPLE BALANCE SHEET AND INCOME STATEMENT ADAMS v JARVIS N W d Wis Facts - Partnership of three doctors - Partner withdraws - Partnership agreement stipulates that in case of withdrawal accounts receivable will remain with partnership no distribution of proportionate part to withdrawing partner Procedural history - Trial court Withdrawal of plaintiff woked as dissolution of partnership under UPA of partnership agreement did not apply Issue s - Is withdrawal of partner a dissolution under UPA notwithstanding partnership agreement to the contrary - As a practical matter is withdrawing partner entitled to share of accounts receivable Holding s Reasoning - NO Partnership agreement did not violate statute UPA contemplates a discontinuance of the day-to-day business but does not forbid other methods of winding up a partnership - NO UPA applies only unless otherwise agreed Distribution must be made pursuant the agreement QUESTIONS ON ADAMS v JARVIS In-kind distribution or in cash DREIFUERST v DREIFURST N W d Wis Facts - Partnership dissolution - Partners disagreed on form distribution in cash or in kind feed mills Issue s - Upon dissolution does partner have right to sale assets or only in-kind distribution - Can trial court force actual sale of assets or determine and let other partners pay fair market value Holding s - UPA no in-kind distribution unless all parties agree - YES trial court can force actual sale Reasoning - In-kind distribution only permitted in very limited circumstances Rinke v Rinke conditions for in-kind distribution - Conditions not fulfilled in this case QUESTIONS ON DREIFUERST A LAST BRUDNEY QUESTION On what terms should an old partner leave payment in cash in kind force sale and a newcomer enter UPA - and RUPA Dissolution of partnership for a term PAGE v PAGE P d Cal Not discussed in class QUESTIONS ON PAGE v PAGE Limited Liability Modifications of the Partnership Form General partnership features Tenancy in partnership Beneficial owners Agents Extra fourth element Limited liability The Limited Partnership ULPA RULPA A general partner No limited liability May bind partnership in relation with third parties Limited partners Limited liability May participate in profits May not participate in general management otherwise loss of limited liability NOTE ON CONTROL IN LIMITED PARTNERSHIPS Used to be control test if partner has control over business it loses its limited liability UPAC No control test anymore Limited partner can have limited liability even if he has control QUESTION General partners do not enjoy limited liability Limited Liability Partnerships and Companies Combine partnership taxation with limited liability The Limited Liability Partnership What is All partners have limited liability at least for certain liabilities and limited periods depend on state law QUESTION Eg firms with large class actions see movie a civil action The Limited Liability Company Class Introduction to the Corporate Form Class Introduction to the Corporate Form Why does something like the corporate form dominate other organization forms around the world Characteristics of the form their efficiency implications History of the form from mandated form to enabling philosophy and free incorporation The Incorporation process today The Federal Role and State Role in U S Federalist System Why Delaware dominate incorporation choice in U S Governance role of the certificate and bylaws Central role of management board The Shareholder collective action problem and Evolution of Institutional Investor Voice Role of Incorporation statute and of fiduciary duty Reading pp - AKS Key characteristics of corporate form compared to partnership Separate legal entity Limited Liability Transferable shares Centralized management SH appoint Board Chapter THE corporate form Introduction to the Corporate Form Why is corporation standard legal form adopted by large-scale private enterprises Meets problems of General Partnership characteristics of corporate form are Legal personality with indefinite life Limited liability for investors Free transferability of shares Centralized management Appointed by equity investors Highly efficient legal form for enterprise organization Distinctions Public company Close corporations Controlling SH No controlling SH Creation of a Fictional Legal Entity Legal personality reduces transaction costs Indefinite life enhances stability A note on the History of Corporate Formation Succes of Delaware p - The Process of Incorporation Today RMBCA to DGCL The Articles of Incorporation or Charter What goes in Charter Overriding concept contractual freedom But - must provide for - may not be in contravention of law The Corporate Bylaws What are What goes in bylaws Right to amend SH or BoD In some states SHs have inalienable right to amend bylaws Conflict with directors that amend bylaws What are limits of SH power Shareholder s Agreements Typically address More formal form Voting trust Limited Liability What does it mean SH cannot lose more than the amount they invest Absent some special circumstances It s a default rule SH can give personal guarantees Economic reasons for Limited Liability More easy to evaluate equity investment Encourages to invest in risky adventures Incentives for creditors to monitor their corporate debtors Change in attitude in history Chief purpose of limited liability is to encourage investment in equity securities so make capital more available for risky ventures FRANK EASTERBROOK DANIEL FISCHEL LIMITED LIABILITY AND THE CORPORATION U Chi L Rev - Limited liability reduces agency costs LL decreases need to monitor managers LL reduces cost of monitoring other SHs By promoting free transfer of shares LL gives managers incentives to act efficiently LL makes it possible for market prices to impound additional information about the value of the firms LL allows more efficient diversification LL facilitates optimal non risk averse investment decisions QUESTION Problem not enough money to pay damages Solution break-trough rules for some intentional torts Transferable Shares SH own a share interest not corporation s property Transferable shares Tied to limited liability Encourages active stock market Is default provision Complements centralized management Constraint on self-serving behavior Centralized Management Agency problem policy guidelines for corporate law Encourage managers to be diligent Mitigate collective action problem Encourage cys to make investment decisions that are best for SH residual claimants Details of Board s structure in charter or bylaws Distinction between board and managers officers Board is usually elected by SHs Legal Construction of the Board The Holder of Primary Management Power BoD ultimate locus of managerial powers Is this what SHs want AUTOMATIC SELF-CLEANSING FILTER SYNDICATE CO LTD v CUNNINGHAME Facts - The articles of association of Automatic Self-Cleansing Filter Syndicate Co Ltd the company allocated management powers to BoD However BoD was subject to regulations adopted by a majority SH vote - McDiarmid plaintiff together with his friends a majority SH wanted to sell the company s assets A special SH meeting voted in favor of selling of the assets However BoD refused to sell assets Plaintiff asked the court to order the BoD to sell assets Court refused Issue s Management powers BoD v SH Does the BoD has to execute management decision taken by the majority of SHs Applicable Rule s of Law Art en of the company law Holding s BoD was entitled to reject SH s resolution to sell assets To alter powers of BoD an extraordinary resolution of SHM is required Reasoning Directors are not agents of the majority Directors are neither agents of the company It is by consensus of all the individuals in the company that these directors become agents and hold their rights as agents The minority must also be taken into account Concurring opinion Cozens-Hardy Articles of association are a contract between SH in this case majority required Comments If BoD thwarts the will of a majority SH the latter has alternatives eg remove BoD QUESTIONS ON AUTOMATIC SELF-CLEANSING FILTER SYNDICATE BoD has primary management power but mostly it designates managers or a CEO who in turn nominates other officers But managerial powers of directors acting as a board are extremely broad Structure of the Board Default rule Elected annually to one-year term Board has inherent power to establish standing committees Charter may provide that board seats are to be elected by certain class of stock Statutes permit staggered board DGCL d NYBCL Formality in Board Operation Directors act as a board only At a duly constituted board meeting by majority vote formally recorded in minutes Notice and quorum required minimum requirements DGCL b A board may act without meeting if members give their unanimous written consent DGCL f Fogel v U S Energy Systems Inc Even if majority of directors agree a meeting must be held A Critique of Boards Directors spend have too little time to fulfill their monitoring tasks Corporate Officers Agents of the Corporation What are CEO president vice presidents treasurer secretary Generally corporate charter empowers BoD to appoint and remove officers with or without cause Officers unlike directors are agents of the corporation What kind of authority do officers have as agent JENNINGS v PITTSBURGH MERCANTILE CO A d Pa Facts - Jennings plaintiff is real estate broker - Mercantile defendant is a publicly-held corporation - Egmore and Stern two officers of Mercantile so agents of mercantile asked Jennings to solicit offers for a sale and leaseback Egmore outlined preliminary the terms of an acceptable offer He promised Jennings a commission if transaction was successful - Jennings brought an offer Stern its financial consultant informed that the executive committee had agreed the deal However one week later vice president informed that offer was rejected and refused to pay the commission Issue s - Did Mercantile principal cloth its Egmore agent with the apparent authority to accept an offer for the sale and leaseback thereby binding it to the payment of the commission NB Egmore had no actual authority Holding s NO The Court s Order Reasoning - Apparent authority emanates from actions of principal not agent Jennings based her claim on representations that Egmore made - To draw apparent authority from prior dealings prior dealings must be similar degree of repetitiveness here no similarity - Extraordinary nature of transaction Jennings should have inquire Egmore as to actual authrority Jennings did not do that Questions Comments and Speculations Signal to corporate world that for such a transaction sale of substantially all assets apparent authority is not enough NOTE QUESTIONS ON JENNINGS Class Capital and Shareholders Class Corporate Form Raising Capital Introduction to capital structure of a business - Characteristics of debt and equity as sources of capital - Is there an optimal capital structure for a business - Entrepreneurs try to get capital on lowest terms how can they estimate the costs of debt and equity capital - The problem of equity opportunism Finance module - Risk and return - Asset Valuation Discounted Cash Flow Technique Efficiency of modern markets in shares The Relatively Efficient Market Hypothesis Reading pp - AKS Class Raising Capital Protections for Creditors Whom do creditor protections help Sources of Risk to creditors and Protections Finance Contract Law -Minimum capitalization rules What purpose could they serve -Restrictions on dividends o Balance sheets and real economic value -Fraudulent conveyance law -Creditor equitable remedies o Piercing Corporate Veil o Equitable subordination Reading pp - AKS Class Raising Capital Protection for Equity Investors summary From what losses should equity investors be offered protection Why Market constraints on agency costs Legal Protections Shareholders rights to Sell Vote or Sue Shareholders Collective Action Problem what is it How profound Evolution of institutional investors and activist shareholders Why is it shareholders who vote Economic theory of efficiency of shareholder voice -When may shareholders have incorrect incentives Technical aspects of voting -On what matters do shareholders vote -Power to call meetings -Removing directors staggered board structures and their rapid disappearance in public companies Filling Board Vacancies -Shareholder Information rights o Introduction to proxy statements and state law information rights -Counting votes How a detail really matters majority plurality -Shareholder power through selling shares theory Intro to Shareholder rights to sue Fiduciary duties of the Board of Directors Reading Stat Supp DGCL See e g DGCL a b c Chapter debt equity and economic value Corporate law rules give incentives to create wealth in our society What counts as economic value is critical for a full understanding of corporate law This chapter Survey of corporate finance concepts Capital Structure Two types of raising capital Debt or Equity Capital structure mix of those two for a certain cn Legal Character of Debt Debt securities contract great flexibility but general patterns in practice Allocates risks between debtor and creditor between classes of debtors Characteristics general patterns Principal amount due at maturity date Interest rate Protections Accelerate if in default priority claim over equity covenants securities Interest is a deductable cost Debt is cheaper than equity p p - C C Cost of capital to the corporation depends on i tax deductibility ii higher risk of equity investments iii tax rates of investors in debt iv costs of financial distress Legal Character of Equity Equity contract clear default rules deviations must go in charter Residual Claims and Residual Control Preferred stock stated dividend less risky voting rights Basic Concepts of Valuation Goal attract capital at lowest cost understand how to value securities Four basic finance concepts Time value of money Risk and return Systematic risk an diversification Capital market efficiency The Time Value of Money Basic concepts Future value FV PVx r n Present value PV FV r n DISCOUNTING EXERCISES Other concepts Rate of returen Positive negative net present value A QUESTION ON NET PRESENT VALUE Risk and Return Discount expected cash flows weighted average of value of investment at a rate that reflects both the time discount value of money present value and the market price of the risk risk premium involved risk adjusted rate Diversification and Systematic Risk Diversify across a portfolio Packaging of investments to reduce risks Lower risk premium But not zero risk premium not every risk is diversifiable QUESTIONS ON SYSTEMATIC AND UNSYSTEMATIC RISK Valuing Assets The Discount Cash Flow DCF Approach Valuation of assets is based on understanding of capital structure time value of money and connection between risk and return Discounted Cash Flow DCF approach in valuing assets First step Estimation of all future cash flows generated by the asset Second step Calculation of appropriate discount rate to bring estimated cash flows to present Weighted-average cost of capital WACC Weighted average cost of debt and equity Cost of debt interest rate Cost of equity - Capital asset pricing model CAPM beta C - Based on historical average equity risk premia data DCF approach yields in net present value NPV Debt is cheaper than equity p - p C C The Relevance of Prices in the Securities Market Efficient capital market hypothesis ECMH market price reflects discounted value of future payouts This book Prices in an informed market are prima facie evidence of the true value Chapter the protection of creditors Why should corporate law give extra protection for creditors of corporations Limited liability exacerbates traditional problems in two ways Creditor could negotiate contractual protections however they are costly So default rules giving extra protection is justified Basic protection Fraud Main protection Contract but some transactions to small for contract Three basic strategies to protect creditors Mandatory disclosure Regulating amount and disposition of capital Duties on corporate participants directors creditors SHs Director liability Fraudulent conveyance SH liability Equitable subordination Veil piercing This chapter Each strategy is considered in turn Not about contractual protections only about default provisions of law Mandatory Disclosure Public v closely held corporations Credit bureau reports generally available for small businesses and individuals Capital Regulation Financial Statements Importance and limitations of balance sheet and income statement Balance Sheet assets side liabilities side current assets current liabilities capital assets long-term liabilities stockholders equity stated or legal capital capital or paid-in surplus accumulated earnings or earned surplus both sides are in balance Distribution Constraints Most restrictions look at the legal capital account Examples NYBCL DGCL Cal Corp Code RMBCA If assets are economically worth more than carried in balance sheet GAAP allow to write-up assets what results in a revaluation surplus That surplus can be distributed QUESTIONS Under New York Statute capital surplus Under Delaware Statute capital surplus Under California Statute retained earnings assets are lower than times liabilities Under RMBC cannot pay debts as they come due cash is lower than current liabilities Only assets that cannot be distributed can serve as protection Minimum Capital and Capital Maintenance Requirements Minimum capital at incorporation are not effective Capital maintenance rules require to call SHM to consider dissolution or file for bankruptcy not in US QUESTIONS Standard-Based Duties Duties of corporate participants Directors SHs fellow creditors to protect interests of creditors Director Liability Limits on distributions to SH firms must remain able to meet its obligations to creditors statutory restrictions on dividends to others receive fair value in return fraudulent conveyance act Delaware Chancery Court When firm is insolvent directors owe a duty to consider interests of creditors Court of Chancery in vicinity of insolvency directors should not consider SH s welfare alone but also of the community of interests that constitute the corporation Hypo QUESTIONS Creditor Protection Fraudulent Transfers Besides contract most important protection UFTA Two grounds actual intent no reasonable equivalent value Actual v Constructive fraud Present Future creditors Modern applications LBOs spin-off placing assets of tobacco cy in subsidiary pending class action Shareholder Liability Two legal doctrines Equitable subordination Corporate veil piercing Equitable Subordination What is Debts owed to SH subordinated to debts owed to unaffiliated creditors Requirements Creditor is equity holder and typically officer Unfair or wrong behavior No legal basis for subordination but it s equitable to do so Relationship with cy is for some reason more like owner than creditor COSTELLO v FAZIO F d th Cir Facts - First there was a partnership between Fazio Ambrose and Leonard There was no equal monetary input Fazio - Ambrose - Leonard - Partnership came into financial distress - Partners decided to incorporate the business Each partner withdrew all but of their capital contributions to the partnership The difference was converted into a partnership promissory note for Fazio - for Ambrose - - Finally the corporation filed a voluntary petition in bankruptcy - Fazio and Ambrose filed a claim against the estate for the remainder of their promissory notes Issue s - Where in connection with the incorporation of a partnership and for their own personal and private benefit two partners who are to become officers directors and controlling shareholders of the corporation convert the bulk of their capital contributions into loans taking promissory notes thereby leaving the partnership and succeeding corporation grossly undercapitalized to the detriment of the corporation and its creditors should their claims against the estate of the subsequently bankrupted corporation be subordinated to the claims of the general unsecured creditors Or - Under which circumstances must a corporations debt owed to a shareholder be subordinate to the claims of unaffiliated creditors Applicable Rule s of Law - No rule of law existed now codified at Section c of the U S Bankruptcy Code Holding s - In these factual circumstances the promissory notes must be subordinated The Court s Order Reversed and remanded Reasoning - In allowing and disallowing claims courts of bankruptcy apply the rules and principles of equity jurisprudence Where claim is found to be inequitable it may be subordinated to the claims of other creditors - When is it inequitable Whether within bounds of reason and fairness such a plan can be justified Whether or not under all circumstances the transaction carries the earmarks of an arm s length bargain New Information The court applied a doctrine called Equitable subordination Fazio is not really a creditor The shareholders cannot be proper creditors This was not a law but a remedy invented by the judge It is not veil piercing which is a last resort only if there was blatantly unfair actions by the shareholders but suggests that there is a difference between the status of shareholder-lenders and that of outside creditors QUESTIONS ON COSTELLO v FAZIO All creditors Probably same inequitable conduct Court stresses fact of undercapitalization Probably no less problem of undercapitalization so probably no inequitable conduct Yes It looks to me that Gannet actually tried to make Berwin profitable He feared that there would be a short supply of newsprint Piercing the Corporate Veil What is Set aside the entity status of the corporation Set aside Limited liability of SH Guidelines Vague cases could be argued on both sides Lowendahl test SH who completely dominates corporate policy and uses her control to commit fraud or wrong that proximately causes plaintiff s injury Other formulation If principle of incorporation would extend beyond its legitimate purposes and would produces injustices or inequitable consequences Courts agree that it must be done sparingly Factors that play role disregard of corporate formalities thin capitalization small number of SHs active involvement by SHs in management Essence Fraud Fair summary of Illinois law and probably reflects majority view on corporate veil piercing SEA-LAND SERVICES INC v THE PEPPER SOURCE F d th Cir Facts - Sea-land Appellee could not recover its judgment against PS one of the appellants because PS had been dissolved - PS was cy owned by Marchese Marchese owned five other business entities Procedural history - Sea-land wanted to pierce PS s corporate veil to render Marchese personally liable for PS s debt to Sea-land And reverse pierce Marchese s other cys so that they would be liable as well - Summary judgment in favor of Sea-land Van Dorn test is satisfied - This appeal brought by Marchese and his cys Issue s Did trial court correctly apply corporate veil piercing Applicable Rule s of Law Van Dorn Two requirements Such unity of interest and ownership that separate personalities of the corporation and the individual no longer exist Illinois cases Four factors - no corporate records violation of formalities - commingling funds or assets - undercapitalization thin capitalization is not enough to pierce corporate veil - treating corporate assets as its own Circumstances so that separate corporate existence is fraud or promote injustice - Intent is not required - An unsatisfied judgment is not enough for the promote injustice feature of the test Holding s No The Court s Order Reversed and remanded with instructions Reasoning - First part of Van Dorn test is ok - Second part of Van Dorn test not enough motivated by court An unsatisfied judgment is not enough for the promote injustice feature of the test otherwise every plaintiff would pass the test Comments Other better way find Marchese liable use his stocks in cys to pay liability if necessary liquidate cys NOTE ON SEA-LAND SERVICES QUESTIONS ON SEA-LAND SERVICES KINNEY SHOE CORP v POLAN F d th Cir Facts - Polan defendant formed two cns industrial and polan industries Polan was owner of both cns No organizational meetings were held and no officers were elected - Kinney plaintiff held a lease in a building Kinney subleased the building to Industrial Industrial subleased a part of the building to polan industries - Polan paid first rental out of his personal funds No further payments were made - Polan obtained judgment against industrial for unpaid rent Procedural history - Kinney filed action against Polan individually to collect the amount owed by industrial - District court Kinney was not entitled to pierce corporate veil Issue s - Can Kinney pierce the corporate veil of industrial and hold Polan personally liable Applicable Rule s of Law Laya Supreme Court of Appeals West Virginia Two-prong test Is there a unity in interest and ownership such that separate personalities of corporation and SH no longer exist Treating act as those of corporation alone gives inequitable result In some cases a third prong Some creditors have duty to investigate credit of corporation before entering into a contract If such investigation shows that cn is grossly undercapitalized such creditor cannot pierce Holding s YES Reasoning - District court held that two-prong test was satisfied but third prong not Kinney assumed risks of undercapitalization of industrial - Third prong is permissive not mandatory This is not a factual situation that calls for a third prong if we are to seek an equitable result QUESTIONS ON KINNEY SHOE What should courts look to in considering veil-piercing claims by contract creditors Law and economics Limited liability is merely a default provision should not be enforced if there is a misrepresentation that would cause the deal not to close Veil Piercing on Behalf of Involuntary Creditors Distinctions between tort and contract creditors They did not rely on cn s creditworthiness They cannot negotiate ex ante General rule of veil piercing remains Thin capitalization alone is insufficient ground for piercing the corporate veil WALKOVSZKY v CARLTON N E d N Y Facts - Plaintiff was severely injured when run down by a taxicab - Taxicab was owned by Seon - Carlton was SH of corporations including Seon each of which has only two cabs registered under its name Procedural history - Plaintiff brought action to hold Carlton personally liable because the multiple corporate structure constitutes an unlawful attempt to defraud members of the general public who might be injured by cabs - Court at special term no veil piercing - Appellate division veil pircing Issue s - Can plaintiff pierce corporate veil of Seon to hold Carlton personally liable Holding s NO Reasoning -Thin capitalization alone is insufficient ground for piercing the corporate veil - Enterprise is not fraudulent merely because it consists of many cns Plaintiff s injuries are the same regardless of corporate structure of taxicab that hits him Dissenting opinion Keating Piercing corporate veil if capital insufficient to meet liabilities which are certain to arise in the ordinary course of cn s business NOTES AND QUESTIONS ON WALKOVSZKY v CARLTON NOTE ON SUBSTANTIVE CONSOLIDATION Substantive consolidation is an equitable remedy in bankruptcy that consolidates assets among corporate subsidiaries for the benefit of creditors of the various corporate subsidiaries NOTE ON DISSOLUTION AND SUCCESSOR LIABILITY DGCL and RMBCA c NOTE ON THE LAW AND ECONOMICS OF LIMITED LIABILITY IN TORT Can limited liability for corporate torts be justified at all within a law-and-economics framework LL causes firms to invest less in safety and safe products Solution regulatory requirements for safety mandatory insurance first priority for tort creditors in bankruptcy Class Shareholder Lawsuits Class How Do Shareholder Protections Get Enforced Procedural Aspects of Shareholder Litigation Types of suits Attorney s Fees as a Partial Solution to Collective Action Problem How are they determined Agency costs of shareholder plaintiffs Pre-suit demand and when it is excused Settlement procedures Reading pp - AKS Class Shareholder Suits con t Special board committees Settlement of derivative suits -Who can settle -Role of the Court why does it have a role Reading pp - AKS Stat Supp Fed Rule Civ Proc and i Chapter shareholder lawsuits Distinguishing Between Direct and Derivative Claims Two principal forms of SH suits Derivative suits Fed R Civ P SH is only indirectly harmed Corporate claim results go to cn itself Special procedural hurdles Direct actions mostly brought as class actions Fed R Civ P SH is directly harmed PROBLEM A FRIEND IN DEED IS A FRIEND IN NEED NOTE ON TOOLEY Tooley v Donaldson Lufkin Jenrette Inc - Court SH has to suffer some special injury to state a direct claim - Supreme Court Rejects special injury concept Distinction based solely on following questions who suffered alleged harm SH or cn and who would receive the benefit of any recovery or other remedy SH or cn Solving a Collective Action Problem Attorneys Fees and the Incentive to Sue Problem Collective action when SHship is dispersed Solution court of equity Award attorneys fees to plaintiffs but cn pays those fees and fees for officers FLETCHER v A J INDUSTRIES INC Cal Rptr Cal App d Facts - SHs derivative action Defendants the corporation A J Industries and members of Board a o Ver Halen and Malone - Action was settled Partly in settlement agreement concerning replacement of directors Partly referred to arbitration a o i whether corporation was entitled to monetary recovery ii arbitrator could only reward attorneys fees if cn received a monetary award Procedural history - Plaintiff s attorneys applied to trial court for fees and costs - Trial court Ordered cn to pay plaintiffs attorneys fees and cost Based on i plaintiffs employed attorneys in good faith ii cn was able to pay fees and costs iii settlement gave cn substantial benefits Issue s - Are plaintiffs entitled to attorneys fees and costs Applicable Rule s of Law - General rule in California and most US jurisdictions winning party may not recover attorneys fees unless expressly permitted by statute - Exception to general rule Common-fund doctrine where a common fund exists to which a number of persons are entitled and in their interest successful litigation is maintained for its preservation and protection an allowance of counsel fees may properly be made from such fund - Variant of common-fund doctrine Substantial benefit rule Successful plaintiff in a SH s derivative action may be awarded attorneys fees against the corporation if the latter received substantial benefits from the litigation although the benefits were not pecuniary and the action had not produced a fund from which they might be paid - Benefit is substantial if results of actions maintain the health of the cn and raise standards of fiduciary relationships and of other economic behavior OR prevent an abuse which would be prejudicial to the rights and interests of the cn or affect the enjoyment or protection of an essential right to the SH s intrest - It is insignificant if benefits were achieved through settlement Holding s YES Reasoning - in this case substantial benefit rule were benefits substantial enough yes Dissenting opinion Christian J - Countervailing policy arguments if there is no monetary common fund its is possible that cn has to liquidate assets to pay attorneys fees that could outweigh the substantial benefits - substantial benefits is very broad QUESTIONS ON FLETCHER v A J INDUSTRIES INC NOTE ON AGENCY COSTS IN SHAREHOLDER LITIGATION Agency problems Strike suits SH litigation is not meritorious Lawyers as bounty hunters Shen SH litigation is meritorious SH and D O have incentives to settle mutually advantageous with full escape of personal liability for D O Legal system structures legal fees in dysfunctional way of recovery incentive to settle to soon Chief alternative rule incentive to spend to much time on litigation Auctioning rights lawyers ask for control of litigation This chapter judicially created measures to fine tune balance between litigation and settlement Statutory responses to agency problems not effective better rely on stock market volatility and good corporate governance Standing Requirements Fed R Civ P RMBCA ALI Principles of Corporate Governance QUESTIONS ON THE POLICY RATIONALE FOR DERIVATIVE ACTIONS Balancing the Rights of Boards to Manage the Corporation and Shareholders Rights to Obtain Judicial Review Issue arises in several contexts The demand requirement of rule When board seeks to terminate derivative suit after suit has survived cy s initial motion to dismiss In connection with settlements The Demand Requirement of Rule What is demand requirement of Rule Plaintiff must first ask to directors what he wants before filing a What are circumstances in which complaint may be dismissed once the plaintiff does - or does not - make a demand on the board LEVINE v SMITH A d Del Facts - Derivative action brought by SHs GM Against transaction Buyback of Perot s GM Class E stock in exchange for million Repurchase was in response of disagreement between Perot and GM senior management Defendants All directors and Perot Claim transaction paid Perot a premium for his shares for no reason other than stopping his criticisms Procedural history Issue s - Directors manage business of cn - SH have a right incentive to assert a derivative claim - When can SH bring derivative action Applicable Rule s of Law Holding - Rule strikes a balance between interests SH directors In general directors decide whether to engage in derivative action Right of SH to prosecute a derivative suit is limited to situations where SH has demanded that the directors pursue the corporate claim and they have wrongfully refused to do so Wrongful refusal of demand OR where demand is excused because the directors are incapable of making a impartial decision regarding such litigation Futile demand - Aronson v Lewis Application of futile demand A SH complaint withstands dismissal under Rule based on a claim of demand futility IF plaintiff SH rebuts threshold presumptions of director disinterest or independence OR plaintiff SH casts reasonable doubt that the challenged transaction was the product of a valid exercise of business judgment due care were they informed - interest independence business judgment p - Application of rule to facts - Directors were independent - Declined to revisit question whether directors were disinterested - No reasonable doubt that the GM board acted in so uninformed a manner as to fail to exercise due care NOTE ON PRESUIT DEMAND Compare Delaware Supreme Court Levine Aronson Rule of universal nondemand ALI Principles of Corporate Governance project Rule of universal demand Policy question which one do we prefer Confusing Levine focus on identity of directors i at time of the alleged delict directors that made business decision or ii at time that suit is brought directors that must decide on demand derivative suit RALES v BLASBAND A d Del Facts - In stock-for-stock merger Easco became subsidiary of Danaher - Blasband plaintiff is SH of Danaher prior to merger he was SH of Easco - The Rales Brothers i are directors of Easco ii are directors and SH of Danaher prior to merger i were directors and SH of Easco ii were officers of Danaher - Danaher has six other directors - In Easco issued Notes their prospectus stated that proceeds would be used for see p Instead Easco invested contrary to prospectus in junk bonds offered through Drexel Drexel was under investigation Blasband alleges that the Rales Brothers wanted to help Drexel This investment resulted in a substantial loss to Easco - Blasband brought derivative suit against Easco and Danahar boards Issue s part I - Is demand futile Remark two derivative suits against Easco and Danahar boards Applicable Rule s of Law - Levine SH can only bring derivative suit IF i Wrongful refusal of demand OR ii Futile demand - Aronson v Lewis Demand is futile IF i directors are interested or dependent OR ii reasonable doubt that transaction was the product of a valid exercise of business judgment Issue s part II - Aronson only applies if a decision of the board is challenged in derivative suit - Three situations were no business decision of board is challenged in derivative suit Decision was made by board but majority of directors making that decision has been replaced Subject of derivative suit is not a business decision of board Decision being challenged was made by board of a different corporation - Here two derivative suits against Easco and Danahar boards In derivative suit against Danahar decision of different corporation Easco is challenged - If no business decision of board is challenged in derivative suit what test must be applied to determine whether demand is futile Holding s - Derivative suit against Danaher s directors demand is futile if board that would be addressing the demand can impartially consider its merits without being influenced by improper considerations if factual allegations of SH create a reasonable doubt that as of the time the complaint is filed the board could have properly exercised its independent and disinterested business judgement in responding to a demand - Response to SH demand letter Two steps inform weigh alternatives In doing so it must be able to act disinterested and independent - NOT a more stringent test no universal demand requirement no obligation to demonstrate a reasonable success in the merits - Derivative suit against Easco s directors Aronson test still applies Application to facts Rales brothers Caplin Sherman and Ehrich are interested demand is excused Summary of Levine Aronson and Rales If decision of board is challenged in derivative suit Levine Aronson Look at board at moment of taking decision that is challenged If no decision of board is challenged in derivative suit situations Rales Look at board at moment of filing complaint actually decision that is challanged instead is hypothetical decision of responding to demand QUESTIONS ON RALES v BLASBAND Answer decision of board that decides on refusing a claim Levine and Aronson do that in fact because in these cases board that made challenged decision was same as board that has to decide on SH demand NOTE AND QUESTIONS ON ABA AND ALI PROPOSALS FOR REFORM Compare Delaware courts RMBCA - ALI Principles of Corporate Governance project and Look at Universal demand or universal nondemand Standard of review reasonable success in merits Special Litigation Committees What is Procedure under which a court upon the motion of a special committee of disinterested directors may dismiss a derivative suit that is already under way Different jurisdictions treated the question differently Like Delaware Zapata Corp Giving a role to court to judge appropriateness of a special litigation committee s decision to dismiss a derivative suit Like Delaware Auerbach v Bennet If committee is independent and informed its action is entitled to business judgment deference without any further judicial second-guessing ZAPATA CORP v MALDONADO A d Del Facts - June Derivative action on behalf of Zapata against ten officers and or directors of Zapata Brought by Maldonado SH of Zapata Alleging breaches of fiduciary duty Demand futility because all directors were named as defendants - Four of defendant directors no longer on board remaining directors appointed two new outside directors June Board created an independent investigation committee Composed solely of two new directors To investigate Maldonado s actions and similar pending derivative action To determine whether cn should continue litigations Committee s determination was stated to be final board cannot review binding upon cn - September Committee concluded action should be dismissed Issue s - If derivative suit is properly initiated by SH can a board committee cause that suit to be dismissed If demand is made board can refuse demand if not wrongful If demand is excused some litigation could be against cn s best interests Is there a permissible procedure under a by which a corporation can rid itself of detrimental litigation Under which circumstances can Court grant a committee s motion to dismiss Holding s Court should apply two-step test to committee s motion to dismiss Step one is committee independent If NO deny motion to dismiss If YES go to step two Step two Court should determine applying its own independent business judgment whether the motion should be granted p - NOTES AND QUESTIONS ON ZAPATA v MALDONADO HOW DOES THE COURT EXERICISE ITS BUSINESS JUDGMENT JOY v NORTH F d d Cir Issue s - Business judgment rule of directors does not apply to scrutinize decision of special litigation committee to dismiss a derivative suit Court has to apply its own business judgment - How does court exercise its own independent business judgment Holding s - Burden is on moving party to demonstrate that the action is more likely than not to be against the interest of the corporation - Court s own independent business judgment Compare direct costs of litigation for corporation with the potential benefits Cost that may be taken into account attorney s fees out-of-pocket expenses related to litigation time spent by personnel p May not be taken into account insurance or not negative impact on morale and corporate image Dissenting in part Cardamone Cir J - Pandora s box of unanswered questions How exactly calculate of costs and benefits - Judges are not trained to make business decisions - Director committees cannot be expected to act independently QUESTIONS FOLLOWING JOY v NORTH Yes business judgment rule applies to investment Alternative a more rigorous effort to ensure the independence of the special litigation committee E g Michigan Compiled Laws definition of independent directors shift of burden of proof if motion to dismiss is made by independent directors Settlement and Indemnification Settlement by Class Representatives Parties are strongly driven to settle derivative suit class action Role of D O insurance Settlement procedures in derivative actions largely determined by rules of civil procedure Settlement by Special Committee Use of committees to take control of derivative suits to settle them rarely happens but it happens and sometimes succeeds CARLTON INVESTMENTS v TLC BEATRICE INTERNATIONAL HOLDINGS INC WL Del Ch May Facts - Derivative action On behalf of TLC Beatrice Brought by Carlton very substantial SH of TLC Beatrice Complaint alleged Breach of fiduciary duty corporate waste fraud and conspiracy Principal defendant Former CEO Reginald Lewis Board approved million compensation package to him - Special litigation committee SLC was set up Consisted of two new directors unanimously appointed by board After more than year of extensive discovery and several contested motions - SLC entered in a proposed settlement with Reginald Lewis TLC would pay Reginald approx million - Carlton resists to this settlement plaintiff in this suit Issue s - How does court have to evaluate decision of SLC to settle the suit Holding s - In evaluating the settlement Court does not go into facts and merits of claims Instead court considers whether settlement is fair and reasonable in light of facts and defenses - Since settlement was negotiated by SLC settlement must be reviewed under two step approach set forth in Zapata However this court is rather skeptic about exercising its own business judgment Test is settlement badly off the mark so it doesn t exercises its own business judgment rather it looks whether decision of TLC is reasonable Application to facts - Court first rejects exercising its own business judgment But continues if I am directed to exercise my own business judgment then - Settlement is reasonable When Are Derivative Suits in Shareholders Interests When its benefits outweigh its costs on the company Benefits i suit may confer something of value on the corporation ii deterring of wrongdoing Costs i direct costs ii indirect costs Role of D O insurance QUESTIONS ON COSTS AND BENEFITS Class Duty of Care Class Corporate Directors and the Fiduciary Duty of Care The Basics Nature of the Duty of Attention and Care The Modern Problem diversified investors and risk - Business Judgment Rule - D O Insurance - Indemnification - Waiver of liability for due care Reading pp - AKS Class Duty of Care continued The Delaware Approach Cede v Technicolor Passivity Duty to Monitor Duty to Obey Positive Law Readings pp - AKS Chapter normal governance the duty of care Introduction to the Duty of Care Duties of a fiduciary trustee partner or corporate director or officer Duty of obedience Duty of care Duty of loyalty No liability based on negligence for officers and directors avoid risk-averse management This chapter Evolution of fiduciary duties at common law Duty of care Insulating law that mitigates its effects on directors and officers The Duty of Care and the Need to Mitigate Director Risk Aversion Why is duty of care not just another negligence rule ordinary negligence not sufficient to constitute violation of duty of care Liability under a negligence standard would predictably discourage officers and directors from undertaking valuable but risky projects Illustrated in GAGLIARDI v TRIFOODS INTERNATIONAL INC A d Del Ch Issue s What must a SH plead in order to state a derivative claim to recover corporate losses caused by mismanagement Applicable Rule s of Law Business judgment rule where a director is independent and disinterested there can be no liability for corporate loss unless the facts are such that no person could possibly authorize such a transaction if he or she were attempting in good faith to meet their duty Reasoning SH can diversify risks they don t want directors to be risk averse Directors have very little incentive to take risks if risk risk of liability goes up but no very little sharing in profits Law statutory and courts protects corporate officers and directors from liability for breach of duty of care in many ways Indemnification D O insurance Business judgment rule Waive director smts officer liability for negligence or gross negligence Statutory Techniques for Limiting Director and Officer Risk Exposure Business judgment rule most fundamental protection Indemnification and D O insurance most reliable protection Indemnification What is p DGCL a b c Requirements WALTUCH v CONTICOMMODITY SERVICES INC F d d Cir Facts Waltuch was vice president of Conticommodity services Inc a silver trading company Several law suits were brought against him all of them were dismissed or settled Procedural history Waltuch brought suit against Conticommodity and its parent company for indemnification of his unreimbursed expenses legal fees I Good faith requirement Issue Article nine of articles of incorporation requires Conticommodity to indemnify him for its expenses It contains no requirement of good faith a of DGCL does contain a good faith requirement Is article nine of articles of incorporation consistent with a of DGCL Holding No Reasoning Consistency rule court reads as a whole II Successful defense requirement Issue c of DGCL requires corporations to indemnify its officers for the successful defense of certain claims Cases against Waltuch were dismissed and settled because Conticommodity paid million in settlements Was Waltuch successful on the merits or otherwise Holding Yes Reasoning The only question a court may ask is what the result was not why it was Questions Comments and Speculations - Court poses good faith requirement for indemnification articles of incorporation cannot state otherwise - Also indemnification if case is settled successful on merits or otherwise QUESTION Directors and Officers Insurance What is p DGCL f RMBCA Not for Breach of duty of loyalty Fraud Why not insurance paid by D O themselves Why did directors of WorldCom and Enron paid settlement of their own pockets Judicial Protection The Business Judgment Rule What is p If directors or officers who took decision financially disinterested independent duly informed before exercising judgment and in a good faith effort to advance corporate interests then presumption that decision is conform duty of care almost always safe Court may not compare with what a reasonable prudent person would do negligence test Violation only if extremely not reasonable prudent gross negligence Jury must answer whether conditions are met not whether duty of care is breached conversion of this factual question into a legal question C - against juries bias against cns Illustrated in KAMIN v AMERICAN EXPRESS CO A D d N Y Facts BoD bought stocks that dropped in value BoD had three options do nothing distribute stocks to SHs as dividend in kind or sell stocks on market BoD decided to distribute stocks to SHs Procedural history SHs brought suit because only one option was good selling stocks loss could be set off against profits tax benefit This is a motion for summary judgment and to dismiss brought by BoD Issue Can BoD be held liable for making a wrong business decision Holding s No The Court will not interfere unless a clear case is made out of fraud oppression arbitrary action or breach of trust under state law Reasoning Question of whether or not a dividend is to be declared or a distribution of some kind should be made is exclusively a matter of business judgment for the BoD More than imprudence or mistaken judgment must be shown The Court s Order Motion to dismiss granted QUESTIONS Understanding the Business Judgment Rule Three mysteries What exactly is this rule Why is it necessary at all Why bother with the duty of care at all The Duty of Care in Takeover Cases A Note on Smith v Van Gorkom Evolution of the law of D O duties in context of hostile takeover attempts see Chapter Prefaced here with Smith v Van Gorkom Short facts CEO set up merger agreement with very little advice What is it about About duty of care first time BoD liable for breach of duty of care in which BoD had made a business decision no fraud However according to authors of book first in series of cases in which Delaware courts struggled to work out a new corporate law of corporate takeovers Additional Statutory Protection Authorization for Charter Provisions Waiving Liability for Due Care Violations Reactions to Van Gorkom D O premiums went up Possibility to waive liability eg DGCL b QUESTIONS Significance of waiver provision depends on how it is now read by the Delaware courts Delaware s Unique Approach to Adjudicating Due Care Claims Against Corporate Directors From Technicolor to Emerald Partners Section b waivers are directed to damage claims claims for equitable orders eg injunction are still possible Delaware unique approach to adjudicating such claims Cede Co v Technicolor Inc No proof of injury is required Breach of the duty of care or loyalty rebuts business judgment presumption directors must prove that transaction was entirely fair Interplay between DGCL b and Technicolor How soon in litigation process can a court dismiss directors from litigation charging them with liability in a transaction in which they had no conflicting interests If b waiver Malpiede v Thomson Dismiss if only a duty of care claim Complaint must allege a breach of duty of loyalty but not just any breach of the duty of loyalty will do Once the business judgment presumption is rebutted Emerald Partners v Berlin Facts suit was brought against all directors some of them were interested appointed by majority SH others were independent Majority SH filed for bankruptcy only remaining defendants were independent directors May the case be dismissed against independent directors because b waiver NO if controlling SH is interested standard for review is entire fairness Directors must prove Technicolor rule In this case transaction is entirely fair What if in Emerald board couldn t prove entire fairness No liability for directors if failure to withstand entire fairness analysis is only caused by violation of the duty of care Remark why not first determine whether breach was duty of care or duty of loyalty The Board s Duty to Monitor Losses Caused by Board passivity Need for protection against liability for passive not sufficient monitoring breach of duty of care to give directors incentive to serve on corporate boards Is less than for liability for erroneous decisions but does exist DGCL a Board management can rely on expert if selected with reasonable care FRANCIS v UNITED JERSEY BANK A d N J Facts - Pritchard Baird was reinsurance company - After father died his son and wife mother became sole directors but mother not actually involved in business - Sons misappropriated large sums - Cy bankrupt sons bankrupt - Mother was only solvent defendant principal claim was that she has been negligent as director Issue s - When is a passive director liable Holding s - State law - Directors must have failed to fulfill some obligations to be active p - Non action of director must be proximate cause for the loss p - Possibility for director to absolve himself from liability if he she properly dissents Application on facts - Behavior of mother p even though she was old grief stricken by death of husband psychologically overborne by sons was negligent - Her negligence was a proximate cause The Court s Order She was held liable NOTE Majority view Directors must comply with minimum objective standard of care Case law is divided Is minimum standard the same for all directors Must sophisiticated directors be held to a higher standard QUESTIONS Problem In large public cys board i relies on reports of others ii leaves decisions to management Business history extraordinary losses by failure of appropriate controls What must board do to assure that the corporation functions within the law to achieve its purposes GRAHAM v ALLIS-CHALMERS MANUFACTURING CO A d Del Facts - Some employees of Allis-Chalmers were convicted of violating anti-trust laws None of the directors defendants in this cause were named a s defendant in that cause - Directors had no knowledge of i the anti-trust violation or ii facts which should have put them on notice of anti-trust violation - Allis-Chalmers was very large enterprise with decentralized management - Board considers only general questions company is very large and business is complex so board cannot consider in detail specific problems of various divisions Procedural history - Derivative suit to recover damages from its directors who violated anti-trust laws Plaintiffs allege that director failed to learn of and prevent anti-trust violations - Vice Chancellor directors are not liable Issue s What must board do to assure that the corporation functions within the law to achieve its purposes In very large company where board cannot monitor every employee Holding s - State law - Directors may rely on honesty and integrity of their subordinates until something suspicious occurs Absent cause for suspicion there is no duty to set up system of espionage But if there is such a cause directors must act Red flag principle set aside by Caremark Application on facts No reason for suspicion so no liability Remark Red flag principle is disincentive for board to be involved QUESTION Securities law and the SEC also impose negligence-based duties on directors in a variety of contexts IN THE MATTER OF MICHAEL MARCHESE Release Nos - AAER- Administrative Proceeding File No - April Facts - Marchese was outside director of Chancellor - He never reviewed Chancellor s accounting procedures or internal controls - He generally deferred to other director when board action was required Issue s Did Marchese violate SEC rules by being passive Holding s This is case under federal law YES Reasoning p - QUESTION To what extend goes SEC enforcement action against Marchese go beyond existing red flag doctrine under state corporation law Comparable with red flag doctrine but here applied to outside director NOTE ON THE FEDERAL ORGANIZATIONAL SENTENCING GUIDELINES Some violations of standards of business conduct are treated as criminal matters Sentencing guidelines powerful incentives Corporate compliance programs courts take it into account if cn doesn t have has one IN RE CAREMARK INTERNATIONAL INC DERIVATIVE LITIGATION A d Del Ch Facts - Plea agreement Indictment alleged violations by Caremark employees of federal and state laws and regulations applicable to health care providers Caremark pleaded guilty to a single felony of mail fraud and agreed to pay civil and criminal fines Caremark agreed to make reimbursements to various private and public parties - Following this plea agreement derivative suit Brought on behalf of Caremark by SH To seek recovery of these losses settlement payments from individual defendants Board of directors Claims that directors breached their fiduciary duty of care in connection with violations by employees Issue s - Does duty of care includes duty to supervise or monitor corporate performance As to the facts Did board breach their obligation to supervise or monitor corporate performance Holding s - State law - YES As to the facts NO - Court sets aside Red flag principle Graham Boards must set up information and reporting systems reasonably designed to give accurate information to reach informed judgments concerning cn s compliance with law and its business performance - Which level of detail of such information system Is question of business judgment Reasoning p - Seriousness with which corporation law views role of board Relevant and timely information is essential for board s supervisory and monitoring role under DGLC Potential impact of the federal organizational sentencing guidelines on any business organization that is different since Graham Application to facts Directors did not violate duty of care NOTES FOLLOWING CAREMARK Federal SOX CEO CFO has to discloses weakness in control system to auditor Pro Cons State law Kamin little risk of liability business judgment rule Carmark liability if no system of control Does SOX change predictions under state law Supreme court Struck down federal sentencing guidelines for individuals Now advisory not mandatory What about organizational sentencing guidelines Department of Justice treats them as mandatory So Caremark remains important under federal law as well Stone v Ritter Endorsed and clarified Caremark standard Clarification of Caremark standard p Case further discussed in Ch duty of good faith Caremark standard is put to the test in following case issue is whether demand was excused IN RE CITIGROUP INC SHAREHOLDER DERIVATIVE LITIGATION WL Del Ch Feb Facts - Citigroup made substantial losses in financial crisis due to risky investments subprime CDOs SIVs see p - - SH of Citigroup plaintiffs brought derivative action against current and former directors and officers of Citigroup alleging breach of fiduciary duties by failing to properly monitor and manage risk and failure to disclose Issue s - Plaintiff alleges that Caremark applies Defendants ignored red flags problems of subprime market BUT Caremark is about failure to oversee employee misconduct Here claim is based on defendants alleged failure to properly monitor Citigroup s business risk So plaintiffs try to hold defendants liable for making bad business decisions - Does business judgment rule applies Or does Caremark red flag principle applies Holding s Directors have certain responsibilities to implement and monitor a system of oversight however this obligation does not put aside protection of business judgment rule Reasoning - Court repeats rationale of business judgment rule give board incentives to take risks - Distinguish between blaming someone and holding someone responsible QUESTIONS Detect employee misconduct passive liability Evaluate business risks liability for taking action Knowing Violations of Law Should corporate law also command obedience to positive law MILLER v AT T F d d Cir Facts - AT T failed to collect an outstanding debt owed by the Democratic National Committee in the hope to get favors in return - SH of AT T brought derivative action against AT T and its directors - Plaintiffs alleged that non-collection amounted to violation of law federal prohibition on corporate campaign spending Procedural history - This action motion to dismiss Issue s - Does business judgment rule apply to corporate decision that violates the law Holding s NO Business judgment rule cannot insulate directors from liability if they knowingly violated the law Reasoning - Roth v Robertson Sup Ct Even though committed to benefit the corporation illegal acts may amount to a breach of fiduciary duty about director of amusement park that bribed persons to be silent The Court s Order - Motion to dismiss not granted - Plaintiff still has to prove that AT T directors violated the law PROBLEM - No problem in the case of definite violations of law But what about situation where the legal advice is some likelihood or substantial risk of violating the law - Hypo p Class Duty of Loyalty Class Board and the Fiduciary Duty of Loyalty Good Faith and the Basics of Self-Dealing Safe Harbor Statutes Parent Sub Mergers and Evolution of Special Committees Weinberger Readings pp - - AKS Class Duty of Loyalty and the Corporate Opportunity Doctrine Readings pp - AKS Stat Supp ALI Corp Governance Project Sections Class Director Officer Compensation Readings pp - AKS Legal controls on BoD Duty of care SH s right to appoint directors Duty of loyalty also on SHs Duty to whom The SH primacy norm not always clear Long term v immediate return for SH Charitable giving conditions in A P Smith Manufacturing Co Allowed if it is in long term economic interest of corporation but is based on SH primacy Defense against leveraged buyout transactions constituency statutes see Chapter Loyalty to not only to SH but also to Stakeholders Self-dealing conditions for a valid transaction Disclosure for BoD Fairness for controlling SH Four types of loyalty cases Self dealing Corporate opportunity doctrine Executive compensation Entrenchment case no financial interest but bad motivation Self dealing Disclosure requirement Standard entire fairness Effect of approval by disinterested directors SHs shift burden of proof standard remains entire fairness What constitutes control What in first step of two step tender offer Chapter Conflict Transactions The Duty of Loyalty Legal controls on BoD s discretion to make ordinary business decisions Duty of care weak does not limit BoD s discretion SH s right to appoint directors weak does not limit BoD s discretion Two classes of corporate actions over which it may be sensible to limit board discretion Director or SH has personal interest this Chapter Fiduciary duty of loyalty - self-dealing - appropriation of corporate opportunities - relations between controlling and minority SHs - Fundamental changes Chapter - corporate mergers - dissolutions - sale of substantially all assets - Two can be combined eg Merger w controlling SH self-dealing Duty of loyalty requires Subjective A good-faith effort to advance the interests of the company Objective If self dealing not only subjective good faith Fully disclose intrinsically fair terms for self dealing Corporate officers directors controlling SHs may not deal with corporation in any way that benefits themselves at its expense Importance is greater than in simple agency relationship and more complex Loyalty to whom Enforcement problem Duty to whom Short answer To the corporation as a legal entity Three situations A solvent corporation When corporation faces insolvency When it contemplates a terminal transaction for equity investors e g cash merger The Shareholder Primacy norm Director s loyalty is ultimately loyalty to equity investors Not always clear what additional weight the norm of shareholder primacy carries e g Dodge v Ford Motor Co - Director Mr Ford used retained earnings to give discount to customers instead of paying dividend violation of primacy SH - But is old case unique because director announced that he was acting in the interests of non-shareholders Today Using retained earnings to fund investments price reductions would easily be justified as a device to increase long-term corporate earnings Violation only if BoD claims to advance nonSH interests over those of SH e g Doing Good and Doing Well at Timberland Timberland allows workers to take a full week off with pay to help local charities In context of corporate charitable giving Example A P SMITH MANUFACTURING CO v BARLOW A d N J Facts A P Smith Manufacturing Company made a small grant to Princeton University Stockholders object to it Position of stockholder certificate of incorporation does not expressly authorize donation and common-law principles does not give such power to company New Jersey statutes allow it but may not be applied because corporation was created long before enactment Issue Is this charitable giving allowed Applicable Rule s of Law Common law rule BoD cannot disburse corporate funds for charity unless the expenditure would benefit the corporation Courts have applied that rule very broadly to enable worthy corporate donations with indirect benefits to the corporation Legal rule before incorporation every corporate charter shall be subject to alteration suspension and repeal in the discretion of the legislature Holding Donation is valid Reasoning No suggestion that it was made indiscriminately or to pet charity of director On contrary it was made to preeminent institution modest in amount within statutory limits voluntarily with reasonable belief it would aid the public welfare and advance the interests of the corporation QUESTIONS ON SMITH v BARLOW As far as conditions in reasoning Probably not no preeminent institution of higher learning Favorite charity of director probably not see reasoning Favorite charity of corporate customer probably yes is in interest of corporation Constituency Statutes In context of corporate leveraged buyout transactions If hostile managers resisted But transaction was good for SH value of target increases so they could not shareholder primacy norm as defense They turned to other rationale directors owe loyalty not only to SH but also to stakeholders State legislatures came managers to rescue Chapter deals with constituency in greater depth Self-Dealing Transactions - Clear principle Corporate officers may not benefit financially at the expense of the corporation in self-dealing transactions - How should law deal with that Early Regulation of Fiduciary Self-Dealing - Late th - early th century looked at law of trust - Early th century court would uphold contract if fair and approved by majority of disinterested directors interested directors could not be counted towards quorum if majority of BoD was involved contract could not be approved - Response SH put in charter a provision allowing an interested director to be counted toward quorum courts allowed this - Mid th century statutory embodiment of earlier charter provisions safe harbor statutes The Disclosure Requirement Interested director must make full disclosure of all material facts of which she is aware at the time of authorization How far does this disclosure obligation reach STATE EX REL HAYES OYSTER CO v KEYPOINT OYSTER CO P d Wash Facts - Hayes owns of Hayes Oyster his brother and of Coast Oyster of which he is also CEO - Hayes suggests selling part of Coast to Keypoint Oyster a new cy of which Hayes Oyster will own - BoD and SHM approve sale to Keypoint - Hayes doesn t disclose his interest in Keypoint - see scheme Claim of managers Coast - New managers of Coast brought suit against Hayes brothers for their Keypoint shares and all profits obtained by Hayes as a result of the transaction Procedural history - Trial court absolved Hayes of any breach of duty to Coast Issue s I When does obligation to disclose arises II What are consequences if not disclosed Holding s I At this juncture Hayes was required to divulge his interests in Keypoint When does obligation arise See p pink Profit is clear and undisputed Leppaluoto does not apply Intent to defraud or that any injury result to corporation is not necessary II Principle whatever a director or officer acquires by virtue of his fiduciary relation except in open dealings with the company belongs not to such director or officer but to the company The Court s Order Keypoint must issue new shares of its stock to Coast Keypoint must cancel shares assigned to Hayes Oyster Comments No right to do self dealing just because it s fair owner has right of full disclosure QUESTIONS ON STATE EX REL HAYES OYSTER CO v KEYPOINT OYSTER CO Consideration may be at arm s length but other concerns exist They Coast were entitled to know that their president and director might be placed in a position where he must choose between interest of Coast and Keypoint in the transaction NOTES ON DISCLOSURE OF CONFLICTED TRANSACTIONS What must be disclosed beyond the simple fact of self-interest Fiduciary s role in negotiating a conflicted transaction with his corporation is not an easy one Controlling Shareholders and the Fairness Standard NB What is control Practical not formalistic test Two values collide Dominant value duty for controlling SH to consider their interests fairly when corporation enters into contract with controller or its affiliate Subsidiary value entitlement of all SH to vote in their own interests First principle governs when there is a conflicting transaction But what if controlling SH exercises influence without authorizing a conflicted transaction E g influencing BoD to take certain business decision replace BoD declare dividends Useful structure for thinking about situations when there is not a direct conflict-of-interest transaction SINCLAIR OIL CORP v LEVIEN A d Del Facts Defendant Sinclair Owned about in Sinven Owned of Sinclair Int l Plaintiff Minority SH of Sinven Basic situation Parent has received a benefit to the exclusion and at the expense of the subsidiary Excessive dividends paid by Sinven to Sinclair and minority SH Effectively caused prevention of Sinven s industrial development Issue Dividend payment in relationship Sinclair - Sinven Standard of intrinsic fairness high degree of fairness and burden of proof on majority SH or Business judgment rule Applicable Rule s of Law A parent owes a fiduciary duty to its subsidiary But this alone will not evoke the intrinsic fairness standard This standard will be applied only when the fiduciary duty is accompanied with self-dealing Holding s No self dealing so test is business judgment rule test is ok Reasoning - If majority SH alone would have received dividend it would be self dealing Because Sinclair would have received something from the subsidiary to the exclusion of and detrimental to its minority SHs - A proportionate dividend was paid to minority SHs - So payment of dividend was not self dealing - So business judgment rule not standard of intrinsic fairness Comments and Speculations So self-dealing implies that majority SH gets a special that no one else gets benefit Not sure this case is still law but should be law c QUESTIONS AND NOTES ON SINCLAIR OIL Weinberger Same general rule in transactions between controlling parent and its subsidiary full disclosure deal must be substantially and procedurally fair p p Summary of self-dealing cases WEINBERGER v UOP INC A d Del Facts - Signal is majority SH of UOP - Signal wanted to acquire the remaining outstanding stock of UOP - Feasibility study by two Signal officers Arledge and Chitiea per share would be good investment That report was never disclosed to UOP s minority SHs - Signal s Executive Committee would propose cash-out merger in the range of to per share - UOP s president Crawford voiced no objection to the to price range nor did he suggest that Signal should consider paying more than he agreed after discussions not negotiations - Crawford asked Lehman Brothers for fairness opinion Lehman Brothers was UOP s investment banker for many years Glanville was partner of Lehman Brothers and long time director of UOP Glanville s immediate reaction is that to was fair Lehman Brothers team concluded that to was fair - Signal and UOP board approved to UOP board urged SHs that merger be approved - Merger approved by of total minority merger became effective on May Procedural history - Former minority SH in class action challenged elimination of UOP s minority SHs by the cash-out merger Issue s - Question of breach of fiduciary duty - Was this fair self-dealing - What is fair self-dealing Applicable Rule s of Law There is no safe harbor for such divided loyalties in Delaware When directors of a Delaware corporation are on both sides of a transaction they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of a bargain Holding s - Concept of fairness has two basic concepts fair dealing crucial full disclosure and fair price not highest price D O can afford market price - Test for fairness is not a bifurcated one as between fair dealing and price All aspects of the issue must be examined as a whole since the question is one of entire fairness - Here the merger was NO fair self-dealing The Court s Order Damages this long completed transaction is too involved to undo Reasoning Why in this case no fair self-dealing p - Comments Consequences Here merger was not fair It could have been fair if merger was assessed by actual independent committee That s what law firms do now in mergers the set up independent committee independent lawyer and Banker fair process footnote nr p p p The Effect of Approval By a Disinterested Party Approval by disinterested directors or SH play a key role in the defense of self-dealing transactions What is standard of judicial review after disinterested review and approval Same standard Entire Fairness but shift burden of proof burden on objecting SH The Safe Harbor Statutes Almost all of statutes Director s self-dealing transaction not voidable solely because it is interested so long as it is adequately disclosed and approved by majority of disinterested directors or SHs or it is fair Broad reading of safe harbor statutes never voidable if fully disclosed and authorized in good faith or it is fair NO COOKIES FOOD PRODUCTS v LAKES WAREHOUSE N W d Iowa Facts - Herrig was one of many SH of Cookies He made cookies a successful business by distributing its products After while exclusive distributorship contract between Cookies and Lakes one of Herrig s cys - When majority SH of cookies sold his shares Herrig became majority SH - As majority SH he made several changes to Cookies four agreements in issue extension of exclusive distributorship agreement taco sauce royalty warehousing and consulting fees - Minority SH were not pleased because no dividend was distributed they couldn t sell their stocks because Cookies stock isn t publicly traded - They claimed that sums paid to Herrig and his cys were grossly excessive Herrig breached his fiduciary duties because he didn t fully disclose the benefit he would gain Procedural history District Court held that Herrig had breached no duties owed to Cookies and its minority SHs Issue Was Herrig s self-dealing allowed Applicable Rule s of Law Section A not voidable in three circumstances Is satisfaction of any one of the alternatives in and of itself enough to prove that a director has fully met the duty of loyalty If SH disinterested directors approve no fairness required NO additional element required Directors who engage in self dealing must act in good faith honesty and fairness besides statute Common Law must be respected Holding Yes Reasoning - Four agreements in issue were beneficial to Cookies - All members of Cookies s BoD were aware of Herrig s dual ownership Herrig does not have obligation to disclose the profits he would gain - Compensation he received from the agreements was fair and reasonable approved by disinterested BoD Dissenting Schultz - The fact that Herrig made the company successful does not mean that the transactions were fair to cy - Burden of proof lies on Herrig he has to prove fair market value - Herrig failed to produce such proof minority SH put forth convincing evidence that Herrig was grossly overcompensated p p See also class What Constitutes Control and Exercise of Control Safe harbor statutes two devices to ease burden of proving entire fairness SH ratification Independent director approval With controlled merger special issues Parent-subsidiary merger parent is fiduciary and controller suspicious about efficacy of SH ratification and independent director approval What entails a well-functioning special committee of independent directors What effect should be given to act of a well-functioning special committee Refinement of Weinberger What is standard Entire fairness Who bears burden of proof of entire fairness KAHN v LYNCH COMMUNICATION SYSTEMS INC A d Del Facts - Contested transaction Stock purchase agreement Alcatel acquired of Lynch - Before Alcatel owed of Lynch - Lynch s management wanted to acquire Telco - Alcatel was opposed it it proposed combination of Lynch and Celwave Holding - Business judgment rule does not apply in context of an interested merger transaction even if majority of minority SH approves transaction - Only standard is entire fairness in context of an interested cash-out merger transaction by a controlling or dominating SH Existence of special committee strong evidence that transaction is entirely fair - Approval by informed majority of minority SH or by an independent committee of directors merely shifts the burden of proof of entire fairness Initial burden on interested party If approved burden on plaintiff minority SH - Mere existence of an independent special committee does not itself shift burden At least two factors are required to shift burden Majority SH must not dictate the terms of merger Committee must have real bargaining power against majority SH Application to facts Burden of proof remains on Alcatel Alcatel dominated committee p p See also class Controlling Shareholder Fiduciary Duty on the First Step of a Two-Step Tender Offer Three ways for a controller to do transaction Use its control in board to force approval of transaction Duty to pay fair price burden of proof lies on controlling SH Board accept offer of controller through its independent directors Duty to pay fair price burden of proof lies on objecting SH Skip board and offer a transaction directly to the public SH in the form of a tender offer Does controller have the duty to pay fair price in a tender offer Delaware Court of Chancery In Re Siliconix NO as long as offer is not coercive eg controller threatened to discontinue paying dividends entering transaction is voluntary for minority SH if they don t like price they can remain SH and force controller to cash them out in that case they have protection of an appraisal IN RE PURE RESOURCES INC SHAREHOLDERS LITIGATION A d Facts Unocal Pure s CEO Pure s Managers Aggregate Free Float - Rest Pure Resources - Unocal initiated exchange offer for Pure s minority shares at a premium to market price contingent upon result of ownership for Unocal - Pure created Special Committee sought a higher exchange ratio but Unocal refused Committee voted not to recommend Unocal s offer to minority SH - Unocal launched its offer either way - Minority SH sued for an injunction to block offer Issue What standard of fiduciary conduct applies when controlling SH tenders offer to acquire other shares of cy Entire fairness Holding - When i tender offer is non coercive and ii independent directors of target are permitted to make an informed recommendation and provide fair disclosure offer doesn t have to be entirely fair - Tender offer is non-coercive only when three conditions p Application to facts Although offer is not completely non-coercive plaintiffs do not have a probability of success on the merits QUESTIONS p Blackboard GANTLER v STEPHENS A d Facts Issue What is the meaning scope of shareholder ratification Holding - Scope of SH ratification Must be limited to its classic form a fully informed shareholder vote approving director action that does not legally require shareholder approval to become legally effective But such SH ratification has cleansing effect challenged director action becomes subject to business judgment rule - Ratification and approval of deal must seperate - Overruling Smith v Van Gorkom Only claim that SH ratification can extinguish is a claim that the directors lacked the authority to take action that was later ratified But remains void acts cannot be ratified by less than unanimous SH vote - Approving transaction eg when amendment of charter is required and ratification must in separate vote Blackboard p Corporate Opportunity Doctrine Special application of the duty of loyalty but different focus Self dealing Does the transaction violate the duty of loyalty Corporate opportunity Is transaction interested Chief questions Is opportunity corporate Under which circumstances may a fiduciary take a corporate opportunity Remedies if fiduciary has taken corporate opportunity illegitimately Determining Which Opportunities Belong to the Corporation Is opportunity corporate Three general lines of doctrine Expectancy or interest test Expectancy or interest must grow out of an existing legal interest and the appropriation of the opportunity will in some degree balk the corporation in affection the purpose of its creation Narrowest protection to the corporation Lagarde v Anniston Lime Stone Inc Line of business test Corporate opportunity if it falls within a company s line of business anything a corporation could reasonably expected to do Factors include How matter came to attention of director officer or employee how far removed from core economic activities and whether corporate information is used Guft v Loft Inc a fairness test More diffuse test relies on multiple factors Factors in addition to a company s line of business such as i How a manager learned of opportunity ii whether he used corporate assets how far removed from core economic activities and iii other fact-specific indicia of good faith and loyalty to the corporation When May a Fiduciary Take a Corporate Opportunity Under which circumstances may a fiduciary take a corporate opportunity A fiduciary may take an opportunity if i the corporation is not in a financial position to do so and ii full dislosure Implies that BoD determined not to accept the opportunity BoD must have evaluated the opportunity in good faith Rejection on financial grounds is the genuine business judgment of a disinterested decision maker Burden of proof on fiduciary who takes opportunity What if the director never presented a business opportunity to the board in the good faith belief that it was not a corporate opportunity Constructive trust Director holds opportunity as trustee for cy by force of law BUT Presenting to Board is not required under Delaware law Broz v Cellular Information Systems Inc Presenting is safe harbor but not necessary DGCL explicitly authorizes waiver in the charter of the corporate opportunity constraints for officers directors or shareholders QUESTIONS p p Director and Management Compensation - Compensation is a necessary form of self-interested transaction So if not ratified directors have burden to show entire fairness - Incentive compensation schemes create agency problems themselves - Balance incentives v additional governance costs of these incentives Perceived Excessive Compensation Option Grants and the Law of Director and Officer Compensation Early Delaware Courts stricter than the waste standard Later courts grew comfortable with options to compensate directors Which standard LEWIS v VOGELSTEIN A d Del Ch - Overview of case-law - In this age in which institutional shareholders have grown strong and can more easily communicate shareholder assent is I think a more rational means to monitor compensation than judicial determinations of the fairness or sufficiency of consideration In all events the classic waste standard does afford some protection against egregious cases of constructive fraud - Standards Classic waste standard It s waste if there is no quid pro quo but even giving away can be justified eg Retirement pay for CEO if it is for consulting - But after Disney Case formulates matter differently see slides Business judgment rule NOTE ON CORPORATE LOANS TO OFFICERS AND DIRECTORS BACK TO THE FUTURE - Statutes earlier era shareholder approval or prohibition for loan or guarantee to board or officers - Gradual liberalization eg Section DGCL Board may authorize if loan or guarantee benefits corporation - Federal intervention Sarbanes-Oxly prohibition for listed companies QUESTION In other words is advancing reasonable defense costs equal to extending credit Regulatory Responses to Executive Compensation Overview of and commentary on statutes on D O compensation NOTE ON ACCOUNTING FOR STOCKS Before Enron FASB standards granting of options not required to treat as expense After Enron FASB Rule require to expense fair value of options The Disney Decision Executive compensation next area of corporate governance where the business judgment rule eroded Facts of Disney Procedural history of Disney IN RE WALT DISNEY COMPANY DERIVATIVE LITIGATION WL Del Ch Plaintiffs shareholders must prove that defendants directors violated their fiduciary duties and or committed waste Plaintiffs must prove that the presumption of the business judgment rule does not apply Either because directors breached their fiduciary duties acted in bad faith Or that the directors made an unintelligent or unadvised judgment by failing to inform themselves of all material information reasonably available to them before making a business decision If plaintiffs can rebut the presumption of the business judgment rule the burden of proof shifts to the defendants In that case defendants must prove that the challenged transactions were entirely fair to the corporation So standard for D O pay is business judgment rule NOTE ON DISNEY AND THE DIRECTOR S DUTY OF GOOD FAITH Disney dicta on the duty of good faith Spectrum of behavior for identifying bad faith conduct Open question can duty to act in good faith serve as an independent basis for liability Stone v Ritter duty of good faith is not independent duty How does these three terms care loyalty and good faith relate to each other Synthesis big picture after Disney Three levels of for director liability for inattention Mere negligence lacking degree of attention that a reasonable person in the same or similar situation would be expected to pay to a decision like in Gagliardi and American Express protected by business judgment rule no liability Gross negligence like in Smith v Van Gorkom violation under business judgment rule may be basis for breach of duty but can be waived under b DGCL Acts or omissions not done in good faith business judgment rule does not apply Cannot be waived under b DGCL Details see p - Class Shareholder voting Class Shareholder Voting as a Constraint on Agency Costs Collective Action Problem again Electing Directors Majority or Plurality Staggered Boards Cumulative Voting Class Voting Reducing coordination costs - Proxies and Proxy solicitation - Access to Company s proxy statement Reimbursement of proxy expenses Readings pp - and - AKS Class Judicial Protection of the Vote Vote Buying Schreiber v Carney l Manipulation Schnell v Chris Craft Industries Blasius v Atlas Readings pp - - AKS SH Voting What do SH vote on When do SH vote How do SH vote How are votes counted Majority of outstanding shares Plurality of votes cast w quorum Who is winner Information rights Proxy control and regulation Short slate proxy contest to appoint a few directors not whole board To get control TO Proxy contest Reimbursement of proxy costs Chapter normal governance The voting system The Role and Limits of Shareholder Voting Board discretion is limited by statute most public cys rely on default rules no further restrictions in charter or bylaws by giving SH three kinds of powers which interact Power to vote Power to sell their stock Right to sue directors This chapter normal governance machinery Right to elect BoD Calling annual meetings Affording information to SHs Voting by proxy Removing directors Chapters and Proxy contests Rights to vote on fundamental transactions Problem with SH voting Collective action problem two extremes If only one controlling SH voting system is merely formality If completely dispersed SH voting is also merely formality i cost of obtaining information is too high for one SH ii one SH s vote is quite unlikely to affect outcome of vote Solutions SEC act forced disclosure of information Courts private remedies under that act SEC acting under act elaborate proxy rules but they made information even more expensive Collective action problem is fatal in diffuse capital markets no matter how much information is available Institutional investors holding large block of shares they could influence voting amendments on SEC proxy rules Today s model public corporation Growing institutional portfolios cheaper communication costs SH organizations In between two extremes only one SH completely dispersed Collective action costs may be large but perhaps not large enough to prevent SH from monitoring managerial performance so regulation of SH voting and proxy solicitation really does matter Electing and Removing Directors Electing Directors Three mandatory features Every corporation must have a board of directors Every corporation must have at least one class of voting stock Default one share one vote Why does almost all common stock carry voting rights bondholders have other protections Mandatory annual election of directors The whole board Part of board staggered or classified board Flexible framework for ASM notice period quorum requirement record date Cumulative voting Problem of default rule a minority SH can be entirely excluded from representation on the board Solution