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[Note: Numbers in brackets refer
to the printed pages of the Emanuel Law Outline where the topic is discussed.]
Emanuel Law Outlines
Corporations
Chapter 1
INTRODUCTION
I. CHOOSING A FORM OF ORGANIZATION
A. Partnership vs. corporation:
Choosing a form of organization usually comes down to choosing between a
partnership and a corporation. [2]
B. Nature of partnerships: There are
two kinds of partnerships: "general" partnerships and
"limited" partnerships. [2]
1. General partnership: A
"general partnership" is any association of two or more people who
carry on a business as co-owners. A general partnership can come into
existence by operation of law, with no formal papers signed or filed. Any
partnership is a "general" one unless the special requirements for
limited partnerships (see below) are complied with. [2]
a. Two types of partners: Limited
partners have two types of partners: (1) one or more "general"
partners, who are each liable for all the debts of the partnership; and
(2) one or more "limited" partners, who are not liable for the
debts of the partnership beyond the amount they have contributed.
C. Limited liability: Corporations
and partnerships differ sharply with respect to limited liability. [4]
1. Corporation: Corporations follow
the principle of centralized management. The shareholders participate only
by electing the board of directors. The board of directors supervises the
corporation's affairs, with day-to-day control resting with the
"officers" (i.e., high-level executives appointed by the board).
[5]
2. Partnership: In partnerships,
management is usually not centralized. In a general partnership, all
partners have an equal voice (unless they otherwise agree). In a limited
partnership, all general partners have an equal voice unless they otherwise
agree, but the limited partners may not participate in management. [5]
E. Continuity of existence: A
corporation has "perpetual existence." In contrast, a general
partnership dissolved by the death (or, usually, even the withdrawal) of a
general partner. A limited partnership is dissolved by the withdrawal or death
of a general partner, but not a limited partner. [5]
F. Transferability: Ownership
interests in a corporation are readily transferable (the shareholder just
sells stock). A partnership interest, by contrast, is not readily transferable
(all partners must consent to the admission of a new partner). [6]
1. Corporations: The corporation is
taxed as a separate entity. It files its own tax return showing its profits
and losses, and pays its own taxes independently of the tax position of the
stockholders. This may lead to "double taxation" of dividends (a
corporate-level tax on corporate profits, followed by a shareholder-level
tax on the dividend). [7]
2. Partnership: Partnerships, by
contrast, are not separately taxable entities. The partnership files an
information return, but the actual tax is paid by each individual.
Therefore, double taxation is avoided. Also, a partner can use losses from
the partnership to shelter from tax certain income from other sources. [8]
3. Subchapter S corporation: If the
owner/stockholders of a corporation would like to be taxed approximately as
if they were partners in a partnership, they can often do this by having
their corporation elect to be treated as a Subchapter S corporation. An
"S" corporation does not get taxed at the corporate level, unlike
a regular corporation; instead, each shareholder pays a tax on his portion
of the corporation's profits. [9]
1. Corporation superior: The
corporate form is superior: (1) where the owners want to limit their
liability; (2) where free transferability of interests is important; (3)
where centralized management is important (e.g., a large number of owners);
and (4) where continuity of existence in the face of withdrawal or death of
an owner is important. [10]
Chapter 2
THE CORPORATE FORM
I. WHERE AND HOW TO INCORPORATE
A. Delaware vs. headquarter state:
The incorporators must choose between incorporating in their headquarter
state, or incorporating somewhere else (probably Delaware). [13]
2. Publicly held: But for a
publicly held corporation, incorporation in Delaware is usually very
attractive (because of Delaware's well-defined, predictable, body of law,
and its slight pro-management bias.) [14]
a. Amending: The articles can be
amended at any time after filing. However, any class of stockholders who
would be adversely affected by the amendment must approve the amendment by
majority vote. See, e.g., RMBCA § 10.04.
2. Bylaws: After the corporation
has been formed, it adopts bylaws. The corporation's bylaws are rules
governing the corporation's internal affairs (e.g., date, time and place for
annual meeting; number of directors; listing of officers; what constitutes
quorum for directors' meetings, etc.). Bylaws are usually not filed with the
Secretary of State, and may usually be amended by either the board or the
shareholders. [16]
II. ULTRA VIRES AND CORPORATE POWERS
1. Classic doctrine: Traditionally,
acts beyond the corporation's articles of incorporation were held to be
"ultra vires," and were unenforceable against the corporation or
by it. (But there were numerous exceptions.) [18]
B. Corporate powers today: Most
modern corporations are formed with articles that allow the corporation to
take any lawful action. [19]
1. Charitable contribution: Even if
the articles of incorporation are silent on the subject, corporations are
generally held to have an implied power to make reasonable charitable
contributions. See, e.g., RMBCA § 3.02(13). [19]
2. Other: Similarly, corporations
can generally give bonuses, stock options, or other fringe benefits to their
employees (even retired employees). See, e.g., RMBCA § 3.02(12). [20]
III. PRE-INCORPORATION TRANSACTIONS BY
PROMOTERS
A. Liability of promoter: A
"promoter" is one who takes initiative in founding and organizing a
corporation. A promoter may occasionally be liable for debts he contracts on
behalf of the to-be formed corporation. [22]
1. Promoter aware, other party not:
If the promoter enters into a contract in the corporation's name, and the
promoter knows that the corporation has not yet been formed (but the other
party does not know this), the promoter will be liable under the contract.
See RMBCA § 2.04. [24]
a. Never formed, or immediately
defaults: If the corporation is never formed, or is formed but then
immediately defaults, the promoter will probably be liable.
b. Formed and then adopts: But if
the corporation is formed, and then shows its intent to take over the
contract (i.e., "adopts" the contract), then the court may find
that both parties intended that the promoter be released from liability (a
"novation").
B. Liability of corporation: If the
corporation did not exist at the time the promoter signed a contract on its
behalf, the corporation will not become liable unless it "adopts"
the contract. Adoption may be implied. (Example: The corporation receives
benefits under the contract, without objecting to them. The corporation will
be deemed to have implicitly adopted the contract, making it liable and
perhaps making the promoter no longer liable.) [26]
C. Promoter's fiduciary obligation:
During the pre-incorporation period, the promoter has a fiduciary obligation
to the to-be-formed corporation. He therefore may not pursue his own profit at
the corporation's ultimate expense. (Example: The promoter may not sell the
corporation property at a grossly inflated price.) [27]
IV. DEFECTIVE INCORPORATION
A. Common law "de facto"
doctrine: At common law, if a person made a "colorable" attempt to
incorporate (e.g., he submitted articles to the Secretary of State, which were
rejected), a "de facto" corporation would be found to have been
formed. This would be enough to shelter the would-be incorporator from the
personal liability that would otherwise result. This is the "de facto
corporation" doctrine. [29]
1. Modern view: But today, most
states have abolished the de facto doctrine, and expressly impose personal
liability on anyone who purports to do business as a corporation while
knowing that incorporation has not occurred. See RMBCA § 2.04.
B. Corporation by estoppel: The
common law also applies the "corporation by estoppel" doctrine,
whereby a creditor who deals with the business as a corporation, and who
agrees to look to the "corporation's" assets rather than the
"shareholders'|" assets will be estopped from denying the
corporation's existence. [30]
V. PIERCING THE CORPORATE VEIL
A. Generally: In a few very extreme
cases, courts may "pierce the corporate veil," and hold some or all
of the shareholders personally liable for the corporation's debts. [33]
B. Individual shareholders: If the
corporation's shares are held by individuals, here are some factors that
courts look to in deciding whether to pierce the corporate veil: [33]
2. Fraud: Veil piercing is more
likely where there has been a grievous fraud or wrongdoing by the
shareholders (e.g., the sole shareholder siphons out all profits, leaving
the corporation without enough money to pay its claims). [35]
a. Zero capital: When the
shareholder invests no money whatsoever in the corporation, courts are
especially likely to pierce the veil, and may require less of a showing on
the other factors than if the capitalization was inadequate but non-zero.
b. Siphoning: Capitalization may
be inadequate either because there is not enough initial capital, or
because the corporation's profits are systematically siphoned out as
earned. But if capitalization is adequate, and the corporation then has
unexpected liabilities, the shareholders' failure to put in additional
capital will generally not be inadequate capitalization.
4. Failure of formalities: Lastly,
the court is more likely to pierce the veil if the shareholders have failed
to follow corporate formalities in running the business. (Example: Shares
are never formally issued, directors' meetings are not held, shareholders
co-mingle personal and company funds.)[39]
C. Parent/subsidiary: If shares are
held by a parent corporation, the court may pierce the veil and make the
parent corporation liable for the debts of the subsidiary. [40]
2. Factors: But as in the
individual-shareholder case, certain acts by the parent may cause veil
piercing to take place. Such factors include: (1) failure to follow separate
corporate formalities for the two corporations (e.g., both have the same
board, and do not hold separate directors' meetings); (2) the subsidiary and
parent are operating pieces of the same business, and the subsidiary is
undercapitalized; (3) the public is misled about which entity is operating
which business; (4) assets are intermingled as between parent and
subsidiary; or (5) the subsidiary is operated in an unfair manner (e.g.,
forced to sell at cost to parent). [41]
D. Brother/sister ("enterprise
liability"): Occasionally, the court may treat brother/sister
corporations (i.e., those having a common parent) as really being one
individual enterprise, in which case each will be liable for the debts of its
"siblings." This is the "enterprise liability" theory.
[42]
VI. INSIDER CLAIMS IN BANKRUPTCY
(INCLUDING EQUITABLE SUBORDINATION)
A. Disallowance in bankruptcy: A
bankruptcy court may disallow an insider's claim entirely if fairness
requires. (Example: The insider claims that his entire capital contribution is
a "loan," but the court finds that some or all should be treated as
non-repayable "equity" in the bankruptcy proceeding.) [44]
B. Equitable subordination:
Alternatively, the bankruptcy court may recognize the insider's claims against
the corporation, but will make these claims come after payment of all other
creditors. Many of the same factors used for piercing the corporate veil
(e.g., inadequate capitalization) will lead to this "equitable
subordination" in bankruptcy. [44]
Chapter 3
THE CORPORATE STRUCTURE
I. GENERAL ALLOCATION OF POWERS
A. Traditional scheme: A
"traditional" scheme for allocating power in the corporation
(reflected in most statutes) is as follows: [49]
c. Removal: At common law,
shareholders had little power to remove a director during his term of
office. But today, most statutes allow the shareholders to remove
directors even without cause. See RMBCA § 8.08(a).
3. Fundamental changes: The
shareholders get to approve or disapprove of fundamental changes not in the
ordinary course of business (e.g., mergers, sales of substantially all of
the company's assets, or dissolution). [50]
D. Power of officers: The
corporation's officers are appointed by the board, and can be removed by the
board. The officers carry out the day-to-day affairs. [52]
II. BOARD OF DIRECTORS
A. Election: As noted, members of the
board of directors are always elected by the shareholders. [53]
a. Cumulative: In cumulative
voting, a shareholder may aggregate his votes in favor of fewer candidates
than there are slots available. (Example: H owns 100 shares. There are 3
board slots. H may cast all of his 300 votes for 1 candidate.) This makes
it more likely that a minority shareholder will be able to obtain at least
one seat on the board.
B. Number of directors: The number of
directors is usually fixed in either the articles of incorporation or in the
bylaws. Most statutes require at least three directors. Most statutes also
allow the articles or bylaws to set a variable (minimum and maximum) size for
the board, rather than a fixed size. (If variable size is chosen, then the
board gets to decide how many directors within the range there should be.)
[59]
C. Filling vacancies: Most statutes
allow vacancies on the board to be filled either by the shareholders or by the
board. [60]
D. Removal of directors: Most modern
statutes provide that directors may be removed by a majority vote of
shareholders, either with or without cause. Modern statutes also generally say
that a court may order a shareholder removed, but only for cause. [61]
3. Quorum: The board may only act
if a quorum is present. Usually, the quorum is a majority of the total
directors in office. (Example: If there are nine directors, at least five
must be present for there to be a meeting.) [63]
F. Act of board: The board may
normally take action only by a vote of a majority of the directors present at
the meeting. [65]
2. Requirement for meeting: The
board may normally take action only at a meeting, not by individual action
of the directors. (Example: A contract cannot be executed by the board
merely by having a majority of the directors, acting at separate times and
places, sign the contract document.) But there are some exceptions: [66]
c. Ratification: Also, if the
board learns of an action taken by an officer, and the board does not
object, the board may be deemed to have "ratified" this action,
or the board may be "estopped" from dishonoring it. In either
case, the result is as if the board had formally approved the action in
advance.
G. Committees: The full board may
appoint various committees. Generally, a committee may take any action which
could be taken by the full board. (But there are exceptions. For instance,
under the RMBCA, committees may not fill board vacancies, amend the articles
of incorporation or the bylaws, propose actions for shareholder approval, or
authorize share repurchases. RMBCA § 8.25(e).) [69]
III. OFFICERS
A. Meaning of "officer":
The term "officer" describes only the more important executives of
the corporation, typically those appointed directly by the board of directors.
Most states leave it up to the board or the bylaws to determine what officers
there shall be. [76]
B. Right to hire and fire: Officers
can be both hired and fired by the board. Firing can be with or without cause
(and can occur even if there is an employment contract, though the officer can
then sue the corporation for breach). [76]
C. Authority to act for corporation:
The officer is an agent of the corporation, and his authority is therefore
analyzed under agency principles. An officer does not have the automatic right
to bind the corporation. Instead, one of four doctrines must usually be used
to find that the officer could bind the corporation on particular facts: [76]
a. President: The president is
generally held to have implied actual authority, merely by virtue of his
office, to engage in ordinary business transactions, such as hiring and
firing non-officer-level employees and entering into ordinary-course
contracts. But he does not usually have implied actual authority to bind
the corporation to non-ordinary-course contracts such as contracts for the
sale of real estate or for the sale of all of the corporation's assets.
b. Secretary: The secretary has
implied actual authority to certify the records of the corporation,
including resolutions of the board of directors. Therefore, a secretary's
certificate that a given resolution was duly adopted by the board is
binding on the corporation in favor of a third party who relies on the
certificate.
3. Apparent authority: An officer
has "apparent authority" if the corporation gives observers the
appearance that the agent is authorized to act as he is acting. There are
two requirements: (1) the corporation, by acts other than those of the
officer, must indicate to the world that the officer has the authority to do
the act in question; and (2) the plaintiff must be aware of those corporate
indications and rely on them. [80]
a. President: In the case of a
president, apparent authority will often flow merely from the fact that
the corporation has given him that title -- he will then have apparent
authority to enter into ordinary course arrangements. (Example: If Corp.
gives X the title "President," this will signal to the world
that X has authority to purchase office supplies. Therefore, if X does
purchase office supplies from P, who knows that X has the title
"President," X will bind Corp. even if the board of directors
has explicitly resolved that X does not have authority to purchase such
supplies.)
4. Ratification: Under the doctrine
of "ratification," if a person with actual authority to enter into
the transaction learns of a transaction by an officer, and either expressly
affirms it or fails to disavow it, the corporation may be bound. Usually, P
will have to show that the corporation either received benefits under the
contract, or that P himself relied to his detriment on the existence of the
contract. [83]
IV. SHAREHOLDER ACTION
A. Meetings: Nearly all states
require a corporation to hold an annual meeting of shareholders. See RMBCA
§ 7.02(a). [86]
a. Who may call: The board may
call a special meeting. Also, anyone authorized by the bylaws to call a
meeting (e.g., the president, under many bylaws) may do so. Finally, some
statutes allow the holders of a certain percentage of the shares to call a
special meeting. (Example: RMBCA § 7.02(a)(2) allows the holders of
10% of shares to call a special meeting. But in Delaware, shareholders may
not call a special meeting.)
B. Quorum: For a vote of a
shareholders' meeting to be effective, there must be a quorum present.
Usually, this must be a majority of the outstanding shares. However, the
percentage required for a quorum may be reduced if provided in the articles or
bylaws. [87]
C. Vote required: Once a quorum is
present, the traditional rule is that the shareholders will be deemed to have
approved of the proposed action only if a majority of the shares actually
present vote in favor of the proposed action. [87]
Chapter 4
SHAREHOLDERS' INFORMATIONAL RIGHTS AND THE PROXY SYSTEM
I. SHAREHOLDER INSPECTION OF BOOKS AND
RECORDS
A. Generally: State law generally
gives shareholders the right to inspect the corporation's books and records.
[95]
B. Who may inspect: Usually
"beneficial owners," as well as holders of record, may inspect. [97]
1. Size or length of holding: Some
statutes restrict the right of inspection to shareholders who either have
held their shares for a certain time, or hold more than a certain percentage
of total shares. [98] (Example: New York BCL § 624 gives the statutory right
of inspection only to one who: (1) has held for at least six months; or (2)
holds at least 5% of a class of shares.)
C. What records may be examined:
Under most statutes, the holder has a right to inspect not merely specified
records, but the corporate records in general. [98]
1. More limited statutes: But other
statutes are more limited. (Example: The RMBCA does not give holders an
automatic right to inspect sensitive materials like the minutes of board
meetings, the accounting records, or the shareholder list. For these, he
must make a demand "in good faith and for proper purpose," he must
"describe with reasonable particularity" his purpose and the
records he wants to inspect, and the records must be "directly
connected with his purpose." See RMBCA § 16.02(b).) [98]
D. Proper purpose: The shareholder
generally may inspect records only if he does so for a "proper
purpose." [99]
3. Deal with other shareholders: If
the holder wants to get access to the shareholder's list to contact his
fellow shareholders to take group action concerning the corporation, this
will usually be proper. (Example: A holder will usually be given access to
shareholder lists to solicit proxies in connection with an attempt to elect
a rival slate of directors.) [99]
4. Social/political goals: If the
holder is pursuing only social or political goals that are not closely
related to the corporation's business, this purpose will usually be
improper. (Example: P wants to stop D Corp from making munitions for the
Vietnam War because he thinks the war is immoral; P's purpose is not
"proper," so he cannot have D's shareholder list or its records of
weapons manufacture.) [100]
E. Financial reports: In most states,
the corporation is not required to send an annual report or other annual
financial information to the shareholder. (But federal law requires publicly
held corporations to send a report, and some states require this for all
corporations.) [101]
F. Director's right of inspection: A
director in most states has a very broad, virtually automatic, right of
inspection. (But most states deny him the right of inspection if he is acting
with "manifestly improper motives.") [101]
II. REPORTING REQUIREMENTS FOR PUBLICLY
HELD COMPANIES
A. What companies are "publicly
held": Certain reporting requirements are imposed on "publicly
held" companies. Basically, these are companies which either: (1) have
stock that is traded on a national securities exchange; or (2) have assets of
more than $5 million and a class of stock held of record by 500 or more
people. These companies must make continuous disclosures to the SEC under § 12 of the Securities Exchange
Act of 1934 (the "'34 Act"), and must comply with the proxy rules
described below. [103]
B. Proxy rules
generally: Any company covered by § 12 of the '34 Act (companies
listed in the prior paragraph) fall within the SEC's proxy solicitation rules.
If a company is covered, any proxy solicitation by either management or
non-management (subject to some exemptions) must comply with detailed SEC
rules. Basically, this means that whenever management or a third party wants
to persuade a shareholder to vote in a certain way (whether the persuasion is
written or oral, and whether it is by advertisement or one-on-one
communication), the solicitation must comply with the SEC proxy rules. [103]
2. Proxy statement: Every proxy
solicitation must be accompanied or preceded by a written "proxy
statement." This must disclose items like conflicts of interest, the
compensation given to the five highest-paid officers, and details of any
major change being voted upon. [106]
D. Requirements for proxy: The proxy
itself is a card which the shareholder signs, and on which he indicates how he
wants to vote. SEC rules govern the format of this card. [108]
1. Function: Most commonly, the
proxy will be the method by which the shareholder indicates to management
that he is voting for management's slate of directors. The proxy card will
also be the shareholder's way of indicating how he votes on some major
non-election issue, such as whether the company should merge with another
corporation. The proxy is the method of casting shareholder votes in all
situations except where the shareholder attends the shareholder's meeting.
[108]
3. Must be voted: The recipient of
the proxy (e.g., management or a group of insurgents waging a proxy contest)
must vote the proxy as the shareholder has indicated, even if the
shareholder has voted the opposite of the way the person who solicited the
proxy would like. [108]
E. Revocation of proxies: Generally,
a proxy is revocable by the shareholder, even if the proxy itself recites that
it is irrevocable.
1. Coupled with an interest:
However, if a proxy states that it is irrevocable and the proxy is
"coupled with an interest" then it is irrevocable. A proxy is
"coupled with an interest" when the recipient of the proxy has a
property interest in the shares, or at least some other direct economic
interest in how the vote is cast. (Example: A shareholder pledges his shares
in return for a loan from Bank. The pledge is an interest, so the proxy will
be irrevocable while the loan is outstanding.) [108]
III. IMPLIED PRIVATE ACTIONS UNDER THE
PROXY RULES
A. Generally: The Supreme Court has
recognized an "implied private right of action" on behalf of
individuals who have been injured by a violation of proxy rules. [J.I. Case Co. v. Borak]. There are three
requirements which the plaintiff must satisfy: [109]
1. Materiality: First, P must show
that there was a material misstatement or omission in the proxy materials.
In the case of an omission, the omitted fact is material if it would have
"assumed actual significance in the deliberations of a reasonable
shareholder." [111]
2. Causation: Second, P must show a
causal link between the misleading proxy materials and some damage to
shareholders. However, P does not have to show that the falsehood or
omission directly "caused" the damage to shareholders; he only has
to show that the proxy solicitation itself (not the error or omission) was
an essential part of the transaction. [113] (Example: If holders have to
approve a merger, any material defect in the proxy materials will be deemed
to have "caused" damage to the holders, since the entire proxy
solicitation process was an essential part of carrying out the merger
transaction.)
a. Minority class whose votes are
not needed: If P is a member of a minority class whose votes were not
necessary for the proposed transaction to go through, P may not recover no
matter how material or how intentional the deception in the proxy
statement was. [Virginia Bankshares, Inc.
v. Sandberg].
Example: FABI, a
bank holding company, owns 80% of the shares of Bank. FABI wants to get
rid of the 20% minority shareholders in Bank, so it proposes to buy out
the minority holders at a price of $42. The minority holders are sent a
proxy solicitation stating that the $42 price is "high" and
"fair." Most of the minority holders approve the transaction. P,
a minority holder who opposes the transaction, sues on the grounds that
the proxy materials falsely stated that the price was "high" and
"fair."
Held, P has no
claim here, even if the proxy materials were false. Because FABI could
have voted its own shares in favor of the buyout, approval by the minority
holders was not legally necessary. Therefore, no misstatements in the
proxy materials sent to the minority holders could have "caused"
the merger, or contributed to any damage suffered by P or the other
minority holders. Virginia Bankshares, supra.
3. Standard of fault: Third, P must
show that D was at fault in some way. If the defendant is an
"insider" (e.g., the corporation itself, its officers and its
employee/directors), P only has to show that D was negligent. Some courts
have also found outside directors and other outsiders liable for errors or
omissions under the proxy rules, where the outsider was negligent. [116]
4. Remedies: If P makes these three
showings, he can get several possible types of relief: (1) he may be able to
get an injunction against a proposed transaction (where the proxy
solicitation was for the purpose of getting shareholder approval of the
transaction, such as a merger); (2) he may very occasionally have an
already-completed transaction set aside; and (3) he may obtain damages for
himself and other holders, if he can prove actual monetary injury (e.g., he
shows that due to lies in the proxy statement, shareholders approved the
sale of the company at an unfairly low price.) [117]
IV. COMMUNICATIONS BY SHAREHOLDERS
A. Two methods: A shareholder may
solicit her fellow shareholders to obtain their proxies in favor of her own
proposed slate of directors or her own proposal. Depending on the
circumstances, there are two methods for her to do so, in one of which the
shareholder bears the expense and in the other of which the corporation bears
the expense. [118]
B. Shareholder bears expense: Under
SEC Rule 14a-7, a shareholder who is willing
to bear the expense of communicating with his fellow shareholders (e.g.,
printing and postage) has the right to do so. Management must either mail the
shareholder's materials to the other stockholders, or give the soliciting
shareholder a shareholder list so that he can do the mailing directly. [118]
1. Few restrictions: There are very
few restrictions on when and how this method is used. For instance, there is
no length limit on the materials the shareholder may mail, and management
has no right to censor or object to the contents. [119]
C. Corporation bears expense:
Alternatively, a shareholder may sometimes get a "shareholder
proposal" submitted to fellow shareholders entirely at the corporation's
expense. Under SEC Rule 14a-8, shareholder proposals may
sometimes be required to be included in management's own proxy materials.
(Example: An activist shareholder may be able to get management's proxy
materials to include the activist's proposal that the company cease doing
business with China.) [120]
a. Improper subject under state
law: A proposal may be excluded if "under the law of the [state where
the corporation is incorporated, the proposal is] not a proper subject for
action by security holders." This usually means that the proposal
must be phrased as a recommendation by the shareholders that management
consider doing something, rather than as an order by shareholders that the
corporation do something (since under state law shareholders usually
cannot order the corporation to do anything).
b. Not significantly related to
corporation's business: A proposal may be excluded if it is not
significantly related to the company's business (i.e., if it counts for
less than 5% of the corporation's total assets and less than 5% of its
earnings and gross sales, and is "not otherwise significantly related
to the [corporation's] business"). (Example: A proposal calls for
Corp's widget division to be divested because it has a poor return on
equity; if the widget division accounts for less than 5% of Corp's assets,
earnings and sales, the proposal may be excluded.)
i. Ethical/social issues: But
ethical or social issues may usually not be excluded for failure to meet
these 5% tests, if the issues are otherwise related to the corporation's
business. (Example: The corporation's alleged force feeding of geese to
produce pate de fois gras may not be excluded, even though it accounts
for less than 5% of earnings, assets and sales.)
i. Compensation issues:
Proposals concerning senior executive compensation are not matters
relating to the "ordinary business operations" of the company,
and may therefore not be excluded. (Example: A proposal suggesting that
the board cancel any "golden parachute" contracts it has given
to senior executives -- i.e., contracts that give the executive a large
payment if the company is taken over -- must be included in the proxy
materials.)
d. Election of directors: A
proposal may be excluded if it relates to "the election of
directors." In other words, a holder who wants to propose his own
slate of directors, or to oppose management's slate, must pay for the
dissemination of his own materials, and may not require the corporation to
disseminate for him.
V. PROXY CONTESTS
A. Definition: A "proxy
contest" is a competition between management and a group of outside
"insurgents" to obtain shareholder votes on a proposal. Most proxy
contests involve the election of directors, but there can be proxy contests
over some non-election proposal as well. (Example: A proxy contest over
whether the corporation should adopt a proposed "poison pill"
takeover defense.) [125]
1. List access: The SEC rules do
not give the insurgent group access to the shareholder's list. (However,
they may have this under state law, as described above.) But as noted, the
SEC rules do allow the insurgents to force management to choose between
mailing the insurgents' materials or giving the insurgents the list so that
the insurgents can do this themselves. (Management will usually mail instead
of giving up the list.) [126]
2. Disclosure required: Both sides
must comply with all disclosure regulations. Thus they must make sure that
any "solicitation" (including oral solicitation) is preceded by a
written proxy statement, and in the case of an election they must file
special information about any "participant" in the solicitation.
[127]
2. Insurgents: If the insurgents
are successful at getting control, they will usually be allowed to have the
corporation reimburse them for their expenses (provided that the
shareholders approve). If the insurgents are unsuccessful at getting
control, they must bear their own expenses. [128]
Chapter 5
CLOSE CORPORATIONS
I. INTRODUCTION
A. What is close corporation: A
"close corporation" is one with the following traits: (1) a small
number of stockholders; (2) the lack of any ready market for the corporation's
stock; and (3) substantial participation by the majority stockholder(s) in the
management, direction and operations of the corporation. [136]
B. Significance of close corporation
status: Close corporations present special problems relating to control. The
various devices examined here are mainly ways of insuring that a minority
stockholder will not be taken advantage of by the majority holder(s). [136]
II. SHAREHOLDER VOTING AGREEMENTS,
VOTING TRUSTS AND CLASSIFIED STOCK
A. Voting agreements: A
"shareholder voting agreement" is an agreement in which two or more
shareholders agree to vote together as a unit on certain or all matters. Some
voting agreements expressly provide how votes will be cast. Other agreements
merely commit the parties to vote together (without specifying how the vote is
to go, so that the parties must reach future agreement). [139]
b. Specific performance: Second,
most courts today will grant specific performance of the terms of the
voting agreement. See, e.g., RMBCA § 7.31(b).
B. Voting trust: In a voting trust,
the shareholders who are part of the arrangement convey legal title to their
shares to one or more voting trustees, under the terms of a voting trust
agreement. The shareholders become "beneficial owners" -- they
receive a "voting trust certificate" representing their beneficial
interest, and get dividends and sale proceeds. But they no longer have voting
power. [141]
C. Classified stock and weighted
voting: Shareholders may reallocate their voting power (and give minority
holders a bigger voice) by using classified stock. The corporation sets up two
or more classes of stock, and gives each class different voting rights or
financial rights. [143]
III. AGREEMENTS RESTRICTING THE BOARD'S
DISCRETION
A. Problem generally: If the
shareholders agree to restrict their discretion as directors, there is a risk
that the agreement will violate the principle that the business shall be
managed by the board of directors. If a court finds that the board's
discretion has been unduly fettered, it may refuse to enforce the agreement.
[144]
B. Present law: However, this danger
is not very great today. Most courts will probably uphold even a shareholder
agreement that substantially curtails the board's discretion, so long as the
agreement: (1) does not injure any minority shareholder; (2) does not injure
creditors or the public; and (3) does not violate any express statutory
provision. [145]
IV. SUPER-MAJORITY VOTING AND QUORUM
REQUIREMENTS
A. Modern view: Most statutes allow
the shareholders to agree that a "super-majority" will be required
for a vote or a quorum. In general, such super-majority quorum and voting
requirements are upheld, even if they require unanimity. (Example: Under the
RMBCA, the articles of incorporation may be amended to require some percentage
greater than 50%, even unanimity, both for a quorum for a shareholders'
meeting and for shareholder approval of proposed corporate action. Also,
either the articles or the bylaws may impose a super-majority quorum or voting
requirement for directors' meetings and directors' action.) [148]
1. Changing a requirement: If the
charter is drafted to impose a super-majority voting or quorum requirement,
some statutes allow the super-majority provision to be removed or changed
only by the same super-majority percentage. (Example: Once the charter is
amended to require two-thirds shareholder vote for any merger proposal, a
two-thirds shareholder would be required to remove the super-majority
provision.) In other states, the shareholders must expressly agree to this
kind of "anti-amendment" scheme. [148]
V. SHARE TRANSFER RESTRICTIONS
A. Why used: The shareholders of a
close corporation will often agree to limit the transferability of shares in
the corporation. This lets shareholders veto the admission of new
"colleagues" and helps preserve the existing balance of control.
[149]
B. Enforcement: Today, share transfer
restrictions will generally be enforced, so long as they are reasonable. [150]
C. Various techniques: Here are the
five principal techniques for restricting share transfers: [111]
1. First refusal: Under a right of
first refusal, a shareholder may not sell his shares to an outsider without
first offering the corporation or the other shareholders (or both) a right
to buy those shares at the same price and terms as those at which the
outsider is proposing to buy. (Usually the corporation gets the first
chance, and if it refuses, the other shareholders get the right to buy
proportionally to their holdings.) [150]
4. Stock buy-back: A buy-back right
is given to the corporation to enable it to buy back a holder's shares on
the happening of certain events, whether the holder wants to sell or not.
(Example: The corporation might be given the right to buy back shares of a
holder/employee upon that person's retirement or termination of employment.)
The corporation is not obligated to exercise a buy-back right. [151]
5. Buy-sell agreement: A buy-sell
agreement is similar to a buy-back right, except that the corporation is
obligated to go through with the purchase upon the happening of the
specified event. (Example: The corporation agrees in advance that it will
repurchase the shares at a fixed price upon the death of a
shareholder/employee.) [151]
2. Subsequent purchaser without
notice: A person who purchases shares without actual knowledge of
pre-existing restrictions will generally not be bound by the restrictions.
However, if the restriction is conspicuously noted on the share
certificates, he will be bound.
3. Non-consenting minority holder:
Courts are split as to whether a person who is already a shareholder at the
time the restrictions are imposed (and who does not consent) is bound. RMBCA
§ 6.27(a) provides that a person who is already a holder at the time
restrictions are imposed (e.g., by an amendment to the articles of
incorporation or bylaws) will not be bound if he does not sign any agreement
to that effect, and does not vote in favor of the restriction.
E. Valuation: Most transfer
restrictions require some valuation to be placed on the stock at some point.
There are four common techniques: [153]
2. "Capitalized earnings"
method: If the "capitalized earnings" method is used, the parties
use a formula that attempts to estimate the future earnings of the business,
and they then discount these earnings to present value. [154]
4. Appraisal: Last, if the
"appraisal" method is used, the parties agree in advance on a
procedure by which a neutral third-party appraiser will be selected; the
appraiser then determines the value. [155]
2. Installment payments:
Alternatively, the parties can agree that the shares will be purchased by
the installment method. Usually, there will be a down payment, followed by
quarterly or annual payments, usually paid out of the earnings of the
business. (Often, life insurance is used to fund the down payment.) [155]
G. Requirement of
"reasonableness": Transfer restrictions will only be upheld if they
are "reasonable." [155]
1. Outright prohibition and consent
requirements: Courts are especially likely to strike down an outright
prohibition on the transfer of shares to third parties. Similarly, a
provision that shares may not be sold to outsiders without the consent of
the other shareholders is likely to be found unreasonable, if the others are
permitted to withhold their consent arbitrarily. [155]
2. Options, first refusals and
buy-sell agreements: The other types of restrictions -- first option, right
of first refusal, buy-backs and buy-sell agreements -- are more likely to be
found "reasonable." In general, if the mechanism chosen by the
parties is reasonable at the time the method was agreed upon, it will
probably be found reasonable (and upheld) even though it turns out to
produce a price that is much higher or lower than the market price at the
time of sale. [155]
VI. RESOLUTION OF DISPUTES, INCLUDING
DISSOLUTION
A. Dissension and deadlock: The
courts often have to deal with "dissension" and "deadlock"
among the stockholders. "Dissension" refers to squabbles or
disagreements among them. "Deadlock" refers to a situation where the
corporation is paralyzed and prevented from acting (e.g., two factions each
control the same number of directors, and the two factions cannot agree).
[157]
B. Dissolution: The major judicial
remedy for dissension and deadlock is a court order that the corporation be
involuntarily dissolved. Dissolution means that the corporation ceases to
exist as a legal entity; the assets are sold off, the debts are paid, and any
surplus is distributed to the shareholders. [158]
2. RMBCA: Thus under RMBCA § 14.30(2),
a shareholder must show one of these four things to get dissolution: (1)
that the directors are deadlocked; (2) that those in control have acted in a
manner that is "illegal, oppressive, or fraudulent"; (3) that the
shareholders are deadlocked and have failed to elect new directors for at
least two consecutive annual meetings; or (4) that the corporation's assets
are being "misapplied or wasted." [159]
3. Judge's discretion: Most states
hold that even if the statutory criteria are met, the judge still has
discretion to refuse to award dissolution (e.g., when it would be unfair to
one or more shareholders). [159]
C. Alternatives to dissolution: There
are a number of alternatives to dissolution, including: (1) arbitration; (2)
court appointment of a provisional director (to break a deadlock); (3) court
appointment of a custodian (who will run the business); (4) appointment of a
receiver (who will liquidate the business); and (5) a judicially-supervised
buy-out in lieu of dissolution. [162]
Example: P is a minority
stockholder who has inherited her shares from her husband, an employee of
Corporation. Corporation has previously bought back shares from its majority
stockholder at a high price, but refuses to buy P's shares back at anything
like the same price. Held, the controlling stockholder owed P a fiduciary
duty, and was therefore required to cause Corporation to repurchase shares
from P in the same portion, and at the same price, as it had purchased from
the majority holder. [Donahue v. Rodd Electrotype].
a. Where applied: The few courts
that have recognized this "fiduciary obligation of majority to
minority" tend to find it violated only where the majority holder
causes the corporation to take action that has no legitimate business
purpose. (Example: Majority holders fire P, end his salary, drop him from
the board, and refuse to pay dividends; held, these actions had no
legitimate business purpose, and were used merely to deprive P of a
reasonable return on his investment, so the majority holders violated
their fiduciary obligations. Wilkes v. Springside
Nursing Home, Inc.)
Chapter 6
THE DUTY OF CARE AND THE BUSINESS JUDGMENT RULE
I. INTRODUCTION
A. Duty generally: The law imposes on
a director or officer a duty of care with respect to the corporation's
business. The director or officer must behave with that level of care which a
reasonable person in similar circumstances would use. [171]
1. Damages vs. injunction: If a
director or officer violates this duty of care, and the corporation
consequently loses money, the director/officer will be personally liable to
pay money damages to the corporation. Separately, if the board of directors
has approved a transaction without using due care (and the transaction has
not yet been consummated), the court may grant an injunction against the
transaction. [172]
2. Rare: It is very rare for
directors and officers to be found liable for breach of the duty of due
care. (When this happens, it's usually because there is some taint of
self-dealing, but not enough to cause the court to find a formal violation
of the duty of loyalty.) [172]
II. THE STANDARD OF CARE
A. Basic standard: The basic standard
is that the director or officer must behave as a reasonably prudent person
would behave in similar circumstances. [173]
2. Egregious cases: However,
liability for breach of the duty of due care is generally imposed only when
the director or officer behaves "recklessly" or with "gross
negligence." (Example: D, a director, fails to attend board meetings,
fails to read financial reports, fails to obtain the advice of a lawyer or
accountant even though he is on notice that the corporation is being
mismanaged -- taken together, these acts amount to recklessness, and thus
justify holding D liable for losses suffered by the corporation that could
have been prevented by a director who exercised reasonable care. [Francis v. United Jersey
Bank].)
[173]
B. Objective standard: The standard
of care is an objective one: the director is held to the conduct that would be
exercised by a "reasonable person" in the director's position. So a
director who is less smart, or less knowledgeable about business than an
"ordinary" reasonable director nonetheless must meet this higher
objective standard. [175]
1. Special skills: On the other
hand, if the director has special skills that go beyond what an ordinary
director would have, he must use those skills. Thus a trained accountant,
lawyer, banker, real estate professional, etc., if he learns of facts that
would make a person in that profession suspicious, must follow through and
investigate even though these facts would not make a non-professional
suspicious. [175]
C. Reliance on experts and
committees: Directors are generally entitled to rely on experts, on reports
prepared by insiders, and on action taken by a committee of the board. But all
such reliance is allowed only if it is "reasonable" under the
circumstances. (Example: A director may rely on the financial statements
prepared by the corporation's accountants; therefore, unless the director is
on notice that the accountants are failing to uncover wrongdoing, the director
will not be liable for, say, embezzlement that is not reflected in the
financial statements.) [176]
D. Passive negligence: A director
will not be liable merely for failing to detect wrongdoing by officers or
employees. However, if the director is on notice of facts suggesting
wrongdoing, he cannot close his eyes to these facts. Also, in large
corporations, it may constitute a violation of due care for the directors not
to put into place monitoring mechanisms (e.g., stringent internal accounting
controls, and/or an audit committee) to detect wrongdoing. [177]
E. Causation: In many states, even if
a director or officer has violated the duty of due care he is only liable for
damages that are the proximate result of his conduct. (For instance, if the
loss would have happened anyway, even had the directors all behaved with due
care, there will be no liability in these courts.) However, other states,
including Delaware, allow plaintiff to recover without a showing of causation
against a director who violated his duty of care. [178]
1. Joint and several: If a board
member violates his duty of due care, at least some courts hold him jointly
and severally liable with all other directors who have violated that duty,
so long as the board collectively was a proximate cause of the loss. (In
other words, a director cannot say, "Even if I had been diligent, the
other directors would still have ignored me and the loss would have happened
anyway.") [178]
III. THE BUSINESS JUDGMENT RULE
A. Function of rule: The
"business judgment rule" saves many actions from being held to be
violations of the duty of due care. [179]
1. Relation to duty of due care:
Here is how the duty of due care and the business judgment rule fit
together: (1) the duty of due care imposes a fairly stern set of procedural
requirements for directors' actions; (2) once these procedural requirements
are satisfied, the business judgment rule then supplies a much
easier-to-satisfy standard with respect to the substance of the business
decision. [180]
B. Requirements: The business
judgment rule basically provides that a substantively-unwise decision by a
director or officer will not by itself constitute a lack of due care. However,
there are three requirements (two of them procedural) which a decision by a
director or officer must meet before it will be upheld by application of the
business judgment rule: [182]
1. No self-dealing: First, the
director or officer will not qualify for the protection of the business
judgment rule if he has an "interest" in the transaction. In other
words, any self-dealing by the director or officer will deprive him of the
rule's protection. (Example: X, an officer of Corp, has Corp buy supplies at
inflated prices from another company of which X is secretly a major
shareholder. X's decision to have Corp buy the supplies in this manner will
not be protected by the business judgment rule, because the transaction in
question amounted to self-dealing by X.) [182]
2. Informed decision: Second, the
decision must have been an "informed" one. That is, the director
or officer must have gathered at least a reasonable amount of information
about the decision before he makes it. [183]
a. Gross negligence standard:
Probably the "gross negligence" standard applies to the issue of
whether the decision was an informed one. In other words, even if the
director or officer is somewhat (but not grossly) negligent in failing to
gather all reasonably available information, he will not lose the benefit
of the rule. But if he was grossly negligent, he will lose the protection.
Example: The Ds, directors of a
publicly held corporation, approve a sale of the company without making
any real attempt to learn the "intrinsic value" of the company,
without having any written documentation about the proposed deal, without
learning that no true bargaining took place with the buyer, and while
spending only two hours on the decision even though there was no real
emergency or time pressure. Held, the process used by the directors was so
sloppy that their decision was not an "informed" one, so they do
not have the protection of the business judgment rule and are in fact
liable for the breach of the duty of due care. [Smith v. Van Gorkom]
3. "Rational" decision:
Finally, the director or officer must have "rationally believed"
that his business judgment was in the corporation's best interest. So the
decision does not have to be substantively "reasonable," but it
must be at least "rational" (i.e., not totally crazy). [186]
C. Exceptions: Even where these three
requirements for the business judgment rule are satisfied, there are one or
two situations where the court may find the rule inapplicable: [186]
1. Illegal: If the act taken or
approved by the director or officer is a violation of a criminal statute,
the defendant will lose the benefit of the business judgment rule. (Example:
The Ds, directors of a major corporation, approve the corporation's making
of illegal political contributions. Held, the directors will not be
protected by the business judgment rule, because the transaction in question
violated a criminal statute. [Miller v. American Telephone
& Tele. Co.]) [186]
IV. RECENT STATUTORY CHANGES TO
DIRECTOR LIABILITY
A. Some approaches: Some states have
tried to restrict the liability of directors for breaches of the duty of due
care. Here are some approaches: [188]
Chapter 7
DUTY OF LOYALTY
I. SELF-DEALING TRANSACTIONS
A. Definition: A "self-dealing
transaction" is one in which three conditions are met: (1) a Key Player
(officer, director or controlling shareholder) and the corporation are on
opposite sides of a transaction; (2) the Key Player has helped influence the
corporation's decision to enter the transaction; and (3) the Key Player's
personal financial interests are at least potentially in conflict with the
financial interests of the corporation. (Example: A director/shareholder of
Corp induces Corp to buy Blackacre from him at an inflated price.) [195]
B. Modern rule on self-dealing
transactions: Courts will frequently intervene to strike down (or award
damages for) a self-dealing transaction. [197]
b. Waste/fraud: If the
transaction is so unfair that it amounts to "waste" or
"fraud" against the corporation, the court will usually void it
at the request of a stockholder. This is true even though the transaction
was approved by a majority of disinterested directors or ratified by the
shareholders.
c. Middle ground: If the
transaction does not fall into either of the two above categories -- it's
not clearly fair, but it's not so unfair as to amount to waste or fraud --
the presence or absence of director approval and/or shareholder
ratification will make the difference. If a majority of disinterested and
knowledgeable directors have approved the transaction (or if the
transaction has been ratified by the shareholders) the court will probably
approve the transaction. If neither disinterested-director approval nor
shareholder ratification has occurred, the court will probably invalidate
the transaction.
2. Three paths: Thus there are
three different ways that a proponent of a self-dealing transaction can
probably avoid invalidation: (1) by showing approval by a majority of
disinterested directors, after full disclosure; (2) by showing ratification
by shareholders, after full disclosure; and (3) by showing that the
transaction was fair when made. We consider each of these
"branches" below. [203]
C. Disclosure plus board approval: A
transaction may not be avoided by the corporation if it was authorized by a
majority of the disinterested directors, after full disclosure of the nature
of the conflict and the transaction. [203]
1. What must be disclosed: Two
kinds of information must be disclosed to the board before it approves the
transaction: (1) the material facts about the conflict; and (2) the material
facts about the transaction. (Example: If D, a director of XYZ Corp, wants
to sell XYZ an office building he owns, he must disclose not only the fact
that he owns the office building, but also any material facts about the
deal, such as whether the price is a fair one in light of current market
conditions.) [203]
2. Who is "disinterested"
director: The approval must be by a majority of the
"disinterested" directors. A director will be
"interested" if either: (1) he or an immediate member of his
family has a financial interest in the transaction; or (2) he or a family
member has a relationship with the other party to the transaction that would
reasonably be expected to affect his judgment about the transaction.
(Example: Prexy is president, director and controlling shareholder of XYZ.
He wants to sell Blackacre, which he owns, to XYZ. Sidekick, who is an
employee and director of XYZ, knows that he owes his job to Prexy. Sidekick
will probably not be a "disinterested" director because his
relationship with Prexy would be expected to affect his judgment about the
transaction; therefore, Sidekick's vote to approve the transaction will not
be counted.) [206]
3. Quorum: A quorum for the vote by
the disinterested directors merely has to consist of a majority of the
disinterested directors, not a majority of the total directors. (Thus if
there is a nine-member board, but only three disinterested directors, two of
them will constitute a quorum, and both will have to vote in favor of the
transaction to authorize it.) [206]
4. Immunization of unfairness: The
fact that a majority of the disinterested directors (acting after full
disclosure) have approved or ratified the transaction does not necessarily
immunize it from attack, if the unfairness is very great. But the existence
of such approval/ratification shifts the burden of proof to the person
attacking the transaction, and the transaction will only be struck down if
the unfairness is so great as to constitute fraud or waste. [207]
D. Disclosure plus shareholder
ratification: A self-dealing transaction will be validated if it is fully
disclosed to the shareholders, and then ratified by a majority of them. [207]
1. Disinterested shareholders: The
courts are split about whether the ratification must be by a majority of
disinterested shareholders, or merely by a majority of all shareholders
(including, perhaps, the one who is doing the self-dealing). [208]
E. Fairness as key criterion:
Finally, a self-dealing transaction can be validated by a showing that it is,
under all the circumstances, fair to the corporation. Such "overall
fairness" will suffice even if the transaction was neither approved by
the disinterested directors nor ratified by the shareholders. Fairness is
generally determined by the facts as they were known at the time of the
transaction. [208]
1. No prior disclosure: In most
courts, a fair transaction will be upheld even though it was never disclosed
by the Key Player to his fellow executives, directors or shareholders. (But
the ALI's Principles of Corporate Governance do require disclosure, though
this disclosure may be made anytime up to a reasonable time after suit is
filed challenging the transaction.) [208]
F. Indirect conflicts: A self-dealing
transaction will be found not only where the Key Player is directly a party to
the transaction, but also where he is indirectly a party, i.e., he owns an
equity position in the other party to the transaction. The test is whether the
Key Player's equity participation in the other party is big enough to expect
his judgment to be affected. See RMBCA § 8.60(1)(i), (ii). (Example:
Prexy, in addition to being president, director and controlling shareholder of
XYZ Corp, owns 20% of ABC Corp. A major transaction between ABC and XYZ will
probably be a self-dealing transaction if Prexy influences the XYZ side of it,
because Prexy's own 20% stake in ABC is probably large enough to affect his
judgment about whether the transaction is good for XYZ.) [210]
G. Remedies for violation: If there
has been a violation of the rule against self-dealing, there are two possible
remedies:
1. Rescission: Normally, the court
will rescind the transaction, where this is possible. (Example: Prexy sells
Blackacre to XYZ Corp, of which he is president and director. If the
transaction is unfair, and was not ratified by directors or shareholders,
the court will rescind it, giving title back to Prexy and the purchase price
back to XYZ.) [212]
2. Damages: If because of passage
of time or complexity of the transaction it cannot be rescinded, the court
will award restitutionary damages. That is, the Key Player will have to pay
back to the corporation any benefit he received beyond what was fair. [212]
II. EXECUTIVE COMPENSATION
A. Business judgment rule: If an
officer or director influences a corporation's decision about his own
compensation, this is technically a self-dealing transaction. However, courts
are reluctant to strike down decisions about executive compensation. Such
decisions receive the protection of the business judgment rule: the director's
decision will be sustained so long as it is rational, informed, and made in
good faith. [217]
B. Consideration: In the case of
deferred compensation plans, courts sometimes insist that the plan be set up
in such a way that an executive will receive the deferred compensation only if
he remains with the company. Thus a grant of stock options to all executives
(regardless of whether they stay with the company) might be struck down as
lacking in consideration. [218]
C. Excessive compensation: Even if a
compensation scheme has been approved by a majority of the disinterested
directors, or ratified by the shareholders, the court may still overturn it if
the level of compensation is "excessive" or
"unreasonable." That is, the compensation levels must be reasonably
related to the value of the services performed by the executive. [218]
1. Few cases: But courts very
rarely strike down a compensation plan as excessive. One exception may be
where a plan makes use of a formula which is not amended even though
conditions change. (Example: If XYZ enacts a formula paying its president
10% of pre-tax profits, and the corporation's profits increase so much that
the president is earning $25 million a year, the court might strike the plan
as excessive.) [219]
III. THE CORPORATE OPPORTUNITY DOCTRINE
AND RELATED PROBLEMS
A. Competition with corporation: A
director or senior executive may not compete with the corporation, where this
competition is likely to harm the corporation. (Example: Corp operates
department stores in a particular city. A, B, and C, senior executives of
Corp, secretly purchase a controlling interest in another department store in
the same city. This is competition which is likely to harm Corp, so A, B, and
C are violating their duty of loyalty to Corp.) [221]
1. Approval or ratification:
Conduct that would otherwise be prohibited as disloyal competition may be
validated by being approved by disinterested directors, or by being ratified
by the shareholders. The Key Player must first make full disclosure about
the conflict and the competition that he proposes to engage in. [222]
2. Preparation to compete: Usually,
courts will find that a Key Player has violated his duty of loyalty even if
he just prepares to compete (rather than actually competing) while still in
the corporation's employ. The court often will order the insider to return
all salary he earned during the period of preparation. [222]
3. Competition after end of
employment: But if the executive first leaves the corporation, and only then
begins preparations or actual competition, this does not constitute a
violation of the duty of loyalty. (However, the insider may not use the
corporation's trade secrets. Also, the insider will be barred from competing
if he has signed a valid non-competition agreement.) [222]
B. Use of corporate assets: A Key
Player may not use corporate assets if this use either: (1) harms the
corporation; or (2) gives the Key Player a financial benefit. "Corporate
assets" include not only tangible goods, but also intangibles like
information. (Example: D, the president of XYZ, lives rent-free in a house
owned by XYZ; this is a violation of the duty of loyalty to XYZ and to its
other shareholders.) [223]
C. The "corporate
opportunity" doctrine: A director or senior executive may not usurp for
himself a business opportunity that is found to "belong" to the
corporation. Such an opportunity is said to be a "corporate
opportunity." [223]
1. Effect: If the Key Player is
found to have taken a "corporate opportunity," the taking is per
se wrongful to the corporation, and the corporation may recover damages
equal to the loss it has suffered or even the profits it would have made had
it been given the chance to pursue the opportunity. [223]
a. Interest or expectancy: The
oldest test is the "interest or expectancy" test. The
corporation has an "interest" in an opportunity if it already
has some contract right regarding the opportunity. (Example: Corp has a
contract to acquire Blackacre; it therefore has an "interest" in
Blackacre, so if its president buys Blackacre instead, he has taken a
corporate opportunity.) A corporation has a "expectancy"
concerning an opportunity if its existing business arrangements have led
it to reasonably anticipate being able to take advantage of that
opportunity.
b. "Line of business"
test: A more popular test is the "line of business" test, under
which an opportunity is a "corporate" one if it is "closely
related to the corporation's existing or prospective activities."
(Example: ABC bottles Coca-Cola. President buys the then-bankrupt
Pepsi-Cola company, and builds it into a successful competitor to
Coca-Cola. President has taken a corporate opportunity from ABC under the
"line of business" test.)
c. The "fairness" test:
Under the "fairness" test, the court measures the overall
unfairness, on the particular facts, that would result if the insider took
the opportunity for himself.
4. Who is bound: Generally, courts
seem to apply the corporate opportunity doctrine only to directors,
full-time employees, and controlling shareholders. Thus a shareholder who
has only a non-controlling interest (and who is not a director or employee)
will generally not be subjected to the doctrine. [228]
5. Rejection by corporation: If the
insider offers the corporation the chance to pursue the opportunity, and the
corporation rejects the opportunity by a majority vote of disinterested
directors or disinterested shareholders, the insider may pursue the
opportunity himself. The insider must make full disclosure about what he
proposes to do. (Some but not all courts allow ratification after the fact.)
[229]
7. Remedies: The usual remedy for
the taking of a corporate opportunity is for the court to order the
imposition of a constructive trust -- the property is treated as if it
belonged to the corporation that owned the opportunity. Also, the Key Player
may be ordered to account for all profits earned from the opportunity. [234]
IV. THE SALE OF CONTROL
A. Generally: In some (but not most)
situations, the court will prevent a "controlling shareholder" from
selling that controlling interest at a premium price. [237]
1. "Control block"
defined: A person owns a "controlling interest" if he has the
power to use the assets of the corporation however he chooses. . A majority
owner will always have a controlling interest. But the converse is not true:
a less-than-majority interest will often be controlling (e.g., a 20-40%
interest where the remaining ownership is highly dispersed and no other
shareholder is as large). [237]
a. Exceptions: However, there are
a number of exceptions (discussed below) to this general rule, including:
(1) the "looting" exception; (2) the "sale of vote"
exception; and (3) the "diversion of collective opportunity"
exception.
B. The "looting" exception:
The controlling shareholder may not sell his control block if he knows or
suspects that the buyer intends to "loot" the corporation by
unlawfully diverting its assets. [240]
Example: ABC is an investment company
with $6 per share of assets, but with nearly offsetting liabilities and a net
asset value of six cents per share. Buyer offers to buy Seller's control block
for $2 per share, a sum many times greater than market value. Because Seller
knows or suspects that the only reason Buyer is willing to pay such a huge
premium is because he intends to illegally transfer the liquid assets to
himself, Seller may not sell his control block to Buyer at a premium price. If
he does so, he will be liable to ABC and its other shareholders for damages.
1. Mental state: Clearly if the
controlling shareholder either knows or strongly suspects that the buyer
will loot, he may not sell to him. Also, if Seller recklessly disregards the
possibility of looting, the same rule applies. Most, but probably not all,
courts would also impose liability where the seller merely
"negligently" disregards the likelihood that the buyer will loot.
[240]
2. Excessive price: In many courts,
excessive price alone will not be enough to necessarily put the seller on
notice that the buyer intends to loot. But an excessive price combined with
other factors (e.g., the liquid and readily saleable nature of the company's
assets) will be deemed to put the seller on notice. [242]
C. The "sale of vote"
exception: The controlling shareholder may not sell for a premium where the
sale amounts to a "sale of his vote." [242]
1. Majority stake: If the
controlling shareholder owns a majority interest, the "sale of
vote" exception will not apply. Thus even if the controlling
shareholder specifically agrees that he will ensure that a majority of the
board resigns so that the buyer is able to immediately elect his own
majority of the board, this will not be deemed to be a sale of vote (since
the buyer would eventually get control of the board anyway merely by owning
the majority stake). [244]
2. Small stake: If the seller has a
very small stake (e.g., less than 20%) in the corporation, and promises to
use his influence over the directors to induce them to resign so that the
buyer can elect disproportionately many directors, then the "sale of
vote" exception is likely to be applied. [243]
3. "Working control":
Where the seller has "working control," and promises to deliver
the resignations of a majority of directors so that the buyer can receive
that working control, courts are split about whether this constitutes a sale
of vote. [244]
4. Separate payment: Also, if the
contract of sale explicitly provides for a separate payment for the delivery
of directors' resignations and election of the buyer's nominees to the
board, this will be a sale of vote. [245]
1. Business opportunity: A court
may find that the corporation had a business opportunity, and that the
controlling shareholder has constructed the sale of his control block in
such a way as to deprive the corporation of this business opportunity. If
so, the seller will not be allowed to keep the control premium. [245]
Example: ABC Corp, due to scarce
wartime conditions, is able to get interest-free loans from its customers.
President sells his control block to a consortium of those customers, who
then cancel the no-interest loan arrangements and who sell themselves much
of ABC's production, although at standard prices. The president may be found
to have diverted a business opportunity belonging to ABC, in which case he
will not be allowed to keep the portion of the price he received for his
shares that is above the fair market value of those shares. See Perlman v. Feldmann.
2. Seller switches
type of deal: If Buyer proposes to buy the entire company, but Seller
instead switches the nature of the deal by talking Buyer into buying just
Seller's control block (at a premium), a court may take away Seller's right
to keep the premium, on the grounds that all shareholders deserve the right
to participate. [247]
E. Remedies: If one of these
exceptions applies (so that the seller is not entitled to keep the control
premium) there are two remedies which the court may impose: [248]
2. Pro rata recovery: Alternately,
the court may award a pro rata recovery, under which the seller repays to
the minority shareholders their pro rata part of the control premium (thus
avoiding a windfall to the buyer). [249]
V. OTHER DUTIES OF CONTROLLING
SHAREHOLDERS
A. Possible general fiduciary duty:
Almost no courts have held that a controlling shareholder owes any kind of
general fiduciary duty to the minority shareholders. (A few courts have
recognized such a fiduciary duty limited to the case of a close corporation.
See, e.g., Donahue v. Rodd Electrotype, discussed supra. [252]
1. Jones case: Only one major case
seems to say that controlling shareholders have a general fiduciary
obligation to minority holders. See Jones v. H.F. Ahmanson &
Co.
(controlling shareholders could not form a separate publicly-held holding
company for their control block, thus drying up any public market for the
minority shares). [253]
B. Duty of complete disclosure: When
a controlling shareholder or group deals with the non-controlling
shareholders, it owes the latter a duty of complete disclosure with respect to
the transaction, as a matter of state common law. [256]
Example: Controlling shareholders in
ABC give notice of the proposed redemption of a minority block, without
telling the minority holders that due to secret developments the minority
holders would benefit by exercising certain conversion rights. Held, this
failure to give complete disclosure violated the majority's common law
obligation to the minority. See Zahn v. Transamerica Corp.; Speed v. Transamerica Corp.
C. Parent/subsidiary
relations: When the controlling shareholder is another corporation (the
parent/subsidiary context), essentially the same rules apply. [259]
1. Dividends: When the parent
corporation controls the parent's dividend policy, this is in theory
self-dealing. But so long as dividends are paid pro rata to all shareholders
(including the parent), courts will rarely overturn the subsidiary's
dividend policy even though this was dictated by the needs of the parent.
[259]
2. Other types of self-dealing:
Other types of self-dealing transactions between parent and subsidiary will
be struck down if they are unfair to the minority shareholders of the
subsidiary, and were entered into on the subsidiary's side by a board
dominated by directors appointed by the parent. (Example: Subsidiary and
Parent agree to a price and terms under which Subsidiary will sell to Parent
the oil it produces. If Subsidiary's board is dominated by directors
appointed by Parent, Parent will have to bear the burden of proving that the
transaction is fair to Subsidiary and to the minority holders of
Subsidiary.) [260]
3. Corporate opportunities: If the
parent takes for itself an opportunity that should belong to the subsidiary,
the court will apply the "corporate opportunity" doctrine, and
void the transaction. [262]
Chapter 8
INSIDER TRADING
I. INTRODUCTION TO INSIDER TRADING
A. Generally: The term "insider
trading" has no precise definition, but basically refers to the buying or
selling of stock in a publicly traded company based on material, non-public
information about that company. [267]
1. Not all illegal: Not all insider
trading (as defined above) is illegal. In general, only insider trading that
occurs as a result of someone's willful breach of a fiduciary duty will be
illegal (at least under the federal securities laws, which are the main
source of insider trading law). [267]
a. Buying before disclosure of
good news: Thus if an insider at Oil Corp buys stock at a time when he
knows, and the market doesn't, that Oil Corp has just struck a huge
gusher, this is illegal insider trading.
b. Sale before disclosure of bad
news: Similarly, if an insider at Oil Corp sells his stock at a time when
he knows (and the market does not) that Oil Corp is just about to report
an unexpected large loss, this too is illegal insider trading.
3. Harms: The possible harms from
insider trading include: (1) harm to the reputation of the corporation whose
stock is being insider-traded; (2) harm to market efficiency, because
insiders will delay disclosing their information and prices will be
"wrong"; (3) harm to the capital markets, because investors will
stay away from what they think is a "rigged" market; and (4) harm
to company efficiency, because managers may be induced to run their
companies in an inefficient manner (but one that produces large insider
trading profits). [270]
II. STATE COMMON-LAW APPROACHES
A. Suit by shareholder: A shareholder
can in theory bring a state common law action against an insider trader for
"deceit." [275]
1. Face-to-face: If the insider
buys from the outsider in a face-to-face transaction, the rule is that the
insider has no duty to disclose material facts (e.g., good news) known to
him. So usually, even in this face-to-face situation, the plaintiff outsider
will not be able to recover in deceit even though he would not have sold at
the price he did had he known the undisclosed good news. But there are some
exceptions: [276]
b. Special facts: Many states
recognize a "special facts" exception to the general rule that
silence cannot constitute deceit. (Example: If the insider seeks out the
other party, or makes elaborate attempts to conceal his own identity, the
"special facts" doctrine may be employed.)
2. Garden variety impersonal
insider trading: If the insider trading takes place in an impersonal rather
than a face-to-face way (i.e., it occurs by means of open-market purchases
on the stock market), virtually no states allow the outsider to recover on
common-law principles. [277]
B. Suit by corporation: A very few
states have allowed the corporation to recover against an insider who buys or
sells based on undisclosed material information. [278]
2. ALI: The ALI
follows the approach of Diamond, by making it an actionable
breach of loyalty for the insider to use "material non-public
information concerning the corporation" to either cause harm to the
corporation, or to secure a pecuniary benefit not available to other
shareholders. [280]
III. SEC RULE 10b-5 AND INSIDER TRADING
A. Summary: The principal
proscription against insider trading is SEC's Rule 10b-5, enacted pursuant to the
Securities Exchange Act of 1934. [281]
1. Text: SEC Rule 10b-5 makes it unlawful: (1) to
"employ any device, scheme, or artifice to defraud"; (2) to make
any "untrue statement of a material fact or to omit to state a material
fact. . . ."; or (3) to engage in any "act,
practice, or course of business which operates or would operate as a fraud
or deceit upon any person." All three of these types of conduct are
forbidden only if they occur "in connection with the purchase or sale
of any security." [281]
2.
Disclose-or-abstain: The insider does not have an affirmative obligation to
disclose the material, non-public information. Rather, he must choose
between disclosure and abstaining from trading. [283]
4. Nature of
violation: Violation of 10b-5 is a crime. Also, the SEC
can get an injunction against the conduct. Finally, a private party who has
been injured will, if he meets certain procedural requirements, have a
private right of action for damages against the insider trader. [283]
B. Requirements for private right of
action: An outsider injured by insider trading has a right of action for
damages under Rule 10b-5, if he can meet certain
procedural requirements: [286]
4. Scienter: D must be shown to
have acted with scienter, i.e., he must be shown to have had an intent to
deceive, manipulate or defraud. [287]
5. Reliance and causation: P must
show that he relied on D's misstatement or omission, and that that
misstatement or omission was the proximate cause of his loss. (In cases of
silent insider trading rather than misrepresentation, these requirements
usually don't have much effect.) [287]
6. Jurisdiction: There is a federal
jurisdictional requirement: D must be shown to have done the fraud or
manipulation "by the use of any means or instrumentality of interstate
commerce or of the mails, or of any facility of any national securities
exchange." In the case of any publicly-traded security, this
requirement will readily be met. But where the fraud consists of deceit in a
face-to-face sale of shares, especially shares in a private company, then
the jurisdictional requisites may well be lacking. [288]
C. P as purchaser or seller: P in a
private 10b-5 action must have been either
a purchaser or seller of stock in the company to which the misrepresentation
or insider trading relates. Blue Chip Stamps v. Manor Drug
Stores. [288]
1. Non-sellers: Thus one who
already owned shares in the issuer and who decides not to sell because the
corporation or its insiders makes an unduly optimistic representation, or
fails to disclose negative material, may not sue. [289]
D. "Material" non-public
fact: D must be shown to have made a misstatement or omission of a
"material" fact. [291]
a. Mergers: The fact that the
company is engaged in "merger" discussions is not necessarily
"material." This is a fact-based question that depends on how
far along the negotiations are, whether a specific price is on the table,
whether the investment bankers have been brought in, etc.
b. Fact need not be
outcome-determinative: To be "material," a fact does not have to
be one that, if known to the investor, would have changed the investor's
decision. The "total mix" test means that "a material fact
is one that would affect a reasonable investor's deliberations without
necessarily changing her ultimate investment decision." [Folger Adam Co. v. PMI
Industries, Inc.].
2. Non-public: If the claim is that
D traded silently rather than made a misrepresentation, the omission must be
of a non-public fact. But "non-public" is interpreted broadly:
even if a fact has been disclosed, say, to a few reporters, it is still
non-public (and trading is not allowed) until the investors as a whole have
learned of it. [292]
E. Defendant as insider, knowing
tippee or misappropriator: In the case of silent insider trading, D will not
be liable unless he was either an insider, a "tippee," or a
"misappropriator." In other words, mere trading while in possession
of material non-public information is not by itself enough to make D civilly
liable under 10b-5. [293]
Example: D is sitting
in a taxi, and finds handwritten notes left by the prior occupant. The notes
indicate that ABC Corp. is about to launch a tender offer for XYZ Corp. D buys
XYZ stock. D won't be liable under 10b-5, because he was not an
insider of XYZ, nor a "tippee" of one who was an insider of XYZ, nor
a "misappropriator" who "stole" the information from
anyone.
1. Insiders: An "insider"
is one who obtains information by virtue of his employment with the company
whose stock he trades in. One can be an insider even if one is a low-level
employee (e.g., a secretary). Also, people who do work on a contract basis
for the issuing company (e.g., professionals like accountants and lawyers)
can be a "constructive" insider. See infra. [294]
2. Knowing tippee:
A person will be a "tippee," and will be liable for insider
trading, if he knows that the source of his tip has violated a fiduciary
obligation to the issuer. Conversely, if the tippee does not know this (or
if the insider has not breached any fiduciary obligation), the tippee is not
liable. [295]
Example: X, a
former employee of ABC Corp, tells D that XYZ is engaging in massive
financial fraud. X is not acting for any pecuniary benefit, but instead just
wants to expose the fraud. D tells his clients to sell their ABC stock.
Held, D did not violate 10b-5, because X was not
violating any fiduciary duty, so D was not a knowing "tippee." Dirks v. SEC.
Example: Lawfirm
represents Behemoth, a big company that is secretly planning a takeover of
Smallco. D, a partner at Lawfirm, learns from Behemoth about these plans,
and buys Smallco stock. Held, D has violated 10b-5, because he misappropriated
the information from Behemoth, in violation of an implied promise of
confidentiality. This is true even though neither D nor Lawfirm was an
insider of Smallco, the issuer. U.S. v. O'Hagan. [319]
F. Scienter: A defendant is liable
under 10b-5 only if he acted with
scienter, i.e., with intent to deceive, manipulate or defraud. Probably this
is met if D makes a misstatement recklessly. (In silent insider trading cases,
the scienter requirement means that the defendant must have known that the
information to which he had access was material and non-public.) [298]
1. Misrepresentation: If the case
involves affirmative misrepresentation (not just silent insider trading), P
will be given the benefit of a presumption that P relied on the
misrepresentation and that it caused P's injury. In other words, because of
the fact that the stock market is usually "efficient," D's
misstatement will be presumed to have affected the price at which the
plaintiff bought or sold. (Example: D, an insider at XYZ, falsely says,
"Profits will be up this quarter." P buys for $20 per share.
Profits go down, and the stock drops to $10. The misstatement will be
presumed to have affected the market price, and P will be presumed to have
relied on the fairness of that price.) But this presumption may be rebutted.
[300]
H. "Contemporaneous
trader's" right to sue: In 1988, Congress specifically allowed any
insider-trader to be sued civilly by any "contemporaneous trader"
who traded in the other direction. The plaintiff can recover his own losses up
to the amount of gain achieved, or loss avoided, by the defendant. P does not
have to prove that the insider trading "caused" P's loss. (The
statutory provision creating this right of action doesn't define "insider
trading"; that's left to the courts, as it has always been.) [304]
Example: D, Senior Vice President of
XYZ Corp., learns from his job that XYZ will soon be acquired by ABC Corp. at
a price of $40 per share. D buys 1000 shares of XYZ on March 1 at a price of
$20 per share. On March 2, P sells 2000 shares of XYZ at $20 each. The merger
is announced on March 3, and the price goes to $40 immediately. D sells at
$40, and thus makes a $20,000 profit. P may sue D civilly, and may recover
$20,000. That is, P gets the lesser of: (1) P's lost profits (which are
probably $40,000, since that's the profit he would have made on his shares if
the market had been aware of the inside information at the time P made his
sale); and (2) D's gains ($20,000).
1. Information not from issuer:
This express private right of action applies even though the inside
information does not derive from the issuer, but rather, from some third
party. However, under court rulings that still apply -- like Dirks, supra -- the trade is not
"insider trading" unless the trader knew that the information was
obtained by the trader or his tipper in violation of some fiduciary
responsibility. [305]
Example: On the
facts of the above example, P could recover even if D learned the
information while working at ABC, the acquirer, rather than while working at
XYZ, the issuer. But if D had learned the information by overhearing a
conversation on a park bench -- or in any other way not involving a breach
of fiduciary responsibility by D or D's source -- then this would not be
"insider trading" at all, and P could not recover under the
express private right of action now given to "contemporaneous
traders" injured by insider trading.
I. Damages: If P meets all of these
requirements for a private 10b-5 action, there are various
ways that the measure of damages might be calculated. [306]
2. Silent trading; P is
"contemporaneous trader": If D is a silent insider-trader, and P
is a "contemporaneous trader," P may recover the lesser of: (1)
P's own losses (probably measured by how much gain P would have made, or how
much loss he would have avoided, had the inside information been disclosed
before P traded); and (2) D's gains made, or losses avoided, from the
transaction. See the example to Par. (H) above. [308]
Example: Suitor is planning to
acquire Target. Target's stock is now $20 per share, and Suitor plans to
offer the public $30. Dennis, a managing director at InvestCo., Suitor's
investment banker, buys 1000 shares in Target at $20, and tells his friends
so they can buy too. As a result of this trading and tipping, the price of
Target jumps immediately to $30. Suitor finally has to pay $40, rather than
$30, to buy all Target's 1 million shares. Probably Suitor can recover $10
million -- the amount it had to pay extra -- from Dennis, even though Dennis
only made $20,000. Cf. Litton Industries v.
Lehman Bros.
4. SEC civil
penalties: Also, the SEC may recover civil penalties against an insider
trader. The SEC may recover a civil penalty of up to three times the profit
gained or loss avoided by the insider trader. See '34 Act, § 21A(a)(3) and 21A(b). [309]
a. "Controlling
person's" liability: Furthermore, as the result of changes made by
Congress in 1988 to the Securities Exchange Act, a person or organization
who "controls" an insider trader, and carelessly fails to take
steps to prevent foreseeable insider trading, may be liable for the same
three-fold SEC civil penalties as the insider. (Example: D insider-trades
based on information he learned while working as an associate in the
mergers and acquisitions department of Law Firm. Law Firm can be liable
for three-fold civil penalties if the SEC shows that Law Firm recklessly
disregarded the risk that D might insider trade and failed to take
reasonable steps to limit this risk of such trading.)
IV. WHO IS AN "INSIDER" OR
"TIPPEE"?
A. Recap: Remember that only a person
who is either an "insider" or a "tippee" is covered by 10b-5. [310]
2. Who is "tippee": A
person is a "tippee" only if: (1) he receives information given to
him in breach of the insider's fiduciary responsibility; (2) he knows that
(or, perhaps, should know that) the breach has occurred; and (3) the
insider/tipper has received some benefit from the breach (or intended to
make a pecuniary gift to the tippee). [310]
B. Acquired by chance: Thus if an
outsider acquires information totally by chance, without anyone violating any
fiduciary obligation of confidentiality, the outsider may trade with impunity.
(Example: The outsider randomly overhears inside information in a restaurant
without any fiduciary violation by the speaker or by the outsider.) [314]
C. Acquired by diligence: Similarly,
if an outsider acquires non-public information through his own diligence, he
may trade upon it. (Example: A security analyst ferrets out non-public
information by interviewing former employees and others who when they speak to
the analyst are not receiving or intending to confer any pecuniary benefit.)
[314]
D. Intent to make a gift: If an
insider gives an outsider information with the intent to make a gift of
pecuniary value to the outsider, the outsider will be a "tippee,"
and both insider and outsider will be liable. (Example: A gives an inside
stock tip to his mistress, B, with the intent that B be able to make some
money by buying the stock. Even though A doesn't expect or get any profit
himself, A and B are both liable under 10b-5.) [315]
E.
"Constructive" insider: A person who is given confidential
information by the issuer so that he can perform services for the issuer will
be a "temporary" or "constructive" insider. Thus an
investment banker, accountant, lawyer, or consultant will be a constructive
insider (and thus may not trade, or tip others to trade). [315]
F. Disclosure between
family members: If the tipper learns information from a close relative, this
relationship is not by itself enough to give the tipper a fiduciary
responsibility. This is true even if the relative or the relative's family
control the issuer, the information "belongs" to the issuer, and the
tipper knows all this. [315]
Example: The Waldbaum family, which controls
publicly-held Waldbaum Corp., agrees to sell Waldbaum Corp. to another
company, for a price higher than the current market price. Ira Waldbaum,
President of Waldbaum, tells his sister; she tells her daughter, Susan. Susan
tells her husband, Keith, and then tells him to keep the information secret.
Keith tells D, his stockbroker, who secretly buys Waldbaum stock for himself.
D is charged with the crime of violating 10b-5.
Held, D is not guilty
of violating 10b-5. The mere family relationship
between Susan and Keith was not enough to make Keith a "fiduciary"
regarding the merger information; this is true even though Keith knew the
information came from the issuer (Waldbaum Corp.) and knew that the
information derived from Susan's family's control of the issuer. (But if Keith
had promised confidentiality to Susan as a condition of hearing the news, then
he would have been a fiduciary.) Because Keith was not a fiduciary, his
tippee, D, has no 10b-5 liability. (But D is guilty
of violating SEC Rule 14e-3, which prohibits trading on
non-public information about a tender offer.) U.S. v. Chestman.
G. Confidential
information from other than issuer (the "misappropriation" problem):
Where an outsider receives confidential information but not from the issuer,
the situation is trickier. [317]
Example: D is a reporter for the
Wall Street Journal. He learns that company XYZ will be the subject of a
favorable news story in the Journal. He buys XYZ stock. Held, even though
D's information did not come from the issuer (XYZ) he has
"misappropriated" it from his employer, so he will be criminally
liable under federal wire and/or mail fraud statutes. Carpenter v. U.S.
b. Civil liability to investors:
Even if one who trades on confidential information not derived from the
issuer is civilly or criminally liable in an SEC enforcement action, this
does not necessarily mean that investors may successfully bring a private
damage action against him (in the absence of any statute on point).
c. Suit by acquiring corporation:
If the outsider learns the information in breach of his fiduciary
obligation to the would-be acquirer of a target, and then trades in the
target's stock, there is a good chance that the acquirer will be able to
recover damages against the outsider under 10b-5.
3. Rule 14e-3: SEC Rule 14e-3 prohibits trading on
non-public information about a tender offer, even if the information comes
from the acquirer rather than the target, and even if the information is not
obtained in violation of any fiduciary duty. There may be (this is not yet
certain) an implied private right of action on behalf of the offeror and/or
other investors in the target for a 14e-3 violation.
H. One's own trading plans: It is not
a violation of 10b-5 for one who is about to
launch his own tender offer to buy shares on the open market without
disclosing his plans. (Example: Raider secretly buys 4% of Target Corp stock
on the New York Stock Exchange, without announcing that he plans to institute
a tender offer. He then institutes a tender offer at a much higher price.
Raider has not violated 10b-5 by his open-market purchases,
even though he was concealing the material fact that he would soon be taking
an action which would raise the price.) [322]
V. RULE 10b-5: MISREPRESENTATIONS OR
OMISSIONS NOT INVOLVING INSIDER TRADING
A. Breach of fiduciary duty: The fact
that an insider has breached his state-law fiduciary duties may occasionally
(but rarely) constitute a violation of 10b-5. [327]
1. Lie to directors: For instance,
if an insider lies to the board of directors and thereby induces them to
sell him stock on favorable terms, this would be a 10b-5 violation. (Example: The
chief scientist of XYZ Corp falsely tells the board of directors that there
have been no new developments, when there has in fact been a major
scientific breakthrough that will improve the company's prospects. The board
then issues stock options to the scientist. The scientist will be held to
have violated 10b-5, because he violated his
state-law duty of disclosure to his corporate employer.) [327]
2. Breach of duty
without misrepresentation: But if an insider violates his fiduciary duties
to the corporation or its shareholders without making a misrepresentation,
this will not constitute a 10b-5 violation. In other words,
there is no doctrine of "constructive fraud" to trigger a 10b-5 violation. (Example: The
controlling shareholder of XYZ Corp carries out a short-form merger on terms
that are substantively unfair to the minority stockholders. Even though this
violates a controlling shareholder's fiduciary obligations to the minority
shareholder, there will be no 10b-5 violation because there has
been no fraud or deception. See Santa Fe Industries v. Green.) [327]
B. Misrepresentation without trading:
If a corporation or one of its insiders makes a misrepresentation, it/he will
be liable even though it/he does not trade in the company's stock. (Example:
D, the president of XYZ, falsely tells the public, "Our profits will be
up this quarter." D can be liable under 10b-5 even though he has never
bought any XYZ stock.) [328]
1. Scienter: However, remember that
D will not be liable for misrepresentation in a 10b-5 suit unless he acted with
scienter, i.e., he knew his statement was false or recklessly disregarded
the chance that it might be false. That is, D will not be liable for mere
negligent misstatement. [329]
2. Merger
discussions: If a company is a company is engaged in merger discussions, and
its insiders knowingly and falsely deny that the discussions are taking
place, this may make them liable under 10b-5. (Therefore, they should
say, "No comment," instead of falsely denying.) [329]
C. Omission by non-trader: Where the
company or an insider simply fails to disclose material inside information
that it possesses, it/he will not be liable as long as it/he does not buy or
sell company stock. (Example: D Corp signs a huge contract which improves its
prospects enormously. It keeps the deal quiet for 10 days. So long as neither
the company nor its insiders buys or sells any D Corp stock during this
period, no violation of 10b-5 has occurred.) [331]
b. Involvement:
If the company heavily involves itself with outsiders' statements about
the company, it may thereby assume a duty to correct errors in those
outsider's statements. (Example: X, a securities analyst, submits his
estimates of ABC Corp's next quarterly earnings to ABC's investor
relations director, W. W knows that these estimates are wrong but says
nothing. X releases the estimates to the public. ABC and/or W may have
violated 10b-5.)
D. Defenses based on plaintiff's
conduct: In cases involving misrepresentations (rather than silent insider
trading), D may have two defenses based on P's conduct: [331]
1. Due diligence: Under the due
diligence defense, if D can show that his own misstatements were
contradicted by documents in P's possession, and that P recklessly failed to
read the documents, this will be a defense. [331]
2. In pari delicto defense: Under
the in pari delicto defense, if D can show that P's conduct was at least as
culpable as D's, this may be a defense. Sometimes a tipper will assert this
defense when sued by a tippee for having given a misleading tip. However,
the defense will rarely succeed in this situation. [332]
VI. SHORT-SWING TRADING PROFITS AND
§ 16(b)
A. Generally: Section 16(b) of the Securities Exchange
Act of 1934 contains a "bright line" rule by which all
"short-swing" trading profits received by insiders must be returned
to the company. [333]
1. Gist: The gist of § 16(b) is that if a
statutorily-defined insider buys stock in his company and then resells
within six months, or sells and then re-purchases within six months, any
profits he makes must be returned to the corporate treasury. This rule
applies even if the person in fact had no material non-public information.
[333]
a. P must continue to be
stockholder: P must not only be a stockholder in the corporation at the
time she files suit under 16(b), but she must also
continue to be a stockholder as the suit progresses. However, if P is
forced to exchange her shares for shares in a different corporation as the
result of the target corporation's merger, P may continue her suit as long
as she keeps the shares in the surviving corporation. Gollust v. Mendell.
5. Public filings: To aid
enforcement, any officer, director, or 10%-owner must file with the SEC
(under 16(a)) a statement showing any
change in his ownership of the company's stock. This must be filed within 10
days after any calendar month in which the level of ownership changes. [334]
1. "Officer": Two groups
of people may be "officers" for § 16(b) purposes: (1) anyone who
holds the title of "President," "Vice President,"
"Secretary," "Treasurer" (or "Principal Financial
Officer"), or "Comptroller" (or "Principal Accounting
Officer"); (2) anyone (regardless of title) who performs functions that
correspond to the functions typically performed by these named persons in
other corporations. [335]
a. Attribution: Stock listed in
A's name may be attributed to B. A person will generally be regarded as
the beneficial owner of securities held in the name of his or her spouse
and their minor children (but usually not grown children). Thus a sale by
Husband might be matched against a purchase by Wife; similarly, a sale and
purchase by Wife might be attributed to Husband if Husband is a director
or officer.
3. Deputization as director: A
corporation may be treated as a "director" of another corporation
if the former appoints one of its employees to serve on the latter's board.
(Example: ABC Corp owns a significant minority interest in XYZ Corp. ABC
appoints E, its employee, to serve on the board of XYZ. ABC will be deemed
to have "deputized" E to serve as director, so ABC will be treated
as a constructive director of XYZ, and any short-swing trading profits
reaped by ABC in XYZ stock will have to be returned to XYZ.) [337]
a. Purchase that puts one over:
The purchase that puts a person over 10% does not count for § 16(b) purposes. (Example: D has
owned 5% of XYZ for a long time. On January 1, he buys another 10%. On
February 1, he sells 4%. There are no short-swing profits that must be
returned to the company.)
b. Sale that puts
one below 10%: In the case of a sale that puts a person below 10%
ownership, probably we measure the insider status before the sale.
(Example: D already owns 15% of XYZ. He then buys another 10% on January
1. On February 1, he sells 16%. On March 1, he sells the remaining 9%.
Probably D has short-swing liability for 16% sale, but not for the second
9%, since we probably measure his insider status as of the moment just
before the sale.)
D. What is a "sale," in the
case of a merger: If the corporation merges into another company (and thus
disappears), the insiders will not necessarily be deemed to have made a
"sale." D will escape short-swing liability for a merger or other
unorthodox transaction if he shows that: (1) the transaction was essentially
involuntary; and (2) the transaction was of a type such that D almost
certainly did not have access to inside information. [338]
Example: Raider launches a hostile
tender offer for Target. On Feb. 1, Raider buys 15% of Target pursuant to the
tender offer. Target then arranges a defensive merger into White Knight,
whereby each share of Target will be exchanged for one share of White Knight.
The merger closes on May 1, at which time Raider (like all other Target
shareholder) receives White Knight shares in exchange for his Target stock. On
June 1, Raider sells his White Knight stock on the open market for a total
greater than he originally paid for the Target stock. Raider does not have any
§ 16(b) problem, because the overall
transaction was essentially involuntary, and was of a type in which Raider
almost certainly did not have access to inside information about White
Knight's affairs.
E. "Profit"
computed: If there is a covered purchase/sale or sale/purchase, the courts
will compute the profit in a way that produces the maximum possible number. In
other words, the court takes the shares having the lowest purchase price and
matches them against the shares having the highest sale price, ignoring any
losses. [342]
Chapter 9
SHAREHOLDERS' SUITS
I. INTRODUCTION
A. What is a derivative suit: When a
person who owes the corporation a fiduciary duty breaches the duty, the main
remedy is the shareholder's derivative suit. In a derivative suit, an
individual shareholder (typically an outsider) brings suit in the name of the
corporation, against the individual wrongdoer. [352]
1. Against insider: A derivative
suit may in theory be brought against some outside third party who has
wronged the corporation, but is usually brought against an insider, such as
a director, officer or major shareholder. [352]
B. Distinguish derivative from direct
suit: Not all suits by shareholders are derivative; in some situations, a
shareholder (or class of shareholders) may sue the corporation, or insiders,
directly. [353]
2. Illustration of direct actions:
Here are some of the types of suits generally held to be direct: (1) an
action to enforce the holder's voting rights; (2) an action to compel the
payment of dividends; (3) an action to prevent management from improperly
entrenching itself (e.g., to enjoin the enactment of a "poison
pill" as an anti-takeover device); (4) a suit to prevent oppression of
minority shareholders; and (5) a suit to compel inspection of the company's
books and records. [354]
C. Consequence of distinction:
Usually, the plaintiff will want his action to proceed as a direct rather than
derivative suit. If the suit is direct, P gets the following benefits: (1) the
procedural requirements are much simpler (e.g., he doesn't have to have owned
stock at the time the wrong occurred); (2) he does not have to make a demand
on the board of directors, or face having the action terminated early because
the corporation does not want to pursue it; and (3) he can probably keep all
or part of the recovery. [355]
II. REQUIREMENTS FOR A DERIVATIVE SUIT
A. Summary: There are three main
requirements that P must generally meet for a derivative suit: (1) he must
have been a shareholder at the time the acts complained of occurred (the
"contemporaneous ownership" rule); (2) he must still be a
shareholder at the time of the suit; and (3) he must make a demand (unless
excused) upon the board, requesting that the board attempt to obtain redress
for the corporation. [356]
B. "Contemporaneous
ownership": P must have owned his shares at the time of the transaction
of which he complains. This is the "contemporaneous ownership" rule.
[356]
2. Who is a
"shareholder": P must have been a "shareholder" at the
time of the wrong. It will be sufficient if he was a preferred shareholder,
or held a convertible bond (convertible into the company's equity). Also, it
will be enough that P is a "beneficial" owner even if he is not
the owner of record. But a bond holder or other ordinary creditor may not
bring a derivative suit. [356]
C. Continuing ownership: P must
continue to own the shares not only until the time of suit, but until the
moment of judgment. (But if P has lost his shareholder status because the
corporation has engaged in a merger in which P was compelled to give up his
shares, some courts excuse the continuing ownership requirement.) [359]
D. Demand on board: P must make a
written demand on the board of directors before commencing the derivative
suit. The demand asks the board to bring a suit or take other corrective
action. Only if the board refuses to act may P then commence suit. (But often
the demand is "excused," as is discussed below.) [360]
E. Demand on shareholders: Many
states require P to also make a demand on the shareholders before instituting
the derivative suit. But many other states do not impose this requirement, and
even those states that do impose it often excuse it where it would be
impractical. [360]
III. DEMAND ON BOARD; EARLY TERMINATION
BASED ON BOARD OR COMMITTEE RECOMMENDATION
A. Demand excused: Demand on the
board is excused where it would be "futile." In general, demand will
be deemed to be futile (and thus excused) if the board is accused of having
participated in the wrongdoing. [363]
1. Delaware view: In Delaware,
demand will not be excused unless P carries the burden of showing a
reasonable doubt about whether the board either: (1) was disinterested and
independent; or (2) was entitled to the protections of the business judgment
rule (i.e., acted rationally after reasonable investigation and without
self-dealing). [364]
a. Difficult to get: But Delaware
makes it very difficult for P to make either of these showings. For
instance, he must plead facts showing either (1) or (2) with great
specificity. Also, it is usually not sufficient that P is charging the
board with a violation of the duty of due care for approving the
transaction; usually, a breach of the duty of loyalty by the board must be
alleged with specificity.
2. New York: New York makes it much
easier than Delaware to get demand excused. For instance, demand will be
excused if the board is charged with breaching the duty of due care, not
just the duty of loyalty. Also, New York requires less specificity in the
pleading. [365]
B. Demand required and refused: If
demand is required, and the board rejects the demand, the result depends in
part on who the defendant is. [365]
2. Suit against insider: Where (as
is usually the case) the suit is against a corporate insider, P has a better
chance of having the board's refusal to pursue the suit be overridden by a
court. But P will still have to show either that: (1) the board somehow
participated in the alleged wrong; or (2) the directors who voted to reject
the suit were dominated or controlled by the primary wrongdoer. (These
requirements are similar to those needed to establish that demand is
"excused," but it is usually somewhat easier to get the court to
rule that the demand would be futile and therefore should be excused than to
get the court to overturn the board's rejection of a required demand.) [365]
C. Independent committee: Today, the
corporation usually responds to P's demand by appointing an independent
committee of directors to study whether the suit should be pursued. Usually,
the committee will conclude that the suit should not be pursued. Often, but
not always, the court will give this committee recommendation the protection
of the business judgment rule, and will therefore terminate the action before
trial. [366]
1. New York view: In New York, it
is difficult for P to overcome the independent committee's recommendation
that the suit be terminated. The court will reject the recommendation if P
shows that the committee members were not in fact independent, or that they
did not use reasonable procedures. But if the court is satisfied with the
committee's independence and procedures, the court will not review the
substantive merits of the committee's recommendation that the suit be
dismissed. [367]
2. Delaware: It is somewhat easier
to get the court to disregard the committee's termination recommendation in
Delaware. Delaware courts take two steps: (1) First, the court asks whether
the committee acted independently, in good faith, and with reasonable
procedures. If the answer to any of these questions is "no," the
court will allow the suit to proceed. (2) Even if the answer to all of these
questions is "yes," the court may (but need not) apply its own
independent business judgment about whether the suit should be permitted to
proceed. (This second step will only be applied in "demand
excused" cases.) [368]
3. More liberal view: A few courts
are even more willing than the Delaware courts to ignore the committee's
recommendation of termination. Such courts believe that even a committee of
ostensibly "independent" directors will for structural reasons
rarely recommend a suit against insiders, so that the committee should be
viewed as biased. In a few states, the solution is a court-appointed
committee of non-directors, whose recommendation the court will accept.
[369]
4. RMBCA: Under the RMBCA, the
court must dismiss the action if the committee of independent directors
votes to discontinue the action "in good faith after conducting a
reasonable inquiry upon which [the committee's] conclusions are based."
RMBCA § 7.44(a). So, as in New York, but in contrast to Delaware, the
court under the RMBCA will never review the substantive merits of the suit
if the independent directors vote to discontinue. [370]
IV. SECURITY-FOR-EXPENSES STATUTES
A. Generally: About 14 states have
so-called "security-for-expenses" statutes, by which P must post a
bond to guarantee repayment of the corporation's expenses in the event that
P's claim turns out to be without merit. [373]
B. Not substantial impediment: But
such statutes do not usually serve as much of an impediment to the bringing of
suits, mostly because the corporation often doesn't take advantage of them for
various tactical reasons. [374]
V. SETTLEMENT OF DERIVATIVE SUITS
A. Judicial approval: Most states
require that any settlement of a derivative suit be approved by the court. The
court must be convinced that the settlement is in the best interests of the
corporation and its shareholders. [375]
B. Notice: In the federal courts and
in many states, shareholders must be given notice of any proposed settlement
of a derivative action, as well as the opportunity to intervene in the action
to oppose the settlement.
C. Corporate recovery: All payments
made in connection with the derivative action must be received by the
corporation, not by the plaintiff. [377]
VI. PLAINTIFF'S ATTORNEY'S FEES
A. "Common fund" theory:
Courts usually award the plaintiff's attorneys a reasonable fee for bringing a
successful derivative action. Under the "common fund" theory, the
fee is paid out of the amount recovered on behalf of the corporation. [378]
1. "Lodestar" method:
Under the "lodestar" method, the key component is the reasonable
value of the time expended by the plaintiff's attorney. This is computed by
taking the actual number of hours expended, and multiplying by a reasonable
hourly fee. Often, the award is then adjusted upward to reflect the fact
that there was a substantial contingency aspect to the case. [378]
VII. MISCELLANEOUS PROCEDURAL ISSUES
A. Corporate counsel: There are two
problems that frequently arise in connection with the lawyer for the
corporation: [380]
1. Attorney-client privilege:
First, does the attorney-client privilege bar the corporation's lawyer from
disclosing to P advice the lawyer gave to the corporation? Generally, the
corporation is held to hold the attorney-client privilege independently of
the stockholders, so the corporate counsel may in the first instance refuse
to divulge the communications to P. But if P then shows "good
cause" to the court why the privilege should be suspended in this
particular instance, the court will suspend it and order disclosure. [380]
2. Joint representation: Second,
may the corporate counsel represent both the corporation and the defendants
in the derivative action? Usually, the answer is "no." The best
course is for the corporate counsel to represent the defendant insiders
(since he probably has a pre-existing personal relationship with them). The
corporation should then get its own independent litigation counsel, who can
represent the corporation objectively. [381]
B. Pro rata recovery: Usually, the
corporation will make the recovery. But occasionally this will be unjust, so
the court may order that some or all of the recovery be distributed to
individual shareholders on a pro rata basis (i.e., proportionally to their
shareholdings). Here are two situations where this might be done: [381]
VIII. INDEMNIFICATION AND D&O
INSURANCE
A. Indemnification: All states have
statutes dealing with when the corporation may (and/or must) indemnify a
director or officer against losses he incurs by virtue of his corporate
duties. [383]
1. Mandatory: Under most statutes,
in two situations the corporation is required to indemnify an officer or
director: (1) when the director/officer is completely successful in
defending himself against the charges; and (2) when the corporation has
previously bound itself by charter, law or contract to indemnify. [383]
2. Permissive: Nearly all states,
in addition to this mandatory indemnification, allow for
"permissive" indemnification. In other words, in a large range of
circumstances the corporation may, but need not, indemnify the director or
officer. [384]
a. Third party suits: In suits
brought by a third party (in other words, suits not brought by the
corporation or by a shareholder suing derivatively), the corporation is
permitted to indemnify the director or officer if the latter: (1) acted in
good faith; (2) was pursuing what he reasonably believed to be the best
interests of the corporation; and (3) had no reason to believe that his
conduct was unlawful. See RMBCA § 8.51(a). (Example: D, a director
of XYZ, acts grossly negligently, but not dishonestly, when he approves a
particular corporate transaction. XYZ may, but need not, indemnify D for
his expenses in defending a suit brought by an unaffiliated third person
against D, and for any judgment or settlement D may pay.)
b. Derivative suit: If the suit
is brought by or on behalf of the corporation (e.g., a derivative suit),
the indemnification rules are stricter. The corporation may not indemnify
the director or officer for a judgment on behalf of the corporation, or
for a settlement payment. But indemnification for litigation expenses
(including attorney's fees) is allowed, if D is not found liable on the
underlying claim by a court.
3. Who decides: Typically, the
decision on whether D should be indemnified is made by independent members
of the board of directors. Also, this decision is sometimes made by
independent legal counsel. [389]
5. Court-ordered: Most states allow
D to petition the court for indemnification, even under circumstances where
the corporation is not permitted, or not willing, to make the payment
voluntarily. [391]
B. Insurance: Nearly all large
companies today carry directors' and officers' (D&O) liability insurance.
Most states explicitly allow the corporation to purchase such insurance.
Furthermore, D&O insurance may cover certain director's or officer's
expenses even where those expenses could not be indemnified. [391]
1. Typical policy: The typical
policy excludes many types of claims (e.g., a claim that the director or
officer acted dishonestly, received illegal compensation, engaged in
self-dealing, etc.). [391]
Chapter 10
STRUCTURAL CHANGES, INCLUDING MERGERS AND ACQUISITIONS
I. CORPORATE COMBINATIONS GENERALLY
Note: For the entire following
discussion, the business that is being acquired is referred to as "Little
Corp" and the acquirer as "Big Corp."
A. Merger-type deals: A
"merger-type" transaction is one in which the shareholders of Little
Corp will end up mainly with stock in Big Corp as their payment for
surrendering control of Little Corp and its assets. There are four main
structures for a merger-type deal: [403]
1. Statutory: First is the
traditional "statutory merger." By following procedures set out in
the state corporation statute, one corporation can merge into another, with
the former (the "disappearing" corporation) ceasing to have any
legal identity, and the latter (the "surviving" corporation)
continuing in existence. [403]
a. Consequence: After the merger,
Big Corp owns all of Little Corp's assets, and is responsible for all of
Little Corp's liabilities. All contracts that Little Corp had with third
parties now become contracts between the third party and Big Corp. The
shareholders of Little Corp now (at least in the usual case) own stock in
Big Corp. (Alternatively, under many statutory merger provisions, Little
Corp holders may receive some or all of their payment in the form of cash
or Big Corp debt, rather than Big Corp stock.)
2. Stock-for-stock exchange
("stock swap"): The second method is the "stock-for-stock
exchange" or "stock swap." Here, Big Corp makes a separate
deal with each Little Corp holder, giving the holder Big Corp stock in
return for his Little Corp stock. [404]
a. Plan of exchange: Under the
standard stock swap, a Little Corp holder need not participate, in which
case he continues to own a stake in Little Corp. However, some states
allow Little Corp to enact (by approval of directors and a majority of
shareholders) a "plan of exchange," under which all Little Corp
shareholders are required to exchange their shares for Big Corp shares.
When this happens, the net result is like a statutory merger.
3. Stock-for-assets exchange: The
third form is the "stock-for-assets" exchange. In step one, Big
Corp gives stock to Little Corp, and Little Corp transfers substantially all
of its assets to Big Corp. In step two (which usually but not necessarily
follows), Little Corp dissolves, and distributes the Big Corp stock to its
own shareholders. After the second step, the net result is virtually the
same as with a statutory merger. [406] (However, approval by Big Corp
shareholders might not be necessary, as it probably would for a statutory
merger.)
a. Forward triangular merger: In
the "conventional" or "forward" triangular merger, the
acquirer creates a subsidiary for the purpose of the transaction. Usually,
this subsidiary has no assets except shares of stock in the parent. The
target is then merged into the acquirer's subsidiary. (Example: Big Corp
creates a subsidiary called Big-Sub. Big transfers 1,000 of its own shares
to Big-Sub, in return for all the shares of Big-Sub. Little Corp now
merges into Big-Sub. Little Corp shareholders receive the shares in Big
Corp.)
i. Rationale: This is very
similar to the stock-for-stock exchange, except that all minority
interests in Little Corp is automatically eliminated. (Also, the deal
does not have to be approved by Big Corp's shareholders, unlike a direct
merger of Little Corp into Big Corp.)
b. Reverse merger: The other type
of triangular merger is the "reverse" triangular merger. This is
the same as the forward triangular merger, except that the acquirer's
subsidiary merges into the target, rather than having the target merge
into the subsidiary. (Example: Same facts as above example, except Big-Sub
merges into Little Corp, so that Little Corp is now a surviving
corporation that is itself a subsidiary of Big Corp.)
i. Advantages: This reverse
triangular form is better than a stock-for-stock swap because it
automatically eliminates all Little Corp shareholders, which the
stock-for-stock swap does not. It is better than a simple merger of
Little Corp into Big Corp because: (1) Big Corp does not assume all of
Little Corp's liabilities; and (2) Big Corp's shareholders do not have
to approve. It is better than the forward triangular merger because
Little Corp survives as an entity, thus possibly preserving contract
rights and tax advantages better than if Little Corp were to disappear.
B. Sale-type transactions: A
"sale-type" transaction is one in which the Little Corp shareholders
receive cash or bonds, rather than Big Corp stock, in return for their
interest in Little Corp. There are two main sale-type structures: [412]
1. Asset-sale-and-liquidation:
First, there is the "asset-sale-and-liquidation." Here, Little
Corp's board approves a sale of all or substantially all of Little Corp's
assets to Big Corp, and the proposed sale is approved by a majority of
Little Corp's shareholders. Little Corp conveys its assets to Big Corp, and
Little Corp receives cash (or perhaps Big Corp debt) from Big Corp. Usually,
Little Corp will then dissolve, and pay the cash or debt to its shareholders
in proportion to their shareholdings, in a liquidating distribution. [413]
2. Stock sale: Second is the
"stock sale." Here, no corporate level transaction takes place on
the Little Corp side. Instead, Big Corp buys stock from each Little Corp
shareholder, for cash or debt. (After Big Corp controls all or a majority of
Little Corp's stock, it may but need not cause Little Corp to be: (1)
dissolved, with its assets distributed to the various stockholders or (2)
merged into Big Corp, with the remaining Little holders receiving Big Corp
stock, cash or debt.) [413]
a. Tender offer: One common form
of stock sale is the tender offer, in which Big Corp publicly announces
that it will buy all or a majority of shares offered to it by Little Corp
shareholders. (Alternatively, Big Corp might privately negotiate purchases
from some or all of Little Corp's shareholders.)
b. Shareholder vote: Similarly,
the asset sale will have to be formally approved by a majority vote of
Little Corp's shareholders, whereas the stock sale will not be subjected
to a shareholder vote (each Little Corp shareholder simply decides whether
to tender his stock).
c. Elimination of minority
stockholders: In an asset-sale deal, Big Corp is guaranteed to get Little
Corp's business without any remaining interest on the part of Little Corp
shareholders. In the stock sale, Big Corp may be left with some Little
Corp holders holding a minority interest in Little Corp (though if the
state allows for a "plan of exchange," this minority may be
eliminated).
d. Liabilities: In an asset sale,
Big Corp has a good chance of escaping Little Corp's liabilities (subject,
however, to the law of fraudulent transfers, the bulk sales provisions of
the UCC, and the possible use of the "de facto merger"
doctrine). In a stock sale, Big Corp will effectively take Little Corp's
liabilities along with its assets, whether it wants to or not.
2. Stock sale: In the case of a
stock sale, each Little Corp stockholder would decide whether to sell his
stock to Big Corp, and no approval by Little's board (or any formal vote of
Little's stockholders) is necessary for some or all of Little's stockholders
to do this. [419]
a. Back-end merger: On the other
hand, once Big got control of Little by having acquired most of Little's
shares, it might want to conduct a back-end merger of Little into Big (or
into a subsidiary of Bid), and this would normally require a vote by
Little's board and shareholders. But each of these votes would probably be
a formality, due to Big's majority ownership and board control of Little.
e. Small-scale
("whale/minnow") mergers: If a corporation is being merged into
a much larger corporation, the shareholders of the surviving corporation
usually need not approve. Under Delaware law and under the RMBCA, any
merger that does not increase the outstanding shares of the surviving
corporation by more than 20% need not be approved by the survivor's
shareholders. (But this assumes that there are enough authorized but
unissued shares to fund the merger; if the number of authorized shares
must be increased, this will usually require a shareholder vote to amend
the articles of incorporation.)
f. Short-form mergers: Under most
statutes, including Delaware and the RMBCA, if one corporation owns 90% or
more of the stock of another, the latter may be merged into the former
without approval by the shareholders of either corporation. (Example: Big
Corp owns 92% of Little Corp shares. Under the Delaware or RMBCA
short-form merger statute, Little Corp may be merged into Big Corp, and
the 8% minority shareholders of Little Corp given stock in Big Corp, or
cash, without any shareholder approval by either the Big or Little
shareholders. But Little Corp shareholders will have appraisal rights,
described below.)
a. Stock-for-stock exchange: In a
stock-for-stock exchange, the proposal: (1) must be approved by the Big
Corp board but not by its shareholders; and (2) need not be formally
approved by either Little Corp's board or its shareholders (though in a
sense each shareholder "votes" by deciding whether to tender his
shares).
b. Stock-for-assets deal: In the
case of a stock-for-assets deal: (1) on the Big Corp side, board approval
is necessary but shareholder approval is not (as long as there are enough
authorized but unissued shares to fund the transaction); and (2) on the
Little Corp side, this is like any other asset sale, so Little's board
must approve the transaction, and a majority of shareholders must then
approve it.
i. Forward merger: In a forward
triangular (or "subsidiary") merger: (1) Big-Sub's board and
shareholders must approve (but this is a formality, since Big Corp will
cast both of these votes, and Big Corp's board (but not its
shareholders) must also approve; and (2) on the Little Corp side, both
the board and shareholders will have to approve the merger, just as with
any other merger.
E. Taxation: Merger-type transactions
are taxed quite differently from sale-type transactions. [426]
1. Reorganizations: What we have
called "merger-type" transactions are called
"reorganizations" by the tax law. In general, in a reorganization
the target's shareholders pay no tax at the time of the merger. (Example:
Little Corp is merged into Big Corp, with each Little Corp shareholder
receiving one Big Corp share for each Little Corp share. The Little Corp
shareholders will not pay any tax until they eventually sell their Big Corp
shares, at which time they will pay tax on the difference between what they
receive for the Big Corp shares and what they originally paid for the Little
Corp shares.) There are three different types of tax-free reorganizations:
[427]
a. "Type A"
reorganization: A "type A" reorganization is one carried out
according to state statutory merger provisions. The principal requirement
is that the Little Corp shareholders have a "continuity of
interest," i.e., that most of the compensation they receive be in the
form of Big Corp stock.
b. "Type B"
reorganization: A "type B" reorganization is a stock-for-stock
exchange. To qualify as a type B deal, Big Corp must end up with at least
80% of the voting power in Little Corp, and must not give Little Corp
shareholders anything other than its own stock (e.g., it may not give any
cash).
c. "Type C"
reorganization: A "type C" reorganization is basically a
stock-for-assets exchange. Big Corp must acquire substantially all of
Little Corp's assets, in return for Big Corp stock. (But Big Corp may make
part of the payment in cash or bonds, so long as at least 80% of the
acquisition price is in the form of Big Corp stock.)
a. Asset sale: In an asset sale,
the target pays a corporate-level tax; then, if it dissolves and pays out
the cash received in the sale to its own shareholders as a liquidating
distribution, the target share holders each must pay a tax on the
distribution. (Example: Big Corp buys all of Little Corp's assets for $1
million cash. Little Corp will pay a tax on the amount by which this $1
million exceeds the original cost of Little Corp's assets. If the
remainder is paid out in the form of a liquidating distribution to Little
Corp shareholders, each shareholder will pay a tax based on the difference
between what he receives and what he originally paid for his Little Corp
shares.)
b. Sale of stock: In a stock
sale, there is only one level of taxation, at the shareholder level.
(Example: Some or all Little Corp shareholders sell their stock to Big
Corp. Each shareholder pays a tax on the difference between what he
receives per share and what he originally paid per share.) This tax is
less, typically, than the combined two levels of tax in the case of an
asset sale.
F. Accounting: The rules of
accounting handle merger-type transactions differently from sale-type ones.
[431]
1. Pooling: In a merger-type
transaction, the "pooling" approach is used. Under pooling, assets
and liabilities for both companies are essentially added together on the
resulting company's balance sheet (so that the survivor's post-merger
balance sheet does not reflect the negotiated price that the survivor has
effectively paid for the disappearing company's assets). [431]
2. Purchase method: In sale-type
transactions, by contrast, the "purchase method" is used. Here,
the target assets acquired are valued at their purchase price, not their
historical cost. [433]
3. Significance: In the usual case
where the acquired company's assets have a market value that is higher than
the historical cost of these assets, use of the purchase method produces
higher write-offs, and thus less net income, than the pooling method.
Therefore, a publicly-held acquirer (which typically wants to show as high a
net income as possible) will usually prefer the pooling method. [434]
G. Federal securities law: Here are
the federal securities-law implications of the various types of combinations:
[437]
a. Asset sales: If Big Corp is
acquiring Little Corp's assets for cash, and Little Corp is publicly held,
the only federal securities laws that are relevant are the proxy rules.
Little Corp will have to send its holders a proxy statement describing the
proposed transaction, so that the holders may intelligently decide whether
to approve.
b. Stock sale: If there will be a
sale of stock by each Little Corp shareholder to Big Corp, Big Corp will
usually proceed by a tender offer. If so, it will have to send special
tender offer documents to each Little Corp shareholder.
a. Stock-for-stock exchange: If
the deal will be a stock-for-stock exchange, for securities-law purposes
this is the equivalent of public issue of stock by the acquirer. Thus if
Big Corp will be acquiring each Little Corp share in exchange for a share
of Big Corp, Big will have to file a registration statement and supply
each Little Corp shareholder with a prospectus. Also, the tender offer
requirements will generally have to be complied with.
b. Statutory merger;
stock-for-assets deal: If the deal will be a statutory merger or a
stock-for-assets exchange: (1) Little Corp will have to send each
shareholder a proxy statement to get the shareholder's approval; and (2)
Big Corp must file a registration statement and supply a prospectus, as if
it were issuing new stock to Little Corp's shareholders.
II. CORPORATE COMBINATIONS --
PROTECTING SHAREHOLDERS
A. Appraisal rights: Appraisal rights
give a dissatisfied shareholder in certain circumstances a way to be
"cashed out" of his investment at a price determined by a court to
be fair. [443]
1. Mergers: In nearly every state,
a shareholder of either company involved in a merger has appraisal rights if
he had the right to vote on the merger. (Example: Little Corp merges into
Big Corp. Any shareholder of either Big Corp or Little Corp who had the
right to vote on the merger will in most states have appraisal rights.)
[444]
a. Whale-minnow: In the
"whale-minnow" situation -- that is, a merger in which a
corporation is merged into a much larger one, so that the increase in
outstanding shares of the larger company is small -- the surviving
corporation's shareholders do not get appraisal rights (since they would
not get to vote).
a. Sale for cash, followed by
quick dissolution: But if the selling corporation liquidates soon after
the sale, and distributes the cash to the shareholders, usually there are
no appraisal rights. See, e.g., RMBCA § 13.02(a)(3) (no appraisal
rights where liquidation and distribution of cash proceeds occurs within
one year after the sale).
a. Forward: In the case of a
forward triangular merger: (1) on the acquirer's side, Big Corp's
shareholders will not get appraisal rights; and (2) on the target's side,
Little Corp's shareholders generally will get appraisal rights. [448]
b. Reverse: In the case of a
reverse triangular merger: (1) Big Corp shareholders do not get appraisal
rights; and (2) Little Corp holders will get appraisal rights if Big-Sub
is statutorily merging into Little Corp, but not if Little Corp is issuing
its own stock in return for Big-Sub's stock in Big Corp.
b. Notice of payment demand by
holder: The holder must then give notice to the corporation, before the
shareholder vote, that he demands payment of the fair value of his shares.
Also, the holder must not vote his shares in favor of the transaction.
d. Payment: Then, the company's
obligations vary from state to state. In some states, the corporation does
not have to pay anything until the court finally determines what is due.
But under the RMBCA, the corporation must at least pay the amount that it
concedes is the fair value of the shares (with the rest due only after a
court decision as to fair value).
a. Don't consider the transaction
itself: Fair value must be determined without reference to the transaction
that triggers the appraisal rights. (Example: Little Corp is worth $10 per
share in the absence of any takeover attempt. Big Corp, recognizing
possible synergies with its own business, acquires Little Corp for $15 per
share. For appraisal purposes, the fair value of Little Corp stock will be
$10, not the higher $15 price that reflects the benefits of the
acquisition.)
b. No "minority" or
"nonmarketability" discount: Most courts do not reduce the value
of P's shares to reflect that P held a minority or non-controlling
interest. Instead, the court usually takes the value of the whole company,
and then divides by the number of shares (so P, even though she is a
minority holder, gets the same per-share price as the insiders would have
gotten.) See, e.g., In Re Valuation of Common
Stock of McLoon Oil Co.
c. "Delaware
block" method: Most courts use the "Delaware block"
valuation method. Under this, the court considers three factors: (1) the
market price just prior to the transaction; (2) the net asset value of the
company; and (3) the earnings valuation of the company. These three
factors can be weighted however the court chooses.
i. Abandoned in Delaware:
Delaware itself no longer requires use of the Delaware block approach.
Delaware courts will now accept additional evidence of valuation, such
as valuation studies prepared by the corporation, and expert testimony
about what "takeover premium" would be paid.
a. Illegality: If the transaction
is illegal, or procedural requirements have not been observed, the
shareholder can generally get the transaction enjoined, instead of having
to be content with his appraisal rights.
b. Deception: Similarly, if the
company deceives its shareholders and thereby procures their approval of
the transaction, a shareholder can attack the transaction instead of
having to use his appraisal rights.
c. Unfair: On the other hand, if
the shareholder is merely contending that the proposed transaction is a
bad deal for the shareholders, or is in a sense "unfair,"
appraisal normally is the exclusive remedy (and the shareholder cannot get
an injunction). But if unfairness is due to self-dealing by corporate
insiders, the court may grant an injunction.
B. "De facto merger"
doctrine: Under the "de facto merger" doctrine, the court treats a
transaction which is not literally a merger, but which is the functional
equivalent of a merger, as if it were one. The most common result of the
doctrine is that selling stockholders get appraisal rights. Also, selling
stockholders may get the right to vote on a transaction, and the seller's
creditors may get a claim against the buyer. [456]
1. Only occasionally accepted: Only
a few courts have accepted the de facto merger theory, and they have done so
only in specialized circumstances. They are most likely to do so when the
target has transferred all of its assets and then dissolves, and when the
target's shareholders receive most of their consideration as shares in the
acquirer rather than cash and/or bonds. [456]
Example: Glen Alden Corp. agrees to
acquire all of the assets of List Corp. (a much larger company). Glen Alden
plans to pay for these assets by issuing a large amount of its own stock to
List (so that List will end up owning over three-quarters of Glen Alden).
Glen Alden will assume all of List's liabilities, and will change its name
to List Alden Corp. List will then be dissolved, and its assets (stock
representing a majority interest in List Alden) will be distributed to the
original List shareholders. (The purpose of this bizarre structure is to
deny the shareholders of Glen Alden appraisal rights, which they would have
if Glen Alden was selling all of its assets to List, but will not have if
Glen Alden "bought" List.)
3. Successor
liability: But even courts that normally reject the de facto merger doctrine
may apply it (or something like it) to deal with problems of "successor
liability." (Example: Big Corp acquires the assets of Little Corp, and
carries on Little Corp's business. Normally, Little Corp's liabilities will
not pass to Big Corp unless Big Corp has explicitly assumed them in the
purchase contract. But a tort claimant who is injured by a product
manufactured by Little Corp before the sale might be permitted to recover
against Big Corp, on the theory that Big Corp should be treated as if Little
Corp had merged into it.) [459]
C. Judicial review of substantive
fairness: Courts will sometimes review the substantive fairness of a proposed
acquisition or merger. This is much more likely when there is a strong
self-dealing aspect to the transaction. [459]
1. Arm's length combination: If the
buyer and the seller do not have a close pre-existing relationship at the
time they negotiate the deal, courts will rarely overturn the transaction as
being substantively unfair. For instance, under Delaware law a person who
attacks the transaction for substantive fairness must: (1) bear the burden
of proof on the fairness issue; and (2) show that the price was so grossly
inadequate as to amount to "constructive fraud." P will rarely be
able to satisfy this double-barreled test. [460]
2. Self-dealing: But if the
transaction involves self-dealing (i.e., one or more insiders influence both
sides of the transaction), the court will give much stricter scrutiny. For
instance, in Delaware, the proponents of the transaction must demonstrate
its "entire fairness." [461]
Example: Big Corp attempts to
acquire Little Corp by means of a two-step hostile tender offer. Big Corp
first buys 51% of Little Corp stock for $35 per share. As the second step,
it then seeks to merge Little Corp into Big Corp, with the remaining
Little Corp shareholders receiving $25 per share. (In the original tender
offer, it announces that it plans to take the second step if the first
step succeeds.) An unhappy Little Corp shareholder might (but probably
would not) succeed in getting a court to enjoin this second-step
"back end merger" on the grounds that it is substantively
unfair. (The court would probably scrutinize the transaction fairly
closely, but uphold it on the grounds that all shareholders were treated
equally and knew what they were getting into.)
Example: ABC Corp owns 80% of XYZ
Corp (with the rest owned by a variety of small public shareholders). Most
XYZ directors have been appointed by ABC. ABC proposes to have XYZ merge
into it, with each XYZ share being exchanged for one share of ABC. Nearly
all of the public XYZ minority holders oppose the merger, but ABC's 80%
ownership allows the merger to be approved by a majority of all XYZ
holders. A court would be likely to closely scrutinize this merger,
because ABC's dominance of XYZ (and its ability to persuade the XYZ board
to approve the transaction) amounted to self-dealing. Therefore, ABC will
bear the burden of demonstrating that the merger terms are "entirely
fair" to the minority holders of XYZ, and the court will enjoin the
transaction if this showing is not made. (ABC could guard against this
problem by having XYZ negotiate its side of the merger by the use of only
"independent" directors, i.e., those not dominated by ABC.)
III. RECAPITALIZATIONS -- HURTING THE
PREFERRED SHAREHOLDERS
A. Problem: A board of directors
dominated by common shareholders (as is usually the case) may try to help the
common shareholders at the expense of the preferred shareholders. Typically,
the common shareholders try to cancel an arrearage in preferred dividends, so
that the common holders can receive a dividend. [467]
B. Two methods: There are two basic
recapitalization methods by which the common shareholders can attempt to
eliminate the accrued preferred dividends: [467]
1. Amending articles: First, they
can cause the articles of incorporation to be amended to eliminate the
accrued dividends as a corporate obligation. (But in most states, the
preferred shareholders will have to agree as a separate class that this
amendment should take place. See RMBCA § 10.04(a)(9).) [467]
2. Merger: Second, the corporation
can be merged into another corporation, with the survivor's articles not
providing for payment of any accrued preferred dividends. (Again, in most
states the preferred get to vote on the merger as a separate class. But
under Delaware law, the preferred would not have this right.) [469]
C. Courts don't interfere: Courts are
generally very reluctant to interfere with such anti-preferred
recapitalizations, even where the plans seems to be objectively unfair to the
preferred holders. But in addition to possible veto rights, the preferred
holders will also generally get appraisal rights. [469]
IV. FREEZEOUTS
A. Meaning of "freezeout":
A "freezeout" is a transaction in which those in control of a
corporation eliminate the equity ownership of the non-controlling
shareholders. [470]
1. Distinguished from
"squeezeout": Generally, "freezeout" describes those
techniques whereby the controlling shareholders legally compel the
non-controlling holders to give up their common stock ownership. The related
term "squeezeout" describes methods that do not legally compel the
outsiders to give up their shares, but in a practical sense coerce them into
doing so. Squeezeouts are especially common in the close-corporation
context, and are discussed briefly below. [470]
2. Three contexts: There are three
common contexts in which a freezeout is likely to occur: (1) as the second
step of a two-step acquisition transaction (Big Corp buys, say, 51% of
Little Corp stock, and then eliminates the remaining 49% holders through
some sort of merger); (2) where two long-term affiliates merge (the
controlling parent eliminates the publicly-held minority interest in the
subsidiary); and (3) where the company "goes private" (the
insiders cause the corporation or its underlying business to no longer to be
registered with the SEC, listed on a stock exchange and/or actively traded
over the counter). [471]
3. General rule: In evaluating a
freezeout, the court will usually: (1) try to verify that the transaction is
basically fair; and (2) scrutinize the transaction especially closely in
view of the fact that the minority holders are being cashed out (as opposed
to being given stock in a different entity, such as the acquirer). [472]
1. Cash-out merger: The leading
freezeout technique today is the simple "cash-out" merger. The
insider causes the corporation to merge into a well-funded shell, and the
minority holders are paid cash in exchange for their shares, in an amount
determined by the insiders. [472]
Example: Shark owns 70% of Public
Corp. He wants to freeze out the minority holders. He creates Private Corp,
of which he is the sole shareholder, and funds it with $1 million. He now
causes both Public Corp and Private Corp to agree to a plan of merger under
which each of Public's 1,000,000 shares will be exchanged in the merger for
$1 in cash. The 30% minority holders in Public are completely eliminated by
the $300,000 cash payments, and Shark receives $700,000 with which to pay
down the bank debt that funded Private Corp in the first place. Such a
"cash out" merger is allowed by most modern merger statutes,
including RMBCA § 11.01(b)(3).)
2. Short-form merger: A freezeout
may also be done via the short-form merger statute. If ABC Corp owns 90% or
more of XYZ Corp, then in most states at ABC's request, XYZ can be merged
into ABC with all XYZ holders paid off in cash (rather than ABC stock).
[473]
3. Reverse stock split: Finally, a
freezeout may be carried out by means of a reverse stock split. Using, say,
a 600:1 reverse stock split, nearly all outsiders may end up with a
fractional share. Then, the corporation can compel the owners of the
fractional shares to exchange their shares for cash. [473]
1. 10b-5: A minority shareholder
may be able to attack a freezeout on the grounds that it violates SEC Rule 10b-5. If there has been full
disclosure, then P is unlikely to convince the court that 10b-5 has been violated, no
matter how "unfair" the freezeout may seem to the court. But if
the insiders have concealed or misrepresented material facts about the
transaction, then a court may find a 10b-5 violation. [475]
2. SEC Rule 13e-3:
Also, SEC Rule 13e-3 requires extensive
disclosure by the insiders in the case of any going-private transaction. If
the insiders do not comply with 13e-3, they may be liable for
damages or an injunction. [476]
D. State law: A successful attack on
a freezeout transaction is more likely to derive from state rather than
federal law. Since a freezeout transaction will usually involve self-dealing
by the insiders, state courts will closely scrutinize the fairness of the
transaction. [476]
1. General test: In most states,
the freezeout must meet at least the first, and possibly the second, of the
following tests: (1) the transaction must be basically fair, taken in its
entirety, to the outsider/minority shareholders; and (2) the transaction
must be undertaken for some valid business purpose. [477]
Example: Signal owns slightly more
than half of UOP Corp., with the balance owned by the public. Four key
directors of UOP are also directors of Signal (and owe Signal their primary
loyalty). Two of these directors prepare a feasibility study, which
concludes that $24 is a fair price for Signal to pay for the balance of UOP.
Signal then offers $21 per UOP share. There is no negotiation between UOP
and Signal on this price, and the non-Signal-affiliated UOP directors are
never told about the $24 feasibility study. The deal goes through.
Held, this acquisition did not meet
the test of basic fairness to UOP's minority shareholders. The price was not
fair (since Signal's own directors admitted that $24 was a fair price); the
procedures were not fair (since there were no real negotiations between the
two companies); and the disclosure was not fair (e.g., the public was never
told about the feasibility study showing $24 as a fair price). See Weinberger v. UOP, Inc.
a. Independent committee: A
parent-subsidiary merger is much more likely to be found fair if the
public minority stockholders of the subsidiary are represented by a
special committee of independent directors who are not affiliated with the
parent (e.g., if UOP had been represented by non-Signal-affiliated
directors in a true bargaining session with Signal, the transaction in Weinberger might have been upheld).
3. "Business purpose"
test: Apart from the requirement that the transaction be basically fair,
some but not all courts will strike down the freezeout unless it serves a
"valid business purpose." In other words, in some courts the
insiders, even if they pay a fair price, cannot put through a transaction
whose sole purpose is to eliminate the minority (public) stockholders. [479]
4. Closely-held corporations: If
the freezeout takes place in the context of a close corporation, most courts
will probably scrutinize it more closely than in the public-corporation
context. This is especially true of "squeezeouts." (Example:
Shark, who owns 70% of Close Corp, tries to coerce Pitiful, his long-time
assistant, to sell his 30% stake. Shark fires Pitiful, cuts off his salary,
and refuses to pay dividends, then offers to buy Pitiful's stake for a
fraction of its true value. A court is likely to strike this transaction on
the grounds that it is unfair, since it leaves Pitiful with no way to make a
reasonable return on his investment.) [480]
V. TENDER OFFERS, ESPECIALLY HOSTILE
TAKEOVERS
A. Definition of tender offer: A
tender offer is an offer to stockholders of a publicly-held corporation to
exchange their shares for cash or securities at a price higher than the
previous market price. [482]
B. Disclosure by 5% owner: Any person
who "directly or indirectly" acquires more than 5% of any class of
stock in a publicly held corporation must disclose that fact on a statement
filed with the SEC (a "Schedule 13D" statement). [492]
1. Information disclosed: The
investor must disclose a variety of information on his 13D, including the source of
the funds used to make the purchase, and the investor's purpose in buying
the shares (including whether he intends to seek control). [492]
4. Additional
acquisitions: Someone who is already a 5%-or-more owner must refile his 13D anytime he acquires
additional stock (though not for small additions which, over a 12-month
period, amount to less than 2% of the company's total stock). [494]
C. Rules on tender offers: Here are
the main rules imposed by the Williams Act upon tender offers: [495]
1. Disclosure: Any tender offeror
(at least one who, if his tender offer were successful, would own 5% or more
of a company's stock) must make extensive disclosures. He must disclose his
identity, funding, and purpose. Also, if the bidder proposes to pay part of
the purchase price in the form of securities (e.g., preferred or common
stock in the bidder, junk bonds, etc.) the bidder's financial condition must
be disclosed. [495]
3. "Pro rata" rule: If a
bidder offers to buy only a portion of the outstanding shares of the target,
and the holders tender more than the number than the bidder has offered to
buy, the bidder must buy in the same proportion from each shareholder. This
is the so-called "pro rata" rule. [497]
4. "Best price" rule: If
the bidder increases his price before the offer has expired, he must pay
this increased price to each stockholder whose shares are tendered and
bought up. In other words, he may not give the increased price only to those
who tender after the price increase. This is the "best price"
rule. [497]
5. 20-day minimum: A tender offer
must be kept open for at least 20 business days. Also, if the bidder changes
the price or number of shares he is seeking, he must hold the offer open for
another 10 days after the announcement of the change. [498]
6. Two-tier front-loaded tender
offers: None of these rules prevent the bidder from making a two-tier,
front-loaded tender offer. Thus the bidder can offer to pay an attractive
premium for a majority but not all of the target's shares, and can tell the
target's holders that if successful, he will subsequently conduct a back-end
merger of the balance at a less attractive price. Such an offer often has a
coercive effect on the shareholders (who tender because they are afraid of
what will happen in the back end, not because they really want to be bought
out). However, such two-tier offers are not very common today. [498]
D. Hart-Scott-Rodino Act: The Hart-Scott-Rodino Antitrust
Improvements Act (H-S-R) requires a bidder to give notice to the
government of certain proposed deals, and imposes a waiting period before the
deal can be consummated. H-S-R applies only where one party has sales or
assets of more than $100 million and the other has sales or assets of more
than $10 million. [499]
3. Privately-negotiated purchases:
A privately-negotiated purchase, even of large amounts of stock, usually
will not constitute a tender offer. This is true even if the acquirer
conducts simultaneous negotiations with a number of large stockholders, and
buys from each at an above market price. [502]
4. Open-market purchases: Usually
there will not be a tender offer where the acquirer makes open-market
purchases (e.g., purchases made on the New York Stock Exchange), even if a
large percentage of the target's stock is bought. [502]
F. Private actions under § 14(e):
Section 14(e) of the '34 Act (part of the
Williams Act) makes it unlawful to make an "untrue statement of a
material fact," to "omit to state" any material fact, or to
engage in any "fraudulent, deceptive, or manipulative act," in
connection with a tender offer. [502]
1. Substantive unfairness: This
section does not prohibit conduct by a bidder that is substantively unfair,
but that does not involve misrepresentation or nondisclosure. (Example:
Bidder withdraws an attractive and over-subscribed tender offer, and
replaces it with a much less attractive one. Held, even though this may be
substantively unfair conduct, it is not deceptive, and therefore does not
violate § 14(e) of the Williams Act. See Schreiber v. Burlington
Northern.)
[503]
2. Standing:
Several types of people can bring a suit for a violation of § 14(e), including: (1) the target
(which can seek an injunction against deceptive conduct by the bidder); (2)
a bidder (which can get an injunction against the target's management or
against another bidder, but which cannot get damages against anyone); (3) a
non-tendering shareholder (who can get either damages or an injunction); and
(4) a person who buys or sells shares in reliance on information disclosed
or not disclosed in tender offer documents. [503]
G. State regulation of hostile
takeovers: Many states have statutes which attempt to discourage hostile
takeovers and protect incumbent management. [505]
1. Modern statutes: Most modern
anti-takeover statutes operate not by preventing the bidder from buying the
shares, but instead depriving him of the benefit of his share acquisition,
by: (1) preventing the bidder from voting the shares he has bought unless
certain conditions are satisfied; (2) preventing the bidder from conducting
a back-end merger of the target into the bidder's shell, or vice versa; or
(3) requiring the bidder to pay a specified "fair price" in any
back-end merger. [506]
2. Delaware Act: The most important
modern statute is the Delaware anti-takeover statute, Del. GCL § 203. Section 203 prohibits any
"business combination" (including any back-end merger) between the
corporation and an "interested stockholder" for three years after
the stockholder buys his shares. Anyone who buys more than 15% of a
company's stock is covered. The net effect of the Delaware statute is that
anyone who buys less than 85% of a Delaware corporation cannot for three
years conduct a back-end merger between the shell he uses to carry out the
acquisition and the target, and therefore: (1) cannot use the target's
assets as security for a loan to finance the share acquisition; and (2)
cannot use the target's earnings and cash flow to pay off the acquisition
debt. [507]
H. Defensive maneuvers: Here are some
of the defensive maneuvers that a target's incumbent management may use to
defeat a hostile bidder. [509]
a. Super-majority provision: The
target may amend its articles of incorporation to require that more than a
simple majority of the target's shareholders approve any merger or major
sale of assets. (Alternatively, the target can provide that such a merger
or asset sale be approved by a majority of the disinterested
shareholders.) There are called "super-majority" provisions.
b. Staggered board: A target
might put in place a staggered board of directors (i.e., only a minority
of the board stands for election in a given year, so that a hostile bidder
cannot gain control immediately even if he owns a majority of the shares.)
d. New class of stock: The target
might create a second class of common stock, and require that any merger
or asset sale be approved by each class; then, the new class can be placed
with persons friendly to management (e.g., the founding family, or an
Employee Stock Ownership Plan).
i. "Call" plans: A
"call" plan gives stockholders the right to buy cheap stock in
certain circumstances. Most contain a "flipover" provision
which is triggered when an outsiders buys, say, 20% of the target's
stock. When the flipover is triggered, the holder of the right (the
stockholder) has an option to acquire shares of the bidder at a cheap
price.
a. Defensive lawsuits: The
target's management can institute defensive lawsuits (e.g., a state suit
alleging breach of state-law fiduciary principles, or a federal court suit
based on the federal securities laws). Usually, lawsuits just buy time.
b. White knight defense: The
target may find itself a "white knight," who will acquire the
target instead of letting the hostile bidder do so. Often, the white
knight is given a "lockup," that is, some special inducement to
enter the bidding process, such as a "crown jewel" option (i.e.,
an option to buy one of the target's best businesses at a below-market
price).
e. Greenmail: The target may pay
"greenmail" to the bidder (i.e., it buys the bidder's stake back
at an above-market price, usually in return for a "standstill"
agreement under which the bidder agrees not to attempt to re-acquire the
target for some specified number of years).
f. Sale to friendly party: The
target may sell a less-than-controlling block to a friendly party, i.e.,
one who can be trusted not to tender to the hostile bidder. Thus the
target might sell new shares to its employees' pension plan, to an ESOP
(employee stock ownership plan), or to a "white squire." In
Delaware, if a friendly party owns 16%, the Delaware anti-takeover
statute, GCL § 203, will be triggered, thus
preventing a bidder from arranging a back-end merger or asset sale for
three years.
I. Federal securities law response: A
bidder who wants to overturn the target's defensive measures probably will not
be able to do so using the federal securities laws. If the bidder can show the
target's management has actually deceived the target's shareholders, it may be
able to get an injunction under § 14(e) of the '34 Act. But if
incoming management has merely behaved in a way that is arguably
"unfair" to the target's shareholders (by depriving them of the
opportunity to tender into the bidder's high offer), there will generally be
no federal securities-law violation. [514]
J. State response:
The bidder has a much better chance of showing that the target's defensive
maneuvers violate state law. [515]
i. Reasonable grounds: First,
the board and management must show that they had reasonable grounds for
believing that there was a danger to the corporation's welfare from the
takeover attempt. In other words, the insiders may not use anti-takeover
measures merely to entrench themselves in power -- they must reasonably
believe that they are protecting the stockholders' interests, not their
own interests. (Some dangers that will justify anti-takeover measures
are: (1) a reasonable belief that the bidder would change the business
practices of the corporation in a way that would be harmful to the
company's ongoing business and existence; (2) a reasonable fear that the
particular takeover attempt is unfair and coercive, such as a two-tier
front-loaded offer; and (3) a reasonable fear that the offer will leave
the target with unreasonably high levels of debt.)
(1) Can't be
"preclusive" or "coercive": To meet the
proportionality requirement, a defensive measure must not be either
"preclusive" or "coercive." A
"preclusive" action is one that has the effect of
foreclosing virtually all takeovers (e.g., a poison pill plan whose
terms would dissuade any bidder, or the granting of a "crown
jewels option" to a white knight on way-below-market terms). A
"coercive" measure is one which "crams down" on
the target's shareholders a management-sponsored alternative (e.g., a
lower competing bid by management, if management has enough votes to
veto the hostile bid and makes it clear that it will use this power to
block the hostile bid).
c. Consequences if requirements
not met: If one or more of the three requirements summarized in (a) above
are not met, the court will refuse to give the takeover device the
protection of the business rule. But it will not automatically strike the
measure; instead, it will treat it like any other type of self-dealing,
and will put management to the burden of showing that the transaction is
"entirely fair" to the target's shareholders. [521]
K. Decision to sell the company (the
"Level Playing Field" rule): Once the target's management decides
that it is willing to sell the company, then the courts give "enhanced
scrutiny" to the steps that the target's board and managers take. Most
importantly, management and the board must make every effort to obtain the
highest price for the shareholders. Thus the target's insiders must create a
level playing field: all would-be bidders must be treated equally. [522]
Example: Target is sought by Raider
and White Knight. Target's board favors White Knight. Target's board gives
White Knight a "crown jewels option" to buy two key Target
subsidiaries for a much-below-market price.
1. Management interested: If the
target's management is one of the competing bidders, the target's board must
be especially careful not to favor management (e.g., it must not give
management better access to information). Normally, the target's independent
directors should form a special committee to conduct negotiations on the
target's behalf.
L. Sale of control: Similarly,
"enhanced scrutiny" will now be give to transactions in which the
board "sells control" of the company to a single individual or
group.
Example: Target's shares are widely
dispersed, with no controlling shareholder. Acquirer, although it's a public
company, has a controlling shareholder, Boss, who owns 30% of its shares.
Target negotiates a merger agreement with Acquirer, under which each holder of
Target will get a share of the combined Target-plus-Acquirer company. Because
Target's board is proposing to sell "control" of Target to a single
individual (Boss), the court will carefully scrutinize the deal, and make
extra sure that all other possible buyers or merger partners are treated
equally. [526]
1. Friendly merger into
non-controlled public company: It is only where the target is merging into a
friendly "controlled" acquirer that enhanced scrutiny will be
triggered -- if the target is merged into a friendly acquirer that's already
held by the public at large with no single controlling shareholder or group,
there will be no enhanced scrutiny. [Arnold v. Soc. for Savings
Bancorp, Inc.]
M. Board may "just say no":
If the target's board has not previously decided to put the company up for
sale or dramatically restructure it, then the board basically has a right to
reject unwanted takeover offers, even all-cash, high-priced offers that the
board has reason to think most shareholders would welcome. In other words, the
board may "just say no," at least in Delaware.
1. Illustrations: Thus the target's
board may, as a general rule, refuse to redeem a previously-enacted poison
pill, refuse to recommend a merger or put the proposed merger to a
shareholder vote, or otherwise refuse to cooperate. [Paramount Communications,
Inc. v. Time]
[530]
N. Particular anti-takeover devices:
Here is how the courts respond to some of the particular anti-takeover
devices: [534]
4. Lockups: Lockups
are the type of anti-takeover device that is most likely to be invalidated.
This is especially true of crown jewel options. Lockups, including crown
jewel options, are not per se illegal; for instance, they can be used to
produce an auction where none would otherwise exist. But if a crown jewel
option or other lockup is used to end an auction prematurely rather than to
create one, it will probably be struck down. [537]
5. Stock option: An
option to the acquirer to buy stock in the target will likely be struck down
if it is for so many shares, or for so low a price, or on such burdensome
terms, that its mere existence has a materially chilling effect on whether
other bidders will emerge.[538]
Chapter 11
DIVIDENDS AND SHARE REPURCHASES
I. DIVIDENDS -- PROTECTION OF CREDITORS
b. No-par: If the stock is
"no-par" stock (now permitted in most states), stated capital is
an arbitrary amount that the board assigns to the stated capital account.
(This amount is never more than the shareholders paid for their stock when
they originally bought it, but is otherwise whatever the directors decide
it should be when the stock is issued.)
4. "Capital surplus":
"Capital surplus" is everything in the corporation's
"capital" account other than "stated capital."
"Paid in" surplus, "revaluation" surplus, and
"reduction" surplus are the main types of capital surplus. [553]
2. Two tests: All states place
certain legal limits (mostly financial ones) on the board's right to pay
dividends, and directors who disregard these limits may be liable. In most
states, a dividend may be paid only if both of the following general kinds
of requirements are satisfied: (1) payment of the dividend will not impair
the corporation's stated capital; and (2) payment will not render the
corporation insolvent. [550]
a. Paid-in surplus: Thus an
"impairment of capital" statute allows a corporation with no
earned surplus to pay its entire "paid-in surplus" out again as
dividends. "Paid-in surplus" is the difference between what the
shareholders paid for their shares when they were originally issued, and
the "stated capital" represented by those shares.
b. Revaluation surplus: Many
"impairment of capital" states also allow the board to create,
and then pay out, "revaluation" surplus. This is the surplus
produced by "writing up" the corporation's assets to their
current market value (rather than using the historical prices normally
reflected on a balance sheet).
c. Reduction surplus: Finally, a
"impairment of capital" statute usually allows the
"reduction surplus" to be paid out. "Reduction
surplus" is caused by reducing the corporation's stated capital
(which in the case of stock having a par value requires a
shareholder-approved amendment to the articles of incorporation).
3. Nimble dividends: Some states
allow payment of "nimble dividends." These are dividends paid out
of the current earnings of the corporation, even though the corporation
otherwise would not be entitled to pay the dividends (because it has no
earned surplus in an earned-surplus state, or because payment would impair
its stated capital in an impairment-of-capital state). [555]
D. Insolvency test: Even if a
dividend payment would not violate the applicable capital test (earned-surplus
or impairment-of-capital, depending on the state), in nearly all states
payment of a dividend is prohibited if it would leave the corporation
insolvent. [557]
2. "Equity" meaning: In
most states, a corporation is insolvent if it is unable to pay its debts as
they become due (the "equity" meaning of "insolvent"). A
minority of states define a corporation as insolvent if the market value of
its assets is less than its liabilities (the "bankruptcy"
meaning). [557]
E. RMBCA: The RMBCA imposes only an
insolvency test, not a capital-related test. Under RMBCA § 6.40(c), no
dividend may be paid if it would leave the corporation insolvent under either
the "equity" or the "bankruptcy" definition of insolvent.
[557]
F. Liability of directors: If the
directors approve a dividend at a time when the statute prohibits it, they may
be personally liable: [561]
3. Creditor suit: Usually, the suit
to recover an improperly-paid dividend must be brought by the corporation
(perhaps by means of a shareholder derivative suit, or by a trustee for the
corporation once it declares bankruptcy). But some states allow suit to be
brought by a creditor against the director(s) who approve an improper
dividend. [562]
G. Liability of shareholders: A
shareholder who receives an improper dividend may also be liable. [562]
1. Common law: At common law, the
shareholder will be liable and required to return the improper dividend if
either: (1) the corporation was insolvent at the time of, or as the result
of the payment of, the dividend; or (2) the shareholder knew, at the time he
received the dividend, that it was improper. But if the corporation is
solvent and the shareholder takes the dividend without notice that it
violates the statute, the shareholder does not have to return it at common
law. [562]
2. Statute: Some corporation
statutes make the shareholder liable to return the improper dividend, even
if he would not be liable at common law. Apart from the basic corporation
statute, the statute dealing with fraudulent conveyances (e.g., the Uniform
Fraudulent Conveyance Act) may permit a creditor or bankruptcy trustee to
recover against a shareholder. [563]
II. DIVIDENDS -- PROTECTION OF
SHAREHOLDERS; JUDICIAL REVIEW OF DIVIDEND POLICY
A. Generally: A disgruntled
shareholder will sometimes try to persuade the court to order the corporation
to pay a higher dividend than it is already paying. [565]
1. General rule: This is left to
case law by most states. Usually, P will only get the court to order a
higher dividend if he shows that: (1) the low-dividend policy is not
justified by any reasonable business objective; and (2) the policy results
from improper motives that harm the corporation or some of its shareholders.
[566]
3. Closely-held: Courts are more
likely to order an increase in dividend payments when the corporation is
closely held rather than publicly held. Some courts now hold that minority
stockholders who are not employed by the corporation are entitled to a
return on their investment in the form of a dividend, even in the face of an
otherwise valid corporate objective (e.g., expanding the business). Courts
sometimes say that the insiders have a fiduciary duty to grant a reasonable
dividend to the outside minority investors. [566]
III. STOCK REPURCHASES
A. Repurchases generally: A
"stock repurchase" occurs when a corporation buys back its own stock
from stockholders. This may happen by open market repurchases, by a
"self-tender" (i.e., a tender offer by a public company offering to
buy some number of shares pro rata from all shareholders), or by face-to-face
selective purchases. [567]
B. Protection of shareholders: One
shareholder may object to the corporation's repurchase of another
shareholder's shares (e.g., on the grounds that the corporation has paid too
high a price, or has refused to give all shareholders an equal opportunity to
have their shares repurchased). [570]
1. General rule: Generally the
court will not overturn a corporation's repurchase arrangements at the
urging of a shareholder, so long as the board of directors: (1) behaves with
reasonable care (i.e., makes reasonable inquiries into the corporation's
financial health and the value of its shares before authorizing the
repurchase); and (2) does not violate the duty of loyalty (e.g., the
directors are not buying from themselves at an above-market price). [571]
2. Self-dealing by insiders: The
court will look extra closely at a repurchase that appears to benefit the
insiders unduly. (Example: Ian, 40% owner of XYZ, induces the board to have
XYZ repurchase his holdings for 50% more than the current stock market
price. The court will look upon this as self-dealing, and will strike down
the transaction unless Ian bears the burden of proving that the transaction
is "entirely fair" to the corporation and its remaining
shareholders.) [571]
C. Protection of creditors; financial
limits: In general, share repurchases are subject to the same financial limits
for the protection of creditors as are dividends. [571]
Chapter 12
ISSUANCE OF SECURITIES
I. STATE-LAW RULES ON SHARE ISSUANCE
A. Par value: If shares have a par
value, the corporation may not sell the shares for less than this par value.
This rule protects both the corporation's creditors, and also other
shareholders. [580]
a. "Trust fund" theory:
A minority of courts apply the "trust fund" theory, under which
the stated capital of the corporation is a trust fund for the benefit of
creditors. Under this theory, a creditor can recover even if he became a
creditor before the wrongful issuance, or even if he issued the credit
after the wrong but with full knowledge of it.
b. "Misrepresentation"
theory: But most courts apply the "misrepresentation" theory,
under which only a creditor who has relied on the corporation's false
assertion that the shares were issued for at least par value, may recover.
Under this theory, one who becomes a creditor before the wrongful
issuance, and one who becomes a creditor after the wrongful issuance but
with knowledge of it, may not recover since he has not "relied."
2. Kind of consideration: In most
states, shares may be paid for not only in cash, but also by the
contribution of property, or by the performance of past services. States
vary as to whether shares may be purchased and returned for promises to
perform services or donate property (e.g., Delaware does not allow payment
in the form of a promise to perform future services). [583]
3. Valuation: If the board of
directors sells stock to a stockholder in return for past or future services
or property, the board's good faith computation of the value that should be
attributed to those services or property will usually not be overturned by a
court. See, e.g., Delaware § 152 ("in the absence of
actual fraud in the transaction, the judgment of the directors as to the
value of such consideration shall be conclusive"). [584]
B. Promoters' liability: If a
promoter (i.e., an insider who is putting together the business, recruiting
investors, and dominating the board) receives his shares in return for the
transfer of overvalued property to the corporation, there are four theories on
which the corporation or its other shareholders might recover against promoter
for the overvaluation (even assuming that there is no "watered
stock" problem, as where very low par stock is used): [584]
a. Disclosed to other insiders:
If the overvaluation was disclosed to the rest of the board, all of whom
were insiders, courts are split about whether the corporation or
subsequent public shareholders may later recover. Most states would allow
recovery as long as, at the time that transfer took place, the insiders
contemplated future public participation. (Example: Promoter sells a mine
to ABC Corp, and causes the mine to be recorded on ABC's books as worth $1
million, when in fact it's worth $20,000. All other board members are
aware of the overvaluation, and all, including Promoter, expect to raise
money from the public eventually. Once public shareholders are brought in,
ABC will be able to recover from Promoter at common law for deceit, in
most states.)
2. State self-dealing rules:
Alternatively, ABC Corp (on the facts of the above Example) may be able to
avoid the transfer by showing that it constituted self-dealing by Promoter,
and that it was grossly unfair. [586]
3. Federal-public offering
disclosure: If ABC eventually goes public, it may have an obligation to
disclose the transaction in its registration statement and prospectus. If
required disclosure is not made, an investor will be able to sue both ABC
and Promoter. [586]
C. Preemptive rights: A
"preemptive right" is a right sometimes given to a corporation's
existing shareholders permitting them to maintain their percentage of
ownership in the corporation, by enabling them to buy a portion of any
newly-issued shares. (Example: Inventor holds 49% of stock in Mousetrap Corp.
If preemptive rights exist, then before Mousetrap's 51% holder can induce the
board to issue new shares to himself or to the public, Inventor must first be
given the right to buy as many new shares as will be needed to maintain
Inventor's 49% ownership, on the same terms as offered to the 51% holder or to
the public.) [587]
a. Opt-in provisions: Under most
statutes, the preemptive rights scheme is an "opt-in" scheme. In
other words, the corporation does not have preemptive rights unless it
expressly elects, in the articles of incorporation, to have such rights.
The RMBCA follows this "opt-in" pattern; see § 6.30(a).
b. Opt-out: A minority of states
give the corporation an "opt-out" election -- the corporation
has preemptive rights unless it expressly specifies, in the articles of
incorporation, that it does not want such rights.
a. Initially-authorized shares:
Preemptive rights usually do not apply to shares that are part of the
amount that is initially authorized at the time the corporation is first
formed. (However, initially-authorized-but-unissued shares do become
covered by the preemptive scheme if a certain time period -- e.g., six
months under the RMBCA -- elapses following the date of incorporation.)
b. Treasury shares: Under most
statutes, treasury shares (that is, shares that were once outstanding, but
that have been repurchased by the corporation) are not covered. (But the
RMBCA does not exclude treasury shares.)
3. "Fiduciary duty"
concerning dilution: Even in situations where there are no preemptive rights
(either because they have been waived by the corporation, or because the
case falls into an exception where preemptive rights do not apply), courts
may protect minority stockholders against dilution by a "fiduciary
obligation" theory. According to some courts, a majority stockholder
has a fiduciary duty not to cause the issuance of new shares where the
purpose is to enhance his own control at the expense of the minority. [590]
b. Bona fide business purpose
required: Even if the price is fair, the court will frequently strike down
the sale of new stock by the corporation to its controlling shareholders
if there is no valid business purpose behind the sale. For instance, if
the court becomes convinced that the controlling shareholder has caused
the sale to take place solely for the purpose of enhancing his own
control, the court is likely to strike the transaction even though the
price was fair.
c. Preemptive rights as a
defense: If preemptive rights do apply, but the plaintiff declines to
participate (perhaps because he doesn't have the money), courts are split
about whether P may attack the sale of new shares to other existing
shareholders on the grounds that the price is unfairly low. Some courts
treat the fact that P declined to exercise his preemptive rights as a
complete defense (so the court will not inquire into whether the shares
were sold at an unfairly low price). Other courts hold that the existence
of preemptive rights is not a defense, and that the board must bear the
burden of showing that the price of the sale to insiders was at least
within the range of fairness.
II. PUBLIC OFFERINGS -- INTRODUCTION
A. Generally: Public offerings of
securities are extensively regulated by the Securities Act of 1933 (the
"'33 Act"). [593]
1. Section 5: The key provision of
the '33 Act is § 5. Section 5 makes it
unlawful (subject to exemptions) to sell any security by the use of the
mails or other facilities of interstate commerce, unless a registration
statement is in effect for that security. This "registration
statement" must contain a large amount of information about the
security being offered, and about the company that is offering it (the
"issuer"). Additionally, § 5 prohibits the sale of any
security unless there is delivered to the buyer, before or at the same time
as the security, a "prospectus"
which contains the most important parts of the registration statement. [593]
2. Disclosure: The entire scheme
for regulating public offerings works by compelling extensive disclosure.
The SEC does not review the substantive merits of the offering, and cannot
bar an offering merely because it is too risky, overpriced, or valueless.
[594]
B. "Security": The '33 Act
applies to sales of "securities." "Security" is defined
very broadly. It includes not only ordinary "stocks," but
"bonds," "investment contracts," and many other devices.
[595]
1. Stock in closely held business:
Even where the owners of a closely held business sell all of the stock in
the company to a single buyer who will operate the business himself, this is
still the sale of a "security," so it must comply with the
public-offering requirements (unless an exemption applies). [595]
2. Debt instruments: Debt
instruments will often be "securities." For instance, a
widely-traded bond will typically be a security. But a single
"note" issued by a small business to a bank will typically not be
a security. In general, the more a debt instrument looks like an
"investment," and the more widely traded it is, the more likely
the court will be to find it a "security." [Reves v. Ernst & Young] [595]
III. PUBLIC OFFERINGS -- MECHANICS
1. Pre-filing: During the
pre-filing period (before the registration statement has been filed with the
SEC), no one (including underwriters or issuers) may sell or even offer to
sell the stock. (This means that press releases touting the issue, and oral
offers, are forbidden, with narrow exceptions.) [597]
2. Waiting period: During the
"waiting period" (after filing but before the effective date),
most offers to sell and offers to buy are allowed, but sales and binding
contracts to sell are not allowed. [597]
a. Red herring: The underwriters
may (and typically do) distribute during the waiting period a "red
herring," i.e., a preliminary prospectus which is identical to the
final prospectus except that it typically omits the price.
b. No binding offers to buy:
During the waiting period, no offer to buy or "acceptance" will
be deemed binding. Thus even if Customer says, "Yes, I'll buy 1,000
shares," he is not bound and can renege after the effective date.
3. Post-effective period: Once the
registration statement becomes effective, underwriters and dealers may make
offers to sell, and actual sales, to anyone. However, the final prospectus
(complete with the final price) must be sent to any purchaser before or at
the same time he receives the securities. [598]
IV. PUBLIC OFFERINGS -- EXEMPTIONS
A. Generally: There are two key
exemptions to the general rule that securities can only be issued if a
registration statement is in force: [600]
1. Sales by other than issuer,
underwriter or dealer: First, § 4(1) of the '33 Act gives an
exemption for "transactions by any person other than an issuer,
underwriter, or dealer." Because of an exemption for most sales by
dealers, registration will generally be required only where the transaction
is being carried out by a person who is an "issuer" or
"underwriter." (But these terms are defined in a broad and complex
way.) [600]
2. Non-public
offerings: Second, under § 4(2), there is an exemption for
"transactions by an issuer not involving any public offering." So
if an issuer can show that its sale was "non-public" rather than
"public," it need not comply with the registration requirements.
[600]
B. Private offerings: There are two
different bodies of law by which an issuer may have its offering treated as
"private" rather than "public": [601]
a. Sales to institutions: For
instance, a sale by a corporation of a large block of stock or bonds to
one or a few large and sophisticated institutions (e.g., insurance
companies or pension funds) will be a private offering based on this
statutory exemption.
c. General test: In general, an
offering will not be "private" unless: (1) there are not very
many offerees (though there is no fixed limit); and (2) the offerees have
a significant level of sophistication and a significant degree of
knowledge about the company's affairs. (Example: XYZ Corp offers shares to
10 secretarial-level employees at the company, without giving them any
special disclosure. Since the secretaries' knowledge of the company's
financial affairs is probably limited, this is a "public" rather
than "private" offering, even though the number of offerees is
small. Therefore, a registration statement must be used.)
2. SEC Rule 506: Separately, SEC
has enacted Rule 506. If Rule 506's conditions
are met, the offering will be deemed "private" regardless of
whether it would be private under the cases decided under the general § 4(2) statutory exemption. [602]
a. Gist: The gist of Rule 506 is that an issuer may
sell an unlimited amount of securities to: (1) any number of
"accredited" investors; and (2) up to 35 non-accredited
investors. (An "accredited" investor is essentially one who is
worth more than $1 million, or has an income of more than $200,000 per
year.)
b. Sophisticated:
Although an "accredited" investor can be very unsophisticated
without ruining the Rule 506 exemption, a
non-accredited investor must be sophisticated. (More precisely, the issuer
must "reasonably believe" that the non-accredited investor,
either alone or with his "purchaser representative," has such
knowledge and experience in financial and business matters that he is
capable of evaluating the merits of the investment.)
d. Disclosure: If
the offering is solely to accredited investors, there are no disclosure
requirements. But if even one investor is non-accredited, then all
purchasers (accredited or not) must receive specific disclosures about the
issuer and the offering.
C. Small offerings: Two other SEC
rules give an exemption for offerings that are "small" (as opposed
to "private"): [604]
1. Sales by or for controlling
persons: If a controlling stockholder sells a large number of shares by
soliciting a large number of potential buyers, this may be held to be a
"public offering." If so, the shareholder will have to register
the shares, or else he (as well as his broker) will face liability for the
crime of distributing unregistered stock. The key concept is
"distribution": if a broker sells for a controlling shareholder in
what is found to be a "distribution," a registration statement is
required. (The larger the number of shares sold, and the larger the number
of potential buyers contacted, the more likely a "distribution" is
to be found.) [607]
a. Rule 144: But SEC Rule 144 provides a safe harbor:
if the terms of the rule are complied with, sales by or for a controlling
shareholder will not need to be registered. The key requirements for 144,
in the case of a sale by a controlling shareholder, are:
2. Non-controlling shareholder:
Non-controlling persons may also sometimes have to register their shares
before selling them. A person who has previously bought stock from the
issuer in a private transaction, and who now wishes to resell that stock,
could be liable for making an unregistered public offering if a court finds
that he bought with an intent to resell rather than for investment. [609]
ii. Held for
more than three years: But if a non-controlling shareholder has held his
restricted stock for more than three years, most limitations are
removed: a non-controlling shareholder who buys stock in a private
offering and then holds that stock for three years may sell to whomever
he wishes, and whatever amounts he wishes, by whatever type of
transaction he wishes, without reference to whether the company files
SEC reports, and without any need to file any notice with the SEC. (But,
of course, the resale must not itself constitute a brand new public
offering.)
1. Intrastate offerings: Section 3(a)(11) of the '33 Act exempts
"intrastate offerings." However, this exception is very hard to
qualify for, and is rarely used except in isolated areas that are very far
from any state border. [612]
V. PUBLIC OFFERINGS -- CIVIL
LIABILITIES
A. Generally: There are four
liability provisions under the '33 Act, at least three of which impose civil
liability in favor of an injured investor. [614]
B. Section 11: Section 11 imposes liability for any
material errors or omissions in a registration statement. [614]
3. Who may be sued:
A wide range of people may be sued under § 11, including: (1) everyone
who signed the registration statement (which always includes at least the
issuer and the principal officers); (2) everyone who is a director at the
time the registration statement was filed; (3) every expert who consented to
being named as having prepared part of the registration statement; and (4)
every underwriter. [615]
a. Expertised portions: With
respect to any part of the registration statement prepared by an expert:
(1) the expert can establish the due diligence defense only by
affirmatively showing that he conducted a reasonable investigation that
left him with reasonable ground to believe, and the actual belief, that
the part he prepared was accurate; but (2) all other persons (the
non-experts) merely have to prove the negative proposition that they
"had no reasonable ground to believe and did not believe" that
there was any material misstatement or omission. (Thus an ordinary
director can entrust to the issuer's accounting firm the preparation of
the audited financial statements, as long as he is not on notice of
inaccuracies.)
b. Non-expertised portions: With
respect to parts of the registration not prepared by experts, D must show
that: (1) he made a reasonable investigation; and (2) after that
investigation, he was left with reasonable ground to believe, and did in
fact believe, that there was no material misstatement or omission. (Inside
directors will usually find this harder to show than will outside
directors.)
C. Section 12(1): Section 12(1) imposes liability on anyone
who sells a security that should have been registered but was not. Liability
here is imposed even for an honest and in fact non-negligent mistake. However,
a buyer may only sue his immediate seller, not someone further back in the
chain of distribution. [617]
D. Section 12(2): Section 12(2) imposes liability for untrue
statements of material fact and for omission of material fact. Unlike § 11, it is not limited to
misstatements made in the registration statement. (For instance, misstatements
made orally, or in a writing other than the registration statement, are
covered.) Not only the seller but anyone who is a "substantial
factor" in making the sale (e.g., a broker or public relations consultant
for the seller) may be sued. A negligence standard is used. [617]
E. Section 17(a): Section 17(a) imposes a general anti-fraud
provision. Unlike the three sections discussed above, most courts have held
that 17(a) does not support a private right of action by investors (merely a
right on the part of the government to prevent or punish violations). [617]
VI. PUBLIC OFFERINGS -- STATE
REGULATION
A. State "Blue Sky" laws
generally: Every state regulates some aspects of securities transactions
through regulations collectively known as "blue sky" laws. [618]
1. '96 Act changes rules: However,
Congress took away a large portion of the states' Blue Sky Powers, in the National Securities
Improvement Act of 1996. State regulation of securities issuance is now
largely preempted by federal regulation.
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