Accounting Research and Practice
Chapter 8
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Introduction
• The book defines fiduciary relationship as:
“created when one is give the power that carries a duty to
use that power to benefit another.1”
• Fiduciary relationships include:
➢ Trustee relationships
➢ Beneficiaries of trusts
➢ Partners or agents to principals
• Enforcement of fiduciary duty is used to reduce
mismanagement of the company or unfair self-dealing.
• Fiduciaries are accountable to shareholders and directors
of the company.
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Care and loyalty
• “The characterization of someone as a fiduciary generally
means that the individual has to obey certain duties and
look out for the interests of whoever is owed the duty.”
• Fiduciaries are bound by a duty of care and duty of
loyalty.”
➢ Duty of care:
❖ Directors perform their duties with care and
diligence.
❖ Can be liable for both malfeasance and
nonfeasance.
❖ Protected under business judgment rule (limits
court questioning business decisions).
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Care and loyalty
➢ Duty of care:
❖ Directors perform their duties with care and
diligence.
❖ Can be liable for both malfeasance and
nonfeasance.
❖ Protected under business judgment rule (limits
court questioning business decisions).
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Care and loyalty
➢ Duty of loyalty:
❖ Act in the best interests of the company and in
good faith.
❖ A lack of duty loyalty involves intent to harm the
company and dereliction of duty.
▪ Can occur when the person responsible for the
fiduciary duty puts his/her own interests over
the interests of the company.
❖ Courts will get involved in cases where the person
in charge of fiduciary duty puts their personal
interests over loyalty of duty.
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Care and loyalty
The textbook states the difference between duty of loyalty
and duty of care is as follows:
“Thus, in duty of loyalty cases involving a conflict of
interest, there is more judicial involvement and scrutiny
than in duty of care or good faith cases.11 The difference is
justified because in a duty of care case, the courts want to
protect business decisions that are intended to enhance
corporate gain, while in a duty of loyalty involving a
conflict of interest case the directors may be motivated by
personal gain.12”
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Policy issues
• “The fiduciary duty of those who manage or control is to
the corporation and shareholders and the shareholders
have the right to enforce it through litigation.”
• Publicly traded companies have outside directors to
monitor the inside directors.
• Company representatives disagree on the involvement of
litigation to enforce fiduciary responsibility:
➢ Shareholders want judicial scrutiny.
➢ Managers who have fiduciary duties do not want judicial
scrutiny.
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Policy issues
• Law and economics approach
➢ View the relationship between shareholders and
managers as a contract.
➢ The duties of the fiduciary manager are included in the
terms of the contract.
➢ Detractors of this approach include shareholders who
would not be able to negotiate the contract.
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Duty of care
• Liability under duty of care requires:
➢ Finding duty
➢ Breach
➢ Proximate cause and loss
• “Issues of breach of duty of care can arise in two kinds
of situations; when
➢ There is a failure to act or monitor where a loss
could have been prevented (i.e., nonfeasance)
➢ There is a decision made in a negligent manner
(i.e., malfeasance).”
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Malfeasance and the business judgment rule
• Malfeasance occurs when directors are accused of making
ill-advised decisions or negligence of duties.
• The ill-advised decisions are subject to judicial review and
can be protected under the business judgment rule.
• Even if malfeasance is found, finding causation may be
required.
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Malfeasance and the business judgment rule
• Business judgment rule
➢ “limits judicial inquiry into business decisions and
protects directors who are not negligent in the decision
making process.”
➢ Courts defer to the director’s decision and do not infer
that they have more knowledge over business
decisions than the director’s.
➢ Under this rule, courts will review the process of the
process, not the decision.
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Causation
• Breach of duty does not necessarily end the inquiry.
• The actual cause of the breach of duty must be found.
• Plaintiffs have the burden of proof and must prove
themselves free of negligence.
• Plaintiffs must also show the amount of damages.
Introduction to Fiduciary Duty: The Duty of
Care and the Business Judgment Rule
Good faith
• “Lack of good faith would include
➢ Conduct motivated by subjective bad intent
➢ By an actual intent to harm the corporation
➢ An intentional dereliction of duty and a conscious
disregard for one’s responsibilities would also constitute
a lack of good faith because it shows more culpability..”
Chapter 9
The Duty of Loyalty and Conflicts of Interest
Duty of Loyalty and Conflicts of Interest
Introduction
• “Traditionally, the duty of loyalty was raised when the
fiduciary (or those associated with him or her) had a
conflict of interest with the corporation, suggesting that
personal interests may be advanced over corporate
interests.
• Conflicts of interest may involve a use of position for
personal gain, taking something that belongs to the
corporation,4 or some form of self-dealing with the
corporation where the fiduciary is on both sides of the
transaction and in a position to receive a benefit
unavailable to other shareholders.”
Duty of Loyalty and Conflicts of Interest
Policy
• Duty of loyalty
➢ Tries to prevent directors from going against the best
interests of the corporation or self-dealing to benefit
themselves.
➢ Different from duty of care because duty of loyalty
focuses on self-dealing rather than poor decision
making.
➢ Fiduciary rules are stricter on duty of loyalty than on
duty of care.
Duty of Loyalty and Conflicts of Interest
Interested director transactions
• Common law
➢ “Common law cases generally followed the view that
the process of approval and the terms of the transaction
itself must be fair, with the burden of proof on the
fiduciary.
➢ This rule protects shareholders from exploitation and
permits flexibility in corporate dealings.”
Duty of Loyalty and Conflicts of Interest
Interested director transactions
• Statutory responses
➢ “Many states have enacted statutory provisions that
deal with interested director transactions (“interested
director statutes”).
➢ Many states do not codify the duty of loyalty, but
provide mechanisms that may create presumptions or
deal with the burden of proof or act as safe harbors that
limit any judicial review.”
Duty of Loyalty and Conflicts of Interest
Executive compensation
• Executive compensation can be in various forms, including:
➢ Salaries
➢ Bonuses
➢ Pensions
➢ Fringe benefits
➢ Restricted stock
➢ Severance packages
➢ Golden parachutes
➢ Stock options
Duty of Loyalty and Conflicts of Interest
Corporate opportunity and abuse of position
• Abuse of position happens when the fiduciary taking
advantage of his/her position.
• Fiduciary’s should not benefit personally from their
position.
Duty of Loyalty and Conflicts of Interest
Corporate opportunity and abuse of position
• Financial inability ➢ Corporation’s lack the ability to take advantage of corporate
opportunities.
• Multiple boards ➢ Directors serve on boards for multiple corporations.
• Use of information and competition
➢ “A corporate fiduciary cannot use corporate information, a corporate position150 or assets unfairly for personal profit151 and
may not be able to compete with the corporation.152”
• Undisclosed profits ➢ Improper use of information for personal profits which are not
disclosed to the corporation.
Duty of Loyalty and Conflicts of Interest
Shareholder voting and ratification
• “When shareholders vote on a transaction, an issue arises
as to the effects of that vote.
• A shareholder vote is not optional, but a statutory
requirement, such as voting amendments to the articles of
corporation or to effectuate a merger or fundamental
transaction.”
• Shareholders sometimes vote on ratification of a
transaction.
Duty of Loyalty and Conflicts of Interest
Shareholder voting and ratification
• There are two types of shareholder voting:
➢ Required voting
❖ Voting that is not to validate a transaction. The
voting is more authorize the transaction. The
transaction requires the shareholder vote.
➢ Optional shareholder voting and ratification
❖ Voting when the shareholder vote is not required,
but is optional.
❖ By having the shareholders vote on a transaction, it
may limit the extent of judicial scrutiny.
Chapter 10
Controlling Shareholders
Controlling Shareholders
Introduction
• De jure control
➢ Shareholder or group owns a majority of voting shares
of a corporation.
• De facto control
➢ Working control because no shareholders or group of
shareholders has majority control.
• Control group
➢ Group of shareholders acting together or another
corporation owning control.
Controlling Shareholders
Introduction
• Advantages/disadvantages for shareholders in the control
group
➢ Control group is less diversified ❖ Lack of diversification leads to the corporation fortunes having
a larger impact on the control group.
➢ Control group can monitor potential mismanagement. ❖ Corporation, because of this monitoring by the control group,
could be run more effectively.
➢ “A significant disadvantage occurs when there is an
unfair conflict of interest transaction (i.e., self-dealing)
between the control group and the corporation where
the shareholders are excluded.”
Controlling Shareholders
Use of control
• The Zahn case ➢ “Controlling shareholders cannot use their control to
self-deal unfairly with the assets of the corporation.”
• Parent-subsidiary dealings
➢ “A corporation that is a controlling shareholder
(“parent”) of another corporation (“subsidiary”) often
contracts with the controlled corporation.”
• Sale of corporation
➢ Judicial scrutiny may be higher if controlling
shareholders are involved in a sale of a corporation.
Controlling Shareholders
Sale of control
• “When the control group sells its shares, they are sharing
their personal property, which does not automatically
implicate any breach of fiduciary duty.
• Controlling shareholders who sell their controlling shares
often receive a premium from a purchaser, that is, they
receive more for their shares than the current market price,
and that may raise issues of fiduciary duty.”
Controlling Shareholders
Sale of control
• “The premium for control may represent the advantages of
control, which include the ability to establish business
policy and decide how the business will run,138 as well as
the ability to receive the perquisites of control, including
reasonable salary and benefits from legitimate fair self-
dealing transactions.”
• “The premium may also enable the control group to unfairly
use corporate assets for its own advantages.”
• “Sale of control raises the issue of whether a rule of equal
treatment of shareholders should be a goal of corporate
law.141”
Controlling Shareholders
Sale of control
• Pro rate sharing rule
➢ Purchaser may buy as many shares as they want to
achieve control without buying 100% of the shares.
❖ Purchaser must make the same offer to the
shareholders.
• Mandatory bid rule
➢ Purchaser must offer to buy 100% of the shares at the
same price.
➢ Controlling shareholders would not get a premium price
on their shares as opposed to the minority
shareholders.
Controlling Shareholders
Sale of control
• Looting
➢ Purchasers bought “controlling interest at a premium to
loot the company of its primary liquid assets.”
• The Perlman case ➢ “Perlman v. Feldman150 dealt with the sale of control
issue and explored the idea of a pro rata sharing rule
and equal opportunity for all shareholders to share in
the premium paid to the controlling shareholders.”
➢ “The court recognized that this was no ordinary case of
duty of loyalty because their was no fraud, misuse of
confidential information, contracting with the corporation
or looting.”
Controlling Shareholders
Sale of control
• The California approach ➢ Controlling shareholders in a savings and loan decided
to profit from the increased market value of their
shares.
➢ To profit from the increase in market value, the
controlling shareholders transferred their shares to a
private holding company that became a part of the
parent company.
➢ When the private holding company offered public
shares, the sale of these shares would make the
controlling shareholders a profit.
Controlling Shareholders
Sale of control
• The California approach ➢ Minority shareholders brought a lawsuit against the
controlling shareholders for breach of fiduciary duties.
➢ Court ruled in favor of the minority shareholders.
➢ The controlling shareholders had not established that
their actions were in “good faith”.
Controlling Shareholders
Sale of office
• “When the sale of control takes place, the directors usually
resign and select the designated nominees of the
purchaser of control to replace them as directors.
• While the purchaser could arrange for a shareholder vote,
they prefer to act quickly and without the expense.”
• Resignations of directors can raise the issue of whether or
not an illegal sale of office has happened.
• Purchasers should have actual or de facto control before
electing new directors.
Chapter 13
Disclosure and Insider Trading
Disclosure and Insider Trading
Introduction
• Insider trading
➢ “involves the use of nonpublic information by any
person “having a relationship [director, officer, attorney]
giving access, directly or indirectly, to information
intended to be available only for a corporate purpose
and not for the personal benefit of anyone.9”
➢ Use of the information to trade or give other people tips
that a trade is going to occur.
Disclosure and Insider Trading
Disclosure concepts and elements of a cause of action under
rule 10b-5
• Disclosure concepts
➢ Implication of private rights of action
➢ Standing to sue
➢ Materiality
➢ State of mind (5 culpable states)
❖ Strict liability
❖ Negligence
❖ Recklessness
❖ Knowing conduct
❖ Intentional conduct
Disclosure and Insider Trading
Disclosure concepts and elements of a cause of action under
rule 10b-5
➢ Pleading state of mind
➢ Reliance (Transaction causation)
➢ The fraud on the market theory reliance substitute
➢ Loss causation
➢ The “In connection with” requirement
➢ Privity
➢ Secondary liability for disclosure violations
➢ Statues of limitation
Disclosure and Insider Trading
The prohibition of insider trading: Is it good or bad?
• Arguments for insider trading
➢ “Profits made by insiders through their trading
constitute rewards for their entrepreneurial efforts.
➢ Inside trading profits constitute the very type of
performance-based compensation that aligns corporate
official’s interests with those of shareholder owners.
➢ Insider trading helps move stock prices quickly in the
correct direction and magnitudes, reflective of events
occurring within the particular company, thereby
contributing to stock market efficiency, which is
beneficial to investor.”
Disclosure and Insider Trading
The prohibition of insider trading: Is it good or bad?
• Arguments for insider trading
➢ “Insider trading harms no one because if the inside
information needed to be secret, those who sell when
insiders are buying or those who buy when insiders are
selling would have bought or sold anyway (“No One is
Harmed”).”
Disclosure and Insider Trading
The prohibition of insider trading: Is it good or bad?
• Arguments against insider trading ➢ “Entrepreneurs: Senior managers and directors of publicly held
corporation are for the most part not entrepreneurs.”
➢ “The ideal performance-based compensations: Insiders who possess
negative news may sell before other investors receive the news and
react.”
➢ “Enhancement of accurate securities pricing: information is held back
to benefit the insider.”
➢ “No one is harmed”: “Trading on information intended to be available
only for a corporate purpose, not possessed by other players in the
market, is beyond the rules of the sport, so to speak.”
Disclosure and Insider Trading
Law of insider trading
• Common law background
• The nature of insider trading prohibition
• Who is an insider? ➢ “A traditional insider is a person who, because of a fiduciary or
similar relation, is afforded access to nonpublic investment
information from her corporation.
➢ The paradigmatic insider is the senior corporate official or director in
a corporation, although professionals such as attorneys,
accountants, and investment or commercial bankers may also
become insiders, or temporary insiders, when they learn of nonpublic
information during the course of performing services for the
corporation.”
Disclosure and Insider Trading
Law of insider trading
• Tipper-Tippee liability
• The misappropriation theory
• The misappropriation theory in the Supreme Court
• Tippees of misappropriators
• Remedies and enforcement
• SEC regulation FD
Disclosure and Insider Trading
The insider trading prohibition under state law
• Common law
• Common law exceptions: The Kansas rule
• Common law exceptions: Special facts doctrine
• Modern expansion of the special facts doctrine
• Finding harm to the corporation from the insider’s trading
Disclosure and Insider Trading
Regulation of insider trading under Section 16 of the securities
exchange
• Act of 1934
➢ Statutory provisions
➢ Parties plaintiff and calculation of damages
➢ Who is an officer for Section 16 purposes?
➢ Insider status at only one end of a swing
➢ Takeover players and Section 16(b)
Chapter 5
The Legal Model and Corporate Governance: Themes and the Allocation of Power Under State law
Legal Model and Corporate Governance
• Corporate governance is defined as:
➢ “the system by which companies are directed and
controlled.
➢ Under traditional corporate theory, control of a
corporation is vested in the board of directors elected
by the shareholders.”
Legal Model and Corporate Governance
Themes
• Themes that relate to the study and influence on
development of corporate law and governance
➢ Focus of corporate governance and stakeholders
➢ Publicly held corporation
➢ Stock markets
❖ Benefits of stock markets
❖ Shareholder protection and stock markets
➢ The efficient capital market hypothesis
Legal Model and Corporate Governance
Themes
➢ Role of ownership
❖ The Berle-Means Corporation-Separation of
ownership from control
❖ Institutional investors
❖ Political significance of share ownership
➢ Independent directors
➢ Gatekeepers
➢ Federalism
➢ Publicly held vs. closely-held corporations
Legal Model and Corporate Governance
Theories of the firm
• Different theories of firm and corporate law models for
publicly traded corporations
➢ Regulatory approach
➢ Management, Director, or Shareholder approach
➢ Law and economics approach
❖ Agency costs
❖ Markets
❖ Nexus of contracts
❖ Critics of contractual approach
❖ Behavioral economics
Legal Model and Corporate Governance
Legal model
• “The governing structure of a corporation is composed of
the shareholders as the owners of the company, and the
board of directors who oversee the management of the
company.”
• “The legal model allocates to directors and officers the
authority to manage while it provides the shareholders,
as owners, with some ability to monitor the manager’s
performance.143”
Legal Model and Corporate Governance
Shareholders
• “The common shareholders, as owners of the
corporation, are viewed as residual claimants because
their claim on assets (upon liquidation) and profits
follows creditors and preferred shareholder, who usually
have fixed claims with priority.
• “A significant issue in corporate law is the allocation of
power between the shareholders and the directors and
officers.
❖ The primary source for the allocation of power within
a corporation is state law.147”
Legal Model and Corporate Governance
Shareholders
• Shareholders have the following rights:
➢ Right to vote
❖ Cumulative voting
➢ Rights of expression
➢ Proxy voting
➢ The proxy fight
❖ Change management
❖ Replace directors to facilitate an acquisition
Legal Model and Corporate Governance
Shareholders
❖ Change policy
▪ Shareholder proposals
▪ Withholding votes
▪ Nominating directors in management’s proxy
statement
❖ Collective action problem
❖ Proxy expenses
➢ Shareholder democracy
❖ Fiduciary duty
➢ Vote buying
➢ Right to information
Legal Model and Corporate Governance
Board of directors
• “The board of directors in publicly traded corporations
must give managers flexibility to run the business, while
monitoring them to limit self-dealing and
mismanagement.261
• Most of the legal monitoring devices are aimed at trying
to get the board to monitor managers without too much
interference from shareholders.”
Legal Model and Corporate Governance
Board of directors
• Board structure
➢ Number of directors is set by the bylaws or articles of
incorporation.
➢ Directors are elected by the shareholders.
➢ Actual role of the board is dependent upon many
factors including the make up of the board.
• Meetings
➢ Board acts at meetings
➢ Actions without a meeting
Legal Model and Corporate Governance
Officers
• Daily operations are delegated by the corporate officers,
who can be appointed by the board of directors.
• Officers have fiduciary duty to the corporation since they
are agents of the corporation.
• Authority
➢ Power originates from the board of director’s
➢ “Determining the power of the officers to bind the
corporation is an important issue that is usually
based upon agency law principles.”
Legal Model and Corporate Governance
Financial scandals
• Stock market crash of 1929
• The Sarbanes-Oxley Act of 2002
• Dodd Frank-Act of 2010
Chapter 14
Corporate Litigation
Corporate Litigation
• Two types of corporate litigation
➢ Direct
❖ “If one or more shareholders sue the corporation
alleging that the corporation has denied them a
contract right associated with shareholding (rights
to dividends or disclosure, for example), the action
is direct.
❖ If the shareholder alleges a special or distinct
injury over and above a diminution in the value of
shares, the action is also direct.”
Corporate Litigation
• Two types of corporate litigation
➢ Derivative
❖ By contrast, if shareholders sue to vindicate the
violation of a duty owed to the corporation either
fiduciary duties owed by corporate directors or
officers, or obligations of a third party pursuant to a
contract with the corporation, the action is
derivative.
❖ Any recover goes to the corporate treasury.”
Corporate Litigation
The nature of the derivative suit: Direct versus derivative,
pro rata recover, and other preliminary issues
• The nature of the derivative suit
➢ Action brought by shareholders on behalf of the
corporation.
• Direct vs. derivative – Special or distinct injury rule
• Direct vs. derivative – Denial of contract rights associated
with shareholding
• Direct vs. derivative – Closely held corporation exception
• Pro rata (individual) recovery in derivative actions
• The Tooley test in Delaware
Corporate Litigation
Qualifications of a proper plaintiff-shareholder
• Types of qualifications: ➢ Record ownership
❖ “The vast majority of shares in publicly traded corporations
are held in nominee, or “street” (Wall Street) name, rather
than in shareholders’ names, or “record” ownership.55”
➢ Contemporary ownership
➢ Possible exception: Undisclosed wrongdoing
➢ Continuous owner
➢ Clean hands requirement
➢ Adequate representation requirement
➢ Selection of lead counsel
Corporate Litigation
Qualifications of a proper plaintiff-shareholder
• Demand rule: ➢ Demand refused
➢ Demand accepted
➢ Demand excused
❖ The futility exception
❖ Threat of irreparable harm
❖ Closely held corporation
❖ Delay
➢ Demand on shareholders
Corporate Litigation
The termination of litigation: The advent of the special
litigation committee device
• Background
➢ 1960s and 1970s: US corporations made illegal
payments to procure business abroad.
➢ SEC gave corporations the opportunity to investigate
their own affairs to reduce the court case load.
❖ By doing this, corporations that disclosed the
amounts of the illegal payments, received only a
slap on the wrist from the SEC.
• Application of the business judgment rule
Corporate Litigation
The termination of litigation: The advent of the special
litigation committee device
• Two approaches to dismissing litigation
➢ Auerbach business rule judgment approach ➢ Zapata approach
• Structural bias and other considerations
➢ Structural bias is defined as “inherent prejudice
against any derivative action resulting from the
composition and character of the board of directors”
and of special litigation committees.178”
Corporate Litigation
Proposed reforms of the modern strike suit era
• Pro defendant
➢ Business judgment rule application of Auerbach ➢ ALI position
• Pro shareholder
➢ Zapata v. Maldonado theory
Corporate Litigation
Right to trial by jury, attorneys’ fees, and miscellaneous
issues
• Right to trial by jury
➢ “Fiduciary duties have their genesis in trust law, at the
heart of the Chancery Court’s jurisdiction.
➢ The derivative action itself was the creation of the
equity courts.
➢ For many decades, the prevailing view was that
derivative actions belong exclusively to the equity
courts; there was no right to trial by jury.
➢ US federal law altered the theory that derivative
actions belonged to the equity courts.”
Corporate Litigation
Lawyering problems in corporate litigation
• Attorney-client privilege
• Attorney-client privilege in derivative litigation
• The corporation as a client
• Sabanes-Oxley Act: The conflict between “reporting up”
and the prohibition of disclosure of client confidences
Corporate Litigation
Indemnification and insurance
• “Before agreeing to serve as director, especially on the
board of a publicly held corporation, an individual will want
to know what protections she will have if she is named as
a defendant in a class action, derivative suit, or
governmental proceeding involving the corporation’s
affairs.
• Protection includes a payment for, or provision of, legal
services to the director.
• Protection also includes full or partial payment of any
settlement or judgment in proceedings against the
directors.”
Multiple choices questions:
1. Promoter’s owe a duty of care and loyalty to:
a. The corporation they form
b. Others with financial interests in corporation
c. All of the above
2. Defective incorporation occurs when:
a. Improper or incomplete filing necessary to create the Corporation or LLC
b. When there has been a piercing of the corporate veil
c. In midlife by Secretary of State Corporation is administratively dissolved for failure to pay annual taxes or file
annual reports
d. A and C
3. "in which of the following shareholders and directors are held personally liable for the company and their assets are
held accountable."
a. Parent –subsidiary Corporation relationships
b. Brother-Sister (Sibling) Corporation settings
c. Personal Shareholder liability’
Old Quiz for Law 401 Multiple choices questions:
1. Example of lack of good faith include a. In international act in not advancing the corporation’s best interest b. An intent to violate positive law c. Intentionally failing to act when in the face of duty to act d. All of these answer choices are correct
2. Which of these are disadvantages for shareholders in a corporation with a control group? a. Neither of the answers presented here is correct b. Many monitoring devices are not available when there are separation of ownership and control c. Both answers presented here are correct d. Truly independent directors are less likely to serve on the board of directors
3. Which of these are steps in freezeout merger? a. The controlling shareholders of the old corporation of vote to merge b. The controlling shareholders creates a subsidiary c. The merger agreement calls for minority shareholders to receive cash or securities d. All of these answer choices are correct
4. The purpose of the business judgment rule is a. To allow judicial inquiry into the substance of a directors business decisions b. To prohibit judicial review of the process of a business decision c. To limit judicial inquiry into the substance of a directors business decisions d. To set a standard of conduct
5. Which methods of acquiring control of a corporation does not require the approval of the board of directors of the target corporation
a. Merger of the target into the buyer or buying its subsidiary b. Acquire substantially all the assets of the corporations c. Acquire stock from shareholders d. All of the answers choices are correct
6. In most cases courts use which standard of review to evaluate the actions of directors of a target corporations in a hostile tender offers
a. Duty of loyalty with fairness test and no business judgment rule b. Modified business judgment rule or proportionality test c. Duty of care d. All of these answer choices are correct
7. In corporate law waste is referred to as a transaction such as an example of options for executive compensation a. Involving nominal or almost no payment or services b. Which is a gift c. Unnecessary d. All of these answer choices are correct
8. which of the following is requirement is privates right of action is disclosure action under rule 10b-5 ? a. purchaser seller standing rule b. reliance transaction causation c. loss causation d. all of these answer choices are correct
9. which of these statements supports thee propositions that insider trading should be prohibited? a. Insider trading profit align the interests of corporate officials and shareholders b. Profits made through insider trading rewards insiders entrepreneurial efforts c. Investors would perceive a disadvantages if insider trading where permitted d. All of the answer choices are correct
10. Shareholder may vote on a transaction a. To approve amendments to the articles of incorporations b. To potentially minimize judicial scrutiny c. To ratify a transaction already completed d. All of these answer choices are correct
11. If a shareholder can establish a cause of action for both a direct and derivative lawsuit which may be filed in court? a. Both simultaneously b. A direct lawsuit c. A derivative lawsuit d. Either one or the other or both simultaneously
12. In a direct lawsuit shareholder can be bring an action a. When there is a contractual duty b. In the case of a denial of right related to shareholding c. When there is a special duty d. All of these answer choices are correct
• Question 1
"On January 10th, Tom, acting as a promotor for a corporation not yet formed, leases a building from Mick
and signs the lease under the name ABC Inc. . On January 20th ABC Inc. is incorporated. Who is liable for
the contract?"
Answers: "Tom, because he signed the contract "
ABC Inc. will be liable for the contract providing the board of directors approved it (novation)
ABC Inc. will be liable for the contract
"Mick, because at the time the contract was signed the corporation was not yet formed "
• Question 2
A corporation and a limited liability company share the same feature of
Answers: The ability to raise capital by selling its shares to the public in the stock market
Limited liability of shareholders
Double taxation
Incorporation procedures
• Question 3
• Question 4
Ultra vires act occurs when
Answers: The corporation acts beyond its scope and power
The corporation acts within its scope and power
The corporation has been incorporated defectively
The corporation has been incorporated properly
• Question 5
Which of the following is defense to defective incorporation?
Answers: De jure corporation
Corporation by estoppels
Ultra vires act
None of the above
• Question 6
Which of the followings business organization is considered a legal entity separated from its owners
Answers: Sole proprietorship
General partnership
Limited partnership
Corporation
To whom a Promotor owes the duty of loyalty and care?
Answers: Co-promotors
The corporation to be formed
The shareholders of the corporation to be formed
All of the above
• Question 2
"ABC Inc. is a corporation organized under the laws of the United States. The certificate of incorporation of
ABC Inc. indicates that the corporation purpose is to manufacture and sell refrigeration components ,
however ABC Inc. manufactures and markets children clothes. What is the legal term for this situation?"
Answers: Defective incorporation
Defective purpose
Ultra vires act
De facto corporation
• Question 3
Defective incorporation occurs in all the following events except
Answers: When there has been improper or incomplete filing during incorporating the company
When annual reports have not been filled
When there has piercing of corporate veil
When fees have not been paid
Question 1
1. "In a corporation, who is viewed as residual claimant: "
Common shareholders
Preferred shareholders
Creditors
Board of directors
Question 2
1. Plaintiff may pierce the corporation through:
Parent-subsidiary settings
Brother-sisters corporate settings
A and B
None of the above
Question 3
1. Raising capital may include:
Borrowing
Investment of funds by owners
A and B
None of the above
Question 4
1. Which of the following are NOT a shareholders right:
Rights to information
Right to compensation
Rights to vote
Right to receive dividends
Question 5
1. The [n] _______ are delegated with the power to run the day-to-day business in the corporation.
The shareholders
The directors
The officers
All of the above
Question 6
1. Preemptive rights refer to:
Preferred shares
Right to purchase a proportionate number of shares in order to maintain the percentage of ownership
Shareholders right to vote and control
None of the above
• Question 1
According to the legal model:
Answers: Directors and officers monitor shareholders
Directors and officers manage while shareholders monitor their performance
All of the above
None of the above
• Question 2
The Board of Directors can act within its fiduciary power to run the corporation:
Answers: For the interest of the shareholders that elect them
Only if the majority of shareholders approve
"Best interests of the corporation, including all of the shareholders"
For the benefit of the officers of the corporation
• Question 3
"In a corporation, who is viewed as residual claimant: "
Answers: Common shareholders
Preferred shareholders
Creditors
Board of directors
• Question 4
Debt is denominated by:
Answers: Bonds
Common shares
Preferred shares
Stocks
• Question 5
"""Minimum price at which a share must be sold"" is a definition of:"
Answers: Liquidation value
Par value
Book value
Dividends
• Question 6
"According to US state law, the number of the board of directors should be: "
Answers: Set in the bylaw or article of incorporation
At least 3 directors
At least 1 director
A and B
1- Business that need to raise large amount of capital by attracting public investor will chose :
Corporate form
2- Which of this concept related to piercing the corporate veil
Must first establish independent basis for holding the corporate liable
3- Structural setting for piercing the corporate veil include:
a- Parent subsidiary corporation relationship
b- Personal shareholder liability
c- Brother-sister corporation setting
d- All of above
4- in forming corporation:
a- the incorporator is responsible for filling the article for incorporation
b- upon acceptance of article of incorporation, corporate existing begin.
c- The process is complicated and expensive
d- All of above
5- The board of director can act within its fiduciary power to run the corporation:
In the best interest of the corporation including all of shareholders.
6- In consolidation where A Inc. and B Inc. merge to form a new C Inc. which companies are in existence after the
merger
C Inc. only
7- Which is the primary factor to weigh when evaluating different securities:
Risk
8- The priority of payment of dividends and liquidation right to preferred shareholder is ass follow:
After creditors but before common shareholders
9- A promoter will want to provide for what in a contract with a third party before a corporation is formed:
Substitution of a new party to a contract (novation)
10- Which of these are viewed as residual claimant of a corporation:
Common shareholders
11- Defective incorporation means:
Loss of limited liability or limited liability that never existed
12- In a statutory merger who must approve the merger:
The board of director and the shareholders of both the buyer and seller
1- Which of the following are true regarding corporate officers?
a- The power of officers to bind a corporation is usually based on agency principle
b- An officers` s power originates from the board of directors
c- An example of express authority provided to an officer can be evidenced by corporate bylaws, valid
employment contract, or board resolution.
d- all of the above
2- In a publicly traded corporation, in which situation can a proxy fight occur:
a- Challenge to current directors by replacing with new directors( change management)
b- Changing directors with new directors to facilitate an acquisition.
c- Seeking a shareholder vote on a policy decision or corporate governance rules.
d- All of the above
3- Under a Berle-Means thesis, much of corporate governance has focused on balancing the cost and
benefits of:
a- The separation of ownership and control the prevent managers from unfairly dealing or
mismanaging the business when shareholders are dispersed.
4- undercapitalization in a piercing the corporate Veil case is determined in most U.S jurisdictions as
including:
a- Equity
b- Loans
c- Liability insurance
d- All of the above
5- Which relationship between the corporation is considered contractual?
b-creditor
6- Which of the following valuation methods focuses on net present value and cash flows?
a- Liquidation value
b- Book value
c- Earnings value
7- Ultra vires results when:
c-the corporation has been incorporated defectively
13-
8- Which of the following are true regarding corporate officers?
e- The power of officers to bind a corporation is usually based on agency principle
f- An officers` s power originates from the board of directors
g- An example of express authority provided to an officer can be evidenced by corporate bylaws, valid
employment contract, or board resolution.
h- all of the above
9- Who is viewed as residual claimants of a
b- common shareholders
10- In a publicly traded corporation, in which situation can a proxy fight occur:
e- Challenge to current directors by replacing with new directors( change management)
f- Changing directors with new directors to facilitate an acquisition.
g- Seeking a shareholder vote on a policy decision or corporate governance rules.
h- All of the above
11- Under a Berle-Means thesis, much of corporate governance has focused on balancing the cost and
benefits of:
b- The separation of ownership and control the prevent managers from unfairly dealing or
mismanaging the business when shareholders are dispersed.
12- the Board of Directors can act within its fiduciary power to run the corporation:
c-Best interest of the corporation, including all of the shareholders
13- undercapitalization in a piercing the corporate Veil case is determined in most U.S jurisdictions as
including:
e- Equity
f- Loans
g- Liability insurance
h- All of the above
Question 1
1.
Which of the following is NOT a factor to piercing the corporate veil
Corporate bankruptcy
Commingling assents and funds
Undercapitalization
Failure to maintain adequate corporate records
Board of directors in a corporation can take action by:
Approving resolution at meetings
Unanimous written consent without a meeting
Approve resolution at meetings or unanimous written consent without a meeting
None of the above
Question 11
1.
Debt is denominated by:
Bonds
Common shares
Preferred shares
Stocks
14- Structural setting for Piercing the corporate Veil include:
a- Parent-subsidiary corporation relationship.
b- Brother-sister (sibling) corporation setting
c- Personal shareholder liability
d- All of the above
15- What is the primary factor to weight when evaluating different securities?
c-Risk
16- The priority of payment of dividends and liquidation rights for preferred shareholders is as follow:
c- After creditors but before common shareholders
17- Which relationship between the corporation is considered contractual?
b-creditor
18- Which of the following valuation methods focuses on net present value and cash flows?
d- Liquidation value
e- Book value
f- Earnings value
19- Ultra vires results when:
c-the corporation has been incorporated defectively
20- In forming a corporation:
a- The incorporator is responsible for filing the article of incorporation
b- The process is complicated and expensive
c- Upon acceptance of articles of incorporation, corporate existence begins
d- All of the above
21- Businesses that need to raise large amount of capital by attracting public investors will choose:
Corporate form
22- A promoter will want to provide for what in a contract with a third party before a corporation is
formed?
Substitution of a new party to a contract (novation)
23- Defective incorporation means:
Loss of limited liability or limited liability that never existed
24- Which of these is a concept related to piercing the corporate Veil?
Must first establish independent basis for holding the corporation liable.
25- In a statutory merger, who must approve the merger?
The board of directors and the shareholders of both the buyer and the seller
26- In a consolidation, where A Inc. and B Inc. merge to form a new C Inc. which companies are in
existence after the merger?
C Inc. only
3rd assign …
Multiple-choice questions (3X1=3)
Q1- In Mergers, the Board of Directors and shareholders must approve the merger by:
51% of the votes. -1
2- 64% of the votes.
3-75% of the votes.
4- It depends on the corporate policy.
Q2 - When a corporation purchases another corporation assets that can not considered as merger because:
The liabilities of the corporation do not transfer to the corporation which purchased the assets.-1
2- It is not require approval from the board of directors and shareholders.
3- The corporation which purchased the assets of another corporation con not control their decisions unlike
mergers.
4- Actually it can consider as merger.
Q3- Aggressor (acquiring corporation) offers target shareholders a price above current market value of their
stock is:
1-Exchange Offer.
tender offer. Cash -2
3- Beachhead Acquisition.
4- Tender Offer.
SEU 301 Companies Law Week 2: (CHAPTER 1)
1. In forming a corporation:
a) The incorporator Is responsible for filing the articles of incorporation
b) The process is complicated and expensive
c) Upon acceptance of articles of incorporation, corporate existence begins
d) All of the above
Source: Paragraph 1.08
2. Ultra vires results when:
a) The corporation has been properly formed
b) The corporation has been incorporated defectively
c) The corporation has acted beyond its purpose or powers
d) The corporation has acted within its purpose or powers
Source: Paragraph 1.10
3. The law of the state of incorporation should govern most intra-govern relationships, such as
a) Between officers and corporation
b) Between directors and corporation
c) Between shareholders and corporation
d) All of the above
Source: Paragraph 1.09
4. Businesses that need to raise large amounts of capital by attracting public investors will choose:
a) Partnership
b) Corporate form
c) Limited Liability Company (LLC)
d) Limited Partnership
Source: Paragraphs 1.04 thru 1.06
5. What are sources of corporate law?
a) Independent legal organizations, like the American Law Institute
b) State Statutes
c) Judicially created common law
d) All of the above
Source: Paragraph 1.02
6. Which of the following is true?
a) Corporations pay tax on the profits they receive and when profits are distributed to shareholders in the form
of dividends; it is again taxed in the hands of the individual shareholders
b) Answers A and D
c) The formation of a partnership requires a formal written agreement
d) A corporation is viewed as a separate entity distinct from its owners
Source: Paragraphs 1.04 and 1.07.
Week 3: (CHAPTER 2)
1. Defective incorporation occurs when:
a) Improper or incomplete filing necessary to create the Corporation or LLC
b) When there has been a piercing of the corporate veil
c) In midlife by Secretary of State Corporation is administratively dissolved for failure to pay annual taxes or file
annual reports
d) A and C
Source: Paragraph 2.01
2. A Promoter will want to provide for what in a contract with a third party before a corporation is formed?
a) Guarantee that corporation will be formed
b) Confirmation of Promoter as party to contract
c) Substitution of a new party to a contract (novation)
d) Fee for signing contract as Promoter
Source: Paragraph 2.02
3. Promoter’s owe a duty of care and loyalty to:
a) The corporation they form
b) Co-promoters
c) Others with financial interests in corporation
d) All of the above
Source: Paragraph 2.02
4. The newly formed corporation will not be subject to the liabilities of contracts entered into by the promoter in
which of the following :
a) Directors affirmatively rejects the contract
b) Directors review the contracts and accept no benefits
c) A and B
d) Directors accept the contract
Source: Paragraph 2.02
5. Defective incorporation means:
a) Loss of limited liability
b) Limited liability that never existed
c) Both A and B
d) None of the above
Source: Paragraph 2.03
Week 4: (Chapter 3)
1. Which of the following are concepts of Piercing the Corporate Veil?
a) Due to abuse of the corporate form, shareholders should be held liable
b) Must first establish an independent basis for holding the corporation liable
c) Piercing the Corporate Veil doctrine is not frequently invoked
d) A and B
Source: Paragraph 3.01
2. What are grounds for piercing the corporate veil?
a) When there is an intermixture of affairs between the concerns of corporation and owners
b) When all corporate formalities have been followed
c) When there is inadequate capitalization
d) A and C
Source: Paragraph 3.03
3. Undercapitalization in a Piercing the Corporate Veil case is determined in most U.S. jurisdictions as including:
a) Equity
b) Loans
c) Liability Insurance
d) All of the above
Source: Paragraph 3.03
4. Structural settings for Piercing the Corporate Veil include:
a) Parent –subsidiary Corporation relationships
b) Brother-Sister (Sibling) Corporation settings
c) Personal Shareholder liability
d) All of the above
Source: Paragraph 3.08
5. What are the characteristics of Enterprise Liability?
a) Common control
b) Contribute to a collective endeavor
c) Multiple corporate veils are disregarded
d) A and B only
e) A and B and C
Source: Paragraph 3.08
Week 5 – (Chapter 4)
1. Attributes that all Securities share include:
a) Risk of loss on investment
b) The power to control the business
c) The ability to share in the success of the business
d) A and C only
e) A and B and C
Source: Paragraph 4.02
2. What is the primary factor to weigh when evaluating different securities?
a) Inflation
b) Lost opportunities
c) Risk
d) All of the above
Source: Paragraph 4.02
3. The priority of payment of dividends and liquidation rights for preferred shareholders is as follows:
a) Before creditors and common shareholders
b) After creditors but before common shareholders
c) After creditors and common shareholders
d) Before creditors but after common shareholders
Source: Paragraph 4.02
4. Which of the following valuation methods focuses on net present value and cash flows?
a) Liquidation value
b) Book Value
c) Earnings Value
d) None of the above
Source: Paragraph 4.05
5. Which relationship between the corporation is considered contractual?
a) Common shareholder
b) Creditor
c) Preferred shareholder
d) None of the above
Source: Paragraph 4.02
Week 6 (Chapter 5):
1. Which of the following are true regarding corporate officers?
a) The power of officers to bind a corporation is usually based on agency principles
b) An officer’s power originates from the board of directors
c) An example of express authority provided to an officer can be evidenced by corporate bylaws, valid
employment contract, or board resolution
d) All of the above
Source: Paragraph 5.07
2. Who is viewed as residual claimants of a corporation?
a) Preferred shareholders
b) Common shareholders
c) Creditors
d) All of the above
Source: Paragraph 5.05
3. In a publicly traded corporation, in which situation(s) can a proxy fight occur:
a) Challenge to current directors by replacing with new directors (change management)
b) Changing directors with new directors to facilitate an acquisition
c) Seeking a shareholder vote on a policy decision or corporate governance rules
d) All of the above
Source: Paragraph 5.05
4. Under a Berle-Means thesis, much of corporate governance has focused on balancing the costs and benefits of:
a) The separation of ownership and control to prevent managers from unfairly dealing or mismanaging the
business when shareholders are widely dispersed
b) corporate governance so officers can run the corporation without unnecessary interference
c) the role of Directors so they can make proper decisions for controlling shareholders
d) B and C
Source: Paragraph 5.02
5. The Board of Directors can act within its fiduciary power to run the corporation:
a) For the interest of the shareholders that elect them
b) Only if the majority of shareholders approve
c) Best interests of the corporation, including all of the shareholders
d) For the benefit of the officers of the corporation
Source: Paragraph 5.06
True and False Questions:
1. Liquidation value is the amount for which the assets could be sold minus the liabilities owed. Ture
2. Courts are more successful when piercing the veil of corporations if the corporations in question have not
followed corporate formalities. Ture
3. Residual claimant refers to preferred shareholders. False
4.
5. Q1-The name of corporation do not change after consideration.
6. False
7. Q2- The government _Ministry of Commerce in Saudi Arabia_ must approve tender offers.
8. True
9. Q3- In mergers, the corporation which continuous to exist is the absorbed corporation.
10. False
questions:
Q1: Define corporations? And list the people who play a really important part in a corporation?
To define corporation clearly there were a number of terms that comes together to describe the existence of corporation. Such as, artificial, intangible, invisible in inspection of law. Existence a meager creature of law, it holds just those properties that been charters of its establishment based on it, whichever expressly, or incidental with its actual existence. moreover, there are different people who play a really important part in a corporation and they are shareholder who consider as the owners of the corporation. And the board of directors been selected by shareholders. Finally, board of directors chose the officers. And the whole people are working upon the law and state regulations to run the corporation smoothly and efficiently. Q2: What are the characteristics of having a Sole proprietorship? Sole proprietorship is one of an important type of a company forms. Which been described as, the existence of property which owned by an individual person who is the owner. Without any formal requirements requested from that promoter for both of ownership or management of that company. The characteristics of having a Sole proprietorship starting with the simplest and flexible structure by the promoter who have to be an individual person. That person is the sole owner and total control with the fully power of decision making. Also, there is no formal requirements needed of how to own or manage or control the business. Therefore, the owner is the responsible for every liability, setting the company's obligations and selecting the employees. And for taxes it's got the lowest charging taxes if we compared it with the corporation. Because it's been taxed over the sole proprietor's marginal tax rate. Finally, it's easy to end and closed the business. From another hand, there were a number of negative characteristics. Such as the huge risk that might face the owner e.g. bankruptcy. The death or long period illness, which case end the business. Finally, the difficulties that raised from limitation of individual owner such as expand the business or rising an extra capital. Q3: What is the legal process in which the corporation can be incorporated?
To answer this question there four general legal processes which have to applied in each corporation type. Firstly, the financial deal. Which been considering the budget and the financial resources. Secondly, the legal roles of capital. And it was considered as the law or resolution that necessity applied within a corporation. Aim to restricted for purposes of both of dividends or other distributions. Thirdly, establishing and forming the fundamental characteristics and structures for the board directors. Fourthly, emphasis that the right, power, and control belong to the shareholder.
There a set of legal process that must been applied in corporation. First of all, At forming the corporation there is only an individual person who is acting as an incorporator. Who prove a set of bylaws. And chose the initial shareholders’ and directors’ meetings. To Assemble for election of directors and officers. Also, Open bank accounts for the corporation. Then Issue shares. Finally, Demeanor other important acts.
Secondly, corporation articles should be filed by the government entity. Thirdly, corporation name must be "unique" differ name than others corporation. finally, Business entity identifier, using a denomination ( Inc., Ltd., Pc, Co or Corp) after the corporation name. some countries considered that, the name of the corporation have to be in an English alphabet or Arabic numerals.
Q4: What are the differences between Partnerships and Corporations?
Advantages & disadvantages
Partnership Corporation
association of two or more persons
co-owners in a business for profit
Owner liable for
partnership debts
separate legal entity
owes its existence to the
state
which Protects owners from:
liabilities
any attacked on its
shareholders that going
after the company .
The entity
No formal action or
written agreement
required
Files articles of
incorporation with state
The form of the entity
Interests are not freely
transferable
Shareholders can freely
transfer shares.
Transferability
ends partnership no effect Interests are not freely transferable
limits continuity of
business perpetual existence Continuity of existence
Right as co-owners to
participate in management
Agent in normal course of
business
Centralized management
Shareholders no
management limited
capacity
Management
pays only one layer of tax
Less expensive to operate
double taxation
Higher costs to operate
Taxation
Cost
Partnership law is more
protective
corporation is protected
against attacks on its
shareholders.
- The protection offered
by the formation of a
corporation is one of the
Protection
biggest advantages of
forming a corporation
Assign... from coordinator - Madinah Branch
1st. assign...
Q1: Define corporations? And list the people who paly a really important part in a corporation?
Answer:
A corporation is an artificial being, invisible, intangible, and existing only in contemplation of law. Being a mere
creature of law, it possesses only those properties which the charter of its creation confers upon it, either
expressly, or as incidental to its very existence.
• Owners are called shareholders • Board of directors (elected by the shareholders) oversees the management of the company
➢ Select officers run the company
Q2: What are the characteristics of having a Sole proprietorship?
Answer:
➢ An individual is the sole owner.
➢ No formal requirements for the ownership and management of the company.
➢ Owner is the principal and can employ people to work for him/her.
➢ Owner is personally liable for the obligations of the business
Q3: What are the differences between Partnerships and Corporations?
Answer:
• Partnership: Owners are personally liable • Corporation
➢ Shareholders are insulated from the liabilities of the corporation. Shareholders are protected from anyone going after the company.
➢ Conversely, the corporation is protected against attacks on its shareholders cr.
➢ The protection offered by the formation of a corporation is one of the biggest advantages of forming a corporation.
Q4: What is the legal process in which the corporation can be incorporated?
Answer:
• When forming a corporation, one person must act as an incorporator. • The articles of incorporation are filed with a government entity. • Name of the corporation must different from any other corporation. • Corporations must also use a denomination after the corporation name such as Inc., Ltd., or
Corp. • Incorporator must:
• Adopt a set of bylaws • Hold the initial shareholders’ and directors’ meetings • Arrange for election of directors and officers • Open bank accounts for the corporation • Issue shares • Conduct other important acts
-----------------------------------------------------------------------------------------
2nd assign …
Q1: Define promoters, and what are the promoters’ responsibilities and duties in regarding to the
corporation?
Answer:
➢ Promotor is someone who takes responsibility for the existence of the business.
➢ Promoters:
❖ Bring important parties together
❖ Raise capital
❖ Make arrangements for the business
➢ Promoter’s fiduciary duties
❖ Must be loyal to other promoters, the corporation being formed, and investors in the corporation.
❖ May not profit self-deal or secretly profit from his/her duties.
❖ Must act in the best interests of the company.
Q2: When defective incorporation occurs? And “De Facto Corporation” consider as one of the remedies for
defective incorporation and it has three elements that must be satisfy, what are they?
Answer:
➢ According to the text, “the de facto corporation defense has three elements.
❖ There must be a law pursuant to which the contemplated enterprise could have incorporated.
❖ The defendants must prove a good faith or “colorable” attempt to incorporate under that law.
❖ The defendants must demonstrate actual use or exercise of the corporate powers the participants believe themselves to have, which in the usual case will involve doing business under a corporate name.”
Q3: On what grounds will the court be able to pierce the corporate veil? And discuss two of them in more
details.
Answer:
• Intermixture of affairs “Refers to the blurring of the distinction between the concerns of the corporation
and those of the owners. When affairs are intermixed, it becomes difficult for a third party to determine
where the affairs of the owner leave off and those of the incorporated business begin.
This ground for piercing the corporate veil usually occurs in connection with, and is closely related to, the next ground, lack of observation of form”
• Lack of corporate formalities Courts are more successful when piercing the veil of corporations if the corporations
in question have not followed corporate formalities. “Failure to observe formalities may indicate an impermissible intermixture of affairs
or may indicate the use of a corporation as a “mere instrumentality.” • Inadequate capitalization
Q4: Define and discuss the legal rules for each of the following terms:
✓ Par value ✓ Dividends and repurchasing of share
Answer:
1. Par Value: Minimum price at which a share must be sold.
✓ The board of directors sets the price for the shares of the corporation. ✓ However, government agencies may require the share price be set at a certain value. ✓ Almost all shares are sold at the par value. ✓ Par value assures creditors that the corporation has a cushion to pay them.
2. Dividends and repurchasing of share
“Dividends are payments to shareholders which represent a current return on investment.32 Dividends are paid at the discretion of the directors. As an alternative to paying dividends, the board of directors may decide to have the
corporation buy back or repurchase shares. Like dividends, this repurchase is another means by which shareholders may receive funds from
the corporation. The basic principle is not to permit payment of dividends or stock repurchases in cases where
the payment will adversely impact investors or creditors.”
1- Name two of the reasons for court ordered involuntary dissolution of corporation?
❖ Defunct corporations may be reinstated b filing annual reports and paying fees owed.
❖ Neither shareholders nor their attorney can reinstate a company after the two year period has elapsed.
2-What is the definition of consolidation?
Consolidations occur when corporation A and corporation B merge into a new corporation, corporation C.
Corporation A and Corporation B cease to exist as individual corporations.
----------------------------------------------------------------------------------------------------------------------------- ----- End.-----
1. Duty of loyalty is protected under business judgment rule.
False
2. A corporate fiduciary who unfairly profits from her corporate role is committing
Abuse of position.
True
3. Fiduciary rules are stricter on duty of care than on duty of loyalty.
False
4. The right to vote for directors is the most significant right that the shareholders
of publicly traded corporations possess.
True
5. Publicly held corporations have fewer shareholders than closely held
corporations.
False
6. Shareholders must approve the sale of the assets of the company that is being
merged.
True
7. Defunct corporations can be reinstated.
True
8. Under business judgment rule, courts will review the decision itself, not the
decision making process.
False
Of - 2 - Page 8
9. Breach of duty of care can arise in two kinds of situations; nonfeasance arises
when there is a failure to act or monitor where a loss could have been prevented.
However, malfeasance occurs when there is a decision made in a negligent
manner.
True
10. The allocation of power between the shareholders and the directors and officers
is a significant issue in corporate law.
True
11. Piercing the veil vertically occurs when the claimant try to reach down to the
assets of another corporation which is the sibling of the corporation first sued.
False
12. Insider trading is the use of the information to trade or give other people tips
that a trade is going to occur.
True
13. Attorneys, accountants, and commercial bankers may become insiders, or
temporary insiders, when they learn of nonpublic information during the course
of performing services for the corporation.
True
14. Directors are responsible to carefully review all contracts made by promoters
on behalf of the corporation.
True
15. When a corporation sells its shares to a large number of investors, it becomes
privately held.
False
16. Enforcement of fiduciary duty is used to reduce mismanagement of the
company or unfair self-dealing.
True
17. "Corporate governance is ""the system by which companies are directed and
controlled."
True
18. Control group cannot monitor potential mismanagement.
False
19. Controlling shareholders can use their control to self-deal unfairly with the
assets of the corporation.
False
20. Judicial scrutiny may be higher if controlling shareholders are involved in the
sale of a corporation.
True
21. Owner is personally liable for the obligations of the business in sole
proprietorship.
True
22. "In a duty of good faith cases involving a conflict of interest, there is more
Of - 3 - Page 8
Law 401- Companies Law
judicial involvement and scrutiny than in duty of care or loyalty cases."
False
23. Any recovery from derivative litigation goes to the corporate treasury.
True
24. Compensation paid to executives and directors may raise both duty of care and
duty of loyalty issues.
True
25. A tipper has the same liability as an insider who actually trades.
True
Of - 4 - Page 8
a. Defective incorporation occurs when a clerk not filing paperwork or
the government agency sending back the paperwork.
1. The owner of are protected from anyone going after the company.
b. a partnership business c. a Limited liability Partnership business d. a Limited liability
2. One qualification of a proper plaintiff-shareholder is that of the , that the plaintiff not have any complicity in the
wrongdoing.
a. Clean hands requirement
b. Adequate representation requirement c. Contemporaneous ownership requirement d. Record ownership requirement
3. Which of the following roles are NOT classified as part of the incorporator
duties?
a. The incorporator is responsible for filing the articles of incorporation. b. Organizing the initial meeting of the board of directors and
shareholders.
c. Run “day-to-day” business of firm d. Raise capital
4. Which of the following statements is true?
b. "The concepts of Piercing the Corporate Veil is due to abuse of the corporate form, shareholders should be held liable."
c. Preferred stock has lower priority and greater risks of loss. d. a & b are correct.
a. a corporation
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5. Fiduciaries are bound by: a. Duty of loyalty only b. Duty of care and duty of loyalty c. Duty of good faith d. b & c.
6. is primary factor to be weighed against potential return in
deciding among business investment opportunities.
a. Lost opportunities.
b. Risk.
c. Inflation. d. All of the above.
7. are often referred to as residual claimants.
a. Corporate directors. b. Preferred shareholders. c. Creditors of the corporation. d. Common shareholders.
8. Which of the following statements is correct?
a. Shareholders are held liable for the defunct corporation. b. Shareholders and their attorney can reinstate a company after the two
year period have elapsed.
c. Shareholders are not held liable for the defunct corporation.
d. Defunct corporations cannot be reinstated.
9. Which of the following is defined as the minimum price at which a share must
be sold?
a. Book Value b. Liquidation value c. Par value d. None of the above.
10. "If one or more shareholders sue the corporation alleging that the corporation
has denied them a contract right associated with shareholding, the action is :"
a. Private Litigation b. Direct litigation c. Derivative Litigation d. None of the above
11. Salaries, bonuses, pensions, fringe benefits, restricted stock, severance packages, golden parachutes, and stock options are all forms of .
a. The strong form approach b. Common law c. Judicial review
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d. Executive compensation
12. Which of the following is (are) factors that result to pierce the corporate veil? a. Lack of corporate formalities
b. Inadequate capitalization
c. Intermixture of affairs
d. All of the above
13. If a shareholder, or a group of shareholders acting together, own a majority of voting shares of a corporation, it usually means for most
shareholder decisions.
a. Deadlock votes b. Non-participation c. De jure control d. De facto control
14. Which SEC rule covers a wide variety of fraudulent activity, including ‘insider trading’?
a. Rule 14a-9 b. Rule 144 c. Rule 10b-5 d. Rule 17a-3
15. existence of the business.
a. A director b. A subscriber c. A shareholder
is someone who takes responsibility for the
d. A promoter
16. Traditionally, the duty of loyalty was raised when the fiduciary had a (n) with the corporation, which could involve a use of position for
personal gain, taking something that belongs to the corporation, or some form
of self-dealing with the corporation.
a. Duty of disclosure b. Lawsuit c. Conflict of interest d. Promoters’ liability
17. A transaction in which a director contracts unfairly with her own corporation, creating a conflict of interest, is called a (n) .
a. Unfair contract b. Interested director transaction
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c. Director mishandling d. Tender offer
18. occur when purchasers bought the controlling interest at a premium to loot the primary assets of the company.
a. Pro rate sharing rule b. Mandatory bid rule c. Tender offer d. Looting
19. A corporate fiduciary who unfairly profits from her corporate role is committing .
a. Legal advantages b. Directorship benefits c. Subsidiary action d. Abuse of position
20. Shareholders have the following rights, except: a. Day-to-day business operations
b. Proxy fight
c. Proxy voting
d. Right to information
21. A pro rata sharing rule allows a purchaser to buy as many shares as she wants
to obtain control without being required to buy 100%, but she must make that
offer at the same price to .
a. All shareholders
b. Controlling shareholders
c. The subsidiary
d. The parent
22. Which of the following is not a type of qualifications of a proper plaintiff- shareholder?
a. Adequate representation requirement b. Selection of lead counsel c. Record ownership d. Fringe benefits
23. What is the term for the ‘use of nonpublic information by any person having a relationship [director, officer, attorney] giving access, directly or indirectly, to
information intended to be available only for a corporate purpose and not for
the personal benefit of anyone’?
a. Parent corporation
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b. Insider trading c. Merger d. Shareholder control
24. Under......................................Purchaser may buy as many shares as they want to achieve control without buying 100% of the shares.
a. Mandatory bid rule b. hostile takeover c. Pro rate sharing rule d. looting
25. "Daily operations of a business are delegated to , who can be
appointed by ........................... "
b. "the board of directors, the corporate shareholders." c. "the corporate promoters, the board of directors." d. "the corporate shareholders, the corporate officers."
*******End of Exam*******
Good Luck
a. "the corporate officers, the board of directors."
1
Week 9 (Chapter 8)
1. Examples of Lack of good faith include:
a) An intentional act in not advancing the corporation’s best interest
b) An intent to violate positive law
c) Intentionally failing to act when in the face of a duty to act
d) All of the above
Answer: D
Source: Paragraph 8.06
2. What of the following is an example of Fiduciary Duty?
a) Duty of disclosure
b) Duty to act lawfully
c) Duty to monitor
d) A and B only
e) A and B and C
Answer: E
Source: Paragraphs 8.06, 8.07, & 8.08
3. Identify the major policy approaches and methods used to enforce fiduciary duty:
a) Litigation as a means of enforcing duty
b) Civil penalties and criminal law as a means of enforcing duty
c) Contracts between shareholders and Directors/Managers as a means of enforcing duty
d) A and B only
e) A and B and C
Answer: D
Source: Paragraph 8.02
4. Breach of the Duty of Care can arise:
a) Failure to act or monitor where a loss could have been prevented
b) Decision made in a negligent manner
c) A and B
d) None of the above
Answer: C
Source: Paragraph 8.03
5. The purpose of the business judgment rule is:
a) Set a standard of conduct
2
b) Limits judicial inquiry into the substance of a Director’s business decisions
c) Allow judicial inquiry into the substance of a Director’s business decision
d) Does not allow a judicial review of the process of a business decision
Answer: B
Source: Paragraph 8.03
Week 10 (Chapter 9)
1. The following is an example of a duty of loyalty and a conflict of interest:
a) A Director who contracts fairly with his own corporation in buying corporate assets
b) An Officer who contracts unfairly with the corporation in buying corporate assets
c) A Director who contracts unfairly with the corporation in buying corporate assets
d) C and D
Answer: D
Source: Paragraph 9.03
2. In corporate law, “waste” is referred to as a transaction, such as an example of options for
executive compensation,
a) Which is a gift
b) Involves nominal, or almost no consideration (payment or services)
c) Unnecessary
d) All of the above
Answer: D
Source: 9.04
3. Different approaches in dealing with Interested Director transactions could include:
a) Fairness in process and substance test (business judgment test)
b) Use of a disinterested Board to approve the transaction plus fairness in process and
substance (business judgment) test
c) Use of a disinterested Board approval, but no fairness test
d) All of the above
Answer: D
Source: Paragraph 9.03
4. Shareholders may vote on a transaction to:
a) Voting on amendments to the articles of incorporation as required by Statute
b) Optional voting, to potentially minimize judicial scrutiny
c) To ratify a transaction already completed
3
d) All of the above
Answer: D
Source: Paragraph 9.06
5. In evaluating corporate opportunity and abuse of position cases, the courts have used which of
the following tests in their evaluation:
a) Interest or Expectancy test
b) Line of Business Test
c) Fairness Test
d) A and C only
e) A and B and C
Answer: E
Source: Paragraph 9.05
Week 11 (Chapter 10)
1. What of the following are disadvantages for shareholders in a corporation with a control group:
a) Many of the monitoring devices when there is separation of ownership and control are not
available
b) Truly independent directors are less likely to serve on the board of directors
c) A and B
d) None of the above
Answer: C
Source: Paragraph 10.01
2. Which of the following are examples of unfair dealing by controlling shareholder:
a) Self-dealing unfairly with the assets of a corporation when not acting solely as a
shareholder, but in its control of the Directors
b) In a Parent-Subsidiary structure, contracting fairly with the subsidiary as determined under
an intrinsic fairness test
c) In a sale of an entire company, securing the best value reasonably attainable for all
shareholders
d) All of the above
Answer: A
Source: Paragraph 10.02
4
3. Which, if any of the following represent sale of control?
a) Selling shares by the controlling group for a premium to allow the purchaser to loot the
corporation of its liquid assets
b) The contribution of shares by a control group into a holding company and the subsequent
public sale of the holding company
c) The purchase of less than 51% of the Company, but due to wide dispersion of shares, de
facto exists sufficient to replace directors of the corporation by resignation instead of a
shareholder vote
d) All of the above
Answer: D
Source: Paragraph 10.04
4. Which of the following are steps in a Freezeout Merger:
a) Controlling shareholder creates a subsidiary (“Newco”)
b) Controlling shareholders of old corporation vote to merge into Newco
c) Merger agreement provides for minority shareholders to receive cash or securities
d) A and B only
e) A and B and C
Answer: E
Source: Paragraph 10.03
5. Which of the following factors generally exist in a Management Buyout (“MBO”)
a) Management who did not control the corporation, decide to take the Company private by
buying the shares of public shareholders at a premium
b) Heavy borrowing to finance the acquisition, usually by using the assets of the corporation as
security (leverage)
c) A and B
d) None of the Above
Answer: C
Source: Paragraph 10.03
Week 12 (Chapter 12)
1. Which method of acquiring control of a corporation does not require the approval of the board
of Directors of the target corporation?
a) Acquire substantially all of the assets of the Corporation
b) Merger of the target corporation into buying corporation or buying Company’s subsidiary
c) Acquire stock from Shareholders
d) All of the above
5
Answer: C
Source: Paragraph 12.1
2. Bidders in a hostile tender officer can do which of the following:
a) Not accept all shares tendered
b) May set conditions to receive enough shares
c) Use cash as consideration
d) All of the above
Answer: D
Source: Paragraph 12.04
3. What defensive tactics can Directors of Target Corporation do without a Shareholder vote?
a) Sell off or grant an option to sell significant assets to a third party (“Crown Jewel”)
b) Split the corporation into different component corporations
c) Seek another bidder to serve as a “White Knight”
d) Establish increased compensation plans if a change of control occurs
e) All of the Above
f) None of the Above
Answer: E
Source: Paragraph 12.04
4. In general, the steps in a Poison Pill defensive tactic may include:
a) Define an initial triggering event as an announcement or threat of a tender offer
b) At initial triggering event, target issues redeemable “Rights” to Shareholders
c) At second triggering event (purchase of X percentage of shares of Target), shares become
effective and nonredeemable
d) All of the above
Answer: D:
Source: Paragraph 12.4
5. In most cases, the Courts use which standard of review to evaluate the actions of Directors of
Target in a Hostile Tender Offer?
a) Duty of Care
b) Modified Business Judgment Rule or proportionality Test, under Unocal v. Mesa. Petroleum
c) Duty of Loyalty with Fairness Test and no Business Judgment Rule
d) A and C
Answer: B
6
Week 13 (Chapter 13)
1. Identify which of the following is a requirement in a private right of action in a Disclosure Action
under Rule 10b-5
a) Purchaser-Seller Standing Rule
b) Reliance (Transaction Causation)
c) Loss Causation
d) All of the Above
e) None of the Above
Answer: D
Source: Paragraph 13.02
2. Which of the following support the proposition that prohibition of insider trading is good?
a) Profits made by insiders through their insider trading reward their entrepreneurial efforts
b) Insider trading profits aligns corporate officials’ interests and shareholders owners
c) Would-be investors would believe the cards are stacked against them if insider trading were
to be permitted
d) All of the Above
e) A and B only
Answer: C
Source: Paragraph 13.03
3. The following are ways Insiders are defined for purposes of the Disclose or Abstain
Requirement:
a) Classical Insider (For example, Fiduciary Relationship)
b) Temporary Insider (For example, Attorney, Accountant)
c) A Tipper or a Tippee who meets the receipt of a benefit test and Tipper Breach of Fiduciary
Duty for Tipper-Liability
d) A Misappropriator, or their Tippee (“fraud on the source”)
e) All of the Above
f) None of the Above
Answer: E
Source: Paragraph 13.04
4. What elements are required to meet the definition of Tipper?
a) Insider
b) Passes information to Another
c) Knowing he will trade
d) A and B only
7
e) A and B and C
Answer: E
Source: Paragraph 13.4
5. Regulation FD (Fair Disclosure) under SEC Rules requires the following from multiple speakers of
a corporation:
a) The exact same words
b) The exact same substance
c) May have differing positive or negative interpretations on material information available to
the public
d) A and B
Answer: C
Source: 13.04
Week 14 (Chapter 14)
1. In a Direct lawsuit, a Shareholder can be bring an action:
a) When there is a special duty
b) When there is a contractual duty
c) Establish Denial by the Corporation or Directors of a right relating to Shareholding
d) All of the Above
e) None of the Above
Answer: D
Source: Paragraph 14.02
2. The following are signs of an Indirect (“Derivative”) lawsuit:
a) Mismanagement or self-dealing that has caused a decrease in shareholder value
b) The harm is directly to the corporation
c) The recovery is directly to the corporation, not the shareholders
d) None of the Above
e) All of the Above
Answer: E
Source: Paragraph 14.02
3. The nature of a Derivative lawsuit includes:
a) An action brought by the shareholders on behalf of the corporation
8
b) It is founded on a right of actions existing in the corporation itself
c) The shareholders must make demand on the corporation, which is refused by the
Corporation
d) A and B only
e) A and B and C
4. The standard of review for a special Litigation Committee (SLC) in Delaware Courts include:
a) Disinterested Board of Director Members
b) Degree of due diligence in process
c) Rational basis for Decision
d) In recent cases where demand is excused, the Court’s business judgment rule (Merits of the
Case before Special Litigation Committee)
e) All of the Above
Answer: E
Source: Paragraph 14.06
5. If a Shareholder can establish a cause of action for both a direct and derivative lawsuit, which
lawsuit may he file with the Court?
a) Direct lawsuit
b) Derivative lawsuit
c) Both Direct and Derivative Simultaneously
d) Either Direct or Derivative lawsuit or Both Simultaneously
Answer: D
Source: Paragraph 13.02
9
Chapter 8: Introduction to Fiduciary Duty: The Duty of Care and the Business Judgment Rule
Overview of the Duty of Care and Loyalty-Much of corporate law is about fiduciary duties and
their parameters. In the corporate context, directors and officers are in a fiduciary relationship
to their corporation and its shareholders. Controlling shareholders may also be characterized as
fiduciaries. The primary problems faced by shareholders are mismanagement of the business or
UNFAIR SELF-DEALING by the people who are fiduciaries. The requirements and enforcement of
fiduciary duty serves as a monitoring device to limit those harms.
The characterization of someone as a fiduciary means that the individual has to obey certain
duties and look out for the interests of whomever is owed the DUTY. Most of the duties have
been developed by the common law. A fiduciary is bound by a duty of care and duty of loyalty.
The duty of care requires directors to perform their duties with the diligence of a REASONABLE
PERSON IN SIMILAR CIRCUMSTANCES which vary depending on the context. Most decisions
involving the duty of care are protected under the business judgment rule which creates a
presumption or SAFE HARBOR that limits courts in questioning business decisions. The focus of
the judicial inquiry will usually be on the decision making process RATHER THAN THE DECISION.
The plaintiff has the burden of proof on the issue of breach of the duty of care and courts rarely
look at the substance of the decision. The BUSINESS JUDGMENT RULE does not protect
nonfeasance lack of good faith, conflicts of interest, or an irrational or wasteful decision. A lack
of good faith is a duty of loyalty violation and can involve actual intent to harm the corporation
or an intentional DERELICTION OF DUTY and a conscious disregard for one’s responsibilities. The
traditional duty of loyalty focuses on conflicts of interest where the fiduciary’s or those
associated with her personal interests may be advanced OVER corporate interests. Generally,
the court will scrutinize a duty of loyalty conflict of interest transaction to determine if it is fair.
The court may not only shift the burden of proof to the directors to show fairness but will
inquire as to both the process and substance of the decision that is fairness. In duty of loyalty
cases involving a conflict of interest, there is more judicial involvement and scrutiny than in duty
of care or good faith cases. The difference is justified because in a duty of care case, the courts
protect business decisions that are intended to enhance corporate gain, but in a duty of loyalty
involving a conflict of interest case the directors are motivated by personal gain.
Sliding Scale-There is a sliding scale of different fiduciary duty rules. Some cases fall between
those duties because the legal standards and burdens may differ in a given case from traditional
loyalty conflicts of interest and care.
As the Delaware Supreme Court indicated in Guth v. Loft, fiduciary duty is subject to NO FIXED
SCALE. The courts, in establishing the legal rules of fiduciary duty, attempt to balance the need
of the fiduciary to act with the protection of the shareholders. There is a tension between the
judicial hands off approach reflected in the business judgment rule and the extensive judicial
scrutiny of a fairness inquiry in duty of loyalty cases. The extent of judicial scrutiny is the key
issue in these cases with plaintiffs seeking extensive judicial scrutiny arguing loyalty conflicts of
interest and defendants seeking minimal judicial scrutiny arguing for application of the business
judgment rule.
Plaintiff shareholders would prefer the courts use a loyalty analysis of conflicts of interest
BECAUSE the defendants have the burden of proof and there is active judicial scrutiny of both
the fairness of substance and process.
Defendants seek limited judicial involvement under the protection of the business judgment
rule which places the burden on the plaintiff to prove that the rule should not apply.
Some courts will MODIFY THE LEGAL STANDARD or shift the burden of proof. For example,
Delaware courts e sometimes scrutinize the implementation of defensive tactics involving
corporate CONTROL and apply a modified business judgment rule or PROPORTIONALITY TEST
with some burden of the directors and some judicial scrutiny of REASONABLENESS. But if the
directors’ primary purpose was to impede or interfere with the effectiveness of shareholder
voting in a contested election, Delaware courts applied a strict duty of loyalty and defendants
needed to prove not fairness but a compelling justification.
Policy Issues-The fiduciary duty of those who manage or control is to the corporation and
shareholders and shareholders have the right to enforce it through litigation. Controlling
shareholders also have some right to use their control for their own personal benefits. Not all
self-dealing is necessarily unfair to the minority shareholders but there needs to be some check
on the power of those who control the business because all of the shareholder’s money is at
risk. The interests of the managers or control persons and the owners are aligned because a
successful business benefits everyone.
Law and Economics Approach-The debate about fiduciary duty rules reflects the differences in
theories of and approaches to corporate law. Some commentators who approach corporate law
from the law and economies perspective view the relationship between the shareholders and
managers as a matter of contract. Under this view, investors could actually contract for this
obligation but the law instead imposes the responsibility because it would be expensive and
time consuming to negotiate detailed contracts delineating managers’ obligations. The law
eliminates the need to actually enter a contract and provides standardized rules which lower
transaction costs of actually contracting. Given the need for managerial flexibility, these
fiduciary rules are rarely detailed. At the same time, since they are based on contract, these
rules are like default rules and should be able to be modified by the parties in order to allow for
efficient private ordering. Thus, under this view, legal rules, and particularly fiduciary duty, can
be contracted away. If needed, there are market mechanisms available that are more effective
in enforcing fiduciary duty.
Duty of Care-Traditionally, liability under the duty of care required finding duty, breach,
proximate cause and loss. The directors’ fiduciary duties have developed primarily through case
law although the duty of care is often described in some state statutes. The traditional statutory
provision indicates that directors must discharge their duties in good faith, with the care an
ordinarily prudent person in a like position would exercise under similar circumstances and in
manner reasonably believed to be in the best interest of the corporation. Nonfeasance-The duty
of care requires directors to undertake certain responsibilities. In Francis v. United Jersey Bank,
the New Jersey Supreme Court set out a model of how directors should act. This case involved
nonfeasance involving a family owned and closely held corporation which operated as a
reinsurance broker. These brokers arrange for the sale among insurance companies of some of
the insurance risks under their policies facilitating the diversification of that risk. RULE: In
general, the relationship of a corporate director to the corporation and its stockholders is that of
a fiduciary. Shareholders have a right to expect that directors will exercise reasonable
supervision and control over the policies and practices of a corporation. The institutional
integrity of a corporation depends upon the proper discharge by directors of those
duties. FACTS: Pritchard & Baird Intermediaries Corporation (P&B) was a broker between ceding
insurance companies and reinsurance companies. They earned a commission on the
transactions between the two entities. Typically, brokers in the reinsurance business hold funds
from the ceding and reinsuring companies in a separate account and pay each party from that
account. The former CEO of Pritchard & Baird Intermediaries Corporation (P&B), Charles
Pritchard, Sr. (the husband of Lillian Pritchard) did not practice this method, but he still ensured
that the funds deposited by third parties were never used as personal funds. Charles Pritchard,
Sr., eventually stepped down and his two sons controlled the business. Once the sons had
control they took out personal loans from the account but never paid back the loans or any
interest. This practice of misappropriating funds continued until P&B could no longer meet their
obligations, and they went into bankruptcy. During the entire period that the sons controlled
P&B, Lillian was the majority shareholder and sat on the Board as a director. During her tenure
as director, she never participated in any business matters of P&B. Defendant argued that Lillian
was elderly and sick, and therefore should be excused for her absence.
ISSUE: Is Lillian Pritchard personally liable for negligently failing to prevent the misappropriation
of P&B funds by her sons? ANSWER: Yes.
CONCLUSION: Lillian Pritchard, as a director on the Board, had a duty of care in managing the
business. She did not have to know every detail of day-to-day operations, but she needed to
have a baseline understanding of the finances and important activities. If she did not understand
the activities, then she was obligated to consult counsel for advice. Her absence from the
business did not excuse her duties. The court determined that if she did intervene in the
dubious financial decisions of her sons, or at least consulted an attorney or expert, it may have
prevented her sons from fleecing the company. Therefore, her lack of care was a proximate
cause of the damages to the company and the third parties who relied upon the company.
Because of the nature of the business (holding assets of third parties), she was liable to the third
parties for any damages.
Malfeasance and the Business Judgment Rule-Due care for directors requires that they be
INFORMED AND DELIBERATE WHEN MAKING a decision. When directors are accused of violating
the duty of care by making a negligent or ill-advised decision which can even involve a decision
not to act they are accused of MALFEASANCE.
Causation-The fact that a director breaches her duty and is negligent does not often end an
inquiry because traditionally the negligence must be the PROXIMATE CAUSE OF THE LOSS. There
must be a finding of causation in fact that the defendant’s actions or omissions were a necessary
antecedent of the LOSS.
The Smith v. Van Gorkom Case- RULE:
The business judgment rule is a presumption that in making a business decision, the directors of
a corporation acted on an informed basis, in good faith and in the honest belief that the action
taken was in the best interests of the company. Thus, the party attacking a board decision as
uninformed must rebut the presumption that its business judgment was an informed one.
FACTS: In a class action against defendant Trans Union Corporation (“Trans Union”) and its
board of directors, plaintiffs, who are shareholders of Trans Union, claimed that the approval of
the cash-out merger of their corporation violated Del. Code Ann. tit. 8, § 251, and did not
warrant business judgment rule protection. It appeared that Trans Union, though generating
hundreds of millions annually, has difficulty offsetting large investment tax credits (ITCs), thus,
Trans Union pursued a program of acquiring small companies to increase taxable income that
may offset the ITCs. Thus, a cash-out merger was entered between Trans Union and New T
Company (“New T”), a wholly-owned subsidiary of the defendant, Marmon Group, Inc.
("Marmon”). The merger was largely due to the efforts exerted by Defendant Jerome W. Van
Gorkom, Chairman and CEO of Trans Union, who struck the deal with Jay A. Pritzker, a known
corporate takeover specialist and owner of Marmon and its subsidiaries. Van Gorkom
successfully convinced the board of the $55 price per share cash-out merger. The price was
merely assumed by Van Gorkom and is not supported by any valuation information. Following
trial, the former Chancellor granted judgment for the defendant directors. Judgment was based
on two findings: (1) that the Board of Directors had acted in an informed manner so as to be
entitled to protection of the business judgment rule in approving the cash-out merger; and (2)
that the shareholder vote approving the merger should not be set aside because the
stockholders had been "fairly informed" by the Board of Directors before voting thereon. The
plaintiffs appeal.
ISSUE: Were the rulings of the Court of Chancery correct?
ANSWER: No.
CONCLUSION: The Court here concluded that both rulings of the Court of Chancery are clearly
erroneous. The Board's decision to approve the proposed cash-out merger was not the product
of an informed business judgment since they based their decision on one Van Gorkom’s
representations, which did not constitute a report on which they could reasonably rely under
Del. Code Ann. tit. 8, § 141(e), and that they did not seek documentation of either the merger
terms or the adequacy of the proposed price per share. The court also found defendant
directors were grossly negligent in permitting the agreement to be amended in a way they had
not authorized. Finally, the directors of Trans Union breached their fiduciary duty to their
stockholders (1) by their failure to inform themselves of all information reasonably available to
them and relevant to their decision to recommend the cash-out merger; and (2) by their failure
to disclose all material information such as a reasonable stockholder would consider important
in deciding whether to approve the Pritzker offer the court found that the stockholders' vote did
not ratify the action, because the stockholders weren't aware of the lack of valuation
information, and because defendant directors' statements were misleading.
The Demise of the Duty of Care-Plaintiffs bringing duty of care cases are rarely successful in
court. They have to prove some form of negligence and in some cases CAUSATION.
Delaware General Corporation Law Section 102(b)(7)-With the enactment of Delaware General
Corporation Law Section 102(b)(7) Without the possibility of damages, plaintiffs’ attorneys were
less willing to bring duty of care cases to court since their fees are paid from those damages
recovered in a lawsuit.
Since damages for both duty and loyalty and acts or omissions not in good faith are explicitly
excluded from the statutory limitation on damages, plaintiffs would try to allege either to avoid
the limitation on damages. Intentional ignorance or willful blindness to problems may be
sufficient to show a conscious disregard of fiduciary duty and thus bad faith.
Good Faith-Plaintiffs have tried to avoid the limitation on damages in a duty of care case as a
result of the provisions from Delaware’s Section 102(b)(7) by arguing that the defendants did
not act in good faith. Lack of good faith is a duty of loyalty violation.
Disney Litigation and Good Faith- RULE:
Fundamentally, the duties traditionally analyzed as belonging to corporate fiduciaries, loyalty
and care, are but constituent elements of the overarching concepts of allegiance, devotion, and
faithfulness that must guide the conduct of every fiduciary. The good faith required of a
corporate fiduciary includes not simply the duties of care and loyalty, but all actions required by
a true faithfulness and devotion to the interests of the corporation and its shareholders. A
failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts
with a purpose other than that of advancing the best interests of the corporation, where the
fiduciary acts with the intent to violate applicable positive law, or where the fiduciary
intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard
for his duties.
FACTS:
Plaintiff stockholders alleged that defendant directors breached their fiduciary duties in
connection with the 1995 hiring and 1996 termination of a corporation's president. The
president was hired in large part due to the efforts of the company's chief executive officer
(CEO).
ISSUE:
Did the directors comply with their fiduciary duties in connection with the president's hiring and
termination?
ANSWER:
Yes.
CONCLUSION:
The court found that the president did not commit gross negligence or malfeasance while
serving as president. As a result, terminating him and paying a no-fault termination payment
(NFT) did not constitute waste because he could not be terminated for cause. The directors did
not act in bad faith, and were at most ordinarily negligent, in connection with his hiring and the
approval of the employment agreement. The CEO stretched the outer boundaries of his
authority by acting without specific board direction or involvement, but did not act in a grossly
negligent manner, and his actions were taken in good faith. None of the other directors
breached their fiduciary duties or acted in anything other than good faith in connection with the
hiring, the approval of the employment agreement, or the president's election. Therefore, the
fact that no formal board action was taken with respect to his termination was of no import.
The Duty to Monitor and Stone v. Ritter- RULE:
The necessary conditions predicate for director oversight liability are: (a) the directors utterly
failed to implement any reporting or information system or controls; or (b) having implemented
such a system or controls, consciously failed to monitor or oversee its operations thus disabling
themselves from being informed of risks or problems requiring their attention. In either case,
imposition of liability requires a showing that the directors knew that they were not discharging
their fiduciary obligations. Where directors fail to act in the face of a known duty to act, they
breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.
FACTS: Two individuals were operating a Ponzi scheme, which operated the majority of its
funding through AmSouth bank. Ultimately, two Ponzi scheming people were convicted and the
bank was required to pay over $50 million in fines. The evidence suggests that employees would
have discovered this information immediately had they instituted any basic monitoring system.
As result of the loss to the company in fines, shareholders sued the bank derivatively claiming a
lack of oversight on the part of the directors.
ISSUE: When specified facts do not create a reasonable doubt that the directors of a corporation
acted in good faith in exercising their oversight responsibilities, will a derivative suit be
dismissed for failure to make demand?
ANSWER: Yes
CONCLUSION: Where a business decision was not involved, as in this case, the standard to
determine demand futility is whether the particularized factual allegations create a reasonable
doubt that, as of the time the complaint was filed, the directors could have exercised their
independent and disinterested business judgment in response to a demand. The Plaintiffs’
attempt to satisfy this standard by claiming that the Defendant faces a substantial likelihood of
personal liability, and therefore causes them to be interested in the outcome. This argument,
however, must take into account the certificate of incorporation’s exculpatory clause, which can
exculpate Defendant from a breach of the duty of care, but not a breach of their duty of loyalty
or a breach that is not in good faith. The failure to act in good faith is a condition to finding a
breach of the fiduciary duty of loyalty and imposing fiduciary liability. “[A] failure to act in good
faith is not conduct that results, ipso facto, in the direct imposition of fiduciary liability.” Failing
to act in good faith may result in liability because the requirement to act in good faith is a
condition of the duty of loyalty.
Duty of Disclosure-Disclosure has always been an important aspect of fiduciary duty. Full
disclosure is required to shareholders and to the stock market. Courts have held that directors
who knowingly disseminate false information that results in corporate injury or damage to an
individual stockholder violate their fiduciary duty and may be held accountable in a manner
appropriate to the circumstances when shareholder action such as a vote is needed or filings are
made to Securities and Exchange Commission.
Duty to Act Lawfully-Directors are also required to act in a lawful manner. Delaware law
suggests that a failure to at lawfully implicates a lack of good faith and the duty of loyalty but
other states may view it as an independent duty. In Miller v. American Telephone and Telegraph
Co (AT&T)
CASE SYNOPSIS: Appeal from the United States District Court for the Eastern District of
Pennsylvania by plaintiff stockholders in a derivative case alleging breach of fiduciary duty by
defendants, the corporate officers and directors, and violations of 18 U.S.C.S. § 610.
CASE FACTS: Plaintiffs alleged that defendants had violated 18 U.S.C.S §610. Plaintiffs sought
permanent relief in the form of an injunction requiring defendants to collect the debt, an
injunction against providing further services to the political party until the debt was paid in full,
and a surcharge for the benefit of the corporation against the defendant directors in the amount
of the debt plus interest from the due date.
PROCEDURAL HISTORY: A request for a preliminary injunction against the provision of services
to the political party was denied by the district court after an evidentiary hearing.
DISCUSSION: On appeal, the court ruled directors had to be restrained from engaging in
activities that were against public policy. The business judgment rule did not insulate the
corporate directors from liability for breaching §610 prohibiting corporate political
contributions.
CONCLUSION: The court reversed the lower court and remanded the case stating that directors
must be restrained from engaging in activities that were against public policy.
Chapter 9: The Duty of Loyalty and Conflicts of Interest Lecture Notes
The duty of loyalty requires a fiduciary person to act in the best interests of the corporation. The
duty of loyalty was raised when the fiduciary (or those associated with him or her) had a conflict
of interest with the corporation, suggesting that personal interests may be advanced over
corporate interests.
Conflicts of interest may involve a use of position for personal gain, taking something that
belongs to the corporation, or some form of self-dealing with the corporation where the
fiduciary is on both sides of a transaction and in a position to receive a benefit unavailable to
other shareholders. Generally, when the duty of loyalty in a conflict of interest APPLIES there is
a duty of complete candor the burden of proof shifts to the directors; and there is greater
judicial scrutiny of both the fairness of the process and the substance of the transaction
(sometimes described as entire fairness).
Policy-The duty of loyalty is different from the duty of care in that it seeks to prevent directors
from acting against the BEST interests of the corporation or self-dealing in such a way as to reap
a personal benefit unavailable to other shareholders.
The duty of care involves poor decision making or lack of ATTENTION but no personal benefit.
Self-dealing leads to corruption at the expense of the corporation and its shareholders. A person
who is self-dealing seeks to avoid disclosure and detection and self-dealing may be difficult to
detect. Even the LAW AND ECONOMICS APPROACH to corporate law which prefers to rely on
market forces instead of litigation to influence corporate behavior recognizes that markets may
be unable to effectively restrain opportunistic behaviors like self-dealing. Managers may use
their power for a one-time significant personal benefit that far exceeds the penalty of the
markets. The fiduciary rules of the duty of loyalty are stricter than the duty of care and may not
be appropriate for modification through amendments to the articles of incorporation.
There is also a strong moral basis to impose fiduciary responsibility in loyalty situations and
some cases and courts reflect these ideas. The traditional view is that fiduciary duty means that
the fiduciary is responsible for someone else and should consider the other person’s interest
AHEAD or over his or her own best interest.
In the case in our textbook, Meinhard v. Salmon, The Judge advised that there are many forms
of conduct allowed in the work environment for those acting at arm’s length but they may are
forbidden to those bound by fiduciary ties. A trustee, for example, is held to something stricter
than the morale of the marketplace. The courts hold the trustee to uncompromising rigidity
under the rule of undivided loyalty. RULE: Joint adventurers, like copartners, owe to one
another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct
permissible in a workaday world for those acting at arm's length are forbidden to those bound
by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not
honesty alone, but the punctilio of an honor the most sensitive is then the standard of behavior.
FACTS OF THE CASE: A joint venture existed in which two partners pooled their money in order
to lease a building for shops and offices. Salmon (defendant) was more business savvy and, in an
effort to increase his wealth, he entered into an agreement with another businessperson to
purchase surrounding property as a leasehold estate. The specifics of this transaction were not
disclosed to Meinhard (plaintiff), and he subsequently sued for breach of the joint venture
agreement when he discovered the transaction. Litigation ensued and Meinhard received a
substantial judgment for breach of contract. The case was appealed.
ISSUE: Was Meinhard entitled to proceeds resulting from Salmon's purchase of a leasehold
estate where Salmon’s lucrative position arose from the creation of a joint venture?
ANSWER: Yes
CONCLUSION:
The Court held that Meinhard was entitled to proceeds resulting from Salmon’s purchase of a
leasehold estate where Salmon's lucrative position arose from the creation of a joint venture.
Salmon would not have been in the rewarding leasehold position if it were not for the joint
venture. Accordingly, after lessening stock distribution, the Court reaffirmed the lower tribunal's
finding on behalf of the Meinhard.
Interested Director Transactions-A classic duty of loyalty defendant is a fiduciary (a director or
officer or in some cases controlling shareholders) who contracts or transacts unfairly with her
own corporation receiving a benefit that is NOT equally shared with the other shareholders and
this creates a CONFLICT OF INTEREST.
In recognition of changed corporate practices, the courts moved from a void standard to a
voidable standard. Under this approach, the courts generally focused on the fairness of the
process of approval and the substance of the transaction. The process would require full
disclosure and approval by either disinterested directors or shareholders. The contract itself
would need to be fair and the burden of proof would generally be placed on the fiduciary. But
loyalty claims also allow the courts to create broad, discretionary and equitable remedies.
Globe Woolen Co. v. Utica Gas & Electric Co. case brief summary
121 N.E. 378 (1918)
CASE SYNOPSIS: Plaintiff company appealed from the judgment of the Appellate Division of the
Supreme Court in the Third Judicial Department (New York) that affirmed a judgment of the trial
court to annul contracts made with defendant electric company.
FACTS OF THE CASE: The company, which operated mills, brought this action against the electric
company to compel the specific performance of contracts to supply electricity to the mills. The
electric company argued that the contracts were made under the dominating influence of a
common director and that their terms were unfair and oppressive.
HOLDING: The trial court held in favor of the electric company and annulled the contracts, and
the appellate court affirmed.
DISCUSSION: In affirming this judgment, the court held that the common director's refusal to
vote on the contracts did not nullify the influence and predominance that he had exerted in
arranging the contracts.
Findings: The court found that as a result of the contracts, the electric company was losing large
amounts of money and that such consequence was foreseeable to the common director who
stood by and said nothing while the contracts were presented to the other directors of the
electric company as a mere formality.
CONCLUSION
The court affirmed the judgment in favor of the electric company, which annulled contracts that
it made with the company.
Common Law-In the case mentioned in our textbook, Globe Woolen Company v. Utica Gas &
Electric Company, Utica Gas and Globe Woolen had a common director named Maynard. Mr.
Maynard was the Globe’s main shareholder and the chairman of the executive committee of the
utility Utica (he had 1 share in the utility). The contract to provide electricity to the mills had a
guarantee of savings that proved to be expensive for the utility because there was a
miscalculation based on the projected future use of electricity.
While Mr. Maynard negotiated for the mills, his subordinate represented the utility.
The directors of the utility approved the contract knowing that Mr. Maynard had a conflicting
interest but Mr. Maynard remained silent and did not vote.
The court voided the contract. Mr. Maynard’s abstention from the vote gave the contract a
presumption of property but did not excuse Mr. Maynard from his responsibility.
Mr. Maynard had a dominating influence which meant that he had a duty to warn, that is to
provide full disclosure of both his interest and the details of the contract itself. The court held
that disclosure alone was insufficient because the contract must also be fair.
In this case, the idea of fairness was that the contract must have some reasonable proportion
between the benefits and burdens that is equivalent to an arm’s length bargain.
***
Statutory Responses-Many states enacted statutory provisions that deal with interested director
transactions (interested director statuses). Many of these statutes do not codify the duty of
loyalty but provide mechanisms that may create presumptions or deal with the burden of proof
or act as safe harbors that limit any judicial review and California was the first state to enact a
statutory provision that dealt with interested director transactions. The California state law
became a model for other states (the California Model) and provided that interested director
transactions would not be voided solely or just because of a conflict of interest or the voting and
presence of an interested director in ONE OF THREE situations: (1) the transaction was
approved by the disinterested directors with disclosure of the conflicting interest or (2)
disclosure was followed by shareholder approval or (3) the contract was just and reasonable at
the time of approval meaning that it was fair.
The statute also dealt with procedural issues by allowing the interested director to be part of
the quorum and indicating that a vote of the disinterested directors was needed for board
approval.
The primary issue of compliance with the interested director laws is that the effect on judicial
scrutiny on the transaction when approved by disinterested directors. When the common law IS
retained, a fairness inquiry allows a court to look at both the process and substance with the
burden of proof on the defendant even with disinterested director approval.
Another view is that approval by disinterested directors retains a fairness inquiry but shifts the
burden of proof to the plaintiff.
Yet another possibility is that such approval means the business judgment rule applies, with the
burden of proof on the plaintiff to prove that the rule is inapplicable and the court looking only
at the process.
These are the three primary approaches to reconciling the implications of compliance with
interested director statute with disinterested directors’ approval. The three approaches are: (1)
weak form, (2) semi-strong form, and (3) strong form statutes.
(1) Weak Form Approach-A weak form view of the statute is that compliance with the interested
director statute was not intended to change the common law, which places the burden of proof
on the fiduciary and requires fairness in process and substance.
This would mean that the statutes only removed the taint of the conflict of interest or dealt with
procedural issues like the quorum and like the common law transactions were still voidable as
opposed to void. Close judicial scrutiny would still be required.
(2) Semi-Strong Approach-A semi-strong view of the interested director statute is that
compliance with disinterested board approval shift the burden of proof to the plaintiff. Under
this view, fairness would always remain an issue when the disinterested directors approve the
transaction (that is, no business judgment rule protection). With a fairness inquiry, rather than
the business judgment rule, rests on the possible influence and detection of the influence the
interested director could have on the other disinterested directors.
(3) A strong form view of the interested director statute is that approval of the disinterested
board would generally limit judicial scrutiny. Disinterested board approval not only shift the
burden of proof to the plaintiff, but removes a fairness inquiry. There still must be full disclosure
but the decisions of the disinterested directors are now protected by the business judgment
rule.
Weak form Approach Cases-
Remillard Brick Co. v. Remillard-Dandini Co.
Stanley and Sturgis were the majority shareholders, managers, and directors of the Remillard-
Dandini corporation and its subsidiary, San Jose Brick & Tile. In their capacity as managers, they
made a decision sell all the products (bricks) made by these two companies to a third company
called Remillard-Dandini Sales Corporation.
Coincidentally, Stanley and Sturgis just so happen to also independently own the Sales Corp.
Minority shareholders of Remillard-Dandini filed a derivative lawsuit against Stanley and Sturgis.
The shareholders argued that Stanley and Sturgis had breached their duty of loyalty by self-
dealing. Basically, they were personally profiting by having the corporation sell bricks to their
Sales Corp. at what was most likely below market values.
Stanley and Sturgis argued that they had fully informed all the shareholders to what was going
on and the shareholders approved of the contract, so there was no conflict of interest.
Technically since Stanley and Sturgis were majority shareholders, the vote approving the
contract was meaningless.
The Trial Court found for the shareholders.
The Trial Court found that directors are fiduciaries. They owe a duty to all stockholders,
including the minority stockholders.
That's known as the duty of loyalty.
The Court found that a director cannot, at the expense of the corporation make an unfair profit
from his position. Where a transaction greatly benefits one corporation at the expense of
another, and especially if it personally benefits the majority directors, it will and should be set
aside.
This case explained the duty of loyalty, which basically says that a director cannot use his
position to benefit himself at the expense of the corporation, even if he is the majority
shareholder.
"While a transaction is not voidable simply because an interested director participated, it will
not be upheld if it is unfair to the minority stockholders."
After this decision, California amended their laws to disqualify shares voted by interested
directors. That meant that in the future if people like Stanley and Sturgis wanted the
corporation to contract with another business they owned, they would have to get a majority of
the minority shareholders to agree that was a good deal.
In the case in our textbook, Cookies Food Products v. Lakes Warehouse Distributing
RULE: The law commonly describes the fiduciary duties of corporate directors as twofold,
consisting both of a duty of care and a duty of loyalty these common law antecedents still guide
the court when interpreting the scope of the statute. The duty of care requires each director to
perform the duties of a director in good faith, in a manner such director reasonably believes to
be in the best interests of the corporation, and with such care as an ordinarily prudent person in
a like position would use under similar circumstances. Such a showing relieves directors of
liability for their actions on behalf of the corporation.
FACTS: This is a shareholders' derivative suit brought by the minority shareholders of a closely
held Iowa corporation specializing in barbeque sauce, Cookies Food Products, Inc. The target of
the lawsuit is the majority shareholder, Duane "Speed" Herrig and two of his family-owned
corporations, Lakes Warehouse Distributing, Inc. (Lakes) and Speed's Automotive Co., Inc.
(Speed's). Plaintiffs alleged that Herrig, by acquiring control of Cookies and executing self-
dealing contracts, breached his fiduciary duty to the company and fraudulently misappropriated
and converted corporate funds. Plaintiffs sought actual and punitive damages. Trial to the court
resulted in a verdict for the defendants, the district court finding that Herrig's actions benefited,
rather than harmed, Cookies Food Products.
ISSUE: Is a transaction voidable as improper self-dealing when the director can show that she
acted in good faith, honesty, and fairness, and that the transaction was fair and reasonable to
the corporation?
ANSWER: No.
CONCLUSION:
The court held (1) the majority shareholder's services to the corporation were neither unfairly
priced nor inconsistent with the corporation's interest, (2) the majority shareholder did not owe
the minority shareholders a duty to disclose any information before the board of directors
executed distributorship, royalty, warehousing, or consulting fee arrangements, (3) statutes
placed the duty of managing the affairs of the corporation on the board of directors, not the
shareholders.
The New York Approach-Section 713(b) of the New York Business Corporation Law indicates that
failure to obtain either shareholder or board approval pursuant to the statute means the
fiduciary has the burden of proof on the fairness of the transaction (the common law
approach).
The Current California Approach-Section 310(a) of the California General Corporation Law
appears to validate a contract if approved in good faith by disinterested shareholders.
Delaware Approach-Delaware has an interested director statute that looks similar to the
California model but in addition to disclosure of the conflict of interest, it requires disclosure
about the transaction itself.
The MBCA Approach-Subchapter F of the Model Business Corporation Act called Director’s
Conflicting Interest Transactions clarified the effect of statutory compliance on interested
director’s transactions. The statute takes a strong form view by LIMITING judicial scrutiny of
fairness if there is either disinterested board or shareholder approval.
Executive Compensation-Compensation paid to executives and directors may raise both duty of
care and duty of loyalty issues. Compensation policy is established within the ORDINARY course
of business in order to retain and reward those who manage the business. Compensation issues
are the kind of decisions that should be protected by the business judgment rule and not be
subject to direct judicial scrutiny.
Stock Options-Compensation may take different forms including salaries, bonuses, pensions,
fringe benefits, restricted stock shares that cannot be sold immediately, severance packages,
golden parachutes significant awarded if the company is acquired or there is a change in control
and stock options to compensate based on the corporation’s stock performance.
Stock options allow the recipient to elect to buy the shares of the corporation for a period of
time at a set price.
Good Faith and Compensation-If the granting of stock options or compensation was not a
conflict of interest transaction, then plaintiffs would need to challenge it as a lack of good faith.
Waste-There are times when courts in scrutinizing a transaction apply a WASTE STANDARD. A
waste of corporate assets is NEVER protected by the business judgment rule. The waste
standard generally means that what the corporation received in a transaction was so
inadequate in value that no person of ordinary business judgment would deem it worth what
the corporation paid. In essence, waste would involve an exchange for consideration so
disproportionately small that a reasonable person would not make the trade. Because waste is
NOT protected by the business judgement rule or Section 102(b)(7) exculpation release from
paying damages in duty of care in executive compensation cases plaintiffs WILL often allege
waste.
Delaware’s Waste Standard-Delaware courts have generally held that shareholder approval of
stock options with full disclosure has the effect of limiting judicial review of the compensation
under a waste standard with the burden of proof on the plaintiff. The court followed a two-
prong test (1) there needed to be a reasonable relationship between the value of consideration
flowing both ways and (2) there had to be a determination that a benefit to the corporation was
received.
The courts used an intermediate review between fairness and the business judgement rule that
would look at substance and assess the reasonableness of consideration value which was called
the proportionality TEST.
Corporate Opportunity and Abuse of Position-Unlike and interested director transaction where
the fiduciary is contracting with her corporation, abuse of position involves the fiduciary taking
advantage of her position and corporate opportunity usually involves taking advantage of
something that should belong to the corporation.
There are tests to determine if there is a corporate opportunity.
(1) Interest or Expectancy Test-The interest or expectancy test focuses on circumstances that
indicate that the corporation had a special or unique interest in the opportunity.
(2) Line of Business Test-The line of business test is similar to but broader than the interest test.
Like the interest test, it is factually sensitive. The test applies if the opportunity embraces an
activity as to which the corporation has fundamental knowledge practical experience and ability
to pursue which logically and naturally is adaptable to its business having regard for its financial
position and is one that is consonant with its reasonable needs and aspirations for expression.
The test focuses on how closely related the opportunity is to the existing business. A director or
officer personally taking advantage of an opportunity that meets this test would essentially be
competing with the corporation.
(3) Fairness Test-The fairness test is more open-ended because it looks at the total
circumstances to see if there is unfairness and if the interests of the corporation call for
protection. Given the broad parameters of a fairness inquiry, the test does not provide sufficient
practical guidance. Some courts have combined the fairness and line of business test to try to
avoid the vagueness of each test. A court would look at whether it was in the line of business
and then look at the circumstances to see if its acquisition by the fiduciary was unfair.
The ALI Test-The ALI test tries to clarify the definition of a corporate opportunity and when a
fiduciary can invest. In defining an opportunity, the ALI distinguishes between directors and
senior executives. There is a corporate opportunity IF the opportunity to engage in a business
activity is presented to either the directors or senior executives under circumstances that (1)
would reasonably lead them to believe that the opportunity was intended for the corporation or
(2) would require that they use corporate information and it would reasonably be expected to
be of interest to the corporation. If the defendant is a senior executive, there is a third test for
the corporate opportunity applicable to them which includes any opportunity that she knows is
closely related to the business in which the corporation is engaged or expects to be engaged.
The first two tests focus on the opportunity resulting from the corporate position or use of
corporate information or property and thus applies to a wider group of both directors and
senior executives. (3) The third test is limited to senior executives who would be expected not to
be able to take advantage of investments that are closely related to the corporation for which
they work full time and outside directors are NOT subject to the third test.
Financial Inability-The financial inability of the corporation to take advantage of the corporate
opportunity has resulted in a variety of outcomes.
Multiple Boards-There are times when directors serve on different boards and are shareholders
of different corporations in similar businesses.
Use of Information and Competition-A corporate fiduciary cannot improperly take a corporate
opportunity. In addition, a corporate fiduciary cannot use corporate information, a corporate
position or assets unfairly for personal profit and may not be able to compete with the
corporation. All three principles corporate opportunity, unfair use of position or assets and
unfair competition are distinct duties but can overlap. For example, a fiduciary could use
corporate information to acquire another business closely connected to her other business that
competes with it.
Undisclosed Profits-even with no usurpation of a corporate opportunity, improper use of
information or competition, a corporate fiduciary could be liable for secret profits gained in a
transaction on behalf of the corporation.
Shareholder Voting and Ratification-When shareholders vote on a transaction, an issue arises as
to the effect of that vote. In some cases, a shareholder vote is NOT optional but a statutory
requirement such as voting on amendments to the articles of incorporation or to effectuate a
merger or fundamental transaction that is required voting. In other cases, the shareholder vote
is NOT required but is sought anyway that is optional voting.
Required Voting-There are times when shareholders take an action that requires their vote
under a particular provision of the statute. In that case, the voting is not to validate the
transaction as much as it is to authorize it, because without the shareholder vote, the action
could not be taken and such voting is NOT a ratification.
Optional Shareholder Voting and Ratification-In some cases a shareholder vote is sought where
it is NOT required, but optional. In addition, even when there is required voting, a controlling
shareholder with sufficient votes may optionally subject the required vote to a majority of
minority shareholder approval. Such shareholder voting is not a statutory requirement but tends
to occur when the shareholder vote is sought to affect how the law will treat the transaction
and what amount of judicial scrutiny will be involved.
Chapter 10: Controlling Shareholders
Use of Control-Controlling shareholders may not use their control to self-deal unfairly with the
assets of the corporation.
The Zahn Case-Zahn v. Transamerica Corporation
Plaintiff Class A stockholder appealed the decision of the United States District Court for the
District of Delaware dismissing his class action complaint alleging breach of fiduciary duty on the
part of defendant Class B stockholder in its decision to redeem Class A stock and then liquidate
the company.
Facts of the case
Plaintiff held Class A stock in a company. Defendant owned virtually all of the same company's
Class B stock and dominated the management, business, and affairs of the company. Plaintiff
filed a class action suit alleging that defendant caused the company to redeem its Class A stock
and then liquidated the company so that defendant could acquire most of the value of the
company for itself. Defendant moved to dismiss the complaint, and the court below granted the
motion. Plaintiff appealed.
Discussion: The appeals court reversed because defendant, as the board of directors of the
company and as controlling stockholder, had a fiduciary duty to minority Class A stockholders
that was violated if the allegations of plaintiff were true.
The act of redeeming the Class Act stock was consummated at the direction of defendant, for its
own profit, not for the protection of the minority stockholders' interests.
Conclusion: Dismissal of the complaint was reversed because defendant, as board of directors
and as controlling stockholder, had a fiduciary duty to minority Class A stockholders that was
violated if the act of redeeming the Class A stock was not consummated impartially, but at the
direction of defendant for its own profit.
Parent-Subsidiary Dealings-A corporation that is a controlling shareholder (parent) of another
corporation (subsidiary) often contracts with the controlled corporation. The result is a conflict
of interest transaction similar to interested directors’ transaction and the application of the duty
of loyalty. Generally, the duty of loyalty in conflicts of interest requires a shifting of the burden
of proof and the use of a fairness standard, allowing the court to look at both the process and
substance of the decision.
If the parent owns 100% of the subsidiary there are no fiduciary representative issues, but if the
parent corporation has chosen not to own 100% of the shares of the subsidiary, there are other
shareholders. As a result, transactions between the two corporations may involve conflicts of
interest because of the existence of minority shareholders.
Sinclair v. Levien-RULE:
Under the business judgment rule, a court will not interfere with the judgment of a board of
directors unless there is a showing of gross and palpable overreaching. A board of directors
enjoys a presumption of sound business judgment, and its decisions will not be disturbed if they
can be attributed to any rational business purpose. A court under such circumstances will not
substitute its own notions of what is or is not sound business judgment.
FACTS: Sinclair Venezuelan Oil Company (Sinven) is a subsidiary of Sinclair Oil Corporation
(Sinclair). The plaintiff stockholders of Sinven brought a derivative action against Sinclair to
account for damages sustained by its subsidiary, as a result of dividends paid by Sinven, the
denial to Sinven of industrial development, and a breach of contract between Sinclair's wholly-
owned subsidiary, Sinclair International Oil Company, and Sinven. The Court of Chancery
granted an order to the plaintiffs. The Chancellor held that because of Sinclair's fiduciary duty
and its control over Sinven, its relationship with Sinven must meet the test of intrinsic fairness.
Sinclair appealed, arguing that the transactions between it and Sinven should be tested, not by
the test of intrinsic fairness with the accompanying shift of the burden of proof, but by
the business judgment rule under which a court will not interfere with the judgment of a board
of directors unless there is a showing of gross and palpable overreaching.
ISSUE: Was the intrinsic fairness test erroneously applied on the dividend payments?
ANSWER: Yes.
CONCLUSION: The Supreme Court of Delaware reversed the order. It must be determined
whether the dividend payments by Sinven were, in essence, self-dealing by Sinclair. The
dividends resulted in great sums of money being transferred from Sinven to Sinclair. However, a
proportionate share of this money was received by the minority shareholders of Sinven. Sinclair
received nothing from Sinven to the exclusion of its minority stockholders. As such, these
dividends were not self-dealing. Thus, the Chancellor erred in applying the intrinsic fairness test
as to these dividend payments. The business judgment standard should have been applied.
Moreover, since there is no proof of self-dealing on the part of Sinclair, it follows that the
expansion policy of Sinclair and the methods used to achieve the desired result must, as far as
Sinclair's treatment of Sinven is concerned, be tested by the standards of the business judgment
rule. Accordingly, Sinclair's decision, absent fraud or gross overreaching, to achieve expansion
through the medium of its subsidiaries, other than Sinven, must be upheld.
Sale of Corporation-In an arm’s length transaction involving the sale of the business, there is the
duty of care and disclosure. In a sale of an entire company, the director’s should focus on
securing the best value reasonably available to all shareholders. When controlling shareholders
are in the picture, the judicial scrutiny may be heightened. If the controlling shareholder is itself
buying the corporation and eliminating the minority shareholders, then it is a viewed as a
freeze-out transaction.
Freeze-outs-Freeze-outs involve controlling shareholders forcing the minority shareholders to
relinquish their equity position in the corporation. Usually, the shareholders receive cash for
their shares but they also may receive non-voting securities such as debt or preferred shares. In
a publicly held corporation, the result is usually that the corporation becomes a privately held
corporation. Many of the freeze-outs involve the practice of using large amounts of debt to
finance the freeze-out and are described a leveraged buy-outs (LBOS).
In management buyouts (MBOs), the managers who controlled the operations of the
corporation but did not have control through large share ownership decide to take the
corporation private by offering the public shareholders a premium for their shares.
State Law-In order to facilitate a freeze-out, the control group must comply with a state’s
statutory scheme of regulation for mergers and case law on fiduciary obligation. The statutory
requirements for a merger invite approval by the board of directors and a shareholder vote.
Corporate statutes permit the use of cash or securities other than common stock as
consideration value resulting in a freeze-out merger. When a vote is required, most statutes
require a majority vote of all shareholders which is easily obtainable for those in actual or de
facto control of the corporation. The short form merger provisions require no shareholder vote
when the control group owns a large percentage of stock usually 90% or more.
The Weinberger Case-RULE: The concept of fairness has two basic aspects: fair dealing and fair
price. The former embraces questions of when a merger transaction was timed, how it was
initiated, structured, negotiated, disclosed to the directors, and how the approvals of the
directors and the stockholders were obtained. The latter aspect of fairness relates to the
economic and financial considerations of the proposed merger, including all relevant factors:
assets, market value, earnings, future prospects, and any other elements that affect the intrinsic
or inherent value of a company's stock. Del. Code Ann. tit. 8, § 262(h). However, the test for
fairness is not a bifurcated one as between fair dealing and price. All aspects of the issue must
be examined as a whole since the question is one of entire fairness. However, in a non-
fraudulent transaction, price may be the preponderant consideration outweighing other
features of the merger.
FACTS OF THE CASE: Plaintiff William B. Weinberger, a former shareholder of defendant UOP,
Inc. (UOP), filed an action challenging the elimination of UOP's minority shareholders by a cash-
out merger between UOP and The Signal Companies, Inc., its majority owner. The lower court
held that the terms of the merger were fair to Weinberger and the other minority shareholders
of UOP.
ISSUE: Were the terms of the merger fair to Weinberger and the other minority shareholders?
ANSWER: No
CONCLUSION: The state supreme court held that the record did not establish that the
transaction satisfied any reasonable concept of fair dealing, as the matter of disclosure to UOP's
directors was wholly flawed by conflicts of interest raised in feasibility study, and the minority
shareholders were denied critical information; thus, the vote of the minority shareholders was
not an informed one. The Court further held that the standard "Delaware block" or weighted
average method of valuation, should not control, rather, the Court endorsed a more liberal
approach requiring consideration of all relevant factors pursuant to Del. Code Ann. tit. 8, §
262(h).
Fair Dealing-In Rabkin v. Philip A. Hunt Chem Corp., the Delaware Supreme Court restated the
Weingerber courts view of unfair dealing as requiring more than non-disclosure, including other
procedural fairness issues such as timing, structure, and negotiation.
RULE: On a motion to dismiss for failure to state a claim, it must appear with a reasonable
certainty that plaintiff would not be entitled to the relief sought under any set of facts, which
could be proven to support the action.
FACTS OF THE CASE: Plaintiffs, minority stockholders of defendant Philip A. Hunt Chemical
Corporation (Hunt), filed a class action challenging the merger of Hunt with its majority
stockholder, Olin Corporation (Olin). Plaintiffs challenged the proposed merger on the ground
that the price offered was grossly inadequate because Olin unfairly manipulated the timing of
the merger to avoid a one-year commitment regarding the purchase of the additional shares.
Additionally, plaintiffs contended that specific language in the majority stockholders' schedule
13D, which they filed when they first purchased the stock, constituted a price commitment by
which they failed to abide contrary to their fiduciary obligations. Olin filed a motion to dismiss
the action, arguing that plaintiffs' claims were primarily directed to the issue of fair value,
therefore appraisal was the only available remedy. The court ordered the case dismissed on the
ground that absent deception, appraisal was the only remedy available to plaintiffs. Plaintiffs
sought and were denied leave to amend their complaint.
ISSUE: Did the trial court correctly dismiss the case on the ground that plaintiffs' sole remedy
was an appraisal?
ANSWER: No
CONCLUSION: The court held that the facts alleged by plaintiffs regarding Olin's avoidance of the
one-year commitment supported a claim of unfair dealing that was sufficient to defeat the
motion to dismiss. Thus, the decision of the trial court was reversed.
Negotiating Committee of Independent Directors-In trying to lessen the scrutiny placed on their
decisions, controlling shareholders may use the Weinberger case suggestion and have a group of
independent directors as a committee of the board negotiate over the freeze-out merger. In the
case in our textbook, Kahn v. Lynch Communication Systems, Inc. RULE: A controlling or
dominating shareholder standing on both sides of a transaction, as in a parent-subsidiary
context, bears the burden of proving its entire fairness. The standard for demonstrating entire
fairness is fair dealing and fair price. Fair dealing addresses the timing and structure of
negotiations as well as the method of approval of the transaction, while fair price relates to all
the factors which affect the value of the stock of the merged company. However, the test is not
bifurcated or compartmentalized but is one requiring an examination of all aspects of the
transaction to gain a sense of whether the deal in its entirety is fair. A board of directors will
have to demonstrate entire fairness by presenting evidence of the cumulative manner by which
it discharged all of its fiduciary duties.
FACTS OF THE CASE: Lynch, a Delaware corporation, designed and manufactured electronic
telecommunications equipment, primarily for sale to telephone operating companies. Alcatel, a
holding company, is a subsidiary of Alcatel (S.A.), a French company involved in public
telecommumcations, business communications, electronics, and optronics. In 1981,
Alcatel acquired 30.6% of Lynch's common stock pursuant to a stock purchase agreement. As
part of that agreement, Lynch amended its certificate of incorporation to require an 80%
affirmative vote to approve any business combination.
Alcatel's proposed a stock-for-stock merger with Lynch. The Lynch board approved the merger
with Alcatel with an offer of $15.50 per share. At the time of the merger, Alcatel owned 43.3%
of Lynch's outstanding stock and designated five of the eleven directors on Lynch's board of
directors. Kahn, a Lynch minority shareholder, brought suit, later certified as a class action,
challenging Alcatel's acquisition of Lynch through a tender offer and cash-out merger. Kahn
alleged the merger to be unfair in that Alcatel, as a controlling shareholder, breached its
fiduciary duties to Lynch's minority shareholders. Specifically, Kahn charged that Alcatel dictated
the terms of the merger, made false, misleading, and inadequate disclosures, and paid an unfair
price. The Court of Chancery of the State of Delaware in and for New Castle County determined
that a cash-out merger was entirely fair and rejected Kahn’s claim. It was determined that the
controlling shareholder dominated the merger negotiations despite the fact that the directors
had appointed an independent negotiating committee.
Kahn sought further appellate review.
ISSUE: Did the trial court err in rejecting Kahn’s claim?
ANSWER: No
CONCLUSION: The Supreme Court of Delaware affirmed the judgment in favor of the acquired
corporation, its directors, the controlling shareholder, and its parent corporation. The Court
found that the trial court properly considered how the directors discharged their fiduciary duties
with regard to each aspect of the non-bifurcated components of entire fairness: fair dealing and
fair price. Mere initiation by the acquirer was not reprehensible because the controlling
shareholder did not gain a financial advantage at the minority's expense. Unanimity regarding
fair price was not required. The controlling shareholder made a sufficient showing of fair value,
but the minority shareholders failed to establish sufficient credible evidence to persuade the
finder of fact of the merit of a greater figure. There was proper disclosure such that a
reasonable minority shareholder was under no illusions concerning the leverage available.
Majority of Minority Shareholder Voting-In Delaware, there is no statutory requirement that a
merger or other transaction with a controlling shareholder must be approved by a majority of
the minority shareholders. The merger statutes generally require a majority vote which means
the controlling shareholder can force the merger since it has the votes and is entitled to vote as
it pleases.
Business Purpose-In the case in our textbook, Coggins v. New England Patriots Football Club.
Brief Fact Summary. Plaintiffs, David Coggins sought a rescission of a freeze-out merger enacted
by Defendants, New England Patriots Football Club.
Synopsis of Rule of Law. A controlling shareholder in a transaction between boards of directors
wherein he and others are common members has the burden to prove that the transaction
serves a legitimate purpose for the corporation and is fair to the minority shareholders.
Facts of the case. Defendant president, William Sullivan, Jr., bought the New England Patriots in
1959 for $25,000. Four months later, he had nine others buy into the team for $25,000 each,
and each of the ten owners was given 10,000 shares. Another four months later, 120,000
nonvoting shares were issued for $5 each. In 1974 the other owners removed Sullivan from his
presidency but by November of 1975, after securing a personal loan for over $5 million, he
owned all 100,000 voting shares (at $102 per share) and put in his own directors. The loan
required Sullivan to use the Defendant corporation’s profits and assets to repay the loan, but he
could not do this without complete ownership. Sullivan then created a second corporation,
appointed the same directors, and then voted to merge the two companies into the new one.
The shareholders of the old company would receive $15 per share. Plaintiff was a fan of the
team and proudly owned ten shares of the corporation. Plaintiff brought this act
ion after he was forced to sell his shares pursuant to a freeze-out merger initiated by directors
who, he asserted, violated their fiduciary duties when they voted while holding directorships for
both companies. Defendants argued that each class of shares approved of the merger.
Issue. The issue is whether the freeze-out merger illegal.
Held. The court held that the merger was unfair and illegal, but since the merger was now ten
years old it should not be reversed. The controlling shareholder owed a fiduciary duty to the
minority shareholders, and the burden was on Sullivan to prove that the merger furthered the
goals of the corporation rather than just his own interests and is fair to Plaintiffs. Sullivan failed
to prove either point.
Discussion. The typical equitable remedy for an illegal merger such as the one at issue is a
rescission. However, the length of time between the merger and the holding made an appraisal
a better alternative.
The Controlling Shareholder’s Tender Offer-In the case in our textbook:
IN RE PURE RESOURCES, INC., SHAREHOLDERS LITIGATION Case Summary
The issue of the equitable standard of fiduciary duty to be applied when a controlling
stockholder sought to acquire the rest of a company's shares was fraught with doctrinal tension.
The two basic methods of acquisition were negotiated merger and tender offer/short-form
merger. The court discussed possible disparate treatment of minority stockholders, depending
on the method used. The court found that the absence of convincing reasons for the disparity in
treatment inspired the minority stockholders to urge the application of the entire fairness
standard of review. Although not granting this, the court found that the instant offer, in its
present form, was coercive, as it included within the definition of "minority" those stockholders
that were affiliated with the majority stockholder as directors and officers. Requiring the
minority to be defined exclusive of stockholders whose independence from the controlling
stockholder was compromised was the better rule.
SEC Rule 13e-3-In addition to the proxy rules, Section 13e of the Federal Securities Exchange Act
of 1934 empowers the SEC Securities and Exchange Commission to issue rules to avoid
fraudulent deceptive and manipulative acts whenever an issuer purchases its equity securities.
SEC Rule 10b-5-Has broad language that on its face prohibits fraud in the purchase or sale of any
securities.
Sale of Control-When the control group sells its shares they are selling their personal property,
which does not automatically implicate any breach of fiduciary duty. Controlling shareholders
who sell their controlling shares often receive a premium from a purchaser that is receive they
receive more for their shares than the current market price.
Looting-Looting is described in the case in our textbook: Gerdes v. Reynolds
RULE: A wrongdoer is liable for the ultimate result of his conduct, i.e., the consequences which
actually ensue therefrom, even though they were not foreseeable and were novel or
extraordinary. That liability stops only at the point where the sequence of events is broken by
the intervention of a new and independent cause as distinguished from a connected or
contributing or concurrent cause.
FACTS OF THE CASE: The defendants, Reynolds et al., owned the majority of the voting stock of
Reynolds Investing Company, Inc., an investment trust, and constituted its board of directors.
They sold their stock to a group composed in part of the Defendants. A motion was made to
confirm a referee's report, which found that Reynolds et al. were liable to Gerdes et al. for
turning over control of practically negotiable assets to strangers who had not completed
payment of the purchase price of the majority stock being bought.
ISSUE: Were Reynolds et al. liable to the corporation for turning over control of almost
negotiable assets to strangers who had not finished paying for the majority stock?
ANSWER: Yes.
CONCLUSION: The Court confirmed the referee's report holding Reynolds et al. liable to the
corporation for turning over control of almost negotiable assets to strangers who had not
finished paying for the majority stock. The Court added to the report that Reynolds et al. were
liable for the ultimate results of their conduct, regardless of whether they were foreseeable. The
Court then found that, in determining liability, it was unnecessary to decide whether
consequences harmful to the corporation from turning over the assets were reasonably
foreseeable because there was an additional basis for liability, an illegal sale of corporate
offices, and as liability because of violation of duty had already been found, the question of
what consequences were reasonably foreseeable were immaterial.
The Perlman Case-RULE: A director and dominant stockholder stands in a fiduciary relationship
to the corporation and to the minority stockholders as beneficiaries thereof.
FACTS OF THE CASE: Plaintiffs, Jane Perlman and other minority stockholders of Newport Steel
Corporation, brought an action to compel accounting for, and restitution of, allegedly illegal
gains which accrued to defendants (a majority shareholder and director of the Corporation) as a
result of the corporation’s sale to Wilport Company in August, 1950, of their controlling interest
in the corporation. The principal defendant, C. Russell Feldmann, who represented and acted for
the others, members of his family, was at that time not only the dominant stockholder, but also
the chairman of the board of directors and the president of the corporation. Plaintiffs contend
that the consideration paid for the stock included compensation for the sale of a corporate
asset, a power held in trust for the corporation by Feldmann as its fiduciary. This power was the
ability to control the allocation of the corporate product in a time of short supply, through
control of the board of directors; and it was effectively transferred in this sale by having
Feldmann procure the resignation of his own board and the election of Wilport's nominees
immediately upon consummation of the sale. According to the plaintiffs, the defendants must
account to the non-participating minority stockholders for that share of their profit which is
attributable to the sale of the corporate power. The district court judge denied the validity of
the premise, holding that the rights involved in the sale were only those normally incident to the
possession of a controlling block of shares, with which a dominant stockholder, in the absence
of fraud or foreseeable looting, was entitled to deal according to his own best interests.
Furthermore, the district court judge held that plaintiffs had failed to satisfy their burden of
proving that the sales price was not a fair price for the stock per se. Plaintiffs appealed from
these rulings of law which resulted in the dismissal of their complaint.
ISSUE: Did the district court err in its decision to dismiss the plaintiffs’ complaint on the grounds
that the rights involved in the sale were only those normally incident to the possession of a
controlling block of shares?
ANSWER: Yes.
CONCLUSION: The Court reversed the lower court's judgment and held that a director and
dominant stockholder stood in a fiduciary relationship to the corporation and to the minority
stockholders as beneficiaries. According to the Court, absolute and most scrupulous good faith
was the very essence of a director's obligation to his corporation. The Court held that when the
sale of a controlling block of stock, as in the present case, necessarily resulted in a sacrifice of
the element of corporate good will and resulted in unusual profit to the fiduciary who caused
the sacrifice, he was required to account for his gains.
The California Approach- The case in our textbook Jones v. H.F. Ahmanson
RULE: Majority shareholders may not use their power to control corporate activities to benefit
themselves alone or in a manner detrimental to the minority. Any use to which they put the
corporation or their power to control the corporation must benefit all shareholders
proportionately and must not conflict with the proper conduct of the corporation's business.
FACTS of the case: Defendants were majority shareholders of the corporation, in which plaintiff
was a minority shareholder. Defendants created a second corporation and offered certain
defendants an exchange of corporate stock. After the exchanges, the second corporation owned
85 percent of the first corporation's outstanding shares: thus, defendants became the majority
shareholders of the new corporation and continued to control the original corporation's stock.
The new corporation made its first public offering based primarily on book value attributed to
the first corporation and enjoyed a rapid rise in stock trading and share value increase in which
the first corporation did not share. The second corporation offered to purchase individual shares
of the first corporation for a price under book value. When the first corporation's shareholders
refused, the second corporation terminated the first corporation's dividends. The first
corporation's shareholders refused a proposed stock exchange and filed suit. Judgment of
dismissal was entered by the Superior Court of Los Angeles County after an order sustaining
certain of defendants' general and special demurrers without leave to amend. Plaintiff
appealed, and defendants filed a protective cross-appeal from the part of the judgment that
overruled other demurrers with respect to laches, insufficiency of plaintiff's designation of the
class she purported to represent, and her failure to state separately her multiple cause of
action.
ISSUE: Did the lower court err in its decision to dismiss the plaintiff’s complaint?
ANSWER: Yes
CONCLUSION: The Court held that the plaintiff had sufficiently stated a claim for injury to
herself, as such, sustaining the defendant’s demurrer and consequently, dismissing the
plaintiff’s complaint was improper. The Court posited that California no longer follows the rule
recognizing the right of majority stockholders to dispose of their stock without the slightest
regard to the wishes or knowledge of the minority. The prevailing rule, according to the Court, is
that of inherent fairness from the viewpoint of the corporation and of those interested therein,
and majority stockholders may not use their power to control corporate activities to benefit
themselves alone or in a manner detrimental to the minority. Therefore, the Court concluded
that defendant controlling shareholders had a fiduciary duty not to abuse their power to control
a corporation to the detriment of the minority shareholders.
Sale of Office-When a sale of control takes places, the directors usually resign and select the
designated nominees of the purchaser of control to replace them as directors.
Chapter 13: Disclosure and Insider Trading
SEC Rule 10b-5 Disclosure and Insider Trading-The Securities and Exchange Commission
promulgated Rule 10b-5 in 1943, pursuant to authority granted by Section 10(b) of the
Securities Exchange Act of 1934. Since that time, Rule 10b-5 has been the general antifraud rule
applicable to the purchase or sale of any security. The rule prohibits material omissions or
misleading statements, whether oral or written.
Even though an issuer or broker-dealer has compiled with an SEC or self-regulatory organization
form calling for item-and-answer disclosure, Rule 10b-5 nonetheless applies and requires
disclosure of any remaining material information.
A plaintiff alleging an omission or misleading statement in a formal prospectus filed with the SEC
may pursue both the implied remedy under Rule 10b-5 and any applicable express remedy as
well, such as that under Rule 10b-5 and any applicable express remedy as well, such as that
under Securities Exchange Act Section 11.
In the case in our textbook, Janus Capital Group, Inc. v. First Derivative Traders
RULE OF LAW: For purposes of 17 C.F.R. § 240.10b-5(b), the maker of a statement is the person
or entity with ultimate authority over the statement, including its content and whether and how
to communicate it. Without control, a person or entity can merely suggest what to say, not
"make" a statement in its own right. One who prepares or publishes a statement on behalf of
another is not its maker. And in the ordinary case, attribution within a statement or implicit
from surrounding circumstances is strong evidence that a statement was made by -- and only by
-- the party to whom it is attributed.
FACTS OF THE CASE: Respondent First Derivative Traders (First Derivative), representing a class
of stockholders in petitioner Janus Capital Group, Inc. (JCG), filed this private action under
Securities and Exchange Commission Rule 10b-5, which forbids “any person . . . [t]o make any
untrue statement of a material fact” in connection with the purchase or sale of securities. The
complaint alleged, inter alia, that JCG and its wholly owned subsidiary, petitioner Janus Capital
Management LLC (JCM), made false statements in mutual fund prospectuses filed by Janus
Investment Fund--for which JCM was the investment adviser and administrator--and that those
statements affected the price of JCG's stock. Although JCG created Janus Investment Fund, it is a
separate legal entity owned entirely by mutual fund investors. The District Court dismissed the
complaint for failure to state a claim. The Fourth Circuit reversed, holding that First Derivative
had sufficiently alleged that JCG and JCM, by participating in the writing and dissemination of
the prospectuses, made the misleading statements contained in the documents. JCM sought
certiorari review in the United States Supreme Court.
ISSUE: Did the investors state a claim?
ANSWER: No
CONCLUSION:
The United States Supreme Court held that to be liable, an advisor had to have "made" the
material misstatements. The "maker" of a statement for purposes of § 240.10b-5(b)'s private
right of action was the entity with authority over the content of the statement and whether and
how to communicate it. Without such authority, it was not "necessary or inevitable" that any
falsehood would be in the statement. The advisor and the fund were legally separate entities,
and the fund's board was more independent than 15 U.S.C.S. § 80a-10 required. Furthermore,
the Court held that there was no allegation that the advisor filed the prospectuses and falsely
attributed them to the fund. Nor did the prospectuses indicate that they came from the advisor
rather than the fund--a legally independent entity with its own board of trustees. Being involved
in preparing the prospectuses, subject to the ultimate control of the fund, did not mean the
advisor "made" any statements in the prospectuses. Although the advisor may have assisted the
fund with crafting what the fund said in the prospectuses, the advisor itself did not "make"
those statements for purposes of § 240.10b-5(b). Lastly, the Court added that absent liability by
the advisor, the creator was not liable as a control person.
Disclosure Concepts and Elements of a Cause of Action Under Rule 10b-5 The
Implication of Private Rights of Action-In 1946, a federal district court accepted the existence of
an implied right of action under Rule 10b-5. On several subsequent occasions, the Supreme
Court ruled on issues in Rule 10b-5 cases without comment on the existence of a right by
investors to sue for damages or for injunctive relief.
In the case in our textbook, Basic v. Levinson
RULE OF LAW:
To fulfill the materiality requirement there must be a substantial likelihood that the disclosure of
the omitted fact would have been viewed by the reasonable investor as having significantly
altered the total mix of information made available.
FACTS OF THE CASE:
The Securities and Exchange Commission's Rule 10b-5 of the Securities Exchange Act of 1934
(Act), prohibited in connection with the purchase or sale of any security, the making of any
untrue statement of a material fact or the omission of a material fact that would render
statements made not misleading. In December 1978, Combustion Engineering, Inc., and Basic
Incorporated ("Basic") agreed to merge. During the preceding two years, representatives of the
two companies had various meetings and conversations regarding the possibility of a merger.
During that time Basic made three public statements denying that any merger negotiations were
taking place or that it knew of any corporate developments that would account for heavy
trading activity in its stock. Respondents, former Basic shareholders who sold their stock
between Basic's first public denial of merger activity and the suspension of trading in Basic stock
just prior to the merger announcement, filed suit against Basic and some of its directors, alleging
that Basic's statements had been false or misleading, in violation of § 10(b) and Rule 10b-5, and
that they were injured by selling their shares at prices artificially depressed by those statements.
The district court certified respondents' class, but granted summary judgment for petitioners on
the merits. On appeal, the court of appeals affirmed the class certification, agreeing that under a
"fraud-on-the-market" theory, respondents' reliance on petitioners' misrepresentations could
be presumed, and thus that common issues predominated over questions pertaining to
individual plaintiffs. Nevertheless, the court of appeals reversed the grant of summary judgment
and remanded, rejecting the district court's view that preliminary merger discussions are
immaterial as a matter of law, and holding that even discussions that might not otherwise have
been material become so by virtue of a statement denying their existence.
ISSUE: Was the appellate court's decision proper?
ANSWER: No
CONCLUSION: The United States Supreme Court held that an omitted fact was material if a
reasonable shareholder would consider it important in making his or her vote and this standard
should be applied to all § 10(b) and Rule 10b-5 actions. The Court also held that materiality
required a case by case review of the facts and that a rebuttable presumption existed that
stockholders relied on available information when buying or selling securities. The judgment of
the court of appeals was accordingly reversed and remanded.
Standing to Sue-Who would be harmed by a belated report of a spectacular mining discovery by
a company which had earlier denied the find? In the case in our textbook-
RULE OF LAW: Section 21(e) of the Securities Exchange Act of 1934 , 15 U.S.C.S. § 21(e), does
not restrict the remedies which the Securities and Exchange Commission can pursue to
injunctive relief. The district courts have equity power to authorize as ancillary relief the
appointment of receivers under the Securities Exchange Act of 1934 at the request of the
Securities and Exchange Commission even though no specific statutory authority exists for such
action.
FACTS OF THE CASE: Texas Gulf Sulphur ("TGS") discovered rich ore deposits in Ontario; the
discovery lead to a series of stock transactions connected to the discovery. On April 12,
1964, TGS issued a press release dispelling rumors about the results of its exploratory drilling at
Timmins, Ontario. The District court found that the release satisfied all the elements of a
violation of § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.S. § 78j(b), and Rule 10b-
5, 17 C.F.R. § 240.10b-5 and that the framers of the press release failed to exercise due
diligence. The court also issued an injunction. TGS appealed, alleging that mere negligence in the
issuance of the April 12 press release infringed its First Amendment rights.
ISSUE: Did Texas Gulf Sulphur violate Rule 10b-5?
ANSWER: Yes
CONCLUSION: The court held that the finding that TGS violated Rule 10b-5 was well founded
and unassailable. The Court further held that the injunctions against two defendants from
committing future violations of Rule 10b-5 were proper as there was sufficient distinction in
those defendants' cases for the district court to single them out and the district court did not
abuse its discretion. However, the court reversed and remanded the order cancelling one
defendant's TGS stock option for a hearing on the appropriateness of the remedy because he
was deprived of a hearing on the question.
In the case in our textbook-Blue Chip Stamps v. Manor Drug Stores-
RULE OF LAW: The principal express non-derivative private civil remedies, created by Congress
contemporaneously with the passage of § 10(b) of the Securities Exchange Act of 1934 (1934
Act), for violations of various provisions of the Securities Act of 1933 and the 1934 Act are by
their terms expressly limited to purchasers or sellers of securities. Thus § 11 (a) of the 1933 Act
confines the cause of action it grants to "any person acquiring such security" while the remedy
granted by § 12 of that Act is limited to the "person purchasing such security." Section 9 of the
1934 Act, prohibiting a variety of fraudulent and manipulative devices, limits the express civil
remedy provided for its violation to "any person who shall purchase or sell any security" in a
transaction affected by a violation of the provision. Section 18 of the 1934 Act, prohibiting false
or misleading statements in reports or other documents required to be filed by the 1934 Act,
limits the express remedy provided for its violation to "any person who shall have purchased or
sold a security at a price which was affected by such statement." It would indeed be anomalous
to impute to Congress an intention to expand the plaintiff class for a judicially implied cause of
action beyond the bounds it delineated for comparable express causes of action.
FACTS OF THE CASE: As part of an antitrust consent decree, petitioner corporation was required
to offer shares of common stock to a group of retailers, which included respondent drug store.
The drug store did not purchase any stock, but later sued the corporation and its shareholders
under § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, 17 C.F.R. § 240.10b-5,
alleging it had not purchased stock due to a prospectus that was misleading as it was overly
pessimistic regarding the corporation's status. The district court dismissed respondent's
complaint. But on appeal, the court of appeals reversed holding that respondent drug store
could maintain an action.
ISSUE: Could respondent drug store maintain an action?
ANSWER: No
CONCLUSION: The United States Supreme Court reversed and concluded respondent was not
entitled to sue for a violation of Rule 10b-5, and held that a plaintiff class, for purposes of a
private action under § 10(b) and Rule 10b-5, was limited to actual purchasers and sellers of
securities. Moreover, the Court declined to create an exception to that rule, as the court of
appeals had, that would permit an offeree of securities pursuant to a consent decree, such as
respondent, to sue under Rule 10b-5 regardless of whether it had purchased securities, at least
in the absence of a contractual right or duty to purchase.
Materiality-A fact is a material fact is there exists a substantial likelihood that a reasonable
shareholder would consider it important in deciding whether to purchase or sell a security.
State of Mind-State of mind is a measure of the degree of fault (scienter) knowledge of
wrongdoing.
Courts typically recognize five levels of fault or five culpable states of mind: strict liability,
negligence, recklessness, knowing conduct, and intentional conduct. Intent is distinguished from
motive and motive is the desire which incites or stimulates a person to act. Intent is the purpose
to resolve to do the act itself.
In the case in our textbook Ernst & Ernst vs. Hochfelder
RULE OF LAW: A private cause of action for damages will not lie under §10(b) of the Securities
Exchange Act of 1934, 15 U.S.C.S. § 78j(b), and Securities and Exchange Commission Rule 10b-
5, 17 C.F.R. § 240.10b-5 (1975), in the absence of an allegation of "scienter" - intent to deceive,
manipulate, or defraud.
FACTS OF THE CASE: Petitioner, an accounting firm, had been retained by a small brokerage firm
for 21 years to perform periodic audits of the brokerage firm's books and records. Respondents
were customers of the brokerage firm who had invested in a fraudulent securities scheme
perpetrated by the president of the brokerage firm. Respondents filed an action for damages
against petitioner under § 10(b) of the Act and Rule 10b-5. Respondents' complaint was based
on a theory of negligent nonfeasance. The district court's grant of summary judgment to
petitioner, on the basis that a cause of action could not be maintained under § 10(b) of Act
and Rule 10b-5 merely on allegations of negligence, was reversed by the circuit court. The
Supreme Court reviewed the Act and the judgment for respondents was reversed. The Court
concluded that the language of § 10(b) clearly connoted intentional misconduct.
ISSUE: Can a private cause of action for damages prosper under § 10(b) of the Securities
Exchange Act of 1934 (1934 Act) and the Securities and Exchange Commission Rule 10b-5 in the
absence of an allegation of intent to deceive, manipulate, or defraud on the part of the
defendant?
ANSWER: No.
CONCLUSION: The Court stated that the language of a statute controls when it is sufficiently
clear in context. The Court held there could be no private cause of action for damages under §
10(b) of Act and Rule 10b-5 without an allegation of scienter, i.e., intent to deceive, manipulate,
or defraud.
The Private Securities Litigation Reform Act (PSLRA) of 1995, pleasing state of mind in court
requires that a plaintiff alleging a securities fraud claim under Rule 10b-5 must state the facts
that give rise to a strong inference that the defendant acted with the requisite knowledge state
of mind.
Reliance (Transaction Causation)-In common law fraud cases, a plaintiff must prove that he
heard or saw the offending misstatement which played a significant part in a decision to
purchase, invest, or tender.
The Fraud on the Market Theory Reliance Substitute-All investors do rely on the integrity of
prices in the securities markets that those prices accurately reflect all available information
about the issuing corporation.
Loss Causation-In a Rule 10b-5 case, the plaintiff must establish not only a causal link between
the defendant’s wrongdoing and the plaintiff’s conduct but also a causal link between the
defendant’s acts and the plaintiff’s loss or damages.
The “In Connection With” Requirement-The defendant’s wrongful acts must have occurred in
connection with the purchase or sale of a security as stated in Section 10b. The in connection
with requirement is a means of testing whether there is a connection between the securities
and the fraud that is being alleged.
Privity-A common law fraud claim must have direct dealings between the plaintiff and the
defendant because the problem is that- in securities markets- most transactions take place using
intermediaries.
Secondary Liability for Disclosure Violations-Secondary violators become liable because
someone else, the primary violator has violated the securities laws including disclosure rules
under Rule 10b-5.
The case in our textbook, In re Enron Corporation Securities, Derivative & Erisa Litigation
SUMMARY: This is a class action brought on behalf of purchasers of Enron corporation’s publicly
traded equity and debt securities, (Plaintiffs), against (1) Canadian Imperial Bank of Commerce,
2) CitiGroup Inc., 3) J.P. Morgan Chase & Co., 4) Vinson & Elkins LLP, 5) Arthur Andersen LLP, 6)
Barclays PLC, 7) Credit Suisse First Boston, 8) Kirkland & Ellis, 9) Bank of America Corporation 10)
Merrill Lynch & Co., 11) Lehman Brothers Holdings Inc., and 12) Deutzche Bank AG, and others,
(Defendants).
RULE OF LAW: Scienter knowledge may be inferred through circumstantial evidence. FACTS OF
THE CASE: The complaint alleges that Defendants, “are liable for i) making false statements, or
failing to disclose adverse facts while selling Enron securities and/or ii) participating in a scheme
to defraud and/or a course of business that operated as a fraud or deceit on purchasers of
Enron’s public securities during the Class Period.” Plaintiffs assert that Defendants participated
in massive Ponzi scheme to inflate Enron’s reported revenues, mask its growing debts, sustain
its falsely high stock prices and investment grade credit rating, and allow individual defendants
to enrich themselves by looting the corporation while continuing to raise money from public
offerings of Enron or related entities’ securities to uphold the scheme and to delay the collapse
of the corporation. Lead Plaintiff further alleges that Enron’s accountants, outside law firms, and
banks by rubber stamping their opinions deceived investors and the public and benefited from
enormous fees and increasing business, as well as investment opportunities for personal
enrichment.
ISSUE: Whether Plaintiff has alleged that Defendants acted with the requisite scienter.
HOLDING: Because Lead Plaintiff has alleged numerous violations of GAAP and GAAS and
pleaded facts giving rise to a strong inference of scienter, he has pleaded a securities fraud claim
against Arthur Andersen.
These transactions were not isolated, but deliberate, repeated actions with shared
characteristics that were part of an alleged common scheme through which all Defendants
profited exorbitantly. The pattern that is alleged undercuts claims of unintentional or negligent
behavior and supports allegations of intent to defraud. Further, Plaintiff has pleaded effectively
the common motive of obsession with financial gain. The allegations asserted against most of
the secondary actor Defendants such as the long-term, continuous, and intimate relationships
with Enron and daily interaction with Enron’s top executives necessarily raise the specter of
potential opportunities to learn about and participate in Enron’s financial affairs.
Statutes of Limitation-Securities law provides a short statute of limitations for Rule 10b-5
actions (lawsuits) 2 years after discovery of the facts constituting a violation and in any case no
later than 5 years after the violation.
Common Law Background-The common law approach to insider trading was based upon an
action in fraud. Most insider trading involves a misrepresentation or half-truth and lack of
disclosure that is silence.
Who is an Insider-A traditional insider is a person who, because of a fiduciary or similar relation
is afforded access to nonpublic investment information from her corporation.
Tipper-Tippee Liability-An insider who passes information to another person knowing that the
other person will trade using the information is a tipper. Whether she trades or not, a tipper has
the same liability as an insider who actually trades. The recipient of the information is a tippee
and also has insider trading liability BUT only is she trades.
The Misappropriation Theory-The case in our textbook, United States v. Chiarella
RULE OF LAW: Silence in connection with the purchase or sale of securities may operate as a
fraud actionable under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.S. § 78j, despite
the absence of statutory language or legislative history specifically addressing the legality of
nondisclosure. Application of a duty to disclose prior to trading guarantees that corporate
insiders, who have an obligation to place the shareholder's welfare before their own, will not
benefit personally through fraudulent use of material, nonpublic information.
FACTS: While working for a financial printer, petitioner handled announcements of corporate
takeover bids. Without disclosing his knowledge the printer purchased the targeted companies
stock, selling the shares immediately after the takeover attempts were made public. He was
indicted and convicted of violating § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.S. §
78j, and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5. Petitioner appealed the decision.
ISSUE: Did petitioner's failure to disclose non-public market information prior to trading make
him liable for fraud?
ANSWER: No
CONCLUSION: Reversing petitioner's conviction, the Court held that petitioner had not violated
the duty to disclose material information where no relationship of trust or confidence existed
between petitioner and the shareholders. While noting that silence in connection with the
purchase or sale of securities could have been fraud under § 10(b), the Court held that
petitioner had not violated § 10(b) where he was under no affirmative duty to disclose the
information before trading. Because petitioner was not an agent or fiduciary of the sellers, the
Court found that he had no duty to the sellers.
The classical theory requires the person accused of insider trading to be an actual insider—an
officer or employee of the company whose securities they are buying or selling. Under this
theory, only the corporate insider owes a fiduciary duty to the corporation and its shareholders
not to engage in buying or selling the corporation's securities using material non-public
information. The outsider who happens across some material non-public information does not
owe that fiduciary duty and cannot be guilty of insider trading.
Under misappropriation theory, however, the outsider who happens across some material non-
public information of a corporation may not use that information to trade because they owe a
fiduciary duty to the source of the information. Misappropriation theory is intended to protect
securities markets from outsiders who have access to confidential corporate information but
who do not owe a fiduciary duty to the corporation or its shareholders.
SEC Regulation FD-Regulation Fair Disclosure is a rule passed by the Securities and Exchange
Commission in an effort to prevent selective disclosure by public companies to market
professionals and certain shareholders.
Regulation of Insider Trading Under Section 16 of the Securities Exchange Act of 1934-Section 16
of the original explicit insider trading provision presumes that any officer, director, or holder of
10% or more of an SEC reporting company who purchase and sells or sells and purchases within
a 6-month period is presumed to have traded on inside information. Such person is therefore
liable to the corporation for the profit and subject to a derivative lawsuit. The provision is
commonly referred to as the short swing profits provision as section 16a is a reporting provision.
Parties Plaintiff and Calculation of Damages-Section 16b liability is often referred to as draconian
in part because it is strict liability but also because of the manner in which damages are
calculated. To calculate damages, the only rule the court noted is whereby all possible profits
can surely be recovered is that of the lowest price IN highest price OUT within six months.
Who is an Officer for Section 16 Purposes-Officer includes presidents, chief executives officers,
chief operating officers, vice-presidents in charge of a principal business unit or division,
principal financial and accounting officers.
Insider Status at Only One End of a Swing-Section 16b provides that this subsection shall not be
construed to cover any transaction where such a 10% beneficial owner was not such both at the
time of the purchase or sale and purchase of the security involved.
Takeover Players and Section 16(b)-Defeated bidders often have on hand more than 10% of the
equity securities of a target corporation. Because they usually have borrowed a significant
portion of the purchase price, often at high interest rates they are under significant pressure to
sell.
Chapter 5: The Legal Model and Corporate Governance Themes and the Allocation of Power
Under Stress
Focus of Corporate Governance and Stakeholders-Under corporate law, control of a corporation
is vested in the board of directors elected by the shareholders. These directors run the business.
Although various stakeholders such as creditors or employees are affected by how corporations
are governed the primary relationship which has shaped corporate law is between the managers
who are the officers and inside directors and the owners are the shareholders.
Focus of Corporate Governance and Shareholders-In the case in our textbook, Dodge v. Ford
Motor Co.
RULE OF LAW: Courts not interfere in the management of directors unless it is clearly made to
appear that they are guilty of fraud or misappropriation of the corporate funds, or refuse to
declare a dividend when the corporation has a surplus of net profits which it can, without
detriment to its business, divide among its stockholders, and when a refusal to do so would
amount to such an abuse of discretion as would constitute a fraud.
FACTS OF THE CASE: Defendant corporation's directors decided to exercise their discretion and
hold back part of the company's capital earnings for reinvestment, thereby denying certain
expected dividend payments to plaintiffs. Plaintiffs contended that the reason defendant
corporation was holding back dividends, partially to reinvest in the company and bring down the
ultimate cost of buying a car, was semi-humanitarian and was not authorized by the company's
charter. The trial court held that defendant corporation was entitled to reinvest surplus capital
gains at their discretion and did not order further dividends paid out. The appellate court
reversed that decision.
ISSUE: Did the trial court err in its failure to order that further dividends paid out?
ANSWER: Yes.
CONCLUSION: The accumulation of so large a surplus established that there was an arbitrary
refusal to distribute funds to stockholders as dividends and ordered that such dividends, plus
interest, should be paid by defendant corporation.
In the case in our textbook, Shlensky v. Wrigley
RULE OF LAW: In a purely business corporation the authority of the directors in the conduct of
the business of the corporation must be regarded as absolute when they act within the law, and
the court is without authority to substitute its judgment for that of the directors.
FACTS OF THE CASE: Plaintiff, William Shlensky, a minority stockholder of defendant
corporation, Chicago National League Ball Club (Inc.). The defendant corporation owned and
operated the major league professional baseball team known as the Chicago Cubs. The
individual defendants were directors of the Cubs and have served for varying periods of years.
Defendant Philip K. Wrigley was also president of the corporation and owner of approximately
80% of the stock therein. Shlensky alleged that every member of the major leagues, other than
the Cubs, scheduled substantially all of its home games in 1966 at night, exclusive of opening
days, Saturdays, Sundays, holidays and days prohibited by league rules. Allegedly this has been
done for the specific purpose of maximizing attendance and thereby maximizing revenue and
income. According to Shlensky, in the years 1961-1965, Chicago National League Ball Club
sustained operating losses from its direct baseball operations. Shlensky attributed those losses
to inadequate attendance at Cubs' home games. He concluded that if the directors continue to
refuse to install lights at Wrigley Field and schedule night baseball games, the Cubs will continue
to sustain comparable losses and its financial condition will continue to deteriorate. Shlensky
further alleged that defendant Wrigley has refused to install lights, not because of interest in the
welfare of the corporation but because of his personal opinions that baseball was a daytime
sport and that the installation of lights and night baseball games will have a deteriorating effect
upon the surrounding neighborhood. Plaintiff further alleged that the other defendant directors,
with full knowledge of the foregoing matters, have acquiesced in the policy laid down by
Wrigley and have permitted him to dominate the board of directors in matters involving the
installation of lights and scheduling of night games, even though they knew he was not
motivated by a good faith concern as to the best interests of defendant corporation, but solely
by his personal views. Because of these concerns, Shlensky filed a stockholders' derivative suit
against the directors for negligence and mismanagement. According to Shlensky, fraud, illegality
and conflict of interest were not the only bases for a stockholder's derivative action against the
directors. On the other hand, defendants argued that the courts will not step in and interfere
with honest business judgment of the directors unless there is a showing of fraud, illegality or
conflict of interest. The lower court ruled in favor of the defendants and held that Shlensky’s
complaint did not state a cause of action. Shlensky thereafter appealed the judgment.
ISSUE: Did Shlensky’s complaint state a cause of action?
ANSWER: No.
CONCLUSION: The Court held that Shlensky’s complaint did not state a cause of action. The
Court maintained that courts should not interfere in a corporation's management unless fraud
or a breach of faith existed. In the case at bar, the decision at issue was one properly before the
corporation's directors, and the motives alleged in the complaint showed no fraud, illegality, or
conflict of interest in their making of that decision. According to the Court, the allegations in
Shlensky’s complaint were mere conclusions, which were insufficient to except the directors
from the business judgment rule.
Publicly Held Corporation-When a corporation or its shareholders sell their shares to a large
number of investors it becomes publicly held and the shares trade in a stock market. The United
States has the largest number of publicly traded corporations in the world.
The Stock Markets-Given the number of publicly held companies and shareholders, there is an
extensive market for the trading of shares.
Benefits of Stock Markets-Public markets provide numerous investment choices, allowing the
public to purchase shares in different companies. This makes diversification of investment
possible. Diversification is beneficial because investors reduce their risks by buying a portfolio of
different investments rather than concentrating ownership.
The Efficient Capital Market Hypothesis-The stock markets are also significant because the
active trading of shares provides a market mechanism to monitor the running of the business.
The share price set by the market can be a benchmark for the performance of the business and
its management. In order for the share price to serve that purpose, the shares must trade in an
efficient market, that is, the share price generally reflects all available information.
The Efficient Capital Market Hypothesis (ECMH) states that the numerous active traders in the
stock market react quickly and efficiently to information. Whenever new information is available
about a company it is immediately reflected in the price of the shares. According to the ECMH,
the only factor that will change the value of a company’s shares is new information because the
current share price contains all currently available information. Thus, the share price in an
efficient market can reflect how well a corporation is run.
Role of Ownership-Share ownership is a significant influence on the development of corporate
law and publicly traded corporations. There are THREE particular aspects of share ownership
that play a role (1) Separation of Ownership from Control (Berle-Means Corporation) (2)
Institutional investors and (3) Political Significance of Share Ownership.
The Berle-Means Corporation-Separation of Ownership from Control-In many publicly traded
corporations, there are a large number of widely dispersed shareholders so there is no large
shareholder to monitor the business. Professors Berle and Means in their book the modern
corporation and private property studied the publicly traded corporation. They found that many
publicly traded corporations had a dispersion of ownership in which no single shareholder
owned a large number of shares which meant a separation of ownership from control.
Ownership usually implies control, but without a concentration of ownership in shares
managers who control corporate assets, information and the voting mechanisms are in de facto
control of the corporation with little oversight by the owners, the shareholders.
Institutional Investors-In the last several decades, the ownership of shares has shifted to large
institutions consisting of private and public pension funds, insurance companies, foundations,
hedge funds, universities, brokerage firms, bank trust companies, and mutual funds.
While the Berle-Means model of widely dispersed owners continues, institutional ownership
means that those owners now hold a larger number of shares representing a big dollar
investment.
Political Significance of Share Ownership-The political voice of shareholders can play a
significant role in the development of corporate law. The household savings of many United
States households are directly and indirectly tied to share ownership. While institutional
shareholdings have increased, individual shareholders such as mutual funds are holding shares
indirectly for individuals.
Independent Directors-Many of the recent corporate governance proposals have centered
around proposals to strengthen boards of directors in protecting shareholders through the use
of independent directors.
Gatekeepers-In addition to legal and market mechanism intended to limit mismanagement or
fraud, the regulatory system also relies on outside parties or gatekeepers who may vouch for
the corporation or specific transactions. The principal gatekeepers are independent
accountants, credit rating agencies, investment banks and outside legal counsel. Since these
gatekeepers have their reputations to uphold it is believed that they will not sacrifice that
reputation to assist a client in wrongdoing.
Publicly Held vs. Closely Held Corporations-Closely held corporations have fewer shareholders
and shares are not traded in the stock market.
Shareholders of closely held corporations are often active in the management of the business.
Theories of the firm-The Regulatory Approach-A regulatory approach views managers as
unaccountable and likely to take advantage of the shareholders and not necessarily protect
other stakeholders.
Management, Director, or Shareholder Approach-The management approach favors laws which
give managers (officers and inside directors) tremendous latitude in their activities. This model is
premised on the idea that managers will protect the interests of shareholders because they
have a mutual interest in protecting the corporation.
Law and Economics Approach-Since the 1980s, the dominant theory of the firm has been the
law and economics approach or contractual model. This approach views the separation of
ownership from control as beneficial because the passive investors provide capital in return for
the managers maximizing profile for shareholders. Under this approach, managers should run
the business and abuse by managers would best be controlled privately with market based
solutions as opposed to government regulation.
Agency Costs-Financial economists look at the corporation and describe the relationship
between the shareholders and managers as an agency relationship. In any such relationship, the
agent managers in the corporate context does not always act in the best interests of the
principal shareholders.
Markets-The law and economics approach views a market oriented approach as the optimal way
of looking at the firm and for lowering agency costs. Markets present a more efficient cost less
and benefit more means to monitor the agency relationship than government regulation.
Nexus of Contracts-Some law and economics theorists conceptualize the corporation in terms of
contract law. A corporation can be viewed as a nexus of contracts through which various
claimants such as creditors, workers, shareholders, and consumers enter into agreements.
Critics of Contractual Approach-While many corporate law rules can be waived or modified
because the statutes explicitly allow for it critics of this contractual approach argue that some
minimal protection and regulation is needed and some of the rules should not be changed so
easily.
Behavioral Economics-The field of behavioral economics reflects the use of cognitive and social
psychology applied to economics. The traditional law and economics view and its impact on
corporate law is based on the rational profit maximizing individual.
Shareholders-The common shareholders as owners of the corporation are viewed as residual
claimants because their claim on assets upon liquidation and profits follows creditors and
preferred shareholders who usually have fixed claims with priority. All amounts above those
fixed claims are for the benefit of the common shares. Thus, as the value of a firm increases, so
does the value of the common shares.
Right to Vote-Shareholders are given the explicit power to vote on such issues as the election of
directors, and amendments to the bylaws usually can be done by the shareholders without
board approval while article amendments require both directors and shareholder approval.
Cumulative Voting-The normal shareholders voting procedure is that each shareholder votes his
or her shares for a particular issue. A plurality vote wins. This procedure is followed with regard
to the election of directors. If a group of shareholders own a majority of the shares under this
straight voting scheme, the group will elect all the directors by voting their majority in favor of
each candidate.
Right of Expression-There are times when shareholders seek to express their views with
nonbinding resolution proposed by shareholders.
Proxy Voting-Annual shareholder meetings are required by statute at which the directors are
elected and other issues may be voted upon. Special meetings prior to the annual meeting can
also be called if action needs to be taken before the next annual meeting.
The Proxy Fight-The right to vote for directors is the most significant right that the shareholders
of publicly traded corporations possess especially when there is no control group. But the rights
to amend the bylaws to try to mandate changes and to propose proposals for change are also
significant.
Change Management-If a corporation is not being run effectively then an outside group could
initiate a proxy fight to replace the directors with a view to changing management or having a
voice in the running of the business.
Replace Directors to Facilitate an Acquisition-If someone wants to acquire a corporation and the
incumbent directors are opposed there may be a proxy fight to replace those directors with a
new board that will favor the acquisition.
Change Policy-Shareholder Proposals-In seeking to change policy shareholders have the option
of using management’s proxy statement to propose resolutions pursuant to Securities and
Exchange Commission Rule 14a-8 or to solicit proxies using their own proxy materials which are
not subject to the limitations of the rule.
Withholding Votes-When voting for directors who are running unopposed shareholders have a
choice of voting in favor or withholding their vote. Some institutional shareholders have actively
asked shareholders to withhold votes in favor of certain directors as an expression of protest.
Nominating Directors in Management’s Proxy Statement-Because of the costs of mounting a
proxy contest advocates of increasing shareholder power and voice have tried for many years to
allow significant shareholders access to management’s proxy statement to nominate some
directors to run against the company’s nominees.
Collective Action Problem-Proxy fights are infrequent and often fail because shareholders are
passive. The passivity of widely dispersed shareholders their failure to exercise their voting
rights, and their inability to network even if they desire to do so has been described as involving
a collection action problem.
Proxy Expenses-Management has an advantage in proxy solicitations because corporate funds
pay their expenses.
In the case in our textbook, Rosenfeld v. Fairchild Engine & Airplane Corporation
RULE OF LAW: Management may look to the corporate treasury for the reasonable expenses of
soliciting proxies to defend its position in a bona fide policy contest.
FACTS OF THE CASE: Appellant William Rosenfeld brought a stockholder's derivative action
where he sought to compel the return of funds paid out of the corporate treasury to reimburse
both sides in a proxy contest for their expenses. The lower courts affirmed the judgment of the
official referee that dismissed appellant's complaint. The court affirmed the dismissal.
ISSUE: Was the dismissal of the appellant’s complaint proper for the reason that the appellant
did not argue that the funds were fraudulently extracted from the corporation, but instead
admitted that the charges were fair and reasonable?
ANSWER: Yes.
CONCLUSION: The court noted that appellant did not argue that the funds were fraudulently
extracted from the corporation, but instead admitted that the charges were fair and reasonable.
The court held that since appellees acted in good faith in a contest over policy, they had the
right to incur reasonable and proper expenses for the solicitation of proxies and in defense of
their corporate policies, and were not obliged to sit idly by. The court also noted that
stockholders had the right to reimburse successful contestants for reasonable and bona fide
expenses incurred by them in any such policy contest, subject to court scrutiny. Thus, the
dismissal of appellant's complaint was proper.
Fiduciary Duty-In the case in our textbook, Schnell v. Chris-Craft Industries
RULE OF LAW: Stockholders may not be charged with the duty of anticipating inequitable action
by management, and of seeking anticipatory injunctive relief to foreclose such action, simply
because the new Delaware Corporation Law makes such inequitable action legally possible.
FACTS OF THE CASE: Appellant stockholders Andrew Schnell, Jr. and Jack Safer sued to enjoin
appellee Chris-Craft Industries, Inc. (“corporation”) from advancing the date of the annual
stockholders' meeting. The corporation claimed it was allowed to do so by amendments to the
Delaware business law. The trial court found in favor of the corporation and denied the
stockholders’ petition for injunctive relief. The stockholders appealed.
ISSUE: Where stockholders sought to prevent the corporation from advancing the date of the
annual stockholders' meeting, did the trial court err in its decision to deny the stockholders’
petition for injunctive relief?
ANSWER: Yes.
CONCLUSION: The Supreme Court of Delaware reversed the judgment of the trial court.
According to the Court, the conclusions of the trial court amounted to a finding that the
corporation attempted to utilize the corporate machinery and the Delaware Law for the purpose
of perpetuating itself in office, and to that end, for the purpose of obstructing the legitimate
efforts of dissident stockholders in the exercise of their rights to undertake a proxy contest
against management. The Court held that these were inequitable purposes, contrary to
established principles of corporate democracy. In reversing the judgment, the court stated that
inequitable actions, such as those of appellee corporation, would not be allowed to stand simply
because they were permitted by law.
Vote Buying-There is a breach of duty when shareholders are coerced into voting a certain way.
Right to Information-In addition to the power to vote, shareholders are granted the right to
receive some information. The right is conferred by both federal securities laws and state law.
Board of Directors-The board of directors in publicly traded corporations must give managers
flexibility to run the business while monitoring them to limit self-dealing and mismanagement.
Board Structure-The unitary or single board of directors is the statutory norm for American
corporations. The number of directors is usually set out in the bylaws or articles and the
directors are elected by the shareholders at their annual meeting usually for a one-year term.
Meetings-The board traditionally acts at a duly-called meeting. Rules on voting, notice and
quorums are usually set out in the bylaws pursuant to the requirements of the corporate
statute.
Actions Without a Meeting-There has been some debate in the context of closely held
corporations about whether the board may only act at a meeting as opposed to more informal
arrangements.
Officers-The daily operation of business is usually delegated to the corporate officers who are
appointed by the board of directors. The appointment of an officer may be for a term. Officers
may be removed by the directors at will even if no cause exists.
Authority-An officer’s power originates from the board of directors. Statutes usually say little
about the actual power of an officer.
There are THREE ways that an agent may bind the principal. (1) express (2) implied and (3)
apparent authority. In each case the authority comes from the principal the corporation.
Express actual authority is present where the principal expressly endows the agent with
authority. For example, express authority exists when the board or president tells a manager of
one of its stores to hire employees.
Implied actual authority exists where the principal implicitly gives the agent authority to act.
This implication can result from the manager’s title or by the behavior of the principal.
Apparent authority is created when the principal manifests to third parties that the agent has
authority to act express and implied results from the manifestation from the principal to the
agent.
The Sarbanes-Oxley Act of 2002- The Sarbanes-Oxley (SOX) Act of 2002 came in response to
highly publicized corporate financial scandals earlier that decade.
The act created strict new rules for accountants, auditors, and corporate officers and imposed
more stringent recordkeeping requirements. It added new criminal penalties for violating
securities laws.
Dodd Frank-Act of 2010-The 2009 financial crisis primarily involved problems at large financial
institutions but also raised general corporate governance issues. Under the Dodd-Frank Act,
publicly traded companies are now required to allow shareholders a say on pay by requiring an
advisory vote from the shareholders on executive compensation packages as well as advisory
voting n golden parachutes when voting on an acquisition.
Chapter 14 Corporate Litigation
Corporate litigation falls into two categories: direct and derivative.
If one or more shareholders sue the corporation alleging that the corporation has denied them a
contract right associated with shareholding rights to dividends or disclosure for example, the
action is direct. The shareholder may maintain the action in his or her own name. If the
shareholder alleges a special and distinct injury over and above a diminution in the value of
shares the action is also direct.
In a direct action, damages recovered are paid to the shareholders.
Direct Litigation: If one or more shareholders sue the corporation alleging that the corporation
has denied them a contract right associated with shareholding (rights to dividends or disclosure,
for example), the action is direct.
If the shareholder alleges a special or distinct injury over and above a diminution in the value of
shares, the action is also direct.
Derivative Litigation- By contrast, if shareholders sue to vindicate the violation of a duty owed to
the corporation either fiduciary duties owed by corporate directors or officers, or obligations of
a third party pursuant to a contract with the corporation, the action is derivative.
The Nature of the Derivative Suit-A derivative action is an action brought by shareholders on
behalf of the corporation. The derivative action is initiated to remedy an alleged wrong to the
corporation perpetrated either by those in control of the corporation such as officers, directors,
or controlling shareholders, a third party, such as a supplier who has breached a contract with
the corporation or both.
In the case of a supplier who has allegedly breached a contract with the corporation, the
plaintiff may allege a cause of action against the third party supplier, and may also plead in the
alternative against the directors.
Plaintiff can allege mismanagement duty of care by the board, in that board members were
indifferent, or inattentive to the breach by the third party of an important contract.
Alternatively, plaintiff could allege self-dealing that for some quid pro quo the directors favored
the interests of the supplier as a friend, associate, family member over the best interests of the
corporation.
Any recover goes to the corporate treasury.
Direct Versus Derivative-Special or Distinct Injury Rule-Assume a corporation that has allegedly
paid a dividend in the form of financial benefits for some, but not all, common shareholders.
The aggrieved shareholders those who did not share in the financial benefit may certainly bring
a derivative action alleging that the directors carelessly violated an obvious precept of corporate
law that all shares of the same class be treated equally a duty of care claim.
Due to all of the procedural and other requirements surrounding the derivative action such as
the need to pot bond or to make a demand on the directors, plaintiffs tend to view derivative
actions as something to be avoided.
An important threshold issue is whether an action based on a claim such as the payment of a
dividend to some of a class of shareholders may be maintained as a direct action.
A direct action can be brought either when there is a special duty, such as a contractual duty,
between the wrongdoer and the shareholder, or when the shareholder suffers injury separate
and distinct from that suffered by other shareholders.
Direct Versus Derivative-Denial of Contract Rights Associated with Shareholding-Even if a
shareholder is not able to establish separate and distinct injury she may be able to proceed in a
direct action if she can establish denial by the corporation or directors of some right belonging
to the shareholders.
Direct Versus Derivative-Closely Held Corporation Exception-A growing number of jurisdictions
permit actions that should be derivative claims to be prosecuted in a direct action if the
corporation is closely held. A widely accepted view of the close corporation perceives the
participants as owing not just duties to the corporation but to each other just like partners in a
partnership. Shareholders are able to proceed directly against shareholder-directors for
violation of those duties.
Pro Rata Individual Recovery in Derivative Actions-The norm in an action based upon violation of
a fiduciary or other duty owed to the corporation is that the recovery goes to the corporate
treasury. In close corporations, a growing number of courts permit plaintiff-shareholders to
proceed directly resulting in direct payment of damages. Plaintiff-shareholders recover damages
in proportion to the shared they hold pro rata.
In other cases involving closely held and other corporations courts continue to style the action
as derivative but permit any recovery to go directly to shareholders,
The theory of pro rata recovery cases is that if the wrongdoers own a substantial amount of
shares and if the damages are paid to the corporate treasury the recovery flows in part to the
wrongdoers. Although not facially limited to close corporations in practice individual
recoveries are found in closely held corporations.
The Tooley Test in Delaware- The Tooley test, as it has come to be known,
requires Delaware courts to ask the following two questions: "(1) who suffered the alleged harm
(the corporation or the stockholders); and (2) who would receive the benefit of any recovery or
other remedy (the corporation or the stockholders individually)
Qualifications of a Proper Plaintiff-Shareholder/Record Ownership-The vast majority of shares in
publicly traded corporations are held in nominee or street name (named after Wall Street)
rather in the shareholder’s names or record ownership. From a shareholder-investor standpoint
the reason for the use of the nominee is convenience in buying and selling. Persons who are
record owners usually have a share certificate. To retrieve the certificate from a safety deposit
box and deliver it to a broker’s office is inconvenient requiring far more effort than a mere
telephone call as is possible when shares are held in street name.
Contemporaneous Ownership-Another requirement is that the plaintiff own hares at the time
the wrong about which she complains occurred and that she maintain ownership continuously
throughout pendency of the pleadings of the case. An interruption or termination of
shareholder status automatically ousts plaintiff on the grounds of lack of standing to sue or
bring the case to court.
Possible Exception: Undisclosed Wrongdoing-Under California’s statute, the judge may dispense
with the requirement of contemporaneous ownership is the plaintiff acquired the shares before
there was disclosure to the public or to the plaintiff of any wrongdoing.
Exception: Continuous Wrong-A principle that may enable a subsequent purchasing shareholder
to avoid the contemporaneous ownership requirement is to find that the wrong committed is a
continuous one extending into the period of the named plaintiff’s share ownership.
Exception: Double Derivative Actions-An owner of shares in a parent corporation or holding
company may sue to remedy wrongdoing in a subsidiary. This action is called a double derivative
action.
Continuous Owner-Sales of shares, gifts of shares, or merger of the issuing corporation even if
contrived to end the plaintiff’s lawsuit are events that extinguish the named plaintiff’s right to
maintain a shareholder suit. Ownership must be maintained through trial and appeal, if any.
Clean Hands Requirement-The derivative suit relates to equity. Most often the underlying claims
of breaches of fiduciary duty are equitable as well. Courts require plaintiff to have clean hands.
If the plaintiff has any complicity in the wrongdoing either as shareholder, officer, director, or in
some other capacity she is not an adequate representative of the shareholder class in court.
Adequate Representation Requirement-The adequate representation requirement in derivative
suits has two components first that the plaintiff-shareholder be an adequate representation of
the shareholders in general and second that counsel be able adequately to prosecute the case.
Reforms of the earlier strike suit era-Verification Requirement-A strike suit era reform that
survives today is the requirement that a derivative action plaintiff verify the complaint.
Verification requires that a plaintiff read the allegations and attests that in good faith and based
upon personal knowledge she believes them to be true. A verified complaint must be signed by
the plaintiff.
Security for Expenses Requirements-Another requirement is that a shareholder-plaintiff or at
least a party plaintiff with a small take in the corporation undertake to pay defendants’ costs
should the plaintiff lose or abandon the litigation.
The Demand Rule-Demand is not merely a pleasing requirement. Courts have held that the
demand requirement is a device whereby corporate law has made an important substantive
allocation of power among shareholders, directors, and the corporation.
Demand is the name whereby the board of directors which is charged with managing the
corporations’ business and affairs has an opportunity to manage litigation in the corporations’
name or on its behalf. It also represents an opportunity for intra-corporate dispute resolution.
By receiving and acting upon a demand, the board may save the corporation great expense.
Demand Refusal-A shareholder generally makes demand by letter to the board of directors a
senior manager such as the CEO to the corporation’s counsel. In the letter, the shareholder sets
out the grievance.
The Futility Exception-The law will not command an act which if done would be futile. Requiring
a shareholder to make demand upon a board of directors who will not give that demand a fair
hearing would be to require a futile act. A board of directors may be unable to give a demand a
fair hearing because a critical mass of the directors who would act are likely to be motivated by
an illicit objective in their treatment of the shareholder demand if it were made.
Legal Tests for Demand Futility-The best font of general principles regarding demand futility is
the case in our textbook Aronson v. Lewis.
RULE O FLAW: To establish demand futility, a plaintiff need not allege that the challenged
transaction could never be deemed a product of business judgment. Rather, a plaintiff must only
allege facts which, if true, show that there is a reasonable inference that the business judgment
rule is not applicable for purposes of considering a pre-suit demand pursuant to Del. Ch. Ct. R.
23.1.
FACTS OF THE CASE: Beginning 1981, Meyers Parking System, Inc. (Meyers) entered into an
employment agreement with Leo Fink, a director who owned 47% of the outstanding shares of
the company. The terms of the agreement were alleged to be highly in favor of Fink. Meyers’
board also granted interest-free loans to Fink amounting to $225,000. Thereafter, the plaintiff,
Harry Lewis, a stockholder of the company instituted an action, challenging the transactions
entered into by Fink and Meyers. According to Lewis, the aforementioned transactions were
approved only because Fink personally selected each director and officer of Meyers. Lewis
further contended that the transactions violated the business judgment rule. The board of
Meyers responded by moving to dismiss the claim in its entirety. The chancery court denied the
motion and held that under Del. Ch. Ct. R. 23.1, Lewis successfully alleged demand futility in that
he allowed the board of directors to correct the alleged wrong. Subsequently, the board of
directors appealed.
ISSUE: Did Harry Lewis successfully allege demand futility under Del. Ch. Ct. R. 23.1?
ANSWER: No.
CONCLUSION: The Court held that Lewis’ failure to allege facts implicating director bias, lack of
independence, or involvement in activities contrary to corporate interest acted as a bar to
meeting the requirement of demand futility.
New York seems to have retained flexibility better than Delaware. The case in our textbook,
Marx v. Akers.
RULE OF LAW:
Demand is excused because of futility when a complaint alleges with particularity that a majority
of the board of directors is interested in the challenged transaction. Director interest may either
be self-interest in the transaction at issue (receipt of "personal benefits"), or a loss of
independence because a director with no direct interest in a transaction is "controlled" by a self-
interested director. Demand is excused because of futility when a complaint alleges with
particularity that the board of directors did not fully inform themselves about the challenged
transaction to the extent reasonably appropriate under the circumstances. A director does not
exempt himself from liability by failing to do more than passively rubber-stamp the decisions of
the active managers. Demand is excused because of futility when a complaint alleges with
particularity that the challenged transaction was so egregious on its face that it could not have
been the product of sound business judgment of the directors.
FACTS OF THE CASE:
Plaintiff Sylvia A. Marx, a shareholder in International Business Machines Corporation (IBM),
filed a shareholder derivative action in New York state court against IBM and its board of
directors ("Board"), including defendant John F. Akers. Marx filed the action without
first demanding that the Board initiate a lawsuit. Marx alleged that Board wasted corporate
assets and that the directors engaged in self-dealing by awarding excessive compensation to
company executives and outside directors during a period of declining profitability. On
defendants' motion, the trial court dismissed Marx's complaint for failure to state a cause of
action; the appellate division affirmed. Marx appealed, by permission, to the Court of Appeals of
New York.
ISSUE: Did the trial court err in dismissing the action?
ANSWER: No.
CONCLUSION: The Court of Appeals of New York affirmed the order dismissing Marx's complaint
for failure to state a cause of action, with costs. The court found that because only three
directors were alleged to have received the benefit of the compensation scheme, a majority of
the Board was not "interested" in it. It held that the allegations that the Board used faulty
accounting procedures to calculate executive compensation levels were "conclusory allegations
of wrongdoing" insufficient to excuse demand. The court noted that a director who voted for a
raise in directors' compensation was always "interested" because that person received a
personal financial benefit from it. Consequently, a demand was excused as to the allegations
that the compensation set for outside directors was excessive. The court held, however, that the
allegations that the compensation bore no relationship to duties performed or to the cost of
living were insufficient as a matter of law because they lacked factually-based allegations of
wrongdoing or waste which could, if true, sustain a verdict for Marx.
Disabling Conflicts of Interest-Material interests that disable include financial or pecuniary
interests or familial associations.
Merely being named as defendants in the lawsuit does not disable directors so named. Receipt
of directors’ fees or long board service do not automatically disable.
Lack of independence-Even though directors may have had no pecuniary interest in the
transaction under attack, plaintiffs may allege that directors are beholden to a controlling
shareholder, a family member, the CEO, or some other person who does have an interest in
approval of the transaction or refusal of a demand. These directors are said to have been
dominated. In more polite terms, the allegation and finding will be that they lack independence.
Threat of Irreparable Harm-Both the ALI Project and the Model Business Corporation Act excuse
demand in cases in which the corporation is threatened with irreparable harm.
The American Law Institute Project (ALI Project)- The American Law Institute (ALI) approved a
new project last month – Restatement of the Law, Corporate Governance. Over 25 years ago,
the ALI approved and published the Principles of Law, Corporate Governance and this new
project will examine the evolution of corporate governance over the last 25 years and reflect the
current state of the law. New York University Law School Professor Edward Rock will serve as
the Reporter for the Restatement, assisted by a number of associate reporters and advisors with
diverse experiences. The project is likely to take several years to complete.
Termination of Litigation: The Advent of the Special Litigation Committee Device-The
mechanism by which corporations have come to find their voice for speaking out about whether
or not a derivative action should continue is the Special Litigation Committee (SLC). To form an
SLC, the board of directors delegates to a committee of two or three directors all the board’s
power with respect to the litigation.
Application of the Business Judgment Rule-The case in our textbook, Auerbach v. Bennett,
RULE OF LAW:
The business judgment doctrine bars judicial inquiry into actions of corporate directors taken in
good faith and in the exercise of honest judgment in the lawful and legitimate furtherance of
corporate purposes.
FACTS OF THE CASE:
A specially appointed committee of disinterested directors - acting on behalf of defendant, a
board of directors of a corporation - made a decision to terminate a shareholders' derivative
action. The plaintiff shareholders filed suit to challenge the decision, and defendant filed
motions for summary judgment and to dismiss. The trial court granted defendant's motions, and
the intermediate court reversed.
ISSUE: Can the decision of the defendant’s committee be subjected to judicial inquiry?
ANSWER: No.
CONCLUSION: The Court found that the decision of defendant's committee was beyond judicial
inquiry under the business judgment doctrine. The Court acknowledged that it could inquire as
to the disinterested independence of the members of that committee and as to the
appropriateness and sufficiency of the investigative procedures chosen and pursued by the
committee. However, the Court concluded that there was no basis to warrant either inquiry.
Delaware and the Zapata Second Step-The case in our textbook Zapata Corp. v. Maldonado
RULE OF LAW: The court should apply a two-step test to the motion an independent committee
files to dismiss a derivative suit. First, the court should inquire into the independence and good
faith of the committee and the bases supporting its conclusions. Limited discovery may be
ordered to facilitate such inquiries. The corporation should have the burden of proving
independence, good faith and a reasonable investigation, rather than presuming independence,
good faith and reasonableness. If the court determines either that the committee is not
independent or has not shown reasonable bases for its conclusions, or, if the court is not
satisfied for other reasons relating to the process, including but not limited to the good faith of
the committee, the court shall deny the corporation's motion. If, however, the court is satisfied
under Del. R. Civ. P. 56 standards that the committee was independent and showed reasonable
bases for good faith findings and recommendations, the court may proceed, in its discretion, to
the next step. The second step provides the essential key in striking the balance between
legitimate corporate claims as expressed in a derivative stockholder suit and a corporation's
best interests as expressed by an independent investigating committee. The court should
determine, applying its own independent business judgment, whether the motion should be
granted.
FACTS OF THE CASE: In June 1975, William Maldonado, a stockholder of Zapata Corporation,
instituted a derivative action in the Court of Chancery on behalf of Zapata against ten officers
and/or directors of Zapata, alleging breaches of fiduciary duty. Maldonado did not first demand
that the board bring this action, stating instead such demand's futility because all directors were
named as defendants and allegedly participated in the acts specified. After replacement of
some board members, the new board created an investigation committee. The committee
determined that each action against the corporation should be dismissed. The chancery court
denied the corporation's motion for summary judgment or dismissal, holding that the "business
judgment" rule was not appropriate for dismissal of a stockholder's derivative suit. The
corporation thereafter brought an interlocutory appeal.
ISSUE: Did the chancery court properly deny the corporation’s motions for dismissal and/or
summary judgment?
ANSWER: No.
CONCLUSION: The Court reversed and remanded the decision of the chancery court, holding
that a court should inquire into the independence and good faith of an independent committee
and the bases supporting its conclusions. The chancery court was then directed to determine,
applying its own independent business judgment, whether either motion should be granted.
Structural Bias and Other Criticisms-No matter which of the early approaches (Auerbach or
Zapata) is under consideration, shareholder activists and attorneys had a number of criticisms of
the procedure.
Structural bias may be defined as inherent prejudice against any derivative action resulting from
the composition and character of the board of directors and of special litigation committees.
Proposed Reforms of the Modern Strike Suit Era/The ALI Proposals Briefly Considered-The ALI
Project reporters came up with the ideas that has become the centerpiece of modern reforms:
universal demand. To implement universal demand the legislature enacts a statute that
eliminates the demand excused branch or the futility sub-branch. Every shareholder-plaintiff
must make a pre-suit demand which then must be accepted or refused on the corporation’s
part.
The American Bar Association (Model Business Corporation Act) Proposals-The ALI drafters may
have opened a Pandora’s Box when they introduced the universal demand concept. That is
because American Bar Association Committee on Corporate Laws took universal demand and
turned it around. Demand is required in all cases and in all cases in which directors refuse
demand judicial review is limited to business judgment rule factors: A derivative proceeding
shall be dismissed by the court on motion by the corporation if one of the groups specified.
Right to Trial by Jury, Attorney’s Fees-Fiduciary duties have their genesis in trust law at the heart
of the Chancery Court’s jurisdiction. The derivative action itself was the creation of the equity
courts. Many decades the prevailing view was that derivative actions belonged exclusively to the
equity courts: there was no right to trial by jury.
In the case in our textbook, Beacon Theatres Inc. v. Westover-
RULE OF LAW:
In the Federal courts right to a jury cannot be dispensed with, except by the assent of the parties
entitled to it, nor can it be impaired by any blending with a claim, properly cognizable at law, of
a demand for equitable relief in aid of the legal action or during its pendency. This long-standing
principle of equity dictates that only under the most imperative circumstances, circumstances
which in view of the flexible procedures of the Federal Rules can the right to a jury trial of legal
issues be lost through prior determination of equitable claims.
FACTS OF THE CASE:
A competitor had brought an action against petitioner theatre for duress and coercion for
making threats of litigation and treble damage suits. Petitioner filed an answer, a counterclaim
against the competitor, and a cross-claim against an exhibitor who had intervened. The district
judge denied petitioner a jury trial on certain factual issues as provided for in Fed. R. Civ. P.
38(b), and petitioner sought mandamus to require the judge to vacate certain orders depriving
petitioner of a jury trial.
ISSUE: Is the defendant entitled to a jury trial seeking treble damages and equitable relief?
ANSWER: Yes
CONCLUSION: The Supreme Court noted that the right to grant mandamus to require jury trial
where it had been improperly denied was well settled. In the Federal courts the right to a jury
cannot be dispensed with, except by the assent of the parties entitled to it, nor can it be
impaired by any blending with a claim, properly cognizable at law, of a demand for equitable
relief in aid of a legal action.
The Cosmetic Collusive Settlement Problem-Since a route to a fee award may be corporate
therapeutics as well as production of a common fund a plaintiff’s attorney may trade a slap on
the wrist non-monetary settlement in return for a tacit agreement to a generous attorney fee in
the derivative or class action settlement proffered to the court for approval.
The WorldCom Case in our textbook- How the Fraud Happened- In 1999, revenue growth
slowed and the stock price began falling. WorldCom's expenses as a percentage of its total
revenue increased because the growth rate of its earnings dropped. This also meant
WorldCom's earnings might not meet Wall Street analysts' expectations. In an effort to increase
revenue, WorldCom reduced the amount of money it held in reserve (to cover liabilities for the
companies it had acquired) by $2.8 billion and moved this money into the revenue line of its
financial statements. That wasn't enough to boost the earnings that Ebbers wanted. In 2000,
WorldCom began classifying operating expenses as long-term capital investments. Hiding these
expenses in this way gave them another $3.85 billion. These newly classified assets were
expenses that WorldCom paid to lease phone network lines from other companies to access
their networks. They also added a journal entry for $500 million in computer expenses, but
supporting documents for the expenses were never found. These changes turned WorldCom's
losses into profits to the tune of $1.38 billion in 2001. It also made WorldCom's assets appear
more valuable. How the Fraud was discovered After tips were sent to the internal audit team
and accounting irregularities were spotted in MCI's books, the SEC requested that
WorldCom provide more information. The SEC was suspicious because while WorldCom was
making so much profit, AT&T (another telecom giant) was losing money. An internal audit
turned up the billions WorldCom had announced as capital expenditures as well as the $500
million in undocumented computer expenses. There was also another $2 billion in questionable
entries. WorldCom's audit committee was asked for documents supporting capital expenditures,
but it could not produce them. The controller admitted to the internal auditors that they
weren't following accounting standards. WorldCom then admitted to inflating its profits by $3.8
billion over the previous five quarters. A little over a month after the internal audit began,
WorldCom filed for bankruptcy.
The Reprise of the Shareholder Class Action/The Death of the Derivative Action and the Rise of
the Stock Drop Class Action-In the 1980s with a special litigation committee a corporation could
sidetrack all but the most egregious breach of fiduciary duty claims. Derivative litigation had
come to have a number of potential outcomes most of which from a plaintiff’s perspective were
bad. Quite naturally, plaintiff’s attorney’s turned to pursuit of direct rather than derivative
claims.
The Private Securities Litigation Reform Act (PSLRA)-
Lawyering Problems in Corporate Litigation- DEFINITION of Private Securities Litigation Reform
Act – PSLRA The Private Securities Litigation Reform Act – PSLRA - is a piece of legislation passed
by Congress in 1995 to stem the filing of frivolous or unwarranted securities lawsuits. The PSLRA
increased the amount of evidence that plaintiffs are required to present before filing a securities
fraud case with the federal courts. It also changed the way securities class action lawsuits are
handled by giving judges the authority to determine plaintiffs and to take other actions to
reduce legal system abuses. The purpose of the Private Securities Litigation Reform Act was to
prevent unwarranted, flimsy, or fraudulent lawsuits from being filed, which can be expensive
and tie up the efficiency of the legal system. It also reduced litigation risk for certain companies
who faced these types of lawsuits on a regular basis. BREAKING DOWN Private Securities
Litigation Reform Act – PSLRAA shareholder may file a securities fraud claim in federal court to
recover damages believed to be sustained as a result of the actions of a firm or individuals
related to the sale, trading, or price manipulation of securities..
Indemnification and Insurance-Directors’ and Officers’ liability insurance serves two functions as
a funding source, providing resources for defense of directors and for payment of settlements or
judgments and as potential gap filler, filling in gaps in the indemnification statute and in the
articles bylaws or contracts implementing the statute.