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I. EFFICIENCYmaximizing output with minimum waste

A. Intuitive Notion = GREED IS GOOD.
1. Efficiency is when things are not wasted, and the laws correct role is to assist people in their
2. Use minimum inputs to get the maximum output while eliminating waste
B. Formal Notionscorporate law succeeds when increasing individual utility
1. Pareto Efficiency = distribution of resources is efficient if no one could be made better off
without making someone else worse. This is pareto-optimal
i. Look to voluntary exchange to gage efficiency
ii. Look at peoples utility and happiness in the world
iii. Difficulties:
(a) Uses utilities, which are difficult to define because it focuses on measuring
someones happiness or usefulness (subjective, hard to judge)
(b) Ignores initial distribution of wealth in society (could make rich richer and poor
poorer and still be considered efficient)
(c) Almost impossible to implement because very likely someone is going to be worse
(i) Ex) rule against fraud would not be pareto-optimal because it would make the
person committing fraud worse off
2. Kaldor-Hicks Efficiency (Wealth Maximization Model) = efficiency is attained if the
people who benefit from the transaction have benefitted more than people who were harmed
by the same transaction. Looks to aggregate and asksdid winners win more than the losers
i. Better than Pareto model because it focuses on wealth rather than subjective utilities
ii. Difficulties
(a) Ignores initial distribution of wealth
(b) Ignores impact of distributional consequence, exacerbation
(c) Some things are not monetary
A. Ageny Cost theory
1. Hiring individuals to work for you creates tremendous gains. Corporations allow people to
specialize, improve at their tasks, and create less waste
i. Economies of scale will increase overall production and reduce waste BUT if people are
not working for themselves they will not work as hard or efficiently
2. Agency Cost = costs associated with the exercise of discretion over Ps property by A
i. Nature of agency relationship: where P and A have divergent interests, A would like to
work for A and P would like A to work for P so A will follow his own interests. Worker
is not going to work as hard if his interests are divergent
3. Types of Agency Costs
i. Monitoring Costs = energy/money P will spend to ensure A is doing his job/is loyal
ii. Bonding Costs = cost A expends to show P his reliability of Ps interests over As (ex.
Entering into a commission agreement or getting paid per sale)

iii. Residual Loss = cost arising form divergent interests even after monitoring and bonding
costs are incurred
(a) This will always be present
(b) Biggest losses come from management lazinessfailure to innovate, explore other
options/suppliers/distributors, etc.
B. Transaction Cost theory
1. Transaction within a company is more efficient than transacting on the open market
i. Why companies exist and no-one is running around alone in the market place
2. Source of cost = searching, negotiating, finding the best price
3. Reduction of costs through governance structures like partnerships/corporations/agency
4. Types of Transactions Costs
i. Asset Specificity: more specific, more vertical integration makes sense. How specific is
the asset?
ii. Uncertainty: how much uncertainty is there within the transaction?
iii. Reception: how often does the transaction take place? More repetition, lower the cost?
C. The Role of Lawyers
1. Role of Organizational Law
i. Doctrinal/Internal Perspective: how is the case before us now like others we hae seen?
How does the doctrine develop as transactions become more complex?
ii. Functional/External Perspective: concerned not only with internal consistencies as the
doctrine develops but also with its impact on society as a whole
iii. Role of law = assist people in maximizing wealth, distributive should be subsequent and
not stand in the wayachieve KH efficiency
2. Role of Lawyers
i. Reduce/limit waste
ii. Facilitate organization of transactions in 2 ways:
(a) Regulatory arbitrage: making sure people comply with the regulations as closely as
possible for the lease amount of money
(i) ex) minimizing taxes, environmental lawyers seeking to conduct business with the
least amount of costs, like buying rights to pollute
(b) Private ordering: assist parties in organizing their business so that transaction costs
are reduced and trade is facilitated
(i) Write Ks that help deals go through, help businesses order their affairs

I. Formation
A. Agency = fiduciary relationship that arises when one person (a principal) manifests
asset to another person (an agent) that the agent shall act on the principals behalf and
subject to the principals control, and the agent manifests assent or otherwise consents so
to act [R3, Agency, 101]
1. Special agents = agency limited to a single act or transaction
2. General agents = agency contemplates a series of acts or transactions
3. Disclosure of the Principal
i. Disclosed = when third parties understand that an Agent acts on behalf of
a particular Principal

ii. Undisclosed = when third parties believe an Agent to be the Principal
iii. Partially Disclosed = when the third party deals with an Agent without
knowing the identity of the Principal
B. Consentboth parties must manifest their intention to enter an agency relationship,
verbally or in writing.
1. Agent must reasonably believe from the Principals action that she has been
authorized to act on the Principals behalf
2. Person manifests consent or intention through written or spoken words or other
conduct if person has notice that another will infer such consent or intention
from the words or conduct [R3. Agency, 102]
C. Parties Conception does not matter, CONTROL matters
1. Often P & A dont realize they have agency relationship
i. Bad for Ps who may be liable for As actions
ii. Law implies agency relationship in order to protect third parties who do
not know the nature of the P-A relationship, and it would drain their
resources to figure it out.
iii. P has the incentive and is in the best position to manage/clarify the
situation and level of control over A
2. Only objective manifestation matters
i. Gallant Insurance Co v. Isaac (MN 1981) Factor-based analysis to find
what is fair. What is fair is that the last people get paid, and economic
a. Constant recommendations by phone (Principal/Agent)
b. Right of first refusal on grain (Buyer/Seller)
c. Inability to enter into mortgages, purchase stock or pay dividends
without approval (Lender/Borrower)
d. Right of entry onto the property to carry on periodic checks/audits
e. Correspondence and criticism regarding finances, officer salaries
and inventory (Principal/Agent)
f. Provision of drafts and forms to A upon which Ps name was
imprinted (Principal/Agent)
g. Financing of all As purchases of grain and operating expenses
h. Power to discontinue financing (Lender/Borrower)
D. Bases for asserting or denying P-A relationship:
1. Indica of Control: Control P exerted over Ainclude financial control
2. Scope of Employment: Financial structure doesnt suggest much if the scope of
As employment conclusively sees him acting on Ps behalf
3. Nature of Relationship: Look at what both parties are providing to each other
i. Hanson v. Kynast (OH 1991) a contractual relationship does not imply
P-A relationship.
a. Court focuses on the money (no scholarship/compensation, used
his own equipment, students who watched games did not pay
admission fees)

b. Schools will never be held liable as principals for their students
because there are too many students to monitor/exert control over
all of them
c. Factors to determine if relationship is Agent-Principal
i. Individual performing in course of business?
ii. Individual receiving compensation from the principal?
iii. Whether principal supplied tools and place of work in
normal course of relationship
iv. Length of employment
v. Right to terminate employee at will
II. Termination
A. P or A can terminate agency ay any time
B. If a K between them fixes a set term of agency, then Ps decision to revoke or As
decision to renounce gives rise to a claim for breach of K
III. Liability in ContractAUTHORITY
A. Actual Authority = Agent reasonably believes in accordance with Principals
manifestations to Agent that Principal wishes Agent to so act [R3, Agency, 2.01]
1. Express Actual Authority = limited by what the Principal expressly authorizes
the Agent to do [R3, Agency, 2.01]
2. Implied Actual Authority = authority to do all thing incidental or necessary to
achieving Principals objectives [R3, Agency, 2.02]
i. Ex) P tells A to negotiate a K, so A has authority to travel and incur other
expenses incidental to negotiations. A has authority to set the terms of the
K if they were not specified by P.
ii. Even if P does not agree with As spending/bargaining, P is bound
3. Gives Principal incentive to be very clear as to what he wants the Agent to do
B. Apparent Authority = created by Principals words or conduct which reasonably causes
a third party to believe that Principal consented to have Agent act on his behalf [R3,
Agency, 2.03]
1. Belief is traceable to Principals manifestations to third party
i. Not possible to have apparent authority if 3P didnt know P exists
2. Ex) Home office tells customer that the sales manager has authority to sell
widgets without confirmation, and then withdraws that actual authority without
telling the customer, the sales manager still has apparent authority.
3. Differs from implied actual authority because apparent authority may exist even
if P has expressly forbidden As actions (but the third party does not know this)
4. White v. Thomas (AK 1991) we evaluate manifestation based on the
reasonableness of the third party
i. FACTS: P gave A blank check with instructions to purchase land up to a
certain price. A spent more than allowed and upon realizing this,
contracted to sell some of it to 3P. P was fine with the extra spending but
not the sale to 3P. 3P sued for specific performance of K
ii. HELD: No apparent authorityno manifestation by P to 3P that gave
authority to A to sell to 3P

5. Rule is efficient because it incentivizes P to clearly define what A can and
cannot do, and doesnt require extreme transaction costs for 3P to contact P or
get adequate assurances.
C. Inherent Authority = gives a general Agent the power to bind a Principal whether
disclosed or not to an unauthorized K as long as the general Agent would ordinarily have
the power to enter such a K and the Third Party does not know that matters are different
in this case [R2, Agency, 8A]
1. Not in the third restatementno need for inherent authority because other
doctrines encompass the justifications underpinning it [R3 2.01, comment b]
i. Interpretation by the Agent of the Agents relationship with Principal
ii. Apparent Authority
iii. Estoppel [R3 2.05]
iv. Restitution [R3 2.07]
2. Designed to protect third parties (usually in cases where Principal is
3. Gallant Ins. Co. v. Isaac (IN 2000) agent conducted an act which usually
companies or is incidental to insurance transactions it was authorized to conduct
and the third party lacked notice that agent didnt have authority to act that way.
HELD: agent acted under inherent authority.
Did P say to A you have Did P say to 3P A has
authority? authority?
Actual Authority YES NO
Apparent Authority NO YES
Inherent Authority NO NO

IV. Liability in Tort(1) CONTROL, (2) SCOPE OF EMPLOYMENT

A. Types of Control (see gas station cases below)
1. Principal = Master when P employs A to perform services in his affair and
who controls or has the right to control As physical conduct in performance of
2. Agent = Employee/Servant when P secures from A the right to control in
detail how A performs his tasks (time he denotes to it, precautions used)
3. Agent = Independent Contractor when Ps control rights are limited and A
exercises considerable discretion
B. Respondeat Superior = P is liable for employee torts when done in the scope of
employment [R3 219-220]
1. Where an employee commits a tort that does not serve the interests of the
employer, the principal is not responsible [R3 228]
C. Gas station cases
1. Humble Oil & Refining Co. v. Martin (TX 1949)
i. FACTS: Woman left car at a gas station and it rolled back and injured
family. HELD: Owner liable as principal because the station attendant was
an employee.
2. Hoover v. Son Oil Co. (DE 1965)

i. FACTS: Fire injured someone while car was filled at the station. HELD:
station operator was an independent contractor so the principal is not
Humble/Schneider (station Sunoco/Barone (station attendant)
- Humble set hours - Barone set hours
- Schneider sold only - Barone could sell any goods
Humble goods - Barone took title to goods
- Humble held title to the (owned them himself)
goods (consignment) - Lease terminable yearly by
- Lease terminable at will either party
(could fire Schneider at - Responsible for
will) rent/utilities (only thing he
- Schneider was not received was a subsidy in
responsible for rent or case of price wars)
utilities (set as a % of
profits he made)
B is independent
S is employeeHumble is liable contractorSuoco not liable

D. Analysis:
1. Where is locus of control?
2. What is the evidence of control?
i. Operation requirements
ii. Role of the financial structurewho has a capital risk?
3. What are the consequences of the allocation of control
V. Methods of Governance for Agency Relationships
A. Exit Rights
B. Cotnract
C. Fiduciary Duties
A. Duty of Obedience = duty to obey the Principals command [R3 8.07]
1. Duty to act in accordance with the express and implied terms of any K between
the agent and the principal
2. Not much litigation on this basis because if an Agent violates the duty, will just
get fired
B. Duty of Care = duty to act with care/competence/diligence normally exercised by agents
in similar circumstances, including special skills or knowledge [R3 8.08]
1. Not much litigation on this basis because if Agent violates the duty, usually
C. Duty of Loyalty = obligation to act loyally for the principals benefit in all matters
concerned with the agency relationship [R3 8.01]
1. Duty of A not to acquire a material benefit from a third party in connection with
Agents position [R3 8.02]
i. Tarnowski v. Resop (MN 1952)

a. FACTS: P hired A to check out jukebox business he wanted to
buy. A says theyre good, receives a secret commission from
seller. Turns out the business is bad, and P sues to rescind sale.
Wins that, and then sues A for the secret commission he got form
the seller. HELD: he gets the secret commission
b. P gets this commission even though it was more than he lost
because this is efficient and disincentivizes the secret commission
behavior; notions of fairness to prevent unjust enrichment.
2. [R3 8.06] Conduct does not constitute a breach of this duty if the principal
consents to the conduct, provided that:
i. In obtaining the principals consent, the agent:
a. Acts in good faith
b. Discloses all material facts the Agent knows, and
c. Otherwise deals fairly with the Principal
ii. The Principals consent concerns either a specific act or transaction that
could reasonably be expected to occur in the course of the agency
3. Trustee is accountable for any profit made by him through the administration of
the trust, although the profit does not result from a breach of trust [R2, Trusts,
i. Private trust is a legal device that allows a trustee to hold legal title to trust
property, which the trustee is under a fiduciary duty to manage for the
benefit of the trust beneficiary
ii. Similar to the agency relationship insofar as the trustee has power to affect
the interests of the beneficiary, but differs in that the trustee is subject to
the terms of the trust as they have been fixed by the trusts creator (settlor)
iii. In Re Gleeson (IL 1954)
a. FACTS: testator created a trust and passed away. Trustee
continued to farm the land for a year after her death and gave the
profits to the principals, who were not hurt in any way.
Nevertheless, a guardian for one of the beneficiaries sued.
b. HELD: trustee is bound never to deal in the property of the trust
i. Not true for traditional Agent-Principal relationship
c. Unlike Principal in A/P relationship, testator is dead. Thus,
benefactors are in a less powerful position because they could not
protect themselves like a P could.

I. Types of Partnerships
A. General Partnerships = association of two or more persons to carry on as co-owners of a
business for profit [Uniform Partnership Act 6(1)]
1. Each partner is liable for all the debts of the partnership
2. Now most people choose Limited Liability Companies over general partnerships, which
combine the tax advantages of corporations with limited liability and contractual flexibility
of the partnership form
i. Advantages of LLC:

(a) Limited liabilityno member can be liable for anything other than the amount of his
investment into the LLC, regardless of how active in management
(b) Can elect to be treated as a partnership for tax purposes, so get a pass-through and
avoid double taxation
(c) Complete flexibility in operations based on the operating agreement (need not be in
ii. Disadvantages of LLC:
(a) Complex to form
(b) Easier to pierce the veil of an LLC than that of a corporation
(c) State income/franchise taxes applicable in some states to LLCs just as they are to
corporations, but are not applicable to partnerships
B. Limited Partnerships = 2 kinds of partners:
1. One or more general partner, who are each liable for all the debts of the partnership
2. One or more limited partner, who is not liable for the debts of the partnership beyond the
amount that they have contributed to the partnership
3. Cannot be actively participating in management (if they do, lose limited liability)
C. Limited Liability Partnership = no general partner with unlimited liability and complete
control are limited; no partner is personally liable for others mistakes
1. Level of limited liability applies only to (of partners or agents under authority of other
i. Negligence
ii. Malpractice
iii. Wrongful act or misconduct
2. Many law firms use this
II. Nature of Joint Ownership
A. Principal reason is access to capitalpeople lack capital to go into business alone so enter jointly
1. Operational expertise (synergies)
2. Financial support (investments)
3. Partitioning of assets and liabilities
4. Tax consequences
i. Pass-through statusincome of the partnership passes through the entity to the partners,
so partnership itself does not pay tax
ii. If partnership is losing money, partners can take the losses on their taxes
5. Specializations (partners can divvy up responsibilitieslower transaction costs)
B. Difficulties with partnerships:
1. Agency costsamong partners, between partners and employees
2. Transaction costswhen partners or employees interact with third parties
3. Ownership costscollective decision-making
III. Formation of Partnerships
A. Partnership = association of two or more persons to carry on as co-owners of a business for
profit [Uniform Partnership Act 6(1)]
1. Consequences: unless partners K around following, partnership will exist:
i. Share in net profits (not gross returns)Focus on profits because it is a proxy for control.
Focus on NET profits [UPA 7]
ii. All partners are liable as principals
iii. All partners liable for debts of partnership

iv. All partners are agents of the partnership
v. All partners share equally in control
vi. Managing partner has a greater fiduciary duty to other partners and business
2. Property held by partnership is tenancy in partnership [UPA 25(1)]
i. Partnership qua firm, rather than individual partners, exercise ownership over the
ii. Creditors of partnership are prior in partnership assets > creditors of partners if
partnership is liquidated
iii. Partners cannot possess/assign rights to partnership property [UPA 25(2)]
iv. Equity contributors do not own assets themselves, but rather own the rights to the net
financial returns those assets generate, as well as certain governance or management
rights [UPA 26, 27; RPUA 502, 503]
B. Partnership can come into existence by operation of law, without filing any papers
1. Intention does not matterif they represent to the outside world that they are in a partnership
together, they can be found to have created a partnership
2. Volhand v. Sweet (IN 1982)
i. FACTS: V employs S. V says he will pay S 20% of net profits and cover all expenses if S
does labor. 10 years later S claims he wants to dissolve partnership so he can get money
owed to him. V says youre just employee and commission salesman, why S gets portion
of the sales. V says thats NOT like relying on and sharing net profits
ii. HELD: parties do not have to explicitly say they will form a partnership. If they share
profits, they are in a partnership [UPA 7(4)]
(a) Court found that the money paid to S was profits, not wages
(b) Partnership formation requires:
(i) Voluntary K of association for purpose of profit and loss-sharing
(ii) Intention to form partnership BUT intent is for those thins that constitute a
partnership, not explicitly to be partners
3. Agency by Ratificationaccepting benefits under unauthorized K will constitute acceptance
of its obligations as well as benefits AND/OR learning of unauthorized K an doing nothing
constitutes ratification, so P can be bound [R 82, 83]
IV. Governance of Partnerships
A. Making Decisions
1. Partners have an equal right to management of the business in regards to ordinary matters
connected with the partnership as a business can only be contravened by a majority of the
2. Any difference arising as to ordinary matters may be decided by a majority of the partners
[UPA 18(h)]
i. Exception: if something is extraordinary, it must be unanimous consent
ii. Majority is NOT decided by capital contribution
iii. Can contract out of this, even if only by oral agreement
3. National Biscuit Co v. Stroud (NC 1959)
i. FACTS: S and F were in general partnership to sell groceries. S told 3P he would not be
responsible for any more deliveries, but F still instituted deliveries from them
ii. HELD: S id bound by Fs orders
(a) Co-partners cannot restrict power/authority of other partners in doing things for the
partnership that are ordinary matters connected with business

(b) Each partner has equal right to management of the business under scope of
(c) This rule protects companies making agreements with partnership AND other
partners so that one partner cannot undermine business
iii. Partners can change the scope of their agency, but if agreement is not written, the default
rule of UPA 18(h) requires majority of partners to agree to decision
B. Conflicts among partners
1. Fiduciary Duty of Loyalty re: Conflict Among Partners: Joint ventures owe one another
the duty of loyalty so as to require disclosure of future business learned during functioning of
the Partnership
i. Meinhard v. Salmon (NY 1928)
(a) FACTS: M&S partners in hotel business, at end of lease term a developer approached
S for a much larger project. S uses his own company and cuts M out of the deal. M
sues for a piece of the action when he finds out about it
(b) HELD: Joint adventurers owe to one another, while their enterprise continues, the
duty of finest loyalty, a standard of behavior most sensitive
(i) Cardozo Joint ventures, like co-partners, owe to one another, while the
enterprise continues, the duty of the finest loyalty. . . Not honesty alone, but the
punctilio of an honor the most sensitive is then the standard of behavior
(ii) Opportunities belong to the partnership, not individuals
(iii)Whenever a court quotes Meinhard v. Salmon the defendant loses big!!!
(c) Rationale: EFFICIENTstrict duties of loyalty are KH efficient because it removes
complex outcomes that would have greater transaction costs
(i) Removes need to K for contingencies
(ii) Creates bright-line rules that act as a deterrent and reduces litigation
(iii)Strengthens disclosure requirements between partners
(d) Options on how to handle dispute:
(i) Continue on same terms, default rule that effectively imposes a burden on the
parties and ensures there is no competition
(ii) Compete for new opportunity (simple disclosure and market competition)
(iii)Grant right of first refusal
(iv) Winner take all (what S is arguing for)
V. Relations of Partnerships with Third Parties
A. Who Is a Partner for the Bases of These Claims?
i. Partner In Fact: 2 or more persons who agree to carry on for profit a business they share
in profits. Partners can bind other partners, can if partners commit torts in course of
business all of the partnership is liable
(a) Incoming partners are liable to all obligations arising before his admittance
(b) Knowledge of one partner is knowledge of all partners, so all are liable [UPA 12]
ii. Partnership by Estoppel [UPA 16]: If someone allows someone else to think he is a
partner, there is a partnership if there is (1) reliance, (2) no correction of the statement,
(3) he is liable
(a) Rational is agency monitoring principles
iii. Departing Partners are still liable, but there are 2 ways to release (balancing the policies
of making it too easy for departing partners to escape debts and making it too difficult, so
partners would still be liable even though they lose control benefits)

(a) Dissolution of partnership does not itself discharge he existing liability of all partners
[UPA 36(1)]
(b) Explicit Agreements: if partner withdraws and other partners continue, the
withdrawing partner is released from debt liability if an agreement can be formed
between existing partners and the creditors [UPA 36(2)]
(c) Material Alteration: partners can escape debts of partnership if there are material
changes in the agreement so that it is clear that all parties know the partnership was
dissolved. [UPA 36(3)]
(i) Test = material change that puts everyone on notice of the partner in questions
B. Claims of Partnership Creditors against Partnership Property/Partners Individual Property
1. Partnerships bankruptcy frequently triggers bankruptcy of its partners, and in these
situations conflicts of priority in individual assets arise between business and personal
creditors of partners
2. Jingle Rule [UPA 40(h), (i)]: Partnership Creditors have first priority to partnership assets,
and Individual Creditors get first priority for individual assets
i. People get what they expected based on prior dealings
ii. Traditional rule
iii. TEST: applies only to UPA state (ie. New York) and if 723 of bankruptcy code does
NOT apply (individual not in bankruptcy or partnership isnt CH 7)
3. Parity Rule [RUPA/1978 Bankruptcy Act 723]: Partnership creditors have priority to
partnership assets and are on parity with individual creditors for individual assets
i. TEST: followed if:
(a) RUPA is controlling state law OR
(b) 723 applies (partnership is in CH7 AND Partner is in bankruptcy)
ii. Rationale
(a) Placing partnership creditors and individual creditors on par with each other creates
incentives to use the partnership form, which is KH efficient
(b) Individual creditors have stronger incentives to monitor individual partners if they
know they will have to share assets with partnership creditors in partnership
(c) Better protects creditors and allows partnership creditors to get paid first
VI. Termination (Dissolution and Disassociation) of Partnerships
1. If any partner withdraws, the partnership dissolves [UPA 29], but re: liabilities, partnership
does not end until the end of winding up financial affairs [UPA 30]
i. Can Contract around this provision, however
(a) Adams v. Jarvis (WI 1964)
(i) FACTS: Partner withdrew, but the partnership contract had a clause to the
(ii) HELD: if the partnership agreement provides for something different than one
partners withdrawal dissolving partnership and requiring the distribution of
assets, can respect that K.
1. Allows for negotiation
2. If one were unable to K around statute each partner would have a hold-up
power by threatening to trigger dissolution all of the time

3. All parties on equal footing, not against public policy
4. Encourages people to think through their decisionsdont want to wind-up,
distribute assets, and then reverse engineer partnership again (Efficient!)
2. Causes of dissolution:
i. Expiration of K terms
ii. Any partners express will when no term is specified (if specified, agreement prevails)
iii. Death or bankruptcy of any partner [UPA 31]
iv. Decree of the court [UPA 32]
v. Illegality
vi. Expulsion of any partner pursuant to the agreement by other partners
3. Consequence of dissolutionmust wind-up the business affairs by liquidating all assets and
dividing equally through partners. Liquidation is favored over in-kind distribution
i. Best to terminate once the business of partnership has ceased
ii. If partner personally wants to retire, the partner has to make sure the K is negotiated so he
no longer has continuing liability
iii. Once terminated partners are entitled to distribution of assets
iv. Business and affairs would up and distributed like bankruptcies
4. Statutory dissolution of Partners are constrained by fiduciary dutiesif there is a dissolution
in bad faith, then breach and damages
i. Page v. Page (CA 1961)unless otherwise agreed, no term regarding the length of
partnership. Termination of an at-will partnership is subject to fiduciary duties
(a) FACTS: P and D were partners in linen supply business pursuant to an oral agreement
(until we make profits = not specified term, and at will partnerships can be
terminated at any time). Finally, business started showing a profit. P was sole
ownership of the corporation that was the partnerships main creditor and he wanted
to terminate the partnership
(b) HELD: if partners want to create business for a term (make profit) that will be
enforceable over time, but if there is nothing written, courts will use the default UPA
rule that when there is no agreement, there is a partnership at will [UPA 31(1)(b)]
(i) Must be exercised in good faith [UPA 38(2)(a)]
1. Damages = right of partners upon wrongful dissolution
(ii) Rationale:
1. No one would go into business with anyone else if they were stuck in a
partnership until profits were made
2. Very specific definition of profitable is necessary

I. Accounting Purposes
A. Organize financial information
B. Compare financial performances across industries and businesses
C. Evaluate adherence to fiduciary duties
II. Accounting terms
A. Assets = things of value the company has/economic resources at a particular time
1. For an accountant to consider a resource an asset, it must:
i. Arise out of past transactions or events
ii. Have probable future economic benefits

iii. Owned or controlled by the entity
2. Implicitly excludes a variety of resources that may be quite important to a firms prospects
i. Resources with only a possibility (not probability) of yielding future benefits
ii. Inventions, forms of IP
iii. Reputation
3. Listed in a particular order
i. Cash and cash equivalents (bank accounts)
ii. Current assets (short term investments, inventories)
(a) Assets likely to be exchanged for cash in relatively near future, usually a year
iii. More permanent assets at the bottom
B. Liabilities = probable future sacrifices of economic benefits arising from present obligations to
transfer assets or render services in the future as a result of past transactions or events
1. Claims of creditors
2. Listed in a particular order
i. Current liabilities (accounts payable, product development, etc.)
ii. Long-term liabilities
C. Owners Equity = residual interest in assets of an entity after subtracting its liabilities
1. Claims of owners
i. For the typical US corporation, with owners being shareholders, owners equity is the
funds originally contributed by shareholders and accumulated profits
(a) Capital stock = funds originally contributed by shareholders
(b) Retained earnings = accumulated profits
D. Total Assets = Liabilities + Equity
E. Capital Accounts = Partners capital
1. Used to make sure that the partners are being treated fairly, may be a way to provide how to
divide up the business in case of dissolution of partnership
2. Reports income/revenues etc for the year
i. Opening = amount of capital partner invested in the company that year
ii. Income for year = their share of the net profits of the business
iii. Drawing = the amount that each one of the partners took from each year
(a) Note: Partners may decide to take money out of the business even if it has not made
iv. Closing = how much interest each partner has in the business at the end of the year
(a) If a partner has a negative amount in his capital accounts it will be subtracted from
the share he is owed before he is paid out in full
(b) Acquisition cost must be fair market value, so when recording acquisition cost of a
building, use value you use from the time of acquisition
III. 3 Basic Accounting Formats
A. Balance Sheets = measures the value by equity as of a specific date
1. Record assets and liabilities at lower of acquisition cost and fair market value (conservative)
2. Picture of a companys financial status at a particular moment in time to be used in
conjunction with an income statement
3. Using balance sheets for several years will yield a better picture of what a company looks
B. Income Statements = measures value by net income (profit) for a specified period (typically 12

1. Net income = revenues expenses / Income Expenses = net revenue
i. Revenue = increases in equity resulting from asset increases and/or liability decreases
ii. Expenses = decrease in equity form asset decreases and/or liability increases
iii. Income = net profit/co-owners sharing in the profits
iv. Expenses > revenueentity has suffered a loss
v. Expenses < revenueentity has earned profit
2. Records non-cash items (depreciation, rather than maintenance costs)
i. In earlier years, expenses will be too high in comparison with actual cash amount. In later
years, they will be too low
(a) Think about it: as you have an asset, you are going to have to spend more on
maintenance as it gets over
(b) This is spread evenly across ownership of the entity on income statements
3. Net sales cost of goods = gross margin
i. Net sales = measure of total revenue
ii. Cost of goods = figure roughly equal to the direct cost of producing this revenue
iii. Gross margin = measure of profitability
4. Gross margin operational expenses = operational earnings
i. Operational expenses = salary, administrative expenses
5. Operational earnings financial expenses = Net Income
i. Financial expenses = interest charges on loans, income tax
6. Does NOT show liquidity because it does not differentiate between cash and debt
7. A typical corporations net income is included in owners equity
i. Conforms to intuition that corporations profits belong to the shareholders
ii. Retained earnings can be invested in corporation for future use or distributed to
shareholders as dividends
C. Cash Flow Statements = measures value by cash for a specific period (usually 12 months)
1. Shows the true liquidity of the company
2. Cash = cash from operating expenses + cash from investing activities + cash from financial


I. Nature of the Corporate Form
A. Reification = legal personality independent and distinct from investors/managers
1. Considered a person (can enter into Ks, sue/be sued, own assets/liabilities)
2. Indefinite life = greater stability
3. Also economizes on the monitoring costs of creditors
4. Santa Clara County v. Southern Pacific R.R. Co., 118 U.S. 394 (1886) provided
precedential basis for view that corporations are citizens and qualify for protections
guaranteed by 14th amendment
5. Citizens United v. Federal Election Commission, 130 S.Ct. 876 (2010)
i. FACTS: Citizens United created an ad aimed at Senator Clinton before the 2008 race.
Issue was whether this ad was in violation of 441(b) of the Bipartisan Campaign
Reform Act, which criminalizes ads produced by corporations that expressly advocate for
or against a candidate within a specified period before voting.
ii. HELD: Corporations enjoy free speech, just as individuals do.

(a) If a corporation is a personality in itself, it is unconstitutional to deny it/penalize it for
free speech
(b) Concurrence: bill of rights only spoke about individuals, but association of
individuals in a business corporation is no different
iii. Costs of granting corporation free speech rights equivalent to individuals
(a) Shareholders are the ones stuck paying for electioneering rather than that money
going back into the corporation or being paid as dividends
(b) Economically motivated decisions of investors, not political
B. Limited Liability for Investorsshareholders are not responsible for the debts of the corporation
and are only liable up to the amount they invested. Creditors can only reach the assets of the
1. Reduces agency costs
i. Limited monitoring of managers (shareholders do not monitor directly, just hire
accountants to audit business)
ii. No monitoring of other shareholders (partners bear cost of dealing with other partners)
iii. Permits takeovers (market for control0
2. Reduces ownership costs
i. Focus on profits (efficiency)
ii. Decision-making criteria is only what is most profitable
iii. Permits easy diversification
3. Reduce transaction costs (financing)
i. Facilitates development of active trading market for shares
ii. Fungible shares (would be hard to be a partner in dozens of partnerships)
4. Easier for shareholders to invest in risky businessencourages investment
5. Encourages desirable risk-taking for managers
6. Market prices can impound additional information about a firms value
7. Facilitates optimal investment decisions
C. Transferability of Shares
1. Limited liability reduces costs associated with transfer of shares
i. Shareholders can sell to other investors
ii. Corporation has no obligation to repurchase
2. Allows for management changes to be forced
i. Pressures management to act effectively to avoid takeovers
3. Business uninterrupted by change in ownership (no issue with dissolution/reformation)
4. Encourages development of active stock marketfacilitates investmentprovides liquidity
and encourages diversification of equity investment
i. Investments are made attractive so it increases the ability of firms to raise capital
D. Centralized Management
1. Board of Directors/BOD [DGCL 141]
i. Because shareholders are not involved in micro-managing the corporation, there are
lower transaction costs
ii. Only the Board manages business of the corporation and has final say unless the
shareholders vote to unseat them
iii. Charlestown Boot & Shoe Co. v. Dunsmore (NH 1880)
(a) FACTS: Company is not doing well so the BOD invites a specialist to help improve
business. Specialist says they should purchase insurance on their factory because if it

burns down, it would result in tremendous losses. BOD decides not to, the factory
burns, and shareholders sue
(b) HELD: BOD can ignore the advice of an outsider because they have the ultimate
power to make decisions, not outsiders or shareholders
(c) Duties of directors in managing business of corporation
(i) Ordinary care/diligence with the management of the business
(ii) Ordinary negligence threshold
(d) Rationaledont want to take BOD authority away because it would make them
unable to do their job (less efficient) and would get a million experts to give every
opinion so could escape liability in suit
iv. Duties of Directors
(a) Direct/manage business of corporation
(b) Designate managers of officers who nominate other officers
(c) Appointment power
(d) Compensation power
(e) Removal power
(f) Declare dividends
(g) Amend bylaws
(h) Initiate charter amendments
(i) Mergers
(j) Sales of assets
(k) Dissolutions
v. All member elected to certain terms (can be all at once, but is usually staggered)
(a) Ordinary/Basic boards [DCL 211]
(i) Annual votes for all of the BOD
(ii) BOD treated as only in 1 class voted on each year by shareholders
(iii)Most fortune-500 companies have basic boards
(b) Staggered Boards [DGCL 141(d)]
(i) BOD split up into 3 classes and each up for election at X-year intervals
(ii) Rationale
1. Anti-takeover device, because it takes at least 2 election terms to gain control
of the BOD
2. Protects against hostile takeovers
(iii)BOD cannot adopt staggered BOD when goal is to make it impossible to change
the current board
1. The court will analyze circumstantial evidence to determine this
vi. Can establish committees
vii. Can act only as a group, not as individuals
(a) BOD only in formal meetings as an effort to discourage manipulation of board
(i) Must have proper notice of meetings
(ii) Quorum must be present
2. Officers/Managers [DGCL 142]Agents of the corporation who administer day-to-day
affairs of the corporation under supervision of the board. Subject to fiduciary duties
i. Traditional officers = president, VP, treasurer, secretary. Today, most senior officer
designated as CEO

ii. Substantial officer actions must be sanctioned, explicitly or reasonably implied by BOD
(a) Jennings v. Pittsburgh Mercantile Co. (PA 1964)
(i) FACTS: Company wants to sell real estate and lease it back, so VP hires Jennings
to do this for them. Jennings brings them 3 deals and all were rejected (because
they didnt want to pay his commission). Next day made the deal and cut Jennings
out. Jennings sues for his commission
(ii) HELD: Corporations executive officers do not have apparent authority to accept
an offer for a transaction that, for the corporation, is extraordinary
1. Huge transaction, so VP doesnt have authority to secure commission re: that
2. Jennings should have gone to BOD and not VP because the transaction was
big, and so should be aware that officers do not have authority
3. Attempted to rely on past dealings (for apparent authority argument) but cant
because none of the prior dealings had been this big
a. Court concerned recognizing inherent authority would disincentive BOD
monitoring of officers
II. Types of Corporations
A. Closely held v. Publicly Held
1. Closely Held = small corporation held by a small # of people who are also the
i. Donahue v. Rodd Electrotype sets up definition for Close corporation as one that meets 3
(a) Small number of stockholders
(b) Lack of any ready market for the corporations stock
(c) Substantial participation by the majority stockholder in the management, direction
and operation of the corporation
2. Publicly Held = big corporations held widely by members of the public who elect directors
who then hire professional managers to run the business
i. Market in which shares are easily traded exists
B. Controlled v. Diffuse
1. Controlled = corporations controlled by a shareholder or a small group of affiliated persons
2. Diffuse = corporations that lack a controlling shareholder or control group
i. Practical control over affairs of the corporation reside wit the companys incumbent
III. Benefits of the Corporate Form
A. Ease of Financingcreditor looks at assets of corporation and need not concern itself with
shareholders assets
B. Ease of Contractingmerchandising, renting, third parties need not be concerned with any assets
besides those of a corporation
1. You know exactly what youre dealing with when you K with a corporation
2. In a partnership it is harder because you need to consider the individual assets of the partners
C. Ease of Entry/Exitmarket facilitates this; shares move about freely and anonymously so you
can go in and out
D. Ease of Controlmanagers are hired by directors managed by shareholders
1. Managers should be managing efficiently and with the best interest of the corporation at
mind, so just thinking about how to make shareholder richer

2. In partnership you might have competing interest other than getting rich but never in a public
IV. Forming a Corporation
A. Choosing State of Incorporation
1. Doctrine of Internal Affairs: governance of the corporation is dictated by the state of
i. Internal affairs = everything relating to legal relationships between the corporate
(a) Ex) circumstances under which corporation may declare dividend, setting rules about
what percentage of stockholders must approve merger/sale
ii. Corporation does not need to be HQed in the state of incorporation
iii. Permissive states give corporations organizers and shareholders nearly unlimited scope
to establish whatever corporate governance rules they wish
(a) DE is a permissive state
iv. Non-Permissive State provide certain rule regardless of what the articles of incorporation
2. Role of Franchise Taxes
i. Business Tax = paid to state where you do significant business
ii. Franchise Tax = paid to state of incorporation and calculated based on # of corporate
shares outstanding
(a) Due upon corporation, yearly, and when issuing new shares
i. Well-developed body of law governing corporations
(a) Enables companies to predict with greater certainty how particular issues of corporate
law would be resolved by courts
ii. Ability to accomplish specific transactions without a shareholder vote or with a lesser
iii. Race to the Bottom (Cary 1974)
(a) Gives protection to managers and directorsDE panders to the agents of
shareholders, so directors will pursue their own interests
(b) Race to deregulate because more favorable the laws of their state, more money in
franchise taxes
(c) DE has incentive to maintain legal positions, but dont have incentive to have the best
(d) Arguments supporting thisDE gives weakest shareholder protection but remains
highest incorporation
iv. Race to the Top (Winter)
(a) Shareholders are not dumb and would see this theory, choose not to buy shares in DE
(b) Management will incorporate where corporate law best protects shareholder because
they will buy stock in those, and it will be easier to raise capital for those companies
B. Process of Incorporating
1. Old process: formation required a special statute of incorporation issued by state legislatures
2. Modern process: fill out form, file with secretary of state, and pay small fee
3. Articles of Incorporation (aka Charter) filed with the secretary of state

i. Required/Form Elements: [DGCL 102(a)(3)]
(a) Corporations name
(b) Corporations purpose
(i) Very broad usually, ex) to engage in any lawful act or activity for which
corporations may be organized under this title [DGCL 102(a)(4)]
(c) Number of shares the corporation wants to issue (The capital structure) [MBCA
(i) Should be substantially more than corporation plans to issue in near future so that
if more shares need to be issued the articles of incorporation will not need to be
amended by shareholder vote
ii. May (Custom/Bespoke):
(a) Establish the size of the board or include other governance terms
(b) Contain any other provision not in contravention of law
iii. Date of incorporation is usually made retroactive to the date of filing the charter [MBCA
iv. Articles can be signed by any individual, called an incorporator, who need not reside in
the state of incorporation or have any connection with the corporation once it comes into
v. Amendmentsdifficult to amend the charter and only allowed by shareholder vote
[DGCL 242(b)(1)]
(a) Charter can never be altered by the shareholders over the objection with the board
because the process begins with the boardboard proposesshareholder majority
4. By-Laws created = specific provisions governing the running of the company
i. Usually include
(a) Date/location of annual meeting of shareholders
(b) Number of directors of the corporation
(c) Whether cumulative voting for directors will be allowed
(d) A listing of the officer of the corporation (that there will be a CEO, VP, etc) and the
duties of each
(e) What shall constitute a quorum for the meeting of directors
ii. Not filed with the Secretary of State and are not matters of public records
iii. Amendmentsbylaws are easily amended
(a) Charter can provide for directors right to amend bylaws
(b) DE lawshareholders have inalienable right to amend bylaws (other state limit this
power to the board)
(i) Shareholders cannot limit the boards authority through bylaws [DGCL
(c) Directors frequently propose amendments and put important things in the bylaws
because the board controls them
5. Elect Directors
i. Corporations BOD normally elected by shareholders, but before the corporation is
formed there are no shareholders who can elect directors
ii. States allow either:
(a) The incorporators have the power to elect initial directors
(b) Initial directors can be named in the charter

(i) Initial directors usually resign at a meeting of shareholders held immediately after
6. Appoint Officers
V. Fundamental Financial Aspects of the Corporate Form
A. Elements of the Capital Structure: mix of debt and equity
1. Debt = money that is borrowed or leveraged. Debt securities are K
i. Priority debt = where creditors come in line to collect corporations assets, determined
by K
(a) Senior = debts that must be paid before anyone elses debt is paid
(i) Gets paid regular interest, and principal at maturity, before anyone else gets their
(b) Subordinated = second to senior (usually what corporations issue as bonds)
ii. Security
(a) Secured = once an interest is secured, those assets are given to the lender only until
the debt is satisfied
(i) Attached to assets
(ii) If you cant pay back, bank will take property, sell it, pay the interest and
principal, and pay other creditors
(b) Unsecured = everyone else, fixed obligations
(i) No particular assets attached to it
(ii) Paid out of whatever cash one has
iii. Terms of Debt
(a) Principal amount = amount lent, and must be paid on maturity. Legal obligation
specifying a date when debtor must repay principle amount in addition to any
outstanding interest not yet paid
(b) Interest payments = payments paid during a specified period set at an interest rate
(c) Default = if principle or interest not paid by maturity, bonds are in default and debtor
has defaulted. Creditors remedy is to receive an acceleration of the principle amount
form its original maturity date to the present
iv. Benefits of debt
(a) Advantages of leverage (other peoples money)
(b) Tax advantages
v. Costs of debt
(a) Agency costsmanagement and equity holders are likely to take money and give
last-ditch effort to save company (bet the farm problem)
(b) Financial distressnot just bankruptcy, but costs on the way down. Costs of
operating business increases dramatically once fear of bankruptcy comes
2. Equity = raising capital by selling shares in the corporation
i. Characteristics:
(a) Guided by K law but operates by statute
(b) Holders cannot force corporation into bankruptcy
(c) Characterized broadly not by right to payment, but by right to vote
(d) One vote per share is default, alterable by the charter
ii. Preferred Stock gets preference with
(a) Liquidation during bankruptcypaid out debt before common stockholders
(b) Dividendspaid before common stock

(c) Voting and BODsometimes can vote/designate BOD seats if dividends have been
skipped for a long period
iii. Common Stock
(a) Liquidation during bankruptcy as residual claimants (paid after everyone else if
money is still left over)
(b) Dividends paid at a lower rate than preferred stock, if at all
(c) Possesses voting rightswant to place voting in hands of those paid last and have
highest risk because they will monitor best
iv. Benefit of equity = dividends dont have to be paid in tough times
v. Costs of equity = control. Since shareholders vote, to bring equity in you lose control of
B. Foundational Concepts of Valuation
1. Time Value of Money = relationship between value of money received today and value of
money received in the future (comparing current $ to future $)
i. Helps clients decide whether to accept payment immediately or get a somewhat larger
payment at a point in the future
ii. UNDER CERTAINTY (no risks) $1 today is worth more than $1 tomorrow
iii. A = amount, R = interest rate earnings, n = # of years
(a) Discount rate (cost of waiting to invest) = (1+r)n
iv. Future Value (FV) = future value of a present investment
(a) FV = A(1+r)n = PV(1+r)n
v. Present Value (PV) = present value of a future return accounting for the time value of
(a) PV = FV/(1+r)n
vi. Net Present Value (NPV) = (-)cost + present value of return
2. When interest rate is higher, more painful to wait for money (lower PV)
3. When interest rate is lower, not costly for you to wait, which means PV is higher because PV
measures how costly it is for you to wait
C. Valuation under Uncertainty (with risk) $1 for sure is worth more than $1 with risk
1. Terms for risk
i. Investment Risk = chance that expected security returns will not materialize or the
securities you own will fall in price
ii. Variance = measure of the dispersion of returns (greater variance, greater risk for
disappointment/greater risk)
(a) Average square deviation of each possible return from its average/expected value
iii. Standard Deviation = square root of variance
(a) 2/3 of monthly returns tend to fall within one standard deviation of average return
(b) 95% of returns fall within 2 standard deviations of returns
2. Source of risk
i. Risk of no payment at all
ii. Risk of payment of another amount
iii. Risk of payment at another time
3. Consequences of risk
i. Imposes costs on individuals
ii. Due to risk aversion because

(a) Individuals have declining marginal utility of wealth (as you become wealthier,
money begins to lose value)
(b) Downside losses are weighted heavier than upside gains
(c) Risk Premium = additional amount that risk-averse investors demand for accepting
higher-risk investments in the capital markets. Whatever you pay someone to accept
that risk.
4. Measuring Risk
i. Expected Value = px (p = probability, x = return)
(a) Multiply probability of each outcome by the amount received in that outcome.
Weighted average of the value of investment, sum of what the returns would be if
investment succeeded, multiplied by probability of success, plus what returns would
be if investment failed multiplied by the probability of failure
(b) EX) coin toss$0 if tails, $50 if heads. Expected value = .5(0) x .5(50) = 25. No
chance youd leave with 25, only 0 or 50. So 25 is future value, and can use that for
other equations.
ii. Value of a future risky return must account for (1) the time value of money (interest) and
(2) risk
5. Types of Risk
i. Unsystematicrisks associated with particular business/industry
(a) CAN be eliminated through diversification
ii. Systematicrisks relating to the entire market (ex. War, inflation)
(a) Need premium to bear the risk
(b) CANNOT be eliminated
6. Diversification: minimizing risk while maximizing gains
i. Technique is to invest in stocks in opposite directions
ii. Result is that it eliminates idiosyncratic/unsystematic risk and there no longer exists a
risk premium for holding stocks with unsystematic risks
VI. Models for Determining the Role of Stock Prices in Securities Market (Estimating costs of debt and
A. Discounted Cash Flows Model (DCF)
1. Intrinsic value of an asset depends on markets belief of the likely ability of that asset to
produce free cash flows in the future
i. Free cash flow = amount of cash an asset can be expected to produce for its owners, net
of amounts that will be required to keep the asset in good shape to keep producing cash
ii. Profit does not reflect capital expenditures required to keep the firms assets in a steady
state of productivity
(a) Capital expenses are an investment, not an expense, so in accounting terms they will
not reduce profit, but they will reduce cash flows
(b) Expected amount of capital expenses has to be added to estimate future profit
2. Relies on discounting future cash flows back to net present value
3. New types of evidence allowed:
i. Valuation studies prepared by corporation by its own purposes
ii. Expert testimony about how much an acquirer would be likely to have paid in the present
situation (including testimony about the takeover premium, ie. the amount by which
price paid in a takeover generally exceeds market value of target just before
announcement of takeover)

4. Pro: relevant to financial markets
5. Con: because expert testimony is needed, there are disagreements about underlying factors
that lead to different valuations for what the NPV is for appraisal
B. Contemporaneous Transactions Involving Substantially Similar Assets
1. Reference to a recently established market price of identical/substantially similar assets
2. Adjustments made to reflect differences in comparables upon which the appraiser has relied
C. Efficient Capital Markets Hypothesis (ECMH)
1. Security prices at all times fully reflect available information
i. Weak Form = prices fully reflect all information contained in historical pattern of
market prices
(a) Investor cannot, merely by looking at the pattern of past prices of a particular stock,
predict the course of future prices
(b) Stock price movement are random
(c) Very well accepted by economists
ii. Semi-Strong Form = prices reflect all public information, including that in financial
(a) If accepted, 2 important corollaries emerge:
(i) An investor without inside information can never systematically beat the market
(ii) Investor can always buy any share at any time at the prevailing market price
without having to worry whether the price is too high/low because it will always
be fair in the sense that the price will always reflect all publicly known
(b) Well accepted by scholars
(i) All required is that new pieces of public information become rapidly reflected in
the companys share price
iii. Strong Form = prices fully reflect all information including no-public or inside
(a) Strong body of evidence that this is wrong
2. Drives policy for disclosure regulations

I. Rationale for Protection
A. Corporations creditors reasonably expect that the corporation will maintain sufficient assets to
pay the creditors
B. Protecting lenders protects the lending market
C. Mitigates the effects of limited liabilityholds shareholders accountable
1. Limited Liability opens opportunity for misrepresentation
2. Makes it possible and sometimes attractive to shift assets out of the corporation after a
creditor has extended credit
D. Can dilute claims of unsecured creditors by taking on senior debt
E. Can increase the riskiness of their debt by altering investment policy
F. Partnerships are not as troublesome for creditors because they can get at investors personal
II. Mechanisms for Protection: (1) Mandatory Disclosure, (2) Capital Regulations, (3) Duties
owed to Creditor
A. Mandatory Disclosure = Forced disclosure of the financial position of the corporation

1. State Lawsno states require any mandatory disclosure
i. Want to attract corporations so they get tax benefits
2. Federal Securities Law require disclosure, predicated on the efficient capital markets
i. SEC requires disclosure:
(a) Quarterly
(b) With large events
(c) When large loans are taken out
B. Capital Regulations = State law regulations requiring corporations to keep certain money in the
1. Dividends are cash payments made by a corporation to its common shareholders pro rata
i. Decision to pay a dividend made by the BOD, and these decisions are usually protected
by the Business Judgment Rule subject two 2 exceptions: [See below for directors duties
to creditors]
(a) Nearly all states place certain legal limits on BODs right to play dividends, and
directors who disregard these limits may be liable
(b) If BODs choice of dividend policy is made not for purpose of furthering corporate
welfare, but instead is made in bad faith or for directors own personal purposes, the
court might overturn this policy
(c) Public corporations typically try to have regular, predictable dividends based upon a
particular payout ratio (certain percentage of its earnings)
(d) Close corporations pay ad hoc because they are taxed twice
2. Dividends come from equity: equity is what makes assets = liabilities (because a balance
sheet must always be balanced!)
i. Stated Capital = capital in the corporation at the moment of incorporation, stockholders
permanent investment in the corporation
(a) Par value = (arbitrary $ amount stated in articles of incorporation) x # of shares
(b) If a corporation chooses to issue no par stock, the BOD must set aside some portion
of the sale price as the companys stated capital [DGCL 154]
ii. Surplus = capital surplus + retained earnings
(a) Retained Earnings = profits at the end of the year not yet distributed to shareholders
(net income)
(i) Amount that a profitable corporation earns but has not distributed to its
(b) Capital surplus = (# of shares)(market price) (# of shares)(par value)
(i) If stock is sold for more than par value, excess is accounted for in the capital
surplus account
(ii) Paid-in Surplus = total amount paid for shares by shareholders at time of initial
share issuance stated capital
3. Distribution Constraints: What can be paid from the equity to shareholders?
i. Nimble Dividend Test [DGCL 170]Dividends can be paid out of Surplus, and if no
surplus, out of Net Profits in current and/or preceding fiscal year
(a) Useful when corporation had a number of years of losses, and then one or two years
of earnings
(b) Still protects preferential stockholders

ii. Fair Market Value Test [RMBCA 6.40]dividends can be paid from anything so
long as (1) corporation is still able to pay its debts and (2) assets remain greater than
liabilities combined with preferential claims of preferred shareholders
(a) Asset valuations are based on reasonable market measures
(b) Dividends prohibited if corporation would become insolvent under either
(i) Equity meaning of insolvent (unable to pay debts as they mature)
(ii) Bankruptcy meaning of insolvent (assets less than liabilities)
(c) Most modern and flexible, and focuses on corporations real-world ability to pay its
(d) Insufficient protection for creditors, especially banks
(e) Quite popularabout 37 states have adopted it wholly or with minor variations
4. Other Protections
i. Minimum Capital Requirementsrequiring the shareholders to commit a stated
amount of capital to the firm
(a) DGCL nor RMBCA require minimum capital amounts as condition of incorporation
(b) Within the US basically do not exist
(c) Benefits: provides protections for creditors at the initial stage of incorporation where
there is high risk and limited information
(d) Cons: does not provide long-term protection because the corporation could take huge
loans after meeting the requirement, also a statutory standard minimum does not
account for differences between companies
ii. Capital Maintenance Requirements shareholders must maintain a certain amount of
capital at all times and failure to do so will trigger the ability for shareholders to move for
(a) EU uses this
(b) Benefits: provides more long-term protection for creditors and will accelerate
(c) Cons: may permit shareholders too much control, and want to avoid costs of pushing
the corporation into bankruptcy when there is a chance of recovery
C. Duties Owed to Creditors
1. Duties Owed by Directors
i. Under certain circumstances, directors owe obligations to creditors not to render the firm
unable to meet its obligations to creditors by making distributions to shareholders or
others without receiving fair value in returns
ii. When the company is in the vicinity of insolvency, BOD duties are owed to the
corporation itself, not just the shareholders
(a) Credit Lyonnais Bank v. Path Communications Corp (DE 1991)
(i) FACTS: company going towards insolvency and has possession of $51 million
dollar judgment. Weighing litigation options to try and get more to satisfy
shareholders/creditors based on the amount and potential of settlement
(ii) HELD: directors should always accept settlement offers with values greater
than the expected value of litigation
1. Rationale: in insolvency, BOD doesnt have incentive to take low settlement
offers even if they are greater than the expected value. SO, force them to owe
fiduciary duties not to any one group of constituents, but to the corporation as
an economic/legal entity

iii. Pros:
(a) More protection by keeping money in the corporation
(b) Stops BOD from swinging for the fences and winning litigation to satisfy
shareholders (while taking big risks and maybe unable to pay creditors)
(c) Hard for corporations to go bankrupt if they are just having cash flow problems
(d) Protects BOD as viewed ex-post
iv. Cons:
(a) Rule itself looks ex-post at a decision that was made ex-ante
2. Duties Owed by Other Creditors
i. Fraudulent Conveyance Law: imposes an effective obligation on parties contracting
with an insolvent debtor to give fair value for the cash/benefits they receive, or risk being
forced to return those benefits to the debtors estate
ii. Fraudulent Transfers [Uniform Fraudulent Transfers Act 4(1) and (2)] = transfers made
for purpose of delaying, hindering, or defrauding creditors, and are VOID
(a) Can void transfers if there is
(i) Actual Fraud (flat-out lie, where intent is hard to prove)
(ii) Constructive Fraud (giving ambiguous information and allowing others to draw
conclusions if:
1. Debtor transfers assets without receiving fair value
2. Debtors assets left to run business are unreasonably small
3. Debtors incur debts beyond capacity to pay them when due)
(b) Rationale: statutes stop people from avoiding creditors or engaging in bet-the-farm
transactions, and assets forced back into corporation so it can satisfy all liabilities
3. Applications of Fraudulent Conveyance Law
i. Leveraged Buyouts
(a) Transaction: company (acquirer) borrows money, then company uses borrowed
money to buy all the shares of stock of another company (target) at a premium over
the current market price
(b) Guarantees: acquiring company then controls target company (now a subsidiary),
directs its new subsidiary to guarantee the borrowed money
(c) BUT acquired company gets nothing at allso fraudulent conveyance
ii. Retention payments/severance payments
(a) Directors pay top officers money throughout bankruptcy process in order to have
them stay. Transfers of these bonuses are made without receiving reasonably
equivalent value in return, so the result is that the transaction is usually set aside but
rarely enough money left to repay the corporation
4. Duties Owed by Shareholders
i. Equitable Subordination = if equitable to do so, bankruptcy courts will recognize the
shareholders claim against the corporation, but will require that these claims are satisfied
only after all other creditors (and perhaps preferred shareholders) have been fully
(a) Places insiders interests below those of arms-length creditors
(b) Doctrine used when:
(i) Failure to follow corporate formalities
(ii) Fraud or wrongdoing
(iii)Inadequate capitalization

1. Costello v. Fazio (9th Cir. 1958)
a. FACTS: defendant director/creditors file voluntary bankruptcy and file
claims for money based on promissory notes, leaving the company grossly
undercapitalized. P holds that owners/shareholders were trying to put
themselves in the same class as unsecured creditors and their interests
should have bee unsubordinated.
b. HELD: in situations involving undercapitalization, equity holders
cannot convert to debt
i. Undercapitalization coupled with self-serving transfer warrants
equitable subordination because it is not within the bounds of reason
and fairness and not within the interest of the corporation as a whole
ii. D violated duty because acted in self interest
2. History of the company DOES matter in undercapitalization situations
because start up companies (like near-bankrupt companies) have little
(c) Generally, less of a departure from ordinary corporate practice is required for a
bankruptcy court to apply the equitable subordination doctrine than for an ordinary
court to pierce the corporate veil and favor a creditor
ii. Veil Piercing = court setting aside entity status of the corporation so that individual
shareholders can be held directly liable on K or tort obligations
(a) Most frequently invoked form of shareholder liability in cause of creditor protecting
(b) Voluntary Creditors/K Creditors
(i) Van Dorn Test (8th Cir. 1985)
1. Can Pierce the Corporate Veil IF a. AND b. are true:
a. Disrespect corporate form such that unity and interest of ownership such
that separate personalities of the corporation and individual are merged.
Factors for this prong include
i. Failure to maintain adequate corporate records or to comply with
corporate formalities
ii. Commingling of funds or assets
iii. Undercapitalization
iv. One corporation treating the assets of another corporation as its own
b. Circumstances are such that adherence to the fiction of separate corporate
existence would sanction fraud or promote injustice
i. Inability to pay judgment in itself is insufficient to satisfy the prong.
2. Sea-Land Services, Inc. v. The Pepper Source (7th Cir. 1991)
a. FACTS: After Sea-Land, ocean carrier, shipped goods for Pepper Source,
it could not collect substantial freight bill because PS had been dissolved
and apparently had no assets. Unable to recover on a default judgment
against PS, SL filed another lawsuit seeking to pierce the corporate veil
and hold Marchese, sole shareholder of PS and other corporations,
personally liable.
b. HELD: Cannot pierce corporate veil. Court not satisfied that SL showed
evidence that honoring separate corporate existence would sanction fraud
as required by Van Dorn test. Remanded back to district court for inquiry
into this

i. M co-mingled personal and business assets
ii. Other companies had money in them
iii. Court says 2nd prong would be satisfied by false assurance and tax
iv. One of the other companies M owned 50/50.
(ii) Laya Test: 3 prongs, with the third as permissive:
1. Disrespect of the corporate form with unity of interest and ownership such
that personality of corporation and individual are merged
2. If the acts were treated as those of the corporation alone, an inequitable result
would occur
a. Much lower standard than Van Dorn test can suffice here
b. Undercapitalization is enough for this (not for VD test)
3. Creditors are charged with knowledge that a reasonable credit investigation
would disclose. If so, they are deemed to have assumed risk of gross
a. Permissive
4. Kinney Shoe Corp v. Polan (4th Cir. 1991)
a. FACTS: Polan formed IR company and Polan Industries. Charters were
issued, but no organizational meetings were held and no officers elected.
Company had an agreement with K, and he defaulted on the lease. P goes
after Polan because the company has no assets. He was the sole
shareholder who controlled the corporation. Polan made first rental
payment out of personal funds but no other payments
b. HELD: can pierce the corporate veilmeets requirements of Laya test
i. Polan used money from his own account, ignored corporate formalities
ii. If he had kept good books/records he would not be in this mess
iii. Under Laya test, undercapitalization is enough for the second prong
(iii)Veil Piercing and Inadequate Capitalization: inadequate capitalization can play
one of 2 roles:
1. Van Dorn Test (Sea-Land Services IL)
a. Unity of Interest
i. One of the factors to determine this is inadequate capitalization
b. Bad conduct (sanctioning of a fraud or promotion of an injustice)
2. Laya Test (Kinney Shoe)
a. Unity of interest
i. Way in which corporation maintains books/records
ii. Focuses directly and exclusively on corporate formalities and way in
which finances are kept
b. Allowing inequitable results to occur
i. One of the factors to determine this is inadequate capitalization
c. (PERMISSIVE) third prong
i. Party looking to pierce the veil may be charged with the knowledge of
a reasonable credit investigation (including inadequate capitalization)
(c) Involuntary Creditors/Torts
(i) VERY hard to pierce corporate veil in tort
(ii) Different with K creditors because

1. Involuntary creditors do not rely on the creditworthiness for the corporation
for risk
2. Cannot negotiate with corporate tortfeasors ex-ante for K protection from risk
3. Victim may be unaware of existence of tortfeasor and less able to monitor its
capitalization/insurance coverage
(iii)Inadequate capitalization alone is NOT enough to pierce the corporate veil
1. Walkovszky v. Carlton (NY 1966)
a. FACTS: Cab driver hits a man and sues to get his expenses reimbursed.
Sued owner of the cab company. Owner has a lot of separate cab
companies, each with 2 cabs at $10,000 in insurance (the bare minimum of
b. HELD: Carlton not liablethin capitalization alone is not enough to
pierce corporate veil. In order to be individually liable, plaintiff would
have needed to show that owner was furthering his own business purpose
rather than those of the corporation. Here, there was no divergence of
i. Respecting the corporate form
ii. Efficiency concerns
(iv) Limited Liability in Tort: cuts transaction costs but incurs social costs (public
safetyunderinvestment in safety and overproduction in unsafe products).
Solutions to the problem could be:
1. Direct regulation
a. But legislation has not taken part in giving relief to tort claimants. Why?
i. Corporations have pull with legislation because they contribute to
ii. Could slow the economy
2. Mandatory insurance requirements
3. Price tort risks and motivate safety precautions (first priority in corporate
bankruptcy is to tort creditors)
4. Justifications for and against Limited Liability in torts
a. Inefficient because if all costs are internalized (including tort liability)
there will be fewer cabs on the road
b. Efficient because it creates incentives to take risks


I. Rights of Shareholders4 main rights: (1) voting, (2) selling, (3) suing, (4) information
A. Voting Rights
1. Unless otherwise provided in the charter, each stockholder shall be entitled to 1 vote for each
share of stock [DGCL 212(a)]
2. Stockholders right to vote is the ground upon which the new corporate governance is erected
and thus the law establishing and regulating its exercise is vitally important for the typical
public corporation today
i. Common stock has voting power because:

(a) Places hands in the power of the most unsecured creditors (paid their dividends last,
after all other creditors have been paid), which is KH efficient
(b) They lack any other financial guarantees so most likely to care about the
corporations well being
ii. Common stock is limited on what it can vote because otherwise it would be inefficient
3. Entitled to vote on sale of all property and assets [DGCL 271]
4. Entitled to vote on merger with another company [DGCL 251]
5. Entitled to vote for amendments to the certificate of incorporation [DGCL 242(b)]
i. Usually ends up increasing the power of the BOD
6. Election of Directors
i. Every corporation must have a BOD with at least one member [DGCL 141(a)]
ii. Every corporation must elect directors annually at a SH meeting [DGCL 211]
(a) Actual notice requirement [DGCL 222(b)]
(b) Quorum requirement [DGCL 216]
(i) Quorum default rule is over one half of all shareholder eligible to vote
(ii) Corporations are allowed to reduce the quorum requirement to no less than 1/3
(c) Record date established by charter or in bylaw [DGCL 211(c)]
7. Removal of Directors
i. State law governs the removal of directors
ii. Shareholders can remove directors only for good cause unless charter provides
(a) Good cause is usually obvious fraud or unfair self dealing, but uncertain [DGCL
(b) Campbell v. Loews Inc (DE 1957) established a director is entitled to certain due
process rights
iii. Board can only remove Board members if it has explicit shareholder approval
i. Individual investors remain apathetic because they have diversified portfolios and can
sell shares when they are disappointed
ii. Institutional investors (pension funds, insurance companies) CANNOT. Portfolios are too
large so they cant sell when disappointed because it would make their portfolio not
iii. Activist hedge funds seek to profit by purchasing shares in disappointing companies and
then seeking to reduce the (extreme) agency costs
B. Proxy System
1. 1934 SEA 14 sought to empower shareholders through mandatory disclosure of
informationPromulgates proxy rules, which ensures investors have adequate information
before they exercise their right to vote by filling out a proxy card
(a) SEC-Mandated Disclosure: require that anyone soliciting proxies from public
shareholders must file with the SEC relevant informationalso prohibits fraudulent
or misleading proxy solicitations
(b) No Open-Ended Proxies: substantive regulation of process of soliciting proxies from
shareholdersprescribe form of proxy card and the scope of proxy holders power

(c) Shareholder Access: 14a-8 permits shareholders to gain access to the corporations
proxy materials shareholders gain a low-cost way to promote certain kinds of
shareholder resolutions
(d) Private Remedies: general anti-fraud provision14a-9 allows courts to imply a
private shareholder remedy for false or misleading proxy materials
ii. Proxy system gives SEC broad opportunity to regulate:
(a) Mechanics of the proxy system
(b) Information that must be furnished to a shareholder when his proxy is solicited
(c) The information that must be furnished to each shareholder annually, whether or not
his proxy is solicited
(d) Furnish shareholder with means of submitting proposals to fellow shareholders
(e) Dictate specific requirements for conducting proxy contests
iii. SEC Rules:
(a) Rule 14a-1: 14a-1 defines terms, including the critical terms proxy and
solicitation. Proxy statement is any communication to result in procurement of a
proxy. A proxy can be any solicitation or consent whatsoever
(i) SOCILITATION = any communication reasonably calculated to result in a
procurement of proxy
(b) Rule 14a-2: is broadly framed to insure that most proxy solicitations will be subject
to regulation BUT, Exempted proxy solicitations are listed under subsection 2(b).
(c) 14a-2(b)(1): (proxy exemptions in this section added in 1992 amendments) Press
release or letter to someone announcing how you intend to vote your shares in a
future mtg and why it is not a proxy solicitation Announcement exemption.
Applies to shareholders and non-shareholders
(i) This allows large financial institutions to announce whether they are going to
support a merger or not
(ii) There is no limit on the # of announcements that can be published or broadcast.
(d) 14a-2(b)(2): A communication sent to no more than 10 individuals is not a proxy
(e) 14a-2(b)(3): Communication that urges a shareholder to vote in a particular manner.
One shareholder can write to another and urge them to vote in a certain way provided
the writer doesnt solicit a proxy or doesnt act in concert with someone who is
soliciting proxies (this exemption does not apply to any person affiliated with the
company- i..e CEO cant do this)
(i) Person who own $5mill or less of the cos securities that are the subject of the
solicitation will not be required to submit written soliciting material to the SEC
(ii) notice is required to be delivered or mailed to the SEC within 3 days of first use
of the soliciting material
(iii)No notice or filing requirement for oral communication
(f) 14a-3(a): may not solicit a proxy unless provide proxy with statement containing the
information provided in schedule 14A
2. Proxy Cards sent out by management to shareholders. They usually vote in line with CEO,
or else he wouldnt initiate a vote in the first place.
3. Essentially, you can get CEO managers/officers to vote for you/on your behalf [DGCL
4. Disclosure and Filing Requirements

i. Any documents sent to shareholders as part of solicitation must be filed first with the
ii. Proxy statements must disclose [SEC Rule 14a-3(a)]:
(a) Conflicts of interest
(b) Details of any compensation plan to be voted on
(c) The compensation paid to the 5 most highly-paid officers
(d) Details of any major corporate change being voted upon
iii. Annual reports must be sent out detailing annual reports including audited balance sheets
and profit and loss statements [SEC Rule 14a-3(b)]
5. Proxy statement Anti-Fraud rule [SEC Rule 14a-9(a)]
i. Prohibits use of proxy solicitation materials that contain any statement which, at the
time and in the light of the circumstances under which it is made, is false or misleading
with respect to any material fact, or which omits to state any material fact necessary in
order to make the statements therein not false or misleading
(a) TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976)
(i) Material = if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote
ii. If violated, shareholders can bring private actions for injunction or damages
(a) Virginia Bankshares, Inc. v Sandberg, 501 U.S. 1083 (1990)
(i) FACTS: A freeze out merger required BOD approval and vote of majority
shareholders. Bank told minority shareholders they believe theyd received a good
and high price based on information provided by the bank. Price was not actually
good, so shareholders sue on theory of fraud and conflict of interest (Director
voted in way to keep his job)
(ii) HELD: knowingly false statements of reasons for director recommendation are
actionable if they are misleading here but shareholders here fail to show causation
(injury resulting from the fraud) and also, the vote was not essential to the
transaction (because he was a member of a class minority shareholders, whose
consent was not legally needed for the merger so misstatements were not found to
have caused harm
1. Matters that the statement is only an opinion because what is material is that it
carrier gravitas.
2. If the vote doesnt actually directly cause the material decision to be
made, proxy fraud rule does not apply and there are state rights of action
6. Proxies are revocable unless the holder has contracted for the proxy as a means to protect a
legal interest or property, such as an interest in the shares themselves [DGCL 212(e)]
7. Proxy Contests
i. Any competition between two competing factions to obtain shareholder votes on a
ii. Incumbent management has advantages at the start of a proxy contest
(a) Stockholders tend to vote for management
(b) Management can use corporate funds to pay for its side of the contest
(c) Management knows who the shareholders are, whereas insurgents will usually have
to litigate to get access to the list
8. Bearing Costs of Proxy Votingdifferent treatment for incumbents and insurgents

i. Note: Shareholders never get reimbursed in a proxy fight because the cost is borne by
them in their reduced future dividends. Can avoid this by classifying the BOD and
making company harder to take over
ii. Froessel Test:
(a) Incumbent BOD may incur reasonable expenses related to defense of proxy contest
(i) Dispute related to a policy matter rather than personal matter
(ii) Incumbents act in good faith
1. Rationale: use funds to defend corporate policies anyways because they want
to keep their job. SO if reimbursement, there will be more incentive to keep
shareholders informed, etc.
(b) Insurgents only reimbursed if:
(i) They win
(ii) Shareholders ratify it
1. Rationale: discourages frivolous proxy fights. High costs, so only engaged in
if a good chance of winning
(c) Rosenfeld v. Fairchild Engine & Airplane Corp. (NY 1955)
(i) FACTS: Fairchild paid money out of its treasury to reimburse both sides after a
proxy fight. Shareholders ratified expenses. Rosenfeld, a stockholder, argued that
they were not legal charges that could be reimbursed and sued to compel a return
of all the funds to the corporation
(ii) HELD: Corporations may pay reasonable expenses to defend itself and its
corporate policies. Objective standard determined by the court, looking to
good faith
1. Shareholder approval means to the court that there was good faith, so court
will not change decision
2. Rationale:
a. Incumbent directors would be unable to defend their positions and operate
corporate policies if this was not the case
b. The old board entitled to reimbursement (fair fight)
c. Encourages only valid proxy contests by reimbursing reasonable
insurgence and discourages frivolous proxy contests by not guaranteeing
insurgent reimbursement
(d) Almost always when insurgents win, both sides get reimbursed
C. Shareholder Proposals
1. IF shareholder is willing to bear the expense, SEC Rule 14a-7 says management must either
male shareholders materials to other stockholders or give the soliciting shareholder a list of
shares so he can do the mailing directly
i. Requirements for the rule
(a) Proxy materials must relate to a meeting in which company will be making its own
(b) Stockholder must be entitled to vote on the matter
(c) Shareholder must defray the expenses that the corporation would incur in mailing the
ii. No length limit or censorship
2. IF shareholder wants corporation to bear the expenses [SEC Rule 14a-8]

i. Requirements for the rule;
(a) Own either at least 1% or $2000 in market value of securities in the company and
(b) Have held the shares for at least one year prior to submission
ii. Shareholder does not have to have anything to do with a matter management plans to
raise at the meeting
iii. Can only be less than 500 words
iv. Exclusions under which management may refuse to include the proposal [SEC Rule 14a-
(a) Relating to the proposal itself:
(i) Proposal is not a proper subject for action by stockholders under state law
(ii) Proposal would result in violation of state, federal, or foreign law
(iii)Proposal is not significantly related to companys business
(iv) Proposal is beyond companys power to implement
(v) Proposal relates to the companys ordinary business operations
(vi) Proposal relates to a nomination or election of a candidate to the BOD or to a
procedure for such nomination
(vii) Proposal is moot because company has already substantially implemented
(viii) Proposal relates to specific amounts of dividends
(b) Relating to abuse of process:
(i) Violates proxy rules
(ii) Relates to a personal claim or grievance, or designed to further a personal interest
not shared with other stockholders
(iii)Counter to a proposal to be submitted by the company
(iv) Duplicates a proposal of another shareholder for inclusion in the same proxy
(v) Deals with substantially the same subject matter as a prior shareholder proposal
made at recent meetings, unless earlier proposal received a sufficiently large vote
D. Information rights
1. Federal Law33 SEA regulations information given on the initial sale of a company and
2. State Law [DGCL 220(b)]: shareholders may inspect (1) company stock ledger, (2)
shareholder list, and (3) other books and records for any proper purpose
i. Any proper purpose is BROADLY construed as purpose reasonably related to the
persons interest as a shareholder
3. Shareholder List/Stock List
i. IDs shareholders and lists their contact information, ownership interest
ii. Used by shareholders to contact other shareholders to:
(a) Give proposals
(b) Instruct how to vote on certain manners
iii. All you need is any proper purposeessentially never denied
(a) Potential secondary motives do not matter when seeking a stock list as long as there
exists a proper purpose
(b) Rationale: more information means a more efficient market
iv. Does NOT contain proprietary information
4. Books and Records

i. Provides a close look at corporations financial statements. Sensitive and competition
information so COURT PROTECTS MORE
ii. Accesscase-by-case scrutiny of the courtalmost always REJECTED
iii. Rationale:
(a) Deter sneaky people form buying one share of stock and requesting sensitive
competitive information
(b) Also can just look at balance sheet/income statement/statement of cash flows. Dont
need more information than this.
iv. Court places burden of proof directly on shareholder. Analyzes:
(a) Shareholders position towards corporation
(b) Shareholders stated purpose, which must be strong
II. Separating Rights (Cash Flow Right and Voting Rights)
A. Vote Buying (aka. BRIBES)
1. Shareholder may not sell vote other than:
i. As a part of transfer of underlying share AND
ii. transferor must give his transferee a proxy to vote to the stock (unless transferor officially
retains voting rights to protect his legal interest in the stock or the corporation is strong
enough to support grant of an irrevocable proxy)
2. NOT in corporations best interest to separate voting right from equity interest
i. By not separating, it ensures that an unnecessary agency cost will not come into being
(separating shares from votes introduces a disproportion between expenditure and
(a) Ex) if owner of 20% of stock acquires all votes, his incentive to take steps to improve
firm is only 1/5 the value of those decisions, and holder of votes will invest too little
and have incentive to engage in non-profit maximizing behavior
ii. Transactions in votes are bad because
(a) Hard to value
(b) Creates costs without conferring benefits over transactions in votes tied to shares
(c) Collective action problemif no voter believes their vote will influence, sell vote for
any non-zero price, and would not reach equity-dilution
3. Schrieber v. Carney (DE 1982)vote buying not per se illegal, just voidable UNLESS
purpose is not to defraud or disenfranchise shareholders AND is intrinsically fair
i. FACTS: TX Intl and TX Air entered into merger discussions. Jet Capital was 35%
shareholder in TX Intl and had effective veto power over any merger. To merge, a
committee of non-interested directors and independent counsel formulated a loan plan
that the shareholder of TX Intl overwhelmingly approved. Schrieber, a dissenting voter,
sued saying vote buying happened and was per se void.
ii. HELD: corporate vote buying is permissible as long as it does not work to prejudice of
other shareholders
(a) Agreement was a voidable act of vote buying BUT it was cured by shareholder
(b) Purpose of the agreement was not to defraud/disenfranchise shareholders but rather to
further their interests
iii. Courts use standard of intrinsic fairnessif shareholder majority votes in favor,
presumed fair.
iv. If such a plan works to the detriment of the non-participating shareholder, then void.

v. Rule itself is efficient, but inefficient because its case by case analysis so cant inform
people how to act
B. Controlling Minority Structures
1. The following structures allow a SH to control a firm while holding only a fraction of its
i. Dual Class Equity Structures: Single firm issuing two or more classes of stock with
different voting rights. Planner can attach all voting rights to the fraction of shares that
are assigned to the controlled, while attaching no voting rights to the remaining shares
distributed to the public or other SH. Essentially, this gives certain people voting rights
in the stock and then attaches no voting rights to the remaining shares that are distributed
to the public or other shareholders at that time. i.e. class A shares get 10 votes/share but
other stockholders get 1 vote/share on the market. This allows a family/concentrated
majority to control the company.
(a) ex) Facebook
(i) Zuckerbeg has, through his ownership of class B shares, has 54% of voting power
but only 20% of cash flows (economic interest)
(b) Ex) Ford
(i) Ford family has 40% of voting power because of class B shares, but only 5%
economic interest in the company
(ii) This means for every $1 of waste/costs from decisions Ford family makes, they
shove 95 cents of the cost onto shareholders
ii. Stock Pyramids: Most popular of the three.
(a) Two-tier pyramid: controlling minority SH holds a controlling stake in a holding
company that holds a controlling stake in an operating company.
(b) Three-tier pyramid: primary holding company controls a second-tier holding
company that in turn controls the operating company.
(c) This structure rapidly separates equity from control.
iii. Cross-ownership Ties: Companies are linked by horizontal cross-holdings of shares that
reinforce and entrench the power of central controllings.
(a) Differs from pyramids in that voting rights used to ctrl the corporate group re
distributed over the entire group rather than concentrated in the hands of a single
company or SH.
(b) Similar to pyramids because a controller can exercise complete control over a
corporation with an arbitrarily small claim on its cash flow rights
iv. In the US and UK , neither pyramids nor cross-ownership are popular because:
(a) We impose an income tax on inter-corporate dividends, thus there is a significant tax
penalty on moving corporate distributions through two or more levels of corporate
(b) Investment Company Act of 1940 imposes regulations and reporting requirements on
group structures tied together by webs of minority holdings


Summary of the 3 principle duties
1. Duty of Obedience: Fiduciary must act consistently with the legal documents that create her
authority (Ex: charter, bylaws, etc.)

2. Duty of Care: duty to not be an idiot // applies in all decisions D and O make must be grossly
negligent, mere negligence does not suffice
a. Definition: D or O has duty to the corp to perform Ds or Os functions: (1) In good faith and
(2) In a manner that he or he reasonably believes to be in the best interest of the corporation
and (3) With the care that an ordinarily prudent person would reasonably be expected to
exercise in a like position under similar circumstances
3. Duty of Loyalty: duty to not be a thief // applies where there is a conflict of interestrequires that
corporate fiduciaries exercise their authority in a good faith attempt to advance corporate purposes
i. Applies where D or O can benefit on both sides of a transaction
ii. Bars corporate officers and directors from competing with the corporation

A. Summary
1. Duty of Care = officer must, in handling corporations affairs, behave with the level of care
that a reasonable person in similar circumstances would use
2. Business Judgment Rule = courts will not second-guess the wisdom of directors and
officers business judgments, and will not impose liability for even stupid business decisions
so long as the director officer:
i. Had no conflict of interest when he made the decision, and
ii. Gathered a reasonable amount of information before decision, and
iii. Did not act wholly irrationally
3. Effect of combining DOC with BJRscheme that looks closely at the process by which the
director or officer makes his decision, but then gives very little scrutiny to the substantive
wisdom of the decision itself
4. Liability for Damages vs. Injunction
i. If D or O violates DOC to corporation, and this violation causes loss to the corporation,
the D/O will be personally liable to pay money damages to the corporation
(a) Often will come about by means of a shareholder derivative suit (shareholder sues on
behalf of the corporation against the negligent D or O)
ii. Injunctionsituation in which BOD has approved but not yet consummated a
transaction, and a shareholder or outsider sues for an injunction to block the proposed
(a) Court can block the proposed transaction until it is approved with the required level
of diligence
(b) Courts probably wiling to block a proposed transaction (especially in areas of
takeovers) on les of a showing of violation of due care than they would require before
imposing personal liability on D and Os
iii. Very rare for Ds and Os to be found liable for breach
(a) When they are, mostly cases in which the court believed that Ds were engaged in self-
dealing (violated duty of loyalty) BUT because proof of self-dealing not strong
enough, court based decision on lack of duty of care
iv. Directors v. Officers
(a) Officer typically has deeper knowledge about the companys affair than will an
outside director

(b) Facts which might not give outside director cause to investigate but might give officer
such cause
B. Requirements of the Duty
1. Standard of care is gross negligence
2. Definition: D or O has duty to the corporation to perform D or Os functions (1) in good faith
AND (2) in a manner that the director reasonably believes to be in the best interest of the
corporation [MBCA 8.30(a)]
3. Approach:
i. Question #1: Does company charter have a 102(b)(7) provision (eliminating personal
liability of Ds for breaches of duty or care, except if actions were in bad faith or against
the law)?
(a) Yesunless breach of DOL, or good faith, then D is protected from liability
(b) Nogo to Q2
ii. Question #2: Does BJR apply?
(a) BJR applies unless (1) D/O failed duty to monitor, (2) there is waste, (3) illegality or
knowing violation of existing regulation, or (4) fraud or gross negligence
(b) If none of theseBJR applies and D not liable
(c) If any of theseBJR does not apply and D liable
4. Standard of care is objective
i. If D has special skills that go beyond what an ordinary D would have ,he must use those
(a) Accounting, legal, baking, real estate training
5. Surrounding Circumstances
i. Circumstances include nature or size of the particular business
ii. If business serves as trustee or custodian for funds of others, reasonable degree of care
under circumstances would include being on lookout for misappropriation
(a) Why directors of banks sometimes said to have a higher standard of care
6. Director is ENTITLED TO RELY on experts and committees [MBCA 8.30(b)]
i. However, if director knows facts that indicate that the expert is lying or otherwise
mistaken, cannot bury head in the sand and continue to rely on third party statements
[MBCA 8.30(e)]
C. Protection of the Business Judgment Rule
1. BJR = business decisions made upon reasonable information and with some rationality
do not give rise to directorial liability even if they turn out badly from the standpoint of
the corporation
2. Rationales for limiting director liabilities via BJR
i. Certain amount of innovation and risk-taking is essential if businesses are to grow and
ii. Courts are poor judges of business reality
(a) Kamin v. American Express Co. (NY 1976)
(i) FACTS: AmEx held stock in a company, and the stock declined a lot. AmEx
directors had a meeting to decide what to do with worthless stock. Declared
special dividend to shareholders of that stock, rather than use cash for business
reasons. Shareholders complain saying it was a bad decision because if they sold
the stock they would have gotten a tax write of for selling stock at a loss

(ii) HELD: Where there is no evidence of illegality, fraud, negligence, or conflicts
of interest, the BOD is protected as under BJR despite foolish decisions
(b) Board has experience and qualification to make decision
iii. Shareholders can spread risk of business misjudgments far more easily by diversifying
their portfolio than directors can spread this risk by serving on multiple boards
(a) Shareholders can diversify the risks of their corporate investments
(b) Directors have no diversification. Enjoy only a small proportion of upside gains
earned by the corporation on risky investment projects. However, if thy were to be
found liable for corporate loss from too risky a project, liability would be joint and
several on the whole loss
(c) Gagliardi v. Trifoods International
(i) FACTS: shareholders of Trifoods brought a derivative action against them for
recovery of losses sustained by reason of mismanagement unaffected by any
directly conflicting interests. Directors went to move to dismiss.
(ii) HELD: To Sustain a derivative action from recovery of corporate losses
resulting from mismanagement unaffected by directly conflicting financial
interests a shareholder must plead that a director did not act in good faith
and/or failed to act as ordinary prudent person would have acted under
similar circumstances
3. Requirements for application of the rule [ALI Prin. Corp. Gov., 401(c)]
i. No Self DealingD must not have any private interest in the outcome different from the
corporations interest (no taint of self-dealing)
ii. D must have made the judgment only after gathering reasonable information
(a) Aronson v. Lewis (DE 1984)
(i) HELD: Directors must inform themselves prior to making a business
decision, of all material information reasonably available to them
(ii) Gross negligence standard
iii. Must have rationally believed that his judgment was in the corporations best interest
(a) No scrutiny of merits of decisioncourt focuses on directors decision-making
process, and rarely consider merits of underlying decision, because that is what BJR
(b) Court will not use 20/20 hindsight (Brehm v. Eisner, DE 2000)
4. BJR in Takeover Cases
i. Smith v. Van Gorkom (DE 1985)
(a) FACTS: CEO decided to sell Trans company. Approached someone he knew, offered
to sell Trans for $55/share, BOD approved in 2-3 hour meeting without ever seeing
the K or valuations of $55, which CEO decided himself. Shareholders sued.
(b) HELD: Trans directors had been grossly negligent in their decision making and cold
not claim BJR protection
ii. Consequences of Smith-Exculpation Clauses
(a) Corporation can put a provision in its charter eliminating personal liability of
directors for breach of duties of care (except if taken in bad faith or against law)
[DGCL 102(b)(7) and MBCA 202(b)(4)]
(i) Cannot cover breach of good faith or duty of loyalty, but can cover breaches of
the duty of care
5. Overcoming of BJR Presumption

i. Lack of Good Faith
(a) Illegalityif act taken or approved by Ds is violation of criminal statute, D loses
benefit of BJR
(b) Fraud
(c) Conflict of Interestpursuit of social goals/self dealing
ii. Wastelack of rational business purpose (receiving very little consideration for a
massive giving)
(a) Plaintiffs will almost never be able to show waste, but they may be able to show that
a transaction lacked fairness.
iii. Gross negligence: discharging duties to supervise and become informed
(a) If a REALLY STUPID business decision, judge may hold you liable (Smith v.
(i) This case has been limited to merger context by some judges
D. Extension of Duty of Care
1. Duty to Monitor
i. Minimum Standard
(a) Definition: BOD and O have a general duty not to be inactive in monitoring, being
reasonably informed, attend meetings, review financial statements, obtain help when
sees or ought to see things going wrong
(i) Failure of BOD to act mush have cost shareholder loss
(ii) Must be a circumstance that gives the red flag to shareholders that someone is not
doing the right thing
(b) Passive Negligenceviolation of duty to monitor results from agency costs of
passivity (failure to act or respond may constitute breach of duty to monitor)
(i) No explicit duty to in fact detect wrongdoing by officers or employees of the
ii. Summary of Duty to Monitor:
(a) Duty to be informed
(b) Only way to fail in the duty is to consciously choose not to gather information or to
ignore gathered information
(c) Only after reasonable suspicions that directors have a duty to take care of any
wrongdoings by the corporate officers/employees
iii. Francis v. United Jersey Bank (NJ 1981) BJR does not apply to Duty to Monitor
(a) FACTS: Mrs. Pritchard ignored duty as Directors and allowed her sons to withdraw
over $12 million from client trust acts.
(b) HELD: Pritchard breached duty of care to corporation and is therefore liable for
losses caused by the misappropriations
(i) Failed to act in good faith by not being informed at all about the business
(ii) Had a duty to stop illegal activity once she knew about it (more than a duty to
object, but to go to authorities)
(c) Business Judgment Rule only protects informed decisions
(d) Liability of a corporations directors to its clients requires a demonstration that:
(i) A duty existed
(ii) The directors breached that duty
(iii)The breach was a proximate cause of the clients losses

(e) Rationale
(i) No benefit to shareholders to protect D and O from own laziness
iv. Directors do not have explicit duty to in fact detect wrongdoinga red flag,
sufficient notice of potential wrongdoing is needed to signal the Duty to Monitor
(a) Graham v. Allis-Chalmers Mfg. Co. (DE 1963) [RED FLAG DOCTRINE]
(i) FACTS: Shareholders of Allis contended in derivative suit that corporate directors
were liable as matter of law for failing to take action to learn of and prevent
antitrust violating activity of non-director employees
(ii) HELD: a corporate director who has no knowledge of suspicion of wrong
doing by employees is not liable for such wrongdoing as a matter of law
1. Absent cause for suspicion there is no duty upon directors to install and
operate a corporate system of espionage to ferret out wrongdoing which they
have no reason to suspect exists
(b) Member of BOD shall be fully protected in relying on good faith upon the records of
the corporation and the information provided by the officers [DGCL 141(e)]
2. Oversight Requirement
i. Under Federal Securities Law
(a) Court holds outside D violates SEA by recklessly failing to inquire into corporations
financials when he knows of a fact to put him on notice that inquiry is warranted
(b) A recklessness standard
(c) In the Matter of Marchese (SEC)
(i) FACTS: SEC contended Marchese, outside D of Chancellor who served on audit
committee, violated and caused Chanellor to violate SEA rules because he failed
to adequately monitor companys financial statements
(ii) HELD: Outside D of corporation who series on audit committee violates and
causes his corporation to violate the exchange act by recklessly failing to
inquire into corporations financials where he has knowledge of facts to put
him on notice that inquiry is warranted
1. He had the information and let the company make fraudulent financial
ii. Duty of care DOES require that reasonable control systems be put in place to detect
(a) BOD wont be liable for failure to supervise because the controls system fails to
detect the wrongdoing
(b) In Re Caremark Intl. Derivative Litigation (DE 1996) [DUTY TO BE
(i) FACTS: Caremark entered into contractual agreements with hospitals and worried
about kickbacks. To combat this, had a compliance program in place, even with
an 800 number where you could call in violations. Despite this, employees were
found breaking the rules.
(ii) HELD: BOD has affirmative duty to attempt in good faith to assure that a
corporate information and reporting system exists and is adequate.
(iii)So now there is liability for failure to monitor (deviates from Allis-Chalmers)
1. NO LONGER TRUE that mere reliance on senior officers is sufficient. Now
BOD needs to put in type some independent system for reassurance

2. Federal Rules now expressly require public companies to institute system
of internal controls
a. 13(b)(2) of Securities Exchange Act requires every publicly-held
corporation to devise and maintain a system of internal accounting
controls to guarantee accurate financial statements and to guard against
misappropriation of assets
i. Most companies do this by creating an audit committee
(c) Stone v. Ritter (DE 2006)Delaware Supreme Court affirms basic test articulated in
Caremark for when Ds could be liable (assuming corporation has exculpation clause)
for violating duty to monitor if:
(i) Directors utterly failed to implement any reporting information system or
controls, or
(ii) Having implemented such a system or controls, consciously failed to monitor or
oversee its operations
(iii)In EITHER case, imposition of liability requires showing that Ds knew they
were not discharging their fiduciary obligations
1. Gross negligence is not enoughdeference here is almost absolute because it
requires conscious decisions and failuresP will have very hard time
showing D knew they werent doing their job
3. Differentiating between BJR and failure to monitor
i. In re Citigroup (DE Chancery 2009)
(a) FACTS: shareholders of Citi brought action against D and O alleging they breached
duty to monitor by failing tom manage the risks the company faced from problems in
subprime lending market and for failing to properly disclose Citis exposure to
subprime assets
(b) HELD: deferential status of BJR is applied where there are no blatant red flags.
Court distinguishes between duty to monitor and BJR cannot hold D directly
liable for a bad business decision alone. A risky decision does not constitute a
failure of your duty to monitor
(c) A way out from underneath duty to monitorif court can make the decision about
risk is a business decision, entitled to BJR
4. Knowing Violations of Law
i. Ds engaged in illegal activity or knowing violation of existing regulation will not receive
BJR protection, regardless of whether actions are intended to benefit shareholders
(a) Miller v. AT&T (3d Cir. 1974)
(i) FACTS: shareholder of AT&T brought suit when corporate directors forgave a
1.5 million dollar debt owed to it by the Democratic National Convention.
Shareholders maintain BOD violated 16 U.S.C 610, an anti-campaign financing
law by corporations.
(ii) HELD: BJR will not insulate Ds from liability where it is alleged they have
committed illegal or immoral acts
ii. Violations of law are not protected by immunity shield provision DGCL 102(b)(7)
(a) Rationale: cannot give benefit of doubt to BOD when they are breaking the laws and
thus injuring shareholders
iii. When knowing violation of law, removes protection of BJR BUT DOES NOT MEAN

(a) P must prove there was a net loss
(b) If company benefits, and benefits exceed loss, no recovery for P.
(i) Ex) company violates environmental laws and is subject to crime fines of $1
million. Directors may be liable if no benefit. BUT if the violation earned
company $4 million, there was no net loss ($3 gain) and so a derivative suit would
be unsuccessful.
A. Summary
1. Issue spotting: look for self-dealing when:
i. Deal is between corporation and director
ii. Deal is between corporation and a controlling shareholder
(a) Fiduciary duty of loyalty implied through obligation to be fair for controlling
shareholder because often the BOD is beholden to the controlling shareholder who
elects them
iii. Arises frequently in the following situations
(a) Self-dealing transactions
(i) Key player can avoid breaching DOL if:
1. Approach 1:
a. Discloses conflict and nature of transaction in advance and
b. Has majority of disinterested directors or disinterested shareholders pre-
approve transaction after disclosed
2. Approach 2:
a. Transaction is fair to the corporation
b. Disinterested directors or shareholders ratify the transaction after the fact
and having received full disclosure about it
(b) Executive compensation
(c) Corporate Opportunity Doctrine
(d) Sale of Control
(e) Insider Trading
2. Approach:
i. Q1: Is there an interested party?
(a) If Directorgo to Q3
(b) If Controlling Shareholdergo to Q2
(c) If no interested partyno duty of loyalty breach, claim dismissed
ii. Q2: Was there self-dealing? Apply the benefit/detriment test (Controlling Shareholders
defensive measure). Did controlling shareholder receive a benefit to the exclusion and
detriment of the minority shareholders?
(a) Yesgo to Q3
(b) Nono duty of loyalty breached, claim is dismissed
iii. Q3: Is there an applicable safe harbor statute? [DGCL 14]
(a) If Yes, analyze under 3 approaches:
(i) Disclosure/approval and fairness
(ii) Disclosure/approval alone
(iii)Disclosure and fairness (likely only in close/smaller corporations where
disinterested D approval is impossible, and either no shareholders or no time to
submit to shareholders)

(b) If nogo to Q4
iv. Q4: Did interested party to transaction disclose all material information relevant to their
conflict (to the transaction and to the conflict) to the relevant parties?
(a) Yesgo to Q5
(b) Notransaction is voidable because of non-disclosure and unfairness
v. Q5: Was there approval by a disinterested party?
(a) Yesgo to Q6
(b) Nocorporation must show Entire Fairness (fair process and procedure) when
challenged (no burden shifting to the plaintiff because no approval)
vi. Q6: Which disinterested party approved the transaction?
(a) Directorsburden shifts to PP must show waste to overcome BJR
(b) Shareholdersgo to Q7
vii. Q7: Who are the interested parties in the transaction?
(a) If Controlling Shareholdersburden shifts to P P must show the transaction was
not entirely fair (fair process and fair procedure)
(b) If Directorsburden shifts to PP must show waste to overcome BJR
B. Requirements of the Dutycomes into play where D or controlling shareholder has interests in
both sides of the transactions
1. Definition: Stands for the principle that directors and officers of a corporation in making
all their decisions in their capacity as corporate fiduciaries, must act without personal
economic conflict
i. Can be breached by:
(a) Diverting corporate assets
(b) Taking business opportunities from the corporation
(c) Using proprietary information for personal gain
(d) Setting ridiculous compensation selfishly
(e) Corporate waste, etc.
ii. Corporate officers and directors occupy a fiduciary relation to a private corporation and
the shareholders thereof akin to that of a trustee, and owe undivided loyalty and a
standard of behavior above that of the workaday world (think Meinhard v. Salmon)
2. Dodge v. Ford Motor Co. (MI 1919)
i. FACTS: Ford announces company will no longer pay any dividends and will reinvest
profits into the business. Plaintiffs, the Dodge brothers, who are minority stockholders,
sue to have the court force Ford to resume payment of dividends because (1) company is
already making enough money, and (2) wants to reduce the price of cars to benefit
working man instead of increasing corporate profits
ii. HELD: corporation is organized for the benefit of its stockholders, not for charitable
purposes. BODs cannot sacrifice the interests of shareholders without breaching the
duty of loyalty
3. What it means to be conflicted:
i. Direct ConflictKey player is on both sides of the transaction
ii. Indirect conflictKey player has interest or association with some other entity, and that
entity enters into a transaction with the corporation
(a) Pecuniary interest: if Key players financial interest in other entity is such that this
interest would reasonably be expected to affect his judgment concerning the

(i) Ex) Key player is a significant stockholder of the other corporation or partner in
the partnership
(b) Interlocking directors: Key player is a full time executive or director of the other
(i) Usually state statutes do not think that when a person serves on the BOD of both
companies by itself is self-dealing
(ii) MBCA is much stricter, and says a D has conflicting interest if D knew that a
related person was a party or had a material financial interest in the transaction
[MBCA 8.60(1)(iii)]
1. Related Person = domestic or foreign business of which the director is a
director [MBCA 8.60(5)(v)]
C. Transaction Cleansing
1. Disclosure
i. Disclosure is so critical that failure to disclose = unfairness and will render any
transaction voidable
(a) Hayes Oyster Co. v. Keypoint Oyster Co. (WA 1964)
(i) FACTS: Coast Oyster CO. claimed Hayes, its CEO, D, and shareholder, breached
DOL to Coast by failing to disclose a secret profit and personal advantage he
would gain from the approval of Coasts sale of oyster beds to Keypoint.
1. Note: SH not suing on price (was a fair price), just breach of duty
(ii) HELD: Failure to disclose information at the time the other Directors and
Shareholders approve and transaction is being put together is a PER SE
violation of the DOL because non-disclosure of self-interest by interested D/O
is in itself unfair
(iii)Remedycourt makes Hayes give up profits and the shares. Punitive to deter.
ii. Rationale:
(a) Disclosure allows corporation to consider all facts when making a decision
(b) Burden placed on the party (D) best able to bear the facts with the least transaction
(c) KH efficient because a base-line rule that makes people aware (even though this
particular instance was fair many times it would not be)
iii. What needs to be disclosed:
(a) Material facts about the conflict
(i) Usually BOD will know about the conflict, but not all the time with indirect
conflicts, where the key player has an interest or association with some other
entity, and that entity enters into transaction with the corporation
(b) Material facts about the transaction
(i) Goes beyond duty of one party to a K to disclose essential facts to the other
2. Safe Harbor Statueslegislatures ay they dont want a blanket rule that NO conflicted
transactions are permitted or the ALL are
i. Rationale
(a) Recognition that here will generally be an economic benefit to the corporation from
allowing fair but self-dealing transactions, especially in the case of close corporations
(b) Sometimes transactions between a key person and the corporation may be the only
way a corporation can obtain funds, goods, or things it needs

ii. DGCL 144(a): sets out ways to cleanse conflicted transactions to BJR can be applied.
Conflicted transactions must be:
(a) Fully disclosed + affirmed by vote of majority of disinterested directors (cheapest)
(b) Disclosed + approved by a vote of the disinterested shareholders (more expensive)
(c) Corporation can prove that the transaction was fair to the corporation (most
expensive, because must go to trial)
iii. Even with approval of disinterested BOD or shareholders, transaction must still be
fair and disclosed (NOT THE CASE IN DE)
(a) Cookies Food Products v. Lakes Warehouse (IA 1988)
(i) FACTS: Controlling shareholder of BBQ sauce company is profiting from
exclusive distributorship he had, excessive royalty and consulting fees, on top of
his salary. He continued to run the business and enhance Cookies products.
Shareholders sued for breaching DOL.
(ii) HELD: directors who engage in self-dealing must establish they acted in good
faith, honesty and fairness
1. Transaction here okay because he did disclose and was actually trying to help
the company
2. No breach because transaction was substantively fair, fully disclosed AND
approved by disinterested directors
(b) Burden of proof is on the plaintiff to show it is not fair
(c) Rationale:
(i) Directors are never really disinterested
(ii) Distinction between factually and legally disinterested
(iii)Shifts burden of proof of fairness from D to P and possibly stretches fairness to
include a reasonable belief in fairness
(iv) More likely to rule for the P in these cases
(v) Note: if issue is with non-leading D or not-controlling SH, court is more
deferential to BOD because there is more independnce of interest
(d) This factor is true in most places, but DE usually makes the third (fairness)
requirement an OR (not AND) because they trust intrinsic value of the corporation
and are deferential to the BOD (because they know the company in the way the
market/others do not)
iv. Sometimes without approval by the disinterested policy, court will allow if fairness
standard and disclosure standard are met
(a) Most likely to be used when corporation is small or closed because there is a smaller
chance of disinterested directors
(b) Where there IS disclosure but NO disinterested approval, Courts may still allow
interested transaction to stand if it passes a fairness review
3. Mechanics to Cleanse Self-Dealing Transactions re: Safe Harbor Statutes
i. Director Approval: approval by disinterested directors
(a) Court will apply business judgment rule to actions of an interested director, who is
not majority shareholder, if the interested director fully discloses his interest and a
majority of disinterested directors ratify the interested transaction [DGCL

(b) A self-dealing transaction may not be avoided by the corporation if it was authorized
by a majority of the disinterested directors, and full disclosure of the nature of the
conflicts and the transactiongets production of BJR
(c) Rationale:
(i) Ratification by disinterested directors is enough to cleanse taint of interest, and
we do not want to give the court so much leverage as the BOD is more capable of
making business decisions
(ii) Equalizing risk between shareholders and directors
(iii)Relies more on the fact that not all directors are inherently interested. They are
capable of disinterest
(iv) more likely to be used with lower level management or shareholders
(d) Cookie v. Oolie (DE Chancery 2000)
(i) FACTS: Oolie was director and creditor of TNN. Voted to pursue an acquisition
proposal that allegedly best protected interests of TNN creditors instead of
pursuing other proposals that allegedly offered superior value to TNNs
shareholders. TNNs two disinterested directors also voted in favor of the
acquisition. TNN shareholders brought suit for breach of DOL.
(ii) HELD: interested directors vote to pursue a transaction beneficial to the
director at the expense of shareholders is protected by BJR where
disinterested directors ratify the vote.
1. Court presumes the vote of a disinterested director signals the interested
transaction furthers the best of interests of the corporation despite the interest
of one or more directors
2. Let it stand unless something seems fishy, and then theyll investigate
(e) NOTE: DE courts define interest very narrowly
(f) Approval by a Special Committee of Independent Directors
(i) Sarbaine-Oxley Act requires 50% of the BOD to be independent
ii. Shareholder Ratification: approval of disinterested shareholders
(a) Claim for Waste: power of shareholders to affirm self-dealing transactions is limited
by the corporate waste doctrine, which holds that even a majority vote cannot protect
widely unbalance transactions that irrationally dissipate corporate assets
(i) Courts will not let minority shareholders get abused by majority shareholders who
vote on something clearly wasteful
1. Shareholder ratification KILLS DOC claim and in DOL claim, moves
burden to P (invokes BJR) to show Waste
(ii) Lewis v. Vogelstein (Del. Ch. 1997)
1. HELD: if majority of shareholders ratify an action, Plaintiffs can only defeat it
by showing waste, since no one should be forced against their will to make a
gift of their property
2. WASTE = exchange of corporate assets for consideration so
disproportionately small as to lie beyond the range at which any reasonable
person might be willing to trade
(iii)Only thing that will overcome waste is UNANIMOUS shareholder approval
1. Must be unanimous because shareholders are free to throw their own money
away. We assume no shareholder is invested in a company where they expect
the Ds and Os to engage in corporate waste

(iv) Directors and Officers will hire experts with corporation (shareholder) money to
not waste, or show the transaction does not waste.
(b) Claim for Breach of DOC
(i) In re Wheelabrator Technologies (Del. Ch. 1995)
1. FACTS: minority shareholders of Wheelabreator, whose company was bought
by Waste Management in a merger, brought a derivative action claiming that
the W directors breached DOL because 4/11 W directors were also Waste
officers. Majority of shareholders approved the sale to Waste. Ds contended
that approval by Ws non-Waste (disinterested) shareholders extinguished
their claims. Also brought breach of DOC claim that directors failed to
adequately inform themselves.
2. HELD: fully informed shareholder vote operates to extinguish a DOC
breach claim
(c) Claim for Breach of DOL
(i) In re Wheelabrator Technologies (Del. Ch. 1995)
1. FACTS: shareholders of Wheelabreator, whose company was bought by
Waste Management in a merger, brought a derivative action claiming that the
W directors breached DOL because 4/11 W directors were also Waste
officers. Ds contended that approval by Ws non-Waste (disinterested)
shareholders extinguished their claims. Also brought breach of DOC claim
that directors failed to adequately inform themselves.
2. HELD: fully informed shareholder vote ratifying an interested director
transaction subjects a DOL claim to BJR rather than extinguishing the
claims altogether (so P forced to show waste)
a. SH ratification + full disclosure = okay, court will use BJR and burden
will shift
(ii) TEST:
1. Transaction between corporation and director or nonmajority
shareholder (shareholder ratification casesno interested shareholders)
a. Approval by a fully informed, majority of disinterested shareholders
invokes BJR and limits judicial review to issues of waste with burden of
proof on party attacking transaction
2. Transaction between corporation and controlling shareholdersif
majority of minority shareholders vote, then:
a. Burden shifts to the plaintiff to show that the transaction was not
ENTIRELY FAIR (much easier of a standard than waste) (SEE BELOW)
iii. Fairness Standard (Transaction between Corp and Controlling Shareholders)
(a) Plaintiff (dissenting minority shareholders) must show transaction was not entirely
fair to the corporation
(i) Entire Fairness = Fair Dealing + Fair Price
1. Fair Dealing = when transaction timed, how initiated, structured,
negotiated and disclosed, and how approvals of BOD/SHs obtained (ie.
need for SLC to engage in arms length)
a. Duty of Candor = part of fair dealing, where one who possesses superior
knowledge may not mislead other stockholders (controlling SH must be
honest with SHs and provide them will all facts)

2. Fair Price = economic and financial considerations of merger, including
all relevant factors
(b) Fairness in parent/subsidiary transactions: Sinclair Oil v. Levien (DE
1971)Sinclair establishes a benefit/detriment test for applying the fairness norm to
parent-subsidiary transactions: fairness review is required only if the parent
receives something from the subsidiary to the exclusion of, and detriment to,
minority shareholders of the subsidiarywe can tell this with B/D test
(i) Threshold test has fallen into disuse in recent yearsin favor of reviewing all
majority actions under an entire fairness test
(ii) FACTS: Sinclair MNC oil co. is the parent company, and Sinven is 97% owned
subsidiary in Venezuela (Sinven). Sinven decides to pay out huge dividends from
capital surplus rather than re-invest and undertake productive enterprises.
Conflict was fully discl b/c all Bd members knew they were attached to Sinven.
3% shareholders say theyre bleeding Sinven dry, and violating the duty of
loyalty. Apply BJR or intrinsic fairness test?
(iii)HOLDING: Sinclair not engaged in self-dealing because minority shareholders
were not harmed
1. there is never self-dealing when pro-rata distribution occurs b/c minority is
never excluded at the bereft of the majority SHs
(iv) Benefit/Detriment Test to assess for intrinsic/entire fairness
1. controlling SH can make decisions, even decisions that appear to benefit
it, so long as its not to the detriment of the minority SHs. Asks: are you
the controlling shareholder taking a benefit to the detriment to the
2. self-dealing occurs when the parent by virtue of its domination of the
subsidiary causes the subsidiary to act in such a way that the parent receives
something from the subsidiary to the exclusion of, and detriment to, the
minority stockholders of the subsidiary
a. Court says there is no detriment to the shareholders that benefits
controlling shareholder
(v) Parent/Subsidiary controlled transactionsapproval by a board minority of
independent directors (footnote 7 in Weinberger)
1. Requirements:
a. Properly charged by full board
i. Committee members must understand that their duty is not only to
negotiate a fair deal, but also to obtain the best deal
ii. A committee must just say no when a controlling shareholder
refuses to consider advantageous alternative sunless the controller
proposes terms that are the financial equivalent
b. Comprised of independent members
c. Vested with resources to accomplish the task (ie. outside bankers/lawyers)
i. Committee will always retain outside counsel
2. Ex) Lynch v. Kahn: even if the committee process IS valid, only shifts burden
proving fairness from D to P in controlled transactions

4. Random duty of loyalty situations
i. What if a company does a transaction like this with no approval (i.e., doesnt take the
time to have a disinterested director or shareholder vote)? Then the corporation has the
burden of showing the transaction was completely fair.
ii. What if the company just has disinterested directors approve it? Then the plaintiffs have
the burden of showing waste. Lewis case strong presumption of fairness because
directors are protected by the BJR.
iii. What if shareholders approve it at the regular annual meeting vote? This immediately
kills all duty of care claims if theres been full disclosure. For duty of loyalty claims,
(a) If the transaction was with the directors, the burden is on the plaintiffs to show waste
(b) If the transaction was with the controlling shareholder, the burden is on the plaintiffs
to show the transaction wasnt completely fair (easier hurdle). Court will look at
disinterested shareholders only.
iv. Why set up this complex, burden-shifting system with different standards for different
situations when none of it is laid out in the statute? Has to do with how the courts and
commentators feel about peoples ability to evaluate the transaction. In loyalty cases, the
transactions are likely to be very complex not straight stealing but shady deals. Even
with full disclosure, these situations could be misleading or unfair to shareholders.
Also, more likely that duty of loyalty cases are valid than duty of care cases. Its hard to
believe the BOD could really be idiots. They must be intelligent. But its not so hard to
believe they might steal or take advantage of their position.
D. Close Corporations
1. Close corporations resemble partnerships in many ways because there are very few
shareholders and most of the shareholders work in the company
2. Some states hold that a majority stockholder in a close corporation has a fiduciary obligation
to a minority shareholder
(a) Rationale: increases ease to raise capital because it facilitates transferability of shares
(b) Gives minority shareholders a DIRECT cause of action against the majority
shareholder instead of the corporation like in lager corporations (not subject to the
usual impediments of derivative suits)
ii. Donahue v. Rodd Electrotype Co. (MA 1975) [EQUAL OPPORTUNITY RULE]
(a) Sets up definition for Close corporation as one that meets 3 requirements:
(i) Small number of stockholders
(ii) Lack of any ready market for the corporations stock
(iii)Substantial participation by the majority stockholder in the management, direction
and operation of the corporation
(b) FACTS: P was a minority holder in a corporation who inherited shares from her
husband, an employee of the corporation. The corporation had previously bought
back shares from its majority stockholder at a high price. Refused to buy a similar
portion of Ps share back from her at anything close to that price, leaving her with an
unmarketable interest
(c) HELD: a controlling stockholder in a close corporation who cause the corporation to
purchase his stock breaches his fiduciary DOL to the minority stockholders if he does

not cause the corporation to offer each stockholder an equal opportunity to sell a
ratable number of share stock the corporation at an identical price
(i) Equal Opportunity Rule = Pro Rata: Closely Held Corporations must offer
each shareholder an equal opportunity to sell a pro rata percentage of their
shares to the corporation at an identical price
3. Other courts (like DE) reject a special fiduciary0obligation approach to close corporations
i. Rationale: much more flexible for closely held corporations (but issue is that it doesnt
necessarily permit insiders to monetize their shares)
ii. Smith v. Atlantic Properties, Inc.
(a) FACTS: 4 shareholder corporation where there was a special agreement in the charter
requiring unanimous votes for all decisions. One shareholder vetoed payment of
dividends that resulted in the majority incurring tax penalties, so they sued
(b) HELD: duty of loyalty in closely held corporations can extend to minority
shareholders. Where a closed corporations charter includes a provision
designed to protect minority stockholders, the minority stockholders have a
fiduciary duty to use the provision reasonably
(i) Court says he was being irrational and so he is liable for that and not exercising
good faith and DOL
(ii) Qualified duty of utmost good faith and loyalty with a balancing test that
recognized controlling shareholders right of selfish ownershipif controlling
shareholder can demonstrate a legitimate business purpose for its actions, then
there is no breach of fiduciary duty unless the minority shareholder can
demonstrate that the same legitimate objective could have been achieved through
an alternate course of action less harmful to the minoritys interest
E. Uses of Corporate Profits
1. Charitable Contribution
i. Corporations may make charitable gifts as long as there is some benefit to the
corporation and the gift is not (1) unreasonable or (2) made to the directors pet
(a) Rationale:
(i) Good for public welfaregood for business
(ii) Unnecessary to have stricter limitations because the market will regulate. If gifts
are unreasonable, shareholders will dump the stock
ii. 2 competing Duty of Loyalty norms re: corporate gift-giving
(a) Shareholder primacy normdirectors must act primarily to advance shareholders
(b) Corporate constituency normdirectors must act to advance the interests of all
constituencies in the corporation
iii. 3 approaches to balancing the competing concerns
(a) Judicial review of the actions (most jurisdictions take this role)
(b) Mandatory disclosure (Congress and SEC like this)
(c) Substantive rules (least common, caps on the amount of money that can be given to
charities, common abroad)
iv. Benefits of charitable gifts:
(a) Agency costswhat better way to expand business and promote self then to endow
charitable organizations

(b) Tax deductions
(c) Reputational value
v. Costs of charitable gifts:
(a) Agency cost of finding the organization and the organization for donating
(b) Takes time away from the corporation
vi. A.P. Smith Manufacturing v. Barlow (NJ 1953)
(a) FACTS: Barlow and other shareholder of AP challenged its authority to make a
donation to Princeton university
(b) HELD: a corporation should be allowed to make charitable gifts using corporate
funds. State legislation adopted in the public interest can be constitutionally applied
to preexisting corporations under the reserved power
(i) Court upheld donation to Princeton because it:
1. Upholds morals of importance of philanthropy for strength of society
2. Enhances good name of corporation in the community
3. Should defer to capitalistic decisions
(ii) Rational to create
1. Reasonable limit
2. That benefits the corporation
3. And furthers the corporate ends, not to be exceeded
4. Even though what would really be KH efficient would be to give the
dividends to shareholders
(iii)Gift must be in the name of the corporation
vii. Public Benefit Corporation [DGCL 362]for-profit corporation that is intended to
produce a public benefit and to operate in a responsible and sustainable manner
(a) Balance stockholder pecuniary interest with those most affected by the corporation
(b) Identify this in the charter of the corporation
(c) CHAGES DOL analysis
(d) Requires reports every other year to stockholders to show what the corporation has
done to serve the public benefit
(i) Experts certify these reports, so shareholders end up paying for them
2. Corporate Opportunity Doctrine
i. Arises when corporate manager can pursue business opportunity that may otherwise
belong to the corporation
ii. Managers may not pursue the opportunity on his own and must turn it over to the
corporation if the opportunity is one that can be said to belong to the corporation
iii. Litigated when shareholder believes a fiduciary breached a duty by usurping opportunity
belonging to the corporation
(a) P has burden of proving the existence of corporate opportunity
(b) Remediesmust share fruits of opportunity as though the corporation had originally
taken it
(i) Liability for:
1. Profits realized by the manager
2. Lost profits and damages suffered by the courts
(ii) Imposition of a constructive trust on the new business or subject matter of the
opportunity, so property is treated as if it belonged to the corporation that owned
the opportunity

iv. Determination of Corporate Opportunity
(a) DE multi-factor test: business opportunity presented to a corporate officer/director
will count as a corporate opportunity if it meets the following requirements:
(i) The corporation is financially able to exploit the opportunity
(ii) The opportunity is within the corporations line of business
1. DE courts take a broad definition of line of business
2. Likely to find line-of-business test satisfied if court feels company has some
special expertise that equips it to compete in the new area
3. A functional relationship between type of activity the corporation already
engages in and the prospective activity may be enough
(iii)Corporation has an interest or reasonable expectancy in the opportunity, and
(iv) If the director or officer were to embrace the opportunity, he would thereby be
placed in conflict with his duties to the corporation
1. NOTE: line of business OR interest or expectancy works, dont need both
(b) Fairness Test: is it fair of the corporation to allow individual to pursue the
opportunity? (turns on the financial ability of the corporation)
(i) Focuses on the fairness of holding the manager accountable for his outside
(ii) Looks to factors like:
1. How manager leaned of the disputed opportunity
2. Whether he used corporate assets in exploiting the opportunity
3. Fact-specific indica of good faith and loyalty to corporation (did he disclose?
Usually good indication that corporation was not interested)
4. Corporations line of business
v. Directors, full-time employees, and controlling shareholders are subjected
(a) A non-controlling interest holder (who is not a director or employee) is not subject to
the doctrine
(b) Senior executives have a stricter standard than an outside director
(c) Controlling shareholder is treated more like a senior executive than an outside
(i) Opportunity is a corporate one as to the controlling shareholder if EITHER
[ALI Principles of Corporate Governance 5.12(b)(2)]:
1. She learns of it while acting on the corporations behalf, or
2. The opportunity is one that is held out to the other shareholders of the
corporation as being a type of business activity that is within the scope of
business in which the corporation is engaged, or expects to engage in, and will
not be within the scope of the controlling shareholders business
vi. Permissibility of Taking Corporate Opportunityeven if court finds there is a corporate
opportunity, interest is negated if:
(a) Disclosure to Boardif opportunist fully discloses to the board, then healthy
competition ensures a heightened social gain (needs official presentation to board)
(b) Decision of Boardif BOD passes on the opportunity in good faith because they
cannot financially undertake the opportunity then the opportunist is fully protected
(c) DGCL 122(17)authorizes waiver in the charter of corporate opportunity constraints
of managers and shareholders
F. Executive Compensation

1. Since executive is to some extent on both sides of the transaction, there is a risk that the
corporation will not be treated fairly (because it will pay executive more money than it ought
to, and this will be money that belongs to shareholders)courts look essentially to the
FAIRNES of the transaction, and are influenced by the fact that there has (or has not) been
approval by disinterested directors and/or ratification by shareholders
2. Types of Executive Compensation
i. Current Payments (salary and annual bonus)
(a) Salary paid throughout the year
(b) Bonus at the end of the year, typically geared in some way to the corporations profits
(c) Salary and bonus are deductible by the corporation when paid, in computing
corporations taxable income
ii. Incentive Arrangements (stock options, restricted stock, phantom stock, and stock
appreciation rights)
(a) Tries to get executives to think more like an owner (shareholder)
(b) Stock Options: right to buy shares of the company stock at some time in the future,
for a price set today
(i) Exercises the option by paying the now-bargain price and then either
immediately reselling at a profit or holding onto the stock hoping for more
(ii) If stock never rises above the exercise price, executive never exercises option and
has not lost anything
(iii)Non-Qualified Stock Options do not get any special tax treatment under IRC
1. When executive exercises the option, he receives immediate income equal to
the difference between exercise price and present market value of stock
2. Corporation gets current deduction for difference between exercise price and
present market value
(iv) Incentive stock options: executive is not taxed on any gain at the time he exercises
the option, but only when he sells the underlying stock. Corporation never gets
tax deduction. To be considered Incentive Stock Option, IRC requires it meet
several factors:
1. Option price cannot be less than stocks per-share market value at time option
is granted
2. Employee may not own more than 10% of companys voting stock
(c) Stock Appreciation Rights are the rights to be paid a future cash bonus based on any
increase in the price of a companys stock
(d) Phantom Stock is similar to SAR, but deferred cash bonus that executive receives
under phantom stock is often equal to the total value of a share of the companys
stock in the future
iii. Deferred-Cash Compensation (pensions, etc)
(a) Executive receives regular cash payments during retirement
(b) If retirement plan qualifies under IRC, company gets a current deduction for money it
puts into plan, the money inside the plan compounds tax-free and executive is not
taxed until he actually starts receiving the cash payments following his retirement
3. Regulatory Responses to exorbitant CEO Payment (mostly involves trying to get
shareholders to take a stand)have mostly not worked
i. Mandated disclosures required by SEA 1934

ii. Proxy-Statement Disclosures
(a) 2010 Dodd-Frank Act 953 requires disclosure of CEO annual compensation and
relationship between the annual change in share price and the median employees
annual compensation
iii. Repayment Requirements
(a) 2002 Sarbanes-Oxley Act 304
(b) 2010 Dodd-Frank Act 954: claw-back all incentive compensation paid to
current/former executive officers within the past 3 years upon any restatement of
corporations financial statements
iv. Say on Pay
(a) 2010 Dodd-Frank Act 951: nonbinding shareholder advisory vote to approve
executive compensation
(i) Nonbinding because they are affairs of the corporation and therefore governed by
the directors
(ii) Shareholder setting executive compensation would infringe on the power of the
4. Corporate Law Issues with Executive Compensation
i. Self-dealing problemexecutive compensation scheme much more likely to be upheld if
(1) majority of disinterested directors have approved it or (2) shareholders have approved
(a) More likely to be upheld if in the courts judgment it is fair to the corporation
(b) Burden of Proof: If the disinterested directors/shareholders have approved the
scheme, a much greater showing of unfairness will be needed to strike the plan
(i) In many courts, disinterested directors decision to approve compensation will
award it protection of BJR
(ii) Lewis v. Vogelstein
1. HELD: in determining whether stock option grants constitute waste, court
should accord substantial effect to shareholder ratification
2. Look to determine whether stock options violate DOLin order to show
waste, must show exchange was one which no reasonable person acting in
good faith could agree (BJR)
3. Could look at waste in 2 ways: reasonableness v. classic waste standard
4. Court suggests that one-time grant of options is potentially valid, but second
grant can be unreasonably risky because such a transfer could be absent of
true consideration
5. Traditional rule for court to approve decision to grant stock options:
corporation must: (not used in this situation because it was too difficult to
apply to circumstances)
a. Gain sufficient value in exchange, and
b. There must be conditions making it likely that corporation will get such
(iii)Calma v. Tempelton: standard of review = waste standard because once BOD is
entitled to BJR protection, can only be overcome by showing of waste
(iv) Looks to precise nature of shareholder vote
1. Must be a majority of shareholders (informed, uncoerced) to approve specific
decision of BOD

2. Cannot be general compensation plan, must be actual compensation paid to
3. Shareholder assentgrants BJR protection
4. No shareholder assent (voted against or non-effective vote)BOD must
show entire fairness of compensation arrangement
(c) Executive should not be present t the directors vote on his compensation
ii. Consideration issuescourts insist there be consideration for each element of an
executives compensation plan
(a) Means that it must be very likely that an executive will receive the deferred
compensation only if he remains with the company
iii. Excessive compensationeven if compensation scheme has been approved by a majority
of disinterested directors or shareholders, court may still overturn if the level of
compensation is excessive/unreasonable
(a) Must bear a reasonable relationship to the value of the services performed
(b) Easier to satisfy than the fairness rulecourts are more reluctant to strike down the
transaction: harder to show a compensation level is Excessive than to show that a
different sort of transaction is unfair
(i) Main reason for this judicial reluctance to strike down executive compensation is
that courts feel they do not have the appropriate standards by which to judge the
reasonableness of compensation
(ii) In Re the Walt Disney Company
1. FACTS: Eisner hired Ovitz to work as a high-level executive. Ovitz employed
for 14 months, fired with a crazy high severance package because they
couldnt fire him with cause and he was tanking the stock price. Shareholders
2. HELD: If breach is alleged with particularity that directors have
intentionally and consciously disregarded their responsibilities regarding
material corporate decision, there will be liability
a. No liability here
b. GROSS NEGLIGENCE NECESSARYdeliberate regard to interests of
corporation, failing to pay attention to what all this means for the company
(c) Courts will generally only invalidate compensation if it is so excessive that it = waste
(i) Remember, waste = an exchange that is so one sided that no business person of
ordinary, sound judgment could conclude that the corporation has received
adequate consideration (Brehm v. Eisner)
(ii) In Re Goldman Sachs: Incentive compensation for employees is a core function
of BOD so:
1. Entitled to BJR
2. Can only be overcome by showing waste
5. Current State of Law Post-Disney
i. Mere director negligence does not give rise to liabilityBJR covers circumstances
ii. Facts that establish gross negligence (as in Smith v. Van Gorkum) may be the basis of
breach of duty for any losses that result, but under DGCL 102(b)(7) liability can be
iii. Waiver may not waive liability that results in part upon breach of DOL and that inability
to waive damages is extended to acts or commission not done in good faith

G. Insider Trading
1. Nature of Inside Information and Insider Trading
i. Definition = insiders (employees, directors, officers) making money (or losing money)
off of using material non-public information by executing trades and selling stock in open
market against others who do not have information
ii. 3 bodies of law govern insider trading
(a) State common law
(i) States are especially likely to bar trading by an insider that is accompanied by
face-to-face fraud (insider simply lies about companys prospects while making
face-to-face trade with outsider)
(b) Federal SEC Rule 10(b)(5)
(i) Prohibits any fraudulent or manipulative device in connection with the purchase
or sale of a security
(ii) Interpreted to bar most kinds of insider trading
(iii)Violation can give rise to criminal liability, SEC injunctive proceedings, and to a
private right of action on the part of outside investors who have been injured
(c) Short Swing Profits SEC 16(b)
(i) If the insider buys and then sells within 6 month period, or sells and then buys
within 6 month period, he must repay to the corporation all of the profits
iii. Potential Costs of Insider Trading
(a) Trading partnersno need to be concerned about trading partners because there will
likely be a party with more knowledge on one side of any trade, inside or not
(b) Market integritySEC works hard to root out insider trading over a fear that if you
think youre always interacting with an insider who knows more than you, you will
never invest in the first place
(i) Harms efficiency of the ECMH
(c) Policy analysisbased much more on the unquantifiable feeling that there is
something wrong/unfair with insider trading
(d) Delayed disclosureinterferes with the prompt disclosure of important corporate
information that should otherwise be immediately released to the public
iv. Critiques of insider trading regulation
(a) Market Priceinsider trading arguably causes the company stock price to better
reflect new and unannounced developments. Stock move more smoothly and is closer
to true value
(b) Communicationthe more the market has the more efficient the market becomes
(c) Compensationperhaps insider trading should be taken into account when settling
director/officer compensation. No need for huge salaries, just balance it out with the
right to insider trade
(d) No lack of fairnesstruly not unfair. Shareholders have the option of the wall street
(e) Enforcement difficultiesvery difficult and expensive to monitor and stop insider
training. Outweighs benefits
(f) Economic analysis
(i) Efficient capital markets hypothesis is predicated on dissemination of
information, and the limitations on that are inherently problematic, thus regulation
on insider trading should be limited

(ii) Rationale:
1. The only person really harmed is the acquirer who has to pay more and had
the potential to make the corporation more efficient, and courts should focus
on protecting acquirer (confidentiality agreements) and trust the market will
correct itself as to shareholders
2. Importance of disclosure in securities context is different than in any other
market because non-disclosure costs entire market
3. If public distrust of market reaches a certain threshold then it will be much
harder for companies to raise capital, and economy will suffer
2. Duties under Common Law
i. Difficult to prove fraud for insider trading under state law because absent special facts
and circumstances, you must bring an action for fraud
ii. Elements for claim of fraud: (1) a false statement of (2) material fact (3) made with the
intention to deceive (4) upon which one reasonably relied and which (5) caused injury
(a) Very hard to prove intent b/c there a million reasons why someone might trade at a
certain time. Reliance also almost impossible to show
(b) In general, CL does not impose upon a party to transaction any duty to disclose, there
is a duty to disclose where D has some fiduciary duty to P frown out of a special
relationship and majority of CL says insider has fiduciary duty only to the corporation
not to present of prospective SH. Therefore, no way for a SH to bring a successful
suit if the insider is silently selling based on inside information
iii. 3 approaches to state law insider trading
(a) MajoritySPECIAL FACTS RULE: absent fraud, there exists no special duty of
disclosure to directors/officers possessing insider information where the transaction
occurs on the public stock exchange
(i) In other words, duty on insiders not to trade with corporate shareholders in face to
face transactions, while in the possession of highly, material non-public corporate
(ii) Goodwin v. Agassiz (MA 1933)
1. FACTS: A found out there might be copper underneath the land. G sold his
Cliff Miming Co. shares on the Boston stock exchange to A because there
were incorrect news reports. A knew stock would go up because he had
material facts about the copper. G sues.
2. HELD: Fiduciary obligation of directors are not so onerous as to preclude
all dealing in the corporations stock where there is no evidence of fraud
a. No breachunfortunate G lost money by selling shares to
b. It was an impersonal tradethe insider who buys silently on the exchange
has no common-law liability to the other party to the trade
(b) Minorityduty on insiders not to trade with corporate insiders in face-to-face
transactions regardless of special facts
(c) NYduty on insiders to the corporation not to advance their own pecuniary position
using corporate info regardless of harm to the corporation
iv. Recovery by corporation
(a) Inside information is not a corporate asset under agency law, so corporation is
not entitled to the profits of its agents from insider trading

(b) Minority (ALI) holds that if corporation does not suffer any harm, it may recover for
unjust enrichment by the insider [ALI Principles 5.04(a)(5)]
3. Duties under Federal Securities Law
i. SEC rule 10b-5
(a) Purposeto prevent insiders from making explicit fraudulent statements to investors
about how badly the company was doing, so that insiders could buy up the share
completely. Now, however, gives a private right of action by investors
(b) In connection to the sale or purchase of any security it is unlawful to (a) employ any
device, scheme or artifice to defraud (b) make any misstatement or omission of
material fact (c) engage in fraud or deceit on any person
(c) Test : (1) evidence of false or misleading statement or omission about a material
fact in connection to the sale or purchase of securities (2) made with intent to deceive
(3) and reasonable reliance on misstatement by buyer or seller of security causing the
(i) Statue mandates that the requisite reliance must be a buyer or seller of stock, the
harm must be to a trader in stock and the misleading statement must be made in
connection with a purchase or sale of stock.
(d) Approach look for (1) duty to disclose and (2) whether reliance reasonable
(e) Note: materially misstatement can typically be proven under A or C, omission is
much harder to prove typically
(f) Broad Application
(i) Applies to any form of deceit or fraud, including when insider silently buys or
sells on material non-public information (and never makes any affirmative
(ii) Applies to one who makes a misrepresentation that induces others to buy/sell,
even if the maker of the misrepresentation never buys or sells himself
(iii)Applies when an investor who meets several procedural requirements can bring a
private suit alleging a violation of 10b-5 and can recover damages
1. In re Cady Roberts: SEC concluded that insider trading gives a private right
of action even though the text itself does not mention it
a. Court held that since investor in companys securities are members of the
class Rule was designed to protect, they should be able to recover in
damages for violations of the Rule
b. A federal application of the well-known state common-law principle
allowing tort claims to be based upon statutory violations
ii. Duty to Disclose or Abstain
(a) SEC v. Texas Gulf Sulphur Co. (2d Cir. 1968)
(i) Important case because:
1. First major case in which a court asserted silent trading in impersonal
securities market on basis of material non-public information violated 10b-5
2. First major case in which SEC successfully compelled insiders to disgorge
their trading profit, encouraging private actions for damages
(ii) FACTS: insiders deny rumors that they struck ore and meanwhile purchase call
options (buy stock at prearranged price at future date buy at todays price, sell it
at tomorrows price = huge profit) SEC sues for violation of 10b-5.

(iii)Holding: Anyone in possession of material inside information must either (1)
disclose it to the investing public or, if ordered not to, (2) abstain from
trading in the securities concerned while such inside information remains
undisclosed (equal access theory)
1. Not duty for directors to tell anyone about material inside info, but they do
have a duty to abstain or disclose!
(iv) MATERIAL = information to which a reasonable man would attach importance
in determining his choice of action in the transaction in question
1. Importance attached by who knew about it
(b) Can be no violation of 10b-5 absent manipulation or deception
(i) Santa Fe Industries (SUPREME COURT 1977)
1. FACTS: Ps were minority shareholders of a company, and brought action to
recover a greater share price after D majority shareholder forced Ps to sell
2. HELD: P did not state any 10b-5 claim10b5 does not cover incidents of
fiduciary breach
a. Rationale: did not want to federalize law of fiduciaries
b. Here was a violation of fiduciary duty, but did not involve any
misrepresentation or non-disclosure
iii. Bases for Duty
(a) Equal Access TheoryTaking advantage of insider information for personal gain,
which was intended to be available only for corporate purpose, is inherently unfair
(i) Application: when insider has material, non-public information, he must either
disclose the info before trading or abstain from trading entirely [DISCLOSE OR
(ii) COURTS DO NOT LIKE THIS THEORY ANYMORE (but was used for Texas
Gulf and Santa Fe)
1. Easily understandable and applied as a blanket rule
2. Reaches all conduct that might be popularly understood as insider trading (ex.
(iv) Cons
1. Difficult to differentiate between those buying/selling based on insider
information and those buying/selling on good research
2. If every person who comes in contact with insider information will be
charged, then none of those people will trade and the market will suffer
(b) Fiduciary Duty Theorythough manipulation/deception/misrepresentation may
exist, there can be no breach of a duty to disclose insider information to other traders
where no relationship of trust and confidence exists between insiders and
(i) Natural outgrowth of the Santa Fe case
(ii) Need some kind of special relationship based on fiduciary duty
1. Under this theory, a purchaser of stock who is neither insider or fiduciary has
no obligation to disclose material information when trading on such
a. Chiarella v. United States (445 US 222, 1980)

i. FACTS: Chiarella, financial printer, figured out the target companies
of the merger even though the company tried to use code names.
Accused of insider trading because he traded on that information
ii. HELD: Chiarella did not violate 10b-5 because he had no duty to
disclose/abstain. Only applies where there is a relationship of
trust and confidence between parties to a transaction
iii. Merely trading on the basis of nonpublic material information cannot
trigger duty to disclose or abstain
(iii)Expanding relationships of trust and confidence
1. Tippees liable for disclosing non-public material information received
rorm insider IF:
a. Tipper has relationship of trust and confidence with corporation that
will transfer to the tippee when
b. Tipper breaches by disclosure as tippee knows/should have known
that insider will benefit from such disclosure, and
c. Breach occurs when benefit occurs
2. Dirks v. SEC (463 US 646, 1983)
a. FACTS: Dirks was a security analyst who got tipped of to fraud by a
company insider and he tipped off his clients, who dumped the stock
before the sandal went public. SEC charged Dirk with being a tippee
b. HELD: 10b5 liability of a tipper is breaching his fiduciary duty to
shareholders, then essentially the tippers breach taints tippees
liability all the way down the line
i. No breach of fiduciary duty here because tip was not made by insider
to obtain personal benefit
iii. Test for determined whether corporate insider breached fiduciary
duty = whether the insider personally will benefit directly or
indirectly, from his disclosure. Absent some personal gain, there
has been no breach of duty
c. No benefit here, no violation
i. Tip from insider to D did not benefit tipper, as he did not trade from
the information, and
ii. Supreme Court said Chiarella holding was too under inclusive, so
expended the gamut slightly to say that relationship of trust and
confidence can be passed on with benefit creating temporary insider
out of tippee
iii. Court is concerned about analysts because they do not want to
discourage behavior akin to that in this case
3. U.S. v. Newman (2d. Cir. 2014)
a. FACTS: Newman is a hedge fund trader, who received info from a
financial analyst working for him about earnings reports re: dell/nuvidia.
He traded on this information and was accused of violating 10b-5.
b. HELD: For a tippee to be liable, must be proven beyond a reasonable

i. The corporate insider was entrusted with a fiduciary duty
ii. Corporate insider breached that duty by (a) disclosing the confidential
information to a tippee (b) in exchange for a personal benefit
iii. The tippee knew of the tippers breach (he knew the information was
confidential and divulged for personal benefit)
iv. The tippee still used that information not trade in a security or tip
another individual for personal benefit
(iv) Pros
1. Supports an analogy to common law fraud
2. Allows case-by-case review so courts can selectively target insider trading
(v) Cons
1. Doesnt answer how trading on one of many information disparities defrauds
uninformed traders
2. Can be underinclusive (Chiarella)
1. Rule 14e-3 (response to Chiarella re: tender offers): imposes duty on (1) any
person, regardless of a fiduciary obligation, who obtains inside information
about a tender offer (2) that originates either wit the offeror or the target (3) to
disclose or abstain from trading
a. Note: buying the share in preparation for a tender offer is exempt from this
b. Equal Access Theory for tender offers
2. Regulation FD (responding to Dirks re: failure to disclose rule): if issuer
issues information to certain people, it also has to issue information to the
public so not as to favor a particular patty
(c) Misappropriation Theory (current theory)(1) the deceitful misappropriation of
market-sensitive information is a fraud that may violate R10b-5 (2) when it occurs in
connection with a securities transaction (3) caused by a breach of a fiduciary
relationship between an individual with insider information and the source of that
(i) Liability arises when a person trades on confidential information in breach
of a duty owed to the source of the information even if the source is a
complete stranger to the traded securities
(ii) U.S. v. Chestman (2d Cir. 1991)
1. FACTS: Ira selling Waldbaums, tells sister who tells daughter who tells
husband who tells broker (even though she told husband not to say anything)
and broker and husband both trade on confidential information about an
upcoming sale
2. HELD: No 14e-3 liability, and No 10b-5 liability because kinship (marriage)
is not enough to create a fiduciary duty under the tippee theory if youre not
involved with the management of the business
a. Courts trying to balance the tension of protecting markets without making
too many lawsuits
b. Chestman (trader) not guilty because the alleged misappropriator did not
have a fiduciary duty with Waldbaum family and no benefit to tipper (Ira)
(iii)SEC Rule 10b-5-2

1. OHagan establishes misappropriation theory, and application of the theory
turns on whether the recipient of the information indeed had a fiduciary
responsibilityduty of trust or confidencenot to trade on the information
2. SEC adopts this non-exclusive list of three circumstances in which a duty of
trust and confidence will be found to exist on the part o the recipient of
a. Recipient agreed to keep information confidential
b. People involved in communication have a history, pattern, or practice of
sharing confidences and have reason to know communicator expected
recipient to maintain secrecy
c. Communicator of information was spouse/parent/child/sibling of recipient
unless can show no reasonable expectation of confidence (OVERRULES
3. Pros: Broad scope
4. Cons: no civil recovery for uninformed traders who dont own information
(iv) U.S. v. OHagan (521 Us 652, 1997)
1. FACTS: OHagan was a partner of a law firm representing GM in a tender
offer to Pillsbury, but was not working on that transaction. OHagan bought
2500 options of Pillsburys stock in his own name and exercises the option.
SEC charged him with insider trading. OHagan tried to say he was not guilty
because he did not have a relationship with Pillsbury
2. HELD: 10b-5 liability can be based upon the misappropriation of
confidential data from a person other than the issuer
a. Unauthorized use of confidential information is a deceptive device under
10b-5 and in connection with insider trading
b. OHagan breached his duty to law partners, who were the source
(v) Under the theory, law firms, investment banks, brokerage firms, and accounting
firms have this duty. Associates and partners have a duty.
(vi) Insure maintenance of fair and honest markets, promotes investor confidence
(vii) Role of disclosure under misappropriation
1. You only have to tell your source that you are going to trade, and if you do,
there is no deceptive device and thus no obligation (and if you tell them,
youll just get fired)
4. SUMMARY: Requirements for a Private Right of Action based on 10b-5
i. P must be a purchaser or seller of companys stock during time of nondisclosure
ii. D must have misstated or omitted a material fact
iii. D must be shown to have had a special relationship with the issuer based on some kind of
fiduciary duty
(a) D was a true insider of the issuer (eg. An employee)
(b) D was a constructive insider (in possession of confidential information that the
issuer temporarily entrusted him with, such as a lawyer working as outside counsel
for issuer)
(c) D was a tippee given information by the insider (tipper) in violation of the tippers
fiduciary duty
(d) D was a misappropriator (outsider) vis a vis the issuer who gets the information
form one other than the issuer in breach of a promise of confidentiality

iv. Defendant must be shown to have known (mental state with intent to deceive,
manipulate, defraud)
(a) This requirement is historically important where the D was a professional firm
(Accounting or law firm) charged with aiding and abetting a 10b-5 violation
(i) Unless P can show professional firms conduct amounted to something worse
than negligence, the firm would not be liable under 10b-5
(b) Ernst & Ernst v. Hochfelder (425 US 185, 1976)
(i) FACTS: D was an accounting firm that audited the books of a small brokerage
firm. The brokerage firms president had been carrying on massive fraud for ears.
Accounting firms missed an umber of clues as to the fraud, but there was no
indication that the accounting firm ever intended to defraud/mislead those who
relied on its audit
(ii) HELD: Scienter necessary in any 10b-5 actions
(iii)Scienter can be:
1. Knowing falsehood
2. Absence of belief (if representation is made without any belief as to whether it
is true or not, this constitutes scienter)
3. False statement of knowledge (if D says he knows a fact to be true but doesnt
really know if it is)
4. Recklessness
a. Affirmative misstatement
b. Omission: where D ignored a danger so obvious that any reasonable man
would have known it, he acted recklessly
(iv) P must plead facts relating to scienter with particularity [SEC 34 Act,
(v) One situation in which D is without scienter and may be liable for insider trading
1. SEC may obtain large civil penalties against D if D controlled an insider
trader, and D knew/recklessly disregarded fact that X was likely to insider
trade and D did not institute safeguards/take steps to prevent the act [SEC 34
Act 21A(b)(1)(A)]
v. P must show he relied on Ds misstatement or omission
(a) In the usual silent insider trading situation, this is of little importance
vi. Ds conduct must be shown to have been the proximate cause of Ps loss
(a) In the usual silent insider trading situation, this is of little importance
vii. Federal jurisdiction requirement
(a) In case of any publicly-traded security, this requirement is met even if D himself did
not buy/sell
(b) Where fraud consists of deceit in face-to-face sale of shares, especially in a private
company, jurisdictional requirements may be lacking
5. Federal Limitations on Short Swing ProfitsProphylactic Rule
i. SEC Rule 16(b) requires:
(a) Statutory insiders to file public records of any transaction in the corporations stock
within 2 days of the trade
(b) Statutory insiders to disgorge to the corporation any profits made on short-term
turnovers in the issuers shares (purchases and shares made within 6 months)
ii. 16(b) defines insiders covered as:

(a) Officers
(i) Anyone who holds an official title [SEC R32-b]
(ii) Also functional analysis, so if he does not hold an enumerate title within the rules
but still is performing duties similar to those typically performed by one of the
named titles
(b) Directors
(c) Anyone who is directly/indirectly beneficial owner of more than 10% of any class of
the companys stock
(i) Direct/indirect means that courts sometimes attribute stock listed in As name as
being indirectly beneficially owned by B
(ii) Usually spouse and minor child considered beneficial owner
(iii)Must have ALREADY owned 10%+ of the stock, so if the purchase in question is
what put the person above the 10% mark it does not count
1. Rationale: trying to prevent people buying on inside information and then
reselling soon after, and a person who at the moment he decides to buy does
not yet own 1% is not an insider at moment of decision and presumably has
no information
iii. Only applies to public companies registered with the SEC under 12 of 34 Act
(a) Listed on national securities change, or
(b) Has assets greater than $10 million and a class of stock held of record by 500 or more
(a) Recovery is to corporation
(b) Suit can be brought either by the corporation or by shareholders in a derivative suit
v. Cons:
(a) Underinclusivenot all insider trading takes place within 6 months
(b) Overinclusiveshort swing transactions do not necessarily involve insider
vi. If corporation merges into another corporation, the insiders will not necessarily be
deemed to have made a sale
(a) D can escape short-swing liability for merger or other unorthodox transaction if he
(i) Transaction was essentially involuntary AND
(ii) The transaction was of a type such that D almost certainly did not have access to
insider information


2 types of shareholder lawsuits:
I. Derivative Actions = suit in which shareholder sues on behalf of the corporation, on the theory
that the corporation has been injured by the wrongdoing of a third person, typically an insider
A. 2 suits in one: against directors (improperly failing to sue on existing corporate claim) and
underlying claim of corporation itself (typically allege corporations Ds have failed to vindicate
its claims because they themselves are the wrongdoers)
B. Basics of Derivative Actions (see below for more details)

1. Step 1Shareholders bring claim against directors/officers of corporation, alleging harm to
corporation itself (and derivatively to shareholders) by D/Os failure to sue on existing
corporate claims. Ps sue for corporation, not personal claim for themselves
2. Step 2if step 1 successful, D/O will bring action against corporation itself
3. Remedy = recovery given to corporation, and shareholders do not receive awards
4. Consequences of successful suit = Ps get costs and attorneys fees expended
5. Consequences of unsuccessful suit = P liable to people sued for costs/attorneys fees if sued
without reasonable cause. If reasonable cause, you probably wont have to reimburse the other
side, but likely your own fees.
C. Illustrations of derivative actions
1. Due Caresuit against BOD for failing to use due care in overseeing companys operation
2. Self-Dealingsuit against officer for self-dealing
3. Excessive compensation
4. Corporate opportunity
II. Direct Actions = gathering of many individual or direct claims that share some important common
aspect (usually class actions under FRCP 23)
A. Shareholders bring claims of individual harm against the corporation
B. Remedy = given to shareholders
C. Illustrations of direct actions
1. Votingaction to enforce holders voting rights
2. Dividendssuit to compel payment of dividends
3. Anti-takeover defensesaction to prevent management from improperly using corporate
machinery to entrench itself
4. Inspectionaction to compel inspection of corporations books and records
5. Protection of minority shareholderssuit to prevent oppression of or fraud on minority
shareholders, especially where corporation is closely-held
III. Differentiating between Derivative and Direct Suits
1. Tooley v. Donald-Son, Lufkin, & Jenrette, Inc. (DE 2004)
i. Test must ask:
(a) Who suffered the alleged harm?
(i) If corporationderivative
(ii) If shareholderdirect
(b) Who would receive the benefit of any recovery or other remedy?
(i) If corporationderivative
(ii) If shareholderdirect
2. Consequences of distinction are mostly procedural
i. If derivative, P must go through procedural hoops to proceed at all
ii. If derivative, P much more likely to lose control of his action
iii. Who gets recovery
3. Similarities between direct actions and derivative actions
i. Both require s to give notice to absent interested parties
ii. Both permit other parties to petition to join the suit
iii. Both provide for settlement and release only after notice, opportunity to be heard, and
judicial determination of fairness of settlement
iv. In both actions, successful Ps are customarily compensated from the fund their efforts

I. Pros and Cons of Derivative Actions
A. Benefits
1. Derivative suits are practically the only effective remedy when insider wrongdoing occurs
2. Useful deterrent effect
i. Particular wrongdoer and particular corporation in which the name the suit is brought
ii. Other potential wrongdoers in different corporations
3. Enforcement action is generally without direct cost to the corporation
i. Because Ps attorney only receives fees if he is successful, and will receive these fees
only out of the recovery made on behalf of the corporation
B. Detriments
1. Prosecution of derivative suit wastes time and energy of corporations senior executives,
taking them away from managing the business
2. Corporate managers will fear derivative suits and become needlessly risk-averse
3. Management often tempted to settle even the suits that have little merit in order to be rid of
them and waste less time
i. Gives Ps lawyers incentives to bring strike/nuisance suits
II. Litigation Incentives
A. Collective Action Issues
1. Fundamental problem in governance of publicly financed corporations; associated with
dispersed share ownership
2. No shareholder would ever try to enforce duties of care or loyalty without compensation for
their fees because any compensation awarded would go to the corporation, not to them
3. No single shareholder has a strong incentive to invest time/money to monitor management,
or to initiative derivative suits
4. For large public corporations, law must construct incentive system rewarding shareholder
prosecution of valid claims
B. Theories of payment to Plaintiffs attorneys
1. Lodestar Formulapays attorneys a base hourly fee for the reasonable time spent on a
case, inflated by a multiplier to compensate for unusual difficulty or risk
i. Decouples attorneys fees from recovery amounts
ii. Eliminates incentive of attorneys to settle too soon, but creates opposite incentive to
spend too much on litigation
2. Salvage Value Approachcourt calculates counsel fees by awarding a percentage of total
3. Common Fund Doctrinecorporation, which is a common fund, should pay counsel fees
from common fund to those who protect or increase the value of the corporation
i. Encourages meritorious actions
ii. All beneficiaries must pay their share of the expense necessary to make benefit available
to them
4. Substantial Benefit Doctrineaward attorneys fees when there is a substantial benefit to
the corporation, even if the action does not produce a fund from which they can be paid
i. Does NOT need to be monetary benefitsGovernance Reforms Too: can be for
maintaining health of corporation, raising standards of fiduciary relationships, preventing

abuse that would be prejudicial to rights and interests of the corporation, affect
enjoyment/protection of shareholder rights
ii. Fletcher v. A.J. Industries (CA 1968)
(a) FACTS: Corporation dominated by Vern Halen, who lets high salaries be paid that
damages the corporation. There was a fiduciary breach in allowing the excessive
compensation to be paid. P and D came to a settlement that there would b e changes
in corporate governance. The award to the corporation does not have any monetary
benefit. Attorneys wanted to get paid
(b) HELD: even though the corporation receives no money from a derivative suit,
attorneys fees are properly awarded if the corporation has substantially benefited
from the action
(i) Court adopts the substantial benefit rule, stating right of P lawyers to be
compensated where benefit was not only monetary but also was governance
improvements, negating need to employ a common fund
(ii) Conhard to measure if corporate governance actually changes
C. Cost of expanding circumstances whereby P may recover attorneys fees in litigationdouble
agency problem whereby both sides have incentive to settle
1. Management will want to settle because derivative suits are:
i. Tremendous distractions
ii. Negative publicity
iii. Litigation may be found meritorious and directors/officers held liable
2. Lawyers will want to settle
i. Financing the litigation, getting paid
ii. Incentives to bring strike suits = suits that have little probability of succeeding on the
merits but are troublesome enough to induce the corporation to make a settlement
D. Statutory responses to agency problems of fee-driven litigation
1. Security for expenses statutes permit corporate Ds to require Ps or their attorneys to post a
bond to secure coverage of the companys anticipated expenses in litigation [NYCBL 627l
Cal. Corp. Code 800]
i. Purpose is to engineer fee rules discouraging strike suits and encouraging meritorious
ii. Appears to have failed in practice
2. Private Security Litigation Reform Act 1995 embraces variety of devices to discourage non-
meritorious suits
i. Particularized pleading requirements, changes in substantive law
ii. Most adequate plaintiff rule encourages institutional shareholders to assume control of
shareholder litigation
E. In order to control this litigation and make sure attorneys/directors are not in it together to pay
settlement fees out of the corporate treasury (shareholders money), there are 2 controls:
1. Standing requirements
2. Judicial Oversight
III. Mechanisms for Controlling Litigation
A. If P may litigate derivative suit on corporations behalf even though BOD apposes action, BODs
customary power to make major business decisions concerning corporations operations is

1. Courts want to find rules that will on one hand maintain BODs ability to control
corporate affairs and terminate strike suits quickly, and on the other hand prevent BOD
from covering up from wrongdoing by its own members or other insiders
2. Courts protect boards autonomy by:
i. Requiring a demand to be made on board in most instances
ii. Giving substantial weight to boards decision not to pursue action, and
iii. Increasingly, by giving significant weight to the recommendation of a specially-
appointed board committee, made after investigation, that suit be dismissed
3. Court blocks coverups by:
i. Excusing demand on the board in many instances, in which case the suit is typically
allowed to go forward even though the board would or does oppose the suit, and
ii. Ignore the BOD or special committees opposition to the suit where the essence of the
complaint is that the BOD, or people dominating it, have received improper persona
financial benefit by act complained of
B. Standing Requirements [FRCP 23.1; Del. Code. Com. 327]: To have standing, P must
1. Have been a shareholder at the time of the acts complained of (contemporaneous
i. Rationale
(a) Discourages litigious people from bringing strike suits, since they cant look around
for wrongdoing and then buy shares that will support standing
(b) A person who buys after the wrong with knowledge of it may pay a lesser price, and
would thus receive a windfall if he obtains corporate recovery
ii. Criticism of this rule
(a) Screens out meritorious suits as well as frivolous ones (for example, bars suits by P if
he purchased the shares after the wrongdoing, even if neither P nor anybody else
knew o the wrongdoing at the time of purchase
2. Still be a shareholder for the duration of the action
i. This can be unfair in the situation in which all shares in the corporation are involuntarily
exchanged into cash or share sin a different corporation as part of a merger transaction
(a) Here, many courts ease the unfairness that would result from mechanical application
of the continuing ownership rule
(b) Allow shareholders in no-longer existing corporation to bring non-derivative suit
against the wrongdoers, or they allow the surviving corporation (or its shareholders)
to bring suit [ALI Principles, Reporters Note 3 to 7.02]
3. Fairly and adequately represent the interests of shareholders
i. No obvious conflict of interests
4. Complaint must specify what action the P has taken to obtain satisfaction from the
companys BOD or state with particularity the reasons for not doing so (reasons for not
making demand)
i. See below
C. Judicial Oversight
1. Demand upon the BOD: P must make a written demand on BOD before commencing
derivative suit, asking BOD to bring suit or take corrective action to redress wrongdoing--
.only if the BOD refuses to act may P commence suit
i. However, many jurisdictions excuse the demand requirement where such a demand
would be futile

(a) Important because it determines scope of judicial review of the action
(i) If demand is required and the board rejects demand, court will only very rarely
allow the action to proceed
(ii) If demand is excused, although court may still termination the action on the
corporations motion, it is less likely to do so
(a) Demand on BOD is excused where it would be futile
(b) Most cases are when the BOD itself is charged with some sort of wrongdoing (usually
breaching DOC/DOL)
(c) Aronson Test In order to overcome demand requirement, must show:
(i) Specific facts that overcome notion of director independence (ie. majority of
BOD has material interest of transaction OR majority of board dominated
by alleged wrongdoer) (//s DOL) AND IF NOT
1. NOTE: this prong is NOT met by showing merely that outside directors were
misinformed by insider directors
2. Potential ways to show this:
a. Each member of board was hand-picked by D (president and controlling
b. When BOD approve a very generous salary for D, did so because they
wanted to be re-elected
(ii) Sufficient facts to present reasonable doubt that transaction was product of
valid exercise of BJR (//s DOC)
1. NOTE: this can be shown by proving bad faith or gross negligence (ie. BOD
made no effort to be informed)
2. Potential ways to show this
a. BOD did not follow adequate procedures in reaching their decision
b. BOD decision was substantively so irrational as to be outside the bounds
of reasonable business judgment
3. Note: here the court employs a relaxed modification of BJR to screen
derivative suitscourt is conscious that it is addressing a pleading standard
and does not want to pre-judge merits of the claim. What is really relevant is
the boards capacity to decide at the time the suit is being brought
(d) Why the 2 prongs of this test?
(i) Easy to construe a set of facts where you couldnt prove the majority of BOD is
(ii) But you can use the second prong to say that regardless of this, transaction itself is
bad enough, enough to show there is something wrong with the BOD
(e) Practical impactcourt now decides what happenedwhether decision was part of
BODs business judgment or not
(f) An attorney would NEVER bring demand instead of trying to first prove it is
futile because if they make demand, they are deemed to have conceded
everything in the Aronson test and they will automatically be protected by BJR
(g) Levine v. Smith (DE 1991)
(i) FACTS: GM buys EDS (Ross Perots company). Pay him in GM stock and put
him in BOD, where Perot realizes the company is poorly run. Tries to tell others
in company, but they wont listen so he goes public. They buy out his shares at a

premium to shut him up, and shareholders sue without making demand BOD
saying they overpaid Perot
(ii) HELD: P failed to make demand to plead the necessary particularized facts that
demand would be futile
1. Here, shareholders did not satisfy the Aronson test because they did not
satisfy either prong
(h) This is a hard standard to meet, and it will be a relatively rare DE case in which P is
able to allege board misconduct with enough specificity to gain the demand excuse
(i) 3 circumstances when courts should NOT apply Aronson test for demand futility
(where BOD did not make business judgment being challenged). In these
circumstances, examine whether board that would be addressing demand can
impartially consider its merits without being influenced by improper
considerations (aka. first prong of Aronson test only)
(i) Where business decision was made by BOD of a company but the majority of
directors making decision have been replaced
(ii) Where the subject of the derivative suit is not a business decision of the board
(iii)Where (as in Rales) the decision being challenged was made by the board of a
different corporation [aka double derivative suits]
1. Rales v. Blasbad (DE)
a. FACTS: Company supposed to use proceeds for certain goals, but used
instead to buy junk bonds. Action was taken by subsidiary and there was
change in parent BOD, which never had opportunity to evaluate action
since taken by subsidiary. P says D did it just to help the person from
whom the junk bonds were bought.
b. HELD: Shareholder Ps must overcome powerful presumption of BJR
before they can pursue the claim (aka. to show that demand is futile)
c. Court should examine whether BOD that would be addressing
demand can impartially consider its merits without being influenced
by improper considerations
d. Note: even though court professes to only look at first prong of the test,
they look at the same factors as under 2nd prong in analyzing the issue
e. Rationale: doesnt make sense to look at underlying decision when boards
are different
(j) Consequences of Excuse
(i) If demand is excused, action may normally proceed without any early judicial
overview of its merits
1. BOD may appoint independent committee to review the suit
2. If that committee investigates and recommends dismissal, court usually can
consider whether to accept the recommendation and dismiss the suit, just as if
demand had been made and committee appointed
(ii) In general, P has a much easier time having action go forward if demand is
excused because he does not concede that BOD has protection of BJR [Universal
Non-Demand Rule]
(a) Suits against unaffiliated third party
(i) P will almost never be permitted to continue his suit

(ii) BODs rejection constitutes a decision about how corporation should conduct its
ordinary business affairscourt will almost always give directors decision not to
pursue the suit protection ob BJR
(b) Suit against insider
(i) Court usually gives boards decision not to sue the protection of BJR unless P
alleges that the board
1. Somehow participated in the alleged wrong (got some personal benefit from
it), OR
2. Directors who voted to reject the suit were dominated/controlled by primary
(ii) If can prove both, then courts will remove cloak of BJR from boards decision not
to sue and will allow suit to go forward
(iii)Basically the same standards as how to get demand excused, but will likely
scrutinize more
1. Some argue that because it is so similar, demand should be required in all
cases [MBCA 7.42(1)]
2. However, some say that by requiring demand in all cases, even when it would
clearly be futile, it would create delay and expenses
2. Review by the Special Litigation Committeeformed if court excuses demand or if BOD
grants demand, so shareholder brings derivative action
i. Once shareholder brings derivative action,
(a) SLC will be formed of BOD members that have no financial stake in transaction that
P is complaining about (So they are independent)
(b) SLC procures independent counsel and goes to make an extensive investigation
(c) In virtually all instances, SLC recommends Ps suit be dismissed
(i) Sometimes based on finding that {s allegations have no substantive merit
(ii) Often because even though there is merit, burden to corporation of pursuing suit
would outweigh any possible recovery
1. P can show SLC not really independent
2. P can show SLC did not conduct a reasonably careful investigation
3. Even so, some courts may use independent judgment about whether Ps
suit has merits (see Zapata, Auerbach, and Oracle)
ii. DELAWARE MAJORITY: Zapata Test (also note [DGCL 141(c)])
(a) TEST:
(i) Q1 (procedural): IS SLC truly independent and acting in good faith?
1. Notes:
a. Burden of proof on D
b. Look at how SLC members are related to rest of the board
c. Independence standards determined by Oracle
2. YESgo to Q2
3. NOCourt will dismiss SLCs motion to dismiss and let P proceed
(ii) Q2 (substantive): according to courts independent business judgment, was the
SLCs motion to dismiss correct?
1. Notes:

a. Look at best interests of the corporation by balancing financial (fees,
negative publicity, employee distraction) and policy issues (deterrence,
b. For this prong, look to Joy v. North
c. This prong is an exception to the norm of judges refusing to second-guess
D/O business expertise
2. YESCourt will grant SLC motion to dismiss
3. NOCourt will dismiss SLCs motion to dismiss
(b) Zapata Corp. v. Maldonado (DE 1981)
(i) FACTS: M files derivative action. 4 years later, BOD appoints 2 new independent
directors to serve as its SLC, which conducts a full investigation and decides to
dismiss the suit.
(ii) HELD: Court should apply 2 prong test to analyze SLC motion to dismiss: (1) has
the corporation proved independence, good faith, and reasonable investigations,
and (2) does the court feel, applying its own independent business judgment, that
the motion should be granted?
1. Burden on D to show first prong, and then court proceeds with second prong
2. Court evaluates the second prong because they feel particularly capable of
evaluating this type of litigation
(iii)ONLY WHEN DEMAND IS FUTILE, do we use Zapata test. In cases
requiring demand (where P did not satisfy Aronson test) everything board
does IS protected by BJR
(c) In Re Oracle Corp. Derivative Litigation (Del. Ch. 2003)consider social ties (not
just direct financial ties) in deciding whether directors are independent
(i) FACTS: Shareholders brought derivative suit alleging insider trading of four
Oracle directors, including CEO and Trading Defendants, all alumni from
Stanford and big donators. In response, Oracle formed SLC, made up of 2
Stanford professors.
(ii) HELD: SLC does not meet burden of independence where members have social
ties to the corporation
1. Here, SLC members had long standing professional and academic relationship
with principal Ds
2. Chancellor Strine (Judge) says never trust SLC and courts should always
analyze 2nd prong of Zapata
(iii)NOT a dominion and control inquiry, but a broad, holistic method looking at
non-economic social ties in addition to financial interests
(d) Joy v. North (2d cir. 1982) if litigation has positive net value, SLC motion to
dismiss is denied. If litigation has negative net value, SLC motion to dismiss is
(i) FACTS: Citytrust SLC recommended dismissal of an action brought in federal
court. Federal court said it needed to review committees decision and that the
committee would bear burden of proving that continuing litigation would be more
likely than not against the corporations interests
(ii) HELD: SLC recommendation re: termination of suit must be given a HARD
LOOK by courts and supported by a demonstration that the derivative action is
more likely going to be against interests of corporation

1. Court says pursuing litigation is no different than pursuing any project, so
look to net present value like in a business decision
2. Courts will balance financial and policy considerations
a. NPV only looks at financial, so criticism that it is under inclusive
3. Does NOT mean that the court will mimic a loyal BOD because the BOD
would consider other factors (how many suits they expect to be strike suits,
(iii)TEST: Where court determines that likely recoverable damages discounted
by probability of finding of liability < costs to corporation of continuing
action, should dismiss
1. BUT IF SUPER CLOSE, and the court finds a likely net return which is
not substantial in relation to shareholder equity, take in 2 additional costs
a. Consider impact of distraction of key personnel by continued
b. Consider lost profits on account of the bad publicity of a trial
(iv) Considerations the court did not consider:
1. Ex Ante effects of bringing suit
a. Benefits: Deterrenceif courts decide that in certain decisions SLC was
wrong, then future BODs will avoid that action
b. Costs: Insurance premiums will increase because riskier chances for
2. Ex Post effects of bringing suit
a. Benefits: If successful, corporation will get money or governance change
b. Costs: Litigation costs expensive and will only hire great lawyers
iii. NEW YORK: Auerbach Test
(a) If (1) SLC was independent, (2) acted in good faith, and (3) did some reasonable
investigation, it is protected by BJR
D. Ending Litigation/Evaluating Litigation
1. Going to Trial
i. Benefits
(a) Recovery/change in corporation
(b) End of
(i) Expensive litigation
(ii) Negative publicity
(iii)Distraction of D/Os prepping for litigation
ii. Costs
2. Settlement Agreements
i. Benefits
(a) Recovery to/change in corporation
(b) End of
(i) Negative publicity
(ii) Expensive litigation
ii. Costs
(a) Lack of valuable recovery/change in corporation due to double agency courts
(b) Can have a settlement that doesnt provide any meaningful change, just gets lawyers

3. Settlement is in everyones interest
i. 100% chance of getting money v. some probability of loss/costs of trialbetter for risk-
averse people (most attorneys)
ii. Time value of money
iii. Directors/Officers cant be indemnified if theyre found guilty
iv. Litigation disruptive to corporate jobs
v. Can be bad press for the corporation
4. BECAUSE there are incentives for collusive deals, any settlement must be approved by
the court [FRCP 23.1]
i. Standard of review = FAIR AND REASONABLE
(a) When analyzing settlements, courts must consider whether proposed settlement is fair
and reasonable in light of factual support for the alleged claims and defenses in the
discovery record before it
(b) Courts should consider factors like:
(i) Best possible recovery that might occur at trial
(ii) The likely (as opposed to highest possible) recovery at trial
(iii)The probable expense to the corporation of litigating through trial
(iv) The defendants ability to pay a judgment higher than the proposed settlement
(v) KEY FACTOR: net financial benefit to the corporation under settlement v
probable net financial benefit to corporation if the case were to be trial
1. Court will often subject anticipated lawyers fees and indemnification
payments made by corporation to Ds in calculating net benefit to the
2. So, court might not approve settlements even where Ds pay a substantial sum
if once corporation pays Ps attorneys fees too little money will remain in the
(c) Rationale: Shareholder has interest in quick settlement (double agency problem) so
much protect P somehow, by the fair and reasonable standard
ii. Settlement by Special Committeeparties can K to use a different standard (Zapata)
(a) Having a SLC take control of settlements is rare
(b) Carlton Investments v. TLC Beatrice International Holdings, Inc. (Del. Ch. 1997)
(i) FACTS: Lewis worked with a group of banks on an LBO. Lewis ends up with
45% of the corporation and a payment of $20 million in settlement. He dies and
shareholders file suit claiming that $20 million payout was excessive now that
hes unavailable to work
(ii) HELD: A proposed settlement negotiated by SLC is to be reviewed under
Zapata test
1. Should conduct NPV calculation to see if settlement is more efficient tan trial
2. Here, 1st prong of Zapata was so solidly a yes, but court had trouble applying
2nd step
3. Here we have Zapata standard because parties agreed to it, instead of the fair
and reasonable standard
IV. Protection from the Costs of Litigation
A. Costs of derivative suits can be resolved in 2 ways:
1. Direct costs

i. Corporation must pay price of defending successful derivative suits
ii. Shareholder-Ps bear their own costs if thy lose, and culpable managers may be charged
with D costs if they lose
iii. In practice, most suits settle after which companys liability insurer picks up costs of both
sides of the suit
(a) Insurer in turn passes these settlement costs back to the corporation in form of
insurance premia
2. Indirect costs
i. Corporation must pay in advanced for at least some of the prospective costs of
managerial liability
ii. Corporate D/O must be compensated ex ante for their expected litigation costs
B. Indemnification and Insurance
1. Indemnification = money corporation itself it provides, v. Insurance = from a third party
i. All corporations get insurance because shareholders pay for it
2. Generally, statutes authorize corporations to commit to reimburse any agent, employee,
officer, or director for reasonable expenses for losses of any sort (attorneys fees, settlement
amounts and sometimes judgments) arising from any actual or threatened judicial proceeding
or investigation
i. Limitationlosses must result from actions undertaken on behalf of corporation and in
good faith. CANNOT arise from criminal conviction [DGCL 145(a)-(c)]
3. DGCL 145: Corporation can amend the charted to indemnify D/Os to: (1) protect them for
personal liability, or (2) reimburse expenses they incur defending themselves
i. 145(a) applies to direct actions (third party actions)courts may indemnify expenses,
any settlement agreed upon, or any judgment D/O must pay as required by court if:
(1) good faith and (2) not in opposition to corporate interests
ii. 145(b) applies to derivative actionscourts may indemnify expenses only if: (1) good
faith and (2) not in opposition to corporate interests
(a) Does NOT permit corporation to indemnify D/O for a judgment on behalf of the
corporation, or for a settlement made by D to the corporation
(i) If indemnification were allowed, there would be circular recoverycorporation
would be receiving judgment/settlement with one hand and paying out again with
the other hand in form of indemnification
iii. 145(c)corporation must indemnify any Defendant that is successful on the merits or
(a) Any escape from adverse judgment, criminal OR civil, is enough to indemnify D/O
under 145(c)
(i) Waltuch v. ContiCommondity Services (2d Cir. 1996)
1. FACTS: Silver-trading VP found guilty by future commodities trading
commission of market manipulation, acting in bad faith. Won the lawsuit
2. HELD: he can be eligible for indemnification under 145(c) because he was
successful re: private claims (P will bring claims against company AND its
individual directors/officers if enough liability to make them potentially
personally liable, so re: personal suit)
a. CCS settled for a lot of money, how Waltuch gets success. Ps are willing
to let Waltuch leave the lawsuit, since they got huge windfall from the

3. Corporations must indemnify its officers and directors if successful
a. 145(a) and 145(b), the company may
(ii) Rationale: this rule is likely due to intense lobbying by D/O of Congress
(b) NOTE: Even if not a successful defense on merits (just a technical defense, like SoL),
is entitled to indemnification [DGCL 145(c); NY BCL 722(a)]
iv. 145(a)-(c) depend on many questions of fact like (1) whether D acted in good faith, (2)
whether D reasonably believed he was acting in best interests of the corporation, and (3)
whether D had reason to believe his conduct was illegalWHO DECIDES Qs OF
(a) Sometimes these factual issues are answered by the court as part of the basic action
for which indemnification is later sought
(i) Nut mere fact D lost case will not necessarily dispose of these factual issues
(ii) 145(d)(3) allows decision to be made by independent legal counsel
1. Corporations regular outside law firm is not independent for this purpose, so
a new firm is usually called in specially for this task
v. 145(f) states indemnification is not exclusive benefit D/O is entitled to, and corporations
can also take out insurance for D/O
(a) D/O insurance provides way for company to pay legal fees
(i) Usually comes in 2 parts:
1. Corporate Reimbursement provides coverage to corporation for its expenses
in defending and indemnifying its D/Os
2. Personal Coverage provides overage directly to D/Os when the corporation
does not or cannot indemnify them
(b) Every company has D/O insurance and provides upper bound on these settlement
(c) Shareholders effectively pay for the D/O insurance
(d) Policies for Individual Directors
(i) Reduce agency costs:
1. Additional monitoring by insurance company
2. Alleviation of residual loss caused by sub-optimal risk acceptance
(e) Group Policies for All Directors/Officers
(i) Reduce transaction costs
1. Corporation bargains for all directors
2. Corporation receives tax deductions
(ii) Reduce ownership costs
1. All directors receive some coverage, easier for them to make joint decisions
(f) Mostly all D/O policies contain important exclusions
(i) Claims based on individuals gaining personal profit or advantage to which he was
not legally entitled
1. Ex) D usurped corporate opportunity, engaged in self-dealing, improperly
spent corporate funds
(ii) Knowing and willful violations of law
(iii)Claims for returns of illegal remuneration, if court agrees with its illegality
1. Ex) compensation that is ruled by a court to have been excessive wont be
(iv) Claims of libel and slander

(v) Claim for return of short-swing profits under 34 Act 16(b)
(vi) Fines nad penalties in criminal cases
(g) Why corporations purchase D/O insurance instead of raising heir salaries/board fees
and allowing them to purchase their own insurance?
(i) D/O insurance might be cheaper if company acts as central bargaining agent for
all D/Os
(ii) Uniformity may have value in standardizing D/Os individual risk profiles in
decision making, and avoids potentially negative signaling arising from different
levels of coverage
(iii)Tax law may favor firm-wide insurance
(iv) Ds may under-invest in D/O if left to themselves, because shareholders also
benefit from it
4. DGCL 102(b)(7)Exculpation Clause: permits corporations to include a clause in their
charter eliminating personal liability for monetary damages (NOT injunctive damages) for
breaches of DOC but not for (1) breaching DOL, (2) acts/omissions not in good faith, or (3)
knowing violations of law
i. Passed by DE Congress in reaction to Smith v. VankGorkum where court found D/O were
grossly negligent and thus personally liable for their carelessness in mortgage approval
ii. Can still get an injunction in some cases
iii. Rationale
(a) Protects D/O where no insurance exists, to limit monetary liability thereby giving
D/O greater freedom to take riskier bets (same rational for protection BJR)
(b) Dont want to include DOL because dont want to make it okay for D/O to steal and
not be liable for personal damages against the company
iv. Bad faith = refusal to act in face of known duty to act or in derelict of duty (Stone v.


If there is a controlling shareholderbuy all the shares
If there is NO controlling shareholder
- Acquisition
- Tender Offer
- Merger

I. Investors can acquire control over a corporation in 2 ways:
A. Purchasing a control block of shares from existing control shareholder
B. Purchasing the shares of numerous smaller shareholders (Tender Offer)
C. Efficient Transactionif you believe the market is efficient then argue that transactions increase
wealth of society maximizing wealth and minimizing costs, raising shareholder prices
1. Want to encourage such transactions, so less regulation
D. Consequences of Agency Costsif you believe market is NOT efficient, the buyer can take
advantage of the corporation for himself which encourages waste and inefficient markets
1. Those who believe in this theory want to restrict transactions, and have more regulation
II. Transactions in Control (Blocks/Positions)
A. Control Premia

1. Share for share, controlling blocks of stock inevitably sell in negotiated transactions at a
premium over market price of non-control shares
2. Premium = additional value above the financial value of a share that comes with controlling
corporate business
3. Paid for the private benefits of control (range of possible sources of value from power to
capture salary/perks/self-dealing opportunities)
4. A function for the nature of capital marketscontrol blocks are costly to create, so they
command a premium on sale
i. Just need effective control (sway over majority of BOD), not numerical amount
B. Sales of Control Blocks (Duties of Sellers)
1. Issues with sale of control blocks
i. Extent to which law should regulate premia
ii. Laws response to sales of managerial power over corporation (sales of corporate office)
iii. Sellers DOC to screen out buyers who are potential looters
2. Market Rule = sale of control is a market transaction that confers rights and duties
between the parties, but does not confer rights on other shareholders
i. Controlling shareholder may sell his control block for a premium, and may keep
premium himself
ii. Means minority shareholders are not entitled to premia of a control sale (with 3
exceptions, see below)
iii. Rationale: minority shares do not have same attributes as controlling shares (no private
benefits of control), so they do not command the same share price
(a) Premium belongs to controlling shareholder because it is inherent in the control, and
not the stock itself
(b) Wouldnt sell the company to someone who doesnt want to improve the company
(they wouldnt pay for it unless they wanted to make more money off of it)
(c) Efficiency of the market
iv. Zetlin v. Hanson Holdings (NY 1979)
(a) FACTS: Ds sold controlling block for $15/share when it was on open market for
$7/share. Plaintiffs want to impose a duty on the buyer to pay the control premium to
all shareholders
(b) HELD: Absent looting of corporate assets, conversion of a corporate opportunity,
fraud or other acts of bad faith, a controlling stockholder is free to sell, and purchaser
is free to buy, that controlling interest at a premium
(i) Ps were looking essentially for a tender offer (requiring controlling interests
transferred only by means of offer to all stockholders)
(ii) Such a radical change should only be done by legislature, not the courts
v. Alternative to market rule (most reject this rule) = Equal Opportunity Rule, stating that
minority shareholders are entitled to sell their shares to a buyer of the control block at the
same terms as the seller of control block
(a) Argue that control should be viewed as a corporate asset in which shareholders
should share
(b) Rationale is fairness, but nothing about market play
(c) Criticism of this theory

(i) People do not buy control blocks for private benefits of control as they are too
limited, but because they want to (1) improve corporation, or (2) loot the
(ii) Limiting sales like this hurts the minority, looting is easily hindered by
regulations, so dont limit the transactions because they limit ways efficient
management can take over the corporation
(iii)Can also leave inefficient management entrenched in companies, dilute value of
control held, and efficient management is likely preferred by shareholders
3. Exceptions to Market Rule
i. Selling a Collective Opportunity: Courts will not permit a controlling shareholder to
exclusively enjoy control premia where there is a collective corporate opportunity
associated with the sale of the control block. Under such circumstances, minority must be
included under equal opportunity rule
(a) 2 main situations in which courts have found a diversion of collective opportunity:
(i) Where the court decides that the control premium really represents a business
opportunity that the corporation could and should have pursued as a corporation,
(ii) Where a buyer initially tries to buy most or all of the corporations assets (or to
buy stock pro rata from all shareholders), and the controlling shareholder instead
talks him into buying the controlling shareholders block at a premium instead
(b) Perlman v. Feldmann (2d Cir. 1955)
(i) FACTS: Feldman controlled 37% of Newport Steel, and sold shares at 20 when
market price was 12. Shareholder brought suit claiming breach of fiduciary duty
because company follows Feldman Plan (allows company to take interest free
loans from customers to reinvest), but the buyer is not going to use the FP and
instead will take all the steel for itself and use it.
1. Essentially, buyer is not going to protect the FP asset, so it matters to minority
shareholders because that will affect stock price
(ii) HELD: when a market shortage creates an unusually large premium, a controlling
shareholder may not take the value of the premium for itself
1. Control cannot be sold if premium is used to cash out on a collective
2. Repay directly to minority shareholders instead of to the corporation, because
it gives the buyer (person who agreed to pay the premium) an undeserved
(iii)Rationale: violates fiduciary relationship (punctilio of honor) of controlling
shareholder to minority shareholder
ii. Minority Shareholders Have Negotiated Protections: when the charter grants
protections to minority shareholders regarding premia, controlling shareholder may not
dismantle protections without a shareholder vote
(a) In Re Delphi (DE 2000)
(i) FACTS: R has class B shares that control 49.9% of voting rights. Wants to sell to
TMH. Problem is that class A shareholders wrote into charter that if merger
requires sale of class B shares, then class A participates pro rata. R browbeats
BOD so gets roughly 54/share and class A gets 40/share, and requires a charter

amendment. Shareholders have proxy statement saying in order to get high
valuation, need vote to strip away protection. Sue R for breach of DOL.
(ii) HELD: Court allows the bribe in this case because it allows shareholders to get
the premium price (they approved transaction)
1. Shareholders paid higher price for their shares because they expected to be
protected by what is happening form the charter
2. The charter is like a K, and therefore there is an implied covenant of good
faith and fair dealing
iii. Sale of Corporate Office: occurs where seller of control block promises as part of the
sale to give buyer working control of BOD. Sellers directors resign and are filled with
buyers. without such a promise, buyer would have to conduct special shareholders
meeting to elect new board or wait until annual meeting
(a) Courts treat board succession promises as PROHIBITED sales of offices (like
bribery) if the challenger shows either:
(i) The buyer did not acquire working control and therefore could not have elected
his own slate, OR
1. If its a controlling block they can put in who they want as BOD
(ii) The sales price exceeds the premium the control block alone commands,
suggesting the price included a prohibited sale of office (meaning they got paid
more if seller delivers prompt control of board)
(b) Rationale: against public policy, when now officers come in, you hope they are there
to improve the corporation. But if they are there for own selfish reasons, dont want
(c) Note: where sale is in the grey area, court will not always reject
(d) Carter v. Muscat (NY 1964)
(i) FACTS: Board appointed new slate of directors as part of a transaction in which
companys management sold 9.7% block of stock to new controlling person at a
price slightly above market
(ii) HELD: upheld reelection of new directors at the annual shareholders meeting
1. Looks more like a market transaction
(e) Brecher v. Greg (NY 1975)
(i) FACTS: 4% control block sold with a premium of 35%, but the CEO is fired.
(ii) HELD: Shareholder suit against seller was successful and premium is disgorged
to corporation
1. Court trying to create a scenario where just sold small number of shares
absent ability to control
2. Paying premium for control while purchasing such a small amount of shares is
contrary to public policy and illegal
iv. Selling to Looters: a controlling shareholder may not sell control if he has reason to
suspect the buyer will use control to loot the corporation and leave the shareholders
(a) Looter = someone who will extract through control position private benefits or
control sufficient block of the corporation and destroy its value
(b) If controlling seller has reason to believe buyer will steal corporate assets or engage
in unfair self-dealing transaction, seller becomes liable for any damages caused by the
buyer INCLUDING any damage to the corporations earning power

(c) Corporate recovery ins not limited to the control premium the seller received
(d) If circumstances would alert the reasonably prudent seller of a control block to
be suspicious of buyers honesty, there is a duty on such a seller to make (1) a
reasonable investigation and (2) exercise reasonable care
(i) Harris v. Carter (Del. Ch. 1990)
1. FACTS: P (minority shareholder) sues defendant (old shareholder), new
owners, and directors, alleging the new owners looted the corporation and that
the selling shareholders were negligent, and that their negligence breached a
duty to the corporation. The company they sold to didnt have any corporate
information and people knew they were a scam
2. HELD: enough red flags existed that Carter should have known to investigate
(ii) Rationale: reflects red flag doctrine
1. Fiduciary DOC and transaction costs majority shareholders in better position
to investigate
2. Regulation is efficient because it prohibits transactions that should not occur
3. Reflects negligence/tort policycourts often awarding damages = harm
suffered by corporation
(iii)Does NOT put liability on looters because
1. It will be hard to find them
2. They will likely have no money
3. Prophylactic, want to create preventative rule
(e) Some factors courts have treated as ones that would arouse the suspicion of a
reasonably prudent seller and thus trigger duty to conduct further investigation
(i) Buyers willingness to pay an excessive price for shares
(ii) Buyers excessive interest in the liquid and readily saleable assets owned by
(iii)Buyers insistence on immediate possession of liquid assets following the closing,
and on immediate transfer of control by resignations of incumbent directors, and
(iv) Buyers lack of interest in details of how corporation operates
(f) Clearest looting cases are those in which corporations principal or sole assets are
stocks, bonds, and other liquid assets (investment companies
C. Purchases of Control Positions (Duties of Buyers)TENDER OFFERS
1. TENDER OFFER = public offer made by a bidder to a targets shareholders, in which the
bidder offers a substantial premium above market price for most or all of the targets shares
i. I will buy any and all shares at price X so long as at least controlling% of outstanding
shares are tendered for purchase
ii. Can set as many conditions as like on the offer
2. Williams Act 1968 attempts to make takeovers fairer to targets shareholders by reducing
pressure upon them to make a quick decision and by ensuring all shareholders will be treated
equally. 4 principal elements(1) early warning system, (2) mandatory disclosure
requirements, (3) antifraud provisions, and (4) substantive requirements
i. Before Williams Act, offeror could make Saturday Night Special offers that left public
shareholders 24-48 hours to decide whether to tender shares without providing any
information about the identity of plans of the offeror

(a) Any person or group that acquires beneficial ownership of more than 5% of
companys voting stock must file a disclosure document of the SEC
(b) Disclosure alerts stock market/management of a possible change in control
(c) Must be filed within 10 days of acquiring the 5%+ beneficial ownership [13d-1(a)]
(d) Reports must be amended annually, or upon acquiring 10%+ of any issuers shares
(e) Must disclose:
(i) Acquirers identity/background
(ii) Source and amount of funds for making purchase
(iii)Number of the targets shares held by acquirer
(iv) Any arrangement that the acquirer has with others concerning share of the target
(v) Acquirers purpose for acquisition and intentions with respect to the target
(f) Implication: Shareholders may sue for injunction if acquirer fails to make 13D filing
(g) Rationale:
(i) Signals management and other possible purchasers to think that maybe the
corporation is ripe for a takeover attempt
(ii) Reallocates money from acquirer to target shareholders by notifying shareholders
of a possible tender offer, so they dont sell prematurely
(h) If a person violates 13(d) by failing to file a S13D at all, or by filing but putting false
information on the document:
(i) SEC can get a judge to order the wrongdoer to comply and file, or can get an
injunction against future violations
(ii) No implied private right of action, so continuing shareholders nor issuers have
standing to sue for a 13(d) violation
(a) Mandates disclosure of identity, financing, and future plans of a tender offer
(including plans for any subsequent going-private transactions)
(b) Must keep records current [14d-3]
(c) Targets board must comment on the tender offer [14e-2]
(d) Companies must make similar disclosures as third parties do [13e-4]
(e) Particularly strict disclosure requirements when insiders (including controlling
shareholders) plan going-private transactions that would force public shareholders out
of the company [13e-3]
(f) Implication: upon disclosure, the target BOD must recommend to shareholders
whether they should accept or reject the transaction, or state that they cannot reach a
(g) Rationale: goal of having as informed shareholders as possible when deciding to sell
iv. ANTIFRAUD [S14(e)]
(a) Prohibits misrepresentations, nondisclosures, and any fraudulent, deceptive, or
misrepresentative practices in connection with a tender offer
(b) Bars trading on insider information in connection with a tender offer [14e-3]
(c) Requires tender offers to be open for a minimum of 20 business days, and for a
minimum of 10 business days following any change in the offer [14e-1]
(i) Do not over substantive unfairness
(ii) Gives an implied private right of action. P will have to show:
1. Misrepresentation/nondisclosure was material

2. Probably that D made it with scienter, and
3. In most cases, that the P relied upon the misrepresentation
(iii)Remedies for these suits are injunctive relief, damages, or both
1. Injunctive relief(1) targets management can enjoin bidder from
consummating tender offer, (2) bidder can enjoin target from making
misrepresentations in connection with the targets opposition to takeover
attempt, and (3) one of 2 or more rival bidders can enjoin the other from
proceeding without disclosureBUT THESE ARE TEMPORARY (buys the
target time, during which they can come up with a more permanent means of
defeating tender offer)
(d) Implication:
(i) Shareholders have a private right of action to enforce this section
(ii) Reaches beyond 10b-5 because under that you need to be a shareholder during
entire duration whereas here, you need only to have held during period of tender
or have proven you would have purchased in tender but did not because of fraud
(e) Rationale: unproductive and inefficient to allow trades based on fraud
(a) A dozen rules that regulate the substantive terms of the tender offer, like how long
offers must be left open, when shareholders can withdraw previously tendered shares,
how bidders must treat shareholders who tender, etc.
(b) Offer must be held open for 20 days [14e-1]
(c) Best price ruleif the bidder increases price from the initial offered price, must pay
increased price to each stockholder whose shares are tendered, not just to those who
tender after the price increase [14d-10a2]
(i) Rationale: to reduce coercion and ensure all tendering shareholders are treated fair
and equally
(ii) But a clever bidder can circumvent best price rule by waiting until original tender
offer is completed, buying up the tendered shares at originally-announced price,
and then announce a new offer at a higher price
(d) Pro rata requirementif bidder offers to buy only a portion of the outstanding shares
of the target, and holders tender more than the # the bidder has offered to buy, the
bidder must buy in the same proportion from each shareholder [14d-6]
(i) Ex) bidder seeks 50% of target stock but 75% is tendered. Bidder much purchase
2/3 of each shareholder tendered shares, then return un-purchased stock (because
(ii) Rationale: prevents bidder from making tender offer on first come first served
basis for less than all of the shares, which used to be used to coerce stockholders
into tendering immediately and to prevent rival bids from shaping up
(iii)But you dont have to buy them all. You can say Ill by any and all shares up to
(e) Tender offer must be open to all shareholders of the same class and not exclude
anyone from tendering [14d-10a1]
(f) Withdrawal Rightsa shareholder can withdraw their shares at any time while the
offer is still open [14d-7]
(g) Implications:
(i) Allows time for management to respond under disclosure requirements

(ii) Encourages auctions by allowing time for other potential acquirers to place
competitive bids above current tender offer, thus the windows result is only the
potential of hurting the offeror
1. Auctions:
a. Pros: (1) make sure assets go to highest valuing user, (2) target
shareholders receives highest possible return on shares, (3) dont want
there to be too many tender offers because they are costs
b. Cons: (1) bid up the price, (2) if first wins he will pay more, (3) if loses,
wasted costs
3. Acquirer will often try to structure a transaction so that it is NOT a tender offer, especially
where he only wants a relatively small % of the targets stock or when substantial percentage
of targets stock is in hands of a few sophisticated holders with whom he can negotiate
privately. This is because tender offers require:
i. Advanced notice and more extensive disclosure
ii. Longer waits, during which time other bidders can materialize
iii. He will have to follow all the substantive rules
iv. Takes the risk of a fraud action
most but not all factors are present, acquisition should be considered a tender offer)some
but not all courts accept the SEC test
i. Active and widespread solicitation of targets public shareholders
ii. Solicitation is for a substantial % of targets stock
iii. Offer is made at a premium over prevailing market price
iv. Terms of offer are firm, rather than negotiable
v. Offer is contingent on the tender of a fixed # of shares (and is perhaps, though not
necessarily, subject to a fixed maximum # that will be purchased)
vi. The offer is open for a limited period of time
vii. Offerees are subjected to pressure to sell their stock
viii. Buyer publicly announces an acquisition program, preceding or accompanying his
accumulation of stock


I. Motives/Rationales
A. Motives:
1. Increases efficiency in economy by creating synergies that meet demands at lower costs
i. Economies of scale: spreading fixed costs over a wider group of assets
(a) Explains HORIZONTAL mergers between firms in same injury
ii. Economies of scope: being able to spread costs across a broader range of related
(a) Ex) business with great marketing can merge with another company that
manufactures a product. Can use the marketing to market the product, and that talent
can be economy of scope if it extends talent to larger base
(b) VERTICAL INTEGRATION (Special form of economies of scope)
(i) Ex) cheaper to merger with a supplier sometimes than to buy the product
2. Redistributes Gains/Wealth:

i. Gives wealth from controlling holders to shareholders
ii. Tax benefits for carrying net operating loss (NOL)
(a) Corporations that lack sufficient income to overcome NOL, so if they merge with ah
high-income company, they can match NOL and realize benefits
3. Lower Agency Costs
i. Gets rid of management that is not performing well
ii. Realize benefits of this because third parties are more willing to pay a premium for
majority of voting power
iii. Motivation for hostile takeovers
iv. Friendly mergers use compensation to get Ds to leave
v. Diversification of companys business portfolio and projects to increase corporate
B. Opportunistic motives to enter mergers that end up destroying value:
1. Squeeze-out mergers
i. Controlling shareholder acquires all of a companys assets at a low price, at the expense
of minority shareholders
2. Mistaken Mergers
i. Planners misjudge the difficulties of realizing mergers
ii. Common errorsunderestimating costs of overcoming disparate firm cultures, neglecting
intangible costs, failing to take into account added coordination/transactional costs
resulting from increase in size
3. Wanting to expand the empire
i. Companies always perform a little worse after the merger (target does better)
ii. This may be a bad reason to mergegenerally do not justify premium paid over the
market price for the assets acquired
II. ACQUISITION: where purchasing all/substantially all of the companys assets, but also the
liabilities attached to those assets
A. 3 legal forms of acquisition:
1. Acquirer can buy target companys assets
2. Acquirer can buy all of the target corporations stock
3. Acquirer can merge itself or a subsidiary corporation with the target on terms that ensure its
control of the surviving entity (essentially a merger)
B. Can use cash, its own stock, or any other agreed-upon form of consideration
C. ASSET ACQUISITION: acquisition of a business through purchase of its assets
1. Sale of substantially all assets requires a vote by the targets shareholders and approval
by targets board, but purchasers do not need a shareholder vote [DGCL 271]
i. Rationale:
(a) Transformation of investment relationship (rather than D/O deciding on heir own)
(b) Common skillsprobably as good as the BOD in evaluating
(c) Severe agency problems/costs
(i) Only officers and BOD have detailed information to evaluate offers, but are also
the very people fired in a takeover
(a) Qualitative Approach: Katz v. Bregman (Del. Ch. 1981)
(i) FACTS: Plant Industries sells a bunch of company, and only one left is one that
makes steel drums. IT represents 51% of the assets of the parent company. Vulcan

makes offer to buy the steel drum company, and Universal Drum offers even
more in a three-round bidding. Even so, they end up selling to Vulcan.
(ii) HELD: substantially all just means that the quality of the company will
significantly change with the loss of that asset.
1. Cites CERBCOwhat were looking for is not just quantity, but whether
transaction is out of the ordinary course and substantially affects the existence
and purpose of the corporation
2. Main reason probably required the vote was because stockholders would want
to sell to Universal, not Vulcan offering the lower price. Plant Industries CEO
was friends with Vulcan so that was why they accepted the offer
(b) Literal Approach: Hollinger (Del. Ch.)
(i) HELD: substantially all means essentially everything
(c) Why does Delaware Supreme Court not resolve which approach is better?
(i) Allows it to choose either way
(ii) If seems like sale is in good faith and in the best interest of shareholders, they can
not worry about the vote
(iii)But if something seems off, like there is a self interest of some sort (like in Katz),
they can use this as an excuse to require a shareholder vote
2. Benefit of asset acquisitionacquirer accedes only to the asset and not liabilities of the target
(low liability costs) (true so long as purchase is at arms length and doesnt violate fraudulent
conveyance act)
3. Costs of asset acquisitionhigh transaction cost: costly/time consuming to transfer
individual assets of a large business
i. Unexpected business risknot doing as well as you thought, dont get everything you
thought you were going to
(a) Can allocate by:
(i) Covenant if discover missing assets, then they will give them to you
(ii) Covenant will indemnify if liabilities are larger than the given amount
ii. Transaction risktransaction itself may result in unexpected/unusual costs
(a) Lawyers craft K terms that might hold some price in escrow to pay for unusual
III. MERGER: Legal event that unites 2 existing corporations with a public filing of certificate of
merger, usually with shareholder approval. Normally, one of the 2 companies absorbs the other and
is termed the surviving corporation
A. Merger requires majority vote by shareholders of each corporation entitled to vote [DGCL
1. Requirements:
i. Step 1: Recommendation of the BOD
ii. Step 2: affirmative vote of majority of shareholders
(i) Absolute majority of all stockholders
1. Default is all classes of stock vote on a merger unless charter says otherwise
[DGCL 251(a)]
2. Does NOTE protect preferred stock with the right to class vote in most
circumstances unless their formal (NOT economic) rights are adversely
affected by charter [DGCL 242(b)(2)]
(ii) Absolute majority = majority vote by outstanding stock of each corporation

iii. Step 3: File certificate of merger with a state office
(a) Surviving corporation may be restructured through an adoption of an amended charter
and bylaws that are approved by shareholder votes, and dissenters have appraisal
rights if they have voting rights on a merger
2. Exceptions:
i. Acquiring companys shareholders do NOT vote when it is much larger than the target
[DGCL 251(f)]
(a) Rationale: reason for requiring approval is that it is a major structural change to
corporation, and likely will represent a change to shareholders expectation about
nature of their investment. But when a whale swallows a minnow, nature of whales
shareholders investment changes very little, so rationale for shareholder approval
does not apply
ii. Short-form mergers, where the acquirer owns 90% or more of the stock in target
company, there does not need to be a vote [DGCL 253]
(a) Rationale: Target vote would be futile because acquirer is controlling shareholder.
Approval by acquirer is not required because since the overwhelming majority of
shares in the target area already held, a final merger would not make much economic
difference for the acquirers shareholders.
(b) If minority holders of subsidiary receive cash or stock in parent company and they
feel not enough, they have appraisal rights (right to have court determine fair value of
minority shares and right to compel parent company to pay dissenting minority holder
fair amount, see below)
B. Types of Mergers
1. Traditional Statutory Merger: 2 companies merge together, and pick which one survives
the merger
i. Key feature = continuing ownership. Shareholders of T are not cashed out, but instead
they continue to have an equity participation, though it is now in the new, combined
2. Stock-for-Stock Exchange (stock swap/2-step merger): A, instead of entering into a
plan of merger with T, makes a separate deal wit each of Ts shareholders, giving that holder
shares in A in exchange for shares in T
i. Economically the same as a traditional statutory merger EXCEPT T keeps its separate
corporate identity (even though now it is a subsidiary of A)
ii. A can take a second step and liquidate T, distributing Ts assets to itself, to end up
exactly like a traditional merger
iii. Rationale: this form does not require the consent of Ts BOD
(a) Also can likely avoid need for formal vote of approval by Ts shareholders (in the
traditional merger, definitely need T shareholder vote)
(i) This can also be an issue because dissenting T shareholders can keep their T
holdings, whereas in a statutory traditional merger the dissenting minority
shareholder would be compelled to accept A shares in substitution for their T
3. Triangular Mergers: creates a third, dummy company specifically for the purpose of
merger so as to end up with target as a separate subsidiary of acquirer. A creates the dummy
corporation as its subsidiary

i. Forward Triangular Merger: where dummy corporation is surviving entity (dummy
acquires target)
(a) A creates subsidiary, and T merges into dummy
(b) Unlike usual merger, T shareholders do not receive stock in dummy corporation but
rather stock in A
(c) Rationale: guaranteed to eliminate all minority interest in Ts assetsevery T
shareholder is forced to become A shareholder
(i) Arrangement does not have to be approved by As shareholders (because
agreement comes from the dummy corporations shareholders, likely BOD of A)
ii. Reverse Triangular Merger: where target is surviving corporation (target corporations
shareholders given shares in acquiring company or cash during the merger)
(a) In this case, the As dummy subsidiary disappears when it merges with T, so T
(b) Now, Ts original shareholders have stock in A, and T is now a subsidiary of A (with
Ts asset still held by T corporation)
(c) Comparable to share-for-share exchanges
(d) Advantages over stock-for-stock exchange:
(i) Stick-for-stock is more easily obstructed by minority shareholders of T, whereas
in this case it would be eliminated
1. This advantage does NOT exist where a plan of exchange is allowed by
2. Plan of Exchange = allows share-for-share exchange to be made compulsory
if plan is approved by majority of Ts shareholders. DE DOES NOT HAVE
(e) Advantages over traditional statutory merger:
(i) A can limit Ts creditors to the assets of T, because T still survives even after the
(ii) Dispenses with the need for As shareholder voteonly needs dummy
corporations vote, which is usually As BOD
(f) Advantage over forward triangular merge:
(i) T survives as a separate legal entity, so certain rights and properties of T are more
likely to remain intact than if it disappeared
(ii) T might have valuable K rights, licenses, leases
(iii) Certain tax refunds
4. Short Form Merger/Squeeze Out: If parent company owns 90% of subsidiary, just say
were buying out at X per share and accomplish merger [DGCL 253]
i. Basically were in a parent-subsidiary relationship
ii. Rationale: Eliminates the need for shareholder vote fro either corporation
(a) T vote would be futile because acquirer is controlling shareholder.
(b) Approval by A is not required because since the overwhelming majority of shares in
the target area already held, a final merger would not make much economic
difference for the As shareholders.
iii. Dissenting minority T shareholders have appraisal rights (see below)
5. Two Step Merger: Boards of target and acquirer negotiate two linked transactions
i. First transaction = tender offer for most/all targets shares at agreed-upon price OR
private negotiated purchases from some or all of shareholders

ii. Second transaction = merger between target and a subsidiary of the acquirer/acquirer
(a) If offer same price to shareholder as tender offer, will get BJR protection
iii. Rationale: Requires no action by T (so if T BOD is opposed, it cannot do anything about
(a) Also not subject to shareholder votes
IV. Challenges/Objections: Protecting Shareholders
A. Problems with M&A for minority dissenting shareholders
1. Majority-approval procedure gives no guarantee that minority shareholders (those not
approving the transaction) are being treated fairly
i. Especially true when there is a controlling shareholder
2. If transaction is a merger of one corporation into another, even though the transaction may be
fair in the economic sense, each stockholder, including those opposing the transaction, is
being force to trade his investment for stock in a company that may be different/stranger to
him, and may have most of its operations in a completely different industry
B. Three main ways that courts and legislatures try to protect shareholders when M&A occurs
1. Appraisal rights, by which shareholder may demand payment of the value of his shares in
cash, instead of being forced to accept other securities
2. Judicial scrutiny of the substantive fairness of the transaction
3. de facto merger doctrine, by which some courts treat what is not formally a merger as in
fact being one, usually for the purpose of conferring appraisal rights when they would not
normally exist (DE DOES NOT DO THIS)
C. Appraisal Rights: Right for shareholders who dissent form a mergerexercise such rights when
as a minority shareholder you know BOD has not done anything wrong, but believe that the
stock is very undervalued in deals
1. Allows shareholders to disinvest at a fair price
i. Instead of being forced to trade shares for shares in a different company (from a merger)
OR instead of being forced to receive cash consideration determined in a not-arms-
length manner (the case in shot-form mergers where minority shareholders are redeemed
for cash in amount determined by controlling parent corporation), appraisal gives
shareholders a way to be cashed out of his investment at a price determined by the court
to be fair
2. Delaware mandates appraisal ONLY in connection with corporate mergers [DGCL 262]
3. Transactions that trigger appraisal rights:
i. Merger, Consolidation, or Compulsory Share Exchange
(a) Generally shareholders of T have appraisal rights, but shareholders of A do not. Tied
to voting rights, so usually if you had right to vote on merger, will have appraisal
rights. Exception = short form merger
(b) Short form MergerShareholder squeezed out have appraisal rights even if they
dont vote [DGCL 262(b)]
(i) Appraisal rights are the EXCLUSIVE remedy for minority shareholders
(Glassman v. Unocal)
(c) Triangular mergers
(i) Forward Triangular Mergers: A shareholders will not get appraisal rights (dont
vote on transaction) and T shareholder will have appraisal rights

(ii) Reverse Triangular Mergers: A shareholders probably do not have appraisal rights
since A is not party to the merger. Ts appraisal right depends on the form by
which T is combined with the dummy corporation:
1. Statutory mergerT probably has appraisal rights so they have right to
approve transaction
2. Stock-for-assets deal (T buys all of dummy assets, which is just A stock,
funded by issuing more of T stock)T does not have appraisal rights
ii. Sale of Assets
(a) Shareholders have no appraisal rights re: sale of assets UNLESS provided in
corporations charter [DGCL 262(c)]
iii. Charter Amendment
(a) Permits but does not require an appraisal remedy when the corporations charter is
amended or when substantially all assets are sold [DGCL 262(c)]
4. Limits to Appraisal Rights: Appraisal rights only come into play if youre being cashed out
and your stock is NOT liquid (ie. when your investment is taken away from you) [DGCL
262(b)] (Market-Out Rule)
(a) If privately traded, ALWAYS Get appraisal rights
(b) If publicly traded, look to consideration paid for merger:
(i) All stock? NO appraisal rightscourt assumes share price will increase and you
can sell it later
(ii) Anything elseappraisal rights
ii. Rationale: limit appraisal rights to such shareholders because shareholders could sell
shares and obtain fair market value for themselves, so they wouldnt need appraisal
5. Pre-Requisites for Appraisal Rights:
i. Continuously hold shares from announcement to completion of merger, and
ii. Vote against or abstain or dont vote at all re: merger, and
iii. File written request within 20 days prior to effective merger date, and
iv. Exercise appraisal rights within 120 days of merger
6. Mechanical Requirements:
i. Notice to Shareholdershave to inform shareholders they have appraisal rights before
the shareholder meeting [DGCL 262(d)(1)]
ii. Shareholder Petitionhave to mail BOD petition seeking appraisal and NOT vote in
favor of transaction (smarter not to vote at all) [DGCL 262(d)(1)]
iii. Valuation Proceedinghear expert testimony from corporation about why they were paid
X in the merger. Plaintiff must initially bear cost of litigation [DGCL 262(h)]
i. Does not take into account benefits from the merger
ii. Just fair value of shares + fair interest rate
iii. Traditional DE Block Method: Courts consider weighted average of:
(a) Market price of shares just before transaction is announced (45% of value)
(b) Net assets from balance sheet (10% of value)
(c) Earnings valuation of the income statement (45%)
(d) Pro easy to use and set numbers, information contained in all merger documents
(e) Cons: no correlation to financial markets

(f) This valuation method was abandoned in Weinberger v. UOP, Inc (1983) because it is
unduly rigid
iv. Discounted Cash Flow (DE Majority)
(a) Intrinsic value of an asset depends on markets belief of the likely ability of that asset
to produce free cash flows in the future
(i) Free cash flow = amount of cash an asset can be expected to produce for its
owners, net of amounts that will be required to keep the asset in good shape to
keep producing cash
(ii) Profit does not reflect capital expenditures required to keep the firms assets in a
steady state of productivity
1. Capital expenses are an investment, not an expense, so in accounting terms
they will not reduce profit, but they will reduce cash flows
2. Expected amount of capital expenses has to be added to estimate future profit
(b) Relies on discounting future cash flows back to net present value
(c) New types of evidence allowed:
(i) Valuation studies prepared by corporation by its own purposes
(ii) Expert testimony about how much an acquirer would be likely to have paid in the
present situation (including testimony about the takeover premium, ie. the
amount by which price paid in a takeover generally exceeds market value of
target just before announcement of takeover)
(d) Pro: relevant to financial markets
(e) Con: because expert testimony is needed, there are disagreements about underlying
factors that lead to different valuations for what the NPV is for appraisal
D. (No) De Facto Mergers
1. More than one way of structuring a business combination to produce a given result: if A
wants to buy T in return for A stock, can structure the transaction 2 ways:
i. T merges into A, and Ts shareholders receive A stockT SHs get appraisal rights
ii. T sells all assets to A in return for A stock, T then liquidates and distributes A stock to
own shareholdersT SHs do NOT get appraisal rights
2. De Facto Merger Doctrine: when a transaction is not literally a merger, but is the functional
equivalent of a merger, it should be treated as if it were one for purposes of appraisal rights
and shareholder votes
i. When accepted, most common result is giving selling stockholders appraisal rights. Other
results include:
(a) Selling stockholders may get right to vote on the transaction, which they otherwise
may not have had
(b) Creditors of seller may have claim against buyer, which they otherwise may not have
i. Equal Dignity Rule: a merger and acquisition transaction each has its own formalities
and rights, and courts should give each equal dignityso no appraisal rights if not an
ACTUAL merger
(a) Effect: If transaction structured as merger, courts will treat it as such; if transaction
structured and identified as an asset deal, courts will treat it as such
(b) Rationale: formalistic requirements exist so that individuals can predict legal
consequences of their actions. If people choose to structure a transaction a certain

way and comply with its formal requirements, then the court will not surprise them
with liability
ii. Hariton v. Arco Electronics, Inc (DE 1963)
(a) FACTS: Acro sold all assets to Loral for shares of Loral (stock-for-asset swap). Arco
shareholders approved dissolution of company, so liquidated and distributed to its
shareholders the Loral shares it had received in return for its assets. Net economic
result was exactly the same as had Arco merged into Loral, yet Arcos shareholders
did not get any appraisal rights.
(b) HELD: A corporation may sell its assets to another corporation even if the result is
the same as a merger without following the statutory merger requirements
E. Unfair Treatment of Minority Shareholders
1. Controlling shareholders owe DOL to corporation and minority shareholders, yet all
shareholders have the right to vote their share in their own best interestcreates a conflict
i. You bring appraisal claim just when claiming about price, but if you feel DOL was
breached you can bring a fiduciary duty claim
2. Freeze-out Merger/Cash Out Merger and Short Form Mergers
i. Freeze Out = transaction in which those in control of a corporation eliminate the equity
ownership of the non-controlling stockholders. The insiders somehow force outsiders to
sell their shares. Net result is controlling shareholders go from mere control to exclusive
ownership to the corporation
(a) Different from Squeeze-Out merger because it does not legally compel outsiders to
give up their shares, whereas in freeze-outs controlling shareholders legally compel
non-controlling holders to give up their common stock ownership
ii. 3 common contexts in which freeze-out likely to occur:
(a) Second step of a two-step acquisition
(i) Serves to get rid of minority shareholder who failed to take the tender offer in the
first step
(ii) When consideration offered is cash, called a cash out merger
(b) Where two long-term affiliates merger
(i) Ex) parent-subsidiary merger: every time parent company wants to take action,
has to have shareholder vote even though it controls majority stake and will
always win. Eventually, majority will get rid of shareholders and purchase shares
for cash to avoid the pointless expenses of proxy votes
(c) When a corporation goes private
iii. Why Freeze-Outs and Short Form Mergers are allowed:
(a) Pros: lower costs, allows corporation to get into new markets more quickly,
eliminates future expenses related to shareholders, keeps information private
(b) Cons: squeezes out minority for less than they deserve. Raises duty of loyalty
3. Federal claims against freeze-outs based on either 10b-5 or SEC Rule 13e-3
i. Probability of success for 10b-5 action by shareholder who opposes freeze-out is likely to
depend mostly on whether there has been full disclosure by insiders
(a) If there HAS been full disclosure, P is unlikely to convince court that 10b-5 was
violated, no matter how unfair freeze-out may seem to the court
(i) This is because 10b-5 bans only conduct that is deceptive or manipulative,
not conduct that is unfair or a violation of fiduciary duty

(b) If there was not full disclosure, and the proxy statements or tender offer documents
concealed or misrepresented material facts about the transaction, federal court may
hold that the failure to disclose was material and deceptive, and thus violated R10b-5
ii. SEC R13e-3: requires extensive disclosure by insiders when they propose a going-
private transactions
(a) Covers transactions in which corporations stock will no longer be registered, or any
transaction whereby company will be delisted, applies not only to pure going
private transactions, but also to many mergers of long-term affiliates (parent-
(b) Insiders required to disclose some things that they would often rather not disclose,
(i) Purpose of the transaction
(ii) The reason for particular structure they have chosen for the transaction
(iii)A reasonably detailed discussion of the benefits and detriments of the transactions
to unaffiliated security holders
(iv) Whether they reasonably believe that the transaction is fair/unfair to the
unaffiliated security holders
(c) Seems to have little effect on either structure of going-private transactions or case law
in the area
i. Summary:
(a) Transaction must be Entirely Fair (fair price, fair procedure, adequate disclosure)
(i) Burden of proof:
1. Burden of proof can shift to P to show that terms of transaction were unfair if
ALL of the following occur:
a. Majority of minority of shareholders vote to approve transaction
b. Ds must carry burden of showing that they made adequate disclosure of
transaction (Weinberger)
c. Must be a simulation of arms-length process, in which representatives of
majority and minority negotiate. Usually done through a committee of
independent directors who negotiate with majority-holder (Kahn)
(b) Transaction must be undertaken for some valid business purpose
ii. Entire Fairness Standard: Weinberger v. UOP (DE 1983)
(a) FACTS: Signal Corp. owned 50.5% of UOP, with balance owned by public
shareholders. Four key directors of OP were always Signal directors. 2 of these
directors prepared a feasibility study, concluding that anything up to 24$ a share
would be a fair price for Signal to acquire balance of UOP shares. Signal offered to
buy out UOP minority at 21$/share. UOP board approved, but there was never any
real negotiation on the price. Deal went through approved by majority of UOP
stockholders, including a bare majority if minority UOP stockholders.
(b) HELD: was not a fair transaction
(i) Procedurally unfairSignal never really negotiated, Signal used confidential
UOP data to prepare study, and only work done on behalf of UOP to ascertain the
fairness was not carefully prepared

(ii) Price was not fairstudy itself demonstrated a higher price was fair
(iii)Signal and UOP did not make fair disclosure to UOPs minority public
(c) Insiders can insulate transaction from attack by making sure a special committee of
independent directors is appointed to negotiate the transaction
(d) Court endorsed DISCOUNTED CASH FLOW analysis (used by investment
(i) Note: this appraisal remedy is understood as protection against self-dealing, so
refashions DGCL 262(h) from idea of appraisals reflecting value of corporation
before merger
(e) Need informed majority vote OR special committee that can bargain in order to
comply with DOL
(i) Directors on both sides of merger so owed ENTIRE FAIRNESS (fair dealing +
fair price)
(f) When duty breached, have to give up value created and give it back to minority
iii. What subsidiary boards should do in approving freeze-out
(a) Bargainingforming special committee of independent directors and have them
(b) Adviceindependent committee has meaningful advice (bankers, lawyers)
(c) Showing the above shifts burden to Ps to show transaction was not fair
(i) JUST shifts burden of proof. Kahn v. Lynch
iv. Consequences of Weinberger
(a) Now there is always an independent committee with independent advisors in a merger
(b) Courts now say you can bring class action for breach of DOL AND appraisal
proceedings at the same time
(i) In case you cant show breach, you have appraisal proceedings
5. In general: SO when there is a claim that owed fiduciary duty to SHs (as in parent-
subsidiary merger OR 2 step merger) appraisal is NOT the exclusive remedy for
complaints concerning price
i. NOTE: if youre alleging breach you can try to block merger beforehand with
preliminary injunction
6. BUT where there is NO fiduciary duty owed (one-step cash/stock merger b/w firms with no
shared ownership interest a.k.a arms length transaction) complaints about price alone may
be relegated to appraisal remedy
7. NOTE: Breach claims brought more often than appraisal
i. Making out claim of breach = turbo statutory rt get appraisal + speculative value
ii. Breach claim can be brought on behalf of all whereas appraisal can only be brought by
those who didnt vote in favor this affords counsel a means to get larger payout than
mere appraisal
iii. Appraisal may not be available due to market-out provision [DGCL 262(b)(1), (2)]
iv. Breach claim and injunction request can be brought before merger which increases
settlement leverage (as opposed to appraisals where s bear their own litigation expense)
(i) Kahn v. Lynch Communication
NOTE: ct here is (ii) Facts: Alcatel, a subsidiary, acquired 43% of Lynch stock in a SH vote. A later
recognizing implicit opposed Lynchs intention to acquire Telco and proposed that Lynch acquire
coercion minority
SHs fear retribution
if they go against
majority SH thats
why ind. Fairness. Is 95
HERE. Committee
Celawave instead, an indirect subsidiary of Alcatels parent co. after an
independent committee opposed that proposal, A offered to acquire the entire
equity interest of L. A offers were rejected by L as insufficient and A said they
would proceed with unfriendly tender if not approved. Then it was approved. K,
a minority SH, brought class action suit.
(2) Holding: judicial standard of review in interested cash-out merger transaction by
controlling or dominating SH is entire fairness (i.e. fair procedures, price, adequate
disclosure, etc)
(a) If NO special committee was formed BURDEN IS ON THE TO SHOW ENTIRE
(b) If special committee formed BURDEN ON CHALLENGING SH- TO SHOW LACK OF
(i) 2 factors required in order for independent committee to prove entire fairness
1. majority SH must not dictate terms of merger
2. special committee must have real bargaining power that it can exercise with
the majority SH at arms length basis
(ii) Where independence of special committee is questionable THE CO. () HAS THE
(3) NOTE: If this was NOT a transaction with controlling SH LEGAL BURDEN WOULD BE
ii) Controlling SH fiduciary duty on first step of a two step tender offer
(a) No federal law duty to pay fair price if skips board and TOs
(b) In TO, company already has control and is just purchasing more control by going
straight to SH
b) M&F Worldwide Corp: Perelman owns MacAndrws & Forbes which has M&F as subsidiary;
owns 43% and wants to get rid of the other minority shareholders. I bankers tell Perelman that
worth 10-32 per share; he offers 24 (currently trading at 17).
i) Issue: What is standard of review?
ii) Rule: BJR will be applied as long as merger is conditioned on:
(1) Two things:
(a) The approval of an independent, adequately informed special committee
(b) And approval of a majority of minority shareholders
(2) So, will need to show lack of good faith, informed, etc.
(a) Shorter and easy trial than entire fairness or lack of fairness

V. Control Contests
A. Market for Corporate Control
1. Non-negotiated transactionsBOD is hostile to the deal
2. Motives:
i. Acquirer (bidder): has to offer premium over market price, and potentially a large one to
overcome target BOD
(a) Public benefitmaybe he has really good plans for company so efficiency enhancing
ii. Target Directors: why resist?

(a) Acquirer is going to fire them, otherwise they would have negotiated the transaction
where could negotiate for jobs
3. Dutiesnot exactly DOL because BOD is not on both sides of transaction, but they have
strong motives to protect own interest, so there seems to be a conflictwhy the standard of
review is in the middle: Enhance Business Judgment
4. Methods of Hostile Change of Control
i. Proxy Contest: running an insurgent slate of candidates for election to the board
(a) Also techniques to pursue a partial slate of directors who will promote change
through constructive engagement
ii. Tender Offer: purchasing enough stock to obtain voting control (costly technique)
iii. Hybrid: proxy contest and tender offer merged into a single form of hostile takeover
because defensive tactics have made it difficult to pursue either avenue alone
iv. 2 Step Merger:
(a) Front end = Tender Officer (because BOD wont recommend the deal)
(b) Back end = once in controlling position, merge it into ready purpose entity
(controlling majority stake so vote for merger)
(c) If offer same price as in tender offer to buy out minority, courts will not review
the mergerBJR not fiduciary duty
(i) Entirely fair because everyone got same price and because individuals accepted
the offer and had no connection to acquirer or BOD of target
B. Defending Against Takeovers
1. Target corporations may take defensive maneuvers to defeat a hostile bidder
2. Distant Threats (Pre-Offer Techniques): before a concrete takeover attempt has been
announced, there are a number of things the targets management can do to make an attack
somewhat less likely to occur, or somewhat less likely to succeed if it does. AKA. Shark
i. Most of these tactics are carried out by means of amendments to the corporations
charter, so almost always require approval by majority of shareholders
ii. Super-Majority Provisions: target might amend charter to require more than simple
majority of companys common stockholders to approve any merger or any major sale of
(a) Target might provide a merger or asset sale must be approved by a majority of the
(b) Somewhat effective against partial tender offers and 2-tier-front-loaded offers, but
NOT very effective against bids for ALL of the targets shares
iii. Staggered Board: only minority of board stands for election any given year
(a) Even if bidder acquires a majority of targets shares, he cannot gain control
(b) Common anti-takeover device and relatively effective
iv. Anti-Greenmail Amendments: amending the charter to prevent the paying of
greenmail, ie. the repurchase by the target of shares from a would-be take-over artist at
a premium over market price
(a) Bidder will be less likely to attack a target where there is no possibility of greenmail
as an outcome
(b) Not very effective

v. New Class of Stock: company might create a second class of common stock and require
that any merger/asset sale be approved by each class (so that the new class has veto
(a) New class of stock can be placed with persons friendly to management
vi. Poison Pill/Shareholder Rights Agreement: try to ensure that bad things will happen to
the bidder if it obtains control of the target, thereby making the target less attractive to the
(a) Call plangives stockholders the right to buy cheap stock in certain circumstances
(i) Distribute to each target shareholder one right for each target share
(ii) Rights are triggered if someone acquires more than a certain percentage of the
companys outstanding stock without board approval
(iii)Party whose acquisition is the triggering event is excluded from buying the
discounted stock
(iv) Result: buying a substantial block of stock without the prior consent of targets
board will be ruinously expensive, shares will be diluted, and buyer will end up
losing most of investment
(v) Flip In = right to acquire some # of shares of the targets common stock at the
market price
(vi) Flip Over = create a right to buy some number of shares of stock in the
corporation whose acquisition of target stock had triggered the right
1. Works if after the acquiring control of T through a tender offer, the bidder
attempts to do a second step freeze-out merger
2. After the merger, the bidder is bound by the K rights of target, including the
option to buy the bidders shares at a discount
(b) GENERAL RULE: Poison pill adopted in anticipation of the possibility of a
takeover (no immediate bidder on horizon) and is a permissible defense
mechanism and will receive BJR protection
(i) Moran v. Household Intl, Inc (DE 1985)
1. FACTS: HH BOD adopted poison pill, which is triggered after announcement
of a tender offer for 30% of the shares OR the acquisition of 20% of HH by a
single entity. Also a flip-over provision, where right to purchase $200 of the
common stock of the tender offeror for $100. Moran, HHs largest
shareholder, sues
2. HELD: as long as it is related to a perceived threat, defensive measures to
a hostile takeover are okaybenefit of BJR extended to adoption of rights
plan under corporate financing structure
3. Poison pills are permitted under a literal reading of DGCL 151, 157:
a. 151(g): BOD permitted to issue stock of its own accord as long as there
are sufficient authorized shares as long as BOD is authorized to issue
blank check preferred stock (court reads this very narrowly)
b. 157: BOD is authorized to issue rights over stock
4. Court says when and if threat of takeover happens, it will evaluate whether
leaving shareholder rights plan in place is reasonable in relation to the threat
(under Unocal)
a. After bidder bids, BOD will condition their bid on getting 51% of shares
PLUS redemption of poison pill. Hostile bidder will sue if not removed.

Bidder can also try to start proxy contest and get new BOD members who
will retract bid
b. BOD has ongoing fiduciary obligation to redeem pill if it is no longer
reasonable in relation to acquisition offer (see Revlon)
(c) Pro of poison pillneed to protect management long term plans
(d) Con of poison pillmanagements method to stay in power, and share prices go
down when you adopt poison pill because it means someone is trying to take over the
company due to poor management
vii. If a defensive measures thwarts the vote of shareholders, standard of review is
(a) Blasius Industries v. Atlas Corp (Del. Ch. 1988)
(i) FACTS: Blasius owned 9% of Atlas, and intends to increase board from 7 to 15.
It is going to fill new board seats with its own nominees. Atlas then amends
bylaws to add 2 new board seats and fills them with 2 of its own candidates.
(ii) HELD: This is a defensive tactic that limits the ability of shareholders to vote.
Therefore, it is invalid because VOTING IS SPECIAL
1. A board cannot enlarge the size of the BOD for purpose of preventing
majority shareholder from voting and giving control to his own board
3. Immediate Threats (Post-Offer Techniques)
i. Types of Post-Offer Techniques
(a) Defensive Lawsuits: Ts management can institute defensive lawsuits, suing bidder
and alleging that the offer violates fiduciary principles
(i) in general, litigation rarely does more than gain the targets management extra
time to take other defensive measures
(b) Finding a White Knight: target may find itself someone who will acquire target
instead of letting hostile bidder do so
(i) For it to work, white knight will generally have to offer price at least as good as
hostile bidders
(ii) Management loses independence, but keeps its job
(c) Defensive Acquisition: Target might make itself less attractive by making a defensive
(d) Greenmail: Target may try to buy back the partial stake he bidder has already bought
at an above-market price
(i) In alternate form of greenmail, target arranges for some third party to buy the
bidders stake at a premium
ii. Courts allow these techniques if they meet the ENHANCED BUSINESS
JUDGMENT RULE (intermediate scrutiny)
(a) UNOCAL/UNITRIN framework:
(i) Must show defensive measure is not draconian
1. Not preclusive
2. Not coercive
(ii) Must show threat to corporate policy (not to perpetuate self in office)
(iii)Must show defensive measure is proportional to the threat presented

(iv) Rationale: because of higher-than-usual probability that Ts management and
BOD will act for self-interested purposed rather than stockholder welfare when
instituting anti-takeover defensive methods
(b) Unocal v. Mesa Petroleum
(i) FACTS: Pickens owns Mesa and decides Unocal poorly run; buys a little less than
5%. Unocal turns down offer to merge. Pickens then begins buying up as many
shares as possible (13%) and launches tender offer saying 54 on front end
contingent on getting at least 37% controlling, and securities on back end; and
securities on back end. Unocal says once gets close to 50% they will launch own
tender offer for shares at 72. Pickens sues for breach of fiduciary duty. Company
argues that own coercive action is only in relation to the acquirers coercive
action. Pickens bid coercive because shareholders will rush to accept front
because get more in cash instead of lesser-valued bonds. Now shareholders will
all wait because Unocals 72 is a lot more.
(ii) HELD: whenever omnipresent specter BOD may be acting primarily in own
interest, there is enhanced duty in order to get BJR. Requirements:
1. Corporate Threat: BOD has to show they are acting in interest of the
company and not just to perpetuate themselves in office
a. Argue that they have a long-term plan to keep drilling and Pickens would
ruin that
2. Proportionality: have to demonstrate that the defensive measure is
reasonable in relation to that threat
a. Pickens offer is coercive so ours has to be coercive in response, otherwise
would accept the offer and get money to finance another tender offer
against it
(iii)Blasius v. Unocal:
1. When you are in Blasius-land, you are prohibited from taking any measures
that are defensive aimed at shareholder vote
2. When you are in Unocal-land, you can take any defensive measures
essentially Unocal is less demanding
(c) Unitrin v. American General Corp (DE 1995)
(i) Adds the third non-draconian requirement
(ii) Must first show that defensive measure is not draconian
1. Not preclusivedoesnt stop hostile bid from going through
2. Not coerciveforce shareholders into action favored by BOD
(iii)THEN Unocal branch: complaining shareholder has to show there is no threat, or
that the defensive action is not reasonable in relation to the threat posed
(iv) Takeaway: before going down Unocal path, BOD must show that defensive
measure is neither preclusive nor coercive
1. Assuming defensive measure passes preclusive/coercive test, then it will
satisfy Unocal as long as it is within a range of reasonable action
a. Operation similar to BJR
b. Action will be sustained if it is attributable to any reasonable judgment
c. Will not matter if court would have regarded some other action as more
C. Managing Takeovers

1. Fiduciary Duties (Care/Loyalty)
i. Smith v. Van Gorkom (DE 1985) [DGCL adopts 102(b)(7) direct response to this case]
(a) FACTS: Retiring CEO of Trans Union (VG) initiated, negotiated, and promoted
friendly cash-out merger with acquirer Pritzker. BOD approved the merger, but failed
to review any documents, did not question price, did not seek outside opinion on
fairness of price. Just relied on VGs assertion of fairness and instituted Market Test,
allowing bids for a set period if time. Shareholder sue claiming breach of DOC, as
BOD was not adequately informed when acting
(b) HELD: BOD violated DOC and are personally liable to shareholders
(i) Directors not accorded BJR protection if their decision is uninformed
(ii) Informed Business Decisionsubstantial premium in price alone is
INSUFFICIENT for assessing fairness, and they must review pertinent documents
1. Court sets out roadmap as what BODs should do:
a. Know in advance of any meeting that they will be discussing sale of
b. Should have own investment bankers evaluate price
c. Should have their own lawyers to advise them of their duties in selling the
d. Should review all documents
e. Should ask advisors questions
2. Significance: before this, such BOD decisions were protected by BJR. This is
first of several decisions in which court struggles to construct a new standard
of judicial review for change in control transactions like mergers
(iii)Market Test to ensure get best price. Court says they are good to give a sense of
real price and worth usually
1. Here, too many restrictions by Pritzker, so it wasnt a real bidding process
2. Certainty of Sale
i. Inevitable company will be sold because youre in the process of negotiation or because
bids are so high
ii. Once BOD decides to sell company, it must act as auctioneer and sell for highest
price for shareholders
(a) Revlon v. MacAndrews (DE 1986)
(i) FACTS: BOD of Revlon engaged in hostile takeover bid launched by Perleman.
BOD issued notes to pay for defensive tender; value began to fall. Grant asset
lockup option to white knight bitter, Forstmann, in exchange for propping up
price bonds. Option effectively killed bidding contest for Revlon; allowed
Forstmann to acquire two of Revlons most significant assets (CROWN
JEWELS LOCK UP) at huge discount from value if another bidder acquired
more than 40% of Revlon shares. Was this a legitimate defense measure/
(ii) HELD: When sale or breakup of company becomes inevitable, BOD is no
longer the defender of the corporation but instead an auctioneer, and must
get highest price possible for sharescourt enjoined Revlon from going ahead
with the Forstmann deal
1. BOD may only consider other constituents, such as note holders, in the
context of benefit to the stockholders

a. In Unical you can take into consideration interests of creditors, etc, but not
2. So here, BOD failed to fulfill duty as auctioneer by granting crown jewel lock
up, effectively ending bidding
a. Breached DOC because they did not act in good faith in what they thought
was the best interest the corporation
(b) When are these promises to sell some of companys best assets at less than fair
market value permissible?
(i) When it is necessary to entice the first bidder into the auction
(ii) Becomes impermissible at the moment they are used to STOP the sale of the
(c) Where Ts management is one of the competing bidders, target should form SLC and
it should
(i) Have truly independent legal and investment counsel, and
(ii) Itself conduct the negotiation and/or auction, rather than letting the inside
directors serve on Ts side of the process
iii. Pulling together Unocal and Revlon
(a) Household International: you can put in/adopt a takeover defense (poison pill) even if
there is no threat. BOD can adopt preclusive defense measures at any time
(b) Unocal: Once there is a threat, BODs defense strategy must be reasonable in relation
to the threat posed
(c) Revlon: once youve decided company will be sold/broken up, you must be an
auctioneer to get as much value as possible. APPLY REVLON WHEN:
(i) Company has announce it is for sale and conducts an auction
(ii) Abandons long term strategy for alternative
(iii)Change in control/controlling shareholder
3. Uncertainty of Sale
i. BOD gets to determine not just business/affairs of corporation, but also the time period
over which they are evaluateda company is NOT inevitably for sale if it is pursuing
its long term (not short term) business plan
(a) Paramount v. Time (DE 1989)
(i) FACTS: Time negotiated friendly stock-for-stock merger with Warner.
Paramount then makes a bid, and Time worries shareholders will accept
paramount. Time changes transaction to tender offer for 51% of Warner, avoiding
shareholder vote. To raise money, issued bonds with billions (also makes less
attractive to paramount)
(ii) HELD: A BODs effort to prevent a takeover via tender offer will not be invalid
merely because the takeover offer constituted fair market value
1. Times decision to expand by merging with Warner was analyzed under
Unocal and essentially with protection of BJR. Times board decision that
Paramonts offer posed a threat to the corporations policy was made in good
(iii)According to DE court, basically ANYTHING is a threat
1. Times response was reasonably related to the threat
(iv) Court says that this was not a sale of the company (because it was pursuing a
long-term business plan) so Revlon duties did not attach:

1. A defensive reaction to a hostile tender offer is not an abandonment of
the corporations continued existenceno Revlon duties, only Unocal
2. Says sale is not inevitable because Time could call off the Warner plan OR
adopt a poison pill
(b) GENTILE says it is very easy to show threat to business plan
(i) Revlon collapses Unocal analysis not the BJR because it seems like any idea you
have can satisfy the standard
ii. Similar enhanced Revlon scrutiny happens when BOD sells control of the company
(a) Paramount v. QVC Network (DE 1994)
(i) FACTS: Paramount agrees to sell self to Viacom in friendly acquisition. QVC
offered to acquired Paramount at a higher price, but BOD thinks Viacom offer is
better aligned with long term, despite higher QVC bid. Accepted Viacom, and
argued Revlon had not been triggered (felt like they were Time in the previous
case). Used 3 provision in the Paramount Viacom deal to make it difficult for the
QVC offer to work
1. No- Shop Provision limited Paramounts BOD right to offer to sell or
merge the company with some third party. Could not respond to unsolicited
offers from third parties unless
a. Unsolicited third-party offer was not subject to any material contingencies
related to financing and
b. Paramount BOD decided discussions with third-party were necessary to
comply with fiduciary duties
2. Termination Fees Viacom would get $100 million fee if anything happened
to end the deal
3. Lock up Stock Option gave Viacom right to purchase 19.9% of
Paramounts stock if any triggering events happened
(ii) HELD: A change of corporate control or a break up of the corporation
subjects BOD to enhanced scrutiny and requires them to pursue a
transaction that will produce the best value for shareholders. BOD breaches
fiduciary duty if it contractually restrict s its right to consider competing
merger bids
1. Viacoms defensive measures were improperly designed to deter potential
bidders and they do not meet reasonableness test
(b) RULE: When a corporation undertakes a transaction that will cause (1) a change in
corporate control OR (2) a break-up of the corporate entity, BODs obligation is to
seek best value reasonably available to stockholders
(i) Paramount BOD were wrong in asserting that both a change of control and break
up are required for higher scrutiny
(c) RULE: If a company with diffusely-held shares is acquired by a company with
controlling shareholder, that necessarily is a Revlon transaction and BOD is required
to auction off company
(i) When you unwittingly find yourself in Revlon because youre getting acquired by
controlling shareholder, you have to auction off the company
(ii) In Paramount v. QVC, 51% controlling shareholder would have acquired the
company, so then would have triggered Revlon because of change in control IN

CONTRAST WITH Paramount v. Time, where it was a merger of equals and not
necessarily a change in control