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Novidade! Cadernos Colaborativos de Harvard

Origem: Cadernos Colaborativos, a enciclopédia livre.

ANTITRUST LAW
FALL 2008
JUDGE MICHAEL BOUDIN

Horizontal Restraints

Why should we forbid cartels at all?

When there are many producers offering the same goods and services in a competitive market, the forces of supply and demand
will achieve an equilibrium indicating the level of output and price which maximizes the society’s welfare. At this point, prices are
equal to marginal costs. While prices are above the marginal costs, there is incentive for new entrants to come into the market
and offer the product (assuming they will produce at the same costs), and at a price below marginal costs the suppliers are forced
to withdraw from that market to avoid incurring in loss.
So when the market is perfectly competitive, the consumers surplus (measured by the price the consumers are willing to pay less
the price they actually paid) is at the maximum level, since the price actually paid is the lowest price which suppliers are willing to
offer (equal to their marginal costs). One supplier by himself cannot affect the price in the market, because if he increases the
price his consumers will buy from a different seller at the competitive price.
However, when all the suppliers (or a representative share of the market) joint together to fix prices, the consumers will have no
option except by accepting to buy at the fixed price. In this case, the consumer surplus will be reduced for two reasons: (i) the
consumers who value the product less then it’s actual price (but value more then the price charged in the situation prior to the
agreement) will be excluded from the market and (ii) the consumers who are still willing to buy the product will pay a higher price.
The supplier’s surplus will be increased because, although they lost part of consumers, the other consumers who are still buying
and paying a higher price will compensate this loss and provide more profits. So even with a reduced output, the producers will
be better off with the higher prices, keeping in mind that if they reduced price and increased output they would have to do this for
all the production and not only for the next unit of production.
The result will be a transfer from the consumers surplus to producer surplus (because of the consumers who are still buying the
product at a higher price) and, what is worse for society as a whole, the creation of a deadweight loss (because of the consumers
who are excluded from the market resulting in a lack of efficient transactions that could occur in the absence of price fixing).

Interpretation of Sherman Act # 1 “Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of
trade … is hereby declared to be illegal”

United States v. Trans-Missouri Freight Assn (reasonable contracts are also condemnable under Sherman Act)
The Sherman Act # 1 condemns “every contract, combination or conspiracy in restraint of trade” and the question here was
related to the extension of the broad and vague term “restraint of trade” used by Congress. The main argument of the defendants
was that only unreasonable restraint of trade should be condemnable under Sherman Act. The court rejected this argument on the
grounds that the statute encompassed “every contract” of that nature, regardless if it was unreasonable or not under the common
law.

United States v. Addyston Pipe & Steel Co. (agreements ancillary to a lawful contract can be justified)
This was the first case when the court consented to a slightly flexible interpretation of Sherman Act # 1 arguing that covenants in
partial restraint of trade can be upheld as valid when they are ancillary to the main purpose of a lawful contract and necessary to
make the parties enter in such lawful contract. The examples of acceptable agreements in restraint of trade were (i) by the seller
of property or business not to compete with the buyer in such a way as to derogate from the value of the property or business
sold; (ii) by the buyer of property not to use the same in competition with the business retained by the seller; (iii) by a retiring
partner not to compete with the firm; (iv) by a partner pending the partnership not to do anything to interfere, by competition or
otherwise, with the business of the firm and; (v) by an assistant, servant or agent not to compete with his master or employer after
the expiration of his time of service .
Even though this present case was neither one of these situations and was held invalid, the reasoning of the court demonstrated an
initial acceptance of exceptional agreements which could be justified in light of being ancillary to a lawful contract. Therefore, a
business transaction which generates social benefits, but requires some kind of restrictions in trade, can be a defense that the
court will consider.

United States v. Joint Traffic Assn (high fixed costs is not a defense to justify an agreement among railroads formed to fix rates)
The court rejected the argument that the possibility of destructive competition among railroads justified excluding their
arrangement from the Act’s prohibition. Event though industries such as railroads have to incur in high fixed-costs and need a
larger output to spread the fixed-costs among a higher number of products, as well as higher prices to compensate the massive
costs, the competitiveness will not eliminate the efficient railroads companies from the market since the competitive price will be
equal, and not less, to the marginal cost (which considers the fixed costs).

Standard Oil Co v. United States (establishment of the “rule of reason”)

The court finally established the rule of reason. Even though the present case was clearly unreasonable, Chief Justice White was
successful in determining his earlier dissenting view as the prevailing law, arguing that the Act “not specifying but indubitably
contemplating and requiring a standard, must have intended that the standard of reason which had been applied at the common
law and in this country remain the measure of illegality under the Sherman Act”. The court didn’t expressly overrule its prior
decisions on the grounds that they had actually been condemned because they were unreasonable. Justice Harlan dissented
alleging that the rule of reason had been explicitly rejected in prior decisions and that the majority’s view was a “judicial
legislation”, especially because this case doesn’t even require such an analysis since Standard Oil’s acts were clearly illegal.

Chicago Board of Trade v. United States (Exchange market is subject to private regulation)
Chicago Board of Trade had imposed a regulation restricting the business time of offers and sales by members of the Board. The
court accepted this restriction on the grounds that it didn’t affect significantly the general market prices or the total volume of grain
coming to Chicago. Any exchange market is subject to regulations which can in fact create competitive advantages, such as
bringing buyers and sellers into more direct relations and facilitating trade among them. “Every board of trade and nearly every
trade organization imposes some restraint upon the conduct of business by its members. Those relating to the hours in which
business may be done are common.”

United States v. Trenton Potteries (“Rule of Reason” doesn’t mean the court has to analyze the reasonableness of prices
themselves)
The “rule of reason” stated in Standard Oil doesn’t mean that agreements to fix or maintain prices are reasonable restraints and
therefore permitted merely because the prices themselves are reasonable. “It does not follow that agreements to fix or maintain
prices are reasonable restraints and therefore permitted by the statute, merely because the prices themselves are reasonable”.
The court emphasized the problems of such approach. First what is a reasonable price? Assuming that a reasonable price is the
competitive price, that is, equal to the marginal costs plus a reasonable profit, how can the courts measure the real costs incurred
by certain firm? Should the courts trust the information of costs provided by the firm even knowing that it has incentives to
demonstrate greater costs to justify higher prices? What is a reasonable profit? Should the court take into consideration the level
of risk assumed by the entrepreneur when entering in that particular market? Assuming that the court is able to determine
accurately the costs incurred, is the reasonable price the same as costs in any situation? Prices below costs could be explained
when there is a reduction in the demand curve during a specific period (selling winter clothes in the summer for example) and,
therefore, be reasonable yet differing from marginal costs. Moreover, the price charged by a single firm could be above its
marginal costs of production and still be at the competitive level. This is because the firm may be more efficient than its rivals
(being able to decrease its cost structure) and decide to appropriate the efficiencies by charging the same price charged by its
inefficient rivals and earning a higher than the competitive profit.
In addition to the difficulties of identifying a reasonable price, there is an economic argument which makes this defense at least
suspicious. Why should the firms fix the reasonable price at all if the free market is able to reach this price by itself through forces
of demand and supply (Adam Smith)? Free competition is the best way of achieving a reasonable price and, if firms are willing to
fix a price, probably it’s because they are trying to maximize profits through a price inconsistent with the competitive.

Appalachian Coals v. United States (Single agent is allowed to control all the sales considering the deplorable conditions of the
industry and the achievement of “fairer price levels”)
This case was the court’s most favorable treatment to agreements in restrain of trade and today is seen as an aberration of the
1930’s. The court considered the deplorable conditions the industry was going through to allow the firms to designate a single
agent responsible for all the sales at the best prices obtainable and, if all could not be sold, the agent would apportion orders
among them. The argument was that the agreement would mitigate unsatisfactory, depressed prices and produce “fairer price
levels”. However this idea of an agreement to produce “fairer price levels” is incompatible with the holding in Trenton Potteries,
where it was decided that competition is the main instrument to achieve reasonable prices.

United States v. Socony-Vacuum Oil Co. (Price-fixing is unlawful under the per se rule)
The court held that “Any combination which tampers with price structures is engaged in an unlawful activity. Even though the
members of the price-fixing group were in no position to control the market, to the extent that they rose, lowered, or stabilized
prices they would be directly interfering with the free play of market forces”. In its famous footnote 59, it was stated that any
price fixing violates Sherman Act # 1 “though no overt act is shown, though it is not established that conspirators had the means
available for accomplishing of their objective, and though the conspiracy embraced but a part of the interstate or foreign
commerce in the commodity”. In other words, the conduct of price fixing is illegal per se. The per se rule means that the conduct
is condemnable without regard to its actual effects and the court shall not consider any justifications, or at least, shouldn’t
consider any justifications if the conduct falls within the per se rule.

Why should the court adopt a per se rule?

One reason would be to avoid the burden of proof the court would have to incur when analyzing the possible effects of the price-
fixing in every specific case. But this problem could be solved by shifting the burden of proof to the defendant. If he can prove
that he doesn’t have enough representation on the market share to affect prices or that this conduct has some procompetitive
consequences which compensates the anticompetitive harms, he could be exonerated. The courts, however, prefer to establish a
clear rule in order to make its next decisions more legitimate and consistent with what was already decided in prior cases. The
next decisions are viewed as less arbitrary if the court adopts a clear rule supposed to govern all the cases which falls in that
specific category.

But the sense of clearness of the per se rule is only apparent. Once the court has determined that “price-fixing” is condemnable
under the per se rule, two problems still remain:
1) Is the conduct before the court in fact a “price-fixing” arrangement?
2) Once you decided it is inside the category of price-fixing, is there any exceptional defense?
Monopsony

A monopsony is a concentration among buyers to induce lower prices at the expenses of suppliers. The consequences are
basically the same as when the concentration is among sellers for antitrust purpose: a shift from suppliers surplus to the buyers
surplus (because some suppliers will be forced to offer the product at a lower price) and the creation of a deadweight loss
(because some suppliers are not willing to offer the product at such a reduced price and will abandon the market, reducing the
output and causing a lack of efficient transactions that could occur).
So fixing prices among buyers should also be condemned under a per se rule?
The courts can be more flexible when the agreement is among buyers because there is the reasonable defense that it is a way of
centralizing their orders in a single agent, which can promote an efficient coordination. But one could argue that the same defense
could be used by sellers who want to centralize their sales.
Another defense would be the arrangement of a monopsony to face a monopoly in the seller’s side of the market. This is a
“countervailing power” argument which consists in reaching an equilibrium by increasing one side’s market power when the other
side is already highly concentrated. The idea is that if buyers joint together the monopolist seller won’t be able to impose
monopolized prices since the buyers don’t compete with each other any longer and can force prices down (the seller doesn’t
have any alternative but to sell at the required price).
However, the countervailing argument has its problems. One is that, in this situation, the buyers can become so strong by acting
as a single entity that they could devastate the seller’s business by forcing prices extremely down to insignificant levels. Moreover,
the buyers can create a monopoly in relation to the ultimate consumers since they are joint together, increasing prices and
reducing output. But one could argue that the ultimate consumers would be harmed even without the formation of a monopsony
because the monopoly would raise prices and the buyers would, in turn, pass their costs to ultimate consumers in the form of
higher prices. The third, and most significant, reason to condemn the formation of a monopsony even when it has the
“countervailing power” defense is that the monopsony may interfere with other markets where there is no power to countervail. In
this case, the monopsony would be able to exercise monopoly power against other suppliers who belong to competitive markets
and could be harmed by the formation of the monopsony.

United States v. Topco Associates (Horizontal territorial limitation are always condemnable, regardless if they are ancillary to an
efficient transaction or not)
Topco is a cooperative association of approximately 25 small to medium size regional supermarket chains that operate in 33
states. The cooperative created a new private label product line that aided Topco members in competing with large grocery
chains. The agreement was challenged because it restricted competition among members by limiting each to selling Topco
products in a designated territory.
Territorial limitation among competitors can produce anticompetitive effects because, since there is no other competitor within the
area designated to a single company (which is large enough to impede consumers from driving to the next company), the
companies will take advantage of being the only supplier in that area, charging high prices at a low quality. In fact, the practice
can generate even worse results compared to price-fixing because it will eliminate not only price competition but also non-price
competition.
But in this case, the horizontal territorial limitation is not a naked restraint of trade, but a restraint ancillary to the creation of a new
private label product line which can bring procompetitive effects. Topco argued that the territorial limitation is necessary to the
creation and success of Topco’s brand because by this way the problem of free riders is avoided. A free rider is someone who
takes advantage of an investment made by another without incurring in any costs. If the companies were allowed to enter into
each other’s territory, they would take advantage of the advertising made in that area by one of Topco’s members without
incurring in any advertisement costs. The result would be all of the members trying to take advantage of the advertisement already
made in other areas, without incentives to invest in their own advertisement of Topco’s brand. Therefore, Topco alleged that the
territorial limitations are essential to create incentives for the members to invest in advertisement within their respective areas and
to promote the success of the new brand.
The court rejected Topco’s defense on the grounds that “horizontal territorial limitations are naked restraints of trade with no
purpose except stifling competition”. The dissenting vote, however, considered the agreement as being ancillary to the creation of
the new product line as argued by the defendants and not a naked restraint of trade. Any restraint which offers a combination of
transactions is more likely to produce procompetitive effects and, therefore, should be analyzed under the rule of reason (do the
possible procompetitive effects outweigh the possible anticompetitive harms?).

Broadcast Music v. Columbia (Offering a “new product” which promotes substantial lowering of costs can justify an agreement
interfering with price)
ASCAP and BMI issued blanked licenses to copyrighted musical compositions at fees negotiated by them. Even though the
agreement between ASCAP and BMI involved price fixing (they couldn’t offer the product without establishing the price to be
charged) the court declined to adopt the per se illegality of price fixing. The court argued that “it is not a simple question of
determining whether two or more potential competitors have literally “fixed” a “price”. Literalness is overly simplistic and often
overbroad. When two partners set the price of their goods or services they are literally “price fixing”, but they are not per se in
violation of the Sherman Act.” Instead, the court considered the potential procompetitive effects of the blanked licenses as an
efficient mechanism to promote cost savings, both to buyers and to copyright owners. Direct negotiation with each individual
composer and publisher could represent excessive costs and make such transactions impracticable, especially for other buyers
less powerful than the plaintiff. Therefore, the blanked license might offer an attractive alternative for those consumers who want
to avoid the costs of negotiating directly with each copyright owner. Moreover, the blanked license allows copyright owners a
reliable method of collecting for the use of their copyrights, as compared to individual sales transactions which require expensive
costs of monitoring the use of the compositions. The necessary consequence of the creation of a blanket license was that its price
has to be agreed between ASCAP and BMI. Nevertheless, the court declined to consider the blanked license a “naked restraint
of trade with no purpose except stifling of competition, but rather accompanies the integration of sales, monitoring, and
enforcement against unauthorized copyright use” and found the practice justified because it might serve a “market need”.

Arizona v. Maricopa County Medical Society (Establishment of maximum prices produce the same anticompetitive effects as
minimum prices and shall be condemned under the per se rule)
The Maricopa foundation establishes the schedule of maximum fees that participating doctors agree to accept as payment in full
for services performed for patients insured under plans approved by the foundation. The question in this case was whether the
agreement to fix a maximum fee among competitors is also condemnable at face.
“Our decisions foreclose the argument that the agreements at issue escape per se condemnation because they are horizontal and
fix maximum prices. Kiefer-Stewart and Albrecht place horizontal agreements to fix maximum prices on the same legal – even if
not economic –footing as agreements to fix minimum or uniform prices”.
What is the potential harm of the establishment of a maximum price among sellers?
The category “maximum price” can be a way to disguise minimum price schemes because the members into the agreement will
foresee that the competitors will charge the maximum price and, if all of the competitors charge the maximum price, none of them
ends up loosing costumers and all can enjoy prices above competitive levels. The second problem is that the maximum price
impedes suppliers from offering higher quality products, develop innovations and charge elevated prices compatible with their
higher cost structure. Therefore, the agreement to fix maximum prices also has to be governed under the per se rule.
There are at least two significant differences between this case and Broadcast Music. The first one is that the “insurance
administrator” does not provide the same cost savings as does the “blanked license”. It is easier for the insurance companies to
negotiate individually with each doctor than for the buyers of copyrighted compositions to negotiate with each copyright owner.
The insurance companies represent a powerful industry in the economy and they are able to negotiate with doctors through there
many channels and agencies. Moreover, even if we assume that the “insurance administrator” is an efficient mechanism of cost
savings, it does not follow that the fee schedule must be set by competing doctors. As opposed to Broadcast Music where the
“necessary consequence” of the creation of the blanked license was that its price had to be established, the insurance program is
perfectly feasible if the fee schedule were set in a different way, such as being prescribed by a state agency.

National Society of Professional Engineers v. United States (Price restrictions (refusal to discuss price) cannot be justified on the
grounds that they are necessary to promote higher quality products and increase safety because competition is presumably the
best way of achieving such results)
The Engineers Association prohibits competitive bidding by its members, that is, the engineers are precluded from responding for
request for bids. This practice results in anticompetitive harms since it discourage price competition among engineers, who cannot
disseminate their services based on prices. With no dissemination of prices of engineer services, the consumers are not aware of
the lower prices and cannot select the service based on a cheaper offer. The Association contends that precluding consumers
from selecting engineer services on the basis of a lower price would lead to superior engineer work which, in turn, advances the
public safety.
The court rejects their argument alleging that the defendants are trying to demonstrate that competition among professional
engineers was contrary to the public interest and should be eliminated, but this discussion of whether competition promotes or not
the public interest is not opened. It is assumed that competition will not only produce lower prices, but also better quality, service,
safety and durability. So even if the engineer offers a service at a lower price this doesn’t necessarily means that it will be a lower
quality product (in a free market the consumers will also look for high quality products and not only low prices). “The assumption
that competition is the best method of allocating resources in a free market recognizes that all elements of a bargain – quality,
service, safety, and durability – and not just the immediate cost, are favorably affected by the free opportunity to select among
alternative offers”.
Moreover, even if we assume that in this particular market there is some risk that competitiveness will lead to lower quality
engineer services which are dangerous to society, there are less restrictive methods of assuring safety. There could be
government regulation to guarantee that engineers service respect minimum safety requirements in order to protect the public
interest (for example: a bridge can only be constructed with the use of specific materials, within a minimum time of work, etc)
what would conciliate the necessity of increasing safety without discouraging price competition.

Case analyzed in class (page 173 (e) from the casebook)

Fifteen elite universities decide that in order to preserve a need-blind admission policy, no school should be able to attract
qualified, but non-needy students through merit scholarship or other forms of financial aid. The schools defend their agreement on
the grounds that it serves the social goal of providing a better education to a broader group of students. Lawful?
The potential harms are that, with no competition between the universities to attract better students through merit scholarship, the
high quality students won’t be able to take advantage of schools competing in financial aid in order to maintain their reputation of
having the best students (the schools can be seen as buyers and the students as sellers). This practice doesn’t fall in the category
of the per se rule because it is not a price-fixing, a territorial limitation neither an output restriction, so the next step is to analyze
the benefits of such practice and weight them with the costs.
The benefits would be that the universities would have incentives to attract good students in different manners besides merit
scholarship, such as offering high quality professors, a larger range of courses available to the students, clinical programs and
researching groups. By stimulating this kind of competition among the universities the whole “market of education” would be in a
better position and even the good students who were apparently injured with such a restriction will be better off. This doesn’t
mean that the universities didn’t compete in relation to improve their “intellectual offers” before the restriction, but with no merit
scholarship this kind of competition could be enhanced since it is now the only method that universities have to attract good
students.
Under National Society of Professional Engineers, this argument wouldn’t be accepted because it insists in the argument that
eliminating price competition would increase competition in other areas such as quality, safety and innovation, advancing the
public interest. “The Rule of reason does not support a defense based on the assumption that competition itself is unreasonable”.
Engineers. On the other hand, on California Dental Association it was held that the suppression of advertisement, which is clearly
a way to promote competition, was regarded as a procompetitive practice because it assures accurate information to the
consumers.

National Collegiate Athletic Association v. Board of Regents of the University of Oklahoma (The defense that output restrictions
are necessary to preserve the integrity of the product which is being market is not a proper defense because it challenges the
presumption that competitiveness is the best way to serve the consumer’s interests)
The NCAA adopted a plan for televising college football games. The plan provided that “all forms of television of the football
games of NCAA member institutions during the Plan control periods shall be in accordance with this Plan. NCAA and its
members seek to preserve the character and quality of the “product” (college football games) by establishing a myriad of rules
affecting such matters as the size of the field, the number of players on a team, the extent to which physical violence is to be
encouraged or proscribed and the integrity of athletes (must not be paid and must be required to attend class). NCAA and its
regulations, however, involve restraint on the ability of member institutions to compete in terms of price and output. The District
court found that if member institutions were free to sell television rights, many more games would be shown on television, and that
the NCAA’s output restriction has the effect of raising the price the networks pay for television rights.
The defendants first argue that its television plan can have no significant anticompetitive effect since the record indicates that it has
no market power. The court rejected this defense alleging that “We have never required proof of market power in such a case.
This naked restraint on price and output requires some competitive justification even in the absence of a detailed market
analysis”.
The second defense brought by NCAA to justify its television plan is that it plays a critical role in the maintenance of a revered
tradition of amateurism in college sports. In performing this role, its actions advance the ultimate consumer’s interest by assuring
that college football games will maintain its tradition as an ethical, healthy and decent sport. The court declines to accept such
defense as a procompetitive justification arguing that “By seeking to insulate live tickets sales from the full spectrum of
competition because of its assumption that the products itself is insufficiently attractive to consumers, petitioners forwards a
justification that is inconsistent with the basic policy of the Sherman Act.” The court cited Engineers “The Rule of Reason does
not support a defense based on the assumption that competition itself is unreasonable”.
The dissenting vote distinguished this case from Engineers because it presented important noncommercial dimensions. The
NCAA’s limitations were justified by their need to maintain competition in an amateur context. In addition, the dissenters believed
that output, as measured by total viewers, rather than by games telecast, could increase.

California Dental Association v. Federal Trade Commission (Advertising restrictions arguably protecting patients from misleading
or irrelevant advertising call for more than cursory treatment as obviously comparable to classic horizontal agreements to limit
output or price competition)
The California Dental Association (CDA) imposed a restriction on two types of advertising: price advertising and advertising
related to the quality of dental services. The CDA argues that these restrictions were designed to avoid false or deceptive
advertising in a market characterized by striking disparities between the information available to the professional and the patient.
The Association contends that the advertisement restrictions are necessary in the context of asymmetrical information between
buyers and sellers. Such restrictions, however, make it more difficult for a dentist to inform consumers that he charges a lower
price. That fact, in turn, makes it less likely that a dentist will obtain more customers by offering lower prices, discouraging price
competition among them.
Therefore, the question before the court was whether the hams associated with less price competition can be outweighed by the
gains of accurate information to consumers. The Court of Appeals decided that suppressing all advertisements, regardless to
whether they were in fact false or misleading, would also eliminate true advertisements which could enhance competition and,
therefore, was per se illegal. But the Supreme Court concluded that the case deserved further analysis because, although the
restriction will affect price and output by suppressing true advertisements, the defense of eliminating false information in a market
characterized by asymmetrical information is at least plausible. “The question is not whether the universe of possible
advertisements has been limited (as assuredly it has), but whether the limitation on advertisements obviously tends to limit the total
delivery of dental services”. Indeed, even if discount advertisements were more effective in drawing customers in the short-run,
the recurrence of some measure of intentional or accidental misstatement might make potential patients skeptical of any such
advertisement over time. Patients would not be able to distinguish misleading and true advertisements and the result would be the
discredit in relation to the dental industry as a whole. Finally the court concluded that “As the circumstances here demonstrate,
there is generally no categorical line to be drawn between restraints that give rise to an intuitively obvious inference of
anticompetitive effect and those that call for more detailed treatment…Advertising restrictions arguably protecting patients from
misleading or irrelevant advertising call for more than cursory treatment as obviously comparable to classic horizontal agreements
to limit output or price competition”.
The dissenting vote argued that even if the court assumes that this case is not a candidate for the per se illegality, it should be
condemned because the defendants haven’t met the burden of showing redeeming virtues. When practice falls out of the
established per se illegal practices (price-fixing, territorial restraints or output restrictions), the court should break the analysis into
four classical questions: (1) What is the specific restraint at issue? (2) What are its likely anticompetitive effects? (3) Are there
offsetting procompetitive justifications? (4) Do the parties have sufficient market power to make a difference? In addressing these
questions the court concluded that (1) The Commission has shown that the restriction has anticompetitive tendencies; (2) The
Association has not shown offsetting virtues; (3) The Commission has shown market power sufficient to make a difference.
In fact, even if accurate information is considered a plausible defense, couldn’t the problem of false advertisement be solved in a
different way without affecting price and output? Is the California Dental Association the appropriate entity to control the
advertising? One could argue that there is an evident conflict of interest because the Association could be using the “accurate
information” defense as an excuse to effectuate a plan to discourage price competition among dentists. If there is a real need for
advertisement control, it should be exercised by a state agency (FTC, for example) or by the government of California itself,
which could impose penalties on clinics disseminating false advertisement.

Summary

Cases condemning the defendant:

United States v. Trans-Missouri Freight Assn
United States v. Addyston Pipe & Steel Co. - - - (provide defenses for restraints of trade)
United States v. Joint Traffic Assn
Standard Oil Co v. United States - - - - - - - - - - (provide defenses for restraints of trade)
United States v. Trenton Potteries
United States v. Socony-Vacuum Oil Co
United States v. Topco Associates
Arizona v. Maricopa County Medical Society
National Society of Professional Engineers v. United States

Cases exonerating the defendant:

Chicago Board of Trade v. United States
Appalachian Coals v. United States
Broadcast Music v. Columbia
California Dental Association v. Federal Trade Commission

While analyzing the cases we should have in mind 6 questions:

1) What is the specific restraint at issue?
2) Does it fall into the category of a per se violation?
3) What are its anticompetitive effects?
4) Do the parties have sufficient market power in the relevant market to make a difference?
5) Are there offsetting procompetitive justifications?
6) Is there any other way these procompetitive effects can be reached without harms?

Per se Rule X Rule of Reason

“Agreements or practices which because of their pernicious effect on competition and lack of any redeeming virtue are
conclusively presumed to be unreasonable and therefore illegal without elaborate inquiry as to the precise harm they have caused
or the business excuse for their use”. Northern Pacific.
The decision to apply the per se rule turns on “whether the practice facially appears to be one that would always or almost
always tend to restrict competition and decrease output… or instead one designed to increase economic efficiency and render
markets more, rather than less, competitive”. BMI.
“There are two complementary categories of antitrust analysis. In the first category are agreements whose nature and necessary
effect are so plainly anticompetitive that no elaborate study of the industry is needed to establish their illegality – they are “illegal
per se”. In the second category are agreements whose competitive effect can only be evaluated by analyzing the facts peculiar to
the business, the history of the restraint, and the reasons why it was imposed”. Engineers.

Sherman Act # 1 (horizontal or vertical agreements in restraint of trade)

Agreements between two competitors:

- To fix minimum prices – per se illegal (Socony)
- To fix maximum prices – per se illegal (Arizona)
- To fix territorial restraints – per se illegal (Topco)
- To fix prices as a necessary consequence of offering a product – rule of reason (BMI)

Traditionally, the courts have treated price-fixing among competitors as a per se violation of the Sherman Act # 1. In its famous
footnote 59, it was stated that any price fixing violates Sherman Act # 1 “though no overt act is shown, though it is not
established that conspirators had the means available for accomplishing of their objective, and though the conspiracy embraced
but a part of the interstate or foreign commerce in the commodity”. In BMI, however, the court declined to adopt the per se rule
to condemn an agreement between ASCAP and BMI to offer blanked licenses. Instead of applying the traditional per se illegality
just because the competitors had to establish jointly a price for the product being offered, the court considered the potential
procompetitive effects of the product launched in the market and concluded that the redeeming virtues outweighed the
anticompetitive harms.
It seems that in BMI’s decision the court have narrowed Socony’s holding to “naked price-fixing”, thereby excluding from the
per se illegality agreements which involve a combination of elements besides price. NCAA is a second example of the court’s
denial to adopt a per se illegality to agreements between competitors which restricts output in order to preserve the integrity of
the product being market. “We recognized in NCAA that per se treatment of the NCAA’s restrictions on the marketing of
televised college football was inappropriate – despite the obvious restraint on output – because the case involves an industry in
which horizontal restraints on competition are essential if the product is to be available at all”. Northwest Wholesale Stationers v.
Pacific Stationery & Printing Co. Even though in NCAA the court rejected the defense that the output restriction was necessary
to advance the consumer’s welfare (because it relied in Engineer’s holding that competition is always the best way to serve
consumers), it did so under a “Rule of Reason” analysis.
From this two cases, it can be concluded that the courts have stepped back from a “per se illegality” of agreements interfering
with price or output when it is not clear whether the agreement between competitors is in fact anticompetitive, or if, instead, it
may serve the ultimate end of competition (advance consumers welfare) by providing a product which wouldn’t be otherwise
available.
The questions that become relevant under a rule of reason analysis are whether there are offsetting procompetitive justifications
and if so, whether they can be achieved through less restrictive means.

Agreements between all competitors through a structured Association

- Promote safety and quality by restricting price bids – illegal (Engineers)
- Promote education by restricting merit scholarships – rule of reason (Hypothetical)
- Promote integrity of sports by restricting output – illegal (NCAA)
- Promote accurate information by restricting advertisements – rule of reason (CDA)

In Engineers’ the court refused to accept the defense that an agreement among engineers to preclude them from making bids to
sell their services was necessary to avoid low quality engineering services and protect the public’s safety. “The assumption that
competition is the best method of allocating resources in a free market recognizes that all elements of a bargain – quality, service,
safety, and durability – and not just the immediate cost, are favorably affected by the free opportunity to select among alternative
offers”. Engineers.
Similarly, the court argued in NCAA that an Association that restricted output alleging that its actions advanced the ultimate
consumer’s interest by assuring that college football games will maintain its tradition as an ethical sport, violates the presumption
that competition is always the best way to serve the consumers welfare. “By seeking to insulate live tickets sales from the full
spectrum of competition because of its assumption that the products itself is insufficiently attractive to consumers, petitioners
forwards a justification that is inconsistent with the basic policy of the Sherman Act”. NCAA.
The question that arises is whether Engineer’s presumption that competition is always the best way to serve the consumers
interest and NCAA’s holding condemning a Association which restricts output to preserve the integrity of the product, should
prevail in any situation where there is an agreement among competitors which interferes with price or output in order to advance
other factor valued by the consumers. Indeed, a practice that apparently restricts output and disadvantages the consumer may
have the opposite effect. The court recognized potential procompetitive justifications caused by a practice that apparently
restricted competition in CDA. From the holding in CDA it follows that the relevant inquiry is not whether the restriction imposed
by the Association interferes with output or price in the short-term, but rather if the restriction serves a legitimate propose that can
advance competition in the long-run. See also FOGA and Molinas in “Concerted refusal to deal”.

Joint Venture

The expression joint venture can be used to refer to any integration between two or more people (or companies) combined to a
lawful purpose. Most commonly, it is used when two separate business gather together to perform a single function. It can also
be used to designate any corporate form (GP, LLP, LLC and Corporations). The connection of two separate businesses into
one can lead to anticompetitive effects since the combined entity might have enough market power to buy and sell goods and
services at monopoly prices, but can also generate procompetitive effects, such as producing or buying in economy of scales
levels (high quantity which dilutes the costs). These effects have to be balanced in order to conclude if the joint venture is
desirable or not from an antitrust perspective.

Case analyzed in class (page 198 (225) from the casebook)

Four hospitals, disappointed with their purchasing department, combine to form a “Super Supplier”, which will be their joint
purchasing agent. It will choose products and bargain for the best prices on behalf of the member hospitals as a whole. Under
Socony, it would be hard to defend the agreement because the joint venture will necessarily have to establish a single price while
running the business. However, the court has already decided that “the pricing decisions of a legitimate joint venture do not fall
within the narrow category of activity that is per se unlawful under Sherman Act # 1” (Texaco v. Dagher) arguing that “the firms
are not anymore competing with one another in the same relevant market, but instead participating in that market jointly through
their investments in the venture”. Although the joint venture may fix the price in a literal sense (its part of the business), its not
price fixing in the antitrust sense, in the same way that “when two partners set the price of their goods or services they are literally
“price-fixing”, but they are not per se in violation of the Sherman Act”. Broadcast Music Inc. v. Columbia Broadcasting System
Inc. Rather than applying the per se rule to condemn joint ventures in a quick analysis, it is more appropriate to apply the rule of
reason in order to consider and balance the procompetitive efficiencies with the anticompetitive harms. The idea is to demonstrate
that, even though the number of buyers will be reduced, the efficiencies promoted will lead to better results in output and costs.

In this case, the efficiencies which can be identified are (i) the ability to hire a skillful purchaser who will carry out business with
know-how and cost saving techniques; (ii) the capacity to buy a large amount at once and take advantage of economy of scales
(lower prices but without prejudice to the supplier because the amount sold will be greater); and (iii) concentration of duties such
as handle payments, hire employees and negotiations in a single agent will lead to savings of time and costs.

Therefore, the court should weight efficiencies benefits (if the hospitals are saving costs and time they can provide costumers with
better services and guarantee the hospital will be better equipped with medical resources) with anticompetitive harms (capacity to
depress prices) and conclude what are the probable results.

It is important to note that an analysis of market power is essential to verify the real possibilities of anticompetitive harms. The
question that has to be asked is whether the market share of the joint venture in the relevant market is high enough to impose
monopoly prices without loosing consumers/suppliers? The first step is to identify the relevant market in terms of geographic
conditions (national or local, depending on the capacity of consumers/suppliers to reach distant locations) and product conditions
(depending if there are substitute products to satisfy the willingness of consumers). The second step is to calculate the
participation of the joint venture in the relevant market (sum of the participation of each member). Accordingly to the guidelines
established by the Department of Justice and Federal Trade Commission, joint purchasing arrangements are in the safety zone if
(i) the purchases account for less than 35% of the total sales of the purchased products and services in the relevant market; and
(ii) the cost of the products and services purchased jointly accounts for less than 20% of the total revenues of the competing
participants. It should also be considered the possibility of new entrants in the event of a price increase. In these cases the joint
venture is in the “safety zone” because the capacity to impose monopoly price is low and the competitiveness of the market is
protected. The guidelines are not binding and do not prevent private suits against joint venture even if they are in the “safety
zone”, but it is likely that judges will follow regulations established by public agencies specialized in antitrust subjects, rather than
applying their own view.

Texaco v. Dagher (Joint ventures do not fall within the narrow category of activity that is per se unlawful)
Texaco and Shell Oil formed a joint venture, Equilon, to consolidate their operations, thereby ending competition between the
two companies in the domestic refining and marketing of gasoline. As a natural consequence of the business, the joint venture
would have to price its own products. The joint venture was challenged under a per se violation of the Sherman Act, as a
horizontal price-fixing arrangement. The court denied a per se treatment alleging that it is not a price-fixing agreement among
competitors because Texaco and Shell Oil did not compete anymore with one another in the relevant market, but instead
participated in that market jointly through their investments in Equilon. It was argued that, “As a single entity, a joint venture, like
any other firm, must have the discretion to determine the prices of the products that it sells, including the discretion to sell a
product under two different brands at a single, unified price”. It follows that a joint venture could be challenged only under a rule
of reason, which requires a more deep analysis concerning the benefits and harms to competition.

Labor Unions
The antitrust immunity of employees to joint together and agree in minimum wages rests on a countervailing argument to face the
powerful bargaining position the employers generally have.

Research and Development (R&D)

There are some particularities of the research and development field that should be taken in consideration when analyzing the
competitive efficiencies and harms of the joint venture. First of all, the activity of research and development is always costly and
its results are uncertain, what characterizes the activity as a high-risk one. When the activity is performed by two or more firms,
the risks are spread and the incentives to invest rise. In addition, and most importantly, when there are two or more laboratories
exploring the same research, there is a waste of time and money, placing all the participants and also the society as a whole in a
worse position. If there was a single laboratory it could allocate resources in an efficient manner as to support a variety of
researches and innovations instead of applying them in the same project.
On the other hand, the problem of allowing all the laboratories to joint and eliminate competition between them is that investments
may be under optimal levels. Competition creates incentives for the firms to allocate a large amount of resources in R&D in order
to have the most modern products and advanced innovations.
How could the benefits of a combined laboratory be extracted without eliminating the desirable competition? An easy solution
would be to allow concentration between some laboratories which would compete with a concentration of different laboratories,
and so on.

Market Power

A market power inquiry must be effectuated to determine the defendant’s capacity to impact prices and output. Hardly a naked
restraint to fix price could be justified on the basis of lack of market power (as held in United States v. Socony-Vacuum Oil Co),
but other kinds of agreements which promises procompetitive effects could be defensible through this argument. The reason is
simple: where an agreement is established between firms which represent 10% of the relevant market, an eventual price increase
wouldn’t cause harms because consumers would have the option of buying from another seller. But there is no bright line to
determine what constitutes a significant market power. It will depend not only in the actual share participation of each firm
involved in the agreement, but also in the barriers of entry in that market and also in the capacity of the other competitors to
expand output. Thus, even if the firms have high share participation, this can be insignificant if the market has low barriers to entry
or no barriers at all or if the other competitors are able to expand capacity.

When does a Horizontal Agreement Exists?

The Sherman Act # 1 is structured to condemn every contract, combination or conspiracy in restraint of trade. But the question
that arises is whether it is necessary an explicit agreement to condemn or could the court infer an agreement by the competitors’
behavior. In some situations, particularly when there are only a few competitors in the market (oligopoly), the firms can recognize
their interdependence and coordinate their acts in order to enjoy monopoly prices.
Oligopolistic behavior is achieved when the competitors can coordinate price simply by following the actions undertaken by other
firms in the market. Usually, one of the firms in the market (called the “leader”) starts pushing up the price with the expectation
that the competitors will follow the increase. The competitors, even though they would be individually in a better position by
maintaining the lower price to capture consumers, will understand the leader’s behavior as an invitation for all the firms in the
market to increase price. If one of the firms rejects the invitation, the leading firm will rapidly reduce her price back to its original
level (to bring back her consumers) and all of them will be in a worse position compared to the situation where all the competitors
followed the leader and were able to charge higher prices. The rational firms will foresee these results and perceive the necessity
of a coordinated behavior to achieve a better situation for all of them. This interdependence relationship, when successful, can
substitute express communication to achieve monopoly results.
There are, however, some factors which limit the ability of an oligopoly to coordinate prices. First, the oligopolistic competitors
may differ in their costs of production and may be willing to charge different market price. Also, the products offered by each of
them may differ in quality, making it harder to establish a single price to all of them. Without meetings and discussions it might be
hard (or impossible) to reach a consensual price which satisfies all the participants to the implicit agreement. It follows that
oligopolistic behavior may be facilitated by product or firm homogeneity. When firms have approximately the same size, the same
cost structure and produce standard products, it is easier to make a consensual decision. Moreover, oligopolistic behavior can be
facilitated when the transactions are large and infrequent. In this case there is a high temptation to cheat the implicit agreement
because the amount earned in a large transaction may compensate the risks of detection and the costs of reprisal.
Finally, there is a major restriction to a successful oligopolistic coordination: the difficulty of detecting “cheaters”. The greater is
the number of competitors in the market, the harder it is to detect those ones which are not following the price increase. “Small”
firms don’t believe their actions will have an impact in the market and they will try to take advantage of the coordination of bigger
firms by charging lower prices and capturing consumers. When the market becomes more concentrated the likelihood of
detection of cheaters and punishment (by returning to the original competitive price and even adopting strategies to drive the
cheater out of business) is enhanced. It follows that where market conditions are conducive to timely detection and punishment of
significant deviations, a firm will find it more profitable to adhere to the terms of the coordination than to pursue short-term profits
from deviating, given the costs of reprisal.
Even though oligopolistic behavior presents great danger to competition, courts have resisted attacking them. The reluctance to
condemn mutual coordination among competitors is justified because when there is no sign of actual communication it is hard to
conclude that firms are charging the same prices because they are participants in an implicit agreement. Firms may be charging the
same price because they have the same cost structure, for instance. They may increase prices not because they are following a
“firm leader” but because of changes on demand, changes on costs or changes on technology, which can reasonably justify their
conduct. Moreover, courts are conscious about the difficulties faced by firms to coordinate prices when there is no evidence of
communication between them, and they rely on these restrictions as a strong weapon against oligopolistic behavior. Bell Atlantic
Corp. v. Twombly.

Interstate Circuit v. United States (When concerted action is invited through a letter and the participants know that each of them
is aware of the invitation, no actual communication between them is necessary to infer a conspiracy).
The Distributors of movies business consists in licensing first, second and third runs of movies to the Exhibitors. What happed
was that one of the Exhibitors (Interstate and Consolidated) sent a letter to all of the distributors asking compliance with two
demands as a condition to continue exhibiting the distributors films: (i) the distributors should agree that the other exhibitors could
not charge less than 25 cents in subsequent runs of the movie licensed to Interstate and Consolidated; and (ii) the other exhibitors
cannot offer double features of a pictures licensed to Interstate and Consolidated. The objective was to make it worthwhile for
consumers to watch the first run in Interstate and Consolidated by making the subsequent runs in other exhibitors less favorable
(they won’t be any cheaper, neither presented in conjunction with another feature picture). The distributors adhered to the
proposal and the question before the court was whether any agreement between the distributors can be inferred. It is unknown
whether the distributors actually communicated with each other before accepting the Exhibitors proposal, but is express
communication required?
The court concluded that “It was enough that, knowing that concerted action was contemplated and invited, the distributors gave
their adherence to the scheme and participated in it. Each distributor was advised that the others were asked to participate; each
knew that cooperation was essential to successful operation of the plan”. What was determinant to reach this conclusion was that
the distributors didn’t have incentives to take this decision by themselves and were only encouraged to so because they knew that
the other distributors had received the same letter and would rationally think in the same way. If only one of the distributors had
imposed these restrictions, all the exhibitors would get licenses from the rest of distributors on the market, and that would be
against its self-interest. However, when all of them adhere to the proposal, the exhibitors don’t have any alternative, except for
accepting the restrictions.

Theater Enterprises v. Paramount Film Distributing Corp. (A conspiracy cannot be inferred when there is a rational explanation
for each of the market participants to undertake the conduct in question without regard to its competitor’s behavior)
In this case the distributors of movies license refused the petitioners request for first run licenses granted simultaneously to a
downtown theater. Petitioner had made the request separately to each distributor, and each of them rejected on the grounds that
simultaneous first-runs are normally granted only to noncompeting theaters, and the petitioner is in substantial competition with
downtown theaters. Petitioner argues that concerted action was undertaken by the distributors in violation of the Sherman Act.
The court decided that a mere parallel business behavior doesn’t indicate the formation of a conspiracy. The main distinction from
this case to Interstate Circuit v. United States is that here the competitors had a rational justification for making this decision,
without regard to the future actions of their competitors. “Conscious parallelism” has not yet read conspiracy out of the Sherman
Act”.

Bell Atlantic Corp. v. Twombly (Interdependence action without any evidence of an agreement is insufficient to condemn
because there can be a variety of market conditions capable of explaining the parallel conduct).
This case concerns a parallel conduct among firms in the telecommunication industry to provide service in an exclusive area,
without entering into the area of another competitor. The firms acted interdependently, that is, each of them had incentives to
remain within the limits of their territories because they knew that if they began offering service in a competitor’s area, this
competitor would probably react by adopting the same expansion, and competition would result between them in both areas in
which they used to have a monopoly. Thus, each of them preferred to “respect” the other’s territory in order to enjoy an
exclusive area and avoid competition. To verify if this is a tacit agreement, the relevant question that must be asked is whether
there is a reasonable explanation to stop the firms from entering in another area, besides a strategy to avoid competition through
an “implicit agreement”? The defendants tried to argue that they had the habit of serving their territory with their own costumers
and that it would be too costly to expand to other areas. But this explanation is not rational. If the firms are acting as rational
profit maximizers, like any other private enterprise, it is not coherent to remain in only one area when there is the possibility of
spreading output by offering service in other territories.
However, considering the difficulties of identifying all the possible explanations of the parallel conduct which are alternative to the
assumption that competitors are actually adherents to an implicit anticompetitive conspiracy, the court refused to find a violation
of the Sherman Act # 1. “The plaintiff must show that the inference of conspiracy is reasonable in light of the competing
inferences of independent action or collusive action”.

Case analyzed in class (page 225 (239) from the casebook)

There are thirty firms in the industry of electrical transformer. Every firm publishes a price list and every change in the price list
was initiated by Theta, the industry’s largest firm, and followed within a few days by all the other firms. Despite the similarity of
price, there is no evidence that these firms have ever written or spoken to each other. Is there a violation of Sherman’s Act?
Even though there isn’t any signal of express agreement it is clear that the firms are acting interdependently by observing Theta’s
price increase and concluding that it is on their best interest to follow the action. The result will be a stabilized price at a higher
level (same harms caused by an express agreement to fix prices).
However, when there is no sign of communication between the firms, it is hard to condemn oligopolistic coordination because of
the difficulties to identify the real reasons of the conduct. There are a large range of possible explanations to the change on price,
such as changes on demand, changes on costs or changes on technology, which can reasonably justify the conduct. The question
that remains is: if interdependent behavior by itself is not enough to punish, how many evidence is required to infer a tacit
agreement?

Matsushita Electric Industrial Co. v. Zenith Radio Corp (There can be many other reasons to justify the uniform conduct and the
burden of proof rests with the Plaintiff)
The plaintiffs, U.S. television manufactures, alleged that their Japanese rivals had conspired to charge unduly low prices in the
United States in order to drive American companies out of business. The Supreme Court held that a plausible reason to conspire
is not enough to infer conspiracy, since there can be many other plausible reasons to justify the conduct which are consistent with
permissible competition. It follows that the plaintiff has the burden of proving that the there is no other rational explanation to
justify the uniform conduct except for stifling competition.

Facilitating Practices

It was noted that the courts are unwilling to condemn mere interdependent behavior if no evidence of an actual agreement is
presented. But there are some business practices that can facilitate oligopolistic pricing or mitigate non-pricing competition.
Oligopolistic pricing without an express agreement will hardly be achieved when the products differ in quality because it is difficult
to reach a consensual price for different products (some firms will have more costs to produce higher quality goods and,
therefore, will be willing to charge higher prices as compared to other competitors). But when the firms are informed about the
details of each other’s products, they can offer the same goods and services in order to be able to charge the same price.
Therefore, these practices can generate potential harms to competition, such as making it easier for competitors to form a cartel
or to engage in oligopolistic behavior by increasing the homogeneity of interests among competitors. Moreover, the circulation of
lists makes it easier to identify an eventual “cartel-cheater”, because information about each of them related to past sales,
revenues earned in different periods and price charged during these periods will be revealed.
Generally, the justification for disseminating information about the product is to provide a “comparative shopping” for consumers,
who will be in a better position to choose while being conscious of the advantages and disadvantages of each product. A second
defense is that the circulation of lists will in fact stimulate competition because when prices are revealed to each other there is an
incentive to cut prices slightly to capture a larger portion of consumers.

Why should we condemn practices that facilitate oligopolistic behavior if the courts have already decided that oligopolistic
behavior by itself is not illegal?
The reason why courts are still not attacking interdependent conduct without any evidence of an agreement rests on the difficulties
to identify all the possible explanations to justify the conduct, such as changes in demand, in costs of production or in technology,
making it hard to conclude whether the defendants are actually working together to deprive competition. But this doesn’t mean
that oligopolistic behavior is desirable or that the court shouldn’t pay any attention to the practices which make it easier for
competitors to engage in oligopolistic behavior. Once it is ascertained that the practice has the power of facilitating oligopolistic
behavior, it is necessary to make a comparative analysis between the positive and negative effects generated by the “facilitating
practice”.

American Column & Lumber Co. v. United States (The Exchange of information was considered harmful to competition because
of its capacity to facilitate oligopolistic behavior)
The Association Manager of Statistic included 400 members with the purpose of exchanging information among them basically
related to:
- Past sales
- Products characteristics
- Current price lists
- Inventory of stock
- Future output
- Market conditions (future demand and supply)
Each of this information represents a particular danger to competition. Past sales can help to identify an eventual “cartel-cheater”
or, at least, the firm which is not following the oligopolistic behavior (considering there is no express cartel agreement), because it
demonstrates if one of the members had a sudden increase in output (probably it offered lower prices!). Disclosure about
products characteristics helps to homogenize the production in order to facilitate members to reach a consensus about the price
to be charged. Current price list and conversations about future output obviously helps to fix price and control output since all of
them know how much each other is charging and is induced to charge the same (not more because the costumers would buy
from the competitor and not less because each firm knows that if it charges less the competitor will notice and charge even less,
and price competition would be stimulated, with prejudice to all of them).
Therefore, because of the nature of the information exchanged and its capacity to deprive competition by allowing members to
engage in oligopolistic behavior, the court condemned the Association. “Genuine competitors do not make daily, weekly, and
monthly reports of the minutest details of their business to their rivals, as the defendants did…This is not the conduct of
competitors but it is so clearly that of men united in an agreement, express or implied, to act together and pursue a common
purpose under a common guide…”.

Maple Flooring Manufactures Assn. v. United States (The information exchanged wasn’t so hazardous to competition and was
permitted)
In this case the information exchanged was less hazardous then in American Column & Lumber Co., particularly because there
was no exchange related to current price lists and future output. These were the information exchanged among 22 members of
the Association:
- Average costs
- Sales (in aggregate numbers)
- Basing Point Pricing
- Inventories of stock
The arguments the court found to release the defendant in this case were: (i) the nature of the information exchanged was less
“sensitive” to the extent that it wasn’t so easy for the members to calculate the price actually charged by each of them and,
subsequently, form a tacit agreement fixing price; (ii) the statistics acquired by the Association was given wide publicity through
journals, making it reasonable to argue that the Association provided the consumers with a “comparative shopping”, that is, being
able to evaluate each seller and choose within them; and (iii) there was evidence that the price is stabilized for a long period,
demonstrating the unlikelihood of a tacit agreement to raise prices (note that this evidence is not so significant because the price
could have decreased, as a result of a demand reduction for example, but remained the same because of the oligopolistic
behavior). “We decide only that trade association or combinations of persons or corporations which openly and fairly gather and
disseminate information as to the cost of their product, the volume of production…and who, meet and discuss such information
and statistics without however reaching or attempting to reach any agreement or any concerted action with respect to prices or
production or restraining competition, do not thereby engage in unlawful restraint of commerce”.

Three other important factors should be considered:

- Number of members associated: when there is a large quantity it is harder to monitor the oligopolistic behavior and, therefore,
the facilitating practice can be less harmful. This is because the probability of reaching a consensus about price or output is
reduced and the probability of one member cheating the tacit agreement is increased.
- Share participation of all the members together in the relevant market: if all the members jointly represent a minor share of the
market, even if the exchange of information actually facilitate the oligopolistic behavior, they will not have enough power to affect
the price because the other competitors who are excluded from the scheme would offer lower prices to consumers.
- Whether the members have agreed to the facilitating practice in question. If there is an express agreement to circulate a list, for
instance, then it is possible to use # 1 on the grounds that the agreement to circulate a list will facilitate oligopolistic behavior and,
therefore, will restraint trade.

United States v. Container Corp. of America (The practice was condemned on the grounds of the nature of the information
exchanged (current price) and the fact that the members represented a high market share in the relevant market)
The court condemned the practice on the grounds that the information exchanged was based on current price (the most sensitive
information to facilitate oligopolistic behavior) and also that the members represented 90% of the market. “The inferences are
irresistible that the exchange of price information has had an anticompetitive effect in the industry, chilling the vigor of price
competition”.
But the dissenting vote argued that, although the defendants represented 90% of the market, the ease of entry would dismiss the
danger of any artificial price scheme because potential entrants would actually enter into the market to offer products at a lower
price. The easy entry will preclude the members from raising price above competitive levels. “I do not think it can be concluded
that this particular market is sufficiently oligopolistic, especially in light of the ease of entry, to justify the inference that price
information will necessarily be used to stabilize prices”.

Basing Point Pricing (facilitating practice)

As opposed to the FBO, where the consumer has to transport the product bought on his own, the Basing point is a system where
the seller offers a delivery service which departures from one of its production base (and it is always this same base) and arrives
in the costumer’s desired local. This practice helps the other sellers to calculate the actual price charged by one firm because
once it is determined a unique “departure base” it is simple to verify the price of the freight to each local (which varies accordingly
to the distance) separately from the price of the product itself. If all of the competitors adopts the same base point they can easily
reach a standardized price throughout the country. If there were many departure bases it would be much harder to implicitly
agree in a uniform price because some base points would be closer to the destiny point and, thus, could justify a lower freight
price, making it difficult to reach uniform prices.

Federal Trade Commission v. Cement Institute (Basing point pricing is condemnable even without an express agreement – under
FTC Act # 5)
The defendants used the basing point pricing system but there was no evidence that they had agreed to do so. Thus, the court
was unable to condemn under Sherman Act # 1 (no evidence of conspiracy) and also under Sherman Act # 2 (no monopoly).
The solution found was to condemn the practice under the Federal Trade Commission Act # 5, which uses a very broad term
“unfair method of competition”. The court upheld the decision of the FTC to condemn the basing point delivered price system
under the FTC Act # 5 but it made it clear that the element “combination” is an indispensable requirement of “unfair method of
competition”. The purpose was to condemn a practice that clearly deprived competition and made oligopolistic behavior possible
throughout the whole country with a less rigorous standard than the “conspiracy” requirement from the Sherman Act. It should be
noted that the FTC # 5 has a less rigorous standard in relation to the “conspiracy” requirement (it requires something more like an
“understanding”), but the remedies that can be granted under the FTC are limited (there are no treble damages for example).
“The Commission was authorized to find understanding, express or implied, from evidence that the industry’s Institute actively
worked, in cooperation with various of its members, to maintain the multiple basing point delivered price system; that this pricing
system is calculated to produce, and has produced, uniform prices and terms of sales throughout the country; and that all of the
respondents have sold their cement substantially in accord with the pattern required by the multiple basing point system”.

Summary

Cases condemning the defendant:

Interstate Circuit v. United States
American Column & Lumber Co. v. United States
United States v. Container Corp. of America
Federal Trade Commission v. Cement Institute

Cases exonerating the defendant:

Theater Enterprises v. Paramount Film Distributing Corp.
Bell Atlantic Corp. v. Twombly
Matsushita Electric Industrial Co. v. Zenith Radio Corp
Maple Flooring Manufactures Assn. v. United States

Intraenterprise Conspiracy

Sherman Act # 1 refers to contracts, combination or conspiracy in restraint of trade and the issue here is whether a parent and its
wholly owned subsidiary can conspire with each other. It is clear that there is no conspiracy within the same firm, such as the
board of directors fixing price with shareholders or partners fixing price of the products sold in a partnership, but the question is
“can a parent and its wholly owned subsidiary be considered a single enterprise for antitrust purpose”?
The first question is whether coordination between a parent and its subsidiary can be challenged under any of the antitrust
statutes. The Sherman Act # 1 only applies to two separate enterprises and it is doubtful whether a parent and its wholly owned
subsidiary can be regarded as two separate enterprises. The Sherman Act # 2 only applies when the defendant has enough
market power to characterize a monopoly. The Clayton Act # 7 could be used only at the time of the original acquisition or, if
there was no such acquisition, can’t be used at all. Therefore, if we assume that the parent and its subsidiary are a single entity for
antitrust purpose and that it doesn’t have enough market power to characterize a monopoly, they can coordinate their business
activities without violating any of the antitrust laws.

Copperweld Corp. v. Independence Tube Corp (Parent and its wholly owned subsidiary cannot conspire with each other).
The court argued that “A parent and its wholly owned subsidiary have a complete unity of interest. Their objectives are common,
not disparate; their general corporate actions are guided or determined not by two separate corporate consciousnesses, but one.
If a parent and a wholly owned subsidiary do “agree” to a course of action, there is no sudden joining of economic resources that
had previously served different interests, and there is no justification for # 1 scrutiny. A single firm, no matter what its corporate
structure may be, is not expected to compete with itself”. Considering that a parent and a subsidiary form a single entity,
coordination among them could only be challenged under # 2 of the Sherman Act, which is the appropriate provision to govern
unilateral conduct. The fact that the conduct can’t be challenged under # 2 in the absence of monopoly power is by no means a
reason to treat a single enterprise as two separate agents to permit application of # 1. Finally, the court concluded that such
coordination wasn’t proscribed by any of the antitrust laws and, even if we assume that there are anticompetitive dangers, an
eventual “gap in the legislation” is a problem for Congress to solve.
The dissenting vote emphasized the risk that a holding immunizing coordinated action between a parent and its wholly owned
subsidiary from antitrust liability may present. “Unilateral conduct by a firm with market power has no less anticompetitive
potential than conduct by a plurality of actors which generates or exploits the same power, and probably more, since the
unilateral actor avoids the policing problems faced by cartels. Where there is no agreement with a third party and when power is
insufficient for # 2 condemnation, it is the only way to bring such anticompetitive action under the antitrust laws”. Moreover, one
could argue that if the parent and the subsidiary are treated as separate entities for tax and limited liability purpose, they couldn’t
receive the single entity treatment under the antitrust laws.
It seems that the court is reluctant to attack coordinated conduct among parents and their subsidiaries because that would create
incentives to be organized through a unique corporate structure, no matter the efficiencies generated by the adoption of a
subsidiary organization, to escape from antitrust scrutiny. In fact, separate incorporation may improve management, avoid special
tax problems arising from multistate operations and impede that a bankruptcy reaches all of the assets and, therefore, should be
induced by antitrust regulation.

What if the parent doesn’t own 100% of the subsidiary?

If the parent own 51% or more, it would be likely that the court would reach the same conclusion because the power to control
is clear. But if the parent had 25%, for instance, it would depend on its capacity to exercise actual control over the company by
electing the board of directors and determining the broad business strategies that shall be adopted (depends on the participation
of the other shareholders).

Concerted Refusals to Deal

Concerted refusals to deal might drive a competitor out of the market, resulting in anticompetitive effects. When a single
enterprise decides not to deal with another firm, nothing illegal can be ascertained, because it is in the discretionary power of the
management to decide with whom to contract with. However, when this action is combined (boycott), there is a high probability
that the market will be artificially affected and antitrust concerns may arise. The first question is whether concerted refusal to deal
should be analyzed under a per se rule or a rule of reason.
“Group boycotts, or concerted refusal by traders to deal with other traders, have long been held to be in the forbidden category.
They have not been saved by allegations that they were reasonable in the specific circumstances, nor by a failure to show that
they fixed or regulated prices, parceled out or limited production, or brought about a deterioration in quality”. FOGA.
“Even when they operated to lower prices or temporarily to stimulate competition they were banned. Such agreements, no less
than those to fix minimum prices, cripple the freedom of traders and thereby restrain their ability to sell in accordance with their
own judgment”. Klor’s.
“Not every cooperative activity involving a restraint or exclusion will share with the per se forbidden boycotts the likelihood of
predominantly anticompetitive consequences. Wholesale purchasing cooperatives such as Northwest are not a form of concerted
activity characteristically likely to result in predominantly anticompetitive effects. Rather, such cooperative arrangements would
seem to be designated to increase economic efficiency and render markets more, rather than less, competitive”. Northwest
Wholesale Stationers v. Pacific Stationery & Printing Co.
Therefore, it should be asked whether the cooperative fall within the category of activity that is conclusively presumed to be
anticompetitive.

Fashion Originators Guild of America v. Federal Trade Commission (the secondary boycott, purposed to eliminate pirate
manufactures from the market, was held illegal because the members had enough power to drive competitors out of business and
unauthorized copies wasn’t a justification to structure an anticompetitive agreement)
The manufactures of designed dresses combined not to sell to retailers who sold copied dresses, alleging that even though there
was no copyright or patent protection to the dresses design, copying their original creations was unethical and immoral. This is a
secondary boycott because the entities who suffer the first impact (retailers) are not the main aim (pirate manufactures). The
members of the conspiracy argued that if they didn’t have a way of fighting against this unauthorized copies they would have less
incentive to produce, since the pirate manufactures would get a “free ride” on the new design and sell to the consumers at a lower
price. Thus, there defense are based on promoting ethic in the design industry what will, in turn, create incentives for the original
producers to invest in new designs without the free-rider problem.
The court, however, held that the concerted action, expressly formed to drive competitors out of the business, was illegal under
the Sherman Act # 1. The agreement narrowed the outlets to which garment and textile manufactures could sell and the sources
from which the retailers could buy, representing a restraint of trade. The defense of combating unauthorized copies was rejected
on the grounds that “Even if copying were an acknowledge tort under the law of every state, that situation would not justify
petitioners in combining together to regulate and restrain interstate commerce in violation of federal law”. If members of FOGA
are dissatisfied with copying practices within the industry they should pressure Congress to grant them copyrights and, once they
are protected by copyrights, they should seek the enforcement of such rights in the courts and not in violation of federal law.
Moreover, to the extent that there is a demand for less quality copied dresses and the manufactures of this product would be
eliminated from the market because of the FOBA agreement, there would be injury to consumers who wouldn’t be able to buy
the less quality dresses. Members of FOGA had enough power to persuade all of the retailers to stop buying from the pirate
manufactures because if they didn’t respect FOGA’s request they would have few manufactures to buy from.

Driving unscrupulous persons out of the market

Before FOGA, however, the defense of excluding unscrupulous persons was accepted by the courts. In Cement Manufactures
Protective Assn. v United States, the court held that an agreement between the cement manufactures to exchange information in
respect of the credit of buyers (which costumers were overdue) and on specific job contracts (this option could be exercised in
bad faith by demanding more cement than required for the specific job and afterwards reselling the cement for a higher price) was
lawful because the cement manufactures were preventing the perpetration of fraud upon them. In addition in McCann v. New
York Stock Exchange, defendants allegedly conspired to drive the plaintiff out of business in order to rid themselves of his
competition by spreading the information that plaintiff was a person unreliable morally and financially, with a record of criminal
convictions. The court upheld a jury verdict for the defendant reasoning that “ridding the business of unscrupulous persons was
not only lawful but commendable, and while defendants may have other motives, they have to be proved and could not be
assumed”.
What is the difference between these cases and FOGA? The main difference is that in FOGA, even though the copying of
dresses could be viewed by some people as an “unethical activity” the fact is that there are many consumers willing to buy this
product and, as long as they are not illicit products, they should remain in the market. Therefore, any strategy to drive the
manufactures of these products out of business will cause anticompetitive effects by eliminating a “lower quality option” for the
consumer. On the other hand, the unscrupulous persons who are being boycotted in the other cases are not bringing any
procompetitive effect, such as offering an alternative product. They are simply disrespecting the good faith standards that should
prevail in the market.

And what if there wasn’t an agreement between members of FOGA not to sell to these retailers but there was an agreement to
circulate a list among them identifying the retailers who sold copied dresses?
There could still be a condemnation under Sherman Act # 1 because there is an express agreement to circulate a list, which is
clearly a facilitating practice to engage in oligopolistic behavior in restraint of trade. An individual decision to stop negotiating with
retailers who sold copied dresses wouldn’t be efficient because the retailers would simply buy from other manufactures, but a
joint decision between all manufactures of original designs would have the capacity of stopping the retailers from selling copied
dresses. And this joint decision could be reached by the circulation of the list. The list has no other purpose besides making it
possible for the members to achieve their goal of excluding pirate manufactures from the market.
Note that even if there isn’t an agreement to circulate the list but in fact the list is being circulated among them, there is still a way
to condemn under FTC Act # 5 (unfair method of competition – less rigorous standard)

Case analyzed in class (page 279 (261) from the casebook) - Banks
When the banks get together and decide not to deal with consumers who fail to meet minimum requirements, the demand will
suffer injury which could be avoided if there was competition between the banks. A defense which could be used by the banks is
that a jointly decision will permit them to be more efficient by using a common expert negotiator agent and would allow even an
output increase (but recall that the defense of increasing output was rejected in FOGA). It would be important in this case to
analyze the market power of the banks which are entering in this agreement in order to determine the specific anticompetitive
harms which may be generated.
In relation to the combination of drafting a standard form contract, even if it is not binding, it would be hard to find a reasonable
defense. Anticompetitive harms would result because the tendency of each firm would be to use the standard contract (since they
understand that the other competitors will probably be using it as well and, therefore, there is no risk of loosing consumers for
other competitors offering better conditions) and the competitors would be discourage to offer better alternatives for consumers.
One defense could be that the contract provides for an arbitration clause, for instance, which is unanimously considered an
efficient method of litigating in the event of a conflict between the parties. But the counter-argument would be, if the clause is
collectively considered to have a positive effect for all the agents in the market, why haven’t the Congress passed a statute
implementing this clause in such transactions? Another defense which could be used is that a single model of contract is an
efficient way of saving the costs incurred by drafting long and complex contracts. But the firms could save these costs by having
their own model of contract, without having to draft a model jointly with his competitors.

Klor’s v. Broadway-Hale Stores (Concerted Refusals to Deal are illegal even when the target is so small that his destruction
makes little difference to the economy)
Broadway-Hale Stores, a big retailer in the market of household appliances, agreed with manufactures and distributors not to sell
products to Klor’s, a small competitor. The District Court held that the practice wasn’t illegal under Sherman Act because Klor’s
was too small to affect the market, so even if he was driven out of business, consumers wouldn’t suffer any or almost any lost.
But the Supreme Court reversed the decision arguing that “this combination takes from Klor’s its freedom to buy appliances in an
open competitive market and drives it out of business as a dealer in the defendant’s product. As such it is not to be tolerated
merely because the victim is just one merchant whose business is so small that his destruction makes little difference to the
economy. Monopoly can as surely thrive by the elimination of such small businessmen, one at a time, as it can by driving them out
in large groups”. Therefore, the fact that there wasn’t an immediate impact on demand because the actor which was suffering the
boycott was too small wasn’t enough to dispel the application of the Sherman Act # 1. Moreover, the practice didn’t have any
redeeming virtue.

Molinas v. National Basketball Assn. (The rule of a Sport League to refuse to deal with a player who is gambling is justified in
order to preserve the expectations of the consumers)
The League provided some rules to be followed by the team members, including the rule to deny players who gambled. The
Leagues play an important role in making it possible for teams to offer high quality sport products, by establishing common rules
imposing ethical and fair standards. The question is whether the specific rule establishes a legitimate and reasonable refusal to
deal. First it is important to note that, without an agreement to adopt a rule like this one (rejecting gambling), each team would
have incentive to contract the player, as long as he is a good basketball player and will empower the team. This would allow
gambling players to continue exercising normally their professional sport carriers, what could frustrate the expectations of the
audience and fans of the team once they found out about the gambling. It is likely that consumers of sport products would
repudiate players who are involved with activities which they might consider immoral, such as gambling. Thus, the rule provided
by the League is a method of granting the consumer a guarantee that the players of the team members are not involved with any
immoral activity.
Even though this situation is similar to FOGA in relation to its character and justification (a concerted refusal to deal with the
purpose of eliminating immoral behavior in the market), there are at least two significant differences. First, in FOGA, the
agreement between the members to exclude pirate competitors would clearly be harmful to consumers because it would eliminate
from the market a desirable product: less qualified copied dress. Consumers who cannot afford the original dress but would be
willing to purchase the copied one for a lower price would be deprived from such alternative. Here, there is no anticompetitive
harm to the ultimate consumers (fans of sport teams). The allegedly anticompetitive effect of the regulation imposed by the
League is that it may be that the athlete who gambled is in fact a great player and in the absence such prohibition the teams would
still offer competitive bids for him. In this scenario, the sport teams are viewed as the buyers (disputing the player) and the players
are viewed as the sellers (offering their sport skills). If the teams are precluded from dealing with players who gambled, the
competition for these players is eliminated and there is an injury for the group of “offerors of sport skills who engaged in
gambling”. However, one could reasonable ask whether this is a real anticompetitive effect or a punishment for those who are not
acting consistently with the behavior required by the carrier they have chosen. Most importantly, the practice will benefit ultimate
consumers. By assuring that all the teams will not deal with gamblers, the Association might be satisfying a “market need”, which
is the sport fans’ desire that their teams act ethically and in accordance with the highest moral standards. The natural consequence
will be the stimulation of consumers willingness to focus on college football games. One could argue that in FOGA the practice
also had redeeming virtues to ultimate consumers because it would avoid the free-rider problem and stimulate the original
manufactures to produce new dress designs. But this argument of a potential output increase was rejected by the court on the
grounds that the clear desire to exclude competitors and the fact that a desirable product would disappear from the market was
enough to find a violation of the Sherman Act #1, regardless potential redeeming virtues.
There is a second major difference between this case and FOGA related to the motivation of the concerted refusal to deal. In
FOGA the members were clearly advancing their self-interest by eliminating pirate competitors from the market. They would be
able to capture some consumers who won’t be able to purchase copied dresses any longer. Here, to the contrary, the League is
not gaining anything by adopting such regulation. While the motivation is not conclusive to determine whether the practice will in
fact have anticompetitive effects or not, it is at least an indication that the participants in the agreement themselves believe that
they will be in a better position by adopting the concerted action.

Case analyzed in class (page 283 (264) from the casebook) – Toys manufacturers
The agreement was to stop producing dangerous toys and also stop dealing with any wholesaler who continued handling toys
produced with unsafe materials. Just like FOGA in form, this is a secondary boycott because who is suffering the first impact
(wholesalers) is not the main aim (other manufactures). The first point that should be considered is the market power of the three
members. If they represent a small share of the market, probably no anticompetitive harms will result because the wholesalers will
still have many other sellers of toys to buy from and will not be persuaded to stop buying unsafe toys. But if lack of market power
was the case, probably the three manufactures wouldn’t come to this agreement in the first place because they would foresee that
it wont be effective and could even make them loose competitiveness since they would be producing toys with more expensive
materials (to make them safer) without a fast increase in the demand for this product (costumers wouldn’t notice they were safer).
Therefore, assuming they have enough market power, is there any difference from this exclusionary conduct from the arrangement
in FOGA? In FOGA the members are in fact trying to create an “artificial copyright protection”, which has been denied by
Congress, through a concerted refusal to deal. They are protecting their self interest in an issue that Congress hasn’t ascertained
them the right. On the other hand, in the toys manufactures agreement the value which is being protected is safety, which is
undisputedly a significant element for both sides in the market, suppliers and consumers. It is hard to say that this agreement can
be manipulated by members to charge monopolistic price because they will only eliminate manufactures which are producing
dangerous goods actually declared hazardous by the government.
In addition, the difference from this case to Engineers is that here we cannot assume that competition will lead to the best results
in terms of safety because the consumers of toys (parents of children or children themselves) are not able to distinguish which
materials are safer and what products could present higher levels of risk.
There could still be a less restrictive alternative, such as letting the state establish standards and requirements for the production of
safe toys and punishing the manufactures which fail to follow the rules.

Associated Press v. United States (The court decided that AP members shouldn’t have veto power to exclude other competitors
because the Association was powerful enough to drive non-members out of business and impede new entrants)
AP is a cooperative Association with 1200 newspaper members which offers many advantages for its members, such as allowing
them to publish news in other states without incurring in additional expenses. The Association has some restrictions for the
entrance of new members and United States sued alleging that the newspapers which were vetoed from entering in such
Association could find difficulties to survive in the market and end up being eliminated.
First consideration – Is membership in the Association a necessary condition to survive in the market? No. AP provides its
members with some relevant benefits but this doesn’t mean that the other newspapers will become weak enough to be destroyed
by competition. Moreover, the non-members could form their own Association. Even though the start-up costs may be high
(contract a famous publisher, joint newspapers from all states – AP is already the biggest one) it is not impossible since there are
already two other Newspapers Associations in the market.
Second consideration – It seems like in this case AP is basically a successful joint venture which offers a significant reduction of
costs for its members and, obviously, any joint venture has to prescribe rules governing its business, such as the terms and
conditions for a firm to become a member and the potential justifications to expel an existing member from the group. A rule to
veto other competitors can be justified on the grounds that the potential candidate wouldn’t add significant news contributions to
the Association and would, in fact, be a “free rider” in the high investments incurred by the original members.
Finally, there is an economic justification which is, if you don’t allow AP to decide by itself which firms can joint the Association
or not, you will be discouraging firms to crate this kind of efficient joint venture in the first place, because they will anticipate that
they will be forced to share with their competitors the high investments incurred to set up the Association.
Despite all the above arguments favorable to AP, the court decided differently. It was held that the size of AP and the advantages
it provides are sufficiently beneficial to the members to block the entrance of newcomers who are denied access to the
Association and to destroy the existing newspaper non-members competitors. The costs to form a competing Association are too
high to be considered as an alternative. Therefore, the court’s solution was to condemn the veto power of the members and open
the Association to any interested newspaper. “It is further said that we reach our conclusion by application of the “public utility”
concept to the newspaper business. This is not correct. We merely hold that arrangements or combinations designed to stifle
competition cannot be immunized by adopting a membership device accomplishing that purpose”.

Essential Facility doctrine applied in the R&D context (page 288 (265 b) from the casebook) – G&E
The first difference between G&E and Terminal Railroads is that here there is a single corporation, while in Terminal R.R. there
were many competitors. So in G&E there is no agreement among horizontal competitors as there is in Terminal R.R. (G&E could
only be challenged at the moment of the joint or under FTC Act # 5).
Secondly there is a main difference in relation to the nature of the product: a bridge can be defined as a natural monopoly, that is,
a single industry can supply the market with less costs than two or more (a second bridge would be wasteful), whereas the
development of mousetraps certainly requires competition to be efficient (many firms investing in researches to offer innovation
for the public). The court’s decision in Terminal R.R. that the single bridge would have to be shared between all of the railroads is
justified on the grounds it is a natural monopoly and, thus, it wouldn’t be economically efficient neither socially desirable to build a
second bridge. On the other hand, in G&E it would be economically efficient and socially desirable to create incentives for non-
members of G&E to invest in their own mousetrap, and come up with modern products to be offered in the market and dispute
with G&E products. So they should not have the right to enter in the G&E Corporation.
Northwest Wholesale Stationers v. Pacific Stationery & Printing Co. (The Plaintiff failed to demonstrate that the cooperative
possesses market power or unique access to a business element necessary for effective competition)
Northwest distributes its profits to members in the form of a percentage rebate. Pacific was expelled from the Association
because it failed to act in accordance of a disclosure rule and now sues seeking to reenter in the group. The case is similar to AP
and basically the same arguments should be considered. The main difference is the degree of indispensability of being a member
of the Association to survive in competition. In AP, considering the high advantages provided by the sources of news and the
difficulties of organizing a new Association, the court concluded that it was likely that non-members would be soon driven out of
the market if they were denied membership in an Association composed already by 1200 newspapers. To the contrary, in
Northwest, the non-members, such as Pacific, can easily find a different seller to buy from, and even if it doesn’t get the benefit of
the rebate, this wouldn’t be sufficient to drive it out of business. “Unless the cooperative possesses market power or exclusive
access to an element essential to effective competition the conclusion that expulsion is virtually always likely to have an
anticompetitive effect is not warranted. Absent such a showing with respect to a cooperative buying arrangement, courts should
apply a rule-of-reason analysis. The mere allegation of a concerted refusal to deal does not suffice because not all concerted
refusals to deal are predominantly anticompetitive. When the plaintiff challenges expulsion from a joint buying cooperative, some
showing must be made that the cooperative possesses market power or unique access to a business element necessary for
effective competition”.
There is a second argument related to the merit of the justification to refuse to deal. In this case, the plaintiff had violated a
reasonable rule of the Association to disclosure information and had been punished for this. This makes a difference because it
can be ascertained that the Association has not the purpose of stifling competition by rejecting members regardless of their
behaviors. “Wholesale purchasing cooperatives must establish and enforce reasonable rules in order to function effectively.
Disclosure rules, such as the one on which Northwest relies, may well provide the cooperative with a needed means for
monitoring the creditworthiness of its members”.
The plaintiff contends that Northwest didn’t adopt a procedural course before deciding to expel it from the group. In this case it
was decided that procedural protections are completely irrelevant because antitrust laws do not impose on joint ventures such
requirement. But the court has already said that procedural protections would help to accept a refusal to deal, or even make it
harder to accept it.

Federal Trade Commission v. Indiana Federation of Dentists (Horizontal agreements providing that all the participants shall deny
the consumers’ requests are unlawful, unless there are any offsetting procompetitive justifications)
This concerted refusal to deal can be characterized as a cartel, not to fix the price, but to set the conditions of the product to be
provided to the insurers. It is a horizontal agreement between competitors which the main aim is the consumers. They are jointly
deciding to refuse to offer a specific product (x-rays) required by the consumers (insurers) without offsetting procompetitive
justifications, what is clearly unlawful. “A refusal to compete with respect to the package of services offered to customers, no less
than a refusal to compete with respect to the price term of an agreement, impairs the ability of the market to advance social
welfare by ensuring the provision of desired goods and services to consumers at a price approximating the marginal cost of
providing them. Absent some countervailing procompetitive virtue – such as, for example, the creation of efficiencies in the
operation of a market or the provision of goods and services – such an agreement limiting consumer choice by impeding the
ordinary give and take of the market place cannot be sustained under the rule of reason”.

Summary

Cases condemning the defendant:

Fashion Originators Guild of America v. Federal Trade Commission
Klor’s v. Broadway-Hale Stores
Associated Press v. United States
Federal Trade Commission v. Indiana Federation of Dentists

Cases exonerating the defendant:

Molinas v. National Basketball Assn.
Northwest Wholesale Stationers v. Pacific Stationery & Printing Co.

The cases can be classified in three categories:

1) Concerted refusal to deal with competitors - AP, R.R, G&E and Northwest
2) Secondary boycott (refusal to deal with an entity in a different level of production to affect competitors) – FOGA, KLOR’S,
Toys manufacturers
3) Concerted refusal to deal with a buyer or a seller with the purpose of affecting it directly (Cartels) – Indiana, Molinas, Banks

Influencing Government Action

Individual firms or groups of competitors may seek to achieve anticompetitive ends through government decisions, including
legislation, regulatory actions, the exercise of executive discretion, and court orders. Even though some anticompetitive effects
may in fact result from this combined activity between private actors and government, the general understanding is that Sherman
Act was not designed to cover this practice. Therefore, the courts have granted immunity both for private actors who engage in
political methods to persuade the government to assume a position which may have anticompetitive effects (Noerr immunity) and
for the government itself when taking decisions which could give rise to antitrust concerns (Paker immunity).
Parker immunity: “We have no question of the state or its municipality becoming a participant in a private agreement or
combination by other for restraint of trade…The state in adopting and enforcing the prorate program made no contract or
agreement and entered into no conspiracy in restraint of trade or to establish monopoly but, as sovereign, imposed the restraint as
an act of government which the Sherman Act did not undertake to prohibit”.

Eastern Railroad Presidents Conference v. Noerr Motor Freight (Private action to influence government is not condemned under
the Sherman Act, regardless of purpose or the fact that the methods used were deceptive)
Railroads constructed a political campaign addressed to Congress with the objective of encouraging the Legislator to approve a
statute restricting the trucks activity (limits upon the weight of the loads they are permitted to carry and having to pay a fair share
of rebuilding the roads). The trucks alleged that the campaign was clearly deceptive and sued the railroads for making the
government pass an anticompetitive legislation based on false information. The court rejected the trucks claim on the grounds that
the Sherman Act purpose is to regulate business activity, not political activity. In a representative democracy the branches of
government act on behalf of the people and, to a large extent, the representation depends upon the ability of the people to make
their wishes know to their representatives. It is a natural consequence of democracy that economic agents may seek advantages
for themselves which will bring disadvantages for other agents. “Where a restraint upon trade or monopolization is the result of
valid governmental action, as opposed to private action, no violation of the Act can be made out. These decisions rest upon the
fact that under our form of government the question whether a law of that kind should pass, or if passed be enforced, is the
responsibility of the appropriate legislative or executive branch of government so long as the law itself does not violate some
provision of the Constitution”.
The plaintiff’s argument that the campaign was misleading was dismissed on the grounds that Congress has already exercised
extreme caution in legislating with respect to the appropriate conduct of political activity, so any challenge of corruption or unfair
methods of political campaign has to be analyzed under such legislation rather than bringing an antitrust suit. No antitrust statute
addresses this issue. The rationality behind the court’s position is that it is often extremely hard to investigate whether the method
used to influence the government was in fact deceptive or not. It is difficult to reach objective standards to characterize a political
campaign as misleading and condemnable under the Sherman Act. There is also a risk of restricting the right of petition because
people would anticipate that their request could be considered deceptive and might be discouraged to exercise their right of
petitioning. The result would be less information being provided to Congress, with prejudice to the representative democracy.

California Motor Transport Co. v. Trucking Unlimited (The practice falls into the sham exception because it is not a way of
persuading the government about a specific issue, instead it is a strategy to delay the process by which state agency approves
new entrants)
Truckers had to get a state agency permission to enter into the market. The state regulation wasn’t necessary because the truck’s
industry is not a natural monopoly but an industry where the free market by itself could determine the optimal level of output
(trucks) and price. Who were beneficed by the regulation were the trucks which were already in the market and could enjoy a
situation where the government was banning new entrants and establishing minimum fees. The problem was that the truckers
started to oppose to all the applications of new entrants, using the state agency as a means to block newcomers, regardless of the
merit of the application. This practice seems to fall in Noerr immunity because it is basically a private action putting pressure on a
government actor (state agency) to achieve anticompetitive results. But Noerr immunity has a “sham” exception which covers
activities that were not genuinely intended to influence government action. In other words, the private action in reality is not
addressed to the government. The defendant uses the governmental process – as opposed to the outcome of that process – as an
anticompetitive weapon.
The court concluded that the conduct here fell in the category of the sham exception because the conduct was not directed to
convince the government that the new entrant shouldn’t be authorized to enter in the market, but it was simply a strategy to block
the process by sending objections to all the applications. The evidence which suggested this conclusion was the fact that the
defendants were objecting without regard to the merit of each case and without plausible justifications, making the agency
crowded of objections and delaying the whole process. “Petitioners instituted the proceedings and actions with or without
probable cause, and regardless of the merits of the case”.

Professional Real Estate Investors v. Columbia Pictures Industries (Lawsuit was not considered a sham litigation because there
was reasonable expectation of success)
Columbia sued PRE for copyright infringement. PRE counterclaimed alleging that Columbia’s action was not a legitimate
litigation, but a mere sham designed to exclude a competitor. PRE argued that Columbia was using the Judiciary Power to
exclude him from the market, what would result in anticompetitive harms. The court decided that a sham exception contains an
indispensable objective component. Evidence of anticompetitive intent or purpose alone cannot transform otherwise legitimate
activity into a sham. Because PRE failed to demonstrate evidence of repetitive lawsuits carrying insubstantial claims, Columbia’s
action cannot be considered a sham. As long as there is a probable cause to institute civil proceedings (reasonable belief that
there is a chance that a claim may be held valid upon adjudication) the action is protected from antitrust liability. “The existence of
probable cause to institute legal proceedings precludes a finding that an antitrust defendant has engaged in sham litigation.
Probable cause to institute civil proceedings requires no more than a “reasonable belief that there is a chance that a claim may be
held valid upon adjudication”.
Requirements to characterize a sham exception are: (i) the lawsuit must be baseless (there is no reasonable expectation of
success); and (ii) it affects competition.

City of Columbia v. Omni Outdoor Advertising (Municipality has Parker immunity, as long as its regulation is authorized, and
private actor has Noerr immunity, even though there was some kind of “informal corruption” involved)
COA, a billboard company, controlled 95% of the market and its owners had close relations with the city’s political leaders,
occasionally donating funds or billboard space for political campaigns. COA owners met with city officials to restrict new
billboards and OMNI sued alleging an anticompetitive conspiracy between city officials and COA. Is the Municipality immune?
Is COA immune?
Even though Municipality is a level of government, it is not treated in the same way as state governments by the courts. For the
Municipality to enjoy Parker immunity, which will allow it to take any decision without being condemned for antitrust liability, it
has to be granted authorization to regulate that specific sector in which the conduct is being challenged. If this requirement is met,
than Municipality receives the same Parker immunity granted to the state government, since it has the same rights of deciding
whether to enforce or suppress competition in a specific sector of the economy which it has authority to regulate.
The private actor can enjoy Noerr immunity because, in the same way that a misleading campaign doesn’t make the conduct
condemnable under Sherman Act, a corrupt way of achieving political goals also doesn’t. This claim is rejected because antitrust
legislation is not the correct framework to identify lobbying that has produced selfish motivated agreement with public officials. It
would be impracticable to invalidate lawmaking that has been infected by selfish motivated agreement with private interests.
The court held that this case didn’t fall within the “sham” exception because “although COA indisputably set out to disrupt
Omni’s business relationships, it sought to do so not through the very process of lobbying (…), but rather through the ultimate
product of that lobbying”. In distinguishing this case from California Motor Transport the court argued that “the purpose of
delaying a competitor’s entry into the market does not render lobbying activity a “sham”, unless (as no evidence suggested here)
the delay is sought to be achieved only by the lobbying process itself, and not by the government action that the lobbying seeks”.

Allied Tube & Conduct Corp. Indian Head (When the private action has a commercial essence, rather than political, it may be
condemned under the Sherman Act, even though it might have a political impact)
A private Association, through its product standard-setting process, restricted the industry of “polyvinyl chloride conduits” to
protect the steel industry. The members paid other members to reject the proposal and exclude this industry from the
Association’s Code. The Association claims Noerr immunity alleging that the local governments always adopts their Code as
legislation, so they argued that the standard process was a way to influence government action. The court considered that the
claim to Noerr immunity has some force. The effort to influence governmental action in this case certainly cannot be characterized
as a sham given the actual adoption of the 1981 Code into a number of statutes and local ordinances. It is obvious that when the
activity has no political background or effect, it doesn’t enjoy Noerr protection but the issue here is whether the fact that the local
government adopts constantly the Code, can be enough to assume that the Association was trying to influence government action.
The fact that the activity was not a “direct” petitioning of government officials is irrelevant, since Noerr itself immunized a form of
“indirect” petitioning (through political campaigns). The court decided that “if all such conduct were immunized then, for example,
competitors would be free to enter into horizontal price agreements as long as they wished to propose that price as an
appropriate level for governmental ratemaking or price supports. (…) We thus conclude that the Noerr immunity of
anticompetitive activity intended to influence the government depends not only on its impact, but also on the context and nature of
the activity”.
The particularity of this case is that the activity engaged by the private actor is a commercial activity, not political. In the private
standard-setting process, an economically interested party exercises decisionmaking authority in formulating a product standard
for a private association that comprises market participants. The activity by itself generates anticompetitive effects, regardless if it
is followed by the government or not. In summary, the practice has two aims: influencing the government by formulating a Code
which will be adopted as legislation (in this aspect is immune) and inducing the public to reject “polyvinyl chloride conduits”,
regardless what is the government’s decision, causing condemnable anticompetitive effects. The activity in issue did not take
place in the open political arena, but within the confines of a private standard-setting process, thus, the court concluded that there
is a commercial nature which allows the antitrust laws to take place. “Although one could reason backwards from the legislative
impact of the Code to the conclusion that the conduct at issue here is “political”, we think that, given the context and nature of the
conduct, it can more aptly be characterized as commercial activity with a political impact(…), the antitrust laws should not
necessarily immunize what are in essence commercial activities simply because they have a political impact”.
Missouri v. National Organization for Women (NOW) (The boycott had a political purpose and was considered a “non-
economic boycott” because it didn’t advance the economic self-interest of the participants)
The NOW organized a convention boycott against states that had not ratified the Equal Rights Amendment (ERA). The boycott
consisted in agreeing not to hold conferences in these states, what resulted in significant harms considering the importance of
conferences business in the U.S, especially for the hotels business. The difference between this case and Noerr is that here the
defendant is engaging in an anticompetitive commercial activity (the activity itself is commercial even though it has a political
purpose) to persuade the state to pass a legislation which has no relationship with the antitrust laws. It can be considered a
secondary boycott because the practice is directly affecting the hotels (and those who depend on the conference business) but
the main aim is the state. As the Supreme Court held in Indian Head, the practices which can enjoy Noerr immunity are those
essentially political, not commercial, and the mere fact that a commercial practice is being done with a political purpose is not
enough to receive Noerr immunity. However, in this case, the Court of Appeals considered that, even though the boycott was
affecting economically the hotels, it was not undertaken to advance the economic self-interest of the participants, so it couldn’t be
considered an “economic boycott”, but yet a “a boycott in a political arena”. “Using a boycott in a non competitive political arena
for the purpose of influencing legislation is not proscribed by the Sherman Act”.

Federal Trade Commission v. Superior Court Trial Lawyers Association (Even though the practice has a political purpose, it is
itself restricting competition through a boycott intended to advance the economic self-interest of the participants)
A group of lawyers agreed not to represent indigent criminal defendants in the District of Columbia Superior Court until the
District of Columbia government increased the lawyer’s compensation. They were hired by the state to provide legal services as
independent contractors. The group argued that the concerted refusal to deal was necessary because the fees paid were
unreasonable low, what led even to a reduced quality of representation since they had no economic incentives. The court’s first
conclusion was that the practice was the essence of “price-fixing” by agreeing upon an output which will increase the price
offered.
The argument that the boycott was justified because it seeks “reasonable fees” was rejected on the grounds of the rule
established in Trenton Potteries “is no excuse that the prices fixed are themselves reasonable”.
The second argument that the boycott was necessary to increase the quality of the service offered by the lawyers was also
refused considering the rule that “Sherman Act reflects a legislative judgment that ultimately competition will produce not only
lower prices, but also better goods and services” Engineers. There is, however, a counter-argument to escape Engineers holding
in this case. The presumption that competition is the best way of achieving low prices, quality, safety and durability, is entirely true
when the buyers of the product themselves will decide which product to purchase among the different possibilities offered. This is
because they will take into consideration not only the price, but also the quality of the product. In the present case, however, the
buyer who is purchasing the lawyers’ service (the government) is not the person who will enjoy the benefits of such services
(prisoners). So it would be reasonable to argue that the state might not be totally concerned about providing a good defense for
the criminal indigents, and can be negligently considering the quality of such services as opposed to the situation where the
criminal indigents themselves purchased the service.
The third argument of the defendants is that the boycott was intended to influence government action (to increase the legal
services fees) and, therefore, enjoyed Noerr immunity. The court distinguished this case from Noerr by arguing that “In the Noerr
case the alleged restraint of trade was the intended consequence of public action; in this case the boycott was the means by
which respondents sought to obtain favorable legislation. The restraint of trade that was implemented while the boycott lasted
would have had precisely the same anticompetitive consequences during that period even if no legislation had been enacted”.
Moreover, as it was argued in Indian Head, “the antitrust laws should not necessarily immunize what are in essence commercial
activities simply because they have a political impact”.
In the present case, the defendants were clearly seeking to advance their economic self-interest, what precludes them from using
the defense applied in NOW, which establishes that when the practice is not intended to advance the economic self-interest of
the participants and has a political purpose it is immunized. Neither the group of lawyers can use the defense from Claiborne
Hardware, where black citizens, who had been the victims of political, social and economic discrimination for many years,
engaged in a boycott to seek equal respect and equal treatment. In that case, the defendants were not seeking to increase the
price that they would be paid (as it is occurring here), but yet seeking to protect constitutional rights of equality. A counter
argument that could be used by the group of lawyers to insist in the similarity between this case and Claiborne Hardware is that
they are not seeking only to advance their economic self-interest but yet to increase the quality of the defense which will be
provided to criminal indigents in the state (they will have stronger incentives to dedicate more time to these causes since they will
receive higher fees per hour).
The dissent opinion argued that this case involves “expressive boycotts” since the practice is aimed at the government and not at
private parties. The difference is that the government can terminate the action at any time by requiring all members of the District
Bar to represent defendants pro bono and eliminate the anticompetitive harms. As a practice of expressive nature aimed to the
government, Justice Brennan, considers that the application of a per se rule just because the conduct involved output restriction is
inappropriate. “There may be significant differences between boycotts aimed at the government and those aimed at private
parties. The government has options open to it that private parties do not; in this case, for example, the boycott was aimed at a
legislative body with the power to terminate it at any time by requiring all members of the District Bar to represent defendants pro
bono. If a boycott against the government achieves its goal, it likely owes its success to political rather than market power”.
Note that the Trial Lawyers Association does not represent a labor union, otherwise it could easily receive antitrust immunity
while trying to protect their rights against the employer (government).

Intellectual Property

There is an inherent conflict between IP and antitrust policies. The core purpose of the antitrust laws is to promote competition,
which entails preventing acts of monopolization. By contrast, the IP system attempts to stimulate inventive activity by creating a
government-protected monopoly and specifically by empowering IP owners to enforce their monopolies against unwanted
competition. Allowing IP owners to exclude competitors from the use of their patents is in direct conflict with the antitrust law’s
promotion of competition. Thus, the challenge is to determine which acts of IP exploitation best promote IP policy with the least
damage to competition policy.
Owners of intellectual property rights often try to license it in an effort to gain more money than they could earn if they were the
only user of this property. There can be many reasons why it would be advantageous to license the patent instead of exploring it
alone. First, it may be that the IP owner doesn’t have enough capacity to maximize the use of the patent (maybe he doesn’t have
enough factories or equipments). Secondly, it might be a method of spreading the risks. If the success of the new product is
uncertain, a single firm may not wish to invest the resources necessary to produce a sufficient amount for the entire market,
whereas many firms might each be willing to assume a small portion of the risk. Finally, licensing a patent can be a strategy to
discourage competitors from developing their own new products.
The disadvantage of licensing the patent is that the IP owner would be precluded from enjoying a monopoly price for the new
products, unless he can fix a price with the licensee. The courts are more likely to accept price fixing in IP licensing agreements
because a restrictive license is less restrictive than a simple refusal to license, which would be clearly lawful.

United States v. General Electric Co (The patentee is allowed to fix the price at which the licensee is supposed to sell the
patented product)
General Electric licensed Westinghouse to make, use and sell lamps under GE’s patents. Westinghouse agreed to pay a royalty
and to follow the prices and other terms fixed by GE. The court considered that the agreement was legal because the very object
of these products is monopoly and the conditions fixed only seek to secure pecuniary reward for the patentee’s monopoly.
Otherwise, the licensee would cut prices and destroy the patentee’s legal protected monopoly. An alternative that could be
adopted by the patentee to avoid licensees cutting prices would be to charge higher royalties, what would increase the licensees’
cost of production and impede lower prices. However, if the competitors have a cost curve with an extremely lower potential, the
higher royalties won’t be an efficient mechanism of impeding price cut. “If the patentee goes further, and licenses the selling of the
articles, may he limit the selling by limiting the method of sale and the price? We think he may do so, provided the conditions of
sale are normally and reasonably adapted to secure pecuniary reward for the patentee’s monopoly”.
The rationality behind the court’s holding is to provide incentives for the IP owners to license their patents. Even when the
licensee is charging a fixed monopoly price it is better than if it didn’t had the license at all. First because the patentee would be
charging a monopoly price in the absence of licenses anyway and secondly because it is socially desirable to encourage the
patentee to license in order to allow the competitors to gain experience with the technology, expand its use, improve it, and
compete freely when the patent expires.

Case analyzed in class (page 354 (287) from the casebook)

The major problem of allowing IP owners to license patents with a price fixed agreement is that they can manipulate this
permission to acquire immunity when the core of the transaction is the restriction itself, not the license. In the New Wrinkle
Company case, there are many factors which can lead us to conclude that the patent is not contributing enough for production
(neither through cost savings nor performance improvement) and the plan is arranged actually to fix prices among competitors
(cartel). The first evidence is provision number 2, which establishes that the licenses will only become operative until 12 of the
largest producers had subscribed to the price-restricted licenses. If the patent really creates a new product, why should the firms
be concerned about the other 12 largest firms entering into the agreement? This suggests that the members are concerned with
the largest firms because if the later continue selling the original product the price-fixing won’t work since the consumers will buy
from the firms which haven’t entered into the agreement. Moreover, if the patent had a real value the members shouldn’t be
concerned with the larger firms because consumers would be attracted to the patented product even if it was more expensive.
Provisions number 3 and 7 assured all of the firms that the same price conditions had been given to all of them and that each
licensee was bound by the minimum price only if it was imposed on all other licensees. With this common communication the
firms will have the security that there won’t be any firm cutting prices. Finally, provisions number 6 and 8, which imposes an
extremely low royalty and gives each licensee the benefit of a lower royalty rate in any subsequent license demonstrate that the
patent itself doesn’t have enough value and it’s a mere excuse to form a cartel agreement.

Interpretation of Sherman Act # 2 “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with
any other person or persons, to monopolize … shall be deemed guilty”
The concern about a monopoly firm is similar to the concern about cartels and agreements in restraints of trade: the capacity to
restrict output and raise prices above the competitive level in order to maximize profits. In fact, the monopoly firm is even in a
better position to raise prices, since it decides by itself the level of price and output, without having to face the problem of
coordination and monitoring eventual cheaters. It is likely that the monopoly will be more permanent considering the absence of
reasons that usually lead cartels to collapse (cheaters and differences in products which make it difficult to reach a consensual
price). Moreover, in the case of oligopolies and cartels the actors can still engage in considerable rivalry in respect to quality and
innovation. Finally, a single firm is in a better position to drop prices and drive competitors out of business in order to exclude
existing competitors and make the entrance of potential newcomers less attractive.
Even though monopolies might be more dangerous to competition as compared to cartel agreements and oligopolistic behavior,
there may be some circumstances in which they should not be deemed illegal. A monopoly position can be achieved through
legitimate means, such as higher market performance, lower cost structure, managing with superior skills and producing higher
quality products. This is called “competition on the merits”, where there are no competitors simply because they were unable to
overcome the efficiencies developed by the leading firm. Monopolies acquired through “competition on the merits” shouldn’t be
condemned because the State doesn’t want to discourage firms from improving their means of production and becoming more
efficient than other competitors. A similar and extreme situation would be those markets where there is a natural monopoly, that
is, where it is economically more efficient to have a single firm providing the product, rather than multiple firms (for example, a
small city doesn’t have enough demand for two theaters, so only one could cover the consumer’s necessities). In addition, a
monopoly can be the result of a patent concession, where the state authorizes a single firm to explore a product with exclusivity.
Thus, considering the potential harms of a monopoly on one hand, and the possible justifications on the other, how should the
courts treat monopoly cases? Should they condemn at face monopolies acquired by big mergers and release those ones acquired
through internal growth, natural monopolies or patent-monopolies? The first distinction that should be made is between a mere
“monopoly position” and the “act to monopolize”. A monopoly standing by itself is not enough to condemn. “The law does not
make mere size an offense or the existence of unexerted power an offense”. United States v. International Harvester Co.
Generally speaking, for the monopoly to be deemed illegal there must be “something else” besides the monopoly position. This
“something else” consists in exclusionary acts which are exercised to maintain the monopoly by eliminating the existing
competitors and enhancing the barriers to entry. “The offense of monopoly under section 2 of the Sherman Act has two elements
(1) the possession of monopoly power in the relevant market and (2) the willful acquisition or maintenance of that power as
distinguished from growth or development as a consequence of a superior product, business acumen, or historic accident”.
Grinnell.
To determine if a monopoly should be condemned two questions must be asked: how was the monopoly originally created
(through mergers, which completely eliminate the competitor by incorporating it and can even be unnecessary since there is
always the possibility of expanding without buying a competitor; or through internal growth, which arguably can be considered as
“competition on the merits”)? And the second question is: how is the monopoly condition sustained (are there any exclusionary
conducts exercised to enhance barriers to entry and protect the monopoly once it is created)?
In interpreting section 2 of the Sherman Act, the courts have concluded that some conducts can be characterized as being
exclusionary and representing monopolization, when undertaken by a monopolist. These conducts can be divided into five basic
categories:

Based on Preemptive Expansion (ALCOA)

Based on Leverage – expanding a monopoly to a second industry (Griffith)
Based on Tying up Consumers – Long-term contracts (United)
Based on Unilateral Refusal to Deal – essential facility doctrine (Aspen and Verizon)
Based on Predatory Price – charging prices below costs (ITT Grinnell)

Monopolizing Based Preemptive Expansion (ALCOA)

United States v. Aluminum Co. of America (ALCOA) (The court held that the acts of preemptive expansion undertaken by
ALCOA were sufficient to conclude that it was monopolizing the market in violation of # 2)
The plaintiff argued that ALCOA was monopolizing interstate and foreign commerce, particularly in the manufacture and sale of
“virgin” aluminum ingot, and should be condemned under Sherman Act # 2.
The first defense provided by ALCOA was based on the reasonableness of the profit extracted from the consumer. However, in
the same way that reasonableness of the price doesn’t justify agreements to fix prices among competitors, it doesn’t justify the
possession of unchallenged economic power. Such defense is rejected because (i) a “reasonable price” is hard to measure (it
could eventually be calculated by identifying the costs of production and adding a reasonable profit but this involves an extremely
subjective analysis); (ii) even if the price is considered reasonable, the possession of unchallenged economic power deadens
innovations and discourages efforts to enhance quality. It is hard to know how would be the level of innovations and quality in the
presence of competition, but presumably it would be stimulated.
The second argument raised by ALCOA was that its monopoly position is a result of its skills, energy and initiative with which it
has always conducted its business. The court deals with this argument through two distinct perspectives. The first and stricter one
supported by Judge Hand is that the “defendant has to demonstrate that monopoly has been trust upon it, that it does not seek,
bur cannot avoid, the control of a market”. The second is less severe, it requires that defendant demonstrates that it is not
undertaking exclusionary conducts to sustain its monopoly.
In both of the tests ALCOA was considered an illegal monopoly because of its acts of preemptive expansion. It was always
anticipating increases in the demand for ingot and doubling its capacity to be prepared to supply. “It was not inevitable that it
should always anticipate increases in the demand for ingot and be prepared to supply them. Nothing compelled it to keep
doubling and redoubling its capacity before others entered the field”. The exclusionary conduct was to “embrace each new
opportunity as it opened, and to face every newcomer with new capacity already geared into a great organization, having the
advantage of experience, trade connections and the elite of personnel”. The consequence of such holding is that, to avoid
condemnation, ALCOA should have delayed the construction of new plants until the demand exceeded supply. Only at that
moment it would be legal for ALCOA to expand. However, this decision can generate undesirable effects. Allowing the demand
to increase without prepared suppliers to cover immediately the demand excess will result in higher prices and limited output until
the supply curve becomes adjusted to the demand curve and reach an equilibrium. Moreover, forcing ALCOA to delay its
expansion until the demand excesses supply will not guarantee that newcomers will be encouraged to enter in the ingot market
since ALCOA is able to double its capacity with much more facility than a firm that is not in the market yet and needs to incur in
high start-up expenses. Thus, even if ALCOA was not actually undertaking preemptive expansion, the simple fact that it was
ready to expand easily at any moment would discourage newcomers.
One defense that ALCOA could raise is that the preemptive expansion was not a way to embrace each new opportunity as it
opened, but yet the expansion itself was the reason of the demand increase. Arguably, consumers are willing to buy more from
efficient suppliers which own many plants and are able to reach a large group of consumers.
One of the defenses raised by ALCOA consisted in the absence of intent or purpose to monopolize. However, the court held
that “no monopolist monopolizes unconscious of what he is doing”. In other words, it is presumed that the monopolist is aware
that its conduct will protect its monopoly and this awareness is enough to condemn. No intent is required (as opposed to attempt
to monopolize). The only relevance of intent is that when the court finds out that the practice was undertaken with the intent to
exclude competitors (as occurred in United States v. Microsoft Corp. where there was a letter confirming the objective of the
practice), there is an indication that anticompetitive effects will result. If the creator of the practice himself is expecting
anticompetitive harms from the conduct, this can be used as a guide to confirm the production of such harms.

Monopolizing Based on Leverage – expanding a monopoly to a second industry (Griffith)

Leverage and the Single Monopoly Profit Theorem

A type of monopolization can occur when a monopolist leverages its power to extend its monopoly to other markets and,
thereby, increase the social harm caused by the initial monopoly. The Chicago School of Antitrust, however, challenged this idea
by arguing that when a firm chooses to extend its monopoly power to other market, it will necessarily sacrifice the gains that
could be generated from the initial lawful monopoly. Thus, the firm is not capturing a second monopoly, it is only realizing the
returns from its first monopoly. The courts, however, do not follow this rational and deem illegal the expansion of monopoly
power to a second market, as it was hold in Griffith.

United States v. Griffith (The fact that Griffith negotiated the film rights for its closed towns together with the open towns, helping
it to acquire exclusive rights in the competitive towns through its bargaining power, is deemed a violation of the Sherman Act # 2)
Griffith, an exhibitor of picture theatres, operates in 85 towns. In 32 of those towns there were competing theatres and in 53
there were no competing theatres. What is surprisingly about this case is that five years earlier Griffith had theatres in only 37
towns, 18 of which were competitive and 19 of which were closed. The radical growth of Griffith can be explained in light of its
negotiation policy with the distributors. Griffith negotiated with the distributors through packages by asking for exclusive film rights
in the competitive towns as a condition to buy film rights for the towns in which it had a monopoly. This is a typical case of a
monopsony, where there is a single buyer (Griffith) for multiple sellers (Distributors), and if one distributor doesn’t accept to sell
to Griffith exclusive rights in the open towns, Griffith would still have many other distributors to bargain with, and the distributor
which rejected Griffith’s offer in the first place would loose sales. It follows that Griffith could take advantage of its monopoly in
the closed towns (where there was a natural monopoly considering the size of the town) to monopolize towns where competition
would be possible. This explains why in a short five years period Griffith increased its monopoly power from 19 to 53 towns. The
court concluded that “when the buying power of the entire circuit is used to negotiate films for his competitive as well as his
closed towns, he is using monopoly power to expand his empire. And even if we assume that a specific intent to accomplish that
result is absent, he is chargeable in legal contemplation with that purpose since the end result is the necessary and direct
consequence of what he did”.
According to the Single Monopoly Profit Theorem, however, when Griffith used its bargaining power to pursue the exclusive
rights in competitive towns it was sacrificing the full profits that could be obtained in its closed towns. In other words, the
distributor will grant Griffith exclusive rights in the competitive towns but he will, in turn, be able to sell the films rights in the
closed towns for a higher price. The same result would be achieved if an exhibitor got a large fund from banks and negotiated
exclusive rights in competitive towns by paying a higher price for them (in the same way Griffith is paying a higher price when it
gives up the higher profits it could make in the closed towns).

Monopolizing Based on Tying up Consumers – Long-term contracts (United)

United States v. United Shoe Machinery Corp. (The practices undertaken by United Shoe were considered unreasonably
exclusionary and capable of monopolizing)
United Shoe supplies almost 85% of current demand in the market of shoe machinery. The defendant represents a substantial
share of the market, meeting the first requirement to be condemned under Sherman Act # 2. The second requirement is whether
the defendant is engaging in unnecessary exclusionary acts. Unnecessary exclusionary acts can be defined as practices which
create, enlarge or maintain monopoly power by limiting the opportunities of rivals to compete, without offering market efficiencies
or offering efficiencies which could be achieved through a less restrictive manner. Therefore, an objective analysis with regard to
the potential harms to exclude competitors and the possible efficiencies justifications should be done for each of the practices
carried out by the monopolist. In the present case, United is being accused of undertaking the following exclusionary practices:
- Adopting a policy of refusing to sell the shoe machines and only lease them. The hazardous effect generated by this policy is that
it precludes the creation of a secondhand market of machineries. If United has the control of the market and it refuses to sell the
machines, it is impeding potential business in the secondhand market of machinery which could offer an alternative to consumers
and threat the monopoly. One defense that could be argued by United is that the leasing system might benefit the consumers and
enhance competition in the market of shoe manufactures. It is easier for the shoe manufactures, particularly those which are
starting business, to lease the equipments instead of buying them, considering their high costs and the risks of them breaking
down.
- The fact that the lease contract was for a 10 year term. The consumers become bound to a long term contract, which they can
only get rid by incurring in a penalty for early termination. Thus, even though there will be a small percentage of consumers who
are not bound to United each year (when the term of their contracts expire), this small available group of buyers may be
insufficient to encourage a newcomer.
- A full capacity clause which requires that the consumer uses the machine until he has work available. Obviously that this
requirement discourages consumers from buying machines from United’s competitors since consumers will have to use the full
capacity of the United’s machine before purchasing a new one.
- The early termination penalty clause. The higher is the value of the fee, the more unlikely it is that consumers will switch to other
suppliers. Also, if the consumer wants to return the machine, United gives him more favorable conditions if he replaces it for a
second United machine. Once again, this policy contributes to attach the consumers to United by discouraging them to replace a
United’s machine for one of a competitor.
- Providing “free” service to repair the machines (actually the price of the lease already includes a repair service). The negative
effect of this practice is that it will preclude the creation of a market of independent repair services, since the consumers will
always prefer to fix their machines with United considering that they have already paid for the service. In the absence of
independent repair services, the potential entrants in the market of shoe machinery will face a problem of either having to provide
the services by themselves (what can be impractical considering the high costs, the experience and the knowledge required), or
offering machines with a very lower price to compensate consumers for the risk of having a broken machine and facing difficulties
to find a repair service. United could justify the practice of offering the repair service together with the product alleging that it is
necessary to promote a quality-control of its products. After all, United still own the machines which have been leased and, thus,
it has a reasonable interest in fixing them to preserve their integrity. Moreover, even if the machines were sold, United could
justify a quality-control policy on the ground of protecting the reputation of the brand.
- Price discrimination. United charged higher prices for machines leased in a market with no competition at all and took
advantage of the excessive profit extracted to charge lower prices in the sectors which there is some competition or at least
potential competition. It is basically using its monopoly power in one sector to enhance barriers to entry in another sector
threatened by competition.
The court recognized that United has an advanced understanding of the techniques of shoe making, has offered high quality
products, has efficient designs and provides a knowledgeable service. However, the court considered that United’s market
control did not rest solely on these factors, but also on the barriers erected by its own business policies which were not the
inevitable consequences of its capacities or its natural advantages. Despite the fact that these policies were not immoral and
wouldn’t be condemnable if undertaken by a small firm, they have potential exclusionary affects when undertaken by a firm with
90% of the market share. “United is denied the right to exercise effective control of the market by business policies that are not
the inevitable consequences of its capacities or its natural advantages. That those policies are not immoral is irrelevant”

Case analyzed in class (page 396 (316 - d) from the casebook) – Remedies
Dissolution – When the firm owns a single plant, like occurred in United Shoe, the costs of splitting the plant and shifting assets to
other areas would be too high to make dissolution a practical remedy.
If there were three plants and each of them produced a variety of United machinery, dissolution would be more feasible. The
advantages provided would be the creation of two new competitors.
The disadvantages would be less efficiency on the sales levels, possible loss of economies of scale, harms to the distribution
patterns and “unfairness” to stockholders. It could be also argued that, if the plants are far from each other and the costs of
transportation are high, there will be three monopolies, each in one territory. The firms wouldn’t compete with each other
because the consumer doesn’t have the alternative of buying in the other supplier when the costs of transportation are too high.
But usually when the product is complex and expensive, the cost of transportation doesn’t constraint consumers from buying from
distant suppliers.
Supposing each of the three plants produced a particular United machinery, arguably dissolution would not be appropriate. If
each make a separate product which are not close substitute products, splitting the plants into three firms will generate three
monopolies, each of them monopolizing a specific sector of the shoe industry. One could still defend the dissolution by arguing
that there is the possibility of each of the separate firms expand its production and enter into the other’s market. This possibility is
likely when the producers are able to adjust their machines to produce different types of shoes without incurring in high sunk
costs (uncommitted entrants). The threat of easy entry may be sufficient to maintain the prices at competitive levels.

Monopolizing Based on Unilateral Refusal to Deal – essential facility doctrine (Aspen and Verizon)

Aspen Skiing Co v. Aspen Highlands Skiing Corp. (A monopolist which refuses to deal with a small rival without any efficiency
justifications or benefit for consumers shall be condemned under the Sherman Act # 2)
Ski Co. owned and operated facilities on three mountains in Aspen and Highland Corp. had the fourth. For several years they
have offered 6-day tickets for All-Aspen mountains and divided the revenues from those sales on the basis of usage. By 1977,
Ski Co began to resist the joint offering ticket. It gradually reduced Highland’s revenues on the sales until reach a point at which
Highland could not accept the offer (12,5% fixed percentage of the revenue). With the termination of the All-Aspen tickets,
Highland had to sell tickets for a single mountain, while Ski Co. was selling three-mountains tickets. The result was a steadily
decline in Highland’s sales and share of the market. The solution adopted by Highland was to buy tickets from Ski Co by itself
and offer these tickets to the consumers as a 4-mountain ticket. But shortly thereafter, Ski Co realized its competitor strategy and
refused to sell tickets to Highland at all. The question that arises is whether the Ski Co refusal to deal with its smaller rival can be
characterized as a violation of Sherman Act # 2.
The court recognized that a corporation which possesses monopoly power is not under a duty to cooperate with its business
rivals, as long as valid business reasons exist for that refusal. The defendant has the burden of proving that the refusal to deal is
motivated by efficiency concerns, rather than a mere effort to exclude the smaller rival from the market. “The absence of an
unqualified duty to cooperate does not mean that every time a firm declines to participate in a particular cooperative joint venture,
that decision may not have evidentiary significance, or that it may not give rise to liability in certain circumstances”.
In the present case, the court concluded that Ski Co. has not demonstrated any reasonable motives for terminating the jointly
offered All-Aspen ticket. To the contrary, the unilateral termination of a voluntary (and thus presumably profitable) course of
dealing suggested that Ski Co. was forsaking short-term profits to achieve an anticompetitive end. A second indication that Ski
Co was sacrificing short-term profits is its refusal to sell tickets to Highland at its own retail price. There is no reason why a
rational firm willing to maximize profits would give up revenue from the sale of its products as Ski Co did, unless the purpose is to
drive the competitor out of the market and enjoy long-term monopoly. Moreover, the conduct is not bringing benefits to
consumers by offering a superior product, a more qualified service or innovations. In fact, the evidences prove that the 4-
mountain ticket provided convenience and flexibility to skiers, who could have more available options of mountains during their
ski period. “Thus the evidence supports an inference that Ski Co. was not motivated by efficiency concerns and that it was willing
to sacrifice to sacrifice short-term benefits and consumer good will in exchange for a perceived long-run impact on its smaller
rival”.

Verizon Communications v. Law Offices of Curtis Trinko, LLP (Sectors which are subject to large regulatory frameworks are
unlikely to suffer antitrust scrutiny by the courts considering the highly technical provisions of regulation and the problem of
conflicting judgments. Even if the defendant was subject to antitrust scrutiny, the fact that it didn’t deal with its competitors in the
past indicates that it can have valid business justifications for refusing to deal)
Congress, through the Telecommunications Act of 1996, has imposed network-sharing duties upon incumbent local telephone
companies in order to facilitate market entry by competitors. The local telephone business demands a complex infra-structure,
which duplication requires high costs and is socially undesirable since a single network has enough capacity to attend all the
market necessities (natural monopoly - it would be wasteful to create a second one). Thus, the purpose of the network-sharing
duties was to introduce competition in a market where the entry would be unfeasible if the newcomer had to build a second infra-
structure.
Verizon, an incumbent local exchange carrier which serves New York State, has been reluctant in complying with the sharing
obligations imposed by the Telecommunications Act, and AT&T brought this suit alleging that Verizon is monopolizing the local
telephone market. The question before the court is whether the network-sharing duties imposed by the Telecommunications Act
can be enforced by means of an antitrust claim.
The first consideration made by the court is whether regulated entities are shielded from antitrust scrutiny. The
Telecommunications Act of 1996, in particular, has an antitrust saving clause providing that “nothing in this Act or the
amendments made by this Act shall be construed to modify, impair, or supersede the applicability of any of the antitrust laws”.
Thus, Congress has made it clear that regulated entities from the telecommunication sector are not immune from antitrust scrutiny.
Nevertheless, the court raised several arguments to resist the application of antitrust law where there is already a large regulatory
framework designed to deter and remedy anticompetitive harms. First, in the presence of such framework, the interference of
courts can create the possibility of judgments conflicting with the agency’s regulatory scheme, resulting in uncertainty in respect of
the Agency’s authority and the binding force of its decisions. Second, antitrust courts usually do not have the expertise and
knowledge to interpret the highly technical provisions of sharing and interconnection obligations imposed by a regulatory regime.
In most of the cases, the regulatory agency, which assumes the day-to-day control of the specific regulated industry, is in a better
position to evaluate whether the firms are complying with their network-sharing duties. In this case, when several competitive
local exchange carriers complained about deficiencies in Verizon’s servicing of orders, the FCC responded by imposing a
substantial fine and setting up sophisticated measurements to estimate remediation, with weekly reporting requirements and
specific penalties for failure. This is a clear evidence of the efforts of the Regulatory Agency to enforce the sharing duties and
stimulate competition within the context of the sector it regulates with much more know-how than the courts would have. The
costs for the courts to interfere with the highly technical provision of the regulated sector should also include the costs of a wrong
or inappropriate decision.
A final problematic aspect of the court’s interference is the difficulty in establishing a continuously supervising system by which the
court can ensure if the defendant is following adequately the network-sharing duties.
“One factor of particular importance is the existence of a regulatory structure designed to deter and remedy anticompetitive harm.
Where such a structure exists, the additional benefit to competition provided by antitrust enforcement will tend to be small, and it
will be less plausible that the antitrust laws contemplate such additional scrutiny”.
Despite the fact that the sector is highly regulated, the court followed the antitrust saving clause imposed in the Act and decided
to analyze the antitrust claim. But still the court considered that there was no violation of the Sherman Act. As it was noted in
Aspen “The absence of an unqualified duty to cooperate does not mean that every time a firm declines to participate in a
particular cooperative joint venture, that decision may not have evidentiary significance, or that it may not give rise to liability in
certain circumstances”. To determine if the refusal to deal is improperly exclusionary, the first question is whether the monopolist
has a valid justification, or if it is, instead, a sacrifice of short-term profits which only makes sense if the purpose is to exclude the
competitor from the market. Unlike Aspen, which involved business deals voluntarily undertaken by the defendant and terminated
without any justification, here the monopolist firm has never entered into agreements with its competitors and the sharing
obligation created something brand new. The relevance of this difference rests on the presumption that once a firm has initially
“cooperated” with its competitors there is an indication that the agreement is feasible and profitable for both of them. The
monopolist which has never entered into agreements with its competitor, on the other hand, can present several reasons for
refusing to deal which are not available for the monopolist which has cooperated in the past. Verizon could claim, for instance,
that the conditions offered by the competitor are inappropriate to reimburse its investment or that it does not have excess
capacity to cooperate with its smaller competitor. Therefore, reasons other than an effort to monopolize can be raised by Verizon
to justify the refusal to deal. “In Aspen, the defendant turned down a proposal to sell at its own retail price, suggesting a
calculation that its future monopoly retail price would be higher. Verizon’s reluctance to interconnect at the cost-based rate of
compensation available under 251(c)(3) tells us nothing about dreams of monopoly”.

Essential Facilities Doctrine (“Bottleneck Doctrine”)

The idea of the essential facility doctrine is to force a monopolist which controls a natural monopoly to share its facilities with new
entrants. The plaintiff must demonstrate the following requirements to have a claim under the “essential facility doctrine”: (i)
control of the essential facility by the monopolist; (ii) a competitor’s inability practically or reasonably to duplicate the essential
facility; (iii) the denial of the use of the facility to a competitor; and (iv) the feasibility of providing the facility. Where there is a
natural monopoly, by definition, it is more efficient to have a single market structure than multiple structures. This is because a sole
structure is enough to cover all the demand and duplication would lead to wasteful costs. Many examples can be cited as natural
monopolies, such as the bridge in Terminal Railroads, the electric power transmission lines in Otter Tail Power, and the local
telecommunication network in Verizon Communications. In other cases, it is not clear whether it is feasible and desirable to
duplicate the structure and it may or may not represent a natural monopoly (the newspaper business arrangement in Associated
Press).
In any event, under the essential facility doctrine, the monopolist which refuses to share its facilities (a natural monopoly) with a
competitor or a potential entrant, without any efficiency justifications, is monopolizing the market and should be condemned.
These five cases involve refusal to deal in allegedly natural monopolies controlled by the monopolist:

Terminal Railroads
Associated Press v. United States
Otter Tail Power Co v. United Sates
Aspen Skiing Co v. Aspen Highlands Skiing Corp.
Verizon Communications v. Law Offices of Curtis Trinko, LLP
Terminal Railroads and Associated Press presents a particularity which is a concerted refusal to deal. It is easier for the plaintiff
to attack the concerted action because it is evident that the “essential facility” can be shared among several players, whereas
when the essential facility belongs to a single firm there is the defense that sharing requires high costs or that it is totally unfeasible
(but the unilateral refusal to deal can also be condemned as we saw in Aspen). In this sense, it is more practical for the court to
provide a remedy when the facility is already being shared by simply requiring that the outsider be granted nondiscriminatory
access. Moreover, the fact that the essential facility is already being shared demonstrates a predisposition of dealing with
competitors, while the single firm can be unwilling to deal with any competitor (it is not discriminating by selecting some rivals and
refusing others).

Case analyzed in class (page 434 (d) from the casebook)

(1) Patent (Essential Facility?). A patent is not a natural monopoly because other competitors are able to invest in research and
develop new techniques to produce the same or even a better product. But even if we assume that it is extremely hard for a
competitor to enter in the market without infringing the patent (considering that it is an essential facility) it is unlikely that the courts
would enforce an obligation to license the patent because the very objective of the patent system is to grant the right to refuse to
license and explore the product exclusively. After all, the inventor invested in the new creation relying on the expectation of
exclusive rights conceded by the state. If the courts start to ignore the exclusive rights or mitigate them, the incentives to create
can be diminished.
(3) Repair Service (Essential Facility?). The monopolist has a network of services to repair shoe machines. It is extremely hard
for the newcomer to set up this expensive and complex network, with agencies spread across the country, so it argues that
United is obliged to share by fixing the machines produced by the newcomer for a reasonable cost.
First, United could argue that the repairing system is not a natural monopoly. Even though it is expensive and complex the
potential newcomers could get together in a joint venture to build their own system and share the costs. Moreover, two repairing
services could benefit the consumers because there will be competition, resulting in lower prices and better quality.
The second argument is related to the high investments and risks incurred by United to set up its repairing network. Even if the
payment by competitors to access United’s service includes the costs to repair the machines plus a reasonable profit, the risks
incurred by United in the first place to build up the entire structure are not being compensated. The consequences will be less
incentive for the entrepreneurs to invest in those economically beneficial facilities.
Finally, United could argue that the network does not have excessive capacity to cover the demand of the competitors. If it did
have excessive capacity (idle), it would be hard for United to defend itself since it would be “sacrificing short-term profits without
any rational explanation, except the desire to exclude a competitor”. But without excessive capacity, United could allege that it
would be too costly to expand the structure and the profits wouldn’t compensate the costs.
(4) Warehouse (Essential Facility?). First the plaintiff must demonstrate that the warehouse is to complex to be duplicated. The
refusal to deal with an idle warehouse leads to the presumption of “sacrificing short-term profits without any rational explanation,
except the desire to exclude a competitor”.

Monopolizing Based on Predatory Price – charging prices below costs (ITT Grinnell)

The predatory pricing practice takes place when a monopolist charges unreasonable low prices, incurring in short-term losses, in
order to exclude competitors from the market. Thus, “two prerequisites must be met to condemn a monopolist for predatory
pricing: (i) the price charged must be below the monopolist costs of production (measure of costs can vary); and (ii) for the
investment to be rational, the predator must have a reasonable expectation of recovering, in the form of later monopoly profits,
more than the losses suffered”. Matsushita. The rationality of condemning the monopolist under these circumstances is that there
is no possible explanation for a monopolist to be charging prices below its costs, except to drive its rivals out of business and
enjoy long-term monopoly profits.
This presumption, however, is not always true. A possible defense to justify prices below costs would be that it is a temporary
policy because during that specific season of the year the product is less attractive to consumers, but the future profits in the next
seasons will compensate the transitory loss (suppose a product which is exclusively demanded in the summer. During the winter
the industry will accept to bear some losses by selling the product below its costs, with the expectation that in the summer it will
recover the losses suffered and earn some extra profits). The firm can also be selling a product for a price below its costs when it
is a complementary product which matches with a principal product sold for a price above its costs. If you look to the package
as a whole, the price charged will be above costs. Despite these possible arguments, the general rule is that when a monopolist is
charging a long-term price below costs, the most probable reason is to suppress competition.

Barry Wright Corp. v. ITT Grinnell Corp. (A monopolist charging a price above its total costs is not monopolizing since it is
undertaking an acceptable profitable business and the only possible competitors to be excluded from the market are the inefficient
ones).
Pacific is a monopolist in the production of mechanical snubbers. Grinell is a consumer of mechanical snubbers who has entered
into a commercial agreement with Barry under which it would help Barry to develop a full mechanical snubber line. While waiting
for Barry, Grinell satisfied its current needs by buying mechanical snubbers from Pacific at Pacific’s ordinary discount price –
20% below list. When Pacific realized that Grinnel was trying to develop its own supply source through Barry, it began offering
greater discounts reaching 30% below list. With the new discounted prices, Grinnel decided to cancel its agreement with Barry
and buy only from Pacific. Barry brought this suit alleging that Pacific has monopolized the market through predatory pricing in
violation of the Sherman Act # 2.
The court rejected the claim because the discounts offered by Pacific were still above its total costs of production. Thus, the price
at this level will only preclude Barry from entering into the market if its cost structure is higher than Pacific’s, which implies
inefficiency. As long as the price which is being charged by the monopolist is above its cost structure, the market is attractive for
any efficient competitor (with an equal or lower cost curve). This suggests that predatory pricing is not designed to protect
inefficient competitors.
The Ninth Circuit, however, decided in Transamerica that even “above total cost” price cutting might cause harms to competition.
An efficient monopolist firm can cut prices to a level which is above its own total costs but below its rival total costs in order to
eliminate the less efficient rivals and subsequently increase the price to a monopolist level. The less efficient competitors, even
though failing to fully contribute to competition, can still play an important role which is to impose a limit in the price set by the
monopolist. With the presence of the less efficient competitors in the market, the monopolist can be, and probably will be,
extracting high profits (because its cost structure is more efficient), but it won’t be able to charge unrestricted monopolist prices.
In fact, it is exactly for that reason that it wishes to eliminate the less efficient competitors by cutting the price.
The Supreme Court, on the other hand, is reluctant in punishing monopolists which are charging a price above total costs, even if
this price is excluding competition. First of all, a price cut is perhaps the most desirable activity (from an antitrust perspective) that
can take place in a concentrated industry where prices typically exceed costs. When a monopolist is charging a low price but
which is above its total costs, it is still engaging in a profitable business. But one could argue that it could be maximizing profits by
fully exploring the monopoly and charging a higher price (what would invite competition). But it would be at least paradoxical to
force a monopolist to raise prices even more than the current price (which is above its costs), in order to invite competition,
considering that the main concern of the antitrust laws is to maintain low prices. The court’s interference could threaten to “chill”
highly desirable procompetitive price cutting. “The Sherman Act does not make unlawful prices that exceed both incremental and
average costs”.
There is an additional problem related to the remedies to be adopted. There are only two possible solutions. The first one would
be to force the monopolist to charge monopolist prices in order to invite the inefficient competitors. This would cause serious
injuries to competition and one might ask “why would it be better to have many inefficient firms charging higher prices – due to
their inefficiency – rather than a single monopolist charging a lower price?” The answer to this question might be that in the long-
term the competitors can develop new production techniques which will improve their costs structure and decrease the price until
it reaches a level lower than the price originally charged by the monopolist.
The second solution would be to force the monopolist to charge a competitive price. But that would worsen even more the
market conditions to invite competitors. If the potential newcomers were unwilling to enter in the market at a price above the
competitive level (because of their costs structures and the risks of the investment), with a competitive price (measured by the
efficient firm’s cost structure) they will be even more reluctant.
Therefore, considering that a monopolist charging price above costs is engaging in a profitable activity (it is not necessarily
undertaken to exclude competitors) and that the only rivals which will be excluded from the market are the inefficient ones, the
Supreme Court decided not to condemn monopolists charging prices above their costs.

Case analyzed in class (page 454 (334) from the casebook)

a) A monopolist which is charging a monopolist price is not monopolizing the market in violation of the Sherman Act # 2. It is
exercising its monopoly power through a way which in fact invites competition (high prices).
b) The “limit price” (which is higher than a competitive price but less than a monopoly price) is designed to exploit some extra
profit while discouraging competition. In fact, there is no rational reason why the monopolist is not fully exploiting its monopoly,
except to discourage competition. But as long as the price charged is above its costs structure it will only discourage less efficient
competitors which have a higher total cost curve and are not attracted by the “sub-monopoly” price. As we saw in Barry Wright
Corp. v. ITT Grinnell Corp., the Supreme Court decided not to condemn monopolists which are charging a price above their
costs.
e) In United States v. Trenton Potteries the court rejected the idea of inquiring the reasonableness of the price as a defense to an
agreement to fix prices among competitors. Why should the court care about the reasonableness of the price in analyzing
predatory pricing claims? The first significant difference is that the analysis of the reasonableness of prices to justify an agreement
among competitors is more complicated because it requires a two-steps scrutiny: first the cost structure must be calculated and
secondly a “reasonable profit” must be determined. On the other hand, the analysis of the reasonableness of the price to evaluate
whether the price is predatory requires solely the calculation of the cost structure. The aim of this analysis is to determine if the
price being charged is below costs and, thus, it is irrelevant to measure a reasonable profit. The second, and most important,
difference consists in the aversion to price fixing, which can never (or almost never) bring procompetitive effects. Price cutting, in
contrast, is almost always procompetitive and in very rare exceptions it should be deemed illegal. Thus, to verify if the case falls
within the rare exception of “illegal price cutting” the plaintiff must demonstrate that the price is unreasonably low. Therefore, it
can be said that while in the first situation (price fixing) the reasonableness of the price is raised by the defendant to justify a
conduct which is extremely repudiated, in the second situation (price cutting) the reasonableness of the price is a condition to
justify the condemnation of a conduct which would otherwise be the main goal of the antitrust system. It follows that, the price
fixing arrangement is presumably illegal (the reasonableness of price is a tentative of making them legal) whereas the price cutting
is presumably legal and highly desirable (the unreasonableness of the price is a tentative of making them illegal).

Appropriate Measure of Cost

There is a discussion concerning which is the appropriate measure of costs to determine if a price is predatory (the average total
cost, the average variable cost or the marginal cost). The average total cost includes both the fixed costs and the variable costs
divided by the quantity of output; the average variable cost includes only the variable costs divided by the quantity of output; and
the marginal cost is the cost to produce the next unity of output. This discussion is only relevant when the price charged by the
monopolist is above its average variable cost curve but below its average total cost. In this situation the plaintiff will try to
persuade the court that the average total cost curve is more adequate for the analysis arguing that when the monopolist decides
on the level of output and price it has to take into consideration all the costs of production. Moreover, the production of the next
unit will cause a decrease in the price of each unit already produced. If the additional revenue provided by the sale of this next
unit does not compensate the costs of its production plus the loss in the sales of the other units, it wouldn’t be rational to produce
the next unit (the court, however, rejected such approach in United States v. AMR CORP)
On the other hand, the defendant will argue that the appropriate measure of costs is the average variable cost curve since the
fixed costs are already a “sunk cost” and shall not be taken into consideration when deciding the levels of output and price. The
fixed costs are those ones which do not vary according to the changes in output, such as the salary of the officers, the plant or the
property tax expenses. Because they are costs that will be incurred by the monopolist regardless the increase in the level of
output, it would be reasonable to assume that the total cost curve is not appropriate to measure whether the price is predatory (it
can be below the total cost but still be a legitimate price). When an airline company, for instance, charges the last tickets (one day
before the departure) a price below the average total cost but above the average variable cost, such conduct may be explained
as an effort to fill up the airplane by selling the largest amount of tickets as possible even if they are not compensating the fixed
costs given that these will be incurred anyway (fuel, the staff’s salary, the price to have the gates in the airport).

United States v. AMR CORP. (An appropriate measure of cost to determine whether the price is predatory does not include the
loss of profit in the sales of all other units due to the price reduction).
The issue in this case is whether the price charged by American Airlines was predatory and which is the appropriate measure of
costs to reach this conclusion. What happened was that American responded to lower fares charged by the low cost carriers
(LCC) by cutting price, adding capacity (more flights and larger planes) and making more seats available at the lower price.
Because the LCC couldn’t follow the price cutting, they were driven out of business and the Government sued American Airlines
for predatory pricing. The plaintiff argues that when American increased its capacity it is not only incurring in the evident costs of
making more seats available and providing more food to serve these new passengers, but also, and most importantly, the costs
with the loss of revenues as a result of the price decrease of all the other flights. In other words, for the additional capacity to be
rational, the revenue earned by this extra output should compensate for the costs of producing it plus the revenue lost in the sales
of all other units due to the price reduction. This is because when the output increases and the price decreases, not only the extra
unit produced will be sold for a lower price, but the entire production. Therefore, American Airlines decision to add capacity and
reduce price, wouldn’t be profitable if you analyze the entire business and the losses incurred by its other flights. It follows that,
the only possible reason to explain American’s conduct is to drive the LCC out of business and enjoy long-term monopoly
profits.
The court, however, rejected the plaintiff’s proposal to adopt a measure of costs which includes the revenues renounced by
American. The court concluded that the price charged is still above the marginal cost of production and, thus, it is rational for
American to pursue this strategy in order to maintain its costumers. Even though American will be loosing in the long-term (it has
to pay its fixed costs such as the headquarters salaries and taxes which are not being absorbed by the actual price) in the short-
term it is a profitable strategy to attract the consumers and fill up the flights. American can compensate the fixed costs by charging
higher prices for first class seats.
“Test one effectively treats forgone or “sacrificed” profits as costs, and condemns activity that may have been profitable as
predatory…In the end, Test One indicates only that a company has failed to maximize short-run profits on the route as a whole.
Such a pricing standard could lead to a strangling of competition, as it would condemn nearly all output expansion, and harm to
consumers”. The court also rejected the Government’s test two and three by arguing that they “rely on fully allocated costs and
include many fixed costs and utilizing these cost measures would be the equivalent of applying an average total cost test, implicitly
ruled out by Brooke Group’s mention of incremental costs only”.

Brooke Group Ltd v. Brown & Williamson Tobacco Corp (When the predatory practice is undertaken to facilitate oligopolistic
behavior instead of forming a single monopoly, the practice is not condemnable because the predator will not recoup the loss
suffered during the predatory period)
The cigarette manufacturing has long been one of America’s most concentrated industries and substantial evidence suggests that
the industry reaped the benefits of prices above a competitive level through oligopolistic behavior. The production has been
dominated by six firms: R.J Reynolds (28%), Philip Morris (40%), American Brands, Lorillard, and the two litigants involved
here, Ligget (2%) and Brown & Williamson (12%). The facts are that, in order to increase its market share, Ligget developed a
line of black and white generic cigarettes which had the major characteristic of low price. Because the whole industry is
interconnected (generic cigarettes are substitutes for branded cigarettes, thus, one market affects the other), as the market for
Ligget’s generic cigarettes expanded, the sales of branded cigarettes rapidly reduced, affecting the profits extracted by the other
firms. In reaction to the lost of sales in its branded products, Brown & Williamson decided to enter the generic segment of the
cigarette market and cut prices below its average variable costs, selling the generic product at a loss. Ligget claims that B&W
was cutting prices on generic cigarettes below costs and offering discriminatory volume rebates to wholesalers to force Ligget to
raise its own generic cigarette prices and allow oligopoly pricing in the economy segment once again. Is there any violation of the
Sherman Act?
Section 1 requires an agreement and the Supreme Court has already decided that oligopolistic behavior standing alone is not a
conspiracy or a tacit agreement capable of being condemned under section 1. The only express agreement in this case is the
contract between B&W and the wholesalers, but it is still not enough to characterize a section 1 violation since it is not an
anticompetitive vertical agreement, but yet an unilateral offer made by B&W to the wholesalers.
Under section 2, the practice of monopolization requires the defendant to be a monopolist. But B&W, which has 12% share of
the cigarette industry, is not considered a monopolist. Even if the generic segment is analyzed as a separate market, which could
lead to the conclusion that B&W is monopolizing this specific sector, it is hard to say that it is a monopolist since the other firms
can offer generic cigarettes at any time.
Because the Sherman Act is not appropriate to condemn B&W, the plaintiff sued under the Robinson-Patman Act which makes
illegal a price discrimination resulting in injury to competition. Thus, the question is whether there is any injury to competition. If
B&W is not a monopolist, which means that the price cutting below its costs won’t allow it to charge monopoly prices, what is
the danger to competition? The generic cigarette sector has proven to disturb the oligopolistic behavior in the branded cigarette
industry by offering a similar alternative to consumers for a much lower price. When B&W pursues a strategy to eliminate the low
prices in the generic sector (by charging a price below its costs which will force Ligget to increase its price) it will be undoubtedly
facilitating oligopolistic behavior to take place once again in the cigarette industry. Thus, the objective is to reinforce oligopolistic
behavior threatened by the emergence of a connected sector which offers a substitute product for lower prices. In fact, after
B&W’s “predatory pricing”, the price of both cigarettes (branded and generic) increased substantially, demonstrating that B&W
succeeded in bringing about oligopolistic price coordination and supracompetitive prices. The fact that the growth of the cigarette
industry increased is not enough to conclude that the alleged predation did not cause harms to competition. One could argue that
without B&W practice the rate of segment growth could have increased much more.
The court considered, however, that an essential requirement to characterize a predatory pricing is that the predator recoups the
losses incurred during the predatory pricing period. “For the investment to be rational, the predator must have a reasonable
expectation of recovering, in the form of later monopoly profits, more than the losses suffered”. The court argues that if this
condition is not met, the predatory pricing can cause harms to a competitor, but not to competition, which is the ultimate concern
of the antitrust laws. It concluded that tacit coordination among oligopolists must be considered the least likely means of
recouping predatory losses since the predator’s losses fall on it alone, while the later supracompetitive profits must be shared with
every other oligopolist in proportion to its market share. Because B&W will have to bear the costs of the “predatory investment”
by itself, and share its gains with all the other oligopolist firms (which have a larger market share and will extract the most
benefits) it is unlikely that it will recoup the losses suffered. “The evidence is inadequate to show that in pursuing this scheme,
Brown and Williamson has a reasonable prospect of recovering its losses from below-cost pricing through slowing the growth of
generics. As we have noted, the success of any predatory scheme depends on maintaining monopoly power for long enough both
to recoup the predator’s losses and to harvest some additional gain”. The consequence of such holding is that when the predatory
pricing is undertaking to facilitate oligopolistic behavior instead of forming a single monopoly the practice is not condemnable
because the predator will not recoup its losses through an oligopolistic scheme.
But why should the court care at all about recoupment if it was already demonstrated that the practice of charging prices below
costs in the generic sector will result in oligopolistic behavior and supracompetitive prices causing harms to consumers? Certainly
the temporary benefit the consumers will have in buying generic products at low prices during the predatory period will not
compensate the loss they will suffer after the predatory period is over (both the branded and the generic markets will be charging
supracompetitive prices through oligopolistic behavior). The court is in fact saying that as long as the gains from the
supracompetitive prices, which were made possible by the predatory pricing, do not end up in the predator’s hands allowing it to
recoup its losses, the practice shall not be condemned, what doesn’t make any sense. The important issue is that, from the
suppliers perspective, there are “gains” (regardless of to which firm they are going to) that exceeds the “costs” (losses suffered by
the predator), what means that the consumer will pay a supracompetitive price for a long period (regardless of which supplier
they are buying from) which exceeds the benefit they received in buying the generic cigarette for a low price during the predatory
phase. Nevertheless, the court tends to assume that even if we consider the industry taken as whole (all the oligopolist firms) it
will not be able to recoup the losses suffered by the predator, considering the limits and difficulties of coordination. Therefore,
competition was not injured.

Monopoly Power
The courts have defined the possession of monopoly power as the power to control price. A monopolist has the power to raise
its price substantially above competitive levels because any lost demand will be profitably outweighed by the higher prices that the
monopolist charges its remaining customers. For the price increase to be profitable there must be a lack of alternatives to the
consumers so the eventual lost of sales does not exceed the profits earned by charging the remaining consumers higher prices.
Thus, the main constraint on the exercise of market power is the capacity of competitors to increase output and cover the
demand which is dissatisfied with the price increase. Where the competitors can rapidly and easily increase their output, the
consumers are able to switch to a different supplier and avoid the high prices charged by the potential monopolist. Therefore, to
determine the ability of a firm to exercise monopoly power, the first step is to define the relevant market in which the exercise of
monopoly power would be possible.
According to the Merger Guidelines promulgated by the Justice Department and the Federal Trade Commission “A market is
defined as a product or group of products and a geographic area in which it is produced or sold such that a hypothetical profit-
maximizing firm, not subject to price regulation, that was the only present and future producer or seller of those products in that
area likely would impose at least a “small but significant and nontransitory” increase in price, assuming the terms of sale of all
other products are held constant. A relevant market is a group of products and a geographic area that is no bigger than necessary
to satisfy this test”. As stated by the Guidelines, the relevant market is divided into two dimensions: the product dimension and the
geographic dimension.
To determine the group of products that should be included in the same relevant market the question that should be asked is
whether the products are close substitutes to each other. If they are close substitutes to each other, then the consumers are able
to switch, and a monopolist of only one of these products will be unable to achieve a “small but significant and nontransitory”
increase in price. “The general rule when determining a relevant product market is that the outer boundaries of a product market
are determined by the reasonable interchangeability of use (by consumers) or the cross-elasticity of demand between the product
itself and substitutes for it.” Brow Shoe. “Interchangeability of use and cross-elasticity of demand look to the availability of
substitute commodities, i.e, whether there are other products offered to consumers which are similar in character or use to the
product or products in question, as well as how far buyers will go to substitute one commodity for another”. Cellophane.
An indicator of product substitution is the cross-elasticity of demand, which refers to the rate at which consumers change their
consumption of one product in response to a price change for another. A high cross elasticity of demand suggests that the
products have similar functions, quality and whatever factors that can influence the consumer’s decision to purchase any one of
them. Moreover, the products can be substitutes depending on the type of consumer and the uses he attributes to the product.
Suppose a case where a majority of consumers considers a similar product as a substitute but a small fraction of consumers
considers the product as unique. To determine if the monopolist of this product can exercise monopoly power, we should ask
two questions: first, can the monopolist price discriminate to charge the consumers who are able to switch a competitive price
and the consumers who consider the product unique a monopolist price? If he can price discriminate, then the group of
consumers who are able to switch will not constraint the exercise of monopoly power. This result indicates that the relevant
market must be divided into separate niches each one representing the particular group of consumers which are potential victims
of higher prices (Consider the Apples Computers. Some consumers are able to turn to different computer suppliers in the event
of a significant price increase, while others are locked to Mac because of its sophisticated graphic instruments. If Mac can price
discriminate, then it is appropriate to define the relevant market as “Apple Computers” instead of “Computers in general”). With
this narrower definition of the relevant market it is possible to have a more accurate perception about the hypothetical
monopolist’s capacity to raise prices above competitive levels. But if he can’t price discriminate, then the second question that
should be asked is whether the profits made by charging the remaining consumers a monopolist price will outweigh the loss of
sales caused by the consumers who will switch in response to higher prices. If the profits are able to outweigh the loss (depending
on the number of consumers in each group and the frequency/size of each purchase), then the narrower definition of the relevant
market shall be adopted.
The geographic inquiry has the same rationality as the product analysis. The relevant question here is how far the consumers will
go to obtain the product at a better deal. Depending on the value and complexity of the product, consumers might turn to
different states or even to different countries to obtain a better offer for the product. Usually, the cost of transportation is the main
constraint on the likelihood that consumers will shop in different regions.
Once the relevant product and geographic market is defined, the market share of the defendant shall be calculated in this relevant
market. The market share will indicate whether there are enough competitors to “fill the gap” and effectively restraint the potential
monopolist from profitably raising prices and cutting output. Not only the number of competitors is an important indication of
constraint, but especially their ability to expand capacity and increase output to cover the excess demand. In addition to current
competitors, the “uncommitted entrants” shall also be taken into account due to their probable response to a price increase.
Uncommitted entrants are treated as a market participant because of their ability to start offering the product without the
expenditure of significant sunk costs of entry and exit. With high prices and low costs of entry, the uncommitted entrants will be
stimulated to enter in the market and, thus, represent another potential constraint in the monopolist’s ability to raise prices. The
total current sales plus the potential capacity of uncommitted entrants forms the denominator. The numerator would then be the
sales volume of the defendant in that relevant market. The resulting percentage is the market share of that firm. Note that the
larger is the denominator (as a result both from a broad interpretation of the relevant market and the inclusion of many
uncommitted entrants) the more likely the defendant will have a small market share and will not be considered a monopolist.
Even when it is clear that the defendant has a large market share it doesn’t necessarily follow that it has the ability to exercise
monopoly power. Depending on the barriers to entry, it might be easy for new firms to come into the market and drive the price
down to competitive levels. Probably these potential entrants would be willing to give up whatever business they might be doing
(in which it is presumably extracting competitive profits) in order to come into a market where the price is above competitive
levels.

United States v. Aluminum Co. of America (ALCOA) (Products derived from ingot were included in the same relevant market;
secondary products were excluded since the defendant itself was able to control the availability of such potential substitutes; and
imports were deemed insufficient to constraint the exercise of market power due to tariffs and transportation cost)
In determining ALCOA’s share of the market the court had first to define the relevant market. ALCOA produced over ninety
percent of virgin ingot in United States. The first question was whether the products fabricated by ALCOA which derived from
ingot should be included in the market. The court argued that all intermediate or end products fabricated and sold by ALCOA
reduce the demand for ingot itself. The products are connected because the consumers who buy ALCOA’s fabricated products
do not need to buy virgin ingot. Thus, ALCOA could extract monopoly profits by selling its fabricated products knowing that the
consumers won’t have the option to buy ingot from other competitors. It is irrelevant if the defendant is extracting monopoly
power by selling ingot itself or by selling products derived from its ingot production. “All ingot – with trifling exceptions – is used
to fabricate intermediate, or end, products; and therefore all intermediate, or end, products which Alcoa fabricates and sells, pro
tanto reduce the demand for ingot itself…We cannot therefore agree that the computation of the percentage of Alcoa’s control
over the ingot market should nor include the whole of its ingot production”.
The second discussion was related to the inclusion of “secondary” products in the relevant market. The court decided that, even
though the secondary products could be substitute for ingot depending on the purpose of use, it was not an efficient constraint
due to its availability in the market. The secondary product was a result of ALCOA’s production itself, thus, it could control the
future availability of the secondary product in the market by determining how much to produce currently. Thus, ALCOA could
restrict the availability of the secondary product in the market in order to sustain its monopoly power and, for that reason, the
secondary product wouldn’t be an effective constraint. “The competition of “secondary” must therefore be disregarded, as soon
as we consider the position of Alcoa over a period of years; it was as much within Alcoa’s control as was the production of the
“virgin” from which it had been derived”.
The inclusion of fabricated products and the exclusion of secondary products from the relevant market lead to the conclusion that
ALCOA has 90% market share. If the secondary products were also included, ALCOA’s market share would be reduced to
64% percent of the market. Moreover, if the secondary products were included and the fabricated products were excluded,
ALCOA’s market share would be reduced even more (approximately 33% percent of the market). In Judge Hands famous
proclamation on the relationship between market share and monopoly power, 90% is “enough to constitute monopoly”, 64% is
“doubtful” and 33% is “certainly not enough”. This statement, despite its reasonableness, can be misleading in some situations.
Where the firm has an extremely high market share but the barriers to entry are extremely low or inexistent it is unlikely that the
firm would have the power to raise prices. Also, in a scenario where the firm has a small market share but the barriers to entry
are extremely high and its competitors do not nave the ability to expand capacity, the exercise of monopoly power may be
possible (the deregulated electricity market in California which combines inelastic demands, high barriers to entry and capacity
constraints is a good example)
Finally, the court considered the ability of imports to constraint ALCOA’s exercise of market power. It concluded that the limits
afforded by the tariff and cost of transportation would preclude the foreigner producers to provide enough output to cover the
domestic demand. “Nevertheless, within the limits afforded by the tariff and the cost of transportation, Alcoa was free to raise its
prices as it chose, since it was free from domestic competition(…)”.

Case analyzed in class (page 509 (e) from the casebook)

M represents 40% of the relevant market. When it decides to cut its output by one quarter, there won’t be enough supply for
10% of the demand. The subsequent question is whether the existing competitors are able to expand capacity to cover the
excessive demand generated by the output cut. Since the existing competitors are producing at 99 percent of capacity, the
maximum they can expand is 1%. Considering that the competitors represent 60% of the market, if they use their capacity at the
maximum level, they will be able to supply an extra 1% x 60% (equals to 0,6%). The short supply would then represent 10% -
0,6% of the market (equals to 9,4%). The excess demand over supply suggests that the price would increase (considering that
there are high barriers to entry)
However, when the price is fixed by the government, instead of an excessive demand causing a price increase, the excessive
demand would cause the problem of resource scarcity and a lack of energy for everyone. Whereas in a free market the price
would be adjusted in such a way that only the consumers who value most the product (and have better financial conditions)
would be able to purchase it, the regulated price would impede the price to be adjusted to the excessive demand and encourage
the consumers to seek intensively the product (creating big lines in the stores).

United States v. E.I Du Pont de Nemours & Co (Cellophane) (The fact that the consumers find a substitute product for every
end-use of cellophane indicates a high level of functional interchangeability between cellophane and other flexible packaging
material. In this broad relevant market Du Pont does not have monopoly power)
Du Pont produced almost 100% of cellophane sold in the United States (it produced 75% and the remaining 25% was licensed
by Du Pont to a competitor). Cellophane constituted less than 20% of all flexible packaging material sales. Thus, to decide
whether Du Pont could control the price and restrict output, the court had to consider the cross-elasticity between cellophane
and the other flexible packaging material. If the price of cellophane increased substantially could the consumers switch to
producers of other wrappings? The facts demonstrate that the industries which consume cellophane also use other packaging
materials for the same purpose, indicating a functional interchangeability between these products. The fact that the cigarettes
industry attributes almost a unique importance to cellophane and thus could be exploited by Du Pont is unrealistic when the other
consumers are taken into account. Assuming that Du Pont cannot engage in a price discrimination policy (it has to charge a
uniform price), it is unlikely that it would raise prices since it would incur in excessive loss due to the shift of consumers who can
substitute cellophane for other wrapping materials. Therefore, the court interpreted the relevant market in a broad way, resulting
in a small market share of Du Pont and the conclusion of no monopoly power. “It may be admitted that cellophane combines the
desirable elements of transparency, strength and cheapness more definitely than any of the others. But, despite cellophane
advantages it has to meet competition from other materials in every one of its uses…Great sensitivity of customers in the flexible
packaging markets to price or quality changes prevented Du Pont from possessing monopoly control over price”.
One could argue, however, that from the fact that consumers are using not only cellophane but also other materials for the same
end does not necessarily indicate that they should all be included in the same market. It might be that the buyers are only
substituting cellophane for other wrapping materials for some of its products, but other products depend on the supply of
cellophane. Moreover, maybe the consumers are only buying the other materials because the price of cellophane is already above
competitive levels. In this case, the other materials wouldn’t be an effective constrain on Du Pont’s ability to raise prices because
the current high price suggests that even with the availability of these products in the market the loss of sales of cellophane are not
enough to preclude Du Pont from profitably raising its price.

Price Differentiation
The fact that the products do not have the same price does not mean they are not substitutes. One product can have a much
higher price but also a much higher quality and it can compete with a lower quality and cheaper product. If the consumer can
substitute one sophisticated product for two basic products, both suppliers are constrained from profitably raising their prices to
monopolistic levels because the consumers will start buying the other product at the quantity which is required to satisfy their
desire.
In addition, the fact that the supplier of a potential substitute product X does not lower its price as a response to the defendant’s
price cut does not necessarily mean that the products are not substitutes. There is an alternative explanation for the supplier of X
to maintain its price besides the explanation that it believes that the cut price will not affect its sales (in which case the products
wouldn’t be close substitutes because there is no cross-elasticity). It can be that the supplier of X is already offering the product
at its marginal cost and any additional decrease wouldn’t be economically rational.

Case analyzed in class (page 517 (357) from the casebook)

a) Du Pont is expending large amounts of money with lobby and political campaigns to pressure Congress to protect the
domestic industry of cellophane by enhancing tariff protection. Is this an indication that Du Pont has internal monopoly power and
wants to sustain it by protecting the cellophane industry from foreigner sellers? Not necessarily. Du Pont can be competing with
the domestic producers of substitute goods but can be concerned with an efficient foreigner producer which has a much lower
cost structure and can acquire the domestic demand by under pricing. In other words, the fact that Du Pont may fear an efficient
foreigner rival does not mean that it is not competing with domestic producers of substitute goods.
b) When an internal memorandum is found indicating that the defendant itself does not believe that the other products are
effective substitutes, this evidence should be treated in the same way as intent. It is not conclusive because the memorandum can
be wrong.
c) The accountability books demonstrating high profits are not entirely reliable because they contain conventional measures which
may distort the economic profits. For instance, the books do not reflect opportunity costs and the costs with the risk of the
investment, which are essential to measure whether the profits are unreasonable. By excluding these costs from the analysis the
books can conclude that the profits are high, but according to the economic theory they can still be reasonable. Moreover, even if
the court can access the real profits (by considering the appropriate costs and revenues) how should it be determined what is a
reasonable profit? It is too hard to measure the risk of the particular investment and which level of return is adequate.
d) What should the courts analyze first when faced with a monopolization case? The monopoly power or the “something else”
(exclusionary conduct to acquire or sustain monopoly power)?
- The side in which you have more reliable information (the “something else” analysis can be harder because it involves a policy
judgment of exclusionary conducts: should we consider exclusionary all situations where the monopoly was not trust upon the
defendant? Or should we exclude situations in which the defendant has achieved monopoly through competition on the merits? )
- Monopoly power first because once it is held that there is no monopoly power there is no need of further inquiry. The
something else is only relevant if the defendant has monopoly power.
- “Something else” first because this analysis can aid the court to conclude about monopoly power. Some conducts are only
rational when the defendant has monopoly power, thus, the conduct itself can be an indication of monopoly power.

Case analyzed in class (page 517 (358) from the casebook)

Do decide whether Apple’s computers should be treated as a single relevant market we should turn to the ability of consumers to
switch to different suppliers in case Mac raises its price. Consumers who buy Apple computers generally pay a slightly higher
price in exchange for innovative designs and higher quality, particularly in relation to the graphic conditions. Due to Mac’s ability
to provide graphic advanced mechanisms, which cannot be found in any other computer, some consumers who use this technique
will be “locked into” Mac’s computers. Other consumers, however, despite their initial preference to Mac’s computers, can be
unwilling to continue purchasing them in case of a price increase. Because Mac cannot engage in a price discrimination policy
(charging higher prices from the group of consumers who are “locked in” and competitive prices from the group of consumers
who can find substitute products), its ability to raise prices profitably will depend essentially on the size of the two groups of
consumers. If the group of consumers who can find a substitute is large enough, then the defendant will loose too many sales to
make the price increase profitable. But if the group of “locked” consumers is larger, the profits the defendant will earn by
charging them a monopoly price may compensate the loss sales from the other group of consumers.
In addition, Mac could argue that all the benefits the consumers can have from a Mac computer can be found when the consumer
buys larger quantities of other computers. Thus, suppose the battery of the Mac has a double duration but costs twice as much. If
Mac rises its price above the advantage provided by its product could justify (charge the triple instead of the double), the
consumers could buy two batteries from different suppliers.

Case analyzed in class (page 525 (360) from the casebook)

TrashKings has 100 percent market share in the market of trash collection in Dallas. Its main argument for escaping
condemnation for monopolization is that trash collectors in Fort Worth are potential competitors and if TrashKings increases its
price these firms would be attracted to move into Dallas. Forth Worth is more than an hour’s drive away from Dallas and the
question is whether it can be included in the same geographic market. Arguments against Trash Kings:
1) There is always the threat that once firms from Fort Worth move into Dallas, TrashKings will lower its price to the competitive
level (above its costs, otherwise it could be charged with predatory pricing, but lower than monopoly levels so the new entrant
cannot recoup the start-up costs incurred to enter in the market). But this problem can be mitigated if the new entrant approaches
the consumers with the proposal of charging them prices lower than those ones currently charged by TrashKings in exchange for
their commitment to long-term contracts in advance.
2) Density problem – it wouldn’t be worthwhile to have long-term contracts with consumers who are spread in Dallas within a
large distance between each other (the costs of driving from one locality to another may be significant).
3) Start-up costs, such as buying new trucks and finding garbage to deposit the trash in Dallas can be significant also.
Even if we not include Forth Worth in the same relevant market, TrashKings could still argue that there are “uncommitted
entrants” in Dallas, i.e., firms which already have the machinery required to collect trash (trucks and drivers) and, thus, could
easily adjust their trucks and educate their drivers to enter in the market of collecting trash. Finally, TrashKings could argue that
the market has no barriers to entry.

Summary

Evidence of Monopoly Power

Conduct – a conduct which does not make any sense unless the defendant has monopoly power or is trying to obtain it
(predatory pricing for example)
Performance – High Profits (price charged is above cost of production). However, this indicator is problematic. Firms earning
high profits are not necessarily monopolists since profits maybe excessive as a result of legitimate reasons such as a change in the
demand curve (but in the long run this defense tends to be weakened because the higher prices caused by the change in the
demand will invite new entrants or the expansion of the output of existing firms until the supply is adjusted to the demand and a
new equilibrium is reached). Moreover, the defendant could be an illegal monopolist even when receiving reasonable profits
because (i) its cost of production is inefficient due to lack of competition or (ii) it has unexploited power (the monopolization test
does not condemn only the firms which are actually charging monopoly profits but also those which are in a position to do so.
Maybe it is not charging the maximum monopoly price in order to discourage competition, but it is charging a price above
competitive levels.)
Structure – Market Share (considering the ability of competitors to expand capacity) combined with an analysis related to the
Barriers to Entry.

Structural Analysis
Possible Demand Reactions to price increase
- They can continue buying
- They can switch to a supplier of the same product
- They can switch to suppliers of substitute products

Possible Supply Reactions to price increase

- Suppliers of the same product can expand capacity
- Suppliers of the same product located in a different region can expand capacity
- Suppliers of substitute products can expand capacity
- Suppliers of substitute product located in a different region can expand capacity
- Suppliers of a non-substitute product but which have the machinery to produce the product can expand capacity (uncommitted
entrants)
- Brand new entrants may come into the market

All of these factors are possible constraints on the ability of the defendant to exercise monopoly power. Therefore, they should
be included in the denominator when calculating the firm’s market share. The brand new entrants are not included in the
denominator but the question of barriers to entry is asked after the market share is determined. Thus, even if a defendant has a
high market share it still can be absolved from monopolization due to very low or inexistent barriers to entry.

Examples of Barriers to entry

The entry of a new rival will depend both in the price which is currently being charged by the seller(s) of the specific product and
the costs to penetrate in that market. The costs to penetrate in the market will vary accordingly to the height of barriers to entry.
Barriers often slow entry rather than make it impossible. But still, entry may be insufficient to prevent some degree of
supracompetitive pricing for some period of time.
1) Economies of Scale – The minimum size of an efficient firm may be so large with respect to total consumer demand that entry
at efficient scale would depress prices so severely as to be unprofitable. Put it differently, the new entrant has to build a plant to
serve at least one third of the demand (minimum size to be efficient), but at this level of production there will be too much offer for
the same number of consumers, resulting in lower prices that make entry unprofitable.
2) Blocked Access – Established firms might control the supply of essential raw materials, necessary patents, distribution
channels, or other strategic factors and thus make new entry either impossible or impractical because of a relative cost
disadvantage.
3) Capital requirements – construction of large plants and all sort of “start-up costs” can be significantly high as to inhibit potential
new entrants.
4) Established Network System – the existing supplier might have already established a network system among its costumers,
providing them with a valuable benefit which is to take advantage from an operating system which includes a large number of
consumers. The telephone industry, for instance, can provide an advantageous operating system for its consumers. The greater
the number of existing consumers the more it will attract new consumers since they can all communicate with each other through
the same operator. In this scenario, it can be hard for the new entrant to break this advantage and acquire costumers.

Attempt to Monopolize

According to Justice White’s vote in Spectrum Sports v. McQuillan, “it is generally required that to demonstrate attempted
monopolization a plaintiff must prove (i) that the defendant has engaged in predatory or anticompetitive conduct with (ii) a specific
intent to monopolize and (iii) a dangerous probability of achieving monopoly power.
The predatory or anticompetitive conduct requirement addresses basically the same conducts repudiated in the monopolization
cases. The idea is to exclude from the category of “illegal exclusionary conducts” those ones which are based on competition on
the merits, such as promoting innovations, becoming more efficient and offering higher quality products. These acts can exclude
competitors and lead the efficient firm to a monopoly situation, but they shall not be deemed illegal due to the efficiency gains they
offer to consumers.
The specific intent requirement has been created by common law. Intent can be defined as the purpose to achieve a particular
end, as opposed to the mere knowledge that the particular end will result. The rationality behind such requirement could be the
necessity of mitigating the risk of condemning an efficient firm which does not have monopoly power and does not aim to this
end, but instead is simply trying to improve its business activity. In practice, however, when the plaintiff can demonstrate that the
defendant has engaged in a wrongful exclusionary conduct and that there is a dangerous probability of achieving monopoly
power, the specific intent requirement may be inferred (it would be extremely hard for the defendant to argue that it knew that its
wrongful acts would result in a monopoly situation but it didn’t desire to achieve that end).
The demonstration of dangerous probability of achieving monopoly power is a controversial requirement. The Ninth Circuit does
not require such demonstration to characterize an attempt to monopolize. “If evidence of unfair and predatory conduct is
presented, it may satisfy both the specific intent and dangerous probability elements of the offense, without any proof of relevant
market or the defendant’s market power”. Lessig v. Tidewater Oil Co. The Supreme Court, however, decided the issue in favor
of requiring evidence of probability of monopoly power through an inquiry of the defendant’s market share in the relevant market.
“We hold that petitioners may not be liable for attempted monopolization under # 2 of the Sherman Act absent proof of a
dangerous probability that they would monopolize a particular market and specific intent to monopolize”. Spectrum Sports v.
McQuillan. The Court’s reasoning relies on the main purpose of the antitrust laws which is to protect competition, not
competitors. If an illegal exclusionary conduct of a single firm does not threaten competition, the maximum damage it can create is
the harm to one or more competitors, but this doesn’t mean that it will have the ability to profitably raise prices above competitive
level. On the other hand, the justification for condemning the defendant without proof of its market power is that the damage to
one competitor can be considered itself damage to competition if the particular competitor which has been driven out of business
was capable of adding value to competition by providing good service or good advertising policy which the consumers will not
have access any longer. Thus, the choice between requiring or not prove of market power to characterize an attempt to
monopolize is typically a policy choice, where both the language of the statute and the justifications allow courts to decide in
either way. There is a second argument for the Supreme Court’s decision which is that firms which engage in wrongful acts
without threatening competition can be condemned under tort statutes, rather than antitrust statutes. The main difference is that
the liability under the antitrust statute is far more severe (treble damages and high attorney’s fees).

Why should the statute contain a provision to condemn a mere attempt instead of condemning only firms which are already
monopolizing?
1) If the courts wait for the actual monopolization the defendant might have already caused a considerable amount of damage
which is hard to undue.
2) It is much easier for the courts to preserve competition by forbidding anticompetitive conducts than to restore competition
where it no longer exists.
Note that we cannot, however, ignore the disadvantages of applying such rule. The main problem is the risk of condemning a
defendant which could stimulate competition instead of monopolizing the market.

Lorain Journal Co. v. United States (The refusal to deal with consumers who advertised in the rival was considered an illegal
exclusionary conduct despite the possibility that the defendant could be earning short-term profits)
The market of advertisement was dominated by the newspaper publisher Lorain Journal Co. and the radio station WEOL. The
action was brought by United States alleging that Lorain Journal has attempted to monopolize the market by refusing to deal with
consumers who advertise in WEOL. The first question faced by the court was whether the act to refuse to deal with consumers
who advertise in WEOL was an illegal exclusionary act or a legitimate business practice. To classify as one or another, the
reasons why one would engage in such practice must be analyzed. When Lorain refuses to deal with a consumer who advertises
in WEOL is it sacrificing short-term profits without any rational explanation, except the desire to exclude a competitor? Not
necessarily. Lorain’s practice forces the consumers to make an option between advertising in Lorain or in WEOL. It may be that
this policy will bring short-term gains to Lorain since it can capture the entire advertisement of consumers who would otherwise
share their demand between the newspaper and the radio station. But it may be that the loss caused by consumers who use solely
the WEOL’s service does not compensate the gains from the consumers who direct to Lorain part of the demand which they
would direct to WEOL. The fact that Lorain is incurring in loss due to consumers who are using entirely WEOL doesn’t mean
that this strategy is incapable of driving WEOL out of business (it can be that there are not enough consumers using WEOL to
cover its costs of production). Despite the possibility of a rational explanation to justify Lorain’s practice alternative to the desire
to monopolize, which is to earn short-term profits, the court concluded that it should be condemned. Arguably this decision in
correct, because even if there was evidence of short-term profits there was still a high probability of eliminating the competitor
and taking advantage of long-term profits through monopolization.
This case leads us to the following question: is there any legitimate justification for the seller to insist in an exclusive contract with
the buyer? Yes, one justification would be for a new entrant to come into the market and challenge a monopoly. In this case, it
might be necessary to make long-term contracts with consumers before entering in the market to prevent a situation where the
monopolist drives prices down as soon as the new entrant comes in and the consumer is captured by the monopolist.

Case analyzed in class (page 527 (363) from the casebook)

Webb is the largest retailer in Amesville market, representing 75% of the retail’s market for clothing and appliances. Webb
informs Quickshave Electric Razor Company that it cannot afford to continue to handle the Quickshaver unless it becomes the
exclusive outlet in Amesville. Quickshave ceases to sell its razors to other Amesville dealers. Has Webb violated Sherman Act #
2? In this case the reverse question should be asked: are there any legitimate justifications for the buyer to insist in an exclusive
contract with the seller? Yes, at least two can be argued. First, to avoid the “free-rider” problem. The retailer wouldn’t have
economic incentives to make advertisements and promote the product if its competitors could sell the same product without
incurring in the advertising expenses. Second, the retailer wouldn’t have economic incentives to hire a trained staff to explain the
product to the consumer, particularly when it is a new or complex product, if the consumer could use this service and then buy
the product from the next door retailer at a lower price (the next door retailer would be able to sell for a lower price because it
doesn’t incur in the costs of providing service to inform the consumer). Thus, if the exclusive arrangement makes it possible for
the buyer to engage in practices which will benefit the consumer (increase the output and disseminate relevant information in the
market) it may outweigh the potential anticompetitive harms. In this case the anticompetitive harms are restricted to intrabrand
competition since the consumer can still find other brand razors in different retailers.
Case analyzed in class (page 528 (364) from the casebook)
American Airlines president telephoned Braniff’s president to propose that the two airlines fixed the price at a 20% higher fare.
Braniff not only refused American’s offer but gave the government a tape recording of the telephone conversation.
1) Did American violate Sherman Act # 1? No because there was no agreement. Section 1 doesn’t have any provision of
attempt to conspire.
2) Did American attempt to monopolize? The court concluded it did. Even though American would have only part of the relevant
market, the court argued that the agreement would bring a “shared monopoly”. The problem about adopting such a broad
interpretation is that oligopolistic behavior should also be included in this definition of attempt to monopolize (and the courts have
already decided not to attack oligopolistic behavior). Even though there is no express agreement, the firms are capable of
achieving a “shared monopoly”.

Interpretation of Sherman Act # 1 “Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of
trade … is hereby declared to be illegal”

Vertical Restraints

Vertical exchanges arise whenever all stages in the production process are not fully integrated. A manufacture may sell its product
directly to ultimate consumers through its own employees, agents, or wholly owned subsidiaries. Most manufactures, however,
reach ultimate buyers through intermediate dealers. In these cases, the relationship between the different agents of the levels of
production can be arranged in such a way as to restrain trade in violation of Sherman Act # 1, # 2 or Clayton Act # 3.

Vertical Price Fixing

The first possible restraint is vertical price fixing. Some manufactures may come to agreements with their retailers or other
distributors on the price that resellers are suppose to charge. When the manufacture intends to push up the price charged by its
distributors, it may impose resale price maintenance (RPM), and when the purpose is to drive prices down, they may impose
price ceilings (maximum prices). It is clear that the manufacture should have the legitimate authority to decide the price it will
charge the dealer (as long as it is not a predatory pricing), but why should it also have the authority to decide the price the dealer
will charge the ultimate consumers? The manufacture may have many reasons to force the intermediate dealers to charge
minimum or maximum prices, and some of them serve legitimate economic justifications while others don’t. The most common
defense used by manufactures for restraining trade in the subsequent level of production is that a restriction on intrabrand
competition can be justified through the stimulation of interbrand competition. Interbrand competition is the competition among
the manufactures of the same generic product and is the primary concern of antitrust law. In contrast, intrabrand competition is
the competition between the distributors (wholesale or retail) of the product of a particular manufacture.

Dr. Miles Medical Co. v. John D. Park & Sons Co. (The resale price maintenance imposed by the manufacture upon the dealers
is harmful to ultimate consumers since it eliminates potential competition among dealers which could result in lower prices).
A manufacture of proprietary medicines established minimum prices at which sales shall be made at wholesale and retail levels.
He argues that any manufacture is entitled to control the prices on all sales of his own products. The court denied this argument
alleging that because the manufacture has the discretion to produce and sell, it does not follow in case of sales actually made he
may impose upon purchaser every sort of restriction. The general rule is that, once the manufacturer has sold its product, the
property now belongs to the buyer who is free to use it as he desires, without restrictions imposed by the seller. The price at
which the purchaser shall charge is a matter for him to decide, without interference of outsiders. The minimum fixed price
imposed by the manufacture harms the ultimate consumers because it eliminates potential competition among the dealers and
should be deemed an illegal restraint of trade. The court then explained that the agreements would advantage the distributors, not
the manufacturer, and were analogous to a combination among competing distributors, which the law treated as void at face.
What are the harms caused by a RPM agreement? The RPM affects only the intrabrand competition and it is not as dangerous as
horizontal agreements to fix prices among the dealers. This is because the consumers will face higher prices only in relation to that
specific brand, but they still have the alternative to buy the same product from other brands. In contrast, a horizontal agreement to
fix prices among the dealers would be designed in such a way to push up the price of all the generic products, leaving consumers
without option except to pay the higher prices (this is the strategy to maximize profits).

Justification for RPM

The manufacture’s best interest is met when the distributors are able to sell its products as much as possible, thereby increasing
its output and revenues earned from sales. When the distributors charge the ultimate consumers lower prices, the sales increase
and the manufacture is better off. Thus, it is in the manufacture’s interest to keep the dealer’s markup (profit earned by the sale
discounted by the price paid for the product and the costs of distribution) as low as possible. Having said that, why should the
manufacture impose RPM upon intermediate distributors?
One explanation might be that it is necessary to stimulate the distributors to provide distribution services. A trained staff to explain
the product to consumers, particularly when it is a new or complex product (such as cars), will probably increase sales and
profits, both for the manufacture of the product and for the dealer. But one might argue that if the strategy of providing an efficient
service to explain the product will increase sales, why wouldn’t the dealer, as a maximizing-profit agent, adopt it without the
manufacture’s interference? The “free-rider” problem provides a satisfactory answer to this objection. The retailer wouldn’t have
economic incentives to hire a trained staff to explain the product to the consumer if the consumer could use this service and then
buy the product from the next door retailer at a lower price. The next door retailer would be able cut the price because it doesn’t
incur in the costs of providing service to inform the consumer. “If the consumer can then buy the product from a retailer that
discounts because it has not spent capital providing services or developing a quality reputation, the high-service retailer will lose
sales to the discounter, forcing it to cut back its services to a level lower than consumers would otherwise prefer”. Leegin
Creative Leather Products v. PSKS. The RPM could solve this problem because the mandatory minimum price (which is
calculated to include the costs of providing such service) will impede the rival dealer from cutting the price and offering an
“advantage” to the consumers. The consumers will prefer to buy from the retailer that provides a good explanatory service if the
other retailers are unable to offer lower prices. Therefore, the RPM will eliminate the free-rider problem and stimulate the dealers
to offer the most efficient services to consumers (this is the way available to attract demand if they cannot cut the price) and the
result will benefit the manufacture (the efficient explanatory service will increase its output and profits), the dealer (the efficient
explanatory service will increase its sales) and the consumers (who will be willing to buy more in the presence of valuable
complementary service). Thus, limiting intrabrand price competition may be a tool to improve the interbrand competitiveness of
the product by changing dealer’s incentives to provide distribution services and aiding the manufacturer’s position as against rival
manufacturers. That’s why some courts have recognized that “horizontal restraints are generally less defensible than vertical
restraints”. Maricopa County.
Moreover, such agreements can facilitate new entry. A newly entering producer wishing to build a product name might need the
contribution of some distributors. These distributors would only have the incentives to promote the new product if the producer
can assure them that they will recoup their investment. Without resale price maintenance, later-entering dealers might take
advantage of the earlier investment and, through price competition, drive prices down to the point where the first dealers cannot
recover what they spent. By assuring the initial dealers that such later price competition will not occur, resale price maintenance
can encourage them to carry the new product, thereby helping the new producer succeed.
The counter-argument is that a RPM might lead to a scenario where dealers offer excessive point-of-sale services and advertising
at the expense of charging high price, thus, depriving consumers from buying a product at a lower price without unwanted
service. But this is unlikely to happen because a manufacturer will desire to set minimum resale prices only if the increase in
demand resulting from enhanced service will more than offset a negative impact on demand caused by a higher retail prices.

Reasons for condemning RPM

1) The manufacture can impose a RPM upon the intermediate dealers as a result of pressure by the dealers. A manufacturer
might consider it has little choice but to accommodate the retailer’s demands for vertical price restraints if the manufacturer
believes it needs access to the retailer’s distribution network. In this case, it would be a real cartel among the dealers which is
using the manufacture only to pretend it is a legitimate price fixing. However, a retailer cartel is unlikely when only a single
manufacturer in a competitive market uses resale price maintenance. Interbrand competition would divert consumers to lower
priced substitutes and eliminate any gains to retailers from their price-fixing agreement over a single brand.
2) The manufacture may also sell directly to ultimate consumers so it is in his interest to maintain the price above a minimum level.
3) RPM may be a device that a group of manufactures use to coordinate prices. In the presence of RPM’s it would be hard for
one of the manufactures to cheat a cartel because it would have to lower the RPM level, what would be visible for all other
manufactures. Thus, it can be used as an instrument to discourage cheating on a cartel and make it feasible. However, when only
a few manufacturers lacking market power adopt the practice, there is little likelihood it is facilitating a manufacturer cartel, since
the cartel could be easily undercut by rival manufacturers.

Justification for Maximum vertical price fixing

In White Motor Co. v. United States, the court considered the validity of a manufacture’s assignment of exclusive territories to its
distributors and dealers. The court determined that too little was known about the competitive impact of such vertical limitations
to warrant treating them as per se unlawful. In fact, territorial restraints can be used as a tool to increase the dealer’s effectiveness
at interbrand competition. Dealers wouldn’t have incentives to invest time and energy converting customers from other brands if
the customer could buy from the next door retailer. Thus, the manufacture could grant exclusive territories to its distributors to
incentive them to promote the product through advertisement without the fear that customers will be stolen by the rival distributor.
In sum, the same “free-rider” problem that justifies RPM upon retailers can justify exclusive territories serving output increase and
consumer’s welfare. In addition, exclusive territories could be justified in cases where it is more efficient to have only one
distributor (natural monopoly).
Where dealers operate in exclusive territories, however, there is the danger of monopoly power. If there is no intrabrand
competition, the dealer will not be constraint by the possibility of a rival cutting its prices and, thus, could profitably charge
monopolistic prices at the expenses of consumers (who will have to pay higher prices) and the manufacture (who will loose
sales). In light of these considerations, the strategy that can be adopted by the manufacture is to combine the exclusive agreement
with a maximum vertical price fixing agreement. A ceiling price would impede the dealers from charging monopolistic prices
within their exclusive territories and would benefit consumers and the manufacture.

Reasons for condemning Maximum vertical price fixing

1) Could allow suppliers to discriminate against certain dealers
2) Can be used to masquerade minimum price fixing schemes (the same concern addressed in Arizona v. Maricopa County
Medical Society. The difference is that here this problem is less likely to happen because the manufacture is the agent fixing the
price and as we saw he has no evident incentives for pushing up the price charged by its distributors. Even though there are some
exceptions where the manufacture could be interested in arranging illegal minimum price schemes with its distributors it is not
reasonable to condemn maximum price fixing on the grounds that it can remotely be an illegal minimum price fixing arrangement,
unless there is enough evidence to reach such conclusion).
3) Could be set to low and discourage dealers from offering essential and desired services to consumers (the same concern
addressed in Arizona v. Maricopa County Medical Society. But here this possibility is also unlikely to occur because the
manufacture wouldn’t set a price lower than a reasonable level to encourage distribution services otherwise he would loose
customers).

In this scenario of legitimate economic justifications which can bring efficiency gains on the one hand and illegitimate reason which
can harm competition on the other, how should the courts treat vertical price fixing? Always allowing, adopting a per se rule to
condemn or applying the rule of reason to figure out the circumstances in a case-by-case analysis?

1 Moment:
- Per se rule to condemn nonprice vertical restrictions (Schwinn)
- Per se rule to condemn maximum price fixing (Albrecht)
- Per se rule to condemn RPM (Dr. Miles)

2 Moment:
Congress passed the Miller-Tydings Act in 1937, permitting states to exempt from Sherman Act # 1 vertical agreements
prescribing minimum prices for the resale of branded commodities.

3 Moment:
Congress repealed the Miller-Tydings Act in 1975.

4 Moment:
- Rule of Reason to analyze nonprice vertical restrictions (Sylvania - Schwinn)
- Rule of Reason to analyze maximum price fixing (Khan - Albrecht)
- Rule of Reason to analyze RPM (Leegin Creative Leather Products v. PSKS – Dr. Miles)
The court recognized the potential benefits derived from a RPM arrangement and eliminated the per se treatment arguing that
“Per se rules may decrease administrative costs, but that is only part of the equation. Those rules can be counterproductive. They
can increase the total cost of the antitrust system by prohibiting procompetitive conduct the antitrust laws should encourage”. It
was emphasized on the decision that the Court’s treatment of vertical restraints has progressed away from Dr. Miles strict
approach: (i) only eight years after Dr. Miles the Court hold that a manufacturer can announce suggested resale prices and refuse
to deal with distributors who do not follow them; (ii) the court overturned the per se rule for vertical nonprice restraints, adopting
the rule of reason instead (GTE Sylvania); and (iii) the court overruled a 29-year-old precedent treating agreements to fix
maximum prices as per se illegal (Khan overruling Albrecht)
The dissenting votes argued that the court should continue applying a per se rule treatment to condemn RPM because:
1) The costs of considering when the RPM is serving a legitimate purpose are excessive (it is often difficult to identify who –
producer or dealer – is the moving force behind any given RPM agreement).
2) The potential benefits derived from a RPM agreement do not occur very often
3) Congress repealed the Miller-Tydings Act demonstrating its dissatisfaction with RPM
4) Dr Miles has been valid law for almost a century and the court should seek the preservation of such a well-established
precedent in common law in respect to the principle of stare decisis.
5) Whoever desires to overrule a well-established precedent has to bear a heavy burden of proving why such precedent is
inappropriate considering sufficient new or changed conditions.

Packard Motor Car Co. v. Webster Motor Car Co. (As long as there is interbrand competition, a manufacturer can designate an
exclusive dealer to operate in a specific territory and terminate the distributorship agreements with other dealers)
Packard, a car manufacturer, distributed its cars through four dealers in Baltimore. Zell Motor Car Company, the largest of the
four dealers, told Packard that it was loosing money and would quit unless Packard gave it an exclusive contract. Packard
listened to Zell’s complaint and told it’s other Baltimore dealers that their contracts would not be renewed. One of the dealers
which had the contact terminated brought this suit alleging that the exclusive contract was an unlawful agreement in restraint of
trade and an attempt to monopolize. The court decided that since there was competition with Packard cars in the manufacturer
level, an exclusive agreement for marketing Packards does not create a monopoly. The other dealers can seek distribution
agreements with other manufacturers, and the other manufacturers can seek other dealers besides Zell.
As opposed to the general boycott, where there is a horizontal agreement to exclude competitors and is almost always unlawful,
a vertical contract of exclusivity between a manufacture and a distributor can serve legitimate purposes. First of all, it might be
that there is a natural monopoly in the distributors market. Suppose that the dealers have to incur in high fixed costs to establish a
distribution network, including stores, services and a trained staff. If the dealer cannot spread the fixed costs among a sufficiently
large amount of output, it will have to offer the product at a price higher (following its higher costs) than it would otherwise offer if
the fixed costs were diluted. In this case, two competing dealers may survive in the market, but they wouldn’t be as efficient as if
there was only one of them. Both the manufacturer and the consumers are worse off when there are two dealers competing in a
“natural monopoly” market because the prices tend to be higher resulting in less sales for the manufacturer and reduced consumer
surplus. Thus, the exclusive distributorship can allow economies of scale efficiencies which will lead to lower prices offered by the
dealer. Also, if the distribution market is a real natural monopoly, competition between dealers can drive all of them out of
business.
Moreover, the exclusive agreement can be used to solve the free-rider problem. Dealers wouldn’t have incentives to invest time
and energy converting customers from other brands if the customer could buy from the next door retailer. Thus, the manufacture
could grant exclusive territories to its distributors to incentive them to promote the product through advertisement without the fear
that customers will be stolen by the rival distributor.
For these reasons, the restraint in the intrabrand competition can be justified if it is serving the promotion in interbrand
competition. Interbrand competition will be stimulated because the exclusive dealer will be encourage to engage in efforts to
advance the brand’s image through advertisement and higher quality services, aiding the manufacturer’s position as against its rival
manufacturers.
Potential harms to competition would result if the exclusive dealer took advantage of such position to charge monopoly prices.
But this behavior is unlikely to happen if there is enough interbrand competition. Packard only represents a small fraction of the
manufacturers market, what precludes the dealer from raising prices. If the exclusive dealer raised prices above competitive
levels, the consumers will switch to other brand cars. The situation would be different if there was a monopolist firm in the
manufacturer’s level which entered into an exclusive distributorship arrangement with a dealer. The dealer would be monopolizing
the distribution market by closing the possibility of other dealers to offer the single manufacturer’s products and also there would
be the risk of the exclusive dealer charging monopoly prices since consumers don’t have the option to change to products from
other brands.

Continental T.V. v. GTE Sylvania (Vertical territorial restraints shall be analyzed under the rule of reason since they can generate
desirable consequences, such as stimulate interbrand competition by inducing retailers to provide services and marketing policies
that they would otherwise not provide)
Sylvania limited the number of franchises granted for any given area and required each franchise to sell his Sylvania products only
from the location at which he was franchised. Continental, a retailer that sold Sylvania’s products, didn’t respect the restriction
and began unauthorized expansion into the Sacramento market, which was already being served by other retailers. Sylvania
terminated the franchiser-franchisee relationship with Continental, who, in turn, brought this suit alleging that Sylvania had violated
Sherman Act # 1 by forcing its dealers to sell only under a specific territory. The question before the court is whether a
manufacturer can impose territorial restraints upon its dealers. In Schwinn, the court established a per se rule to condemn such
vertical restrictions arguing that they are so obviously destructive of intrabrand competition that their use would open the door to
exclusivity of outlets and limitation of territory further than prudence permits. Here, however, the court overruled Schwinn to
determine that such restriction should be analyzed under a rule of reason on the grounds that “the market impact of vertical
restrictions is complex because of their potential for a simultaneous reduction of intrabrand competition and stimulation of
interbrand competition.” The territorial restraints have redeeming virtues when the manufacturer is using such restrictions to
compete more effectively against other manufacturers. For example, new manufacturers can use the restrictions in order to induce
competent and aggressive retailers to make the kind of investment of capital and labor that is often required in the distribution of
products unknown to the consumer. Established manufacturers can use them to induce retailers to engage in promotional activities
or to provide service and repair facilities necessary to the efficient marketing of their products. Because of market imperfections
such as the “free-rider” effect, these services might not be provided by retailers in a purely competitive situation, despite the fact
that each retailer’s benefit would be greater if all provided the services than if none did. Therefore, the court ruled that the
anticompetitive harms of the intrabrand territorial restraints might be offset by benefits in the interbrand market and the rule of
reason is the appropriate standard to conclude whether the restriction is unlawful or not.
Note that territorial restraints among competitors are still condemned under the per se rule as established in United States v.
Topco Associates.

Agency Problems
A vertically integrated firm can ordinarily decide to whom it wishes to sell and at what price without violating the Sherman Act #
1. It is clear that a manufacturer can use its employees to sell its products to the consumers at whatever price it determines. The
employee is an agent to the manufacturer (principal) and, like in any other agency relationship, the principal has the power to
dictate the directions that should be followed by its agent. Thus, obviously, the per se rule to condemn vertical price restrictions
wouldn’t be applied to a vertically integrated firm operating through its own agents. There is a large space, however, between
employment arrangements and independent dealers, with many unclear situations within this space. The questions that can be
asked to determine whether the firm is truly integrated or not are: who bears the business expenses? In case the product suffers
damage who assumes the risk? Does the “dealer” have discretionary power to make its own business decisions?
The problem of defining the true relationship between the manufacturer and the dealer arises only when the court adopts a per se
rules to condemn vertical agreements. Under the rule of reason the relevant analysis is focused on the harms and benefits resulted
from the conduct and not on classifying the dealer as an employee or an independent dealer because, even if the court finds out it
is an independent dealer, it might consider the arrangement lawful.

When does a Vertical Agreement Exists?

There can be situations in which the manufacturer has not established an express agreement with its dealers, but has instead used
other methods to achieve the same result. To escape a violation from Sherman Act # 1 (which requires a contract, combination
or conspiracy) and the Dr. Miles holding, the manufacturer could, for instance, suggest minimum resale prices and refuse to sell to
the dealers who failed to follow its suggestions. Thus, the dealer is forced to respect the RPM if it wants to continue distributing
the manufacturer’s products. Could the court infer an agreement in such situation?

United States v. Colgate & Co. (Colgate’s policy to refuse to sell to dealers which didn’t follow the uniform prices recommended
was not considered a concerted action)
Colgate began a business policy which consisted in urging dealers to charge uniform prices and stating it would refuse to sell to
those who didn’t adhere to its request. Surprisingly the court upheld Colgate’s practice arguing that Colgate didn’t ask for a
commitment from the dealers to defer to the uniform price established and the fact that it would refuse to sell to those who cut the
price couldn’t be said to be a contract or agreement between Colgate and its dealers to charge minimum prices.
It could be argued, however, that an agreement does not have to be formally expressed, it can be inferred through the
participants conduct. If one has enough power to force another to act in a specific manner, the imposition of a constraint can be
sufficient to achieve the desired result even without an explicit acceptance. In fact, the court has recognized the possibility of
inferring an agreement from the participant’s behavior in horizontal restraints. In Interstate Circuit the court concluded that it was
enough that, knowing that concerted action was contemplated and invited, the distributors gave their adherence to the scheme
and participated in it. No actual communication had been made between the distributors, they only relied on the fact that all the
other distributors had received the letter from the exhibitor requiring them to impose restriction upon other licensing arrangements
and they knew that all of them would be better off if all complied with the requirements. The possibility of coordination facilitated
by the exhibitor’s letter was enough to characterize a conspiracy under the Sherman Act # 1.
The differences between the “implicit agreement” in horizontal restraints and in the vertical restraints are the reasons for accepting
the restraint. An implicit agreement between competitors is reached because they are conscious that a coordinated behavior can
lead all of them to extract higher profits. An implicit agreement between a manufacturer and a dealer is reached because of the
constraints (and even cut off) that can be imposed in the dealer if he does not follow the “recommendations”. Does the fact that
the situations differ in relation to the motives that cause an implicit agreement justify a difference in the way they should be
treated? It doesn’t look like. Perhaps what could explain the court’s willingness to infer an agreement in the case of horizontal
restraints as opposed to vertical restraints is the tougher standard of review that has been applied to horizontal restraints,
considering the higher danger it presents to competition.

Case analyzed in class (page 572 (422) from the casebook)

(1) S sells to R, who promises to resell at x price.
It is clearly an unlawful contract.
(2) S sells to R subject to the stated condition that R resell at x price but that breach of the condition will not subject R to any
suit.
The fact that R will not be subject to any suit is irrelevant to determine if it is a contract in violation of the Sherman Act # 1
because all unlawful contracts are not enforceable. If the possibility of enforcing the agreement under jurisdictions was the
relevant criterion to determine if there is in fact an agreement, then all of the unlawful contracts would be exonerated from antitrust
scrutiny since none of them are enforceable.
(3) S sells to R while declaring that it will cease selling to any dealer who fails to resell at x price.
This is exactly what happened in Colgate. The court decided that it is not an agreement and, thus, but it could easily be argued
the other way.
(4) S sells generally with the suggestion that the preferable retail price is x but it does not abandon dealers who charge different
prices.
In this case it is clear that there is no agreement because there is no constraint to respect the established price. It is consistent with
Dr. Miles to uphold such practice because here there is no interference with the dealer’s autonomy.

United States v. Parke, Davis & Co. (When the manufacturer imposes a high level of pressure upon its dealers by constantly
announcing it will refuse to sell to those who don’t adhere to the scheme, an agreement can be inferred).
Parke Davis had engaged in the same business policy as Colgate did. The difference is that Parke Davis was constantly making
public announcements of the specified resale price and threatening the dealers who didn’t adhere to the scheme. The court
stepped back from Colgate arguing that in this case the policy imposed too much pressure upon the dealers to consider their
actions as unilateral. They couldn’t exercise an individual free choice since the constant threats to termination of the business
relationship with the manufacturer would force them to accept the specified prices.
Is the court overruling Colgate? No, it is still possible to consider the suggested price followed by the termination of those dealers
who do not respect them as an unilateral conduct (not an agreement), as long as the manufacturer does not put too much
pressure upon its dealers to accept the specified prices.

In Monsanto Co. v. Spray-Ryte Service Corp, the court followed the holding in Parke, Davis & Co condemning Monsato’s
practice which was to approach price-cutting distributors and advise that if they did not maintain the suggested resale price, they
would not receive adequate supplies of Monsanto’s new corn herbicide. It concluded that “evidence tends to prove that the
manufacturer and others has a conscious commitment to a common scheme designed to achieve an unlawful objective.”

In Business Electronics Corp v. Sharp Electronics Corp., the court decided that, even though the manufacturer refused to deal
with price-cutters, there was no agreement because no price level was specified. The distinction the court made between
manufacturers who specify a resale price maintenance and abandon those ones who fail to comply (this situation would be
unlawful) and the manufacturers who simply abandon price-cutters (this situation would be lawful) seems useless. If the court is
concerned with manufacturers who constraint price competition in the distribution level, it should treat manufacturers who
abandon price-cutters in the same way as it treats those ones who specify a RPM. The only explanation of such decision is that
the court is moving towards an overruling of the per se rule against RPM stated in Dr. Miles.

Tying

A tying arrangement exists when a producer of a desired product sells it only to those who also buy a second product from it (“I
will only sell you X if you buy Y”). The manufacturer ties the sale of the tying product (X) to sales of the tied product (Y). The
anticompetitive harms of tie-in arrangements is that they might foreclose other sellers of the tied product from an opportunity to
compete for patronage on the independent merits of the tied product standing alone and without the intrusion of the tying product
as an alien factor. When the seller ties products which are each sold in perfectly competitive markets, no economic effects will
result since the consumers still have the option of buying any of the products from rival suppliers. The problem might arise,
however, when the manufacturer is a monopolist producer of X and will only sell X if the consumer also buys from him a product
which is sold in a competitive market. The manufacturer’s purpose might be to take advantage of its first monopoly as a weapon
to acquirer a second monopoly. (As we saw previously under the topic: “Monopolizing Based on Leverage – expanding a
monopoly to a second industry (Griffith)”). However, as it was argued by the Chicago School of Antitrust, the monopoly profit
can only be extracted once since any attempt to extract higher profits in the second industry will necessarily involve the sacrifice
of some of the monopoly profits which used to be acquired in the first industry. If the monopolist can only extract the monopoly
profits once, why might it still be interested in tying a product in which he has monopoly power with a second product which is
offered in a competitive market?

Possible reasons for A to use the tying strategy:

1) Capture Consumers – Even though the seller might not be charging a monopolist price for the tied product, it may capture the
consumers through a “preferential” clause. This clause gives him the right to lock-up consumers simply by matching competitors
(usually in terms of price and quality)
2) Enhance barriers to entry – If all the independent seller of the tied product are driven out of business because of the tie-in
practice adopted by A, then a new entrant might have to produce both products to succeed (considering the products are
complementary to each other). Forcing the new entrant to operate in the two industries will increase its start-up costs and make
the entrance more difficult. In this way, A can protect more its first monopoly.
3) Eliminating competitive pressures toward cost reduction and innovation in the tied product’s market.
4) The industry of the tied product might be supplied by several manufactures. The elimination of competitors from the tied
industry could, thus, place A in a monopsony position against these manufacturers.
5) Price Discrimination – The best situation to the producer is to charge the maximum price each consumer is willing to pay. The
maximum price each consumer is willing to pay will depends on the value that they attribute to the good. If the seller could identify
the maximum price each consumer is willing to pay it would be possible to charge monopoly prices without losing consumers
(those ones who valued the product less would be able to pay a lower price). A tying arrangement may be a vehicle for price
discrimination. Suppose a situation where a monopolist charges a uniform price to license the use of patented machine and forces
the consumers to buy all of the input they need to produce from the patentee. The consumers who make a more intensive use of
the machine will end up having to buy more input and, thus, paying more, while those ones who use less will buy fewer input and
pay less. The price discrimination might increase the total output by allowing the consumers who wouldn’t buy the product at a
uniform price (because they value the product less than the seller would offer) to buy it in a price discrimination scenario. If the
defendant can demonstrate that the price discrimination will increase output (by proving that he would fix the price at a level that
many consumers would give up buying) would it be defensible? One could argue that even with a higher output the total
consumer surplus will be reduced because of the consumers who are paying a much higher price than they would pay in the
absence of such policy. The courts will usually make the question: is there any other mean by which the same procompetitive
benefits can be generated without the harms?
6) Cost savings – A package sale might save costs.
7) Patents – many patentees see several advantages to licensing their patents in a package, such as (i) package transactions for
several patents reduce the administrative cost per patent of negotiating, licensing and bookkeeping; (ii) the patentee no longer has
to worry about detecting the unlicensed use of a single patent; (iii) the value of a package of patents may be more readily
ascertainable than the value of each patent individually; (iv) a patentee can force licensees to accept less valuable patents by
packaging them with more valuable ones; (v) licensees might be discouraged from litigating the validity of any single patent within
the package because the same price must be paid for the entire package as for one or a few patents. (Recall BMI, where the
court upheld an agreement between ASCAP and BMI to offer a blanked license (a package including individual licenses of many
copyright owners) because it allowed cost savings, both to the buyers and to the sellers.
8) Collections – it might be that a package is more valuable than the entire products separately. Consider a collection of valuable
paintings for example. It will be more profitable for the seller to offer the whole package to a single buyer, who will be willing to
pay a higher price for all the paintings. But why couldn’t we assume that the market itself will lead to this result? Because it might
be that the first purchaser desires only to buy one painting (maybe he doesn’t have enough money to buy the entire collection or
maybe he wants to buy only a specific painting), what would depreciate the value of the collection as a whole. Therefore, the
seller can adopt a tying to guarantee that he will maximize the value he can earn in the sale.
9) Regulated Industry – in a regulated industry a firm with market power may be unable to extract a supercompetitive profit
because it lacks control over the prices it charges for regulated products or services. Tying may then be used to extract that profit
from sale of the unregulated, tied products or services.
10) Quality Control – the seller might attach its repair service to the purchase of its products to assure a quality control. But one
could argue that once the buyer has already purchased the product the seller shouldn’t be concerned with the ex-post treatment
of the product. This is not always true. It might be that the seller is concerned with preserving its reputation and doesn’t want to
see consumers complaining that the product is not functioning properly. This concern is even more persuasive when the seller is
launching a new and complex product in the market, in which case an adequate repair service is necessary to promote the
acceptance of the product in the market.

Violation
A tying arrangement can violate:
- Sherman Act # 1 (unreasonable restraint of trade).
- Sherman Act # 2 (monopolization or attempt to monopolize)
- Clayton Act # 3 (lease or sell on the condition that the lessee or purchaser shall not use or deal with the competitors of the
lessor or seller)

# 3 “Lease or make a sale … on the condition, agreement, or understanding, that the lessee or purchaser thereof shall not use or
deal … (with) the competitors of the lessor or seller”.

Clayton Act was enacted as reaction to the court’s decision in Standard Oil Co v. United States to establish the rule of reason as
the appropriate standard measure of illegality under the Sherman Act. The purpose of the Clayton Act was to point to conducts
that Congress considered unreasonable without further inquiry, such as price discrimination; mergers (# 7); and exclusive
dealings/tying arrangements (# 3).
The tying arrangement violates section 3 because when a seller decides it will only sell product X if the consumer also takes Y, it
is impeding the consumer to purchase from a competitor. But if we interpret section 3 broadly, it could lead us to the conclusion
that even when a supplier sells a single good it is impeding the consumer to purchase from a competitor. (Obviously this is not
forbidden under the statute because this is the essential force of competition).
Note that the Clayton Act is narrower than the Sherman Act in the sense that it doesn’t include services (only goods, wares,
merchandise, machinery, supplies or other commodities), therefore, for a tying to be condemned under the Clayton Act, both the
tying product and the tied product must be commodities (not services). The Clayton Act is broader than the Sherman Act,
however, in respect to the agreement issue (it requires merely an “understanding”). The statute’s decision to exclude service
won’t make much difference in the end because the courts tend to consider the buyer’s acceptance to buy only from the seller an
agreement between buyer and seller, which can be challenged under the Sherman Act # 1.
The courts began treating tying arrangements as illegal per se. The per se rule has not been overruled but the courts have applied
a rather flexible interpretation of the per se illegality of tying. A tying arrangement is “an agreement by a party to sell one product
but only on the condition that the buyer also purchases a different (or tied) product, or at least agrees that he will nor purchase
that product from any other supplier”. Northern Pacific. Such an arrangement violates section 1 of the Sherman Act if the seller
has “appreciable economic power” in the tying product market and if the arrangement affects a substantial volume of commerce
in the tied market. Fortner Enterprises, Inc. v. United States Steel Corp. “Appreciable economic power”, in turn, is the power
“to force a purchaser to do something that he would not do in a competitive market”. Jefferson Parish.

International Salt Co. v. United States (The license agreement between International and its licensees was unlawful because
International would only provide its patented product if the buyer also bought a second product)
International Salt Company owns patents on two machines for utilization of salt products. The principal distribution of each of
these machines is under leases which require the lessees to purchase from International all unpatented salt and salt tablets
consumed in the leased machines. In fact, International used its dominance over the patented products as an effectual weapon to
pressure buyers to take a product sold in a competitive market.
International argued that the lease contracts are saved from unreasonableness because they provided that if any competitor
offered the tied product of equal grade at a lower price, the lessee should be free to buy in the open market, unless International
furnished the tied product at an equal price. The court rejected such defense on the grounds that the injury to competition remains
since International had at all times a priority on the business at equal prices. A competitor would have to undercut International’s
price to have any hope of capturing the market, while International could hold that market by merely meeting competition.
The second argument raised by International was that the sale of the tied product was necessary to assure the satisfactory
functioning of the tying product and, since International remained under an obligation to repair and maintain the machines, it had
to make sure that only high quality input will be used. The court also rejected this defense by stating that there were many other
manufacturers in the market that could provide the same quality of salt required to preserve the machines. It would be reasonable
if International had established a minimum level of quality of the salt that will be used in the machine, but not that this salt has to be
bought from international itself (unless it could prove that no one else was capable of providing the same quality of salt provided
by International). Finally, the court concluded that the restriction violated # 1 of the Sherman Act and # 3 of the Clayton Act.

Northern Pacific Railway Co. v. United States (Even though the preferential clause was only valid if the defendant offered the tied
product at the same price and quality as other competitors (mitigating potential harms to competitors and to consumers) and also
the absence of market power, the court condemned the arrangement applying a per se rule)
The government granted the Northern Pacific Railway Company approximately forty million acres of land in several
Northwestern States and Territories to facilitate its construction of a railroad line. The defendant began selling and leasing the
lands with the condition that the purchaser and lessees gave preference to its own railroad, to the exclusion of its competitors, in
carrying goods produced in the lands. The preferential routing clause provided that the buyer should use only the defendant’s
railroad service as long as the competitors didn’t offer a better quality service or a service at a lower price. The Government
claims that this was a tying arrangement that should be condemned under the Sherman Act # 1. The Clayton Act doesn’t apply
here because neither the tying product is a good (lands) nor the tied product (service). The court condemned the practice under
the per se rule, following the holdings in International Salt Co. v. United States and in Standard Stations (“tying agreements serve
hardly any purpose beyond the suppression of competition”). But it recognized at least that “where the seller has no control or
dominance over the tying product so that it does not represent an effectual weapon to pressure buyers into taking the tied item
any restraint of trade attributable to such tying arrangements would obviously be insignificant at most”. This is because if the
defendant doesn’t have market power in the tying product, the consumer can buy the products separately in the competitive
market and the tying arrangement won’t have enough strength to capture consumers from the tied market. The only possibility
that the defendant may be capturing consumers from a second market even without market power in the first market is if he is
offering a lower price for the package compared to the price of the products sold separately in the competitive market. But in this
case the tying shouldn’t be condemned because if the defendant is being able to sell the package at a lower price than the
products are sold in the competitive market (considering that (i) the defendant is not engaging in predatory pricing and that (ii) the
price offered in the competitive market is not above competitive levels due to cartels or oligopolistic behavior) it is because the
package is providing cost savings or other efficiencies in the production or distribution levels that can justify the tying.
Even recognizing the necessity of market power to cause injuries to competition, the court wasn’t concerned about identifying
Northern Pacific’s power and, if it was, probably it would conclude that there was no dominance since there were many other
lands owned by the Government that were available to potential buyers. Instead of proceeding with a market power inquiry, the
court seemed to have inferred such a power from the tying arrangement itself. The argument is that if the defendant has the power
to force the consumer to buy from him a second product is because some power exists in relation to the first product (tying
product), otherwise the consumer would prefer to buy the first product from other suppliers. This assumption is not necessarily
true. First because the consumer may be giving up a useless option (when the clause provides that the consumer will be free to
deal with a more efficient supplier) in which case it doesn’t make any difference for him to buy the first product from the
defendant or turn to the market. Second, and most important, the defendant may be charging a lower price for the first product in
order to convince the consumer to accept the tying arrangement. Thus, the defendant might be able to capture the consumer even
without market power in the tying product in which case it shouldn’t be condemned.
What are the potential harms of such arrangement?
1) The adverse effects on the defendant’s rivals. The fact that the clause was “preferential” and not “mandatory in any
circumstance” mitigates the harms because a more efficient rival could capture the consumers. But the competitors who matches
the defendant in quality and in price and, thus, could capture some consumers, would be unable to do so since the consumers will
be locked into the defendant’s agreement. Therefore, the arrangement is foreclosing competition on the merits (if the defendant is
really efficient why does it need a “preferential clause”?)
2) The adverse effects on competition in the buyer’s side of the market. The buyers are forced to give up the option of choosing
a different railroad. However, this lost of option is irrelevant considering that the consumer will be forced to deal with the
defendant only if it matches its competitors in price and quality. If there is no other rival offering a more attractive product (in
which case the consumers could abandon the preferential clause) why should the consumers care about having to deal with the
defendant? It might be that a particular consumer has to incur in higher costs itself to reach the tied product (the railroad tied
could be in a greater distance than other railroads).
Why is Northern Pacific insisting is such arrangement?
1) It benefits Northern Pacific because it assures that it will get the consumers even in a scenario where there are other
competitors offering at the same price and quality.
2) It might be a strategy to guarantee a certain amount of business to recoup its investments in building the railroad. Without this
guarantee it wouldn’t have enough incentives to initiate the costly investment.

To what extent is the seller forcing the buyer to take the second product?
Suppose a situation where the seller didn’t oblige the consumer to take a second product, but instead it persuaded the consumer
by offering a large discount if both products were purchased. This kind of voluntary tie is not necessarily excluded from Clayton
Act # 3, which embraces those who “fix a price … or discount … or rebate … on the condition, agreement, or understanding
that the lessee or purchaser … not use … the goods … of a competitor.” Therefore, the discount can be condemned if it is a
way to induce the consumer to take the second product without other justifications. However, it is common to justify the discount
of a package on the grounds that it is less costly to offer a package rather than the products individually. Obviously, the discount
has to be proportionate to the cost savings. As it was stated in United States v. Loew’s “only non-cost-justified price differentials
between the package price and the prices for individual films should be prohibited, although there was some dispute as to which
costs were relevant” (the government claimed that only savings in distribution costs can justify the price differentials, but the court
permitted all legitimate costs to be considered).

The general rule which governs tying arrangements, stated by the Supreme Court in International Salt Co and Northern Pacific, is
a qualified per se rule. That is to mean that the per se rule only applies if (i) the defendant has sufficient economic power with
respect to the tying product and (ii) a substantial amount of interstate commerce is restrained by the tying arrangement (if only a
single purchaser were forced with respect to the purchase of a tied item, the resultant impact on competition would not be
sufficient to warrant the concern of antitrust law). Even though the Supreme Court have constantly repeated this preposition, a
range of cases have represented significant exceptions to the per se illegality of tying and some of them have been affirmed by the
Supreme Court. In light of so many exceptions it is doubtful to believe that the per se illegality will be sustained for much longer.
Even if it is not expressly recognized that the per se illegality is overruled (unlike the resale price maintenance or vertical maximum
price fixing where the per se rule was expressly overruled) one could reasonable argue that the Supreme Court is in substance
following a standard closer to a rule of reason. Indeed, in Jefferson Parish Hospital District No 2 v. Hyde, Justice O’Connor’s
vote which concurred with the majority vote, stated that “A tie-in should be condemned only when its anticompetitive impact
outweighs its contribution to efficiency”. It was recognized that “the examination of the economic advantages of tying may
properly be conducted as part of the rule of reason analysis…This approach is consistent with this Court’s occasional references
to the problem”.

United States v. Jerrold Electronics Corp. (Even though the defendant had market power in the tying product and there was no
such defense as offering a “single product”, the court accepted the compulsory service on the grounds that it was necessary
during a limited period to assure the survival of the new and sophisticated system that was being launched in the market)
Jerrold developed a sophisticated antenna system to serve a number of television receivers. It sells its system only in the condition
that Jerrold install and service the system. The Government challenges the conduct under the Sherman Act # 1 alleging that
Jerrold’s contracts unreasonable restraint trade by tying the system to its installation and service. The court agreed with the
Government that Jerrold was placed in a strategic position in relation to the tying product (it was the only highly specialized
equipment available to meet all of the varying problems arising at the antenna site) which gave it the leverage necessary to
persuade customers to agree to its service contracts. But the court refused to apply the per se rule arguing that “while the per se
rule should be followed in almost all cases, the court must always be conscious of the fact that a case might arise in which the
facts indicate that an injustice would be done by blindly accepting the per se rule”. Instead, the court found that this case was an
exception to the per se illegality because the compulsory service was necessary to assure the survival of the new sophisticated
system that was being introduced in the market. Otherwise, many impatient operators would have attempted to install their
systems without assistance what could lead to unsatisfactory results and make it more difficult for Jerrold to promote the quality
and reputation of its product. The court concluded that it was reasonable to provide compulsory service with respect to a
product that is being launched in the market at least during the development period.

The “Single Product” defense

A common defense used against a tying challenge is to argue that it is not a sale of two separate products, but yet a sale of a
single product. But this question can produce more uncertainty than provide solutions. There are endless variations of products
where there is no bright line to indicate whether they should be regarded as a single or a multiple-parts product (examples are an
automobile manufacture who always delivers its automobiles with a radio installed as standard equipment or a computer
manufacturer who only sells its computers with its own software installed). What question should we make to conclude if the
products are a single one? One analysis could be to ask consumers and experts if they consider the product as a single one or as
a multiple –parts product. “For services and parts to be considered two distinct products, there must be sufficient consumer
demand so that it is efficient for a firm to provide service separately from parts”. Jefferson Parish. This empirical evidence would
be helpful in the sense that it would indicate the likelihood that consumers would turn to a second market to purchase the “tied”
product separately (if they consider them as distinct parts) or if they would simply buy the products always together because they
find it impractical or unfeasible to separate them (if they consider it a single product). But sometimes the answer to the “single
product” inquiry is unclear. Thus, we should address the issue in a different way by asking why do we want to know whether the
product is a single one in the first place? Because the main concerns of tying arrangements are there capacity to foreclose
competition in the market of the tied product and there coercion over consumers to take an undesired product, but, if the product
is in fact a single one, then these harms are mitigated. Indeed, if the general view is that it is a single product, then there is less
danger that consumers would be harmed by the tying (they probably need “both parts” to use the product) although the harm to
competition in the market of the “tied” product (which is not really tied because it in fact belongs to the principal product) is not
necessarily mitigated because it might be that even where the product is considered a single one there could be a competitive
market for the “second part” (suppose a watch that is sold with the battery inside. Even though it is reasonable to assume that it is
a single product – one depends on the other to have any functionality – there could be a competitive market of independent
battery producers which the tying is foreclosing). But one could argue that when the product is defined as a single one, probably
there wouldn’t be a sufficient demand for the purchase of the “second part” separately and, thus, it wouldn’t be economically
efficient to offer them separately. In all events, it is more appropriate to verify whether and how the main concerns are being
affected by the tying arrangement and balance these potential harms with eventual legitimate purposes that it may be serving.

Jefferson Parish Hospital District No 2 v. Hyde (Even though there is evidence that consumers differentiate the tying and tied
products, the court didn’t condemn the arrangement because the defendant lacked the necessary market power over the tying
product to force consumers to buy a second undesired product)
East Jefferson Hospital entered into an exclusive agreement with department Roux & Associates to provide anesthesiological
service for its patients. In addition to the exclusive agreement, Jefferson Hospital only offers a package which includes all the
hospital services plus the anesthesiological services. The question before the court is whether Jefferson Hospital is engaging in an
illegal tying arrangement. First it was made clear that there was no such defense as offering a “single product” because there is
plenty of evidence that consumers differentiate between anesthesiological services and the other hospital services provided. The
choice of an individual anesthesiologist separate from the choice of a hospital is not only possible but also frequent, especially
when the patient is capable of distinguishing between the levels of quality among anesthesiologist or is advised by its doctor. The
court, however, refused to condemn the arrangement on the grounds that Jefferson Hospital lacked market power to force
patients to buy services they would not otherwise purchase “There is no evidence that a patient who was sophisticated enough to
know the difference between two anesthesiologists was not able to go to a hospital that would provide him with the
anesthesiologists of his choice”. The evidence demonstrated that 70% of the patients residing in Jefferson Parish enter hospitals
other than East Jefferson Hospital. “The essential characteristic of an invalid tying arrangement lies in the seller’s exploitation of its
control over the tying product to force the buyer into the purchase of a tied product that the buyer did not want at all, or might
have preferred to purchase elsewhere on different terms”.

United States v. Microsoft (Considering the innovative integrated product which is being offered by Microsoft and the lack of
experience of the court with the complexity of the software market, the per se rule should not be applied. The integration
between the operating system and the software may be serving legitimate business reasons such as offering a multiple
functionalities product which is more capable of satisfying the demand)
The Government challenged Microsoft’s contractual and technological bundling of the IE web browser (the tied product) with its
Windows operating system (the tying product) under the Sherman Act # 1. The District court findings are mainly that the
operating system was designed in such a way to make it unfeasible to remove IE browser and install a different browser. The
court of Appeals stated that four requirements must be met to condemn a tying arrangement: (i) the tying and tied goods are two
separate products; (ii) the defendant has market power in the tying product market; (iii) the defendant affords consumers no
choice but to purchase the tied product from it; and (iv) the tying arrangement forecloses a substantial volume of commerce. In
addressing the two separate products issue, the court decided that the Jefferson Parish separate-products test was not
appropriate to this case considering the particular circumstances of the platform software market. The operating system and the
web browser are innovative integrated products and it is unclear whether the sale as a single unit provides redeeming virtues and
better attends consumer’s demand. It is also ambiguous whether the benefits from IE APIs could be achieved by quality
standards for different browser manufacturers. Because there is not enough experience in this highly complex area of softwares,
the court should not use a per se rule to condemn a package which could be serving legitimate business reasons such as offering a
multiple functionalities product which is more capable of satisfying the demand.

Eastman Kodak Co. v. Image Technical Services (Because the defendant was the exclusive provider of Kodak replacement
parts and it was only selling the parts to consumers who also purchased its repair service the court concluded it was engaging in
illegal tying. The fact that the defendant lacked market power in the primary equipments market wasn’t considered a constraint
for exercising monopoly power in the derivative aftermarkets).
Kodak Company manufacturers and sells photocopiers and micrographic equipment. Kodak also sells service and replacement
parts for its equipment. Beginning in the early 1980s, ISOs began repairing and servicing Kodak equipment and also selling parts
and used Kodak equipments. In order to make it more difficult for ISOs to sell service and parts of Kodak machines, Kodak
sought to limit ISO access to sources of Kodak parts (by agreeing with independent original-equipment manufacturers to refuse
to sell Kodak parts to ISOs) and also to restrict ISOs services by implementing a policy of selling replacement parts only to
buyers who use Kodak service or repair their own machines. ISOs brought this suit alleging an illegal tying arrangement between
Kodak parts and service. Kodak argued first that service and parts constitute a single product, and, second, that it lacked market
power in the tying market which is required to deem a tying arrangement illegal. The single product defense was rejected by the
court on the grounds that at least some consumers would purchase service without parts, because some service does not require
parts, and some consumers, those who self-service for example, would purchase parts without service. In relation to the market
power in the tying product the issue is more complex.
Kodak contends that even if it concedes monopoly share of the relevant parts market, it cannot actually exercise the necessary
market power for a Sherman Act violation. This is so because competition exists in the equipment market. This argument is based
on the presumption that Kodak would not have the ability to raise prices of service and parts above the level that would be
charged in a competitive market because any increase in profits from a higher price in the aftermarkets at least would be offset by
a corresponding loss in profits from lower equipment sales as consumers began purchasing equipment with more attractive
service costs. In other words, consumers can turn to different equipment brands which don’t monopolize the replacement parts
market and allows independent repair services if they are unsatisfied with Kodak’s policy. The question before the court is
whether the defendant’s lack of market power in the primary equipment market precludes the possibility of market power in
derivative aftermarkets. The court concluded that it doesn’t preclude for three reasons:
1) The extent to which one market prevents exploitation of another market depends on the extent to which consumers will change
their consumption of one product in response to a price change in another (“cross-elasticity of demand). Consumers who already
bought Kodak equipments might face high costs to switch to different equipment. These consumers are “locked-in” in the sense
that they will be forced to tolerate some level of service price increase before changing equipment brands.
2) For the service-market price to affect equipment demand, consumers must inform themselves of the total costs of the
“package” (equipment, service and parts) at the time of purchase; that is, consumers must engage in accurate lifecycle pricing.
Because most of the consumers don’t have the knowledge to identify the complete cost of the package at the time of purchase,
even new consumers might not give up buying Kodak equipments due to a deceptive problem. Thus, Kodak might take
advantage of the consumer’s lack of information and knowledge to exercise market power in the aftermarkets without losing
consumers in the primary equipment market.
3) There are not only to prices that can be charged – a competitive price or a ruinous one. Instead, there could easily be a
middle, optimum price at which the increased revenues from the higher-priced sales of service and parts would more than
compensate for the lower revenues from lost equipment sales. The fact that the equipment market imposes a restraint on prices in
the aftermarkets by no means disproves the existence of power in those market.
In light of these reasons, the court concluded that Kodak has a monopoly over the supply of its unique parts and that it used its
control over parts to strengthen its monopoly power of the Kodak service market. The reasoning the court used to explain why
Kodak did posses market power over the aftermarkets despite the competition it faced in the primary equipments market is
based on “lack of information” and deceptive failures in the buyers side of the market. But is it appropriate to solve deceptive and
related problems by means of antitrust laws? Antitrust laws implicate a severe treatment to the defendant, including treble
damages and excessive attorneys’ fees, and maybe it would be adequate to solve the deceptive failures through less strict
remedies.
Kodak could argue that the control over the sale of service allows it to price discriminate (what can produce efficiency as viewed
above). In fact, one of the reasons why Kodak is not simply increasing the price of its parts (given that it has monopoly power
over this market and could do that) and selling them to anyone regardless of the service attachment is because Kodak can price
discriminate by attaching the service (it will charge more for the consumers who use more the repair service, who are probably
the consumers who use the machines more intensively and are willing to pay more). A second defense would be to argue that the
attachment is necessary to establish a quality-control and promote its primary equipment product (but there was evidence that
ISOs provided a good service).
Illinois Tool Works v. Independent Ink (When the tying product is patented there is no presumption of market power to
condemn the tying arrangement under the per se rule)
“We have condemned tying arrangements when the seller has some special ability – usually called market power – to force a
purchaser to do something that he would not do in a competitive market. For example, if the government has granted the seller a
patent or similar monopoly over a product, it is fair to presume that the inability to buy the product elsewhere gives the seller
market power. Any effort to enlarge the scope of the patent monopoly by using the market power it confers to restrain
competition in the market for a second product will undermine competition on the merits in that second market”. United States v.
Loew’s.
Here, however, the Supreme Court reversed this position and concluded that “the mere fact that a tying product is patented does
not support such a presumption(…) Tying arrangements involving patented products should be evaluated under the standards
applied in Jefferson Parish rather than under the per se rule applied in Loew’s”. In fact, patented products not necessarily
implicate in market power because it might be that there are close substitutes to the patented product or that it is easy to develop
a similar product without violating the patent.

Exclusive Dealing

An exclusive agreement concerns arrangements under which a buyer agrees not to use or deal in the goods of the seller’s
competitors or the seller agrees not to sell to any other buyers (or even both – reciprocal exclusivity). Although the exclusivity can
run from the buyer to the seller (the buyer promises not to buy from other suppliers) or from the seller to the buyer (the seller
promises not to sell to other buyers) it is far more common to see the first situation.
The difference from the exclusive agreement to tying arrangements is related to the number of products involved in the contract.
When the buyer agrees to take a seller’s product in order to obtain another product (buyer purchases X to obtain Y), we speak
of a tying arrangement. When the buyer agrees to take the seller’s product exclusively without regard to any other (tying)
product, we speak of exclusive dealing contracts (buyer purchases X on the condition that it will continue purchasing X through a
period of time). Usually the tying arrangement is a one-time sale whereas the exclusive agreement involves a long-term
relationship. In all events, both invoke Clayton Act # 3.
The main concern with exclusive arrangements is that they may foreclose competition. When the buyer agrees to purchase
exclusively from a single seller, the other sellers might be left with a reduced available market to offer their products and may be
driven out of business. Not only are the existent competitors affected, but also the potential newcomers who will have to face
higher barriers to entry because the remaining available market might be insufficient to encourage their entry. In this case, sellers
who were potential entrants to the market would have to enter into two markets simultaneously (both the manufacturing and the
retailing levels) to be able to effectively distribute its products. When a firm is required to enter into two markets simultaneously,
the likelihood of entry decreases significantly as a result of the higher start-up costs and elevated level of risk.
The concern with the coercion over the buyers which is present in tying arrangements (the buyer is forced to buy a second
undesired product) is not the central issue here because the seller is not exercising its market power to constraint the buyer to
purchase exclusively from him. It is true that a monopolist may use its market power to force buyers into exclusive agreements in
order to make new entry more difficult (this was exactly what we saw in Monopolizing Based on Tying up Consumers). But in
most cases, the exclusive agreements are a business strategy adopted by firms in a competitive market. So, if the seller is not
utilizing its monopoly power to force consumers into the exclusive dealing and the buyers are not coerced to enter into such
requirement contracts, what other reasons can explain such arrangement?

1) Assured markets for buyers – the buyer may enter into an exclusive arrangement in exchange for the seller’s promise to
provide him with a certain quantity at a fixed price in the future. Usually the seller will not agree with such a clause if the buyer
does not promise to purchase exclusively from him in exchange. In this way, the buyer can escape price fluctuation and plan its
production and distribution operations with greater precision and efficiency. Newcomers can take advantage of exclusive
agreements to guarantee that their investments will be recouped.
2) Assured markets for sellers – offer the possibility of a predictable market. The exclusive arrangement may provide protection
against price fluctuation and assure future sales, what can encourage the seller to invest in production with a lower risk.
3) Promoting dealer loyalty – issues of dealer loyalty arise mainly when the manufacturer-dealer relationship is more complex than
that of seller-buyer. The manufacturer may finance, train, or advise the dealer, supply or maintain the retail premises, and assist in
various ways in the operation of the dealership. But such manufacturer would resent having these efforts benefit its competitors.
Insisting that the dealer agree to handle its brand exclusively will protect against this danger (free-rider problem).
4) Cost savings – exclusive dealing contracts may reduce selling expenses (larger quantities are sold)

Standard Oil Co. of California (Standard Stations) v. United States (Where the market is highly concentrated and all of the
manufacturers have exclusive agreements with the dealers, these agreements might be serving to block the entrance of
newcomers and sustain the high concentration to facilitate oligopolistic behavior)
The Standard Oil Company sells gasoline through its own gas stations, to the operators of independent gas stations and to
industrial users. Its combined sales amounted to 23% of the total gasoline sold in the prior year, in which sales by company-
owned service stations constituted 6,8% of the total, sales under exclusive dealing contracts with independent gas stations 6,7%
of the total and the remaining were sold to industrial users. The exclusive supply contracts with Standard had been entered into
by the operators of 5.937 independent station, representing 16% of the retail gasoline outlets in the Western area. The
government challenged the exclusive agreements under the Clayton Act # 3, alleging that Standard’s contracts excludes suppliers
from access to a substantial amount of outlets. In the absence of such exclusive contracts the independent gas stations could
purchase gasoline from different suppliers and resale it to consumers (obviously under their respective brands). The particularity
of the refinery market of gasoline, however, is its concentration (Standard had only six leading competitors) and the fact that all
competitors employ similar exclusive dealing arrangements. Thus, the exclusive dealing is primary affecting not the existing rivals
(who have their own exclusive dealing arrangements) but the opportunity for new refiners to come into the market. In fact, the
evidence indicates that there were only 1,6% of retail outlets available (selling the gasoline of more than one supplier) and
probably this restricted demand is not enough to encourage investments by a newcomer. The minimum level of available market
to encourage new entrants will depend on the industry, particularly the start-up costs needed to be incurred by the new investor
and the minimum efficient scale to operate in that market (it might be cheap and easy to build an independent gas station). The
leading refiners might be benefiting from a concentrated industry with high barriers to entry (created by the exclusive contracts) by
engaging in oligopolistic behavior or even sustaining a cartel arrangement (the cartel is facilitated when the industry is concentrated
because it is easier to identify potential cheaters and, thus, firms have more incentives to respect the agreed price).
Considering the exclusive dealings effects of foreclosing new entry and sustaining a dangerous high level of concentration in the
refinery market, the court concluded that Standard’s contracts violated the Clayton Act # 3. It argued that whatever efficiencies
were generated by the exclusive dealing, such as allowing a predictable market to the dealers and the refiners, could be achieved
through less restrictive ways (the seller could promise to sell a certain amount at a fixed price without demanding an exclusive
arrangement – but in most cases when promise comes with the other). Moreover, the court refused to balance the potential
benefits and harms on the grounds that it is too hard to proceed with such inquiry and the courts may end up allowing undesirable
conducts.
But if it is hard to balance the benefits and harms why not exonerate the defendant instead of condemning it? Are the costs of
condemning a legitimate and procompetitive practice less than the costs of exonerating an unlawful conduct? Finally the court
argued that Clayton Act referred to the mere probability of affecting competition and not the certainty. Contracts are prohibited
wherever their effect may be to substantially lessen competition. The term “may be”, however, does not necessarily express the
legislator’s desire to condemn conducts where the harms are unclear, it can be that the term “may be” simply refers to the court’s
duty of acting before the harms actually occur. One thing is to condemn without certainty of harms and another is to condemn
with certainty of harms although they will only take place in the future.

When does an exclusivity contract foreclose substantially competition?

The Clayton Act requires that substantial share of the line of commerce is affected by the performance of the exclusive
agreement. It might be that the first exclusive arrangement between a manufacturer and a dealer does not foreclose enough
competition to be deemed illegal. However, once the first agreement is allowed, subsequent manufacturers can act in the same
way, until reach a point where competition is substantially foreclosed. When the tipping point (whatever it may be – 50%, 60%
or 70%) is reached, the next exclusive contracts will be foreclosing significantly competition and shall be deemed illegal. The
question is whether the later firm should be condemned, all of the firms which are contributing to the substantial foreclosure
should be condemned or none of them (because once you allowed the first ones you have to allow all the subsequent). What is
the degree of foreclosure of the next exclusive contract – the percentage of all market share already foreclosed plus the market
share of the firm considered individually; the percentage of the reduction of the market that is currently available; or the
percentage of the market share of the firm considered individually only? If we assume that the next exclusive dealing has to be
considered together with all the other exclusive dealing arrangements because this is the only way to measure the real effects it
will have in competition, then we will condemn a firm for engaging in exactly the same practice as its competitors were lawfully
engaging. Is it fair to give different treatments for firms engaging in the same practice just because some of them commenced
earlier than others? Why couldn’t the first firms be hold liable instead of the later ones? Indeed, one could argue that the first firms
have contributed for the foreclosure for a longer time and it is reasonable to give them a more severe treatment than to those
which are now trying to enter into exclusive deals. One solution would be to hold all of the firms engaging in exclusive contracts
jointly liable for the foreclosure created by the whole group, without regard to the time in which each of them began the
exclusivity. A second solution would be to forbid exclusive agreements of the first firms even without an actual substantial
foreclosure on the grounds that allowing the practice would open the doors to subsequent exclusive contracts which could, in
turn, foreclose a substantial degree of competition. The negative consequence of the second solution is that the courts would be
forced to forbid an arrangement which does not have enough power to produce harms and that could in fact be beneficial both to
seller and buyer and, ultimately, to consumers.

For how long is the buyer attached to the seller?

An exclusive contract may provide a cancelation clause. Depending on how many days does the seller have to be notified before
the cancelation, the exclusive contract can be held valid. In U.S. Healthcare v. Helathsource, the court remarked that while 180
days might be problematic, the 30-day version would be close to a de minimis constraint. In the case of a 30-day notice
cancelation clause, the newcomer or the existing rivals could encourage the buyer to switch if it has an attractive offer. The
cancelation clause could not be an efficient remedy to mitigate the foreclosure problem because the contract could provide many
other clauses which make the cancelation difficult and unattractive (a cancelation fee, for instance).

Tampa Electric Co. v. Nashville Coal Co (The court recognized potential justifications of exclusive dealing and determined that
they must be taken into account when analyzing the effects in competition)
The Supreme Court refused to condemn an exclusive agreement between Tampa Electric and Nashville Coal to supply coal for
20 years on the grounds that it didn’t foreclose competition in a substantial share of the line of commerce affected. The court
argued that to determine substantially it is necessary to consider not only the percentage of foreclosure but all the effects the
contract might have in competition, including potential efficiency gains.

Case analyzed in class (page 603 (435) from the casebook)

Everybody in Amesville reads the Morning Lever, which is the city’s only morning newspaper. Everybody in Amesville also reads
one of the two evening newspapers, Tide and Time, which have roughly equal circulation. Lever and Tide are both owned by
LeverTide and published in a single plant. The advertising revenue of each newspaper is proportional to its share of total
circulation – 50% for the Lever and 25% each for Tide and Time. Advertising space is not sold separately in the Lever;
advertisers wishing to purchase space in the Lever must also purchase identical space in the Tide. What are the possible antitrust
injuries?

LeverTide’s decision to attach the sale of advertisement in the morning newspaper (Lever) to the evening newspaper (Tide) is
certainly foreclosing the opportunities that Time would have to sell to consumers who could opt to advertise in the Morning Lever
and then in the evening in Time. The consumers who want to purchase advertisement in the morning will be forced to advertise in
the evening Tide newspaper instead of having the option of choosing between Tide and Time. The practice shall be analyzed
under each potential violation of the antitrust laws.
Potential violations to be analyzed in this case:
Sherman Act # 2 (monopolization or attempt to monopolize)
Sherman Act # 1 (contract in restraint of trade)
Clayton Act # 3 (tying)

Sherman Act # 2
Is LeverTide monopolizing or attempting to monopolize the market? To address this issue we have to determine (i) what is the
relevant market which LeverTide might be monopolizing; (ii) what is LeverTide’s market power in that relevant market; and (iii)
which acts are being undertaken by LeverTide to acquirer or sustain a monopoly.

(i) What is the relevant market which LeverTide might be monopolizing?

To determine the relevant market the question that should be asked is: can a hypothetical monopolist in this market profitably
raise its price above competitive levels for a sustained period of time? A monopolist has the power to raise its price substantially
above competitive levels because any lost demand will be profitably outweighed by the higher prices that the monopolist charges
its remaining customers. For the price increase to be profitable there must be a lack of alternatives to the consumers so the
eventual lost incurred by the seller is restricted. Thus, the relevant market shall include the product offered by the seller plus all the
other close substitutes to this product (because the consumers could switch to these close substitutes and escape the high prices
charged by the defendant, in which case it wouldn’t be profitable to charge monopoly prices). In the present case, if LeverTide
raised the price of advertisement in the morning newspaper could the consumers switch to the evening newspaper? One could
argue that the morning and evening newspapers are close substitutes because regardless which newspaper is actually used the
consumer can reach the whole city. That means that both have the same function, the same quality and the same price, so there is
no obvious reason why consumers wouldn’t switch to the evening newspaper if the morning one was to expensive. On the other
hand, it would be reasonable to argue that for certain consumers it might be critical to use the morning newspaper because the
time at which the newspaper reaches the public is fundamental to its advertisement. Suppose a costumer who wishes to purchase
a space in the newspaper to announce the exact weather conditions for that day. It would be worthless to announce it in the
evening since the public is not interested any longer in that announcement (obviously the advertiser could announce in the evening
newspaper the weather for the next day but I am assuming that he would only have access to the exact weather conditions on the
same day and, thus, would need the morning newspaper to make the announcement). Because there is the possibility of
considering the whole advertisement industry as a single market or considering it divided into two separate markets (morning and
evening), we shall proceed with the analysis of monopolization under the two hypothesis.

(ii) What is LeverTide’s market power in that relevant market; and (iii) which acts are being undertaken by LeverTide to acquirer
or sustain a monopoly?
a) Considering the relevant market as the whole advertisement industry in Amesville: LeverTide has 75% of market share of that
market and Time has 25%.
Is LeverTide monopolizing or attempting to monopolize the whole advertisement market in Amesville? Because LeverTide hasn’t
reached a monopoly position yet, if there is any violation of the Sherman Act # 2 it would be an attempt to monopolize.
According to Justice White’s vote in Spectrum Sports v. McQuillan, “it is generally required that to demonstrate attempted
monopolization a plaintiff must prove (i) that the defendant has engaged in predatory or anticompetitive conduct with (ii) a specific
intent to monopolize and (iii) a dangerous probability of achieving monopoly power”. The anticompetitive conduct which
LeverTide is undertaking is to impose an obligation over consumers to purchase space in both of its newspapers. It is not a tying
arrangement because it is not selling two separate products, but instead the same product at different periods in the day. Indeed,
the arrangement is closer to an exclusive dealing, whereby the seller (LeverTide) requires that the consumer continue to purchase
its product in the evening and excludes the opportunity of its competitors to sell to that consumer.
Whether it can be inferred that LeverTide has a specific intent to monopolize depends if there are alternative explanations to the
arrangement besides the purpose of driving its competitor out of business. It might be that LeverTide’s policy promotes cost
savings, after all, the morning and the evening newspapers are published in the same plant and once a consumer purchased space
to advertise in the morning newspaper it would be cheaper for LeverTide to publish the same advertisement in its evening
newspaper. But the plaintiff could argue that if the advertisement in the evening newspaper costs less to LeverTide why doesn’t it
offer a discount on the evening newspaper instead of forcing the consumer to purchase? In other words, the defense of “cost
savings” could justify a discount (proportional to the cost savings) to encourage the consumer to purchase the evening newspaper
but not a mandatory purchase.
The last requirement to constitute an attempt to monopolize is “a dangerous probability of achieving monopoly power”. In Judge
Hands famous proclamation on the relationship between market share and monopoly power, 90% is “enough to constitute
monopoly”, 64% is “doubtful” and 33% is “certainly not enough”. United States v. Aluminum Co. of America (ALCOA).
Considering that LeverTide has 75% share in the market of advertisement in Amesville, it falls close to the “doubtful” category
expressed by Judge Hands. To determine if a 75% market share is enough to constitute a “dangerous probability of achieving
monopoly power”, two other factors shall be taken into consideration. First is the level of barriers to entry. If it is easy for new
entrants to build-up a plant in order to explore the newspaper industry, then LeverTide might be precluded from exercising
monopoly power (considered as the power to raise prices above competitive levels) even with a high market share. Second is the
ability of rival to expand capacity. If the remaining 25% competitor (Time) is able to expand capacity when the defendant raises
price and restricts output, then the consumers will have the option to switch to the existing rival and escape the high prices. Under
this hypothetical relevant market it is hard to condemn LeverTide’s practice as an attempt to monopolize considering that: (i) it
has a “doubtful” level of market share; (ii) the newspaper market doesn’t present high barriers to entry; (iii) Time could expand its
capacity to cover the demand; and (iv) LeverTide might not have the intent to monopolize but, instead, to promote cost savings
which is regarded as an efficiency result.

b) Considering the relevant market as the morning newspaper separately from the evening newspaper: LeverTide has 100% of
the morning newspaper market and 50% of the evening newspaper market; Time has 50% of the evening newspaper market.
A type of monopolization can occur when a monopolist leverage its power to extend its monopoly to other markets and, thereby,
increase the social harm caused by the initial monopoly. The Chicago School of Antitrust, however, challenged this idea by
arguing that when a firm chooses to extend its monopoly power to other market, it will necessarily sacrifice the gains that could
be generated from the initial lawful monopoly. Thus, the firm is not capturing a second monopoly, it is only realizing the returns
from its first monopoly. In all events, LeverTide is taking advantage of its monopoly power in one market to acquirer a monopoly
position in the second market by tying up consumers. Under United States v. Griffith, the fact that Griffith negotiated the film
rights for its closed towns (where it had a monopoly) together with the open towns (where there was a competitive market) in
order to acquire exclusive rights in the competitive towns through its strong bargaining power was considered by the Supreme
Court an unlawful monopolization in violation of Sherman Act # 2. “The use of monopoly power, however lawfully acquired, to
foreclose competition, to gain a competitive advantage, or to destroy a competitor, is unlawful”. Griffith. The only difference from
this case to Griffith is that here the defendant is foreclosing competition in a second market by forcing its consumers who wants
the morning newspaper to take the evening newspaper (where there is competition), whereas in Griffith the practice deemed
unlawful was the negotiation with the suppliers as a whole package to acquire a favorable condition on a competitive market. But
it doesn’t seem that this is a significant difference, the principle is the same: taking advantage of a monopoly position in one
market to extract benefits in a second market by foreclosing competition. The Supreme Court has held many times that power
gained through some natural and legal advantage such as a patent, a copyright, or business acumen can give rise to liability if “a
seller exploits his dominant position in one market to expand his empire into the next”. Times-Picayune Publishing Co. v. United
States. Therefore, in this situation, LeverTide should be condemned for attempting to monopolize a market (evening newspaper)
through its monopoly position in another market (morning newspaper).

Sherman Act # 1
Did LeverTide enter into an unreasonable contract, combination or conspiracy in restraint of trade? The first requirement to
characterize a violation of section 1 is an agreement between two parties, excluding from its coverage pure unilateral conducts.
Did LeverTide enter into any agreement? LeverTide’s policy to sell advertisement space in the morning newspaper only for those
who purchased space in the evening newspaper is itself an agreement between LeverTide and its consumers. In Eastman Kodak
Co. v. Image Technical Services the Supreme Court didn’t hesitate to characterize Kodak’s policy of selling replacement parts
only to buyers who use Kodak service as an agreement, invoking Northern Pacific “a tying arrangement is an agreement by a
party to sell one product but only on the condition that the buyer also purchases a different (or tied) product, or at least agrees
that he will not purchase that product from any other supplier”. Moreover, the court stated that such an arrangement violates
section 1 of the Sherman Act if the seller has “appreciable economic power” in the tying product market and if the arrangement
affects a substantial volume of commerce in the tied market. Fortner Enterprises, Inc. v. United States Steel Corp. “Appreciable
economic power”, in turn, is the power “to force a purchaser to do something that he would not do in a competitive market”.
Jefferson Parish. In the present case it is clear that LeverTide has appreciable economic power over the morning newspaper
(100% market share) and, thus, is able to force the buyer to take its evening newspaper. This gives LeverTide the power to
foreclose competition and preclude Time from capturing consumers since many of them are locked-up through the tie-in
arrangement.
The subsequent question that should be asked is: once it is determined that the defendant’s activities constitute a tying
arrangement and the defendant has appreciable economic power to force the consumer to do something that he would not do in
a competitive market, should the conduct be condemned under the per se rule?
Even though the per se illegality of tie-in arrangements engaged by an agent with appreciable economic power and affecting a
substantial volume of commerce was not expressly overruled, one could reasonable argue that the Supreme Court is in substance
following a standard closer to a rule of reason. Indeed, in Jefferson Parish Hospital District No 2 v. Hyde, Justice O’Connor’s
vote which concurred with the majority vote, stated that “A tie-in should be condemned only when its anticompetitive impact
outweighs its contribution to efficiency”. It was recognized that “the examination of the economic advantages of tying may
properly be conducted as part of the rule of reason analysis…This approach is consistent with this Court’s occasional references
to the problem”. Moreover, in United States v. Jerrold Electronics Corp. the Supreme Court concluded that even though the
defendant had market power in the tying product market, the compulsory service attached to the purchase of the product was
accepted on the grounds that it was necessary during a limited period to assure the survival of the new and sophisticated system
that was being launched in the market. Once more, in United States v. Microsoft, the Supreme Court declined to apply a per se
rule against tying arguing that the integration between the operating system and the software offered by Microsoft may be serving
legitimate business reasons such as providing a multiple functionality product which is more capable of satisfying the demand’s
desire.
Having said that the Supreme Court is beginning to recognize some procompetitive justifications in tie-in arrangements, the next
inquiry is whether LeverTide’s policy serves a legitimate reason from the antitrust perspective. One argument that could be raised
by LeverTide is related to cost savings. The morning and the evening newspapers are published in the same plant and once a
consumer purchased space to advertise in the morning newspaper it would be cheaper for LeverTide to publish the same
advertisement in its evening newspaper. The counter-argument would be that if the advertisement in the evening newspaper costs
less to LeverTide why doesn’t it offer a discount on the evening newspaper instead of forcing the consumer to purchase? In other
words, the defense of “cost savings” could justify a discount (proportional to the cost savings) to encourage the consumer to
purchase the evening newspaper but not a mandatory purchase. A second, and more interesting, counter-argument is: why should
cost savings be recognized as a procompetitive justification? In other words, if the efficiencies generated by the arrangement will
benefit exclusively the defendant, why should the antitrust laws accept them as legitimate justification? From the fact that the tying
will generate cost savings, it does not follow necessarily that this efficiency will advance competition. Therefore, the relevant
inquiry is whether the defendant will have incentives to pass the efficiencies to the consumers, or rather appropriate them for itself.
Usually, when a company in a competitive finds a way of decreasing its cost structure, it will have incentive to pass the efficiency
to its consumers by lowering the price and increasing output in order to capture demand and raise profits. In the present case,
however, it is not clear whether LeverTide would pass the efficiency to consumers by lowering its price because in the market of
the morning newspaper it has a monopoly (so it doesn’t need to lower the price to capture consumers from competitors) and in
the market of the evening newspapers it wouldn’t have incentive to lower its price neither because it is already capturing the
demand through the tying arrangement. One could argue, however, that it would have incentive to charge lower prices (as a result
of the cost savings) in the evening newspaper in order to capture the group of consumers who are exclusively interested in
advertising in the evening newspaper and weren’t captured by the tying arrangement.
Because the Supreme Court is still reluctant in considering justifications for tying arrangements and, even if it was already applying
a standard closer to the rule of reason, it is not clear whether the arrangement will produce procompetitive cost savings (that is,
those ones which will proceed ultimately to consumers), LeverTide should be condemned for an unlawful tying arrangement in
violation of the Sherman Act # 1.

Mergers

Mergers are usually classified according to the market relationship of the merging parties: horizontal mergers involve parties that
are competitors; vertical mergers, parties that are or could become buyer and seller; and conglomerate mergers every other case.
A horizontal merger eliminates a competitor and concentrates the market power of two previously separate enterprises in the
hands of one. Vertical and conglomerate mergers, in contrast, do not increase market concentration in the short run. However,
they may increase market concentration in the long run by creating foreclosure effects.

Clayton Act # 7
No person engaged in commerce or in any activity affecting commerce shall acquire, directly or indirectly, the whole or any part
of the stock or other share capital and no person subject to the jurisdiction of the Federal Trade Commission shall acquire the
whole or any part of the assets of another person engaged also in commerce or in any activity affecting commerce, where in any
line of commerce or in any activity affecting commerce in any section of the country, the effect of such acquisition may be
substantially to lessen competition, or to tend to create a monopoly.

The original text of Clayton Act # 7 was amended in 1950 in order to cover some “loopholes”. First, the amendment included
within the coverage of the Act the acquisition of assets no less than the acquisition of stock. It doesn’t matter whether the
acquiring company is purchasing stock or assets from the acquired company, both transactions are regarded as mergers for
antitrust purpose. Second, the amendment made it clear that section 7 applied not only to mergers between actual competitors,
but also to vertical and conglomerate mergers whose effect may tend to lessen competition in any line of commerce. Finally, the
term “may be substantially to lessen competition” indicates that its concern is with probabilities, not certainties. However, a mere
possibility of anticompetitive harms is not enough to condemn the merger. The calculation of the expected harms involves two
factors: (i) the level of probability that harms will result; and (ii) the expected damages produced if we assume that the concern
will become effective. Thus, the term “may” ought to be interpreted as the combination of the probability and the expected
damages. If the expected damages are less severe to competition, then the level of probability required to condemn is greater.
When the expected damages are extremely detrimental to competition, then the merger could be condemned even with a reduced
level of probability.

Horizontal Mergers

Horizontal mergers raise two main concerns. The first is the possibility that a monopoly may arise as a result of the merger. When
the combined entity has an extremely high percentage of market share in the relevant market and barriers to entry are high, then
there is a strong likelihood that it would be able to impose a “small but significant and nontransitory” increase in price. In fact, a
merger that creates a monopoly can be more harmful to competition than agreements among competitors to fix prices (cartels)
because the merger is permanent while the cartel is subject to cheaters and monitor difficulties. Moreover, the merger eliminates
not only price competition but also competition to innovate and offer better quality products. But the per se illegality of cartels is
not appropriate to govern merger cases because they might also produce procompetitive effects without harms or procompetitive
effects that outweigh the potential harms to competition.
A merger doesn’t need to result in a monopoly to cause anticompetitive effects. In fact, the majority of mergers which were
condemned didn’t produce a monopoly. Mergers may lessen competition by increasing the concentration of the market, which, in
turn, facilitates oligopolistic behavior among competitors.
Oligopolistic behavior is achieved when the competitors can coordinate price simply by following the actions undertaken by other
firms in the market. Usually, one of the firms in the market (called the “leader”) starts pushing up the price with the expectation
that the competitors will follow the increase. The competitors, even though they would be individually in a better position by
maintaining the lower price to capture consumers, will understand the leader’s behavior as an invitation for all the firms in the
market to increase price. If one of the firms rejects the invitation, the leading firm will rapidly reduce her price back to its original
level (to bring back her consumers) and all of them will be in a worse position compared to the situation where all the competitors
followed the leader and were able to charge higher prices. The rational firms will foresee these results and perceive the necessity
of a coordinated behavior to achieve a better situation for all of them. This interdependence relationship, when successful, can
create the same harms as a cartel or a monopoly.
There are, however, some factors which limit the ability of an oligopoly to price at monopoly levels. First, the oligopolistic
competitors may differ in their costs of production and may be willing to charge different market price. Also, the products offered
by each of them may differ in quality, making it harder to establish a single price to all of them. Without meetings and discussions
it might be hard (or impossible) to reach a consensual price which satisfies all the participants to the implicit agreement. It follows
that oligopolistic behavior may be facilitated by product or firm homogeneity. When firms have approximately the same size, the
same cost structure and produce standard products, it is easier to make a consensual decision. Moreover, oligopolistic behavior
can be facilitated when the transactions are large and infrequent. In this case there is a high temptation to cheat the implicit
agreement because the amount earned in a large transaction may compensate the risks of detection and the costs of reprisal.
Finally, there is a major restriction to a successful oligopolistic coordination: the difficulty of detecting “cheaters”. The greater is
the number of competitors in the market, the harder it is to detect those ones which are not following the price increase. “Small”
firms don’t believe their actions will have an impact in the market and they will try to take advantage of the coordination of bigger
firms by charging lower prices and capturing consumers. When the market becomes more concentrated the likelihood of
detection of cheaters and punishment (by returning to the original competitive price and even adopting strategies to drive the
cheater out of business) is enhanced. It follows that where market conditions are conducive to timely detection and punishment of
significant deviations, a firm will find it more profitable to adhere to the terms of the coordination than to pursue short-term profits
from deviating, given the costs of reprisal.
Even though oligopolistic behavior presents great danger to competition, courts have resisted attacking them. The reluctance to
condemn mutual coordination among competitors is justified because when there is no sign of actual communication it is hard to
conclude that firms are charging the same prices because they are participants in an implicit agreement. Firms may be charging the
same price because they have the same cost structure, for instance. They may increase prices not because they are following a
“firm leader” but because of changes on demand, changes on costs or changes on technology, which can reasonably justify their
conduct. Moreover, courts are conscious about the difficulties faced by firms to coordinate prices when there is no evidence of
communication between them, and they rely on these restrictions as a strong weapon against oligopolistic behavior.
Mergers, however, have the ability of mitigating the restrictions faced by competitors trying to achieve coordination by: (i)
reducing the number of competitors in the market and increasing the likelihood of detection and punishment of cheaters; and (ii)
homogenizing the market by creating same size firms, which, in turn, have similar cost structures and similar price interests.
Therefore, mergers ought to be condemned when they increase significantly the market’s concentration or when they increase
slightly the concentration of a highly concentrated market.

Inquiry to verify the legality of Mergers

1) Clayton Act # 7: “(…) the effect of such acquisition may be substantially to lessen competition, or to tend to create a
monopoly”. Prerequisite to establishment of the prima facie evidence that the merger “may be substantially to lessen competition”
is definition of the relevant market within which the merged entity would have significant market power. “The relevant market is
defined by identifying competitors who could provide defendants’ customers with alternative sources for defendants’ services in
the event defendants, as the merged entity, attempted to exercise their market power by raising price above competitive levels.
United States v. Mercy Health Services. A relevant market consists of two separate components, a product market and a
geographic market. “A properly defined market excludes other potential suppliers (1) whose product is too different (product
dimension of the market) or too far away (relevant geographic market), and (2) who are not likely to shift promptly to offer
defendants’ customers a suitably proximate alternative”. Mercy. A geographic market is that geographic area “to which
consumers can practically turn for alternative sources of the product and in which the antitrust defendants face competition”.
Freeman.
The first step is to define the relevant market where a hypothetical monopolist could exercise monopoly power. Addressed under
the monopoly power section. The main difference is that in monopoly cases we usually ask whether the defendant already has
monopoly power, whereas in horizontal merger cases we ask whether the firm that results from the merger will acquire or
increase its individual power over price and, if not, whether the resulting increase in market concentration will create (or
reinforce) oligopoly and the danger of price coordination.

2) Having adequately defined the relevant market(s), the plaintiff must show the proposed merger would result in a significant
increase in the concentration of power in the relevant market(s) and repose in the merged entity an undue share of the market(s).
FTC v. Butterworth Health Corp. The probable effect of the merger in the relevant market is evaluated by identifying the
concentration of the market after the merger and the increase in concentration resulting from the merger. According to the
Guidelines, when the post-merger HHI is below 1000 the market is unconcentrated and the merger is unlikely to produce
anticompetitive effects. When the post-merger HHI is between 1000 and 1800 the market is moderately concentrated and any
merger producing an increase in the HHI in more than 100 points may raise significant competitive concerns and requires further
analysis. When the post-merger HHI is above 1800 the market is highly concentrated and any merger producing an increase in
the HHI in more than 50 points may raise significant competitive concerns and requires further analysis.
The HHI is calculated by summing the squares of the individual market shares of all the participants. The HHI became an
important measure because it reflects the concentration of the whole market, as opposed to the traditional method which focused
only on the market shares of the largest firms. In the case of a pure monopoly (one firm with 100%) the HHI will be 100² =
10.000; in the case of two companies holding 50% each the HHI will be 50² + 50² = 5.000; in the case of four companies
holding 25% market share each the HHI will be 25² + 25² +25² + 25² = 2.500; and in the case of 100 companies holding 1%
each the HHI will be 1² + 1² + (…) = 100.
The increase in concentration resulting from the merger can be calculated by doubling the product of the market shares of the
merging firms. The explanation for this technique is as follows: in calculating the HHI before the merger, the market shares of the
merging firms are squared individually: (a)² + (b)². After the merger, the sum of those shares would be squared: (a + b)², which
equals a² + 2ab + b². The increase in HHI therefore is represented by 2ab.

By showing that the proposed merger will lead to undue concentration in the relevant market, a presumption that the transaction
will lessen competition is created. Philadelphia Bank. Once such a presumption has been established, the burden of producing
evidence to rebut the presumption shifts to the defendants. General Dynamics. To meet this burden, the defendants must show
that the market share statistics give an inaccurate prediction of the proposed acquisition’s probable effect on competition. They
may claim easy entry conditions, efficiencies justifications or the failing company defense.
3) Entry conditions. A merger is not likely to create or enhance market power or to facilitate its exercise, if entry into the market
is so easy that market participants, after the merger, either collectively or unilaterally could not profitably maintain a price increase
above premerger levels. “The existence and significance of barriers to entry are frequently, of course, crucial considerations in a
rebuttal analysis because in the absence of significant barriers, a company probably cannot maintain supracompetitive pricing for
any length of time”. United States v. Baker Hughes.
Entry is easy when it would be timely, likely, and sufficient in its magnitude, character and scope to deter or counteract the
competitive effects of concern. When the entry satisfy the tests of timely, likely and sufficient, the merger raises no antitrust
concern and requires no further analysis. At this point we are considering only the committed entrants, that is, those ones which
incur on significant sunk costs of entry and exit. The uncommitted entrants were treated as market participants (because their
entry is so easy and likely to occur that there is a presumption that they will come into the market in the event of higher prices)
and there ability to constraint the exercise of monopoly power was already considered in the calculation of the defendant’s
market share.
One of the aspects of the likelihood of entry of committed entrants is their ability to secure prices at the level before the entry. If
the minimum viable scale is too large for the market to absorb without depressing prices further, then entry is unlikely to happen.
The potential newcomer will compare the minimum viable scale and the likely sales opportunity available to entrants to decide if
its output can be absorbed without depressing prices.
Another consideration to evaluate the entry conditions is the availability of potential supply channels and distribution channels.
When the newcomer is not able to purchase the necessary input of production from suppliers or when the channels of distribution
are already committed to other participants in the market, the newcomer may be precluded from successfully entering the market.

4) Efficiencies justifications. The Merger Guidelines recognize that “Mergers have the potential to generate significant efficiencies
by permitting a better utilization of existing assets, enabling the combined firm to achieve lower costs in producing a given quantity
and quality than either firm could have achieved without the proposed transaction”. The efficiencies taken into account are those
ones which cannot be accomplished by means other than the proposed transaction (merger-specific efficiencies). Thus, only
efficiencies susceptible to verification, merger-specific, and substantial shall be considered as valid justifications. These are the
following examples of efficiencies that can be generated by a merger:

1) The acquiring company might be buying needed personnel, facilities, or patents. It may be especially cheaper to acquire a
going enterprise than to build one from the ground up, avoiding start-up costs, recruiting and training management, advertisement
and the necessary distribution facilities.
2) Economies of Scale – result when a fixed cost of production is spread over a larger output, thereby reducing the average fixed
cost per unit of output. Consider two companies, each with a widget factory that operates at half capacity. If the companies
merge, the “surviving company” might be able to close down one factory and meet the combined demand for its products at a
much lower cost.
3) Replacement of underperforming management – When the incumbent management has failed to exploit available profit
opportunities, the company’s stock price declines and opens the opportunity for an outsider investor to purchase a controlling
block of stock, replace the management and make profit by maximizing the firm’s value.

The next relevant question is to what extent the demonstration of such efficiencies can justify a transaction which causes also
anticompetitive effects? According to the Merger Guidelines “efficiencies are most likely to make a difference in merger analysis
when the likely adverse competitive effects, absent the efficiencies, are not great. Efficiencies almost never justify a merger to
monopoly or near-monopoly”. Following the same approach, the Supreme Court stated in Clorox that “Possible economics
cannot be used as a defense to illegality. Congress was aware that some mergers which lessen competition may also result in
economies but it struck the balance in favor of protecting competition”. There is a tradeoff between efficiencies (including cost
savings, economies of scale and maximizing the firm’s value) and the danger of reinforcing oligopoly and price coordination, but
the courts and the FTC tend to assume that Congress have already made the tradeoff decision in favor of condemning all mergers
that “may be substantially to lessen competition”, regardless of eventual efficiencies.
So why do efficiencies justifications matter? Even though efficiencies justifications cannot be used as a defense to illegal mergers,
they can be used to prove that the merger is not illegal at all by demonstrating that the HHI statistics give an inaccurate prediction
of the proposed acquisition’s probable effect. In fact efficiencies justifications are most useful to prove that the merger has
reasons other than the purpose of acquiring a monopoly or facilitating price coordination. Thus, when the transaction falls within
one of the categories established by the Merger Guidelines (increase the HHI by more than 100 points in a moderately
concentrated market; or increase the HHI by more than 50 in a highly concentrated market) but it is not clear whether the
transaction will in fact facilitate oligopolistic behavior (because it almost fell out of the HHI statistics or because there was
discussion concerning the definition of the relevant market and the analysis proceeded with the narrowest definition) then the
efficiencies may serve as an evidence that the merger is not motivated to achieve price coordination.

Why deny efficiency justifications when there is a likelihood of oligopolistic coordination?

When price coordination among competitors is possible the presumption is that the efficiencies generated will not be passed to
consumers. Why should the combined firm pass the efficiencies acquired by a lower cost structure to consumers through lower
prices if the market conditions permit it to coordinate price with its rival and charge higher prices without loosing demand? In fact,
when the price coordination is possible, the combined firm will have the incentive to appropriate the efficiencies and it will extract
benefit both from decreasing its costs of production and by charging higher prices through oligopolistic behavior. The
consequences to the market as a whole will be: the price increase and the output restriction will produce a deadweight loss
(consumers who were willing to buy at the pre-merger price will abandon the market) and the shift of consumers surplus to
producer surplus (from the group of consumers who are still purchasing the product but paying a higher price); and the reduction
of the cost structure will enhance producers surplus without affecting consumers surplus. One could argue that the reduction of
the cost structure might outweigh the deadweight loss and, in this case, the society as a whole (including the group of producers
and consumers) is better off than it was without the transaction. But this approach has not prevailed. Indeed, the courts have
focused on the negative consequences to the group of consumers to condemn a transaction, even though the gains to producers
might outweigh the loss to consumers.

Why accept efficiency justifications when oligopolistic behavior is unlikely?

As it was recognized in the Merger Guidelines “Mergers have the potential to generate significant efficiencies by permitting a
better utilization of existing assets, enabling the combined firm to achieve lower costs in producing a given quantity and quality
than either firm could have achieved without the proposed transaction”. When the combined entity is capable of reducing its cost
structure, expanding output and increasing quality and there is no danger in the market of oligopolistic behavior, the merger is in
fact stimulating competition. The merged firm will have the opportunity to cut prices and at the same time its competitors will be
forced to become more efficient.
There is, however, the danger that the industry will become more and more concentrated, and oligopolistic behavior may be
facilitated or even a monopoly may be created. By allowing efficient mergers to proceed, the inefficient competitors will be
eliminated and, to survive, the competitors will be encouraged to merge in order to acquirer efficiencies. The fragmented industry
which Congress and the Supreme Court in its Brown Shoe and Philadelphia’s decisions intended to protect will be threatened by
the growth of many efficient mergers. This argument is raised to condemn mergers despite their efficiencies and despite the
unlikelihood of present oligopolistic behavior, given that the market is unconcentrated. Moreover, this argument is usually
followed by the “incipient theory” which contends that the authorization of the present merger will require courts to act in the
same way in relation to future mergers in the industry and the tendency toward concentration will be accelerated. “If a merger
achieving 5% control were now approved, we might be required to approve future merger efforts by Brown’s competitors
seeking similar market shares. The oligopoly Congress sought to avoid would then be furthered and it would be difficult to
dissolve the combinations previously approved”.
On the other hand, one could argue that even if the mergers are condemned the result will still be the elimination of inefficient
competitors and the concentration of the market because the efficiencies would be realized anyway through internal growth.

Standing Requirements for Private Litigation

Beginning with Brunswick, the Supreme Court has fashioned a requirement that a plaitiff’s case demonstrate antitrust injury. The
plaintiff seeking damages (or injunction) must show that it (1) suffers injury (or threatened injury) that is both (2) actually caused
by the defendant’s illegal conduct and (3) of the kind that the antitrust laws were designed to prevent. The question that must be
asked is whether the injury of which the plaintiff complains or the damages it has actually proved is closely connected with the
purposes of the antitrust laws.
In Billy Baxter, the court said that the causal connection between violation and injury must “link a specific form of illegal act to a
plaintiff engaged in the sort of legitimate activities which the prohibition of this type of violation was clearly intended to protect” (a
firm sued its competitor (A) for adopting tying arrangement/exclusive dealing and the court granted standing because the primary
reason why antitrust law is concerned with the agreement in question is its impact on the market opportunities of (A)’s rivals). In
Brunswick Corp. v. Pueblo Bowl-O-Mat, the court denied standing to a plaintiff who operated bowling centers complaining that
its competitors bowling centers had been acquired by the defendant and, absent the acquisition, the acquired centers allegedly
would have gone out of business, with the result that the plaintiff would have had less competition and greater profits. The
Supreme Court unanimously held that “it is not the purpose of the antitrust laws to prevent such competition or to compensate
such injury. In Cargill v. Monfort, Brunswick’s holding was extended to require that private plaintiffs show antitrust injury in
equity suits as well as in damage actions.
In merger cases, private plaintiffs will usually not have standing because if the merger is one that facilitates oligopolistic behavior
then competitors will not suffer the injury requirement to challenge the merger (because the tendency is that prices will raise) and
if the merger is one that produces high efficiencies capable of eliminating rivals, then competitors may well be injured, but this
injury will not be something the antitrust laws protect against given that competition is being stimulated. “It is competition, not
competitors, which the Act protects”. Brown Shoe. It follows that competitors often do not have a legitimate antitrust action in
the case of mergers. Competitors can sue under specific circumstances, such as by demonstrating that the merger creates a
realistic potential for predatory pricing or perhaps for reciprocity (considered in the conglomerate mergers section).
5) The Failing Company Defense – it was created by the Supreme Court in its International Shoe decision of 1930 and has been
incorporated in the Merger Guidelines. According to the Guidelines, “a merger is not likely to create or enhance market power or
facilitate its exercise if the following circumstance are met: (i) the allegedly failing firm would be unable to meet its financial
obligations in the near future; (ii) it would not be able to reorganize successfully under Chapter 11 of the Bankruptcy Act; (iii) it
has made unsuccessful good-faith efforts to elicit reasonable alternative offers of acquisition of the assets of the failing firm that
would both keep its tangible and intangible assets in the relevant market and pose a less severe danger to competition than does
the proposed merger; and (iv) absent the acquisition, the assets of the failing firm would exit the relevant market. Two rational
have been offered for the failing company defense. The first one is that the failing firm’s contribution to competition is so modest
that its absorption by a rival would not reduce competition significantly. The second one is that a merger is preferable to failure
from the viewpoint of the investors, employees, customers, and communities involved.

6) Other Factors to be taken into consideration:

- Can the actual competitors expand capacity? If the competitors who are left with the remaining market shares are able to
expand capacity, then the merging firm may be incapable of raising price and restricting output even if it possesses a significant
market share and the market is highly concentrated. On the other hand, the existence of unexercised capacity may indicate a
predisposition of the participants in the market to engage in oligopolistic behavior because such coordination requires that all of
them restrict their production. Moreover, the possibility of competitors expanding capacity might be ineffective in a market where
the combined firm has enough power to threat the competitors who expand their capacity instead of following the price
coordination. Threats can vary from the leading firm’s ability to cut prices to a level at which the smaller competitors are unable to
compete and are driven out of business to the possibility of adopting business policies with consumers and suppliers aimed to
exclude the particular competitor who is disturbing the price coordination. Of course, such business policies can be challenged
under the antitrust laws even when aimed at a single small firm as argued in Klor’s. “This combination takes from Klor’s its
freedom to buy appliances in an open competitive market and drives it out of business as a dealer in the defendant’s product. As
such it is not to be tolerated merely because the victim is just one merchant whose business is so small that his destruction makes
little difference to the economy. Monopoly can as surely thrive by the elimination of such small businessmen, one at a time, as it
can by driving them out in large groups”. Klor’s. In all events, it seems unlikely that a small competitor will assume the risk of
expanding capacity knowing that it can be the target of unfair business policies adopted by the leading firm of the industry.
- The numbers may overstate or understate the market resulting in an imprecise valuation of the effects of the merger on
competition. This might be because close substitutes were excluded from the relevant market and a too narrow definition was
adopted (in this case the numbers would be overstating the anticompetitive effects on competition) or, to the contrary, products
which are not really close substitutes were included in the same relevant market and a too broad definition was adopted (numbers
would be understating the anticompetitive effects on competition). It also may occur that the numbers represent a significant
portion of the market when measured by past production but its future ability to compete is overestimated because all of its
current production is already committed under long-term contracts (General Dynamics)
- Are there factors in the market that make oligopolistic behavior more likely to happen?
Oligopolistic behavior may be facilitated by product or firm homogeneity. When competitors have approximately the same size,
the same cost structure and produce standard products, it is easier to reach a consensual decision in relation to the price to be
charged (given that oligopolistic behavior is not literally a cartel in the sense that there is no actual communication between the
firms and without meetings and discussions it might be hard to coordinate prices when the products differ in quality and the
participants differ in their cost structure). It is worth to note that the fact that the products were included in the same relevant
market doesn’t mean that they are homogeneous in terms of quality, there might have a variety of niches of products (varying in
relation to quality, end-uses or physical aspects) which are not sufficiently distinct to constitute a separate relevant market.
Moreover, oligopolistic behavior can be facilitated when the transactions are large and infrequent. In this case there is a high
temptation to cheat the implicit agreement because the amount earned in a large transaction may compensate the risks of
detection and the costs of reprisal.
- Access to information. As we saw under the “facilitating practices” section, there might be information circulating among
competitors which increases the likelihood of successful price coordination.
- Regulatory Status. It might be that the industry in question is subject to an intense regulatory framework, in which case the state
agency will presumably be in a better position to evaluate the consequences of the merger on competition and to monitor the
combined company (Verizon)
- Countervailing Power. A merger of buyers may result in a monopsony which can be justified to face a monopoly (in the seller’s
side of the market). However, the countervailing argument has its problems. One is that the buyers may become so strong by
acting as a single entity that they could devastate the seller’s business by forcing prices extremely down to insignificant levels.
Moreover, the buyers can create a monopoly in relation to the ultimate consumers since they are joint together, increasing prices
and reducing output. But one could argue that the ultimate consumers would be harmed even without the formation of a
monopsony because the monopoly would raise prices and the buyers would, in turn, pass their costs to ultimate consumers in the
form of higher prices. The third, and most significant, reason to condemn the formation of a monopsony even when it has the
“countervailing power” defense is that the monopsony may interfere with other markets where there is no power to be
countervailed. In this case, the monopsony would be able to exercise monopoly power against other suppliers belonging to
competitive markets which could be harmed by the formation of the monopsony.

Brown Shoe Co. v. United States (When the merger results in a “large national chain” holding the control of substantial shares of
the trade in the relevant market it should be condemned without regard to the market concentration. This is because it might be
capable of eliminating smaller competitors and threatening the character of a fragmented industry which Congress intended to
protect).
Brown and Kinney are both manufacturers and retailers of men’s, women’s, and children’s shoes. Brown is the third largest seller
by dollar volume in the United States, operating through over 1.230 outlets, and Kinney is the eighth largest seller in the United
States, operating through over 350 retail outlets. The acquisition of Kinney by Brown resulted in a horizontal combination at both
the manufacturing and retailing levels of their business.
What is the relevant market at the manufacturer’s level? The demand (distributors) is not willing to substitute children’s shoes for
women’s shoes, or women’s shoes for men’s shoes, so we can conclude that each line of commerce is a separate relevant
product market. It might be that the suppliers, however, are able to adjust their shoe machinery to produce different types of
shoes (although this is not likely in the shoe industry), in which case they would be treated as uncommitted entrants, capable of
constraining the exercise of monopoly power in each line of commerce. The geographic relevant market at the manufacturer’s
level must be defined by asking how far would the shoes distributors go to get a better deal. Because the shoe manufacturers are
able to reach retailers from all over the nation, the relevant geographic market was defined as national. The court concluded that
the integration of Brown’s and Kinney’s manufacturing facilities over the nation was economically too insignificant to come within
the prohibitions of the Clayton Act. The remaining question is whether the merger represents any danger at the retailer’s level.
What is the relevant market at the retailer’s level? The demand (ultimate consumers) is not willing to substitute children’s shoes
for women’s shoes, or women’s shoes for men’s shoes, so we can conclude that each line of commerce is a separate relevant
product market.
What is the relevant geographic market? The court defined the relevant geographic market in which to analyze this merger as
those cities with a population exceeding 10.000 and their environs in which both Brown and Kinney retailed shoes through their
own outlets. Such markets are large enough to include the downtown shops and suburban shopping centers in areas contiguous
to the city, which are the important competitive factors, and yet are small enough to exclude stores beyond the immediate
environs of the city, which are of little competitive significance.
It should be noted that a large geographic market isn’t necessarily better to the defendants. It might be that the combination of
Brown’s and Kinney’s stores within a larger area would be more representative than if the geographic market was defined
narrowly. The result will depend on the homogeneity of the distribution of Brown’s and Kinney’s stores: if most of their stores are
located in different regions, then the narrowest definition of the relevant geographic market will help them to justify the merger
(because the merger wouldn’t result in a significant market share concentration in any of the narrow relevant markets); if most of
their stores are located within the same region, then the broadest definition of the relevant geographic market will help them to
justify the merger (because they will need to spread their large market share concentration among the greater number of
competitors as possible, what will drive down the final market share of the combined firm).
Having determined the relevant market as men’s shoes in those cities in which both Brown and Kinney retailed shoes through
their own outlets; women’s shoes in those cities in which both Brown and Kinney retailed shoes through their own outlets; and
children’s shoes in those cities in which both Brown and Kinney retailed shoes through their own outlets, the ultimate question is
whether the effects of the merger may be substantially to lessen competition in one of those relevant markets. According to the
statistics, the combined share of Brown and Kinney sales of women’s shoes exceeded 20% in 32 separate cities. The combined
share of children’s shoes sales exceeded 20% in 31 cities (in 6 cities their share exceeded 40%). In 118 separate cities the
combined shares of the market of Brown and Kinney in the sale of one of the relevant lines of commerce exceeded 5%. In 47
cities, their share exceeded 5% in all three lines.
The statistics demonstrate that the merger creates a large national chain, holding substantial shares of the trade in many cities. In
an industry as fragmented as shoe retailing, a large national chain can adversely affect competition by eliminating smaller
competitors. The large chain can set and alter styles in footwear to an extent that renders the independent firms unable to maintain
competitive inventories. The court recognizes that “It is competition, not competitors, which the Act protects”, but it argues that
“competition is promoted through the protection of viable, small, locally owned business”. Even though there are some costs in
condemning a merger that could produce efficiency results, the maintenance of fragmented industries and markets is the major
value elected by Congress to protect competition. In sum, the increase in concentration resulted from the mergers in a significant
number of cities and their environs in which both Brown and Kinney sell through owned or controlled outlets and the capacity of
the combined firm to eliminate its smaller rivals was enough evidence to conclude that the merger “may be substantially to lessen
competition”.
However, this decision raises many objections. First, is a fragmented industry a means to achieve an end or an end in itself? Here,
it seems that the court treated the fragmented industry as an end in itself, without asking whether competitiveness could be
stimulated through the merger even when resulting in a small increase in concentration. A fragmented industry should only be
protected to the extent it actually promotes the ultimate end, which is competition. When the economy evolves it becomes clear
that integration may provide significant efficiencies (cost savings, economies of scale), challenging the presumption that
competition is always best served through small and locally owned business.
A second problematic issue of this decision is that the court didn’t consider the market share of other firms in the relevant market.
Even if the combined firm is a “large national chain” it may not present danger to competition when it operates in a market with
tons of smaller competitors. If this is the case, the concern of a monopoly would be unrealistic as well as the concern with
oligopolistic behavior. One could argue that the “large national chain” could function as the price leader to conduce price
coordination. But we already saw the unlikelihood of price coordination when there are numerous competitors spread in the
market.
The court suggested the danger of a potential concentrated market by arguing that if this merger is allowed, it might be required to
approve future merger efforts by Brown’s competitors seeking similar market shares. This argument is based on an “incipiency
theory” which provides that Congress elected to eliminate the danger imposed by a merger in “its incipiency”, rather than waiting
the market to become actually concentrated and then take an aggressive position. But there is no obvious reason why the court
should approve a second or a third merger between Brown’s competitors. In fact, beyond the point where the market has some
degree of concentration, the courts may begin resisting accepting further mergers in the industry and justify their decisions on the
grounds that the industry is already too concentrated to permit a subsequent merger. There might be some unfairness in adopting
different treatments to similar transactions just because the first one took place while the market was unconcentrated and the
subsequent appeared in the context of a significantly concentrated market. But this difference is explained at face of the greater
risk of oligopolistic behavior imposed by a merger in the context of a concentrated industry.
Third the court could have proposed the divestiture of the assets. The court could ask Kinney to sell its shoe stores in the cities
where they overlap with Brown’s stores and approve the rest of the merger. Therefore, the efficiencies caused by the merger
would be achieved without the anticompetitive harms. Instead of adopting this alternative, the court hold that anticompetitive
effects in one market are sufficient to condemn the whole merger.
Fourth, the court failed to consider the entry conditions properly. In fact, it seems to be easy for a retailer to come into the shoe’s
market. It is a small locally owned business and there is no sign that Brown or Kinney only sells through their own retailers.
Fifth, the argument that the resulting firm is capable of causing harms to its competitors is at least paradoxical. If it will in fact be
able to overcome its competitors it’s because it became more efficient and it is in a better position to satisfy the consumers. While
this result may be to some extent desirable, there is always the danger that a extremely efficient firm could eliminate its
competitors by charging lower prices and then when the monopoly position is acquired it begins raising prices. In the long-run the
consumers will be worse off because the monopoly prices will outweigh the benefits extracted during the period when there was
still competition.

United States. v. Philadelphia National Bank (When the merger causes a significant jump in the level of concentration and the
market is already highly concentrated it must be condemned without further inquiry regarding entry conditions, economic
efficiencies or actual damages to smaller competitors)
Philadelphia National Bank (PNB) and Girard are the second and third largest commercial banks in the Philadelphia metropolitan
area. In determining the relevant product/services market, the court concluded that “commercial banking” (including checking
accounts and trust administration) composes a line of commerce distinct from the various kinds of credit market. Indeed, the
consumers who are looking for savings account cannot turn to loans as a close substitute. In general, the banks combine both
activities: offering savings account to the public (to capture deposits) and offering loans (with the money captured through the
deposits). But one activity doesn’t depend on the other. Banks can lend money utilizing the capital invested by shareholders
instead of capturing public’s deposits. Therefore, there might be banks offering credit but without offering “commercial banking”
services, or banks which offer “commercial banking” services without offering credit. In sum, the court concluded that
commercial banking products or services are so distinctive that they compose a market “sufficiently inclusive to be meaningful in
terms of trade realities”.
In determining the geographic market the court stated that the “area of effective competition in the known line of commerce must
be charted by careful selection of the market area in which the seller operates, and to which the purchaser can practicably turn
for supplies”. The banking industry has so many different consumers with different demands that the geographic area cannot be
delineated with perfect accuracy. Large borrowers and large depositors may find it practical to do a large part of their banking
business outside their home community; very small borrowers and depositors may be confined to bank offices in their immediate
neighborhood; and consumers of intermediate size deal with banks within an area intermediate between these extremes. When
the demand is divided between consumers who would go far to purchase a better offer (big institutions) and consumers who
conduct their banking business within the immediate neighborhood (individuals who are influenced by the convenience factor and
the transportation costs), can we consider the distant banks as effective competitors capable of constraining the exercise of
monopoly power of the combined firm? The first question we have to ask is whether the combined firm can price discriminate in
order to charge the consumers who would turn to distant suppliers a competitive price, and charge the individual consumers a
monopoly price. If price discrimination is possible, then the distant banks shouldn’t be regarded as effective competitors capable
of constraining the exercise of monopoly power (the combined firm will still be able to charge individual consumers at monopoly
levels). In this case, a narrower definition of the relevant market shall be adopted. If price discrimination is not possible, a
subsequent question must be asked: does the lost of sales caused by the consumers who will turn to different suppliers outweigh
the profits obtained by charging the remaining consumers at monopoly prices? Depending on the cost-benefit analysis the
defendant will have incentive to increase prices above competitive levels or not.
In the present case the court concluded that the four-county Philadelphia metropolitan area is the intermediate region in which the
medium consumers find it practical to do their banking business. This is the area of effective competition.
Having determined the relevant market as “commercial banking” in the four-county Philadelphia metropolitan area, the ultimate
question is whether the effect of the merger “may be substantially to lessen competition”. This relevant market is already highly
concentrated. If the merger is consummated, the resulting bank will be the area’s largest accounting for 35% of the relevant
market. The top four banks would have 78% of the relevant market (1 = 35%; 2 = 23%; 3 and 4 = 20%). In light of this
elevated degree of concentration the court argued concluded that “a merger which produces a firm controlling an undue
percentage share of the relevant market, and results in a significant increase in the concentration of firms in that market, is so
inherently likely to lessen competition substantially that it must be enjoined in the absence of evidence clearly showing that the
merger is not likely to have such anticompetitive effects”. Philadelphia’s holding consists in a two-test analysis: “undue percentage
share” and “significant increase in concentration”. Are these conditions alternative or cumulative? United States v. Aluminum Co.
of America applied the test to condemn the acquisition by ALCOA (a firm with 27,8% market share in the relevant market) of
Rome (1,3%), suggesting that these conditions were alternative, as the second condition does not seem to have been met.
In sum, the market share statistics showing that the merger would increase the concentration of an already highly concentrated
market were enough to condemn the merger without further analysis. “The merger of appellees will result in a single bank’s
controlling at least 30% of the commercial banking business in the four-county Philadelphia metropolitan area. Without attempting
to specify the smallest market share which would still be considered to threaten undue concentration, we are clear that 30%
presents that threat”.
The defendant tried to bring arguments to demonstrate that the statistics were unrealistic. First the defendant claimed that “only
through mergers can banks follow their customers to the suburbs and retain their business”. The court rejected such defense on
the grounds that there is an alternative to the merger route which is the opening of new branches in the areas to which the
consumers have moved. It argues that “corporate growth by internal expansion is socially preferable to growth by acquisition”.
The court, however, failed to consider the counter arguments of “growth by internal expansion”. It may be especially cheaper to
acquire a going enterprise than to build one from the ground up, avoiding start-up costs, recruiting and training management,
advertisement and the necessary distribution facilities. Moreover, and most importantly, it might be that the suburb area only
supports a single bank and any tentative of competition between two banks in the area would necessarily drive one out of the
market as a result of the insufficiency of business for both of them.
The second argument brought by the defendants was that “the increasing lending limit of the resulting bank will enable it to
compete with the large out-of-state banks, particularly the New York banks, for very large loans. The court described the
defense as a “countervailing power” argument, even though the customary use of the “countervailing power” argument refers to a
monopsony (buyers) formed to face a monopoly (seller) and reach an equilibrium between the two extremes. Regardless of how
the court classified the argument, it rejected it on the grounds that “if anticompetitive effects in one market could be justified by
precompetitive consequences in another, the logical upshot would be that every firm in an industry could, without violating # 7,
embark on a series of mergers that would make it in the end as large as the industry leader”. It follows that, even though the
merger is providing a great procompetitive effect in one market (the combined company will be able to compete with the banks in
New York) it cannot offset the anticompetitive effects in another market (the market here in question “commercial banking in the
four-county Philadelphia metropolitan area”). The rational of the court resistance to weigh a market against another is that it
would be prioritizing a group of consumers (those ones who are served by New York banks) at the expenses of a distinct group
of consumers (those ones who are served by the Philadelphia metropolitan area) what makes no sense. One alternative that could
be proposed by the court is to require the divestiture of the facilities of the merging firms which are causing the anticompetitive
danger just as Brown’s court could have done by requiring Kinney to sell its stores located in the cities in which there is a
significant overlap with Brown’s stores. In this way it would be possible to get the procompetitive of the merger without the
harms.
Finally, the defendant alleged that “Philadelphia needs a bank larger than it now has in order to bring business to the area and
stimulate its economic development”. The court also rejected such claim by arguing that it challenges Congress decision of
preserving the traditional competitive economy. The Court didn’t expressly cite Engineers, but the idea is the same: the discussion
of whether competition promotes or not the public interest is not opened. It is assumed that competition will not only produce
lower prices, but also better quality, service, safety and durability. “The assumption that competition is the best method of
allocating resources in a free market recognizes that all elements of a bargain – quality, service, safety, and durability – and not
just the immediate cost, are favorably affected by the free opportunity to select among alternative offers”. Engineers.
The court didn’t consider seriously the possibility of entry in the relevant market or economic justifications.

Case analyzed in class (page 700 (512) from the casebook)

Is sufficient impact present in the following cases? Percentage figures refer to shares of a relevant market that has no unusual
features such as costless new entry.
(1) The original formation of United States Steel Company. The combined company represented 90% of the market share in the
relevant market, reaching almost a monopoly position.
(2) The union of two 0,5% firms in a more or less perfectly competitive industry. Even under Philadelphia National Bank and
Brown Shoe the merger would be approved because the market shares are too small to represent any danger.
(3) The union of two 5% firms in an industry of 3 10% firms and 12 surviving 5% firms. The post-merger HHI will be 4 X 100 +
12 X 25 = 700 and the increase in concentration caused by the merger is 2 X 5 X 5 = 50. According to the Merger Guidelines
the industry is unconcentrated even after the merger so there is no anticompetitive concern.
(4) The union of two 10% firms in an industry with 4 20% firms. The post-merger HHI will be 5 X 400 = 2000 and the increase
in concentration caused by the merger is 2 X 10 X 10 = 200. According to the Merger Guidelines the industry is highly
concentrated and the merger raises antitrust concerns because it increases the HHI by more than 50 points (200 points).
Moreover, in this case the oligopolistic behavior is also facilitated by the homogeneity of the market. When all the market
participants have the same size it is likely that they will have the same output capacity and the same cost structure, reflecting the
similarity of interests required to achieve successfully price coordination.
(5) The union of two 10% firms in an industry with eight other 10% firms. The post-merger HHI will be 400 + 8 X 100 = 1200
and the increase in concentration caused by the merger is 2 X 10 X 10 = 200. According to the Merger Guidelines the industry is
moderately concentrated and the merger raises antitrust concerns because it increases the IHH by more than 100 points (200
points). Moreover, in this case the combined firm will have the double of market share of its competitors so it can function as the
price leader to conduce the oligopolistic behavior.
(6) The union of a 30% firm and a 5% firm in an industry with 5 3% firms and 50 smaller ones. The post-merger HHI will be
1225 + 5 X 9 + 50 X 1 = 1320 and the increase in concentration caused by the merger is 2 X 30 X 5 = 300. Although this
merger falls within the category of dangerous mergers described in the Guideline, oligopolistic behavior is unlikely because there
are too many participants to coordinate. On the other hand there is a powerful “price leader”, which can even adopt a business
strategy to eliminate smaller firms which are nor following the coordination.
(7) The union of a 10% firm and a 1% firm (which is the industry maverick, both in price cutting and innovation) where there are
8 other 10% firms and 9 other 1% firms. The post-merger HHI will be 121 + 8 X 100 + 9 X 1 = 930. Theoretically this merger
wouldn’t represent antitrust concerns because the market is unconcentrated even after the merger. The particularity here,
however, is that the acquired firm was the “maverick” meaning that it could function as a counter-force to coordination through
the expansion of output and price cutting.

Brown and Philadelphia opened a series of cases in which the Supreme Court demonstrated its hostility to mergers. In United
States v. Continental Can Co the court condemned a merger of the country’s second largest can producer (33% share) with the
nation’s third largest producer of glass containers (10% share) arguing that there were specific circumstances where cans and
bottles had been in competition for the patronage of producers of particular end-use products such as baby food, soft drinks and
beer. Although the producers of baby food, soft drinks and beer would not be exploited by a potential monopolist of cans and
glass containers (unless the monopolist can price discriminate) since there are other consumers who would switch in the event of
higher prices, the court ignored the constraining power of other consumers and condemned the merger. In United States v. Von’s
Grocery Co, the Supreme Court adopted the most extreme position. It condemned a merger between two competing grocery
stores retailers in Los Angeles on the grounds that it created the second largest grocery store chain in Los Angeles. But the
market share of the combined firms represented only 7,5% of an extremely unconcentrated market (the CR4 represented less
than 30% of the market) and the barriers to entry to open a grocery store in Los Angeles doesn’t seem significant at all (it’s a
small locally owned business).
The antagonism to mergers reflected in the 1960s cases was begun to change after the Supreme Court’s decision in General
Dynamics in 1974, where it was recognized that courts must look beyond market concentration statistics to find “other pertinent
indicators” that might imply that the increase in concentration will not be anticompetitive”.

United States v. General Dynamics Corp. (Even though the merging companies represented a significant portion of the market
when measured by their past production, their effective ability to compete for future contracts was weak because all their output
was already committed under long-term contracts)
The court considered the legality of a merger between Freeman Coal Mining Corp. and United Electric Coal Companies, both
engaged in the coal business in Illinois. The statistics demonstrated a finding of “undue concentration” but the court considered
other pertinent factors affecting the coal industry to determine the actual effects on competition. Even though United represented
a significant portion of the market when measured by its past production, its ability to continue dominating with equal vigor was
overestimated. This is because nearly all coal sold to utilities is transferred under long-term requirements contracts, under which
coal producers promise to meet utilities’ coal consumption requirements for a fixed period of time, and at predetermined prices.
In this sense, the court hold that “In a market where the availability and price for coal are set by long-term contracts rather than
immediate or short-term purchases and sales, reserves rather than past production are the best measure of a company’s ability to
compete”. Because United’s current reserves were already committed under long-term contracts and there was no prospective
of acquiring new reserves, United’s ability to compete effectively for future contracts was weak, despite its size when viewed as a
producer. The inability to compete for future contracts justification is analogous to the failing company defense, in the sense that
both are based on the presumption that the merger will not cause a lost to competition that wouldn’t be lost anyway (regardless
of the occurrence of the merger).
Vertical Mergers

The antitrust concerns raised by vertical mergers are similar to the concerns raised by exclusive dealing through requirement
contracts. The most significant danger imposed by a vertical merger is the foreclosure of competition, which can, in turn, reinforce
oligopolistic behavior or tend to create a monopoly. In the same way a requirement contract attaches the demand to the
production of a single seller, reducing the market availability for other sellers to offer their products, a merger between a
manufacturer and a retailer precludes other manufacturers from selling to the retailer which is now owned by their competitor.
Not only are the existent competitors affected, but also the potential newcomers who will have to face higher barriers to entry
because the remaining available market might be insufficient to encourage their entry. When the market is foreclosed, sellers who
were potential entrants to the market would have to enter into two markets simultaneously (both the manufacturing and the
retailing levels) to be able to effectively distribute its products. When a firm is forced to enter into two markets simultaneously to
have a profitable business the likelihood of entry decreases significantly as a result of the higher start-up costs and elevated level
of risk required.
In addressing the anticompetitive effects of vertical mergers, the 1984 government Guidelines suggests that three conditions must
be met to conclude that entry barriers were raised and competition was adversely affected. “First, the degree of vertical
integration between the two markets must be so extensive that entrants to one market (the primary market) also would have to
enter the other market (the secondary market) simultaneously”. Challenge is unlikely “where post-merger sales (purchases) by
integrated firms in the secondary market would be sufficient to service two minimum-efficient-scale plants in the primary market.
“Second, the requirement of entry at the secondary level must make entry at the primary level significantly more difficult and less
likely to occur”. Challenge is unlikely “if entry at the secondary level is easy”. Furthermore, “if the capacity of a minimum-
efficient-scale plant in the secondary market were significantly greater than the needs of a minimum-efficient-scale plant in the
primary market” and if there were no readily available buyers for the excess, “entrants would have to choose between inefficient
operation at the secondary level…or a larger than necessary scale at the primary level. Either of these effects could cause a
significant increase in the operating costs of the entering firm”. Third, “the structure and other characteristics of the primary
market must be otherwise so conducive to non-competitive performance that the increased difficulty of entry is likely to affect its
performance”. Challenge is unlikely unless the HHI exceeds 1800 or, with smaller numbers, if “effective collusion is particularly
likely”.
The third requirement set on the Guidelines reflects the major concern caused by market foreclosure. The first and more obvious
concern is that the foreclosure may be supporting a monopoly position. A manufacture may be monopolizing the market by
capturing all the available retailers through vertical mergers or requirement contracts. In this way it blocks the ability of current
manufacturers to compete and enhances the barriers to entry to avoid potential competition. The most common anticompetitive
consequence of the foreclosure, however, is the reinforcement of oligopolistic behavior. Oligopolistic behavior may be facilitated
by vertical mergers because the foreclosure may act as an effective enhancement of barriers to entry and also make its easier to
detect potential “cheaters”, that is, firms which are not following the price coordination. Because retail prices are generally more
visible than prices in upstream markets, widespread vertical integration might increase the ability of oligopolists to monitor each
other’s prices. The government may consider a challenge if the HHI indicates a concentrated market and “a large percentage of
the upstream product would be sold through vertically-integrated retail outlets after the merger”.
Vertical Mergers X Horizontal Mergers
First of all, the vertical mergers are less likely to produce anticompetitive effects. A successful challenge of a vertical merger must
demonstrate that the market will be significantly foreclosed (according to the last Supreme Court case which addressed vertical
mergers, the foreclosure of 15% of the market created a presumption that the effects “may be substantially to lessen competition)
and that oligopolistic behavior is likely to be facilitated. Secondly, the potential efficiencies generated by the two transactions are
different. According to the 1984 Guidelines “An extensive pattern of vertical integration may constitute evidence that substantial
economies are afforded by vertical integration. Therefore, the Department will give relatively more weight to expected efficiencies
in determining whether to challenge a vertical merger than in determining whether to challenge a horizontal merger”. The Chicago
School of Antitrust has argued strenuously that vertical mergers were likely to be procompetitive, as they might improve
coordination and eliminate sequential markups in which each firm in the vertical chain sells at prices above its own marginal cost.
As independent firms mark up their own segment of the chain, they are unconcerned about lost sales to upstream or downstream
firms. An integrated firm, in contrast, will take into account the lost sales when deciding whether to raise prices and the tendency
will be lower prices in the market. Moreover, as we saw under the resale price maintenance (RPM) section, the manufacturer
might need to divide dealers under exclusive territories (Continental T.V. v. GTE Sylvania) and integration may serve as a
legitimate means to avoid the dealers from charging monopoly prices (instead of adopting a RPM). Finally, integration might be a
way of avoiding transaction costs of negotiating and monitoring contracts. Particularly when the firm’s input or output is highly
specialized, being appropriate for the use of a single agent from the market, the transaction costs can be significant due to
possible opportunistically behavior derived from a dependent relationship.

Vertical Mergers X Requirement Contracts (Exclusive Dealing)

There is, however, a subtle difference between vertical mergers and requirement contracts. While under the requirement
contracts the buyer is precluded from purchasing from other sellers (this is the very object of the contract, combined with a fixed
price and a duration period) under mergers the retailer which is now integrated is not necessarily precluded from purchasing from
other sellers. It is true that this is unlikely to happen given that the manufacturer wouldn’t be willing to sell other brands through its
own distribution channels if they are to compete with its own products, but the possibility shouldn’t be completely disregarded.
But mergers can be more worrisome than requirement contracts. While the requirement contracts only sets up a price without
interfering in the production process of each of the participants to the agreement, the vertical merger eliminates all possible
management decisions that would otherwise be taken by two separate entities.

Brown Shoe Co. v. United States

The vertical aspect of the merger between Brown and Kinney consisted in the integration of one of the leading manufacturers of
men’s, women’s, and children’s shoes (Brown) with the largest chain of family shoe stores in the Nation (Kinney, with over 400
stores in 270 cities). The relevant lines of commerce are men’s, women’s, and children’s shoes (each line has characteristics
peculiar to itself rendering it generally noncompetitive with the others) and the relevant geographic market is the entire nation
(manufacturers are able to distribute their shoes on a nationwide basis). Brown represent’s 4% at the manufacturer’s level of the
relevant market and Kinney represent’s 1,2% at the retail level of such market. What is the potential foreclosure of competition
resulted from the integration between Brown and Kinney?
First, there is the concern that Brown’s competitors who could sell their shoes through Kinney’s outlets will be unable to do so
because Brown will probably use all Kinney’s stores capacity and, even if Kinney has excess capacity, Brown may be unwilling
to accept that its own distribution channels offer a product which competes with its own products. Therefore, it is less likely that
Kinney will be available to Brown’s competitors as a potential buyer what can result in the elimination of some existing shoe
manufacturers and also in the enhancement of barriers to enter in the shoe manufacturers market.
However, there are four other factors that can mitigate the foreclosure problem that the court failed to consider. First, it might be
that Kinney’s stores were not available to other shoe manufacturers even without the merger because Kinney itself also operated
at the manufacturer level and it is not clear whether it sold other brand shoes through its stores. If Kinney sold only its own shoes
through its stores, then the merger is not producing any additional foreclosure of distribution channels to manufacturers. Second,
Kinney represented only 1,2% market share of the shoe retailers in the relevant market (entire nation) what is arguably not a
significant foreclosure since the manufacturers can still have access to the remaining 98,8% of the retailers. Third, and most
importantly, to evaluate precisely the availability of the remaining retailers in the market one must inquire if they are integrated or
attached to manufacturers through other forms (requirement contracts or tying arrangements). Under the 1984 Guidelines, “the
degree of vertical integration between the two markets must be so extensive that entrants to one market (the primary market) also
would have to enter the other market (the secondary market) simultaneously”. Finally, if there are no barriers to enter at the
retailing level (open a small store to sell shoes doesn’t seem hard) the foreclosure produced by the merger will not effectively
preclude shoe manufacturers from entering in the market because new retailers will be available to purchase their production.
Under the 1984 Guidelines, “the requirement of entry at the secondary level must make entry at the primary level significantly
more difficult and less likely to occur”. Challenge is unlikely “if entry at the secondary level is easy”.
The second concern that may rise from the vertical merger is that buyers may be precluded from the opportunity of purchasing
from the integrated manufacturer. In this case, Kinney’s competitors at the retailing level will “loose” Brown as a supplier. But this
concern is unrealistic for two reasons. First, there is no evidence that Brown will only sell through Kinney and deny to deal with
other retailers. Seconds, even if Brown sold exclusively through Kinney, buyers wouldn’t face problems to purchase because the
current sellers can always (or almost always) expand capacity. Therefore, unless there is evidence of short-supply in the market
or inability to expand capacity, buyers won’t suffer from the foreclosure. The result is that the existing retailers will probably not
be driven out of business and the potential buyers to enter the market won’t face high barriers. Consequently, the potential sellers
who were apparently precluded from entering the market will be able to enter and supply the new buyers.
The court, however, didn’t consider the relevant factors that could challenge an effective foreclosure (the market conditions of the
remaining buyers and the ability of current manufacturers to expand capacity) and condemned the merger on the grounds that
Brown was a leading manufacturer and Kinney the larger distributor. “Thus in this industry, no merger between manufacturer and
an independent retailer could involve a larger potential market foreclosure. Moreover, it is apparent both from past behavior of
Brown and from the testimony of Brown’s President, that Brown would use its ownership of Kinney to force Brown shoes into
Kinney stores. Thus, in operation this vertical arrangement would be quite analogous to one involving a tying clause”.
Note that the court compared the vertical merger to a tying arrangement. The similarity of the vertical merger to tying is that both
have foreclosure effects. But they differ in relation to the coercion effect because while under a tying arrangement the buyer is
coerced to purchase from the seller, under a merger the buyer is not independent, but a single integrated entity.

Case analyzed in class (page 770 (539) from the casebook)

(a) Suppose that one of many sellers of a product mergers with one of many buyers of that product. What is the significance of
the vertical foreclosure? The foreclosure is insignificant because there are still many available buyers and sellers in the market.
Probably the two firms a merging to acquire the efficiencies (see the discussion under “Why accept efficiency justifications when
oligopolistic behavior is unlikely?”)
(b) Suppose that there are 10 sellers and 10 buyers of a product. If all paired off, what would happen to entry barriers? The
major concern is that potential sellers might be unable to enter into the market given that there are not enough available buyers to
encourage entry. For buyers to come into the market, on the other hand, it might be not so problematic because suppliers
presumably can always expand capacity and sell to independent buyers. But because entry barriers will to potential sellers will be
substantially raised and considering that the market is already moderately concentrated (HHI 1000) the integration may be
supporting oligopolistic behavior among the competitors.
(c) Suppose that a manufacturer, with relatively few competitors, which sells about one third of product Z mergers with a retailer
which buys about one third of product Z (which is also purchased by numerous smaller firms). Will the merger enhance barriers
to entry at the manufacturing level? Depend (i) if the acquired retailer will be precluded from purchasing from other
manufacturers; (ii) if the other small firms which compete with the acquired retailer are also integrated; and (iii) if it easy to enter at
the retailing level of the industry. Will the merger enhance barriers to entry at the retailing level? Probably not because (i) not
necessarily the other sellers are integrated; and (ii) even if they are integrated there is no indication that they wouldn’t be able to
expand capacity and sell to independent retailers.
But, if the other sellers are integrated and are not able to expand capacity to sell to independent retailers, potential retailers would
be precluded from entering into the market what would, in turn, also preclude potential manufacturers from entering into the
market (they would have to enter in two markets simultaneously) and, ultimately, the integration could be serving to facilitate
oligopolistic behavior in the market (given that there is a high concentration at the manufacturing level).

Conglomerate Mergers

Mergers between companies which are not actual competitors neither have a buyer-seller relationship are called conglomerate
mergers. Even though the advantage of generating economies of scale are more effective when the merger is between two
competitors, there might be some similar reasons why two companies producing different products would decide to merge. First,
it might be that the machinery utilized by one company can be easily adjusted to produce the second product, in which case the
companies would be able to increase the output and spread the fixed costs among a higher quantity of products. Second, even
when the products are different, many investments may serve for both products, such as investments on research and
development, transportation structure, investments on advertising, and training management. These costs per product are reduced
when they are spread among a higher quantity of output.

Federal Trade Commission v. Procter & Gamble Co. (Clorox) (Considering the valuable advertising advantages that Procter and
Clorox would have against their competitors, the possibility of predation due to the abundance of resources, and the elimination
of an effective potential competitor, the court concluded that the already highly concentrated market of liquid bleach will become
even more favorable to oligopolistic behavior)
Procter is a large, diversified manufacturer of low-price household products sold through grocery, drug, and department stores.
Clorox is the leading manufacturer of household liquid bleach, accounting for 48.8% of the national sales in a highly concentrated
market, whereby the CR4 account for almost 80% of the market. Prior to its acquisition of Clorox, Procter did not produce
household liquid bleach, but it was in the course of diversifying into product related to its basic detergent-soap-cleanser business.
Liquid bleach was a distinct possibility since packaged detergents – Procter’s primary product line – and liquid bleach are used
complementary in washing clothes and fabrics, and in general household cleaning. Procter had acquired the assets of Clorox and,
because the transaction wasn’t a merger, there was no requirement of premerger notification. The FTC, however, challenged the
transaction after it was already in place and the court affirmed the Commission’s claims.
The first anticompetitive danger resulting from the acquisition of Clorox is that Procter, with its huge assets and advertising
advantages, would be able to use its volume discounts to advantage in advertising Clorox. It should be noted that, since all liquid
bleach is chemically identical, advertising and sales promotion are vital to succeed in the market. Consequently, Procter will have
valuable advantages over Clorox’s competitors and will be able to cut prices in the liquid bleach industry and drive the smaller
competitors out of business.
Secondly, there is the danger of predatory pricing. Procter would be able to sustain a predatory pricing during a long period to
drive Clorox’s competitors out of business by subsidizing the underpricing with revenues from its other products. The fact that
predatory pricing is unlawful and it may be detected and punished later (at the moment when it actually happens) is not a good
justification for not preventing it since the beginning by blocking an acquisition that could facilitate predation because there is
always the problem that the law may no be effective considering the difficulties of identifying predation and calculating what would
be the reasonable price. Moreover, at the time when predation is detected and punished it might be that some smaller
competitors were already driven out of business and part of competition was irreversibly diminished.
Finally, the Commission raised the argument of potential competition. Procter had recently launched a new abrasive cleaner in an
industry similar to the liquid bleach and the similarity between Procter’s products and the liquid bleach indicates that Procter was
the most likely prospective entrant. In effect, potential entrants are those ones which produce similar goods in the same
geographic area and can easily switch production or those which produce the same goods in a close geographic area and can
easily transport the products from one area to another. The potential entrant favors competition for two reasons: (i) the existing
firms in the market perceive the potential competition and are constrained from exercising market power, otherwise the potential
competitor will be stimulated to enter (“The market behavior of the liquid bleach industry was influenced by each firm’s
predictions of the market behavior of its competitors, actual and potential”); (ii) the potential competitor could become an actual
competitor by entering in the market independently, what would improve the market (Procter would compete vigorously with
Clorox). In fact, the barriers to entry by a firm of Procter’s size and with its advantages were not significant. No manufacturer
had a patent on the product or its manufacture, necessary information relating to manufacturing methods and processes was
readily available, there was no shortage of raw material, and the machinery and equipment required for a plant of efficient
capacity were available at a reasonable cost.
Can it be said that giving up a potential entrant “may be substantially to lessen competition”? The counter-arguments would be
that the barriers to entry are insignificant not only to the defendant but also to many other firms which may serve as potential
entrants to constraint the exercise of market power of the existing firms. If the defendant is capable of engaging in predatory
practice, however, it may discourage new entry. But if the barriers to entry are really insignificant, then beyond one point the
defendant will run out of resources to sustain the predatory practice and at this point the potential entrant will represent an
effective threat to its exercise of market power. Therefore, the defendant will not be able to recoup the losses incurred during the
predation and the ultimate consumers will not be harmed. Moreover, the defendant can claim that it wasn’t in fact likely that it
would enter independently.
In sum, considering the valuable advertising advantages that Procter and Clorox would have against their competitors, the
possibility of predation due to the abundance of resources, and the elimination of an effective potential competitor, the court
concluded that the already highly concentrated market of liquid bleach will become even more favorable to oligopolistic behavior.
Moreover, smaller firms would become more cautious in competing due to their fear of retaliation by Procter and Procter, in turn,
will probably become the price leader in the price coordination. Price leadership seems more plausible than outright predation
because disciplinary pricing is likely to cost less tha destroying one’s rivals. “The anticompetitive effects with which this product-
extension merger is fraught can easily be seen: (1) the substitution of the powerful acquiring firm for the smaller, but already
dominant, firm may substantially reduce the competitive structure of the industry by raising entry barriers and by dissuading the
smaller firms from aggressively competing; (2) the acquisition eliminates the potential competition of the acquiring firm”.

The dangers of becoming too much efficient and eliminating smaller competitors or being able to engage in predatory pricing,
reflected in Clorox’s decision, are no longer considered persuasive arguments to condemn a conglomerate merger. Unlike the
inherent anticompetitive tendency of a horizontal merger eliminating competition between the merging parties or a vertical merger
possibility foreclosing rivals from supply or market opportunities, the likelihood of predation is typically more speculative and is
not an inherent tendency of any merger. In relation to the efficient firm argument, it seems contradictory to the purpose of the
antitrust laws to preclude a firm from acquiring efficiencies gains, despite the danger of eliminating smaller competitors. After all,
the essence of competition is about becoming more efficient than competitors and acquiring a larger share of the market. This is
the force of competition that ultimately benefits consumers by providing lower prices and higher quality. Moreover, barring a firm
from acquiring another because it will become more efficient is, if not paradoxical with the purpose of the antitrust laws, useless
because presumably firms will find out other ways of becoming efficient through internal growth.
In light of these considerations, the Merger Guidelines treated conglomerate mergers less rigorously than other mergers.
According to the Guidelines, the government is unlikely to challenge “unless overall concentration of the acquired firm’s market is
above 1800 HHI”; or “if the entry advantage ascribed to the acquiring firm (or another advantage of comparable importance) is
also possessed by three or more other firms”; or unless the probable entry of the acquiring firm “is particularly strong”.

Danger of Reciprocity
Reciprocity is the practice by which a firm buys only from those who buy from it or buys more from those who buy from it. A
firm may increase the likelihood of reciprocity by diversifying – through merger or internal expansion – into products that its
suppliers buy. Reciprocity is analogous to tying arrangements, the main difference is that instead of using its selling power to sell a
second product to the consumer, the firm uses its buying power to sell a product to its supplier. The anticompetitive effects of
reciprocity are the same as tying, mainly the foreclosure of opportunities for the powerful buyer’s competitors to sell to its
supplier. Thus, eliminating reciprocity would channel rivalry into the open, where it would be more intense and afford all sellers an
equal opportunity to win patronage on the merits and without diversion from an “alien factor”.

Reciprocity usually cannot be punished through the Sherman Act # 1 because it is easy to engage in reciprocity without an
express agreement. It is almost instinctive that a firm X will buy from the firm Y who buys from it and if Y stop buying from X, X
will begin buying from Y’s competitors.
In addition, reciprocity cannot be condemned through the Clayton Act # 3 because its language does not embrace the reciprocity
practice.
Consequently, the only remaining legislation to catch reciprocity is the Clayton Act # 7, by blocking mergers that creates
noticeable possibility of reciprocity.

Federal Trade Commission v. Consolidated Foods Corp.

“Merely as a result of its connection with Consolidated, and without any action on the latter’s part, Gentry would have an unfair
advantage over competitors enabling it to make sales that otherwise might not have been made(…). If reciprocal buying creates
for Gentry a protected market, which others cannot penetrate despite superiority of price, quality, or service, competition is
lessened”.

___________________________________________________________________________________

CORPORATIONS
FALL 2008
PROFESSOR REINIER KRAAKMAN

Introduction

Three main issues in corporate law:

1) Facilitating relationship among shareholders (inter owner context)

2) Facilitating relationship between shareholders and managers (officers and directors)
3) Facilitating relationship among stakeholders (creditors)

Purpose of Private Law:

Improve social welfare, increase efficient investment of resources (under Pareto or Kaldor-Hicks) and minimize transaction costs
and agency costs. Corporate courts usually uses arguments related to fairness as to bring a less arbitrary connotation to their
decisions.

THE LAW OF AGENCY

Agency Costs

Agency is the fiduciary relationship that arises when one person (a principal) manifests assent to another person (an agent) that
the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise
consents so to act.
The main problem occurs when the agent does not have the same interests as the principal and, therefore, can act maximizing his
own interests. A way of mitigating this problem is (i) imposing a damage clause in the contract or (ii) aligning interests by giving
the agent a portion of ownership.

Characterizing an agency relationship:

- Consent expressed through a contract, a verbal negotiation or even an implied agreement.
- The potential agent has the power to bind the principal to third parties.

Special Agent: limited to a single transaction

General Agent: series of acts or transactions (ex: main director or partners)

Disclosure to Third Parties and Liability:

Principal Disclosed (Restatement 3 Agency 6.01) – the principal and the third party are parties to the contract; the agent is not a
party to the contract unless the agent and the third party agree otherwise. (Third party can sue the principal but not the agent)
Principal Undisclosed (third party doesn’t know there is a principal behind) (Restatement 3 Agency 6.03) – the principal is a
party to the contract, unless excluded by the contract; the agent and the third party are parties to the contract. (Third party can
sue the principal and the agent)
Principal Partially Disclosed (third party knows there is a principal but doesn’t know who he is) (Restatement 3 Agency 6.02) –
the principal and the third party are parties to the contract; the agent is a party to the contract unless the agent and the third party
agree otherwise. (Third party can sue the principal and the agent)

Termination at Will:
The contract of agency cannot be enforced against the will of one of the parties, even if the contract provides a term-end. This
rule can be explained because the agent has the power to bind the principal into contracts or to control his properties and this
power requires a relationship of absolute trust. (Restatement 3 Agency 3.10). However, damages for breach of contract can
result.
Types of Agency Relationship
1) Actual Authority: an agent acts with actual authority when, at the time of taking action that has legal consequences for the
principal, the agent reasonably believes, in accordance with the principal’s manifestations to the agent, that the principal wishes
the agent so to act (Restatement 3 Agency 2.01).
2) Apparent Authority: authority that a third party reasonable relies on considering the actions or statements of the principal
(Restatement 3 Agency 2.03)
3) Inherent Authority: general A can bind P to an unauthorized contract, if A would ordinarily have the power to enter such a
contract and T doesn’t know that matters stand differently (Restatement 2 Agency 8A and 161). In the context of an undisclosed
principal transaction the inherent authority is particularly useful because the third party cannot invoke the doctrine of apparent
authority (it did not even know of the existence of the principal), but it can invoke the inherent authority (Restatement 2 Agency
194).
4) Agency by Estoppel: the principal can be bound by the agent’s acts if a third person might be induced to believe that the agent
has authority to act on behalf of the principal and the principal intentionally or carelessly failures to inform the absence of an
agency relationship (Restatement 3 Agency 2.05)
5) Ratification: accepting benefits under an unauthorized contract will constitute acceptance of its obligation as well as its benefits
(Restatement 3 Agency 4.01)

Jenson Farms v. Cargill (Agency is inferred from a “paternalistic relationship”)

The major issue in this case is whether Cargill, by its course of dealing with Warren, became liable as a principal on contracts
made by Warren with the plaintiffs (farmers). How can Cargill be liable if he didn’t negotiate with the farmers himself, neither
there was an agency contract between Warren and Cargill? The court inferred an agency relationship even without a contract
arguing that “By directing Warren to implement its recommendations, Cargill manifested its consent that Warren would be its
agent. Warren acted on Cargill’s behalf in procuring grain for Cargill as the part of its normal operations which were totally
financed by Cargill”. The court distinguished this case from an ordinary bank financing because Cargill was economically
interested in the contracts between Warren and the farmers and, to protect its financial interests, interfered intensively in Warren’s
management. The court’s holding was based on the fact that Cargill exercised control over Warren to protect its loan. “Cargill’s
course of dealing with Warren was, by its own admission, a paternalistic relationship in which Cargill made the key economic
decisions and kept Warren in existence”.

White v. Thomas (Denied Agency, the agent had the authority to purchase on behalf of the principal but not to sell.)
Ms. Simpson was given the authority to purchase, on behalf of Mr. White, a 220 acre farm up to $250.000,00. Ms. Simpson,
however, purchased a 217 acre land for $327.500,00 without consulting the principal. When Ms. Simpson realized that her bid
had exceeded the amount authorized by Mr. White, she sold back to the seller 45 acres of the land that she had just purchased
for Mr. White. The question before the court is whether Mr. White is liable for the contracts entered into by Ms. Simpson.
Because there was no actual authority concerning the purchase of a land for more than $250.000,00, neither there was actual
authority for the sale of Mr. White’s property, in order for the principal to be liable, Ms. Simpson actions must have fallen within
the scope of her apparent authority. Ms. Simpson possessed a blank check signed by Mr. White and the plaintiff contends that
this is enough to indicate her authority to bind the principal into contracts. While the possession of a blank check can indicate the
authority to purchase on behalf of the person who signed the check, there is no indication that a third party could reasonably
conclude that the check gave the agent also the authority to sell the principal’s property. “Nor can we conclude that the two
types of transactions, purchasing and selling, are so closely related that a third person could reasonably believe that authority to
do the one carried with it authority to do the other”. The court concluded that Ms. Simpson had the apparent authority to
purchase lands on behalf of Mr. White (thus, he is liable for this transaction) but she didn’t have the apparent authority to sell his
properties (thus, he is not liable for the sale contract). She wasn’t a general representative of the principal to trigger inherent
authority.

Gallant Insurance v. Isaac (Inferred Agency through an Inherent Authority theory)

The insurance company denies coverage of the accident on the grounds that his agent wasn’t authorized to renew T’s policy
without authorization from P. It argues that it didn’t manifest any act toward the third party that could give rise to a reasonable
understanding of authority under the doctrine of apparent authority. The court declined to adopt the apparent authority doctrine
but hold the principal liable under an inherent authority theory. “Inherent agency power indicates the power of an agent that is
derived not from authority, apparent or estoppel, but from the agency relation itself”. The relationship between Thompson-Harris
(an independent insurance agent) and Gallant Insurance Company involved the general duty of issuing insurance coverage and
negotiating the contract. Such duty includes a space of freedom to negotiate renewals and other insurance matters, as part of the
functions to be performed by the agent. It is not reasonable to expect that the Third Party, while contracting an insurance plan
with the representative of the company, will ask for an agreement between the representative and the company to check if there
is any clause limiting his power to negotiate.

Liability on Tort
The main question here is whether the principal is in a position to avoid the agent from committing a tort. Depends on the level of
supervision and control the principal exercises over the agent, which can be high (as in the case of an employee) or low (as in the
case of an independent contractor).

Humble Oil v. Martin (Held Principal Liable)

The conclusive factor here was that Humble bears Schneider costs, what leads us to assume that Humble Oil will have strong
incentives to monitor Schneider’s day-to-day business. The way the contract between Humble Oil and Schneider was designed
leaves no option for Humble Oil except for controlling closely Schneider’s activity in order to avoid costs that will directly affect
him. Therefore, the court concluded that the victims who suffered injury as a result of the negligent conduct of Schneider’s
employees are entitled to recover from Humble Oil. “The facts that neither Humble, Schneider nor the station employees
considered Humble as an employer or master; that the employees were paid and directed by Schneider individually as their
“boss”, and that a provision of the agreement expressly repudiates any authority of Humble over the employees, are not
conclusive against the master-servant relationship, since there is other evidence bearing on the right or power of Humble to
control the details of the station work(…)”.

Hoover v. Sun Oil Co. (Denied Principal’s Liability)

Sun Oil owned the service station which was directly operated by Barone. The plaintiff’s car caught fire at the Barone’s station as
a result of the negligence of Smilyk an employee of Barone. The plaintiff brought suit against Smilyk, Barone and Sun Oil to
recover the damages suffered. Sun Oil claimed that Barone was an independent contractor (not a servant) and therefore the
alleged negligence of his employee could not result in liability to Sun Oil. The plaintiff’s contend instead that that Barone was
acting as Sun’s agent and that Sun may therefore be responsible for plaintiff’s injuries.
Compared to Humble Oil, the main differences were:
- Barone assumed the risks of the business (bears costs)
- Barone was under no obligation to follow Sun’s advices or to fill periodic reports
- Sun exercised no control over the details of Barone’s day-to-day operation
The court concluded that, even though Barone sells Sun’s quality products and Sun’s quality service and many people
undoubtedly come to the service station because of that later representation, “the lease contract and dealer’s agreement fail to
establish any relationship other than landlord-tenant, and independent contractor. Therefore, no liability can be imputed to Sun
from the allegedly negligent acts of Smilyk”.

All these factors must be taken into account to determine whether the principal has the incentive to control and monitor closely
the agent’s activity and, ultimately, would be in a position to avoid the tort committed.
Why should we attribute liability at all to the franchisor (principal) if the franchisee (agent) is actually present and has much better
conditions to exercise control over the management? It’s a way of making the third party’s recovery possible because the
franchisee (agent) usually has fewer assets or no assets at all. But the consequences of attributing liability to the principal are the
increase in the agency costs.

Models of franchise contracts:

Intense Monitor by Franchisor X Autonomy of Franchisee
- Higher agency costs - higher necessity to select carefully the franchisee
before delegating such autonomy (image of the brand)
- require an increased up-front investment to
guarantee there will be enough money for damages.

The Agent’s Duty of Loyalty to the Principal

Tarnowski v. Resop (Principal is entitled to secret commission if the agent breaches its fiduciary duty)
The agent breached its fiduciary duty to the principal by making false statements that he had done a decent investigation in the
market and concluded that the seller’s offer was the most valuable available. The principal believed the agent but, afterwards,
discovered that the agent had received a secret commission from the seller to force the principal into the transaction. The
principal was able to rescind the contract with the seller and brought a suit against the agent to recover the secret commission and
the attorneys’ fees and expenses of suit. Even though the principal had already been successful in rescinding the contract with the
third party, the court concluded that he was entitled to the secret commission received by the agent under the Restatement
Agency #407(1), which provides that “if an agent has received a benefit as a result of violating his duty of loyalty, the principal is
entitled to recover from him what he has so received(…)”. (See also # 8.02). Moreover, his attorneys’ fees and expenses of suit
were directly traceable to the harm caused by defendant’s wrongful act and are recoverable.
One could argue that, since the principal already got rid of the agent’s wrongful act by rescinding the contract with the seller, the
secret commission would be overcompensation. In fact, the principal will be overcompensated but the idea of the court was to
induce agents to respect their fiduciary duty and penalize them for any eventual breach.

In Re Gleeson (Conflict of interest between being a trustee and a tenant simultaneously)

Conflict of interest: Con Colbrook is both the trustee and the tenant of the property. But if Con is acting in good faith and
acquiring high revenues for the trust (because he is paying a reasonable amount as the tenant), why should the court penalize him?
Because there is a presumption of conflict of interest when one is occupying the positions of trustee and tenant at the same time,
which requires the court to apply a per se rule. First it is hard to prove that he is collecting the same revenues that would be
collected if the tenant was a third party and secondly, even if he proves that, there will still exist the potential risk of Con taking
advantage of being both trustee and tenant in the future. The trustee relationship is analogous to the agency relationship and the
general rule is that the agent has a duty not to deal with the principal (Restatement Agency # 8.03). The principal in this case are
both the trust beneficiaries and Mary Gleeson.

THE LAW OF PARTNERSHIP

General Partnership

Partnership law gives distinct legal treatment to partnership property. In the event of partnership bankruptcy or liquidation, this
form of title gives creditors of the partnership first priority over the claims of the creditors of individual partners. Because it owns
assets, a partnership acting through a partner can contract on its own behalf and therefore can be a reliable counterparty for
others. The general partnership form includes unlimited personal liability for partners.
Why should people enter into a partnership instead of borrowing capital from a bank? Because beyond one point it is not
economically interesting to borrow money considering the heavy burden which the financial entity will require. Therefore, taking
on a partner might be a good way to finance the business.
Another reason to joint through a partnership is to add someone who has expertise and skills in the business. But why not simply
contract with this person to manage the “firm”? Giving ownership might be a good way of reducing the agency costs between
managers and owners. Thus, instead of paying salary to managers who have expertise in that business, it might be more
advantageous to give them some ownership to align interests.

Relationship between co-partners in general partnerships

Meinhard v. Salmon (The fiduciary duty in partnerships includes not appropriating new opportunities)
To what extent is the fiduciary duty of one of the co-partners in a joint-venture? The court considered that even though the
existing joint venture between Meinhard and Salmon reached its term-end, Salmon didn’t have the right to appropriate the new
opportunity for himself without at least informing Meinhard, so it would have the chance to compete on an equal basis for the
offer. Even though the new lease with its many changes cannot be considered a renewal of the existing lease (what would clearly
constitute a continuation of the business relationship), it was not an entirely different business. The partner may purchase a new
lease for itself (not the renewal of the existing lease) if he acts open and fairly, which was not the case here. Because Salmon
didn’t act in accordance with the fiduciary duty owed to Meinhard, by disclosing the opportunity, it shall be forced to share the
new lease with Meinhard on the same terms as in the 20-year joint-venture. “Joint ventures, like co-partners, owe to one
another, while the enterprise continues, the duty of the finest loyalty.(…) Not honestly alone, but the punctilio of an honor the
most sensitive, is then the standard of behavior”.
The dissenting vote argued that the existing joint venture had a limited object and a fixed term to end and, therefore, there was no
direct appropriation of the expectancy of renewal.
One of the methods that can be adopted by the courts to determine whether there was a breach of fiduciary duty by one of the
co-partners is to figure out how would have the parties contracted in the past if they had predicted the conflict in question. Would
Salmon and Meinhard agree that any future opportunity related to the joint venture’s business would be equally shared between
them? It is unlikely that the parties would attach their hands to a potential future opportunity without knowing in advance its terms
and conditions. Would they agree that Salmon must inform Meinhard, who is free to compete for, any new opportunity?
Probably not because such clause would be too favorable to Meinhard, who is merely the financing entity. In effect, Salmon was
the manager of the business, contributing alone with his skills to make the joint venture profitable. Thus, if Meinhard required such
a heavy burden, Salmon would probably look after another financing entity.

Recognizing the existence of a Partnership

Express agreements or intent are not required, the partnership can be inferred when one is entitled to a share of the net profit.
This indicates that the person has incentives to be aware of the costs and receivables and, therefore, presumably takes part in the
management of the business.

Vohland v. Sweet (The court inferred a partnership even without agreement or intent)
Sweet contributed with management and skills and, above all, received 20% of the net profits. It would be unfair to leave Sweet
with “empty hands” in the winding up after all the time contributing with work and, especially, sharing profit.

Relationship between partners and creditors of the partnership

In Vohland v. Sweet the question of whether a partnership existed was raised for the purpose of determining if the alleged partner
had the right of receiving part of the business in the winding-up of its affairs. The usual cases in which partnership is inferred by
the courts despite the absence of an explicit agreement, however, involves a third party action against the alleged partner for the
tort or contract liabilities of the partnership. Because the general partnership form includes unlimited personal liability for partners,
three important issues arise under the topic of creditors rights: first, who is a partner for purpose of personal liability? Second,
when can an existing or retiring partner escape liability for a partnership obligation? And third, how are the claims of the
partnership creditors against the partner to be balanced with the individual creditors of that partner?

Who is a partner for personal liability purposes? (UPA # 7)

There is a partnership and the partners are personally liable
- Intent (inferred from name and tax reports)
- Share of the net profit (concerned about costs, induces control over the business) ++
- Contribution with labor and skills
- Partner by Estoppel (third party reasonably relies on the person as a partner)
- Not holding a potential partner liable when the circumstances indicate otherwise, may open space for people to escape
registering as a limited liability partnership
There isn’t a partnership and the partners aren’t personally liable
- Intent (inferred from name and tax reports)
- Share of gross returns (doesn’t share loss so there is no risk assumed)
- Treated as an employee (receiving wages)
- Third party had condition to know
- No contribution to capital

When is a departing partner liable? (UPA # 36(2) and 36(3))

On one hand, making it too easy for departing partners to escape liability would create incentives for partners to leave when
trouble appeared on the horizon. On the other hand, making it too difficult for departing partners to escape liability would allow
the continuing partners to bind the departing partner who no longer has control over partnership decision-making. Therefore, the
rule is that withdrawing partners are only liable for transactions occurred during the period they were partners and, to protect
them even more, if (i) it is possible to infer an agreement between the creditors and the remaining partners that the withdrawing
partner will no longer be liable (UPA # 36(2)); or (ii) when a creditor renegotiates his debt with the continuing partners after
receiving notice of the departing partner’s exit (UPA #36 (3)).

Conflict between partnership creditors and individual creditors

In relation to the assets belonging to the partnership, both the UPA and the RUPA give partnership creditors first priority. But
when the partnership creditors are not able to recover all the debt by partnership property and have to reach the personal assets
of the partner, the UPA and the RUPA diverge in relation to the question of how an insolvent partner’s assets should be
distributed. The UPA follows the “jingle rule” (UPA # 40 (h) & (i)), giving the partner’s individual creditors priority over
partnership creditors, while the RUPA (RUPA # 807 (a)) follows the parity treatment rule codified in #723 of the Bankruptcy
Code. Therefore, the “jingle rule” only applies (1) if the UPA is controlling state law and (2) if # 723 does not apply (that is if the
individual partner is not in bankruptcy or the partnership is not in Chapter 7). And the parity treatment applies either (1) if the
RUPA is controlling state law or (2) # 723 applies (the partnership is in Chapter 7 and the individual partner is in bankruptcy).

Why adopt the parity treatment rule instead of the “jingle rule”?
Since the principle of general partnership is unlimited liability, the law has to create mechanisms to make this principle effective.
Under the “jingle rule”, the partnership creditors ended up without the opportunity to reach the partner’s assets because the
individual’s creditors had priority and the resources were limited. In addition, it is much harder for the partnership creditors to
monitor all the individual’s creditors of each partner to calculate the risk before granting the credit. The individual’s creditors, on
the other hand, can easily have access to all of the partnership creditors by checking the partnership records.

Nabisco v. Stroud (Partners can bind the partnership even when they didn’t have the authority to act and even when the third
party was informed that they didn’t have the authority to act, if the restrictions on such authority was imposed by less than a
majority of the partners)
Under UPA #18 (h) Stroud, his co-partner, could not restrict the power and authority of Freeman to buy bread for the
partnership as a going concern, for such a purchase was an “ordinary matter connected with the partnership business” and Stroud
was not, and could not be, a majority of the partners. The partnership being a going concern, activities within the scope of the
business should not be limited, save by the expressed will of the majority; half of the members are not a majority. Therefore,
Freeman’s acts bound the partnership and Stroud.
An act by one partner does not bind the partnership or the remaining partners when:
1) It is not usual to the business of the partnership (unless when authorized by other partners); (UPA # 9 (2)) or
2) When a majority of the partners tells one of the partners to act otherwise and the third party knows (or should know) that the
partner had no such authority. (UPA # 9 (1)). If the third party is not expected to know that the partner had no authority to act,
then the partnership and the other partners are bound but they can seek damages from the partner who disrespected the
majority’s order).
Rationality
Why should we consider a partner liable if he expressly refused that specific transaction and even notified the third party about his
refusal? Because if you allow each partner to select the transactions which will bind the partnership, an enormous instability will
be created. The partnership constitutes a single entity with its own assets which form a unique conglomerate to satisfy the debts.
Therefore, it would be unpractical to segregate part of the assets of the partnership in order to create many portions to satisfy
specific creditors, depending on the partner who contracted with the third party.

Dissolution
In a partnership at will every partner has the right to force a statutory wind up and is entitled to receive his proportional interest in
shares (UPA # 31 (b)). When a partner ceases to be associated the “firm” is automatically dissolved (UPA # 29). On dissolution
the partnership is not terminated, but continues until the winding up of partnership affairs is completed. (UPA # 30).
Steps:
1) partner withdraws
2) dissolution is caused
3) winding up of affairs
4) termination

On the other hand, in a partnership for a specific term, although the partner is not obliged to remain, he has to incur in penalties
and hasn’t the right to force the statutory wind up. So the partnership can continue its business and the withdrawing partner will
only have the right of his proportional interests in the end of the term (UPA legislation is even more strict with wrongful dissolution
than RUPA)

Adams v. Jarvis (When a partner withdraws but there is an agreement between them to continue the business, the agreement
prevails over the “statutory wind-up” provision and the withdrawing partner is entitled to his proportional interest only at the
subsequent year)
The agreement between the partners that the partnership shall continue its normal business in the event of the withdrawing of any
partner is enforceable. The withdrawing partner will have the right to receive his proportional interest in the end of the year, as
provided also in the agreement. But the main condition is that the continuing partners have to liquidate the accounts receivable in
good business practices, otherwise they could postpone the liquidation of the receivables to avoid sharing with the withdrawing
partner the true profit of the year.

Dreifuerst v. Dreifuerst (When the partnership is at will, withdrawing partner can force liquidation and all the partners have the
right to receive their share interests in cash, unless agreed otherwise. Obviously that this doesn’t mean to sell the assets at pieces)
This partnership is at will, so the partner can withdraw at any time and force the statutory wind up. The statutory wind up
guarantee’s the right of each partner to receive his fair share of the partnership assets in cash, unless otherwise agreed (UPA #
38). Therefore, no partner has the right to receive the assets in-kind if one of the partners wants to exercise his right of receiving
cash. The right to receive assets in-kind is only available when: (1) there are no other creditors to be paid from the proceeds; (2)
ordering a sale would be useless since no one other than the partners would be interested in the assets of the business; and (3) an
in-kind distribution is fair to all the partners (Rinke v. Rinke).
Two reasons can explain the partner’s right to receive his interest in cash. First reducing the assets to cash allows reaching a more
accurate value through the market price. Secondly, it’s efficient to protect creditors because the process of payment is
accelerated when assets are reduced to cash.

Page v. Page (When the partnership is at will, the partner can exercise its right to force the statutory wind up, but the exercise of
such right has to be within the limits of the fiduciary duty owed to other partners)
The term-end of a partnership may be inferred when (i) a partner advances a sum of money to a partnership with the
understanding that the amount contributed was to be a loan to the partnership and was to be repaid as soon as feasible from the
prospective profits of the business (term reasonably required to pay the loan) (Owen v. Cohen); (ii) the partners impliedly agreed
to continue the business until one or more partners recoup their investments (Vangel v. Vangel).
Here, however, the court declined to infer a term-end and concluded that the partnership was at will giving the plaintiff the right of
a statutory wind up. The court argued that the mere expectations of profits and the hope that the initial capital invested in the
partnership will be recovered do not constitute an implied term. In the absence of a demonstration that a term was contracted,
the understanding that it is at will prevails. The withdrawing partner, however, has to exercise his right to force dissolution
accordingly to the fiduciary duty owed to the other partners. “If it is proved that plaintiff acted in bad faith and violated his
fiduciary duty by attempting to appropriate to his own use the new prosperity of the partnership without adequate compensation
to his co-partner, the dissolution would be wrongful and the plaintiff would be liable for damages for breach of partnership
agreement as provided by UPA # 38(2)(a) (rights of partners upon wrongful dissolution) for violation of the implied agreement
not to exclude defendant wrongfully from the partnership business opportunity)”.

It seems like the court tried to conciliate the right to force liquidation with the holding in Meinhard v. Salmon that “Not honestly
alone, but the punctilio of an honor the most sensitive, is then the standard of behavior”.

Limited Partnership (LP)

Limited partnerships have traditionally been popular because they combine the pass-through tax advantages of partnership (as
opposed to the corporation’s treatment – for the purpose of tax see page 74) with limited liability. There are two types of
partners, the general partner and the limited partner. Usually, the general partners are the ones who manage the business and the
limited partners the ones who make the investment. General partners are personally liable for the partnerships debts, as opposed
to the limited partners who enjoy limited liability. When the limited partner, however, takes part in the management of the firm,
they might become personally liable.
Under the Revised Uniform Partnership Act (section 303) there must be a “control test” to determine whether a limited partner
participates in the control of the business. The “control-test” was a way of protecting creditors who relied on the contracts
entered into by limited partners, who expected to reach those partners personal assets if the partnership’s assets were not enough
to satisfy their debts.
The Uniform Partnership Act (section 303), on the other hand, entirely abandons the control test, stating that a limited partner is
not personally liable for partnership liabilities even if the limited partner participates in the management and control of the
enterprise.

Limited Liability Partnership (LLP)

Page 76

Limited Liability Limited Partnership (LLLP)

In these cases the figure of the personally liable general partner doesn’t exist. All of the partners enjoy limited liability.

Limited Liability Company

The members of an LLC enjoy limited liability regardless if they exercise control over the business (unlike the limited partnerships
in the states which adopt the Revised Uniform Partnership Act). The LLC combines the advantage of partnership taxation
(escaping from double-taxation) with corporation characteristics (limited liability, centralized management, freely transferable
ownership interests and continuity of life). In the past there used to be a “four-factor test”, which analyzed if the LLC had three of
the main characteristics of corporations described above in order to exclude the possibility of being taxed as a partnership and
incurring in double-taxation. Nowadays the “four-factor test” is over and the LLC can be flexible as a corporation and still have
pass-through treatment for federal income tax purposes (IRS Reg #7701). The only exception for pass-through treatment is
when the LLC has publicly traded equity (IRC #7704 (a)).

THE CORPORATE FORM

Corporations

Entrepreneurs usually choose to incorporate under Delaware’s jurisdiction even when the business will be carried out in a
different state. Delaware “sells” a flexible statute and also high quality corporate courts in order to earn a lot of income from the
costly process to incorporate.

The main characteristics of a corporate form are:

- Legal Personality
- Limited Liability for investors
- Indefinite life (withdrawing shareholders cannot force liquidation)
- Free transferability of share interests (it is not restricted to other’s consent)
- Centralized management
- Appointed by equity investors
These elements are all connected to permit the most economically efficient form of running a large-scale private enterprise. The
limited liability facilitates the transferability of shares, because the shares value is independent of the assets of their owners. The
limited liability also allows a diversified portfolio of assets since the investors can spread their investments among a variety of
companies without being personally liable in any one of them. And the centralized management allows any person to invest even
without understanding anything about the business.

Core Characteristics GP LP LLC Corp.

Investor Ownership X X X X
Legal personality X X X X
Limited liability X X X
Transferable shares X X X
Centralized management under an elected board X

Types of Corporation

According to how the stock is traded

- Publicly Held: Shares are freely traded in the market
- Closely Held: Smaller business which can contain restrictions on transfers of shares. Usually the shareholders are also likely to
be the officers and directors. Can be a good option because is cheaper than forming a partnership or a LLC.

According to how the control is exercised

- Controlled Corporations: group of shareholders exercise control through its power to appoint the board.
- Control in the Market: lack of a controlling group. Practical control resides with the existing management of the firm.

Who controls the destiny of the company: the shareholders (principal?) or the board (agent?)? Is there an agency relationship? It
might be said that the entire class of stockholders are the principal for the board, but the majority of stockholders are not.

Automatic Self-Cleansing Filter Syndicate Co, Ltd v. Cunninghame (Majority of shareholders cannot force the board of directors
to sell the company’s assets)
The articles of incorporation provided that the directors were empowered to control the company’s assets, subject to regulation
of an extraordinary resolution (75% of the voting shareholders). The question before the court was whether the directors were
bound to the decision of the majority of shareholders (55%) who decided to sell the company’s assets. The court denied the
majority’s power to perform such an action without the acceptance of the board on the grounds that there is no agency
relationship between the board and the majority shareholders. In other words, it is not true to say that a majority at a meeting is
the principal with authority to alter the mandate of the agent. To the contrary, the board is in the position of managing the
company without the majority’s interference, as specified by the mutual arrangement between all the shareholders, including the
minority. Once the charter empowered the board to control the corporate assets unless there is a 75% shareholders vote to act
otherwise, a simple majority of shareholders cannot tell the board how to act. Moreover, according to the DGCL 271 b, the
board may abandon a sale of assets approved by the majority stockholders.
Why should the shareholders agree in the first place to give such an authority to the board?
Three reasons can be pointed. First it is a way of avoiding opportunistic behavior by controlling shareholders vis-à-vis minority
shareholders, making the company a more attractive investment for those who are willing to buy a small ownership of the
company’s interest. Secondly, the board of directors is often much better informed than shareholders about the firm’s business
affairs, being in a better position to determine whether it is the moment to sell the assets or not. The only alternative available to
the shareholders is to change the composition of the board (but this requires a lengthy and costly proxy-contest when the control
is spread on the market). Finally, in a widely held corporation the stockholders face the “collective action” problem and leave
business decisions on their hands can be problematic when an action should be taken rapidly.

Jennings v. Pittsburgh Mercantile Co. (Corporate officer and director doesn’t bind the company when the transaction has an
extraordinary nature – there is no apparent authority)
Egmore, who is Mercantile’s vice-president and director, contracted Jennings to solicit offers for sale and leaseback of the
corporate assets. After Jennings had made the whole job, the full board rejects the services and Jennings sues for commission.
The court decided that the company wasn’t bound to Egmore’s contract with Jennings because the officer wasn’t empowered
with an actual authority from the board to enter into this extraordinary transaction, neither there was an apparent authority which
led the third party to reasonably believe that Egmore had the power to make the agreement. The apparent authority is denied
because there was no signal from the company related to Egmore’s ability to enter into an extraordinary transaction such as
selling the assets of the firm and, therefore, Jennings should have asked for a document from the board confirming Egmore’s
authority before accepting the offer.

DEBT, EQUITY AND ECONOMIC VALUE

Introduction to Finance

A business corporation has basically two methods of raising capital to finance its activities: borrowing money through the issuance
of debt instruments (bonds) or selling ownership claims in the corporate entity by issuing equity securities. The benefits of being a
creditor who lends money is the possibility of enforcing bonds in default, as opposed to the holders, who have no right
guaranteed to a periodic payment and are the last to receive their investments in case of bankruptcy. There is a positive aspect of
debt as a source of finance in the company’s perspective also. When taxable income is calculated, the interests paid to the lender
are deductible as costs, as opposed to the dividends paid to equity holders which are taxed as profits.

Common Stock X Preferred Stock

Owners of common stock have control rights over the company by electing the board of directors. Preferred stock is any equity
security on which the corporate charter confers a special right, privilege or limitation on the income of the company. Generally
speaking they have restricted voting rights but, on the other hand, have priority on receiving dividends (usually fixed dividends)
and also preference over common stock in liquidation.

Hierarchy of Claims on the Corp’s cash flow:

1) Secured Debts
2) Debt (or notes)
3) Subordinate debt (credit granted by a significant stockholder) see also (UPA # 40 b)
4) Preferred stock
5) Common stock

The time value of money

The idea is that an amount of money today worth’s more than the same amount tomorrow, because money can be used in
different investments during this period.
These formulas help to convert future value into present value, and vice-versa:
FV = PV . (1 + r )ª FV: future value a: number of years
PV = FV / (1 + r) ª PV: present value
r = (FV / PV)¹/ª - 1 r: market rate of return

Risk and Return

To evaluate risky investments the investor has to consider the probability of their success and failure. The investor must calculate
the expected return, which is a weighted average of the value of the return. The larger is the space between the minimum return
and the maximum return, the more risky is the investment and the risk averse people will demand a risk premium to accept
bearing higher risk investments.

Problem of page 120

1) r = 11.300.000 / 10.000.000 – 1 = 13% r = 13%

2) Expected return: 0,95 . 11.300.000 + 0,05 . 0 = 10.735.000 ER = 10.735.000

3) Find the present value of the expected return through: ER / (1 + mr + rp) =

(risk premium is 0 because
hypothetically investors are neutral) 10.735.000 / (1 + 0,065 + 0) =
10.079.812,2
Net present value of the loan: the expected return discounted to its present value and the risk of the investment minus the amount
actually lent: 10.079.812,2 – 10.000.000 =
79.812,2

4) 10.735.000 / 1 + (0,065 + 0,02) = (this is the correct method because it clearly

10.735.000 / 1,085 = separates the market rate from the risk premium)
9.894.009,21
Net present value of the loan: 9.894.009,21 – 10.000.000 = -105.990,78

Diversification and Systematic Risk

When you create a wide portfolio your expected return can be exactly the same but the probability that the amount received will
be closer to the expected value increases (difference between flip the coin once and flip the coin 10 times) – less volatility (its not
all or nothing). Also, when the success of one type of stock depends on the failure of another type, when you invest in both
stocks you are lowering your risk (diversifiable risk: you will gain in one way or another). When you lower your risk you will only
be able to charge a lower risk premium.

Market Price
If we assume that the traders in an exchange market have accurate information about the publicly held corporations, then the
market price of the equities will well represent the real value of the investment, considering the expected return, the present value
and the risk premium. In the case of small companies, however, there are less transactions happening (making it harder for
investors to calculate the risks) and also private information which is not disclosed to the market, resulting in a market price
inconsistent with the real value of the investment.

THE PROTECTION OF CREDITORS

Creditor Protection

The law is concerned about creditors’ protection because shareholders can act opportunistically. They can take advantage of the
limited liability rule to shift assets from the company and escape from the payment or to misrepresent the assets of the company
before the creditor grants the credit. Three strategies were established to protect the creditors: mandatory disclosure, capital
regulation/distribution constraints and duties on corporate participants.

Mandatory Disclosure
Only applied to publicly held corporations. Seeks to reduce the likelihood of misrepresentation.

Capital Regulation
Some jurisdictions require investors to contribute with a minimum amount of capital to secure the debts. However, it is not an
efficient method because once the company starts running the business the capital can be used in the normal operation of the firm
and may be easily dilapidated. Neither the DGCL nor the RMBCA requires a minimum capital amount as a condition of
incorporation.

Distribution Constraints
The stockholders equity (difference between corporate total assets and total liabilities) is divided into three accounts: stated (or
legal) capital, capital surplus and accumulated earnings (or earnings surplus). The amount of stated capital is the product of the
par value of the stock multiplied by the number of outstanding shares. If the stock is sold for more than its par value, the excess is
accounted for in a capital surplus. Retained earnings are merely the amounts that a profitable corporation earns but has not
distributed to its shareholders.
New York Bus Corp. Law § 510 (capital surplus test): may only pay distributions out of surplus (§510(b)), and distributions
cannot render the company insolvent. AND: NYBCL § 516(a)(4) allows board to transfer out of stated capital into surplus if
authorized by shareholders.
DGCL § 170(a) (“nimble dividend” test): may pay dividends out of capital surplus + retained earnings, or net profits in current or
preceding fiscal year (whichever is greater). AND: DGCL § 244(a)(4) allows board to transfer out of stated capital into surplus
for no par stock.
Cal. Corp. Code § 500 (“modified retained earnings test”): may pay dividends either out of its retained earnings (§ 500(a)) or out
of its assets (§500(b)(1)), as long as those assets remain at least 1.25 times greater than its liabilities, and the current assets are at
least equal to the current liabilities (§500(b)(2)).
RMBCA § 6.40(c): may not pay dividends if you can’t pay debts as they come due (§ 6.40(c)(1)); or assets would be less than
liabilities plus the preferential claims of preferred shareholders (§ 6.40(c)(2)). BUT: board may meet the asset test using a “fair
valuation or other method that is reasonable in the circumstances” (§ 6.40(d)).

Duties on Corporate Participants

Director Liability
Credit Lyonnais Bank Nederland v. Pathe Communications Corp. (Directors owns a duty to protect creditors interest when the
company is in the vicinity of insolvency)
The Delaware Court of Chancery held that “when a corporation is in the vicinity of insolvency, its directors in making decisions
should not consider shareholders welfare alone but should consider the welfare of the community of interests that constitute the
corporation”. In other words, the board owns a duty to maximize the value of the company, in order to conciliate the interests of
shareholders with bondholders.
This case demonstrates the conflict of interests between shareholders and creditors. While the creditors would be in favor of
accepting a 12.5 million offer (less than the expected value of litigation, because this amount would be sufficient to pay all the
debt), the shareholders may be opposed even to the 17.5 million offer (which is less than the expected value of litigation, because
in this situation they would receive 5.5 million which is less than the probability (25%) of receiving 39 million (25% . 39 = 9.75
million). Because they don’t take into consideration the fact that there is 75% chances that creditors won’t be paid in the litigation
option, they compare 5.5 million (the amount of the offer reduced by the creditors payment) to 9.75 million (the probability of
receiving 39 million in litigation) and, depending on their willingness to take risks, may very well prefer litigating. The directors
should choose the option that maximizes the value of the company as a whole, what is to accept offers superior than 15.5 million
(expected value of litigation) and reject offers inferior to 15.5 million.

North American Catholic v. Gheewalla (When the company is operating in the zone of insolvency but hasn’t yet gone bankrupt,
the directors must discharge their fiduciary duties to the benefit of shareholders and not other constituencies)
The Delaware Supreme Court, narrowing the interpretation of Credit Lyonnais Bank Nederland v. Pathe Communications
Corp., made it clear that when the company is operating in the zone of insolvency but still hasn’t gone bankrupt, the directors
should exercise the business judgment in the best interest of the corporation for the benefit of its shareholders owners. After all,
any business involves risks and the creditors have already received a risk premium included on the payment of the debt to be
compensated for the risks they have assumed.

Fraudulent Transfers
Fraudulent conveyance law (a general creditor remedy) imposes an effective obligation on parties contracting with an insolvent –
or soon to be insolvent – debtor to give fair value for the cash or benefits they receive, or risk being forced to return those
benefits to the debtor’s estate. In this sense, creditors may void transfers made with the “actual intent to hinder, delay, or defraud
any creditor of the debtor” (UFTA # 4(a)(1)) or transfers made “without receiving a reasonably equivalent value” if the debtor is
left with “remaining assets…unreasonably small in relation to its business” or “the debtor intended…believed…or reasonably
should have believed he would incur debts beyond his ability to pay as they become due” (UFTA # 4(a)(2), 5(a), 5(b)). The
rationality is to preserve the reasonable expectations of creditors when negotiating with debtors by precluding a corporation from
making deals with third parties which may put the creditor’s interest in danger. Most fraudulent transfer litigation today takes
place under section 548 of the Bankruptcy Code (since the transfer will only be problematic when the debtor becomes
insolvent), which takes a virtually identical approach as the UFTA.

Equitable Subordination
A shareholder can also grant a credit for the firm, but under the equitable subordination doctrine a general-creditor will have
priority in relation to a shareholder-creditor in the liquidation of the firm. The critical question is what set of circumstances will
permit a court to impose this subordination on a shareholder-creditor ((i) the equity holder has to be an officer of the company;
and (ii) the insider-creditor must have, in some way, behaved unfairly toward the corporation and its outside creditors –
analogous to a fraudulent transfer under UFTA # 4).

Costello v. Fazio (The shareholders loans are subordinated to the unsecured creditors’ claims because they have adopted a
misleading strategy to obtain the same priority as unsecured creditors by withdrawing the capital amount and classifying it as
“Loans”)
Three partners made an initial capital contribution in the amount of U$ 51.620,00 to form a partnership. The business was
suffering substantial business losses when the partners decided to incorporate and withdraw almost all of their capital contribution
to the business. The partnership issued promissory notes to each of the partners and the sum was transferred from the partnership
capital account to an account entitled “Loans from Copartners”. The corporation went bankrupt and the question before the
court was: should the shareholders dispute with the other creditors in parity of terms?
The creditors of the partnership wont be affected by this withdraw because they will still be able to reach the partners personal
assets (unlimited liability), and the secured creditors will have priority over the shareholders in relation to the corporation’s debts
because they have a guarantee, but what about the unsecured creditors from the corporation? Should they have the same rights
of the shareholders in the liquidation of the firm? The court understood that the intention of the ex-partners was to place them in
the same priority as unsecured creditors of the new corporation. If the amount withdrawn (U$ 45.620) remained to serve as
capitalization of the new corporation, it would be used to satisfy the debts of unsecured creditors before being distributed to the
shareholders in the proportion of their shares. By classifying the amount as “Loans”, the shareholders planned to have the same
priority as unsecured creditors. But what is the problem of allowing shareholders to dispute the corporation’s assets in parity of
terms as unsecured creditors if these creditors contracted with the corporation knowing about the reduced capitalization? The
problem is that the unsecured creditors from the new corporation are basically the old partnership’s creditors (suppliers and small
dealers) who didn’t know that the partnership was incorporated (and it is not reasonably expected that they should keep
checking whether the partnership has changed its corporate form) and relied in the partnership form which allowed them to reach
the partners personal assets. Therefore, the court concluded that the shareholders claims were subordinated to the claims of the
general unsecured creditors. Note, however, that the shareholders loans claims have preference in relation to the capital invested
in the company by each shareholder.

Piercing the Corporate Veil

The most radical form of shareholder liability in the cause of creditor protection is the equitable power of the court to set aside
the entity status of the corporation (“piercing the veil”) to hold its shareholders liable directly on contract or tort obligation). The
difference between this method of protecting creditors as compared to fraudulent transfers and equitable subordination is that
here the creditors recovery is not limited to the transaction effectuated wrongfully by the company or to the loan granted by the
shareholder to the company. Instead, when the corporate veil is pierced, creditors are entitled to reach all assets of the
shareholder until the debt is entirely recovered.
In Van Dorn Co. v. Future Chemical and Oil Corp. the court stated that two requirements must be satisfied to justify piercing the
corporate veil:
- Evidence of lack of separateness between the shareholders and the corporation personalities. Failure to observe corporate
formalities, thin capitalization, small number of shareholders and active involvement by shareholders in management, are some
examples. Shareholders themselves must believe in the separation.
- Adherence to the fiction of the separate corporate existence would sanction a fraud or promote injustice. The shareholder is
trying to escape payment to the creditor through the corporate structure.

Reverse Piercing
Besides reaching the assets of the shareholder, the “reverse piercing” allows the creditor to reach the assets of other corporations
owned by this shareholder. Why not simply give to the creditor the shareholder’s stock of the other corporations? Because the
creditor (in the position of a stockholder) would receive only after the creditors from that other corporations. Therefore, the
creditor is permitted to have direct access to the assets of the other corporations. The problem with reverse piercing is: why
should this creditor have priority over the creditors of the other corporations? And a second problem is that the other
corporations might have other shareholders who cannot be harmed if they are not related to the reasons which triggered the
reverse veil piercing.

Sea-Land Services, Inc. v. The Pepper Source (The court considered the shifting of assets from one corporation to another
enough to satisfy the requirement of promoting injustice)
Sea-Land claimed to pierce the veil of PS and reach its sole shareholder Marchese assets, as well as “reverse piercing” to reach
Marchese’s other corporations assets. The first requirement of the Van Dorn’s test was clearly met: corporate records and
formalities have not been maintained, PS has been undercapitalized, and corporate assets have been borrowed without regard of
their source. The second part of the test is more problematic: is there enough evidence to conclude that treating Marchese and
PS as separate entities would promote injustice and sanction fraud? The district court found that the mere fact that the creditor
would be denied a judicially-imposed recovery is enough to conclude that injustice will be promoted. But the Seventh Circuit
Court held that this approach would lead to a result in which the plaintiff would always have the right of piercing the veil because
obviously that if he is trying to pierce the veil is because he couldn’t recover the entire debt from the company’s assets. Thus,
more evidence of injustice was required and the court reversed the district court decision and remanded with instructions.
“Perhaps Sea-Land could establish that Marchese used these corporate facades to avoid its responsibilities to creditors; or that
PS, Marchese, or one of the other corporations will be “unjustly enriched” unless liability is shared by all”.
In the end, the courts allowed the veil piercing on the grounds that Marchese had committed tax fraud. But this was only an
excuse the court used to allow the veil piercing (tax fraud has no relationship with fraud upon the creditor’s and there is no reason
why it should trigger the piercing). What actually supported the court’s conclusion was that the assets from PS were constantly
shifted to the other corporations without any justification or consideration in return. The only reason to explain the transfers is to
escape payment to the creditor. Why wouldn’t the method of fraudulent transfers be adequate in this situation? Because it would
be too hard to identify which assets had been shifted from PS and which ones belongs to each corporations in order to establish
the recovery only of the assets originally from PS.

Kinney Shoe Corp. v. Polan (Even though there was no express misrepresentation and arguably the creditor assumed the risks
(Laya) of contracting, the court found that the form in which the corporation was structured was enough reason to pierce the
corporate veil)
Mr. Polan formed a corporate structure in which Industrial Realty Company was between Polan Industries and Kinney Shoe.
Industrial contracted a leasing with Kinney Shoe and subleased 50% to Polan Industries. The problem was that all the assets
were in Polan Industries and Industrial was completely “empty”, without any resources. Thus, Kinney Shoe claims for the veil
piercing of Industrial in order to reach Mr. Polan personal assets and Polan Industries’ assets. It argued that the business was
organized in such a way that Polan Industries could take advantage of the lease (through the sublease) without being liable and
that the main purpose of placing Industrial Company in the middle was to protect Polan himself and Polan Industries from liability.
The defendant argues that, even if he had this purpose when structuring the business, Kinney Shoe knew since the beginning that
it was contracting directly with Industrial and, therefore, could only reach this corporation’s assets. In other words, Kinney Shoe
assumed the risk of the business when contracting with an “empty” corporation and there was no misrepresentation or
opportunistic behavior from Polan, who had been transparent since the beginning. The defendant invoked Laya v. Erin Homes
where the court held that: “if such an investigation would disclose that the corporation is grossly under capitalized, based upon the
nature and the magnitude of the corporate undertaking, such party will be deemed to have assumed the risk of the gross
undercapitalization and will not be permitted to pierce the corporate veil”.
The court, however, found enough reason to pierce Industrial’s veil alleging that there was no reasonable explanation for
Industrial to be in the middle of the business except to avoid liability (but why is the purpose of avoiding liability illegal per se if it
is made transparently since the beginning?). It might be argued that Kinney Shoe relied on Polan’s Industries assets to cover
Industrial’s debts because, even though there was nothing in the contract between Industrial and Kinney concerning guarantees
from Polan Industries, both of them were seen as a “single enterprise”.

Piercing the Corporate Veil on behalf of involuntary creditors (tort cases)

Surprisingly, courts are considerably more likely to pierce on behalf of contract creditors than on behalf of tort creditors –
perhaps because the presence of explicit misrepresentation in many of the contract cases made the justification for piercing
especially persuasive.

Walkovszky v. Carlton (The court allowed horizontal veil piercing because the sub-corporations were in fact a single enterprise)
Carlton owns 10 corporations, each of which is composed by two cabs and the minimum automobile liability insurance required
by law (U$ 10,000 per cab). The strategy of splitting the business in many corporations was adopted by Carlton to protect the
business as a whole from liability. With this structure each of the sub-corporations would be liable only for their own debts,
excluding the possibility of a creditor from one of them to reach the assets of another.
The court, however, concluded that, despite the separation, the business was operated as a single entity with regard to financing,
supplies, repairs, employees and garaging, and all of the sub-corporations are under the same name. Thus, the court allowed a
horizontal veil piercing, which means that the victim injured by one of the cabs could reach the other sub-corporations’ assets,
which were in fact members of a single enterprise.
Nevertheless, the court denied Mr. Carlton’s personal liability on the grounds that the enterprise doesn’t become either illicit or
fraudulent merely because it consists of many sub-corporations. Mr. Carlton was only exercising a right given by the law, which is
to protect himself from personal liability by using the corporate form. On remand, the plaintiff amended his complaint and
succeeded against Mr. Carlton by showing that he conducted the business fraudulently.

Carter-Jones Lumber Co. v. Ltv Steel (When the company is involved in an illegal activity, its controlling shareholder is
personally liable even if the corporate formalities are observed)
The corporation was involved in illegal business by using PCBs (a hazardous substance regulated by CERCLA) and causing
environmental damages. The main issue before the court was whether Denune, who is the owner of the corporation, could be
considered personally liable for the damages. In Belvedere, the Ohio Supreme Court announced a three-pronged test to
determine if a shareholder is liable for the wrongdoing of the corporation of which he is a owner. The three prongs are: (i) he must
exercise control over the corporation in such a way that the corporation had no separate mind, will or existence of its own; (ii) the
control must be exercised in a fraudulent or illegal way; and (iii) such fraudulent control resulted in injury or unjust loss to the
plaintiff. In this case the second and third requirements were clearly met, so Denune’s main argument was based on lack of
complete control over the business, alleging that the employees were the people involved in the PCBs trading. The court rejected
Denune’s defense because he was unable to identify such employees and it was clear that he controlled the particular transactions
that constituted the CERCLA violations. “The court rejects Denune’s arguments that under Ohio law, mere control of a
corporation, no matter how complete, is insufficient as a matter of law to trigger veil-piercing”.

Substantive Consolidation
When a parent goes bankruptcy the assets of its wholly owned subsidiaries are consolidated in order to satisfy the creditor’s
debt. Even though the creditor didn’t contract directly with the subsidiary, he might have relied on their assets when contracting
with the parent. In most of the circumstances this reliance is reasonable and the court allows a kind of horizontal veil piercing so
the creditor can reach the subsidiaries assets. Veil piercing is a one way remedy. It exposes shareholder assets to corporate
creditors, but protects corporate assets from shareholder creditors. Substantive consolidation is two-way. Shareholder assets are
exposed to corporate creditors, and corporate assets are exposed to shareholder creditors.

Successor Liability
DGCL § 278 & § 282: shareholders remain liable pro rata on their liquidating dividend for three years.
RMBCA § 14.07: same as Delaware, provided that corporation publishes notice of its dissolution.
Successor Corporation Liability: Product line test in some jurisdictions may hold acquiror liable if it buys the dissolved
corporation’s business intact, and continues to manufacture the same line of products => any sophisticated buyer who buys the
business as a going concern will contract for indemnification for tort liability, or pay less.
So the only way for shareholder to escape long-term liability through dissolution is to sacrifice the going-concern value of the
business and keep only the piecemeal liquidation value.
Can limited liability in tort be justified?
The problem about granting limited liability is that it creates incentives for the shareholder to cause the corporation to spend too
little on precautions to avoid accidents. It is a cost externalization, that is, a cost who affects other people, not the person who is
engaging in the activity and the tendency is to spend less than what would be the ideal from the society’s perspective. The result
will be overinvestment in hazardous industries, above optimal levels, since the shareholder won’t take into account the possibility
of having to cover a tort’s victim damage through his personal assets.
On the other hand, there are two main arguments to follow the limited liability rule. First, activities that are hazardous are generally
regulated by the government, which mandates minimum insurance coverage precisely to protect tort victims. Whether the
minimum insurance coverage is lower than optimal levels or not is a decision for Congress to make and not the courts by
extending unlimited liability to shareholders. Secondly, there is the argument, particularly for publicly held companies which have
plenty of small shareholders, that unlimited liability would cause many stockholders to abandon the equity market entirely.
However, this argument is somewhat irrational because, first the probability of catastrophic torts are remote (and if that is not the
case, one more reason to reach the shareholders assets and deter such activities) and second, the unlimited liability would respect
a pro rata rule, accordingly to each shareholders interest in the company (so the shareholders could diversify risk by investing in
many companies).
The idea of protecting tort victims more than general creditors is because they didn’t contract with the corporation so there is no
such defense as “the plaintiff was aware of the corporation’s conditions of payments and assumed the risk of the business”
(Laya’s test). There can be also less dramatic solutions rather than unlimited liability, such as mandating higher insurance coverage
for risky firms, imposing criminal penalties on corporate decision makers who create unreasonable tort risks and giving tort
victims priority over other creditors in the event of a corporate bankruptcy.

THE VOTING SYSTEM

The Voting System

Shareholders are entitled to vote in three main issues:

- Election of the board of directors
- Fundamental changes (merges, sale of assets, corporate dissolution, amendments to charter or bylaws, removing a director
from the board)
- Shareholders resolutions (ratify board actions or request the board to adopt certain actions).

Electing Directors
Every corporation must have a board of directors, even if the board has a single member (DGCL 141 a). The annual meeting is
also mandatory (DGCL 211 b). The procedures to elect the directors at the annual meeting are provided under the DGCL 141
(b) and 216.
Holders of voting stock elect either the whole board, when there is a single class of directors, or a fraction of the board, when
there is more than one class of directors, “staggered board” (under Delaware law it is permitted to have a maximum of three
classes DGCL 141 d). Staggered board makes it more difficult for a controlling shareholder (even if he holds 51% of the
common stock) to gain control over the board because instead of voting the entire board annually, when there are three classes
of directors the shareholder must win two elections to gain majority control over the board (two-thirds of the seats). In addition,
when the board is staggered, the shareholders have no right to remove any director without cause. The charter or the initial
bylaws may contain a staggered board provision, or the bylaws may be amended through a majority of shareholders vote to
include a staggered board provision (the board doesn’t have the right to amend the bylaws to include a staggered board without
shareholders approval – DGCL 141 d).

Cumulative Voting
Cumulative voting is designed to increase the possibility of minority shareholders having representation on the board of directors.
Instead of allowing shareholders to cast one vote for each voting stock owned for each position to be filled in the board, under
the cumulative voting system, each shareholder may cast a total number of votes equal to the number of voting shares that he
owns multiplied by the number of directors for whom he is entitled to vote. The problem about cumulative voting is that when the
board is elected by different shareholders it may be difficult to reach a consensus among the board members about business
issues. In order to preserve the “unity” of the board and, ultimately, the efficiencies provided by a centralized management, few
companies have adopted the cumulative voting in their charters. (DGCL #214)

Removing Directors
The general rule is that directors can be removed even without cause by a majority shareholder vote. There are two exceptions
under Delaware statute: (i) when the board is divided into classes (staggered board); and (ii) in the case of a corporation having
cumulative voting, if less than the entire board is to be removed, no director may be removed without cause if the votes cast
against such director’s removal would be sufficient to elect him under cumulative voting of the entire board. (DGCL 141 k). The
methods of removing a director without having to wait for next annual meeting are either calling a special meeting or through a
written consent (both rights depends on whether the law applied is Delaware statute or RMBCA, as stated below).

Special Meeting
The board may call special meetings to permit shareholders to vote on fundamental transactions. Additionally, in most
jurisdictions, a special meeting is the only way that shareholders can initiate action (such as, the amendments of bylaws or the
removal from office of directors) without having to wait for the next annual meeting. Who can call the special meeting? Under
RMBCA either the board of directors or the holders of at least 10 percent of the votes entitled to be cast on any issue proposed
to be considered (RMBCA 7.02). To the contrary, Delaware law provides that special meetings may be called by the board or
by such persons designated in the charter or bylaws, without any provision of shareholders’ right to call a special meeting (DGCL
211 d)

Written Consent
Delaware statute provides that any action that may be taken at a meeting of shareholders (eg. amendments of bylaws or removal
of directors) may also be taken by a written consent of the holders of the number of voting shares required to approve that action
at a meeting attended by all shareholders (DGCL 228). On the other hand, RMBCA requires unanimous consent to validate
written votes (RMBCA 7.04 a).
Therefore, even though the Delaware statute is more restrictive concerning the authority to call a special meeting, it is more
flexible than the RMBCA in relation to written consent.

“Charter” (Articles of Incorporation) and Bylaws

The charter contains few terms, such as, name of the corporation, address, purpose, and capital structure. On the other hand, the
bylaws fix the operating rules for the governance of the corporation, such as the responsibilities of corporate officers, the size of
the board of directors, date and place of the annual meeting and may establish procedures for the functioning of the board. The
bylaws are much more flexible to alter (either the shareholders or the board can amend the bylaws without the other’s approval).

Amendments to the Charter

The Charter can only be amended through a board proposal in a shareholders meeting. The shareholders themselves do not have
the right of proposing amendments to the charter. (DGCL 242 b 1). The process to amend the charter consists basically in three
steps: one or more directors propose the amendment, the board votes on the proposal and then the proposal is submitted to
shareholders approval.

Amendments to the Bylaws

In the case of bylaws, to the contrary, the right to propose an amendment rests on the shareholders hands (DGCL 109). The
charter, however, may confer the power to amend the bylaws to the board. But the fact that such power has been conferred
upon the directors shall not limit in any way the shareholders power to amend the bylaws. In such case, both the directors and the
shareholders may amend the bylaws without the other’s approval. In practice, however, when the company doesn’t have a
controlling shareholder the board has much more control over bylaw amendments because it doesn’t face the collective action
problem faced by shareholders.

Amendments to the Bylaws by the board

When the directors have the right to amend the bylaws (conferred by the charter), they may increase the board’s size (if it didn’t
reach the limit size established in the charter) and even appoint fellow directors to occupy the new seats until the next annual
meeting, provided that such a right shall not be exercised abusively (See Blasius v. Atlas).

Amendments to the Bylaws by the shareholders

There is a conflict between the shareholder’s right to amend the bylaw and the limits on their ability to interfere with the
management of the company (See CA, Inc. v. AFSCME Employees Pension Plan).

Proxy Voting
Given the widely dispersed share ownership of most publicly held corporations, public shareholders are unlikely to attend
shareholder meetings. Considering the costs of acquiring information to vote intelligently, as well as the presumption that a
minority vote is quite unlikely to affect the result, economically the minority shareholder has the incentive to remain passive
(“collective action problem”). Therefore, a very common method used by shareholders is to grant a proxy card for someone else
to vote on his behalf (DGCL 212 and NYBCL 609). Proxy holders may exercise independent judgment on issues arising at the
shareholder meeting for which they have not received specific instructions. Proxies, like all agency relationship, are revocable
unless the holder has contracted for the proxy as a means to protect a legal interest (DGCL 212(e).
Proxy Fight
In publicly held companies with widely spread share ownership the tendency is that the managers will remain indeterminately
controlling the business considering that the annual meeting is a mere formality and any shareholder has enough power by himself
to elect new directors. A proxy fight is basically a fight between a group of insurgent shareholders who are dissatisfied with the
management and will try to attract proxy votes to elect new directors against the incumbent managers who will, in turn, joint their
efforts to persuade the stockholders of the correctness of their position. Since the costs of getting together through proxy votes
are substantial, shareholders face a serious impediment to engage in a proxy-fight. The question that arises is whether the
corporation should bear the expenses incurred by the insurgent shareholders and the board of soliciting proxies in a proxy-fight?

Rosenfeld v. Fairchild Engine & Airplane Corp (Reimbursement of reasonable expenses in a proxy fight are acceptable for both
sides)
The incumbent directors have been reimbursed for the reasonable expenses of soliciting proxies to defend their position (they
spent out of corporate funds while still in office), and the insurgent shareholders have also been reimbursed, because they won the
proxy fight and the reimbursement was expressly ratified by a majority vote of stockholders. The court held that the
reimbursement was legal because the expenses were part of the normal governance of the corporation, and did not exceed the
reasonable and proper expenses required by a proxy-fight.
The consequence of adopting this rule (“Froessel rule” – it has been decided by a judge called Froessel) is that incumbent
managers are always reimbursed, regardless if they win or lose and insurgent stockholders stand a good chance of being
reimbursed only if they win. If they win, the new board will vote in favor of the reimbursement and a majority of shareholders will
ratify. Without shareholders ratification, however, reimbursement to successful insurgents might be attacked as self-dealing
“Heineman v. Datapoint Corp”. The problem of adopting the “Froessel Rule” is that the insurgents are not encouraged to initiate
a proxy fight because they face the risk of loosing and having to bear all the costs of the proxy campaign by themselves.
Consequently, the likelihood that an incumbent board will be replaced decreases, even when it is failing to maximize the
company’s value.

Rule Benefit if you Win Cost if you lose Minimum G (Gain) required to run proxy contest
Froessel Rule: reimbursed only if you win 0.2(G - $4M) -0.2($2M) - $2M $16 M
“Super Froessel” Rule: reimburse both sides regardless of outcome 0.2 (G - $4M) -0.2 ($4M) $8 M
Reimburse neither side 0.2 (G) - $2M -$2M $20 M

Assumptions:
Dissident owns 20% of shares
G = gain to the corporation from the contest
50% likelihood of winning if insurgent spends $2M; no chance of winning if insurgent spends less; and corporation will spend
$2M opposing.

CA, Inc. v. AFSCME Employees Pension Plan (The shareholder’s proposal to amend the bylaws to provide that the company
shall reimbursed insurgent shareholders for the reasonable expenses incurred during a proxy fight was considered against the
common law rule, since there can be situations where the board would be precluded from exercising its fiduciary duty)
A group of stockholders wanted to propose a bylaw amendment stating that in the event of a proxy-fight, the insurgent
shareholders would have the right to be reimbursed by the company for the proxy expenses, as long as they can get one of their
candidates to be elected to the board. The difference from this rule to Froessel rule is that here the insurgent shareholders
wouldn’t have to take over the entire board to be reimbursed, thus having a greater chance of being “subsidized” by the
company. If the requirements established in the proposal were met, the board would be forced to cause the company to
reimburse the expenses. The court faced two questions in considering the validity of the shareholder’s proposal: (i) is the
proposal a proper subject for action by shareholders as a matter of Delaware Law? (ii) Would the proposal, if adopted, cause
the board to violate any Delaware law to which it is subject?
(i) is the proposal a proper subject for action by shareholders as a matter of Delaware Law? In other words, are the
shareholders entitled to exercise their right of amending the bylaws (DGCL 109) in relation to this specific subject?
The board argued that section DGCL 109 does not exist in a vacuum, it must be read together with DGCL 141 (a), which
provides that “the business and affairs of every corporation organized under this chapter shall be managed by or under the
direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation”.
Moreover, section DGCL 102 b 1, contemplates that the certificate of incorporation may contain a provision limiting the broad
statutory power of the directors, what suggests that this is the only adequate way to restrict the board’s power. The board relies
upon these provisions to argue that the Bylaw would limit the substantive decision-making authority of CA’s board to decide
whether or not to expend corporate funds for a particular purpose and this limitation would only be possible through an
amendment of the certificate of incorporation.
The line between legitimate shareholder’s proposals to amend the bylaws and abusive proposals which interfere with the
exclusive managerial power of the board is defined by deciding whether the proposal is one that regulates a process for
substantive decision-making, or one that mandates the decision itself. The court concluded that, even though the proposal has a
substantive-sounding mandate to expend corporate funds, it also has the intent and the effect of regulating the process for electing
directors of CA. The purpose and effect of the proposal is to promote the integrity of the electoral process by facilitating the
nomination of director candidates by stockholders. The shareholders are entitled to facilitate the exercise of their voting right by
proposing a bylaw that would encourage candidates other than board-sponsored nominees to stand for election. In sum, the fact
that the proposal mandates the expenditure of corporate funds does not necessarily mean that it is not process-related.
(ii) Would the proposal, if adopted, cause the board to violate any Delaware law to which it is subject?
The board justified its refusal to include the shareholder’s proposal in the company’s proxy materials by arguing that the
proposal, if adopted, would preclude the board from fully discharging their fiduciary duties in circumstances which would
otherwise require them to deny reimbursement to the insurgent slate and, thus, violates the Delaware Law. The court agreed that
there can be situations where the proxy contest is motivated by personal or petty concerns, or to promote interests that do not
further the company’s best interest and the board’s fiduciary duty would compel that reimbursement be denied altogether.
Because the proposal was written in such a way that the board would be obliged to cause the company to reimburse the
dissident shareholder regardless of an eventual fiduciary duty to act otherwise, the court concluded that the proposal violates
common law rule. According to Justice Jacobs, a provision like this one could not even be included in the certificate of
incorporation (supposing that the board proposed an amendment to the charter to restrict its own power) because it would still
be capable of violating the director’s fiduciary duty to act otherwise. The situation would be different if the proposal included a
“fiduciary-out” provision.

Class Voting
A transaction that is subject to class voting simply means that a majority of the votes in every class that is entitled to a separate
class vote must approve the transaction for its authorization. Class voting is a way of protecting minorities, so they can have the
possibility of voting separately to any change that might affect their political or economic interests (RMBCA 10.04, 11.04 (f)).
The RMBCA requires a vote whenever an amendment will “change” certain things, thus avoiding argument over whether a
change is adverse or beneficial. In addition it is required a class vote for any change that might affect the economic interest of
preferred stock (RMBCA 10.04 5, 10.04 6; NYBCL 804 a 3). The DGCL (# 242 b 2), on the other hand, requires a separate
vote only if an amendment would adversely affect the legal rights of the existing securities, thereby excluding the possibility of
class votes by economically interested shareholders. Therefore, the protections of preferential shares in the Delaware companies
must be designed in the charter.

Shareholder Information Rights

There are two types of information which can be required: the “stock list” and the “books and records” of the corporation
(DGCL 220; RMBCA 16.02 – 03; NYBCL 624). A corporate stock list discloses the identity, ownership interest, and address
of each registered owner of company stock. Proper purpose for acquiring the stock list is broadly construed and, if the company
denies to disclosure the stock list, it has the burden of demonstrating an improper purpose (DGCL 220 c). On the other hand,
books and records are far more expensive to provide and its inspection may expose proprietary or competitively information. In
this case, plaintiffs carry the burden of showing a proper purpose.

General Time Corp v. Talley Industries, Inc. (The stockholder is entitled to the stock list when the corporation fails to preset a
justification of improper purpose)
Talley Industries, as shareholder of General Time, requested the stock list for the primary purpose to soliciting of proxies to be
used to replace the management of General Time. General Time failed to present a justification of improper purpose and Talley
Industries was entitled to the stock list.
Circular Control Structures
The board could adopt a strategy to entrench itself in office. The strategy would be to issue shares to a subsidiary company
(which it controls by electing the members of the subsidiary’s board) and the subsidiary (acting by its own directors) would be
entitled to vote on the election of the parent’s directors. The result would be that the board of the parent would elect themselves
to occupy the board in the subsidiary (or close friends) and then there election in the parent’s annual meeting would be
guaranteed (the subsidiary’s directors would vote on them). This is the circular control structure.
Section 160 c of Delaware statute prohibits the voting of stock that belongs to the issuer and prohibits the voting of the issuer’s
stock when owned by another corporation if the issuer holds, directly or indirectly, a majority of the shares entitled to vote at an
election of the directors of that second corporation.
The idea is that any stock which belongs to the issuer itself shall not be entitled to vote because this structure could deprive the
true owners of the corporate enterprise to elect who shall serve as directors. If the stock belonged to the issuer was allowed to
vote, who would in fact vote on behalf of the company would be the incumbent directors, who could perpetuate their election
and remain in power. Moreover, the same problem can happen with subsidiaries structures when the subsidiary itself holds a
substantial portion of the parent’s shares (as explained above). Thus, stock held by a corporate subsidiary may be considered as
“belonging to the issuer” and be prohibited from voting. Note that, if the parent doesn’t hold a majority of the shares of the
subsidiary, the strategy of circular control structure might not succeed because the board of directors of the subsidiary will be
sufficiently independent from the parent to replace the parent’s board (thus, the DGCL does not prohibit the votes, but in Speiser
v. Baker, the court prohibited the vote even though the issuer didn’t hold a majority of the votes in the subsidiary because the
subsidiary was dominated by the issuer’s directors). Moreover, it is important to observe that section 160 c does not prohibit the
parent from voting in its subsidiary annual meeting, but instead it prohibits the subsidiary from voting in the parent’s annual
meeting.

Speiser v. Baker (stock held by a corporate “subsidiary” may, in some circumstances “belong to” the issuer and thus be
prohibited from voting, even if the issuer does not hold a majority of shares entitled to vote at the election of directors of the
subsidiary).
Health Chem is owned by the general public (40%), Health Med (42%), Speiser (10%) and Baker (8%). Health Chem currently
holds, indirectly, preferred stock in Health Med which can be converted and would represent 95% of Health Med’s voting
power. The text of section 160 c, if read literally, does not apply to block Health Med from voting in Health Chem’s annual
meeting because “the issuer (Health Chem) doesn’t currently hold, directly or indirectly, a majority of the shares entitled to vote
at an election of the directors of that second corporation (Health Med). The common stockholders in Health Med are Speiser
and Baker, each holding 50% of Health Med’s voting power. The effects produced by such arrangement, however, are the same
effects produced by the circular control structure because Speiser and Baker could elect themselves as directors in Health Med
(as did in fact occur) and subsequently exercise voting power in Health Chem on behalf of Health Med. It is irrelevant whether
Speiser and Baker were able to elect themselves as directors in Health Med by virtue of their position as directors in a company
which holds a majority voting power in Health Med (classical circular control structure), or instead, were able to do so as a result
of their own ownership stock in Health Med. In either way, Speicer and Baker are able to control Health Chem holding together
only 18% of its common stock at the detriment of the public stockholders in Health Chem. Therefore, the court extended the
interpretation of section 160 c, concluding that “stock held by a corporate “subsidiary” may, in some circumstances “belong to”
the issuer and thus be prohibited from voting, even if the issuer does not hold a majority of shares entitled to vote at the election
of directors of the subsidiary”.

Note: In a structure where there are three companies, each of them holding 25% of the shares of each other and 50% of the
shares of each belongs to the public, the situation is quite different. Delaware 160 c provision shouldn’t be extended to such case
because, even though the connection between them might entrench the power of central controllers (where each of them have
interest in voting on a restricted group of directors who will end up controlling the three companies), this structure may in fact
prove to be useful for the best interest of the company and its public shareholders. This is because any fail on the management of
one of the companies will alert the other companies to take a position rapidly (as a block of control), as opposed to a reaction
from the public shareholders which might take longer since they face the collective action problem.

Vote Buying
It is not legally possible to buy a voting right without buying the stock itself. This prohibition is designed to prevent stockholders
who have less ownership interest in the company from exercising control without the correct economic incentives (for instance, a
20 percent shareholder who acquires all of the votes has incentives proportional only to one fifth of the value of those decisions).
In this sense, it was held in Brady v. Bean that “appellant being a stockholder in the company, any contract entered into by him
whereby he was to receive a personal consideration in return for either his action or inaction in a matter such as a sale of all the
company’s assets, involving, as it did, the interests of all the stockholders, was contrary to the public policy and void”.

Schreiber v. Carney (Vote-buying is not illegal per se. Depends on whether the object of the agreement is to defraud the other
stockholders)
Texas International wants to merger with Texas Air, but Jet Capital Corporation, who owns 35% of Texas International’s
common stock, has the right to reject the operation because of adverse tax consequences for Jet. To approve the operation, Jet
requires a loan from the company in very favorable terms, in order to be able to exercise certain warrants it held in Texas
International prior to the merger. The loans are necessary to avoid the tax adverse effects, because they would only result if Jet
exercised its warrants after the merger. If Jet didn’t have a substantial reason for rejecting, could it still exercise its veto right
conferred by the charter? Yes. Most of the times it is hard to evaluate the costs/benefits of a transaction, so it would be easy for
Jet to find out an economic justification to exercise the veto right, and one would never know if it was advancing its own personal
interests or really thinking about the company’s interest.
The plaintiff alleged that the entire transaction (loan and merger) was void since Jet Capital received a consideration
(advantageous loan) to withdraw its opposition to the proposed merger, what represented an arrangement analogous to a vote-
buying agreement (stockholder divorces his discretionary voting power supported by a consideration and votes as directed by
the offeror, which is the company in the present case). The court held that the agreement, despite being a type of “vote-buying”
arrangement, was not illegal because its object or purpose wasn’t to defraud or in some manner disenfranchise the other
stockholders. Indeed, the loan was granted primarily to further the interests of Texas International other stockholders by allowing
a merger which was desired by all of them. The desirability of the merger was confirmed when the majority of the shares voted
by the stockholders other than Jet Capital or its officers or directors voted in favor of the proposal (which included the loan and
the merger).

Separating Control Rights from Cash Flow Rights

Vote-buying is forbidden to the extent that it separates control rights from cash flow rights to the detriment of other shareholders.
There are, however, three legal methods of segregating control rights (votes) from cash flow rights. They are dual class share
structures, stock pyramids, and cross-ownership ties.

Dual Class Structures – allows companies to issue shares carrying one or more votes per share and other shares carrying no
voting rights at all (DGCL 151 (a) and NYBCA 613). Consequently one can control the company (through voting rights) having
less ownership than it would be ideal. The presumption is that the shareholder has the correct incentives when his controlling right
is proportional to his cash flow rights. Dual class structures are rare among public companies because for many years the New
York Stock Exchange would refuse to list common stock that did not possess equal rights (NYSE 313.00). The NYSE
proposed to amend its rules to permit dual class structures but the SEC reacted by enacting rule 19c-4, which provided
effectively prohibited both the NYSE and NASDAQ from listing shares with unequal voting rights, unless initially offered to the
market in that structure. The court decided that the rule was void because the SEC was exercising unauthorized regulation of
internal corporate governance matters. Finally, NYSE, NASDAQ and SEC reached an informal agreement to proscribe
securities that limit the voting rights of existing securities but to permit initial public offers of low-vote or non-vote stock that do
not control the rights of existing stock (therefore, avoid opportunistic behavior of the management to change the voting rights of
the existing stock through the issue of new stock). New rule: company can issue and list in the NYSE low-vote or none-vote
stock as long as they don’t limit the voting rights of existing stock. The restrictions of voting rights might be necessary to preserve
the power of a controlling block which has expertise with the business.

Pyramid Structure – In a pyramid structure a controlling shareholder holds a stake in a holding company that, in turn, holds a
controlling stake in another company, that, in turn, holds a controlling stake in another company, and so on. Each level enlarges
the distance between cash flow rights and control, resulting in a controlling shareholder with very little equity cash flow rights in
the company.

Cross-Ownership Ties – In this case companies are linked by horizontal cross-holding of shares that reinforce and entrench the
power of central controllers. Cross-ownership permits a controller to exercise complete control over a corporation with an
arbitrarily small claim on its cash flow rights (Speiser v. Baker).

Other two strategies of segregating control power from cash flow rights without buying directly the vote is:
“Borrowing shares” – Someone buys shares in the day before the shareholders meeting and sells in the day after for a small fee.
Derivative Market – Someone who is totally protected in relation to any change in the price of the shares (because he has the
option to buy for a fixed price (“call option”) if the price increases and the right to sell for a fixed price (“put option”) if the price
decreases) and thus, can vote without any economic interest to the company’s welfare.
In these cases, even though the other shareholders can suffer the harms of a shareholder voting without economic interests in the
company, corporate law can hardly regulate such behavior. First because it is hard to know whether these transactions are
happening (there is no obligation to disclose) and second because publicly held corporations include many widely scattered
stockholders, making it impracticable to go after all transactions.
Note that sometimes it is good for the other shareholders to have a minority shareholder who controls the company. In cases
such as Google or Newspaper Companies, it is better to have a shareholder with the know-how and expertise of the business to
monitor the management’s activity.

Federal Proxy Rules (Securities Act of 1934 Regulation 14 A)

Proxy rules are federal, regulated by the Securities Act. One might ask: if the “small” shareholders don’t care about voting and
going through all the proxy materials, why should corporate law be concerned about proxy rules? Because nowadays there has
been more and more “block” shareholders, such as institutional investors (funds, banks and insurance companies), which do not
control but hold a substantial stake of shares and are interested in participating in the corporate governance.

Shareholder Communication (Solicitation of Proxy – Rule 14 a 1 and Rule 14 a 2)

For the corporation to communicate with its shareholders or for the shareholders to communicate among themselves, SEC
regulations require the preparation, filing and distribution of a proxy statement. Communication between shareholders may be
held to constitute a “solicitation” of “proxy”, in which case the shareholder are subject to a costly procedure of filing proxy
materials. In order to determine whether the practice is exempt from the costly procedure of filling proxy materials it shall be
analyzed (i) if the practice constitutes a “solicitation of proxy” (Rule 14 a 1 (l) 2 lists some hypothesis which aren’t “solicitation”);
or (ii) when it is a solicitation, it may fall within the exceptions under Rule 14 a 2 (b), in which case the institutional shareholders
are able to solicit widely without being subject to the costly procedure (particularly when the shareholder is not asking for proxy).
Exempts solicitations still requires filling of a Rule 14 a 6 (g) statement within three days after commencement of the solicitation
when the shareholder holds shares with market value above $5 million.

Case analyzed in class (page 220 from the casebook)

Tarper (1% shareholder) is not satisfied with the performance of HLS so it is considering initiating a proxy campaign for the
election of three new directors for the board (“proposal”). The idea is not to take over the entire board, which includes nine
members, but to replace only three of them. So Tarper’s plan has 4 steps:
1) Circulate a list memo to other 15 institutions stockholders to check their sentiments;
2) Get the shareholder’s list;
3) Line up endorsement from ISS;
4) Send out proxy solicitation and statements to all HLS shareholders.
The first question which arises is whether circulating the list memo to other 15 stockholders constitutes a proxy solicitation under
Rule 14 a 1; and if it is a solicitation, whether there are any exceptions which can be used by Tarper under Rule 14 a 2 (b) to
exempt it from filling the costly proxy materials.
Rule 14 a 2 (b) 1, provides that the shareholders can communicate with each other as long as they are not asking for votes in a
specific issue. Tarper couldn’t make use of this rule because in the near future it will in fact ask for votes concerning its proposal,
thus, the court probably will consider the circulation of the list a solicitation of proxy since the beginning.
Rule 14 a 2 (b) 2, provides that communication within 10 shareholders at the most is exempt from soliciting proxy. But Tarper
intends to communicate with more 15 institutions so it can’t use this exception.
Rule 14 a 2 (b) 3, provides that an advise by any person (the advisor) to any other person with whom the advisor has a business
relationship is exempt. Therefore, it should be analyzed if Tarper exercises any business relationship with the institutions it is
planning to communicate with.
The second question concerns the right to have the stock list. HLS cannot escape from providing the stock list unless it
demonstrates an improper purpose (DGCL 220 c), what would be very hard considering that Tarper’s purpose is to indicate
three candidates to the board and this is a proper reason for requesting the stock list (General Time Corp v. Talley Industries,
Inc.).

Indicating Nominees for the Board of Directors

Under Rule 14 a 11, the board is entitled to propose the nominees for the “next” board, unless the bylaws provide otherwise.
The shareholders shall vote in the nominees indicated by the board at the shareholders annual meeting. The SEC proposed a new
Rule 14 a 11, allowing long-term shareholders to place their own nominees in a public company’s proxy material under certain
circumstances (more than 5% and held their stock for at least two years). However, opponents of the rule argued that it would
likely shift a dangerous amount of power into the hands of institutional shareholders that did not necessarily have the best interests
of the corporation at heart. The SEC accepted the objections and the proposal fell.

Town Meeting Rule (Rule 14 a 8)

Rule 14 a 8 – the town meeting rule – entitles shareholders to include certain proposals in the company’s proxy materials. From
the perspective of a shareholder, this is a low cost procedure since she can advance a proposal for vote by her fellow
shareholders without filling with the SEC or mailing her own materials out to shareholders. From the management perspective,
however, a shareholder’s right to include his proposal in the proxy materials can be unwelcomed since directors want to have
control over the content of communications made by a corporation to its shareholders. Considering this tension between
shareholders right to include proposals and the tendency of the management to reject them, the SEC has reached a balance
imposing requirements and reasons to reject:

Rule 14a-8 requirements: Must hold $2,000 or 1% of the corporation’s stock for a year ((b)(1)); must file with management 120
days before management plans to release its proxy statement ((e)(2)); proposal may not exceed 500 words (d); and proposal
must not run afoul of subject matter restrictions.
Thirteen grounds for excluding proposals from the company’s solicitation materials (14a-8(i)): companies that wish to exclude a
shareholder proposal generally seek the SEC approval, which is called a “no-action letter” stating that SEC will not recommend
any disciplinary action against the company if the proposal is omitted. The shareholder proponent has the opportunity to respond
to the request for a no-action letter.

The substance of the proposals can be classified in two categories: corporate governance proposals and social responsibility
proposals.

Corporate Governance Proposals

Usually refers to bylaw amendments that limit the range of options open to the board in managing the firm (limited, however, to
the restrictions under 14 a 8) or structural reforms on the board, such as the number of directors and the way they shall be
elected (like in HP X CPF, where the shareholder proposed an amendment so that directors are elected by majority rather than
plurality vote). There was a case where the company (HP) wrote a “no-action request” to the SEC, seeking to exclude a
shareholder’s (CPF) proposal from the company proxy on the grounds that the CPF proposal had already been “substantially
implemented” and therefore excludable under Rule 14 a 8 (i) 10.
The SEC, however, declined HP’s request on the grounds that the governance policy adopted by HP until then requires only that
a director nominee who received a majority “withhold” vote in an election shall tender his resignation, what is different from
saying that a director must receive a majority vote to be elected or reelected. Under the present governance policy, an incumbent
director who doesn’t receive a majority vote will remain in the board, unless he receives a “withhold” vote. Under the proposal,
however, an incumbent director who failed to receive a majority vote is succeeded by a nominee who received a majority vote. If
no successor has acquired enough votes to be elected, the incumbent director who failed to receive a majority vote to be
reelected shall tender his resignation to the Board of Directors, which will decide whether to accept or reject the tendered
resignation, or whether other action should be taken.
The Delaware Statute solved the problem originated when there are insufficient votes to reelect an incumbent director and
insufficient vote to elect a successor in favor of the incumbent board, by stating that “each director shall hold office until such
director’s successor is elected and qualified or until such director’s earlier resignation or removal” (DGCL 141 b and 216)

Corporate Social Responsibility

This is the shareholders right to place proposals in the corporation’s proxy statement disapproving certain activities, which are
lawful but have a degree of immorality. This right has to be conciliated with the management’s right to exclude any proposal
which interferes with the “ordinary business” of the company (Rule 14 a 8 (i) 7). There was a case where SEC agreed that the
company (Cracker Barrel) could omit a shareholder proposal which forced the board to prohibit employment discrimination
based on sexual orientation. The SEC concluded that employment-related matters fell within the “ordinary business” exclusion,
despite the fact that the proposal contained a social policy issue. In another “no-action letter”, however, the SEC stated that
employment-related proposals focusing on significant social policy issues could not automatically be excluded under the “ordinary
business” exclusion. Thus, the approach will be a case-by-case analysis.
The general idea is to avoid the shareholders from interfering with the “workplace practices”, such as the hiring, promotion and
termination of employees, decisions on production quality and quantity, and the retention of suppliers. However, proposals
relating to these matters but focusing on significant social policy issues generally would not be excludable.

The Antifraud Rule (Rule 14 a 9)

Rule 14 a 9 is SEC’s general provision against false or misleading proxy solicitations. There are three main requisites that should
be demonstrated by the plaintiff in order to receive damages from the directors for a violation of Rule 14 a 9 (usually it is better
for the plaintiff to sue under a Federal Rule, such as the Securities Act, rather than under the State Corporate Law, alleging a
breach of fiduciary duty, because in the Federal level there is no limits for damages to be recovered):

Materiality – The misrepresentation or omission in a proxy solicitation can trigger liability only if there is a likelihood that a
reasonable shareholder will consider it important in deciding how to vote.
Culpability – Some courts have adopted a negligence standard but others have required proof of intention or extreme
recklessness.
Causation and Reliance – It is not necessary for the plaintiff to demonstrate actual reliance on a misrepresentation to complete a
cause of action. Instead, it is required that the proxy solicitation was an essential link in the accomplishment of the transaction. In
order words, without the proxy solicitation the transaction wouldn’t occur.

Virginia Bankshares Inc. v. Sandberg (The materiality requirement was met because the director’s belief was considered enough
to be characterized as material to affect the shareholders votes. But the causation requirement was not met because the
transaction in question didn’t require the minority shareholder’s approval, and arguments that there was a “non-voting” causation
or that the approval was necessary to protect the transaction from future challenge are irrelevant to establish a causation link)
First American Bank of Virginia (Bank) was owned by VBI (holding 85% of the stock) and the public (holding 15% of the
stock). First American Bankshares (FABI), in turn, owned VBI (holding 100% of the stock) and wanted Bank to merger into
VBI. Because VBI was the controlling shareholder of Bank with more than 50% of its shares, it could approve the merger
operation without the minority shareholder’s consent. But still, VBI sent proxy solicitation to the public shareholders in order to
effectuate a “friendly” transaction and avoid future lawsuits by some dissatisfied minority shareholders. Therefore, the VBI
directors sent proxy solicitations to the public shareholders stating their opinion that $ 42,00 per share was a fair price,
recommending them to sell their stock. After the approval of the merger, one of Bank’s shareholder sued the board on the
grounds of violation of Rule 14 a 9, arguing that the opinion that $ 42,00 per share was a fair value was a misleading information.
Indeed, the jury found that the fair value for the stock would be $ 60,00 per share and, thus, each shareholder should receive $
18,00 as a compensation for the low price sold. The court concluded that the materiality requirement was met because, even
though the director’s statement in the proxy was an opinion or a belief, it had the power to persuade the shareholders from taking
an action and, thus, was material on deciding how to vote. However, the court decided that there was no causation between the
minority shareholder’s approval and the accomplishment of the merger, since the transaction didn’t require their consent.
One of the arguments raised by the plaintiff was that there was a “nonvoting causation” because VBI and FABI wouldn’t have
been willing to proceed with the merger without the minority’s approval. They wanted a friendly transaction as expressly stated
by FABI executives. But the court rejected this argument on the grounds that causation does not turn on inferences about what
corporate directors would have thought and done without the minority shareholder approval. The causation link must be analyzed
through an objective method and the question that should be done is whether the approval was necessary to accomplish the
transaction, not speculating what would be the behavior of directors if the minority had rejected the proposal.
The second argument raised by the plaintiff was that, under the state law, the minority had the right to attack the operation since it
resulted from a conflict of interest on the part of one of the Bank’s directors. Thus, the misleading proxy solicitation functioned as
a strategy to make the minority shareholders loose their cause of action by ratifying the proposal. The court also rejected the
second argument on the grounds that the minority shareholder’s approval, induced by a misleading proxy, would not render the
merger invulnerable to latter attack in case of conflict of interests and, thus, there hasn’t been a lost of a cause of action.

DUTY OF CARE (CORPORATE DIRECTORS)

Note: Derivative suit on behalf of the company for corporate waste (excused?)
Fiduciary Duties of a Corporate Director

The fiduciary duties of a corporate director are essentially three. The first is the “duty of obedience”, which provides that a
fiduciary must act consistently with the legal documents that create her authority. The second is the “duty of loyalty”, which states
that fiduciaries shall exercise their authority in a good faith attempt to advance corporate purposes. The third is the “duty of care”,
requiring that the directors should act with the care of an ordinarily prudent person in the same or similar circumstances. This last
duty, however, has been mitigated by the courts, the corporate statutes and the company’s charter in a variety of ways.

The Duty of Care

The reason why the duty of care shouldn’t be interpreted as a common negligence rule is to provide the correct incentives for
director’s action and avoid risk aversion problems. Because directors invest other people’s money, they receive only a small
fraction of the gains from a risky decision. Thus, under a negligence rule of liability, they would be discouraged from undertaking
valuable but risky decisions which wouldn’t bring them any gains and could render them personally liable. To avoid discouraging
directors from assuming valuable but risky decisions, a large framework has been constructed to protect them from liability for
breaching their duty of care.

Statute Protections

Reimbursement of Legal Expenses when Successful (DGCL 145 c)

There is a mandatory reimbursement of legal expenses when an officer or director was successful in the defense of any lawsuit.
Success is interpreted in a broad way as indicated in Waltuch v. Conticommodity Services Inc (the fact that the director didn’t
act with good faith doesn’t mean he can’t be successful in the lawsuit).

Indemnification of Legal Expenses when acting in Good Faith (DGCL 145 a)

The Statutory law authorizes a corporation to indemnify the expenses incurred by officers or directors who are sued by reason of
their corporate activities and were acting in good faith. The fact that the action was decided against the officer or director shall
not constitute a presumption that he did not act in good faith, i.e., in a manner which the person reasonably believed to be in the
best interests of the corporation.

Waltuch v. Conticommodity Services Inc (A clause in the corporation’s charter establishing the company’s obligation to
indemnify regardless of prove of good faith is contrary to Delaware Law and void (DGCL 145 a). However, the director had the
right to be reimbursed under 145 c since he had been successful in the lawsuit).
Waltuch, as vice-president of Conticommodity Services, spent $ 2.2 million in legal fees to defend himself against numerous civil
lawsuits and an enforcement proceeding brought by the Commodity Futures Trading Commission (CFTC). Waltuch claims to be
indemnified by such expenses on two grounds. First, the company’s charter provides that the corporation shall indemnify its
directors for the expenses actually and necessarily incurred by him in connection with the defense of any action. This clause,
however, didn’t require any prove of good faith and the board argued that it was invalid under Delaware Statute which limited the
corporation’s power to indemnify only in circumstances where the director acted in good faith.
Waltuch argued that section 145 f of Delaware Statute is broader than section 145 a, and it doesn’t limit the company’s power to
indemnify only when there is prove of good faith. The court decided that the Delaware Statute should be interpreted as an integral
body of law, and section 145 f could not conflict with section 145 a. Section 145 f referred to different matters, it does not speak
about corporate power and, therefore, it does not conflict with section’s 145 a requirement of good faith. Thus, the clause in the
charter is inconsistent with Delaware Statute and void.
However, there is still section’s 145 c mandatory provision that a company shall reimburse its directors when they are successful
in defense of any lawsuit. Conti argued that Waltuch wasn’t successful since the claims against Waltuch were dismissed only
because Conti’s payments on the lawsuits against it were in part on behalf of Waltuch. The court rejected this argument and
concluded that Waltuch settlement without payment was enough to determine he was actually successful in the lawsuits. Thus, the
company had the obligation of reimbursing his legal expenses on the grounds of 145 c provision, which does not require prove of
good faith, but merely success in the suit.

Directors and Officers Insurance (DGCL 145 g)

The Statutory law authorizes a corporation to purchase liability insurance for its officers and directors. In fact, most of the
corporations purchase insurance in order to avoid the risk aversion problem already discussed. The D&O insurance policies,
however, often cover liability only up to a certain limit and, scandals such as Enron or WorldCom, easily exceed the policies limit.
The coverage by the insurance company does not depend on demonstration of good faith, as stated in Waltuch v.
Conticommodity Services Inc (“whether or not the corporation would have the power to indemnify him against such liability
under the limits of section 145 a”). In practice, however, most of the insurance companies require that the director must have
acted in good faith.

Judicial Protection: The Business Judgment Rule (RMBCA 8.31 a 2)

Because corporate law is state law, there is no canonical statement of the “business judgment rule”, but the general idea is that
courts will refuse to decide whether the decisions of corporate boards are substantively reasonable under a test of the
“reasonable prudent person”. The standard of care required is lower than “reasonable”.
A decision constitutes a valid business judgment decision when (i) it is made by financially disinterested directors or officers; (ii)
who have become duly informed before exercising judgment; and (iii) who exercise judgment in a good faith effort to advance
corporate interests. (ALI # 4.01 (c)). Obviously, this rule does not protect “egregious behavior”, which is presumably assumed
to be action not in good faith.

Kamin v. American Express (The New York Court refused to interfere with the discretionary power of management, as long as it
is exercised in good faith and without conflict of interests).
The board of directors was facing two business possibilities. The first one was to distribute shares of DLJ to stockholders and the
second was to sell the shares in the market. Selling the shares in the market would render the corporation tax savings of $ 8
million, but on the other hand, the company would have to declare a loss of $ 25 million in the American Express financial
statement. The board decided to adopt the first option and two minority shareholders claimed that not selling the shares in the
market was a waste of corporate assets which violated the duty of care. The court held that this was clearly a business decision
without any inference of fraud or bad faith and fell within the discretionary power of the management. “It was enough that the
directors had considered and discussed the second option and reached the decision to adopt the first after being informed of the
advantages and disadvantages of each one”.
The second argument raised by the plaintiff was that there were four directors who acted in conflict of interest since they were
members of American Express Compensation Plan and, for that reason, decided with the only interest of maximizing the value of
the shares at the expense of the long-term value of the firm. Once more, the court rejected the argument because the Plan had
been approved by the entire board, consisting of 20 directors, and there was no claim showing that the other sixteen members
were controlled or dominated by these four.

Smith v. Van Gorkom (The Delaware Court decided that “grossly negligent” conducts are not protected under the business
judgment rule and the directors are liable. The reason why the court assumed this position, however, is that the conduct was in
the context of a “corporate sale”, which is the most fundamental transaction in the company’s life. In other contexts, the courts
usually do not apply the “grossly negligent” standard to prevail over the business judgment rule)
Trans Union is a publicly held company with unused NOL as its assets and a CEO called Van Gorkom who was planning to
retire. Gorkom arranges a sale to Pritzer at the cash price of $ 55,00 per share. The board approves the transaction based on
their own know-how about the company after a two hours meeting, without further analysis. The shareholders sued the board
arguing that, even though there was no conflict of interest or bad faith, the directors had acted “grossly negligent” by taking a
decision to sell the shares for an extremely lower price without enough information. Surprisingly, the Delaware court accepted the
plaintiff’s claim alleging that grossly negligent conducts were not protected under the “business judgment rule”. Grossly negligent
conduct was demonstrated by the evidence of selling the shares without making a credible valuation and without shopping to
other potential buyers. Therefore, the directors had to pay an additional $ 1,87 per share, or $ 23.5 million in total. The Trans
Union D&O policy covered the first 10 million but the remaining 13.5 million had to be paid by the board.

Cede & Co v. Technicolor (The Delaware Court decided that when a “grossly negligent” conduct is demonstrated, the board has
the burden of proving that the transaction was entirely fair, even if it didn’t cause injury to shareholders)
The facts are similar to the Van Gorkom case but the difference is that here the shareholders were not injured by the board’s
decision to sell the company because they had received full value for their stock (in fact more than the fair value!). However,
since the transaction was also effectuated in a grossly negligent manner (no credible valuation, the company wasn’t offered to
other potential buyers), the court decided that the business judgment rule fell and the directors had the burden of proving that the
transaction was “entirely fair”. The rationality behind this decision is that when the directors act in a “lazy” way in relation to such
an important corporate issue (selling its shares) they shall carry the burden of proving that the shareholders didn’t suffer any injury
at all (the mere possibility of a grossly negligent act causing injury to shareholders creates this burden of prove upon the board).
This ruling is slightly distinct from Smith v. Van Gorkom because after detecting a gross negligent conduct, instead of holding the
directors directly liable, the court shifted the standard from the business judgment rule to the entire fairness rule, at least giving the
opportunity for the directors to try to demonstrate that the transaction was entirely fair and escape liability.

Waiving Liability of a Director (DGCL 102 (b) 7)

After Delaware Court’s decision in Van Gorkom, the price of D&O insurance increased radically as well as the risk for
occupying a director’s position in a company. The Delaware Legislature reacted by establishing the provision 102 (b) 7 in the
Delaware Statute, which allows corporations to eliminate the personal liability of a director for monetary damages as long as they
acted in good faith and without intentionally violating the law (the plaintiff can still seek an injuction). This provision protects
directors more than the business judgment rule because even when the directors act in a grossly negligence manner, as long as
they are in good faith, they are not found liable. This avoids liability under Van Gorkom or Technicolor holdings.
In effect, most of the Delaware corporations adopted a 102 (b) 7 provision in their charters. Under the provision, the only way of
holding a director liable is by demonstrating that he didn’t act in good faith. The subsequent cases brought the issue related to the
meaning of “good faith”. Should the interpretation of “lack of good faith” be narrowed to circumstances of “conflicted
transactions” or can “lack of good faith” be inferred when there is evidence of profound inattention and indifference in face of a
duty to act? In the recent cases In Re Caremark International Inc. Derivative Litigation, Stone v. Ritter and In Re The Walt
Disney Company Derivative Litigation the suggestion is that to infer “lack of good faith” a very tough test is required. A single
profound inattention and indifference in face of a duty to act is not enough, it must happen systematically. These cases require
such “tough test” to infer “lack of good faith” even if the company doesn’t have a 102 (b) 7 clause in its charter, suggesting that
they have made the clause a mandatory provision instead of optional.

Emerald Partners v. Berlin (Even with a waiver of liability clause (DGCL 102 (b) 7), a complaint that contains a duty of care
claim shall not be dismissed at face. Directors still have the burden of proving entire fairness in order to maintain their good
reputation)
May Petroleum, a public corporation with a controlling shareholder, entered into transactions in which it acquired through merger
thirteen corporations owned or dominated by its controlling shareholder (who was also a director). The board of directors
approved the transactions and Emerald Partners, a minority shareholder in May, sued all May’s directors claiming that the
resulting transactions were unfair to May. The trial court dismissed the complaint against the “outside” directors on the theory that
they had no conflicting interest, were not shown to have conspired with the controlling shareholder and the corporation had a
waiver of liability for breaches of due care under DGCL 102 (b) 7. However, the Delaware Supreme Court reversed, alleging
that the directors would still have to prove “entire fairness” of the transactions under Technicolor rule. In fact, the directors
couldn’t be found liable because of the waiver of liability clause (they were acting in good faith so they have the protection) but
still the court decided that the claim shall not be dismissed at face and the directors have to carry the burden of proving “entire
fairness”. The only rationality behind this procedural rule is to make the board “clean” its image and maintain its reputation
towards shareholders.

Levels of Care

Indications of breach:
(i) the directors were given no documentation to support the adequacy of the price
(ii) the time spent to consider the proposal
(iii) no investment bankers were called to analyze the offer;
(iv) the adequacy of the premium cannot be measured by comparing it to the value of a minority position;
(v) the company was not “shopped” to other potential bidders;
(vi) the merger agreement in fact made it hard for the board to shop the company;
(vii) market price may be undervalued

Acted in bad faith or conflict of interest:

- Protection from reimbursement of successful defense in lawsuits
- Protection from D&O insurance (when the insurance contract doesn’t exclude losses that arise from “fraud” or “self-dealing”)

Acted in a grossly negligent way without being informed, but with good faith
- Protection from reimbursement of successful defense in lawsuits
- Protection from D&O insurance
- Protection from indemnities for legal expenses
- Protection from DGCL 102 (b) 7 (unless the “good faith” is challenged)
Note: Business Judgment Rule by itself doesn’t protect (Smith v. Van Gorkom)

Acted negligently but with good faith

- Protection from reimbursement of successful defense in lawsuits
- Protection from D&O insurance
- Protection from indemnities for legal expenses
- Protection from DGCL 102 (b) 7
- Protection from Business Judgment Rule (Kamin v. American Express) (disinterested, independent and informed. If one of
these elements is not present, the Business Judgment Rule falls)

Board Passivity

The scope of director liability for corporation’s losses might arise not only from business choices, in which the courts are usually
reluctant to impose personal liability, but also from failure to act under circumstances in which a reasonable alert person should
have taken action. In fact, it is less problematic to hold a director liable for passive violations of the standard of care because it is
less likely to distort director’s incentives. It is different to say that a director will be personally liable every time he takes a
managing decision which is not in the best interest of the company (tends to discourage risk averse persons from occupying a
director’s position), than saying that a director will be held liable only if he doesn’t act when there is a reason to be aware.

Plaintiff must show:

- “Red flag” (Graham v. Allis-Chambers Manufacturing Co) (hard burden on the plaintiff)
- Causation – the director’s action must have been able to avoid the injury (Barnes v. Andrews)
- If the injury resulted from violation of law, a “red flag” requirement is not necessary to attach liability (Federal Sentencing
Guidelines) but the plaintiff must still show “a sustained or systematic failure of the board to exercise oversight” (Stone v. Ritter
and In Re Caremark).

Francis v. United Jersey Bank (The defense of lack of knowledge or psychological incapacity does not exonerate a director from
exercising minimum standards of responsibility in the case of evident misconduct. Causation can be inferred if the objection or
threat of a suit would have avoid the continuity of the corruption)
Pritchard & Baird Inc. was a reinsurance broker owned by Sr. Charles Pritchard, his wife, Mrs. Pritchard, and their two sons,
Charles Jr. and William. They were also the four directors. Sr. Charles, died in 1973, leaving Mrs. Pritchard and the sons the
only remaining shareholders and directors. At that time, the sons took over management of the business and began to draw large
sums from the company’s account, characterizing them as “Loans”, which greatly exceeded profits. By 1975, the corporation
was bankrupt. The trustees in bankruptcy brought this suit against Mrs. Pritchard, who is the only solvent person to pay the
debts, alleging that she had been negligent in the conduct of her duties as a director of the corporation. In fact, Mrs. Pritchard
was not active in the business of Pritchard & Baird and knew virtually nothing of its corporate affairs. Besides her lack of
knowledge and experience with relation to the business, Mrs. Pritchard became incapacitated and was bedridden for a six-month
period due to the loss of her husband.
The court, however, rejected the defense that she “was old, was grief-stricken at the loss of her husband, sometimes consumed
too much alcohol and was psychologically overborne by her sons”. According to the court’s decision, when one is in the position
of a director there are minimum standards of responsibility to be followed which cannot be excused. The financial record of the
corporation clearly disclosed the excessive “Shareholders Loans” and a quick look at them would lead any rational person to
discover the corruption. Therefore, the lack of knowledge or psychological incapacity does not exonerate a director from taking
action towards such an evident misconduct.
A second issue is related to the causation relationship between Mrs. Pritchard’s inaction and the loss suffered by the plaintiff. For
a director to be held liable for negligent omission it must be demonstrated that course of action would have averted the loss. In
Barnes v. Andrews, it was held that “When the corporate funds have been illegally lent, it is a fair inference that a protest would
have stopped the loan, and that the director’s neglect caused the loss. But when a business fails from general mismanagement,
business incapacity, or bad judgment, how is it possible to say that a single director could have made the company successful, or
how much in dollars he could have saved?”. In that case the court concluded that there was nothing the director could have done
to prevent the loss. Here, however, the court decided that causation could be inferred since Mrs. Pritchard objection or the
threat of suit would have deterred her sons.
The question that arises is how far do the courts require directors to act if a mere objection doesn’t prevent the misconduct? In
most instances, an objecting director who attempts to persuade fellow directors to follow a different course of action would be
absolved. Thus, protesting and resigning are usually enough to protect a director from liability

Graham v. Allis-Chambers Manufacturing Co. (When there is no reason to be suspicious of wrongful act carried by officers and
employees, the directors are not required to install monitoring controls into the wide corporate structure)
The shareholders of Allis-Chambers brought an action on behalf of the corporation against its directors to recover fines paid by
the company for violation of the antitrust federal laws. Even though the illegal activity was undertaken by the Allis-Chambers
employees without knowledge of the directors, the plaintiffs argue that the board failed to install internal control to monitor the
business policies and prevent the antitrust activity. The court rejected the claim based on two main reasons.
First, the directors are entitled to rely on their officers and employees in the absence of cause for suspicious. There is no duty to
install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists. As
soon as the directors took notice of possible price fixing, when TVA proposed an investigation, they issued a policy statement
relating to antitrust problems and initiated a series of meetings with all employees to eliminate any possibility of further violations
of antitrust laws. Before that moment there wasn’t a “red flag” to warn the board of illegal practices. In addition, the two FTC
decrees issued twenty years ago were not sufficient reason to alert the board of potential antitrust violations since some of the
directors had no connection with the company at that time and the company has not in fact been found guilty of quoting uniform
prices.
The second reason for absolving the directors from personal liability is connected to the corporate structure. Allis-Chambers is a
huge enterprise which employed more than 30.000 employees and adopts as the operating policy a decentralized arrangement,
where the prices of products (and many other business issues) are ordinarily set by the particular department manager. Thus,
considering the complexity of the venture’s operation, the board is required to control the broad policy decisions, but not the
price of the products of each department.
Note: The employees and officers could be held personally liable in this case for violating the law and causing loss to the
company, but probably they wouldn’t have enough assets to cover the fine recovery.

Beam v. Martha Stewart (There is no duty upon the directors to monitor the personal assets of a shareholder or a fellow director,
regardless if this person is important to preserve the image of the company)
Martha Stewart is a director, chairman, CEO and by far the majority shareholder of Martha Stewart Omnimedia (MSO), holding
94.5% of control rights and 45% of cash flow rights. She is also the “main asset” of the corporation because of her good
reputation and primary creative talent. Martha Stewart, however, used her personal assets to operate in the securities market
with privileged information, what draw the attention of the media and investigations. After the adverse publicity of such a “insider
trader” practice, MSO’s stock price had declined by more than 65%, reflecting the damaged reputation of Martha Stewart. The
minority shareholders of MSO sued the directors alleging breach of their fiduciary duty by failing to ensure that Stewart would not
conduct her personal, financial, and legal affairs in a manner that would harm the Company, its intellectual property, or its
business.
The court rejected the claim for two reasons. First it applied the “red flag” requirement held in Graham v. Allis-Chambers arguing
that there was no indication of reason to be suspicious of Stewart’s activities before her investments of ImClone stock became
public. Secondly, and most important, there is no duty upon the directors to monitor and investigate the personal affairs of a
shareholder or a fellow director. To the contrary, such an investigation is illegitimate and can even trigger liability under tort law in
favor of the person being investigated (Hewlett-Packard case).
Note that the shareholders wouldn’t have a cause of action even against Martha Stewart herself for breaching her fiduciary duty
as a controlling shareholder and director of the company. It is her business to decide where to invest her personal assets,
regardless if the investments are illegal. If Martha had an agreement with the company to conduct her personal affairs in such a
way to protect the company’s image, the stockholders could bring a claim alleging the breach of contract but not the breach of a
fiduciary duty, since there is no fiduciary duty in relation to the way a person conduce her personal assets.

In Re Michael Marchese (Federal Securities Law also impose negligence-based duties on directors, requiring them to adopt
internal control to ensure the accuracy of the financial reporting)
Federal Securities Law also impose negligence-based duties on directors, causing them to become as concerned about the SEC
enforcement actions as they are about shareholders suits under state law. Section 13(a) of the Exchange Act and Rule 13 a-1
require issuers of registered securities to file annual reports with the Commission and require that the information provided in
those reports must be accurate. In the present case, Marchese, an outside director of Chancellor, was found to be reckless in not
knowing that chancellor’s Form 10-KSB for 1998 contained materially misleading statements. There was plenty of evidence to
alert Marchese that the information provided was not accurate (“red flag”), such as the disagreement between the independent
auditors, but he failed to proceed with further inquiry. The SEC concluded that the lack of internal controls to ensure accurate
financial reporting was enough to conclude that Marchese failed to act in accordance with his duties imposed by the federal
securities law.
Under Corporate Law, the result could be different because of the causation requirement. The fact that Marchese had written a
letter expressing concern about Chancellor’s financial reporting and afterwards resigned from the board could be considered
enough to absolve him from liability (there was nothing more he could have done).

Federal Organization sentencing Guidelines

The Guidelines set forth a uniform sentencing structure for organizations convicted of federal criminal violations and provide for
major penalties. They offer powerful incentives for corporations today to have in place compliance programs to detect violations
of the law, to report violations promptly, and to make voluntary remediation efforts, which will reduce the fine imposed. Under
these Guidelines, the courts may hold directors liable, overcoming the decision in Graham v. Allis-Chambers. The courts,
however, haven’t required a strict compliance with the Sentencing Guidelines.
It was held in Stone v. Ritter (2006) that directors are only liable if: (a) the directors utterly failed to implement any reporting or
information system. . .; or (b) having implemented such as system . . . consciously failed to monitor . . . its operations thus
disabling themselves from being informed of risks or problems requiring their attention. . . Imposition of liability requires a
showing that the directors knew that they were not discharging their fiduciary obligations…”. In the same way, it was held in In
Re Caremark that “where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating
activities within the corporation, only a sustained or systematic failure of the board to exercise oversight will establish the lack of
good faith that is a necessary condition to liability”.

In Re Caremark International Inc. Derivative Litigation

Caremark has been required to pay $250 million for violating the terms of the Anti-Referral Payments Law, which prohibits
health care providers from paying any form of remuneration to induce the referral of Medicare or Medicaid patients. The
shareholders brought this suit on behalf of Caremark seeking to recover the penalty from the directors alleging that they failed to
implement enough internal control systems to make sure the employees wouldn’t engage in illegal practices. According to the
plaintiff, there was a “red flag” to warn the directors of possible illegal activity since Caremark’s predecessor has suffered prior
investigation and there was causation because the directors could have deterred the conduct.
After the adoption of the Guidelines, basic internal control systems are required to be implemented by the board, regardless if
there is enough cause for suspicious. In other words, directors do not have to wait a “red flag” to exercise their duty of
establishing minimum monitoring controls, in contrast to the holding in Graham v. Allis-Chamber. In conciliating the new rules
imposed by the Federal Organization Sentencing Guidelines with the common law doctrine of director’s duty of care in omission
cases, it was held that: “where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating
activities within the corporation, only a sustained or systematic failure of the board to exercise oversight will establish the lack of
good faith that is a necessary condition to liability”. In the present case there is enough evidence to indicate that the board acted
in a good faith attempt to be informed of relevant facts by implementing reporting systems and controls within the company.

Waiving Liability of a Director (DGCL 102 (b) 7) Mandatory?

It is suggested that In Re Caremark and Stone v. Ritter ruling have turned 102 (b) 7 into a mandatory clause instead of optional.
The ruling provides that no director who implemented a reasonable reporting system and acted in good faith will be held liable, in
the same way as the waiving liability clause requires a demonstration of “lack of good faith” to attach liability. However, it can be
argued that the clause is slightly more protective since it doesn’t require even the establishment of a reporting system, unless it is
necessary to characterize good faith.

Knowing violation of the law

The outcome is different when the directors are conscious about the illegal activities carried out by the employees or by
themselves.

Miller v. A.T.&T. (Directors who authorize an action which they know is illegal are not protected by the business judgment rule)
Plaintiff sued the board of directors of A.T.&T. for not taking any action to recover the amount owed to the company by the
democratic national committee (DNC), arguing it represented a contribution to DNC in violation of a federal prohibition on
corporate campaign spending. The court decided that, even if the illegal activity carried out by the director is “benefiting” the
corporation, the business judgment rule does not insulate directors from personal liability. Business decisions cannot overcome
the limits imposed by the law.

Why should shareholders have a cause of action?

A question that arises is: if the board of directors considers all the costs of violating the law (including the probability of being
caught multiplied by the value of the fine, reputation of the company, expenses with lawsuits) but decides that it is in the best
interest of the company to adopt the illegal activity (the benefits are higher than the costs), once the illegal practice was
discovered by authorities, why should the shareholders have a cause of action against the board?
The first consideration which must be done to answer this question concerns the nature of the statute infringed. If it is a criminal
statute there is an assumption of seriousness and of a matter which the Legislator considered fundamental to protect the public
interest. The decision to invest in a company concerns many factors besides the economic interests and the distribution of
dividends in the end of the year. An investor may also take into account the company’s behavior towards the environment, the
labor force and the community in general. It follows that he must be entitled to the reasonable expectations that the company in
which he invested will comply with the moral standards which motivated his investments.
On the other hand, if it is an infringement of a civil statute (breach of a private contract or a tort liability) it is easier to find
protection in the business judgment rule. If the directors in fact considered all the costs of violating the civil statute and reached a
consensus that it would be the most efficient option, the shareholders would have to accept the fact that the company will pay
damages without recovering from the directors.
In any event, because it is not clear whether the shareholders would have a cause of action against directors who consciously
violated the law to further the company’s interest, the result will be that the directors will opt not to violate the law (even if it is
economically better) to avoid the risks of personal liability.

THE DUTY OF LOYALTY (CONFLICT TRANSACTIONS)

The Duty of Loyalty

The fiduciary duty of loyalty is concerned with “interested corporate actions”, which includes self-dealing transactions between
the company and its directors or its controlling shareholder, appropriations of corporate opportunities, and compensation of
officers and directors. It is required that a corporate director, officer or controlling shareholder exercises his institutional power
over corporate property in a good faith effort to advance the interest of the company. The core of the duty of loyalty is aimed to
prevent the directors or controlling shareholder from taking advantage of his position on the corporation to benefit himself at the
expenses of the other stockholders.

Duty to Whom?
The first question which arises is to whom is the duty of loyalty owed? Most jurisdictions consider that the duty of loyalty is owed
to the corporation as a whole, including its multiple constituencies, such as stockholders, creditors, employees, suppliers and
customers. In this case, directors are induced to maximize the aggregating value for all the constituencies, not only for
shareholders. The management’s discretionary power is much larger since the directors can justify a business decision on a
variety of grounds (Pennsylvania adopts this approach)
On the other hand, the Delaware Law adopts the shareholder primacy norm, where the board must act solely (or at least mainly)
to advance the shareholders interests. In Dodge v. Ford Motor Co, the director and controlling shareholder announced that he
was acting in the interest of nonshareholders by retaining dividends and the court decided that the act was void because it was for
the primary purpose of benefiting others. (See also North American Catholic v. Gheewalla). However, Dodge v. Ford Motor
Co, is unique because of Mr. Ford’s public announcement. Nowadays, the courts have applied a flexible approach to the
shareholder primacy norm by deciding to absolve defendant directors who justify their actions by reference to long-term
corporate benefits.

A.P. Smith Manufacturing Co. v. Barlow (The board is allowed to make corporate contributions to social institutions without the
authorization of the shareholders, as long as it is a reasonable amount)
Shareholders brought this suit against directors because they have made a contribution to Princeton University without their
authorization. The plaintiff argues that the certificate of incorporation does not allow the contribution and that the new Jersey
statutes, which expressly authorize contributions which does not exceed 1% of capital surplus, does not apply to a corporation
created long before the statute’s enactment.
The court decided that the contribution was legal and in accordance with the limits of the New Jersey statute which must be
applied to corporations created before its enactment. Fifty years before the incorporation of A.P. Smith Manufacturing Co the
Legislature provided that every corporate charter thereafter granted “shall be subject to alteration, suspension and repeal, in the
discretion of the legislature”. Corporate contributions to academic institutions should be encouraged rather than deterred, as long
as it is modest in amount.

Self-Dealing Transaction
A self dealing transaction takes place when a corporation and one or more of its directors, or its controlling shareholder, directly
or indirectly (through another company in which the director or the controlling shareholder has a financial interest) enter into a
contract. It wouldn’t be economically efficient to void completely all of the self-dealing transactions because they can be mutually
beneficial as long as they are “fair”. However, because of the potential danger these transactions represent to the company and its
shareholders, some requirements should be met to validate them.

State Ex Rel. Hayes Oyster Co. v. Keypoint Oyster Co. (Disclosure by an interested director is fundamental to validate the
transaction, regardless if it was made in fair terms and didn’t cause any damage to the corporation)
Verne Hayes was CEO, director, and 23% shareholder of Coast Oyster, a public company, and also 25% shareholder of Hayes
Oyster Co, a family corporation. Hayes proposed to Coast’s board of directors the sale of some assets of the company for
Keypoint, a corporation which would be formed by one of Coast’s employees, Engman and Hayes. Engman agreed with Hayes
to sell 50% of the shares of Keypoint to Hayes Oyster Co. At a Coast shareholder’s meeting, the shareholders approved the
sale to Keypoint – Hayes voted his Coast shares and others for which he held proxies in favor. However, at any moment Hayes
disclosed his interest in Keypoint, keeping it in secret with Engman. When the interest transaction was discovered, Coast new
managers brought suit against Hayes and Sam (his brother who owns 75% of Hayes Oyster Co) for their Keypoint shares and all
profits obtained by Hayes as a result of the transaction. There is no evidence that the price of the sale was too low, neither does
Coast seek a rescission of the contract with Keypoint or claims that it suffered any damage. Instead, the plaintiffs argue that
Hayes acquired a secret profit and personal advantage in the acquisition of the Keypoint stock by virtue of his position in Coast
Oyster.
The court decided that nondisclosure by an interested director or officer is, in itself, unfair. Thus, regardless the fairness of the
value of the sale, Hayes should have disclosed his interest in Keypoint to Coast’s board and to other shareholders. The
shareholders have the right to decide to approve or not the transaction relying on the true facts and being aware that Hayes (as a
significant stockholder and director in both companies) might be placed in a position where he must choose between the interest
of Coast and Keypoint in conducting Coast’s business with Keypoint.
The remedy the court provided was to withdraw Hayes Oyster’s shares in Keypoint and give them to Coast Oyster. Certainly
Coast Oyster will be overcompensated because the value of the stock is worth more than the secret profit acquired by Hayes
and also Coast hasn’t suffered any damage. However, the court applied a punitive penalty in order to enforce the importance of
disclosure by an interested director. In addition, the fact that Sam will be injured by the court’s remedy (he owns 75% of Hayes
Oyster) is irrelevant. Sam knew that his brother was Coast’s director and owed a duty of loyalty to the company but still agreed
to purchase Coast’s assets by the intermediate of Keypoint.
Note: Haynes also owed an obligation to disclose his interest in Keypoint under the federal securities law, given that Coast
Oyster is a public company (Regulation S-K, Item 404 (a))

Controlling Shareholders also owe a Duty of Loyalty to the corporation

The reason why controlling shareholders are required to act with the same loyalty as the directors (under Delaware Law the test
is even tougher) is because they exercise a strong influence over the company’s decisions by electing the majority of the board
and casting a higher number of votes regarding the approval of a transaction at a shareholders meeting. If the shareholder has
50% or more of the controlling rights in a company he will probably owe such a duty, despite evidence that it did not exercise
actual control. A shareholder with less than 50 percent of the outstanding voting power of the firm may have a fiduciary obligation
depending on the actual exercise of control. The action for breach of fiduciary duty against the controller will be brought as a
class action on behalf of the minority shareholders.

Sinclair Oil Corp. v. Levien (A self-dealing transaction is characterized under a benefit-detriment test. If the interested transaction
didn’t cause the parent to receive something from the subsidiary at the expenses of its minority shareholders, the transaction is not
self-dealing and the appropriate standard must be the business judgment rule)
Sinclair owns 97% of Sinven’s stock and dominates Sinven’s board. The minority shareholder of Sinven sued Sinclair for the
excessive dividends paid by Sinven to Sinclair, precluding Sinven from performing industrial development. The Chancery Court
applied the test of “entire fairness”, requiring the controlling shareholder to prove that the distribution of dividends was entirely
fair.
However, the Supreme Court argues that the “entire fairness” standard shall only be applied when there is a self-dealing between
a parent and its subsidiary, which is not the case here. A self-dealing is characterized only when the parent receives something
from the subsidiary to the detriment of its minority shareholders. Therefore, to determine if the “entire fairness” standard should
be applied (with the burden of prove in the controlling shareholder), it should be inquired whether the transaction was in fact self-
dealing under a benefit-detriment test. The Supreme Court concluded that with the dividend declaration the minority shareholders
of Sinven also received a proportionate share of the money and Sinclair didn’t appropriate Sinven’s business opportunities.
The argument of the appropriation of business opportunities has to be viewed in light of the environment in which its subsidiary
was located (Venezuela). At that time, Venezuela was not growing and offering expansion industrial opportunities, thus, Sinclair
was not under a duty to expand its subsidiary. If the context of Venezuela demonstrated that the parent was in fact capturing
business opportunities of its subsidiary, the corporate opportunity doctrine should be applied and the “entire fairness” standard
would be appropriate.
In sum, payment of dividend for all of the subsidiary’s shareholders was rejected as a self-dealing transaction – under the benefit-
detriment test – as well as the appropriation of a corporate opportunity (Venezuela was not offering economic opportunities) and
the transaction must be treated under the business judgment rule.
Counter-argument: Controlling shareholders may assume corporate decisions that, as a formal matter, treats all shareholders
equally, but behind the arrangement he is in fact trying to advance his own personal interests (it may be distributing dividends
because it needs resources now)

Mc Mullin v. Beran (Even though the controlling shareholder was not selling the company to a counterparty in which he had a
financial interested, the fact that his own shares were the object of the sale (together with the rest of the shares) was enough to
conclude it was a self-dealing transaction. It was in the benefit of the controller to sell the shares all together because he would be
able to get a higher control premium, and, even assuming that the controller would look for the highest bid, the entire fairness
standard is the appropriate one. The court seemed to have abandoned the “benefit-detriment” test in order to classify the
transaction as self-dealing).
ARCO which owned 80% of Chemical agreed to sell Chemical to Lyondell at a price of $57,00 per share for all shares.
Chemical’s board of directors (dominated by ARCO) approved the deal solely on the recommendations of ARCO’s investment
banker. In a merger transaction approved by the board and the majority of shareholders, the minority is obliged to sell their share
at the price fixed. The minority shareholders of Chemical sued ARCO and Chemical’s director arguing that the sale was
improper and unfair. The self-dealing transaction is characterized in this case because the controlling shareholder persuaded the
board to sell the company with a personal interest in the sale (he owned the shares which would be sold). Even though it is
reasonable to assume that the majority shareholder will try to maximize the price of the shares (he will be advancing his own
interests) it could also be reasonable to assume, on the other hand, that it needed the money with urgency and would sell for the
first offer.
The Supreme Court considered the transaction as self-dealing since the board was completely dominated by ARCO and applied
the “entire fairness” standard. But under Sinclair Oil Corp. v. Levien a “benefit-detriment” test is required in order to characterize
a transaction as self-dealing and apply the entire fairness rule. Was the establishment of a single price for the sale of Chemical’s
shares at the benefit of the controlling shareholder and at the expenses of the minority (ARCO also has an interest in maximizing
the value of the share)? This case suggests that the “benefit-detriment” test from Sinclair Oil Corp. v. Levien is no longer required
to characterize a transaction as self-dealing and apply the entire fairness rule. As long as the controlling shareholder is interfering
in the business and affecting in some way the minority shareholders (regardless if there is evidence of damage to the minority or
not), the entire fairness rule shall be applied.

Approval by a Disinterested Board or Shareholders meeting (The Safe Harbor Statutes)

The approval by disinterested directors or shareholders began to play a key role in the defense of self-dealing transactions. Most
U.S jurisdictions adopted statutes providing that a director’s self-dealing transaction is not voidable solely because it is interested,
so long as it is adequately disclosed and approved by a majority of disinterested directors or shareholders, or it is fair (DGCL
144; NYBCL 713; Cal. Corp. Code 310). The Safe Harbor Statutes could be interpreted to mean that if the transaction has met
anyone of these requirements it is never voidable. The courts, however, usually adopts a narrower interpretation: when the
transaction has a high potentiality of being unfair, the defendant has to prove entire fairness even when it was disclosed and
approved by a “disinterested board” or shareholders (the courts would be more likely to adopt this narrow interpretation of the
Safe Harbor Statute in the case of self-dealing transactions between the company and its controlling shareholder because in this
case the board is not fully independent)

Cookies Food Products v. Lakes Warehouse (The approval by a “disinterested board” followed by the success of the company
(capable of inferring fairness) is enough to protect a self-dealing transaction involving a controlling shareholder, even though the
controller has been overcompensated for the services he provides to the company)
Herrig acquired majority control of Cookies Food Products Inc (“Cookies”) and replaced four of the five members of the
Cookies board with members he selected. Herrig also owns two other family corporations, Lakes Warehouse Distributing Inc
(“Lakes”) and Speed’s Automotive Co Inc (“Speed’s”). Under Herrig’s leadership, Cookie’s board has extended the terms of
the existing exclusive distributorship agreement with Lakes and expanded the scope of services for which it compensates Herrig
and his companies. Since Herrig became the majority shareholder of Cookies, in 1982, Cookies board has twice additional
compensation for Herrig as a result of his excellent performance as director and distributor. Even though the exclusive
distributorship contract with Lakes has increased Cookies sales extraordinarily due to Herrig’s hard work, Cookies minority
shareholders are dissatisfied because the company is not paying any dividends. In addition Cookies is a closely held corporation
so it is hard for the minority to sell their shares (who would buy them besides Herrig himself?). Thus, the minority shareholders
brought this suit against Herrig and his companies alleging that he has breached his fiduciary duty as Cookies majority shareholder
and director by executing self-dealing contracts with his other companies.
The court decided that the growth and success of Cookies is a reasonable criteria to infer fairness. Even though there is plenty of
evidence to demonstrate that Herrig is providing service for Cookies above market price, his commitment to increase Cookies
sales, growth and success and the profitable results achieved are enough to justify Herrig’s overcompensation. Under the Safe
Harbor Statute, the disclosure of the interested transaction and its approval by a disinterested board protects the transaction from
being void. The fact that Herrig had replaced almost all the board when he became the majority shareholder is not sufficient to
conclude that the board was interested. There must be more evidence of an involvement between the directors and the
transaction itself to consider that the board was interested and, therefore, that its approval won’t be a defense for the self-dealing
transaction. For these reasons, the court applied the Safe Harbor Statute to decide that the approval by the disinterest board
followed by the fact that Herrig’s actions benefit, rather than harmed, the company (what allows to infer some kind of fairness),
protects the self-dealing transaction.
The dissenting opinion argued that Herrig had the burden of proving entire fairness since it was a self-dealing transaction
approved by a dominated board (not fully independent because it was elected by Herrig). According to the dissent, the success
of the company does not prove that the matters of the self-dealing transaction were fair to the minority stockholders, especially
when dividends are not being distributed. Because Herrig had failed to demonstrate the fair market value for his services or
expenses for freight, advertising and storage costs, he cannot succeed and the self-dealing transaction must be void.
Note: the conflicting opinions in this case demonstrate the uncertainty when the self-dealing transaction between the controlling
shareholder and the company is approved by a board which is not fully independent (after all the board was elected by the
controlling shareholder and he can exercise powerful influence). Under Delaware law, the approval by a “disinterested board”
(which is not clearly disinterested) shifts the burden of proving unfairness to the plaintiff who is challenging the deal, but it doesn’t
validate the transaction per se.
An option that the controlling shareholder can adopt to avoid an entire fairness burden is to submit the transaction to the approval
of a “Special Committee of Independent Directors”. The idea is to assure the appearance of honest and independent judgment. If
the independent committee is considered really independent, the burden of proving unfairness shifts to the plaintiff.
The same uncertainty wouldn’t occur when the self-dealing transaction is between the company and a single director. In this case,
the full disclosure and the approval by the board can arguably protect shareholders interest, so the transaction is not subject to
the entire fairness test, but rather to the business judgment rule. There are, however, some opinions to the contrary. Professor
Eisenberg argues that there are two reasons why directors should still be required to prove entire fairness. First, directors have a
collegial relationship, making it hard to assume that they would vote with the same impartiality as if it was a transaction with a
third party. Second, it is hard to utilize a legal definition of disinterestedness in corporate law which corresponds to factual
disinterestedness.

Cooke v. Oolie (The approval by the board of a fully disclosed transaction involving two other directors is enough to apply the
business judgment rule)
Shareholder of The Nostalgia Network Inc (“TNN”) brought this suit against two of its directors, Sam Oolie and Morton
Salkind, alleging that they have elected to pursue a particular acquisition that best protected their personal interest as TNN
creditors, rather than pursue other proposals that offered superior value to TNN’s shareholders. Even though this case is not a
typical self-dealing transaction (the directors are not contracting directly or indirectly with the company) the court considered that
it should be treated in the same way since it is allegedly an interested transaction. Therefore, the provision of DGCL 144 is
applied by analogy. Considering that the two defendant directors had disclosed their interests and the transaction was approved
by two disinterested directors (who are more easily classified as disinterested since the transaction does not involve the
controlling shareholder, but rather their fellow directors), the safe harbor statute determines that the rule to be applied is the
business judgment rule, not the entire fairness test. The rationality is that when the proposal is approved by a board of
disinterested directors there is a signal that the interested transaction furthers the best interest of the corporation despite the
interest of one or more directors.

Summary

Approval by the Board (will be more or less significant depending on whether the interested directors participated in the decision
making)
Interested transactions between the company and its controlling shareholder: (Controlling shareholder defendant is NOT OK)
Mc Mullin v. Beran – Shareholder has to prove entire fairness.
Cookies Food Products v. Lakes Warehouse – Fairness could be inferred (but this doesn’t mean the court applied a business
judgment rule)
Interested transactions between the company and its directors:
(Director defendant is OK)
Cooke v. Oolie – Business Judgment Rule (As opposed to Professor Eisenberg’s idea)

Approval by disinterested Shareholders (Majority of the minority shareholders)

Always business judgment rule because there isn’t the problem of the shareholders not being fully disinterested. The standard to
evaluate the transaction is the “waste” standard, where a transaction will only be void if it represents waste of the company’s
assets. (Controlling shareholder and director defendants are OK)
(ALI # 5.02 (a)(2)(d))

Another issue discussed is related to the moment of disclosure. If the interested party only discloses his interests later, would the
ex-post ratification from the board or the shareholders still validate the transaction without subjecting it to a fairness test?

Approval by the Board (ex-post ratification)

Delaware Law – The ex-post ratification has the same effects as the ex-ante approval since the board could reject the transaction
after knowing about the interested party. (Controlling shareholder defendant is NOT OK; Director defendant is OK)
LIA – The board can face difficulties and costs to reject a transaction after it has been approved, but this doesn’t mean it agrees
with the interested transaction. Thus, the ex-post ratification doesn’t produce the same effects as the ex-ante approval; the
transaction must be submitted to the entire fairness rule (Controlling shareholder defendant is NOT OK; Director defendant is
NOT OK)

Approval by disinterested Shareholders (ex-post ratification)

The ex-post ratification has the same effects as the ex-ante approval. Always business judgment rule because there isn’t the
problem of the shareholders not being fully disinterested. The standard to evaluate the transaction is the “waste” standard, where
a transaction will only be void if it represents waste of the company’s assets. (Controlling shareholder and director defendants are
OK)
(ALI # 5.02 (a)(2)(d))

5.02(b)

Shareholders Waste Waste

Ratify

Director and Management Compensation

In the past, the structure of payment was based on fixed salary in order to reduce the risk problem (managers cannot diversify the
“investments” of their skills). Thus, a fixed salary would guarantee a return for their work in the company regardless of the actual
performance of the company. But this structure increased the “agency-costs” because managers were not compensated for the
good performance of the company, having no economic incentive to gather efforts to promote success. Thus, to better align the
interest of managers and shareholders and reduce the agency-costs of management, the compensation was complemented by
ownership interests in the company, through the traditional stock-option plans. But this incentive compensation has also a
problematic side. It is difficult to measure how much a particular manager contributed to the success of the company, what can
result in the “free rider” problem of managers who have been negligent in exercising their corporate responsibilities but still have a
proportioned share in the company’s success. To supervise these “free riders”, monitoring and governance costs have to be
incurred.
The idea of the stock-option plans is to grant “call options”, that is the right of buying the company’s shares in the future at a fixed
price (“strike price”). If the market value of the share at the moment of exercise of the call option exceeds the “strike price”, then
it will be profitable to exercise the option. The gain will be the difference between the market price and the strike price.
During the last 15 years companies have made astonishing payments to their CEOs. The compensation of CEOs and other board
members is usually ratified by shareholders or disinterested directors. The question that arises is whether the compensation can
be subject to judicial review after being ratified by shareholders or disinterested directors.

Lewis v. Vogelstein (Directors compensation which has been ratified by shareholders is only void if it is considered a “waste”)
The court held that stock option grants which were approved in good faith by a disinterested shareholder vote should only be
void if it the plaintiff can demonstrate it is a “waste” of corporate assets. Nevertheless, the claim shall not be dismissed at face
because further analysis is required to determine if the compensation is a “gift or waste” (Saxe v. Brady: “shareholders may not
ratify a waste except for unanimous vote”). The rationality of requiring a “waste standard” can be explained because the
shareholder ratification generates a presumption of fairness. The contract was negotiated and, even though the actual
compensation can be high, this can be the result of the manager’s hard work, deserving a proportional reward.

Does the CEO compensation require the shareholders approval to be valid?

No, the board has the authority to establish the CEO’s compensation. Senator Obama purposed a Bill which forced public
companies to hold an annual non-binding shareholder vote on executive compensation plans, but it wasn’t approved. The idea of
the bill was to constraint such astonishing payments by submitting them to the shareholders opinion. Even though the
approval/disapproval would be merely advisory, it would probably have an impact since the board wouldn’t be willing to grant a
compensation plan which has been disapproved by the shareholders. The argument against the Bill is that the companies where
the shareholders didn’t approve the CEO compensation plan may end up being harmed, since the CEO will receive this
disapproval as an invitation to look for another company (probably a competitor) which has more “flexible” shareholders,
accepting to pay him what he is asking for.

Corporate Loans to Officers and Directors

Delaware Law allows the board to authorize a corporate loan to a director or officer, as long as it is in the best interest of the
corporation (DGCL 143). The federal Sarbanes-Oxley Act of 2002, on the other hand, prohibits any corporation whose shares
trade on a national exchange or NASDAQ, or the subsidiary of such a corporation, from directly or indirectly extending any
credit to any director or executive officer of the corporation (SOA 402). This prohibition may bar, however, a number of
common corporation practices, such as advancing managers funds to buy stock, exercise options or even finance legal fees. After
all, the company could grant a loan with the condition that the money is used to exercise the options and buy its stock.
The SOA also requires that CEOs shall pay back incentive compensation which was based on financial misreporting (SOA 304).

Federal Interventions into CEO pay

IRC 162 – allows the company to deduce CEO payments below 10 million for tax purpose. If the payment exceeds 10 million
the company shall not deduce it, unless the payment is “performance related”. This provision resulted in even more incentive to
restructure the CEOs payment in the form of ownership interest, through stock option plans.
EESA – establishes a new limit for deduction: 500.000. When the payment exceeds this value it shall be counted for tax purpose.
In addition, this new statute bars compensation packages which encourage “excessive risk”.

Disclosure Duties
The SEC imposed rules requiring corporations to make a detailed public disclosure about the compensation of their top five
corporate officers. The idea was to constraint excessive compensation by pressuring the company to keep them reasonable.
However, this strategy is capable of producing exactly the opposite result. When the companies disclose their CEO
compensation and all the companies in the market and the CEOs themselves have access to this information, a competition
among the companies to pay better their CEOs is stimulated. CEOs will be able to pressure the board to increase their
compensation, arguing that he should gain above the average price because the service he provides is above average. He can
threaten the board to go to another company which will pay him higher compensation. Like any other form of fierce competition
in the buyers’ side of the market (in this case are the companies which are looking for CEOs), the tendency is that the seller
(CEO) can push the prices up.

In Re The Walt Disney Company Derivative Litigation (When the corporation contains a waiver 102 (b) 7 provision in its
charter, the only way the directors can be found liable is for actions taken in bad faith. Bad faith can only be inferred when there
is a sustained neglect in performing the objective duties imposed upon the directors by virtue of their position)
Disney’s board announced to the public that Ovitz would be contracted as President of the company and on the same day
Disney’s stock price rose 4.4 percent, increasing the market capitalization by more than $1 billion. The board interpreted this fact
as a signal that the public was approving the deal and proceeded with the employment agreement. In August 1995, Eisner, who
had been Ovitz personal friend for twenty five years, carried on the negotiations and fixed the terms by which the contract would
operate. However, it rapidly became clear that Ovitz was a poor fit for Disney. In November 1996, Eisner asked Disney’s
general counsel whether Ovitz could be fired “for cause”, which would have avoided the “non-fault termination” payment that
were established in Ovitz’s employment agreement. The counsel concluded that Ovitz could not be fired for cause and Disney’s
board had to fire him without cause, rendering Ovitz a gain of approximately $140 million. The shareholders sued the board
arguing that the directors had approved Ovitz’s employment agreement without adequate information and without adequate
deliberation, and that hey simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss.
The company’s charter contains the 102 (b) 7 provision, which protects directors who have acted even in a grossly negligent
manner, so the only possibility of condemning the directors is by concluding they have acted with “lack of good faith”. The
question that arises is whether “lack of good faith” can be inferred from indifference and inaction in the face of a duty to act.
As it was held in Stone v. Ritter, “imposition of liability for bad faith requires a showing that the directors knew that they were not
discharging their fiduciary obligations”. It is clear from this statement that knowledge is necessary, which means that there must be
an intentional misconduct or a conscious disregard for one’s responsibilities in order to conclude that the directors acted with
“lack of good faith”. Because it is impossible to identify the subjective intent of the director, the Delaware courts recognize that
bad faith must be inferred from the facts. However, the test to infer bad faith is a “tough-test”, the plaintiff must demonstrate
sustained and systematically neglect of the objective duties imposed upon the director, causing damages to the corporation. The
inattention must be so profound as to constitute “lack of good faith”. (Stone v. Ritter and In Re Caremark)
In the present case neither the board nor Eisner can be considered to have acted in bad faith. The old board didn’t really take
Ovitz’s employment seriously, in fact, it simply left all the work for Eisner. The final employment agreement differed substantially
from the original draft which had been rapidly approved by the board, but no further committee was implemented to review the
alterations. From this evidence it can be concluded that the board acted in a negligent way, but this conclusion wouldn’t be
enough to find the directors liable since they are protected by the business judgment rule (the CEOs compensation is in the heart
of the business judgment rule). Even if we consider that they acted in a grossly negligent way because they knew the importance
of the deal to the company and also knew that Eisner was Ovitz personal friend so it could be dangerous to leave the entire
negotiation in his hands, they wouldn’t be found liable because the charter contains a waiver of liability provision.
The facts are insufficient to prove that Eisner has acted in bad faith also. Even though Eisner was a personal friend of Ovitz, at
any time it was demonstrated that the contract celebrated by them contained unfair provisions and exceedingly favorable
conditions to Ovitz at the expenses of the corporation. Indeed, the facts indicate that as soon as Eisner realized that Ovitz wasn’t
doing a good job, he decided to fire him and tried to figure out the cheapest way of doing so. After being informed by the
company’s counsel that there was no way of firing Ovitz without cause, he relied on this conclusion and proposed to fire him
anyway. His conclusion was based on the assumption that, even though Ovitz would be entitled to receive a high compensation
(including the non-fault termination), it is better for the company to incur in this short-term expenses than maintain a president who
is clearly being inefficient. From these facts it can be inferred that Eisner’s action were taken with the subjective belief that those
actions were in the best interest of the company.
From this case it can be concluded that, when the corporation contains a waiver provision in its charter, the only way the
directors can be found liable is for actions taken in bad faith. Bad faith can only be inferred when there is a sustained neglect in
performing the objective duties imposed upon the directors by virtue of their position.

Corporate Opportunity
Under the duty of loyalty, a fiduciary shall not pursue a business opportunity on his own account if this opportunity might arguably
“belong” to the corporation. The American Law Institute (ALI) imposes a corporate opportunity clause in section 5.12. To
determine if a fiduciary “stole” a corporate opportunity, two questions must be considered. First, does the opportunity “belong”
to the corporation? And second, was the opportunity offered to the corporation? To answer the first question, three tests can be
applied:
Expectancy or Interest test – it’s the narrowest test; one must determine if the company has an interest in that particular
transaction according to the purpose of its creation.
Line of Business test – a corporate opportunity is any opportunity falling within a company’s line of business. Factors which shall
be considered: (i) how this matter came to the attention of the director; (ii) how far removed from the “core economic activities”
of the corporation the opportunity lies; and (iii) whether corporate information is used in recognizing or exploiting the opportunity.
Fairness test – it’s a more diffused analysis based on good faith and loyalty to the corporation.

In Re Ebay, Inc. Shareholders Litigation (The defendants were found liable under the corporate opportunity doctrine since the
offer was in the line of business of the corporation, it was offered to them by virtue of their position and they failed to offer it to
the corporation, which clearly had financial conditions to exploit it)
The defendants Pierre Omidyar and Jeffrey Skoll founded eBay, a Delaware corporation, as a sole proprietorship. In 1988,
eBay retained Goldman Sachs and other investment banks to underwrite an initial public offering of common stock. Goldman
Sachs began to engage in business with eBay, by serving as financial advisor and as lead underwriter of subsequent public
offerings. As a form of showing gratitude to eBay’s founders for choosing Goldman Sachs as its major investment bank,
Goldman Sachs “rewarded” the individual defendants by allocating to them thousands of IPO shares, managed by Goldman
Sachs, at the initial offering price. This was an extremely profitable opportunity offered by Goldman Sachs, since the prices of
initial stock offerings often doubled or tripled in a single day. Goldman Sach’s purpose with the consideration given to the
individual defendants was to induce continuity of business relationship with eBay in the future. The shareholders from eBay sued
its founders alleging that they were appropriating a corporate opportunity which belonged to eBay. It was concluded that the
opportunity did in fact belong to eBay. First, investing in the securities market was “in the line of business” of eBay. Second, the
founders were offered the opportunities by virtue of their position in eBay, since the purpose of the offer was clearly to induce the
continuity of business with eBay. Finally, the founders failed to offer the opportunity for eBay, which certainly had financial
conditions to exploit it and make large profits, as did the defendants.

Waiver of the corporate opportunity constraint

The Delaware law now allows corporations to adopt a charter provision waiving the corporate opportunity constraint (DGCL
122 17). This clause goes even beyond provision 102 (b) 7, since it permits the company to renounce a portion of the duty of
loyalty owed to the company by its controlling shareholders and directors. The adoption of this provision is a result of the Silicon
Valley entrepreneur’s pressure because they exercised closely related personal business. The entrepreneurs, who had their
personal related business, wouldn’t accept to serve as directors fearing that they may be held liable for contracting with a third
party for their individual business rather than for the company’s purpose. Therefore, the constraint imposed by the “corporate
opportunity doctrine” in their ability to pursue economic transactions related to the company’s business had to be mitigated.
However, the investors should be concerned with a corporation which adopts this provision because there is always the risk of
directors picking the best opportunities for themselves and leaving the company with the less attractive opportunities, and there
wouldn’t be anything they can do about it.

The Duty of Loyalty in Close Corporations

A close corporation is classified by the absence of a public market for the corporate stock. As a result, the number of
stockholders is small and there is substantial majority stockholder participation in the management, direction and operations of the
corporation. In a large public corporation, the oppressed or dissident stockholder can sell his stock in order to extricate some of
his invested capital. In a partnership at will, a partner who feels abused by his fellow partners may cause dissolution by his
“express will at any time” and recover his share of partnership assets and accumulated profits. By contrast, the minority
stockholders of close corporations are more vulnerable to opportunistic behavior of the majority shareholder since they cannot
sell easily there stock in the market and may become trapped in a disadvantageous situation. For this reason, under some states,
such as MA, the duty of loyalty required in close corporations is more rigorous than usual (duty of utmost good faith and loyalty).

Donahue v. Rodd Electrotype Co. (Under Massachusetts Law, in close corporations the duty of loyalty owed by the majority
shareholder to the minority is more rigorous, thus, in the case of the company repurchasing the shares of the majority shareholder
(even it the price is reasonable), the minority shall have an equal opportunity to sell its shares)
Rodd Electrotype, a close corporation, repurchased its own shares buying 45 of its controller shareholder shares for $800/share
– a price that reflected book and liquidating value. The minority shareholder, Donahue, offered to sell his shares to the company
on the same terms, but the offer was rejected. The minority sued the company arguing that the purchase of Harry Rodd’s shares
constitutes a breach of the fiduciary duty owed by the Rodds, as controlling shareholder, to her, a minority shareholder because
the Rodds failed to accord her an equal opportunity to sell her shares to the corporation.
Although the price of the repurchase was fair (the company was not overcompensating its controller shareholder) and there is no
requirement that a repurchase shall be made in a pro rata basis, the MA Court decided that the standard of behavior of the
majority shareholder in a close corporation must be the utmost good faith and loyalty (UGFAL) to the other stockholders. The
UGFAL is analogous to the fiduciary duty applied in partnerships under the holding in Meinhard v. Salmon). To meet this test, the
controlling shareholder must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of his
shares to the company at an identical price. The rationality behind the rule of equal opportunity in stock repurchase is to provide
a mechanism for the dissident stockholder to sell his ownership for a reasonable price since he has no alternative option to sell at
an open market.
This ruling makes the repurchase of shares a less attractive opportunistic strategy for the controlling shareholder, but still other
opportunistic behaviors could be undertaken against the minority shareholders will, such as restricting dividend distribution,
paying high salaries to the board and the CEO or hiring the controller shareholder as a consultant and offering him a generous
return (unless, obviously, the minority can demonstrate a breach of the duty of loyalty or care).

One year after Donahue v. Rodd Electrotype Co., the Supreme Court of MA stepped back, however, to qualify the duty of
“utmost good faith and loyalty” (QUGFAL) with a balancing test that recognized the controlling shareholder’s right of “selfish
ownership”
(Wilkes v. Springside Nursing Home, Inc.). Specifically, if the 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 alternative course of action less harmful to the minority’s interest”.

Smith v Atlantic Properties, Inc (Whatever the controlling shareholder’s right of “selfish ownership” established in Wilkes v.
Springside Nursing Home, Inc. may be, it cannot go beyond a point that causes damage to the corporation)
Atlantic Properties Inc was owned by four stockholders, Dr. Wolfson, Mr. Paul Smith, Mr. Abraham Zimble and William Burke,
each of them holding 25% of its stock. At Dr. Wolfson demand, the charter contained a provision requiring an affirmative vote of
80% of the capital stock in order to validate any act undertaken by the company. This quorum was designed to avoid abuse from
the controlling shareholder (three shareholders combined against one). However, it turned out that Dr. Wolfson takes advantage
of this provision to become the “controlling shareholder” himself by exercising his veto power to deny the distribution of
dividends. The failure to declare dividends might result in the imposition of a penalty under the Internal revenue Code (IRC),
relating to the unreasonable accumulation of corporate earnings and profits, and that was exactly what happened. Even after the
penalty assessments, which would continue until the dividends were declared, Dr. Wolfson persisted in his opposition. Dr.
Wolfson only reason to refuse the distribution of dividends was to avoid tax payments (but at that point the penalties had already
exceeded any cost savings for tax purposes), but he didn’t offer a legitimate plan to make a better use of the corporate funds and
improve Atlantic’s property. The other shareholders claimed a court determination of the dividends to be paid by Atlantic, the
removal of Dr. Wolfson as a director, and an order that Atlantic be reimbursed by him for the penalty assessed against it and
related expenses.
The court decided that, considering the duty of “utmost good faith and loyalty” in close corporations as is the case here, a
controlling shareholder cannot take serious and unjustified risk of causing the company to incur in penalties as a result of his
egocentric desire of refusing to declare dividends. Therefore, whatever the controlling shareholder’s right of “selfish ownership”
established in Wilkes v. Springside Nursing Home, Inc. may be, it cannot go beyond a point that causes damages to the
company.
Note that in this case, the three dissented shareholders had the option to force a statutory dissolution of the corporation since
only 40% of the vote is required. But even with this alternative, the court considered that the controlling shareholder cannot use
his power to cause the corporation to suffer damages.

SHAREHOLDER LAWSUITS

Shareholder Lawsuits

Having analyzed the content of the fiduciary duties of directors, officers and controlling shareholders, we now turn to the legal
procedures that facilitate their enforcement. There are two principal forms of shareholder suits: derivative suits and direct actions.
The derivative suit is brought by shareholders on behalf of the company. It is appropriate when the company has suffered damage
as a result of a director, officer or third party’s action. The injury to shareholders is only indirect (due to their position as
stockholders) and the remedy provided by the court will go directly to the company itself (although sometimes the court can
approve direct payment to minority shareholders. But this may offend corporate law and violate the creditor’s interest). The
direct action, on the other hand, is a shareholder claim to recover damages suffered by individuals directly (the damage suffered is
generally related to the board’s intention in carrying out the challenged course of action). It is usually brought as a class action,
that is, on behalf of a class of shareholders that suffered the damage.

Which one is appropriate?

In the majority of cases it isn’t clear which suit is more appropriate. Suppose a case where the board causes the company to
issue stock and sell it to a group of investor for a price below the market price in exchange for the promise of the new investor to
vote for the incumbent board for at least two election cycles. The company has suffered damage because its stock was
undervalued and the group of insurgent stockholders suffered damage because they were unable to succeed in the proxy fight due
to the opportunistic behavior of the incumbent board. Therefore, both kinds of actions are appropriate to sue the board and the
plaintiffs’ attorneys may choose to bring one of them or both at the same time.
Certainly, the shareholders will prefer the direct action since the money recovered in the litigation goes to their own pockets. In a
derivative suit, the shareholders/plaintiff would have to share the benefits recovered with the other constituencies of the company,
such as creditors, employees, suppliers and customers. But there are some cases, such as a self-dealing transaction between a
director and the company, in which the damage is clearly incurred by the company and only the derivative suit is adequate. On
the other hand, under some circumstances the only possible suit is a direct action because the company does no longer exist (in
Smith v. Van Gorkom, for instance, the shareholders had to bring a direct action because the company was the target in a merger
and disappeared).

Tooley v. Donaldson, Lufkin & Jenrette, Inc. (A shareholder has the right to bring a direct action whenever he can demonstrate
he suffered an injury, regardless if it is not a special injury but, instead, a injury shared by other shareholders)
The suit was brought by minority shareholders as a direct class action alleging that the board had breached a fiduciary duty to
them by agreeing to a twenty-two day delay in closing a proposed cash merger. The claim was that the extension of time to close
deprived them of the time value of the merger proceeds for the period of the delay. The Delaware Supreme Court stated the test
for determining whether a stockholder’s claim is derivative or direct, which is based on the following questions: (i) who suffered
the alleged harm (the corporation or the suing shareholders); and (ii) who would receive the benefit of any recovery or other
remedy (the corporation or the stockholder individually)? This test doesn’t require that the shareholder must have suffered some
special injury to be able to bring a direct action. As long as this particular shareholder suffered an injury, the fact that the other
shareholders also suffered an injury does not eliminate the possibility of a direct action.
In relation to the plaintiff’s claim, the Supreme Court rejected it because the shareholders had no individual right to have the
merger occur at all. From the corporation’s perspective as well, there was no wrong alleged. Nevertheless, if there had been a
claim stated, it would have been direct.

Derivative Suit

Attorneys’ Fees and the Incentive to Sue

In order to create incentive for shareholders to monitor the governance of the company (considering the collective action problem
faced in publicly held companies where all investors hold small stakes in the enterprise), the law must reward them for
prosecuting meritorious claims. When a derivative suit succeeds on the merits or settles, the corporation is said to benefit from
any monetary recovery or governance change resulting from the litigation. Thus, the courts have forced the company to reimburse
the shareholders/plaintiff for the costs expended in the suit whenever the result brings a substantial benefit to the company. As a
result, the corporation ends up bearing the bulk of litigation costs on both sides by advancing the costs of defense to its managers
and reimbursing the plaintiff for the attorney’s fees in case of success.

Fletcher v. A.J. Industries, Inc. (The facts that the company did not receive any pecuniary compensation, the action has not
produced a fund from which plaintiffs might be paid, and the result was achieved by settlement instead of a final judgment, are not
enough to conclude that the suit didn’t bring “substantial benefits” to the company)
Stockholders brought a derivative action against the board of directors of A.J Industries claiming mismanagement of the
corporation due to one of the director’s domination of its affairs, breach of his employment contract and to the excessive salaries
paid. The result was an agreement providing for the reorganization of the corporation’s board of directors and its management,
removal of one manager, and the amendment of the contract of employment disputed. The court interpreted this agreement as
bringing “substantial benefit” to the company and, thus, ordered the company to reimburse the attorneys’ fees and costs incurred
by the plaintiffs. According to this ruling, the reimbursement should be made regardless if (i) the company does not receive any
pecuniary compensation; (ii) the action had not produced a fund from which they might be paid; and (iii) the result was achieved
by settlement instead of a final judgment. None of these factors are enough to conclude that “substantial benefits” were not
derived from the lawsuit.
The court went even far in considering the amount of benefits resulted by the settlement. In addition to the benefits realized in the
form of immediate changes in the corporate management, the court also considered that the fact that plaintiffs accepted to settle
instead of litigating was an avoidance of cost and, thus, brought a substantial benefit to the company. If the case was litigated, the
company would have to advance the cost of defense to its managers and the settlement saved costs. But this approach is
somewhat exaggerated because the lawsuit only existed precisely because of the shareholders/plaintiff decision to sue and it is
unreasonable to reimburse them for avoiding a cost created by themselves.
The dissent emphasized the fact that if the resulting harm to the corporation by bearing the attorney’s fees exceeds by far the
“substantial benefits” derived from the lawsuit, the company can go bankruptcy.

On one hand, this broad interpretation of “substantial benefits” (which leads to plaintiff’s reimbursement) provides a good solution
for the collective action problem and generates incentive for small stockholders to monitor the corporate governance. On the
other hand, the ruling can generate incentives for the plaintiffs’ lawyers to initiate strike-suits, or suits without merit, simply to
extract a settlement. The board will prefer to settle considering: (i) the risk of personal liability if the case is litigated; and (ii) the
insurance company will bear the costs of the settlement (the costs won’t exceed the limits of the D&O insurance). Thus, even
though the lawsuit wasn’t meritorious, a settlement will be reached and the company will have to bear the attorney’s expenses of
both sides just because the settlement resulted in any kind of benefit for the company (even a benefit of saving litigation costs!).
A rule to encourage meritorious litigation but discourage strike suits could be designed in such a way that the company would
only be forced to pay the attorney’s fees if the plaintiffs demonstrated that the result of the litigation or the settlement brings: (i)
substantial benefit to the company which does not include payments to the company made by the D&O insurance since the
company itself has contracted this insurance (because the insurance would calculate ex-ante the premiums to be paid and will
charge higher premiums the more it has to cover expenses of litigation, see Joy v. North) ; or (ii) elimination of opportunistic or
inefficient managers or directors.

Standing Requirements to bring a Derivative Suit

Federal Rule 23.1, which Delaware follows, establishes four standing requirements. First, the plaintiff must be a shareholder for
the duration of the action (he wouldn’t have the correct incentives if he no longer has any financial interest). Second, the plaintiff
must have been a shareholder at the time of the alleged wrongful act or omission (the contemporaneous ownership rule which
precludes plaintiff from “buying a suit”). Third, the plaintiff must be able to “fairly and adequately” represent the interests of
shareholders, meaning in practice that there is no conflict of interest.
Finally there is the “demand requirement” which forces the shareholders/plaintiff to ask the board to initiate the suit.

Demand Requirement Fed Civ. P. Rule 23.1

The demand requirement is based on the presumption that the directors of a corporation and not its shareholders manage the
business and affairs of the corporation and, accordingly, the directors are responsible for deciding whether to engage in derivative
litigation. However, the demand can be excused when the plaintiff can demonstrate that: (i) the directors are interested or
dominated to make such decision; or (ii) there is a reasonable doubt that the challenged transaction is protected by the business
judgment rule (the Aronson two-prong test to demonstrate demand futility)

Levine v. Smith (The demand was not excused because there were still twelve disinterested directors in the board who were
capable of impartially considering the demand. Even though these directors had approved the challenged transaction (and have
been arguably negligent in doing so) they are still capable of considering a demand because their approval is protected by the
business judgment rule so there is no risk of personal liability)
Shareholders of GM brought a derivative action involving a transaction by which Ross Perot, a director and largest shareholder
of GM, and a few associates sold back to GM their holdings of GM Class E stock in exchange for $743 million. When selling its
stake, Perot also agreed not to compete with GM and to not publicly criticize the company. The suit named all directors, who
approved the transaction, and Perot as defendants, and claimed that the transaction paid Perot a premium for his shares for no
other reason than stopping his criticisms. The plaintiff’s claim of demand futility was based on the fact that the board is incapable
of exercising an independent authority to pursue the derivative claims directly because the seven inside directors were dominated
by Perot and the fourteen outside directors were dominated and controlled by the company’s management directors.
The court found that only two of the outside directors were actually incapable of impartially considering a demand, thereby
leaving at least twelve outside directors who were independent. The plaintiff argues that even these twelve directors, who didn’t
have a direct interest in the transaction, were so misled by management as to reach an uninformed decision in approving the Perot
buy-out. Because they had approved the challenged transaction without enough information and attention, they would prefer to
dismiss the suit in order to prevent personal liability. The court considered, however, that the approval of the Perot buy-out by
the twelve disinterested outside directors was protected by the business judgment rule (there was no gross negligence involved)
and, thus, they were capable of considering impartially the demand. The conclusion is that the demand was not excused and the
suit should be dismissed.

Rales v. Blasband (When the board which is required to consider the demand requirement is not the board which engaged in the
challenged transaction the second prong of Aronson shall not apply. However, the board can still be considered interested in
exercising its business judgment due to its relationship with the directors named as defendants in the derivative suit)
Shareholder-plaintiff Blasband owed 1100 shares of Easco Hand Tools Inc. (“Easco”) before the company entered into a
merger agreement with Danaher Corp. As a result of the merger, Blasband is currently a stockholder of Danaher Corp. Prior to
the merger, Steven Rales and Mitchell Rales (“the Rales brothers”) were directors of Easco, and together owned 52% of its
common stock. The Rales brothers were also members of the board of Danaher and owned 44% of its common stock.
The plaintiff’s complaint is the alleged misuse by the Easco board of the proceeds of the sale of that company marketable
securities. He argues that instead of investing in “government and other marketable securities” the board used over $61.9 million
of the proceeds to favor Drexel, a company which had engaged in prior business relationship with the Rales brothers. The
amended complaint alleges that the misuse of the corporate funds resulted in a loss to Easco of at least $14 million. The question
before the court is whether the board of Danaher can dismiss the lawsuit or is the demand excused?
The particularity of this case is that it is a “double derivative suit”, in which the shareholder-plaintiff of a parent corporation seeks
recovery for a cause of action belonging to a subsidiary corporation. The damage was suffered by the subsidiary corporation so
the action shall be brought on its behalf, but because the plaintiff is no longer its shareholder as a result of the merger, the
consequence will be a shareholder of a parent corporation bringing suit on behalf of its subsidiary. According to Aronson test, the
plaintiff may overcome the presumption of business judgment rule of the board to decide whether the derivative suit should be
brought or not, by demonstrating that: (i) the directors are interested or dominated to make such decision; or (ii) there is a
reasonable doubt that the challenged transaction is protected by the business judgment rule.
In this case the court considered, however, that the second prong of the Aronson test does not apply. This is because the board
to which the demand should be required (Danaher’s board) did not approve the transaction which is being challenged by
Blasband in this action. This situation arise in three principal scenarios: (1) where a business decision was made by the board of a
company, but a majority of the directors who made the challenged decision have been replaced; (2) where the subject of the
derivative suit is not a business decision of the board; and (3) where, as here, the decision being challenged was made by the
board of a different corporation.
Therefore, the plaintiff must demonstrate that the demand is excused based on the first prong. The question that arises is whether
the board could have impartially considered a demand at the time Blasband’s original complaint was filed. The court concluded
that the parent’s board was not independent to consider a claim against the Rales brothers because it was composed by: (i) the
Rales brothers themselves (who were obviously interest); (ii) directors who had business relationship with the Rales brothers
(who are unlikely to approve a suit against the Rales brothers because this would certainly affect their relationship with them); and
(iii) one of the directors was also a director of the Easco board and was named as a defendant. It is important to note that
normally the “mere threat of personal liability for approving a questioned transaction, standing alone, is insufficient to challenge
either the independence or disinterestedness of directors”. Aronson. But in this case, the Third Circuit has already concluded that
“Blasband has pleaded facts raising at least a reasonable doubt that the Easco board’s use of proceeds was a valid exercise of
business judgment”. Such determination indicates that the potential for liability is not a “mere threat” but instead may rise to a
“substantial likelihood”. Thus, the court concluded that the majority of the Danaher’s board could not exercise an impartial
decision because the board was dominated by the Rales brothers, who faced a substantial risk of being held liable. The demand
is excused

There is a difference in Delaware Law and ALI’s Principles/RMBCA in respect to the obligation of making demand. Under
Delaware Law, the shareholder-plaintiff can initiate a derivative suit without making demand to the board if he can demonstrate
that demand is excused. But once he demands, if the board refuses, he waives his right of claiming that the board is interested
with respect to the question to be litigated. “A stockholder cannot be permitted to invade the discretionary field committed to the
judgment of the directors and sue in the corporation’s behalf when the managing body refuses”. McKee v. Rogers. Then, the
only prong of the Aronson-Levine test that the plaintiff is left to contest in the event the demand is denied is the test’s second
prong, which asks whether bad faith or gross negligence may be inferred from the decision itself. The practical effect of this rule is
to discourage any presuit demand at all.
Under the ALI and RMBCA, on the other hand, the rule adopted is the “universal demand”, which means that a plaintiff would
be required to always make a demand, and if she was not satisfied with the board’s response to her demand, she could institute
suit. Then, the plaintiff must show that the board was not in a position to exercise a valid business judgment
Delaware: in practice, demand rarely made due to Speigel v. Buntrock presumption, and court screens based on two-part
Aronson/Levine test: P must establish either that directors are interested/dominated or must allege facts that “creat[e] a
reasonable doubt of the ‘soundness’ of the challenged transaction.”
RMBCA: must make demand unless irreparable injury (§7.42). If demand is refused shareholder may continue by alleging with
particularity that board is not disinterested (§7.44(d)) or did not act in good faith (§7.44(a)).
ALI: must make demand unless irreparable injury (§7.03), and if demand is refused and shareholder continues, court will review
board motions to dismiss derivative suits using a graduated standard: BJR for alleged duty of care violations (§7.10(a)(1)) and
reasonable belief in fairness for alleged duty of loyalty violations (§7.10(a)(2)), except no dismissal if plaintiff alleges undisclosed
self-dealing (§7.10(b)).

Special Litigation Committees

In response to the growing number of derivative suits brought by shareholders facilitated by the demand futility doctrine, the
managers of corporations reacted by adopting a Special Litigation Committee (or at the moment the suit is filled – more
appropriate to validate the SLC decision – or after the demand was already excused because the board is interested – less
appropriate). The SLC is composed by independent directors who are appointed by the board to investigate the challenged
action and decide whether the maintenance of the suit is in the best interest of the company. The first case was brought in a New
York Court and the authority of the SLC to dismiss the suit was upheld: “If a committee, composed of independent and
disinterested directors, conducted a proper review of the matters before it, considered a variety of factors and reached, in good
faith, a business judgment that the action was not in the best interest of the corporation, the action must be dismissed”. The issues
become solely independence, good faith, and reasonable investigation. The Delaware Court, however, in deciding Zapata Corp.
v. Maldonado applied a stricter test to enforce a SLC decision to dismiss a derivative suit.

Zapata Corp. v. Maldonado (In addition to the demonstration of independence, good faith, and reasonable investigation (the
SLC has the burden to prove), the court may exercise its own business judgment to decide whether the lawsuit shall continue or
not)
William Maldonado, a stockholder of Zapata, instituted a derivative action on behalf of Zapata against ten officers/directors of
Zapata, alleging essentially breaches of fiduciary duty. Maldonado did not first demand that the board bring this action, stating
instead such demand’s futility because all directors were named as defendants and allegedly participated in the acts being
challenged. The demand was excused and then the board appointed two new outside directors to the board. An “Independent
Investigation Committee” was created, composed solely of the two new directors, to consider if the suit should continue to
advance the company’s interest. After some inquiry, the Committee concluded that the action should be dismissed since its
continued maintenance is against the company’s best interest.
Is this technique to eliminate a derivative suit legitimate? Section 141 (c) allows a board to delegate all of its authority to a
committee and, accordingly, a committee with properly delegated authority would have the power to move for dismissal. But the
question should turn to whether it is legitimate for a SLC to dismiss a lawsuit which was properly initiated and demand upon the
board was excused because its members were incapable of exercising an impartial consideration on the matters of the litigation.
Some attention should be paid to the fact that the members of the SLC, even though can be formally disinterested, were
designated by the board itself and are being paid by the corporation. The court considered the following factors:
1) The suit was already in an advanced stage (four years of litigation) suggesting that some merit can be attributed to the claim;
2) The litigation has already imposed high costs on both sides (sunk costs which cannot be recovered) so now it should be
terminated;
3) If it is too easy for the SLC to get rid of the suit, the institute of derivative suit (as the main legal procedure available for
shareholders to enforce the fiduciary duties) could lose much of its effectiveness; and
4) The members of the SLC were designated by the board, which is self-interested in the litigation because the demand was
excused, and are being paid by the board.
In light of all these reasons to resist upholding the SLC motion to dismiss, the court concluded that a two-step test to the motion
should be applied. First, the corporation (through its SLC) shall have the burden of proving independence, good faith and a
reasonable investigation, rather than presuming these elements from the mere creation of a SLC. If the Court is satisfied with the
proof of independence brought by the SLC, it may proceed to the second step. “The court should determine, applying its own
independent business judgment, whether the motion should be granted”. The second step is a type of court discretion to impede
inappropriate suits dismissals, even if the SLC is disinterested. The court will consider not only the best interest of the company
but also matters of law and public policy.
Zapata’s two step test was narrowed by the subsequent decisions. In Joy v. North the court proceeded with the second step to
exercise its business judgment but it was made clear that the court should act considering exclusively the interests of the company
and not public policy. Moreover, in Carlton Investments the court refused to exercise its own business judgment in considering
the merits of the settlement, alleging that the “courts should not make such judgments but for reasons of legitimacy and for
reasons of shareholder welfare”.

In Re Oracle Corp. Derivative Litigation (Even though the defendant directors didn’t have a direct relationship with the members
of the SLC, the fact that they contributed to the institution where the members served was enough to challenge the degree of
impartiality required from the SLC)
Oracle stockholders brought a derivative suit against Oracle directors and officers alleging that they had engaged in insider trading
while in possession of material non-public information (breach of the duty of loyalty for misappropriating inside information). The
demand requirement was excused because Oracle’s board was not capable of exercising an impartial decision in relation to
whether the suit should be brought. A Special Litigation Committee was installed to evaluate if the lawsuit should proceed and,
after an extremely hard work, the SLC produced a lengthy Report totaling 1.100 pages that concluded that Oracle should not
pursue the plaintiff’s claims against the defendant Oracle directors.
The court applied Zapata’s test and concluded that the SLC has not met its burden of proving independence and good faith. The
two members who were designated to the SLC are both tenured professors at Stanford University, an institution to which the
Trading defendants Oracle made charitable contributions. Even though the members of the SLC, Grundfest and Garcia-Molina,
were not responsible for fundraising, neither were the Trading defendants in a position to affect their employment in Stanford, as
sophisticated professors they undoubtedly are aware of how important large contributors are to Stanford and they share the
benefits that come from serving at a university with a rich endowment. The rationality behind this rule relies on the social nature of
humans, who can, even unconsciously, favor particular interests at the detriment of others, especially when they share material
affiliations with one of the sides in dispute. The court does not challenge the good faith of the professors as engaging in a
conscious desire to favor the Trading defendants, but it recognizes that they were not situated in a position to act with the
required degree of impartiality.

And what if the court is satisfied with the SLC demonstration of independence and good faith, how may it exercise it own
business judgment in considering the dismissal of the suit? Must the court weigh matters of public interest as well as the private
interest of the firm? No. Joy v. North.

Joy v. North (In exercising its own business judgment the court should act as a loyal board would act, making a benefit-detriment
analysis of continuing the action)
Connecticut Court, in interpreting Zapata’s test, ruled that once the SLC has proved its independence and good faith the court
must proceed to a benefit-detriment analysis concerning the interests of the corporation. In exercising its own business judgment
the court’s function is to calculate the recoverable damages discounted by the probability of a finding of liability compared to the
costs to the corporation in continuing the action.
As the dissent vote argued, however, this calculus is unworkable for its complexity and subjectivism to judicial caprice. How is a
court to determine the inherently speculative costs of future attorney’s fees, time spent by corporate personnel preparing for trial
and mandatory indemnification? Should a court also take into account the potential adverse impact of continuing litigation upon
the corporation’s ability to finance its operation? Should future costs be discounted to present value and, if so, at what rate?
Should the ex-ante costs such as the premium of the D&O insurance be considered? Typically, the payment of the recovery will
be covered by the D&O insurance, not by the directors themselves, what will probably result in higher premiums in the future
paid by the company. Thus, is the recovery covered by the D&O insurance a real benefit?

Despite these difficulties in engaging in a benefit-detriment analysis, especially for courts, which are not equipped either by training
or experience to make business judgments, this approach does not follow Zapata’s holding of taking into consideration matters of
public policy. The exercise of business judgment by the court is not merely acting as a loyal board would act, but also the nature
of the misconduct in dispute and its repercussion in society. While for the company it might be better to dismiss a suit challenging
its directors for trading with insider information, for the reputation of the securities market in general it might be better to proceed
with the action. Therefore, under Zapata reasons of public policy could justify the continuity of the action even though it would be
in the best interest of the company to dismiss.

Classification of Costs and Benefits of Litigation to the Company

Ex Ante costs – D&O insurance
Ex Post costs – Attorney’s fees, indemnification (to both sides), time and reputation
Ex Ante benefits – Deterrence
Ex Post benefits – Recovery

However, both the ex ante and the ex post benefits can be analyzed in a critical way. The fact that the directors never (or almost
never) face out-of-pocket costs since the recovery is covered by the D&O insurance makes the deterrence a less effective
method of constraining wrongdoing by directors. Moreover, the fact that the recovery is covered by the D&O insurance and it is
the company itself the responsible for paying the premiums (which tends to increase correspondingly to the number of successful
lawsuit against the directors of that company) makes the recovery a “false” benefit. For these reasons, the derivative suit as it has
been structured and has been treated by the common law, has failed to protect the best interests of the corporation.

Settlement
The parties have strong incentive to settle in the typical derivative suit. Under DGCL 145 (b), shareholders-plaintiff (or their
attorneys) bear their own costs if they lose, and culpable managers may be charged with defense costs if they lose. On the other
hand, when the suit is settled, the company’s liability insurer picks up the costs of both sides. Who ends up paying is the company
itself, because the insurer will pass the settlement costs back to the corporation in the form of insurance premia. Sometimes a
Special Litigation Committee is installed to take control over the derivative suits in order to settle them.

Carlton Investments v. TLC Beatrice International Holdings, Inc. (The settlement proposed by the SLC must be reviewed under
the Zapata two-step approach, but the court should not exercise its business judgment against the merits of the settlement unless
it is necessary for reasons of legitimacy)
The action was brought by Carlton Investments, a substantial stockholder of TLC Beatrice, against certain past and present
directors and officers of TLC Beatrice for engaging in conduct constituting breach of fiduciary duty, corporate waste, fraud, and
conspiracy. The company installed a SLC to negotiate a settlement with the plaintiff and the result was brought to the court for
review. The settlement, negotiated by a SLC, must be reviewed under the two-step approach set forth in Zapata Corp. v.
Maldonado. The court considered that the SLC has proceeded in good faith and was well informed, reaching a proposed
settlement which falls within a range of reasonable solutions. In relation to the second step of Zapata’s test, the judge considered
himself incapable of exercising a business judgment against the merits of the settlement. In his opinion, the court should not make
such judgments, unless they are necessary for reasons of legitimacy, which is not the case here.

TRANSACTIONS IN CONTROL

Transactions in Control

Traditionally transactions in shares have escaped regulation by corporate law. What shareholders do with their own property –
their shares – has been seen as their own business and of no concern of the corporation or other shareholders. Over the past 50
years, however, corporate law has come to recognize that share transactions can raise problems that resemble those arising from
self-dealing and appropriations of business opportunities.

The control of a corporation is a practical matter, rather than a legal concept. It is characterized when the shareholder has enough
power to manage the company, appointing the majority of the board, exercising veto right and determining the broad directions
which should be followed. The number of shares necessary to have the control will depend on the total number of shares issued
by the company and the way they are distributed among the other stockholders. The investor who is willing to take over the
control of a public company has generally two methods. He can approach the largest shareholder and make him an offer to buy
its control block or make a general offer that is open to all shareholders (a tender offer) in order to aggregate the shares of many
small shareholders.

Control purchased from the controller shareholder

When blocks of shares large enough to control corporations are exchanged in the market, the seller usually charges a premium
for control. The premium is the added amount an investor is willing to pay for the privilege of directly influencing the corporation’s
affairs. Scholars have developed several hypotheses to explain why an investor would be willing to pay more than the market
price for a block of shares which will give him control of the company. The most popular explanation is the “private benefits of
control”, by which is meant a range of possible sources of value, from the power to capture salary, perks, and perhaps self-
dealing opportunities, to the prestige value of being the company’s indisputable boss. Other theorists suggests that control premia
are paid not by those seeking to harvest private benefits, but from buyers who have (or believe they have) a superior business
plan that will increase the value of the stock in their hands. This can be called “shared” or “public” benefits of control. Depending
in the reasons why the new controlling shareholder acquired the control, its business experience and its entrepreneurial skills, the
exchange in control can increase or decrease the company’s value. Thus, the premium received by the controlling shareholder
can be at the expenses of the company, where the new controller decreases the company’s value, or can allow the improvement
of the company by transferring its assets to one who will use them in a more profitable way. The question that arises in
transferability of control is whether the minority shareholders have the right sell their own stock to the buyer in the same terms as
the controlling shareholder did. This right could be justified in order to block inefficient transactions in control (by forcing the
buyer to purchase all shares under the same terms as negotiated with the controller, no private benefit extracted from his wholly
owned company would compensate the costs of paying the control premium to the entire class of stockholders).
Hypothetical Example of Inefficient Trade in Control
Suppose a company which has a total of 90 shares, where 45 are traded in the market and 45 are held by the controller. The
controlling shareholder decides to sell his stock for a purchaser who does not have better managerial skills to run the company,
but instead has a better ability to increase private benefits by engaging in opportunistic behavior:
Old Controller Looter
Total Firm Value 1000 900
Private Benefit 100 500
Net Firm Value 900 400
Minority share price 10/share 4.44/share

The old controller values its stake at (45 X 10) + 100 = 550, or 12.22 per share (550/45). The new investor values the stake at
(45 X 4.44) + 500 = 700, or 15.55 per share (700/45). Therefore, any value between 12.22 and 15.55 per share will be
profitable for both the seller and the buyer and the inefficient transaction will take place.
Under an equal opportunity doctrine, the new investor would have to offer to buy the minority’s shares in the same term as
negotiated with the old controller. If the new investor had to buy all the outstanding shares he would value the stake at (90 X
4.44) + 500 = 900 (equal to the total firm value), or 10 per share (900/90). Considering that the old controller wouldn’t accept
an offer lower than 12.22 per share, the transaction wouldn’t happen. The conclusion is that, as long as the old controller values
its stake above the market price (what is natural since he has the block of control), an equal opportunity doctrine would block
any inefficient transaction in transferring control (the new investor would never be willing to pay more than the market price and
the seller will refuse the offer).
At the same time, however, efficient transactions would also be blocked. Efficient transactions would be blocked because the
minimum cost for the new investor to buy the firm would be: 12.22 X 90 = 1.100 and he will only have incentive to buy if he can
increase the total value of the firm above this level. Thus, potential buyers who could increase the total value of the firm between
1000 and 1100 wouldn’t be willing to pay the minimum price at which the old controller is willing to sell, considering that he
would have to pay this price to all other stockholders. For efficient transactions to happen under the equal opportunity rule, the
new investor would have to increase the total value of the firm at a level above the prior total value of the firm plus the private
benefit extracted by the old controller (1000 + 100).
The conclusion is that an equal opportunity rule would deter inefficient transactions at the costs of discouraging efficient
transactions which would benefit the entire company, including the minority shareholders, by improving the quality of
management. On the other hand, the “market rule”, which means that the sale of control is a market transaction that creates rights
and duties between the parties but does not confer rights on other shareholders, could encourage potential efficient transactions at
the costs of allowing opportunistic behavior (as long as the private benefit extracted by the new investor exceeds the private
benefit extracted by the old controller, he would have incentives to purchase). The general rule adopted by U.S. jurisdictions is
the “market rule”, but the courts have created some exceptions. The courts generally refuse to give the minority shareholders the
right to sell their shares in the same terms to the buyer, but in some cases the minority may have the right to share the control
premium obtained by the controller.

Zetlin v. Hanson Holdings Inc. (As long as the controlling shareholder did not appropriate a corporate opportunity or acted with
fraud or self-dealing, the minority shareholders have no right to share the benefits of the premium paid for the controlling stock
interest)
Defendants Hanson Holdings Inc. and Sylvestri were the controlling shareholders of Gable Industries Inc., owning together
44.4% of its shares. The defendants sold their interest to Flintkote Co. for a premium price of $15 per share, at a time when
Gable stock was selling on the open market for $7,38 per share. Plaintiff Zetlin, who owns 2% of Gable’s shares, contends that
minority stockholders are entitled to an opportunity to share equally in any premium paid for the controlling interest in the
corporation. The court denies the plaintiff’s alleged right, arguing that such rule would restrict the transfer of a controlling stock
interest by requiring that the buyer makes an offer to all stockholders (a tender offer).

Perlman v. Feldmann (The court didn’t establish an equal opportunity right of the minority shareholders to the premium paid in
exchange for the control of the company, but it held that the breach of the duty of the controlling shareholder for selling a
corporate opportunity would give rise to an obligation of sharing the premium with the minority)
Minority stockholders of Newport Steel Corporation brought this derivative suit against Feldmann, the company’s controlling
shareholder, member of the board and president of the Corporation, for acquiring illegal gains as a result of the sale of its
controlling interest in the corporation, in breach of its fiduciary duty. Feldmann sold his control block of stock for Wilport
Company for a premium price of $20 per share, at a time when Newport stock was selling at the market for $10-12 per share.
The reason why Wilport paid such a high premium to obtain the control (almost 100% more than the market price) was to have
the power over the allocation of steel. Newport operated mills for the production of steel and Wilport was the end-user of steel
seeking to secure a source of supply in a market becoming ever tighter in the Korean War. In the context of steel shortage,
Wilport’s strategy was to takeover Newport, replace its board and purchase more of Newport’s steel than it could otherwise
have been able to get.
The court hold that the consideration paid for the stock included compensation for the sale of a corporate asset, a power hold in
trust for the corporation by Feldman as its fiduciary. This power was the ability to control the allocation of the corporate product
in a time of short supply, and could be used to advance the company’s interest as it was intended through the “Feldmann Plan”.
The plan consisted of securing interest-free advances from prospective purchasers of steel in return for firm commitments to them
from future production. Thus, instead of using this powerful corporate asset (control over steel supply) in the company’s
advantage, Feldman sold this corporate opportunity for personal gain (in the form of an unusual large premium) in violation of his
fiduciary duty as controlling shareholder and director of the corporation. Therefore, the defendant should share the benefits
derived from the large premium with the plaintiffs.
Unlike the general rule of derivative suits, where the corporation is entitled to the recovery, the court decided that the recovery
shall go directly to the minority shareholders. Even though the claim is in relation to the “sale of a corporate opportunity” and
apparently the right of recovery should go to the corporation, it wouldn’t make sense to share the benefits of the premium with
the larger shareholder of Newport, Wilport, which had paid the premium itself. Otherwise Wilport would be paying for a valuable
corporate asset (control over steel) and subsequently recovering a large part of the amount paid by virtue of his position as a
stockholder.
The dissent argued that the fact that Feldmann was able to sell its controlling interest for a large premium due to Wilport’s interest
in buying the stock to put in a board of directors who would be likely to permit Wilport’s members to purchase more of
Newport’s steel did not represent a violation of fiduciary duty. The breach of fiduciary duty would result if the seller knew that
the purchaser intended to exercise the power of management to the detriment of the corporation, but this was not the case here.

In Re Digex Inc. Shareholders Litigation (When the board cooperates with a transaction to transfer the control by waiving section
203, for instance, the minority shall be entitled to participate in the premium extracted by the controller).
An acquirer who desires to buy the entire company can either negotiate with its board a fair price for all its stock (in which case
the minority is entitled to a premium deal) or can buy the control block and then pursue a cash-out merger to eliminate minority
shareholders. Section 203 from the Delaware Statute, however, prevents a party who purchases control of a Delaware
corporation from pursuing a cash-out merger for a period of three years after the control was purchased. In the present case, the
controller shareholder wanted to sell its block of control separately and appropriate the entire control premium, instead of causing
the entire company to merge into the purchaser and having to share the premium deal with the minority stockholders. But to
convince the purchaser who wanted 100% of the company to buy initially only the control block, the controller had to guarantee
that a subsequent cash-out merger would be available for the buyer and, thus, it pressured the board to waive the applicability of
DGCL 203. The waiver of section 203 would facilitate the transaction, but the board does not serve exclusively the controller’s
best interest, it has to consider the interests of the corporation itself, including its minority stockholders. Thus, the waiver of
section 203 could only be justified if it is a condition to promote an efficient transfer in control (what is hard to conclude in
advance) or if some benefit is extracted from the controller in order to compensate for the cooperation. Because the board is an
agent for the entire corporation and not only for the controller stockholder, the chancery court has required a share in the control
premium when the board cooperates with the transfer in control transaction such as waiving the 203 protection. If the minority is
loosing a statute protection as a result of action of the board, it is reasonable to assume that it shall be compensated by
participating in the control premium.

Brecher v. Gregg (When the controller sells a corporate position together with the block of control the company is entitled to
share the premium given that corporate positions belongs to the corporation)
Gregg, the CEO of a public company, received a 35% control premium on the sale of his 4% block of stock, in exchange for his
promise to secure the appointment of the buyer’s candidate as the company’s new CEO and the election of two of the buyer’s
candidates to the board of directors. The New York court concluded that the CEO’s position belongs to the company and,
because part of the premium was paid as a compensation for this position, the company is entitled to share the premium.
Two relevant factors may indicate whether corporate positions were sold in exchange for the premium: the number of shares sold
and the amount paid. When a small stake is sold for a high premium there is a suggestion that corporate positions are part of the
deal because, otherwise, the purchaser could easily by the small stake in the open market and pay a much lower value.

Harris v. Carter (When there is a “red flag” indicating any reason to be suspicious about the honesty of the potential purchaser
the controller shareholder has the duty to proceed with further investigation and to refuse to sell its stake if it concludes that the
purchaser intends to misuse corporate assets)
The Carter Group controlled Atlas Energy Corporation holding 52% of its stock. Mascolo proposed an agreement to Carter in
which Mascolo would transfer its stock position in Insuranshares of America Inc (ISA) in exchange for Carter’s block of control
in Atlas. The contract called for the resignation from the Atlas board of directors by the Carter designees in such a way as to
permit Mascola and his confederates to assume these board positions. Upon assuming control of Atlas, Mascolo caused the
board to effectuate self-dealing transactions designed to benefit members of the Mascolo group at the expense of Atlas. Atlas
minority shareholders brought a derivative suit against Mascolo to try to recover on behalf of the corporation the looted funds.
The complaint attacks Mascolo defendants for breaching their fiduciary duty of loyalty by engaging in self-dealing transactions
and adds the Carter Group (the past controller) as a defendant, alleging that it had reason to suspect the integrity of the Mascolo
Group but failed to conduct a cursory of investigation before accepting the proposal. The question before the court is whether a
controlling shareholder may under any circumstances owe a duty of care to the corporation in connection with the sale of a
control block of stock.
The court decided that when there is a “red flag” indicating any reason to be suspicious about the honesty of the potential
purchaser the controller has the duty to proceed with further investigation and to refuse to sell its stake if it concludes that the
purchaser intends to misuse corporate assets. “When the circumstances would alert a reasonably prudent person to a risk that his
buyer is dishonest or in some material respect not truthful, a duty devolves upon the seller to make such inquiry as a reasonable
prudent person would make, and generally to exercise care so that others who will be affected by his actions should not be
injured by the wrongful act”.
In the present case, the minority shareholders can bring a direct action (as a class action) against the old controller to require the
share of the control premium or/and a derivative suit on behalf of the corporation which was also injured by the sale of control to
a looter (in which case the court would probably accept the suit as a derivate claim but grant the recovery to the minority
stockholders directly, otherwise the benefits would be shared with the looter). Obviously the minority shareholders also have a
claim against the current controlling shareholder and the current board for breach of fiduciary duty.

Does the market rule still prevail?

Yes, the general rule is the one established in Zetlin v. Hanson Holdings Inc., but four exceptions can be extracted from common
law:
1) Corporate opportunity sold in exchange for the control premium (Feldmann)
Derivative suit is appropriate but the recovery goes to the minority stockholders
2) Board cooperates with the transaction by waiving DGCL 203 (Digex)
Direct suit is appropriate (the minority stockholders clearly lost a protection)
3) Corporate positions were sold in exchange for the control premium (Brecher)
Derivative suit is appropriate but the recovery goes to the minority stockholders
4) “Red Flag” to suspect of Looting (Harris)
Derivative suit is appropriate but the recovery goes to the minority stockholders

Tender Offer

A tender offer is an offer of cash or securities to the shareholders of a public corporation in exchange for their shares at a
premium over market price. The tender offers used to be unregulated, so the offerors would make “Saturday Night Special”
offers that left public shareholders only 24 or 48 hours to decide whether to tender their shares, without providing any information
about the identity or plans of the offeror. The purpose of the offeror was to put pressure in the stockholders to tender their
shares. Indeed, the pressure to tender was strong because the minority shareholders knew that if the tender offer is successful
and the offeror acquirers a block of control, then the value of the minority share will fall due to the lost of power of a minority
shareholder to influence a company which has a controller, rather than being widely held.
The Williams Act sought to provide shareholders sufficient time and information to make an informed decision about tendering
their shares and to warn the market about an impending offer. Four main provisions were established in order to achieve such
objective. The first one is an “Early Warning System” (Rule 13d) which alerts the public and the company’s managers whenever
anyone acquires more than 5% of the company’s voting stock.

Early Warning System

Basic Rule (Rule 13d-1(a)): investor must file a 13D report within 10 days of acquiring 5%+ beneficial ownership. Partial
exemptions for Qualified Institutional Investors and passive investors.
Updating requirement (Rule 13d-2): must amend 13D promptly on acquiring material change (~ +/- 1%)
Key Definitions: “beneficial owner” means power to vote or dispose of stock (13d-3(a)); “group” is anyone acts together to buy,
vote, or sell stock (13d-5(b)(1)). Each group member deemed to beneficially own each member’s stock.
Even though the SEC proxy rules exempts institutional investors from the costly procedure of soliciting proxy when they
communicate with each other (as long as they are not asking for votes – Rule 14 a 2 (b) 1 – or as long as they are a group of less
than 10 shareholders – Rule 14 a 2 (b) 2), the Williams Act imposes a stronger burden upon the group of investors. Rule 13d-
5(b)(1) subjects a group of investors who act together to buy or sell stock to a costly procedure, which includes filling forms,
being exposed to antifraud provisions and to the threat of a lawsuit. This rule can operate as an obstacle to the coordination of
large shareholder institutions who want to buy or sell stock through a tender offer.

The second main provision is the requirement of general disclosure, including the identity of the purchaser, its financing conditions
and plans for any subsequent tender offer or going-private transaction. (Rule 14 d 1)

The third element of the Williams Act is an antifraud provision that prohibits misrepresentations, nondisclosures or fraudulent
practices in connection with a tender offer. (Rule 14 e)
Finally, the fourth element is a dozen rules that regulate the substantive terms of tender offers, such as:
- Tender offer must be open for at least 20 days (14 e 1)
- Tender offer must be made to all shareholders and pay all who tender the same best price (14 d 10) (eliminates the pressure to
tender because the first and the last shareholders who have tendered will receive the same amount on a pro rata basis)
- Shareholders who tender can withdraw while tender offer is open (14 d 7)
- Bidder cannot buy “outside” the tender offer (14 e 5)

The Williams Act purpose of granting shareholders a reasonable time to analyze the proposal and make an informed decision
brought a series of benefits to the potential sellers. First it opened the possibility of other interested buyers make more attractive
bids. By increasing the competition among the potential buyers, the sale price is adjusted above the market price and the control
of the company is transferred to the investor who values it most. In addition, the stockholders, with enough information about the
new controller, are now able to decide whether to sell or not their stock considering the future governance of the company and
the possibility that the new controller will decrease or increase its value. Statistics demonstrate that before the Act, tender offers
usually resulted in high benefits to the acquirer. Nowadays, however, the opposite result occurs, indicating that acquirers need to
pay a much large premium to buy the control of a public company after the Act.

In what circumstances a tender offer occurs and the buyer has to comply with the Act?
The SEC lists eight factors which authorities have considered in determining whether acquisitions constitute a tender offer under
the Williams Act. When many of these factors are met, the acquisition may be classified as a tender offer.
1) Active and widespread solicitation of public shareholders
2) The solicitation is made for a substantial percentage of the issuer’s stock
3) A premium over the prevailing market price
4) The terms of the offer are firm rather than negotiable
5) Whether the offer is contingent on the tender of a fixed minimum number of shares
6) Whether the offer is open only for a limited period of time
7) Whether the offerees are subjected to pressure to sell their stock
8) Whether public announcements of a purchasing program precede or accompany a rapid accumulation

Brascan Ltd. v. Edper Equities Ltd. (There was no de facto tender offer because only the second criteria set by the SEC was
met)
The facts can be summarized as follow: Edper decided to purchase an additional 3 million Brascan shares and, after some
difficulties in purchasing this high quantity of shares on the American Stock Exchange, Edper informed Connacher (president of
Gordon Securities) that it might purchase up to 3 million shares at a premium price if these were available. Gordon Securities
contacted between 30 and 50 institutional investors telling them that there was a potential buyer interested in purchasing 3 million
shares at 22 ¾ (which was several dollars above the market price). Edper authorized the sale at this price and by the end of the
day it had purchased 3.1 million shares. Brascan brings suit claiming violation of the Securities Exchange Act of 1934 section 14
e, because the transaction was a de facto tender offer and didn’t comply with the requirements.
The judge held that Edper did not make a de facto tender offer within the meaning of the Williams Act since only the second
criteria set by the SEC was met. These criterions, however, are very flexible and the same facts can lead to different conclusion.
It could be argued that, even though the offer was not expressly limited within a period of time, the potential buyer could change
his mind at any time and give up the proposal (6). When the institutional investors were contacted by Gordon Securities they
were aware about this danger of loosing the offer, so they were exposed to a certain degree of pressure to decide rapidly (7).
Moreover, it is clear that the buyer was interested in purchasing a minimum number of shares (5) and the sellers were advised
that he would only bid up the price (3) if a large number of shares were available. In sum, from the circumstances it could be
inferred that the buyer was really trying to acquire a block of control by paying a premium price to institutional investors through
an offer that could end at any time at his own discretion.

MERGERS AND ACQUISITIONS

Mergers and Acquisitions

Among the most important transactions in corporate law are those that pool the assets of separate companies into either a single
entity or an arrangement of a parent company and a wholly owned subsidiary. A merger is a transaction between two companies
where one of them absorbs the other. The company which was absorbed disappears (target company) and the “surviving
company” subsequently owns all of the property and assumes all of the obligations of both parties to the merger. Acquisitions are
the generic class of “nonmerger” techniques for combining companies, which generally involve the purchase of the assets or
shares of one firm by another (the target continues to exist).
Economic Motives for Mergers and Acquisitions
Gains from integrating corporate assets may arise from:
1) Economies of Scale – result when a fixed cost of production is spread over a larger output, thereby reducing the average fixed
cost per unit of output. Consider two companies, each with a widget factory that operates at half capacity. If the companies
merge, the “surviving company” might be able to close down one factory and meet the combined demand for its products at a
much lower cost. (considering horizontal mergers between firms in the same industry)
2) Economies of Scope – allow the costs to be spread across a broader range of related business activities.
3) Vertical Integration – a company can buy another one in a higher or lower stage of production in order to avoid transaction
costs of negotiating and monitoring contracts. Particularly when the firm’s input or output is highly specialized, that is appropriate
for the use of a single agent from the market, the transaction costs can be significant due to possible opportunistically behavior
derived from a dependent relationship.
4) Tax planning – corporations with tax losses (i.e., deductible expenses greater than income during the tax year) may set those
losses off against income in subsequent years for up to twenty years. This ability to carry a net operating loss (NOL) provides
itself a valuable asset, but only if its owner has sufficient taxable income to absorb it. Since an NOL cannot be sold directly, a
corporation that lacks sufficient income might prefer to find a wealthy merger partner rather than waste its NOL and both
companies can share the NOL’s present value.
5) Replacement of underperforming management – When the market anticipates that incumbent manages will mismanage the
company, its stock price declines and opens the opportunity for an outsider investor to purchase a controlling block of stock,
replace the management and make profit by increasing the value of the stock and selling its own shares later on. In this strategy,
the new investor would have to pay a control premium for the stock including the “sale of corporate officers”. The incumbent
managers receive part of this premium to resign and the new controller appoints its own management team.

Suspect Motives for Mergers and Acquisitions

Despite the positive motives that increase the value of corporate assets, there are also opportunistic motives to enter mergers that
increase shareholder value at the expense of another corporate constituency:
1) Freeze-out merger – when the stock is undervalued, the controller may acquire all corporate stock at a low price, at the
expense of the minority shareholders.
2) Monopoly Power – acquiring a competitor can be a strategy to eliminate competition and charge monopoly prices for its
products at the expense of the consumers.
3) Mistaken Mergers – the planners can misjudge the difficulties of realizing merger economies and fail to anticipate the added
coordination costs that result from increasing the size of a business organization.

Should a merger transaction require shareholders approval?

In most U.S. jurisdictions, the corporate decisions that require shareholder approval are merger, sales of substantially all assets,
charter amendments, and voluntary dissolutions. But how should the law draw the line between transactions that are completely
delegated to the board and those that also must be approved by shareholders?
1) Matters that are most economically significant – but this is not always true because managers can “sell the company” without
shareholder’s approval
2) Decisions that don’t require managerial expertise – dissolutions and M & A’s look more like investment decisions than
management decisions. The investors can make a valuation of both companies planning to merge without information about the
day-to-day business of the firm.
3) Agency problem can justify shareholders vote – transactions shall require shareholders approval when the board’s relationship
to its shareholders is changed in such a way that the shareholders loose the ability to displace their managers after the transaction
is completed. In other words, what constraints bad managerial decisions is the ability of shareholders to remove directors who
are mismanaging, but in some circumstances (such as a merger or a voluntary dissolution) the shareholders won’t have this power
because the company will disappear together with its board. In such cases shareholders need a prior protection to avoid
unwanted corporate decisions.
This justification can explain why, under the Delaware Law, the sale of substantially all assets require a vote by the target’s
shareholders (who will generally loose control over the board since the company is likely to dissolve after the deal) (DGCL 271
a) but does not require approval from shareholders of the acquiring company. In the same way, mergers require a shareholder
vote on the part of the target company (DGCL 251 c) but don’t require approval from shareholders of the acquiring company,
unless it is a stock-for-stock merger where the acquirer company will increase its outstanding stock by more than 20% (251 f).
This is because at this level, the transaction may shift the control of the acquirer’s company, particularly when its stock is widely
spread in the market (the company is more “vulnerable”) and the target company has a controlling shareholder holding a large
percentage of the target’s stock.

(??)
The company can get rid of shareholders vote and appraisal rights on the buyer’s side if it has authorized more shares than is has
issued. If there is enough quantity of unissued authorized shares, then the company can issue stock as compensation for the
merger without consulting its shareholders even when outstanding shares are increased by more than 20%. This strategy is only
valid for two-step mergers and if it is a publicly held company it still has to comply with the SEC regulations when issuing a large
amount of shares.

Steps to pursue a Merger transaction

Regulated by DGCL 251 (Classical Merger) and DGCL 253 (Short Merger)
1) Acquirer and Target’s boards negotiate the terms of the merger
2) Proxy materials are sent to shareholders who shall be entitled to vote on the proposal
3) Target shareholders always have the right to vote and acquirer’ shareholders only have the right if acquirer’s outstanding stock
is increased by more than 20%. (251 f)
4) In the case of approval by the shareholders, the Target’s assets merge into the Acquirer’s and the Target’s shareholders
receive either cash (cash-out merger) or the Acquirer’s stock in exchange. The Certificate of merger is filled
5) Dissenting shareholders are entitled to appraisal right.

Sale of Assets (Regulated by DGCL 271)

Differences in relation to Merger

1) Only the target’s shareholders are entitled to vote (and only when it is a sale of “substantially all assets” – because the
company is likely to dissolve after the deal). The purchaser’s shareholders are never entitled to vote, regardless of whether the
purchaser will increase its outstanding stock by more than 20%.
2) The transaction costs are higher. Titled assets such as land and automobiles must be transferred formally through documents of
title and by filling with an appropriate state office, as opposed to the merger where all assets owned by either corporation vest as
a matter of law in the surviving corporation without further action.
3) Liability costs are avoided.
Two reasons for a company to pursue an acquisition of assets instead of a merger are to avoid liability costs and to avoid
shareholders vote on the purchaser’s side.

What is a sale of “substantially all assets” that requires the approval of Target’s shareholders?

Katz v. Bregman (An asset which represented 51% of the seller’s total assets was considered to be “substantially all”)
The board of Plant Industries disposed of one of its subsidiaries known as Plant National Ltd. without its shareholders approval.
The subsidiary represented 51% of Plant’s total assets and generated approximately 45% of Plant’s net sales. Even though the
sale represented in fact only half of the corporate assets, the court considered it a “sale of substantial all assets” and granted a
preliminary injunction against the consummation of such transaction until stockholder approval was obtained. The court’s
conclusion to consider half of the assets as “substantially all” was probably induced by the fact that the board had refused to
consider higher bids for the assets in question, what indicated something inherently suspect about the relationship of the board
and the purchaser.

Hollinger Inc. v. Hollinger Intl (The court refused to consider an asset which accounted for 56% of the seller’s total assets as
“substantially all”)
The most recent interpretation of substantially all assets steps back from the position adopted in Katz v. Bregman. The court
considered the sale of the Telegraph Group, which accounted for 56 to 57 percent of International’s value. The decision clearly
rejected the possibility of such sale to be considered “substantially all”, holding that “Has the judiciary transmogrified the words
“substantially all” in DGCL 271 into the words “approximately half”?...A fair and succinct equivalent to the term “substantially all”
would therefore be “essentially everything”.

Stock Acquisition

A third transactional form for acquiring an incorporated business is through the purchase of all, or a majority of, the company’s
stock. To acquire a corporation in the full sense of obtaining complete dominion over its assets, one must purchase 100 percent
of its stock. There are basically three ways available to accomplish such purpose. The first one is through a tender offer, as we
saw above. The second one is available only for those shareholders who already control the company holding 90% or more of its
stock. In these cases, corporate law recognizes the right to cash out a minority unilaterally, called the easy-to-execute short-form
merger statutes. In the “short-form” mergers the controller shareholder can cash out the minority without their approval and even
without notifying them. Finally, some U.S. jurisdictions offer to the acquirer company the possibility of pursuing a compulsory
“share exchange”. This is, in effect, a tender offer negotiated with the target board of directors that, after approval by the requisite
majority of shareholders, becomes compulsory for all shareholders. The acquiring company’s stock (or other tender offer
consideration) is then distributed to the target’s shareholders pro rata, while the acquirer becomes the sole owner of all of the
stock of the target (the difference to the stock-for-stock merger is the continuity of the target)
As opposed to merger transactions, where the target company disappears and all its assets and liabilities are transferred to the
acquiring company, through the acquisition of stock the corporate identity of the target company is preserved. The maintenance
of the corporate identity offers the substantial advantage of preserving the liability shield that protects the acquirer from the risk of
assuming all the liabilities of the target company.
Delaware, however, has no compulsory share exchange statute. Nevertheless, corporate lawyers have developed a form of
acquisition that produces the same result of preserving the liability shield. That is the Triangular Mergers.

Mergers (Regulated by DGCL 251 and 253)

Triangular Mergers
This technique is done by merging the target into a wholly owned subsidiary of the acquirer, instead of merging into the acquirer
itself. In this structure, the acquirer forms a wholly owned subsidiary and transfers to it the merger consideration (which is
typically cash or Acquirer’s shares). Then, the Target company will merge into the subsidiary, if it is a “forward triangular
merger”, or the subsidiary will merge into the Target and the Target will be the surviving company, if it is a “reverse triangular
merger”. The merger consideration will be distributed to Target’s shareholders in exchange for their Target’s shares. Thus, after
the transaction, the Acquirer will own all of the outstanding stock of its subsidiary (or of the Target itself), which, in turn, will own
all of Target’s assets and liabilities.

Two-step Merger
In the two-step merger the boards of the target and the acquirer negotiate two linked transactions in a single package. The first
transaction is a tender offer for most of the target’s shares at an agreed-upon price, which the target board promises to
recommend to its shareholders. Once the control is purchased, the acquirer removes minority shareholders who failed to tender
their shares by pursuing a cash-out merger (when the merger consideration is cash) or a stock-for-stock merger (when the
merger consideration is the Acquirer’s stock). In the second step, the target’s minority shareholders are not entitled to vote
because the controller by himself represents a majority of the votes required to approve the merger. This technique offers a
considerable benefit to the acquirer.
First, the straight forward merger takes a lot of time to be completed (approximately 3 months), as opposed to a first-step tender
offer that generally can be pursued within 20 days. Thus, by securing as fast as possible the control of the company through a
tender offer (and later pursuing a merger), the acquirer can mitigate the risk of competition from potential third parties who may
be also interested in the Target company.
In addition, after acquiring the control, the controlling shareholder can simply cash-out the minority without their approval (they
are entitled, however, to appraisal rights as we shall see).

Timberjack Agreement and Plan of Merger

This merger was structured through the techniques of the “two-steps” and the “reverse triangular merger”. The acquiring
company (“Parent”) formed a wholly owned subsidiary (“Purchaser”) to merge into Timberjack (“Target”). First the Purchaser
commenced a tender offer to acquire any and all issued and outstanding shares of the Common Stock at a price of $25.00 per
share, including the condition that a minimum amount of at least 70% of the stock be available for acquisition. Subsequently,
Purchaser will merge into the Target company, resulting in the termination of the Purchaser and the Target shall continue as the
surviving corporation in the merger. Target minority shareholders will receive the same price per share that was paid in the tender
offer in exchange for their shares. The result is that the Target company becomes a wholly owned subsidiary of the Parent
company and the Target’s shareholder receive cash in consideration. The board of directors of the Target company will resign
and the directors of Purchaser will assume Target’s management.

The Appraisal Remedy

During the nineteenth century, corporate statutes required the unanimous consent of shareholders to perform a merger
transaction. Nowadays, most U.S. jurisdictions permit mergers and charter amendments that receive less than unanimous
shareholder approval, providing that they were recommended by the board and approved by a majority of a company’s
shareholders. Thus, the question which arises is: does a dissenting shareholder receive any protection or is he subject to the
majority’s desire?
In the United States, corporate law has granted the minority dissenting shareholder the opportunity to sell his shares back to the
firm at a price equal to their “fair value” immediately prior to the merger (appraisal right). The Delaware Statute mandates
appraisal only in connection with mergers and then only in certain circumstances (DGCL 262). Generally speaking appraisal is
only granted to shareholders who are entitled to vote in the specific transaction, but there are some exceptions. The sale of
“substantially all” assets, for instance, requires shareholders vote but the dissenting shareholders are not entitled to appraisal
rights. Short-term mergers, on the other hand, do not require shareholders vote but the dissenting shareholders are entitled to
appraisal rights. The claim for appraisal rights may derive from the context of a shareholder who disagrees with the business
judgment of its fellow shareholders or from a controlled merger (parent-subsidiary merger), where the controlling shareholder
itself is merging into the company (in which case the majority shareholder will always approve its self-dealing transaction).

The Market-Out Rule

The Delaware Statute denies the appraisal remedy if target shareholders receive as consideration of the merger the stock of a
publicly held corporation (the acquirer or any other corporation) which is listed on a national security exchange and has at least
2.000 shareholders (DGCL 262 (b)). The rationality behind this rule is that where the equity market is very liquid, the costs of an
appraisal procedure are not justified since the dissenting shareholder can easily find a buyer for his stock in the open market and
get rid of the unwanted investment. The appraisal remedy is mainly concerned with protecting minority shareholders who are
forced to accept an illiquid investment in a new company in which he had no desire to invest (but when its cash, appraisal is
available).
It is puzzling, however, why appraisal rights are available to dissenting shareholders who receive cash in consideration for their
target shares. In a typical cash-out merger, shareholders can claim appraisal rights to object the value paid for their stock.
Considering that cash is the most liquid form of consideration, why does Delaware Law deny appraisal rights for stock-for-stock
mergers (when it is a liquid investment) but recognizes the appraisal rights in cash-out mergers? One possible explanation (but not
satisfactory) is that in the case of cash-out mergers the minority shareholders are completely eliminated from the company against
their will, whereas in a stock-for-stock mergers the minority shareholder has at least the chance to continue his investments by
maintaining his stock position in the merging company. But the counter-argument is that not necessarily he will receive stock from
the Acquirer company, he may receive stock from a different publicly held company, and still be denied appraisal rights. A
second possible explanation is that maybe the courts are unwilling to value the stock received in consideration for the merger and
prefers to trust the price at which this stock is exchanged in the market. The problem is that even when the market price reflects
the real value of the stock received by target shareholders, they might have received a small quantity in proportion to their target
shares. In this case the courts should recognize the appraisal rights but they don’t.

The Nature of “Fair Value”

When the shareholder is entitled to appraisal rights, how are the courts suppose to calculate the “fair value” at which the company
must repurchase his shares? Traditionally, Delaware Law determined fair value for appraisal purposes by a technique known as
the Delaware block method. This technique examined a number of factors relating to a firm’s value: earnings of the firm and price
earnings multiples in the industry, asset values, and share market prices. After Weinberg v. UOP in 1983, the discounted cash
flow (DCF) methodology became the most common valuation technique in appraisal cases. This valuation includes a projection
of future cash flows and estimate of the appropriate cost of capital for discounting those expected cash flows to present value.
Under the new valuation, the minority dissenting shareholders receive not only the market price of the stock at the time prior to
the merger (equal to the value of a minority share), but also the control premium which reflects all future value that were present
at the time of the merger (value of the firm as a going concern). Despite the right to receive the control premium, the Delaware
appraisal statute explicitly excludes from the “fair value” any element of value that might be attributed to the merger (DGCL 262
(h)). But the court didn’t respect such limitation in Weinberg v. UOP when it calculated the “fair value” including the gains derived
from the transaction (because there was self-dealing involved). In sum, there are three possibilities of measuring the “fair value” of
the stock:
1) Value as minority shares (market price) - (Traditional method)
2) Value including the control premium (firm as a going concern) but excluding gains derived from the merger - (DGCL 262 (h))
3) Value including the control premium (firm as a going concern) plus the gains derived from the merger - (Weinberg v. UOP)

In Re Vision Hardware Group, Inc. (When the company is in the verge of bankruptcy the debt shall be valued at its face amount
instead of using its market value since the creditors have the right of forcing liquidation and causing equity holders to be left with
“empty hands”)
The Trust Company of the West (TCW) acquired Better Vision through a two-step merger. First it purchased 51% of Vision’s
stock and then it cashed out Vision’s public shareholders for total consideration of $125.000. The merger was negotiated by
Vision’s old board, which had no association with TCW, but the shareholder vote that approved the merger was dominated by
TCW’s control. A group of minority shareholders countered in an appraisal proceeding that the fair value of their shares was
really $15 million. The discrepancy between the value claimed and the value paid to cash-out the minority is explained because,
even though the two parties agreed upon the company’s enterprise value immediately before the merger (within the range of $82
to $102 million), they disagreed in the valuation of Better Vision’s outstanding debt at the time of the merger. Prior to the merger,
Better Vision was on the verge of bankruptcy due to its accumulated debt in excess of $125 million. At the time TCW purchased
all of Vision’s debt, it renegotiated with Vision’s creditors and reached a deep discount which reduced the debt to $56 million.
The discussion was whether the value of the debt should be the legal liability of the firm ($125 million, what exceeds the value of
the enterprise and, thus, would lead to the conclusion that the equity has no value) or the market value of the debt ($56 million,
what would lead to the conclusion that the going concern value of Better Vision was $40 million, or $2.54 per share). The
plaintiff’s claim was based on the preposition that the market value of the debt should be determinant in considering the value of
the firm as a going concern. The court, however, refused to apply the measure of the market value of the debt arguing that this
calculation was based on the presumption that the creditors of Better Vision would ultimately have been forced to agree to a re-
financing of the debt to a much lower face amount and that in this process the recognition of loss by the lenders would result in
the realization of gain by the holders of equity. The problem is that without injection of money by the buyer (TCW) the creditors
not only wouldn’t be forced to re-finance the debt but also were in a position to enforce the legal liability and to force the
company into bankruptcy. In this case, the company would be liquidated and the equity holders, the last ones to receive in the
distribution of assets, would probably be left with “empty hands”.
In Rapid-American Corp. v. Harris, on the other hand, the court valued the debt at market value for appraisal purposes, but the
difference was that the target company was not on the verge of bankruptcy. This means that creditors wouldn’t have the right to
force the liquidation of the company and, therefore, the equity holders should be entitled to the entire value of the enterprise as a
going concern.

The De Facto Merger Doctrine

As we saw, minority shareholders only have appraisal rights in connection to merger transactions. But should a merger be
regarded as a formal concept precisely defined by the corporation statute or should the courts adopt a functional approach?
Consider, for example, a sale of substantially all assets by one corporation in exchange for stock of the buyer, followed by
dissolution of the seller and distribution of buyer’s stock to seller’s shareholders. In effect, this resembles a stock-for-stock
merger, with buyer as the surviving entity that owns all the assets and the investors in both companies owning buyer’s stock.
Some courts have argued that arrangements that have the same economic effects as a de jure merger should receive the same
treatment and the minority shareholders should be entitled to the same protections, including appraisal rights. Delaware courts
and most of U.S. courts, however, have rejected the de facto merger doctrine on the grounds that corporate law contains a large
element of formalism that should be respected. It is argued that the provisions of the Delaware statute have “equal dignity” and
each transaction should be governed by its correspondent protection.
The leading case is Hariton v. Arco Electronics, Inc, where the court denied the interpretation of a de facto merger in a
transaction in which the company sold all its assets and was subsequently dissolved. “The right of the corporation to sell all of its
assets for stock in another corporation was expressly accorded to Arco by the DGCL 271 of Title 8. The stockholder was, in
contemplation of law, aware of this right when he acquired his stock”.
The RMBCA removes the issue of de facto mergers by giving shareholders a right to dissent and seek appraisal every time a
restructuring is authorized (RMBCA 13.02 (3))

Controlled Mergers
Controlled mergers are those ones effectuate between the controlling company with another company in which the controller is
financially interested, including parent-subsidiary mergers and the two-step mergers, where the acquirer first purchases the block
of control and subsequently accomplishes the merger (Cede v. Technicolor). These mergers expose minority shareholders to an
acute risk of exploitation for two reasons: (i) the board is usually dominated by the controller; (ii) the transaction doesn’t require
their vote because the controller already represents the majority vote required to approve the merger. These mergers are
described as “cash-out” (when the merger consideration is cash), “freeze-out” or “going private” mergers.
Because it is a self-dealing transaction, the fiduciary duty of loyalty owed by the controller to the corporation and its minority
shareholders requires that the merger is performed with entire fairness. A typical opportunistic behavior that was undertaken by
the controlling shareholders of publicly held firms during the 1960s and 1970s was to take advantage of the low market value of
the stock and cash out public shareholders at prices far below the pro rata value of the assets held by the company.

Should the minority challenge a controlled merger transaction through an appraisal action (when it is available) or a fairness action
alleging the breach of fiduciary duty?
In Weinberger v. UOP, Inc the court held that the appraisal right was the exclusive remedy to challenge a cash-out controlled
merger. However, this aspect of Weinberger v. UOP, Inc. was overruled by the Delaware Supreme Court in Rabkin v. Phillip A.
Hunt Chemical Corp. and in Cede v. Technicolor., where it was established that the dissenting minority shareholder can bring
simultaneously an appraisal action and a fairness action to challenge a “cash-out” controlled merger. The argument to overrule is
that a controlled merger is a self-dealing transaction, where there is space for fraud and opportunistic behavior to be undertaken
by the controller, so the minority shareholders should have the right to claim a breach of fiduciary duty. What is most interesting in
Cede v. Technicolor is that the court allowed the plaintiff to bring an action of entire fairness against the acquirer who pursued a
two-step merger, alleging that the acquirer owed a fiduciary duty to pay a fair price to the minority shareholders in the second-
step of the merger. It was argued that the acquirer, as the new controlling shareholder, could already exercise some influence
over the board and, thus, had the burden to prove that the price paid to the minority shareholders was entirely fair.
However, the minority cashed out in a 253 short-form merger (where the controller holds 90% or more of the stock) can only
challenge the transaction through an appraisal action (Glassman v. Unocal Exploration Corp. – appraisal is the exclusive remedy).

What are the differences between challenging the controlled merger through an appraisal action or a fairness action?
In some respect, an appraisal action is easier for shareholders to bring, since the plaintiff need only to establish his good faith as a
dissenting shareholder and does not need to demonstrate that the board or the controlling shareholder has breached a fiduciary
duty. In addition, the remedies provided under the fairness action are not necessarily more favorable, because it was decided in
Weinberg v. UOP that the Chancellor’s power are complete to fashion any form of equitable and monetary relief as may be
appropriate to compensate the injured plaintiff seeking appraisal, including rescissory damages.
In most other respects, however, an action alleging breach of entire fairness is more favorable to plaintiffs. First, appraisal may
not be available because of the “market-out” provisions of the statute (DGCL 262 b 1). Second, unlike an appraisal suit, an
action claiming breach of fiduciary duty can be brought before the effectuation of the merger, which provides the plaintiff with an
opportunity to request a preliminary injunction. Finally and most importantly, suits for breach of fiduciary duty can be brought as a
class action on behalf of all the minority shareholders, as opposed to appraisal actions which grants the remedy exclusively for the
plaintiff. Corporate lawyers usually prefer to bring class action alleging the breach of fiduciary duty because the fee they are
expected to earn is affected by the size of the group that they are representing. Moreover, it is in the discretion of the court to
decide who is going to pay the attorney’s fees in case of a successful appraisal action, whereas under successful class actions the
attorney’s fees are always reimbursed by the company.

Weinberg v. UOP, Inc. (The approval by the target’s board and by the target’s minority shareholders does not immunize the
transaction when interested directors do not disclose relevant information to the entire board and to minority shareholders)
The Signal Companies Inc, the controlling shareholder of UOP Inc., merged into UOP by cashing out UOP’s minority
shareholders. The plaintiff challenges the parent-subsidiary merger alleging the breach of fiduciary duty of the UOP’s board of
directors and UOP’s controlling shareholder and seeking appraisal to be entitled to the fair value of their stock plus rescissory
damages. The defendant argues that the transaction was approved both by UOP’s board (in which Signal had nominated only 6
of its 13 directors) and a majority of UOP’s minority shareholders. The facts occurred as follows: a feasible study was made
concerning the possible acquisition of the balance of UOP’s outstanding shares. Arledge and Chitiea, who were directors both
from the subsidiary (UOP) and the parent (Signal), concluded that it would be a good investment for Signal to acquire the
remaining 49.5% of UOP shares at any price up to $24.00 each. It was ultimately agreed that a meeting of Signal’s Executive
Committee would be called to propose that Signal acquire the remaining outstanding stock of UOP through a cash-out merger in
the range of $20 to $21 per share. The proposal was presented to UOP’s board composed by non- Signal directors and
directors who were also members of Signal’s board. Two directors who were also members of Signal’s board, particularly
Arledge and Chitiea, did not share their report of the top price that Signal was willing to pay with their fellow directors of UOP.
Without complete information, UOP’s board approved Signal’s offer to purchase stock at $21 per share and sent a letter to its
shareholders urging that the merger be approved. At the UOP’s annual meeting, 51.9% of the total minority voted for the merger
while only 2.2% opposed it (the rest of minority shareholders did not vote). Once again, the report indicating the top price that
Signal was willing to pay was not disclosed to the minority shareholders at the annual meeting. The question before the court was
whether the omission of the report by the directors constituted a breach of fiduciary duty which would give rise to the right of
minority shareholders to receive the “fair value” of their shares.
The court concluded that the transaction does not pass the test of entire fairness. The directors who made the report had used
confidential data from the subsidiary for the exclusive benefit of the parent, without disclosing their conclusions to the independent
directors of the subsidiary’s board and to subsidiary’s minority shareholders. It is not that the acquirer must reveal the maximum
price it is willing to pay, but if he wants to keep this information in secret, he cannot take advantage of nonpublic information
acquired by virtue of his position in the target company. The breach of fiduciary duty was reinforced by the fact that there was no
negotiation to reach the price at which the parent would cash-out the minority shareholders.
The approval by the board does not immunize the transaction from judicial scrutiny because it was not an independent board.
Even though there were some independent directors, they were misled by their fellow dependent directors who omitted some
essential information required to reach an impartial business judgment. It was suggested that the result “could have been entirely
different if UOP had appointed an independent negotiating committee of its outside directors to deal with Signal at arm’s length
because fairness in this context can be equated to conduct by a theoretical, wholly independent, board of directors.” The minority
shareholders approval is also insufficient since their own directors did not provide them with all the significant information related
to the merger to make an informed judgment.
For these reasons the court decided that the minority shareholders should be entitled to any form of monetary damages based
upon the “fair price” of the stock and including rescissory damages. On the one hand, the court declared that the appraisal is the
exclusive remedy to challenge a cash-out controlled merger (this aspect was overruled by Rabkin v. Phillip A. Hunt Chemical
Corp), but on the other, it expanded the remedy available under appraisal actions by establishing that when the transaction
involves fraud, misrepresentation, self-dealing or deliberate waste of corporate assets, the fair value to which a dissenter is
entitled includes a share of synergy gains derived from the merger. This was a deliberate rewriting of the Delaware Statute, which
expressly denies the inclusion of the gains derived from the transaction in the calculation of the “fair value” (DGCL 262 (h)). It
seems like the court was more concerned with granting entire protection to minority shareholders who were victims of self-
dealing transactions.

Why should corporate law allow controlled mergers at all?

First, they can bring benefits such as maximizing managerial efficiencies by centralizing the entire ownership in a single agent. The
single owner will have more economic incentives to check the board’s actions and maximize the company’s value.
Second, maintaining a company publicly held is very costly considering the costs of complying with SEC regulations and sending
proxy materials. Thus, “going private” may be a legitimate way to avoid these costs.
The only circumstance where we should be aware of controlled mergers is when the board which approved the transaction is
dominated by the controller shareholder. This is most of the cases where the controller has appointed the entire board, but there
can be cases where the controller has appointed a few members of the board or it can be that the controller has just acquired the
control and negotiated the price of the cash-out merger with the board before purchasing the block of control (Timberjack – a
controlled merger which presents no risk)

What is the standard of review to analyze a controlled merger?

- The plaintiff can bring both an entire fairness action and an appraisal action. (Rabkin v. Phillip A. Hunt Chemical Corp. and in
Cede v. Technicolor)
- The controller has the burden of proving that the transaction was “entirely fair”. (Weinberg v. UOP, Inc)
- Some strategies can be adopted by the controller to shift the burden to the plaintiff (the plaintiff has to prove that the transaction
was unfair):
(i) Parent notifies Target of “going private”;
(ii) Target sets up a Special Committee of Independent directors to negotiate the deal with the parent (usually lawyers and
investment bankers are called to support the special committee);
(iii) The negotiated price between the Parent and the Special Committee is subject to approval by the majority of the minority
shareholders.
But even after all these methods to indicate an arm’s length transaction, the only effect is to shift the burden of prove of entire
fairness to the plaintiff (what is already a substantial benefit for the controller), but not to defer to the decision of the Independent
Committee under the business judgment rule. The conclusion that can be extracted is that if the controller really controls the
company (there is no standstill agreement to restrict the number of directors that the controller can appoint to the board, like the
one in In Re Western National Corp. Shareholders Litigation) the most favorable situation he can reach to proceed with a
controlled merger is to shift the burden of prove to the plaintiff.

Kahn v. Lynch Communication Systems, Inc. (When the controller threats the Independent Special Committee, its approval does
not shift the burden of prove to the plaintiff since there is reason to be suspicious about the consensual price)
Alcatel owned 43.3% of Lynch and wanted to acquire the entire equity interest in Lynch. It approached Lynch’s board and
proposed to buy the remaining 57% of Lynch shares for $14 cash per share. The Lynch’s board adopted a resolution
establishing an Independent Committee to consider the offer. The Independent Committee determined that the $14 per share
offer was inadequate and Alcatel responded with an offer of $15. The Independent Committee considered $15 also insufficient
and Alcatel raised the bid to $15,25. The Independent Committee rejected once again, and Alcatel made its final offer of $15.50
per share advising the Independent Committee that if the offer was rejected it would proceed with an unfriendly tender offer at a
lower price. Threatened by the possibility of a tender offer, the Special Committee decided to recommend that the Lynch board
of directors approve the merger with Alcatel. The board then approved the parent-subsidiary merger between Alcatel and Lynch
and the question before the court was whether the controller had to be subjected to prove entire fairness.
The court concluded that the Independent Committee deferred to Alcatel because of the threaten Alcatel had made to proceed
with an unfriendly tender offer. Therefore, the decision of the Independent Committee was not a valid business judgment, but yet
a decision taken under pressure and constrain of the controller. Thus, the burden of proving entire fairness remains on Alcatel, the
dominant and interested shareholder. This holding reached the peak of the entire fairness standard: even when a controller who
does not own more than 50% (Alcatel owned 43.3% but exercised the de facto control) negotiates the price with an
Independent Committee (the Independent Committee even rejected the three prior offers, indicating its real independence), it
might be subject to the entire fairness test if there is any reason to be suspect about the business judgment exercised by the
Independent Committee.

Short-Term Mergers (DGCL 253)

However, the court began recognizing it was going too far and excluded the short-term merger provided in the DGCL 253 from
the entire fairness standard (Glassman v. Unocal Exploration Corp). This decision opened an attractive alternative to controlling
shareholders who were willing to acquirer its subsidiary. The strategy is to proceed with a two-step merger, where the first step is
to acquirer at least 90% of the subsidiary’s stock through a tender offer and, the second, is to cash-out the remaining minority
through a short-term merger. This was precisely what Unocal did to acquirer its subsidiary.

In Re Pure Resources, Inc., Shareholders Litigation (When the controller adopts a two-step merger to acquire 90% of the stock
and subsequently cash-out the remaining minority, does he escape the burden of entire fairness? Yes, as long as the first step of
the strategy (tender offer to acquire 90% of the stock) is not coercive and the minority shareholders is adequately informed to
make a decision)
Unocal, the holder of 65% of the shares of Pure Resources, Inc., approached Pure’s board with the offer for Pure’s minority
shares at a 27% premium to market price, contingent upon increasing Unocal’s ownership to 90% of Pure’s shares. Pure
responded by creating a Special Committee which, after studying the offer, voted not to recommend it to Pure’s minority
shareholders, based on the advise of its financial advisors. Even in face of opposition by Pure’s Special Committee, Unocal
decided to make a tender offer to the market. Unocal’s strategy was to acquirer at least 90% of the company’s stock and
subsequently cash-out the remaining minority through a short-term merger (two-step tender offer).
It was already decided that when the controller holds 90% of the company’s stock it can cash-out the minority without being
subject to the entire fairness (the second step of Unocal’s strategy). But what about the first-step of the tender offer? Is it
required that the controller offers a fair price? The court concluded that there is no such obligation as long as the offer is not
coercive. The tender offer is non-coercive only when: (i) it is subject to a non-waivable majority of the minority tender condition;
(ii) the controlling stockholder promises to consummate a prompt 253 merger at the same price if it obtains more than 90% of the
shares; and (iii) the controlling stockholder has made no retributive threats. When the tender offer respects such conditions it is
presumably fair because the minority shareholders will be entirely free to decide whether to tender their shares or not. The fact
that they will receive the same price in case of an eventual short-term merger, protects them from the pressure of having to accept
the first offer to avoid receiving a lower price in the second-step of the offer (cash-out).
Nevertheless, the court granted an injunction against the offer because of lack of appropriate information for the minority to make
a valid business judgment.

Advantages/Disadvantages of a two-step merger as a strategy for the parent to acquire its subsidiary through the short-term
merger:
Benefits:
- Escape the entire fairness standard, as long as the tender offer is not coercive
- Escape negotiations with a Special Committee which can take time
- The Special Committee doesn’t have the veto power over the transaction (can only recommend the tender offer to the
stockholders)
Problems
- It is not guaranteed that you will acquirer the minimum 90% to proceed with the second step
- If you don’t succeed through the tender offer, it might be hard to return to the negotiations with the Special Committee, since
the controller was trying to achieve its goal without the Committee’s approval.
- If it acquires less than 85%, then the DGCL 203 provision applies and the offeror is banned from pursuing any subsequent
transaction with the company.
Considering this scenario, it would be better for a controller to proceed with a two-step merger when he is already close to
acquire 90% of the company’s stock (it can pay a lower premium without the board’s interference), but with a small stake it
might be too risky.
PUBLIC CONTESTS FOR CORPORATE CONTROL

Public Contests for Corporate Control

Stock prices fall when companies fail to perform well, and cheap stock presents an opportunity to those who believe they could
do better than the incumbent managers. The acquirer can capitalize on the new value created by different plans or better skills,
and the target shareholders have an opportunity to share in this new value. The flip side, however, is that control contests are
profoundly unpleasant for incumbent managers.
Traditionally, law opened two avenues for initiating a hostile change in control. The first was the proxy contest – insurgent
shareholders indicate candidates for election to the board to replace incumbent directors. The technique of soliciting the proxies
of others is costly and often unsuccessful (at least at first). It is not a complete takeover, but rather a partial slate of directors who
will promote change through “constructive engagement” with the other members of the board.
The second technique was the tender offer – purchasing enough stock oneself to obtain voting control rather than soliciting the
proxies of others. A tender offer is even costlier than a proxy contest, but it also has a great comparative advantage in capturing
the attention of stockholders with its promise of cash-up front rather than future performance. In recent years, hostile takeovers
have been undertaken through the combination of both techniques since the law’s acceptance of increasingly potent defensive
tactics adopted by the board has made it difficult for the acquirer to succeed in a hostile tender offer without replacing some of
the members of the board. (see the “poison pill”)

What is the board’s duty in the face of a takeover bid?

Generally speaking, the board has the duty to adopt defensive methods against a threatened change-in-control transaction
(Unocal Corp v. Mesa Petroleum Co.) and to make efforts to assure that the control will be sold to the higher bidder (Revlon v.
MacAndrews and Forbes Holdings, Inc.). In analyzing the conduct engaged by the board we should always have in mind that a
change-in-control can make them lose their positions, thus they are never truly disinterested and can be acting strategically to
entrench themselves in office.

Defending the company against uninvited takeovers

Unocal Corp. v. Mesa Petroleum Co. (If there is reasonable justification to be concerned about the threat of a tender offer, the
board can adopt defensive tactics such as a discriminatory self tender offer)
Mesa, the owner of approximately 13% of Unocal’s stock, commenced a two-tier “front loaded” cash offer for 37% of Unocal’s
outstanding stock at a price of $54 per share, when Unocal’s shares was being trade at $33 per share in the market. The second
step of the merger would be a squeeze out of the remaining publicly held shares by an exchange of securities purportedly worth
$54 per share, which were true “junk bonds” with a far lower value than $54. The offer was structured in such a way that the
shareholders would feel coerced into tendering at the first tier, even if the price was inadequate, to escape the risk of having to
accept the junk bonds at the back end of the transaction. Unocal’s board met to consider the Mesa tender offer and was advised
by Goldman Sachs & Co that the Mesa proposal was wholly inadequate. Mr. Sachs opined that the minimum cash value that
could be expected from a sale or orderly liquidation for 100% of Unocal’s stock was in excess of $60 per share. Considering
that the shareholders were pressured to accept an offer that was far below the real value of the company (the stock market price
was $33 but it was profoundly undervalued) Unocal’s board decided to pursue a self tender to provide the stockholders with a
fairly priced alternative to the Mesa proposal. The defensive tactic was that, if Mesa acquired 37% of Unocal’s stock through the
first tier, Unocal would buy the remaining 49% outstanding for an attractive price (debt securities having an aggregate per value of
$72 per share) and the offer wouldn’t be opened to Mesa. It was clearly a discriminatory self tender offer. The institutional
shareholders were dissatisfied with this protective strategy because it could scare away the bidder causing them to lose the
control premium that was being offered. Thus, they insisted that the self offer must be kept even if the bidder withdraws
(otherwise they would lose the control premium offered by the bidder and the one offered by the company). The question before
the court concerned the validity of such defense.
The board has inherent powers conferred by DGCL 141 (a), respecting management of the corporation’s “business and affairs”
and by DGCL 160 (a), respecting a broad authority upon a corporation to deal with its own stock. The proper inquiry to
determine if such tactic is legitimate is to analyze the underlying reasons which motivated the board to act in a defensive manner.
Are the directors trying to avoid the bidder’s success in order to perpetuate themselves in office or does the nature of the
takeover bid represents a real threat to the corporate enterprise that requires the adoption of defensive tactics? Concerns about
the nature of the takeover bid that can justify the adoption of a defensive position may include: inadequacy of price offered, timing
of the offer, questions of illegality, the impact on constituencies other than shareholders (creditors, customers, employees, and
perhaps even the community generally), the risk of non-consummation, the quality of securities being offered in exchange and any
kind of coercion upon the shareholders to tender their shares.
The court concluded that there were enough justifications for the board to adopt the discriminatory self tender offer. The coercive
nature of the two-tier tender offer would force the shareholders to tender in the first tier and receive an inadequate price for their
shares (based on Sach’s valuation) so the board had the duty to act to ensure that the minority stockholders receive equal value
for their shares. Unless the plaintiff can demonstrate that the director’s decisions were primarily based on perpetuating themselves
in office, or some other breach of fiduciary duty such as fraud, lack of good faith, or being uninformed, the board’s action is
entitled to be measured by the standards of the business judgment rule.
The plaintiff claims that it is unlawful to discriminate in this fashion against one shareholder. In fact, the bidder will end up being
punished because the self tender offer from which he would be excluded will be paid by the company which is now under his
control. The court rejected the claim on the grounds that the discrimination was reasonable because if Mesa could tender its
shares, Unocal would effectively be subsidizing the former’s continuing effort to undertake a coercive and inadequate tender
offer. If the discrimination is necessary to protect the corporate enterprise against a threatened tender offer it is valid.

Unocal remains good law in the sense that it introduced a new standard for reviewing defensive tactics – what the Delaware
Supreme Court refers to as “enhanced business judgment review”. To determine if the board’s decision deserves the protection
of the business judgment rule, the court must proceed with a “special scrutiny” under the two-part test set forth in Unocal. In the
first step of the test, the directors must demonstrate that they had reasonable grounds for believing that a danger to corporate
policy and effectiveness existed. The second stage of the Unocal test requires the directors to demonstrate that their defensive
response was “reasonable in relation to the threat posed”. In interpreting the second stage of the Unocal test, Unitrin established
that the deal protections devices adopted in response to the threat posed shall not be “coercive” or “preclusive” and must fall
within a “range of reasonable responses” to the threat perceived. If the directors do prove that the board’s action was
proportionate and within a range of reasonableness, the burden would then shift back to the plaintiff to prove that the defensive
action constituted a breach of duty; for instance, by being primarily motivated to entrench themselves in office (Unitrin v.
American General Corp.).
However, the SEC overruled the aspect of a discriminatory self tender offer established in Unocal by promulgating Rule 13e-4
which bars discriminatory tender offers. Under the SEC’s rule, all self tender offers must be opened to all shareholders and all
third party tender offers must also be opened to all shareholders (equal treatment). Despite this prohibition, the courts have
accepted the adoption of a remarkable discriminatory defense unconnected to self tender offers, namely the “poison pill” (also
called the “Shareholders Rights Plan”).

Poison Pill
The poison pill technique was designed by corporate lawyers to empower the board to act as a bargaining agent for
disaggregated and disorganized shareholders who are exposed to abusive tender offers. The poison pill confers to all
shareholders the right to buy the company’s stock at a discounted price in case someone acquirers more than a certain
percentage of the company’s outstanding stock (10 percent or 15 percent usually) without receiving the target board’s blessing.
Moreover (and this is the key), the person whose stock acquisition triggers the exercise of the rights is herself excluded from the
possibility of buying discounted stock. The aggregate effect is to increase the proportionate holdings of all shareholders except
the “triggering person”, which will end up owning a much smaller interest in the company than that for which she initially paid.
Because of the increased number of outstanding shares in the market, the share’s price falls dramatically causing the triggering
person not only to end up with a smaller stake but also which worth’s less than the price it paid for. This effect gives the board
the practical power to veto a tender offer, just as it is able to veto a merger or asset sale under the corporation law.

Flip-Over Plans
The explanation above refers to the “flip-in” plan poison pill, but the “flip-over” plan was the original rights plan adopted by the
boards. They purported, when triggered, to create a right to buy some number of shares of stock in the corporation whose
acquisition of target stock had triggered the right. The triggering event would be the acquisition of shares followed by a merger or
sale of the target’s assets to the triggering shareholder or affiliate (second stage of the tender offer). How can the target’s board
create a right that requires a third party to sell its stock at half price to the target’s shareholders? The target’s board puts terms in
any merger agreement (or asset sale agreement) with the acquirer that will force the acquirer to recognize flip-over rights. But the
flip-in plans are by far more common than the flip-over plans. First because the legality of forcing an acquirer to sell its own stock
for half of the price is uncertain and secondly, because a hostile party may acquirer a large block of target stock but propose no
self-dealing transaction, which would be required to trigger the flip-over rights.

Flip-In Plans Advantages

The flip-in plans offered an attractive way for board’s to protect themselves against unwelcomed hostile takeovers. The first
advantage is that it doesn’t require shareholders approval (of course, the corporation’s charter must authorize enough shares to
cover the exercise of the rights). Second, it has proved to be an effective technique of scaring a hostile bidder. Finally, the event
that triggers the right does not require any second-step beyond the acquisition of a certain amount of the target’s stock.

Redeemable
The rights plan can become excessively expensive to the company, thus, the board can redeem the rights at any time except after
the rights are triggered (the board needs to protect itself from redeemable rights plan after the triggering event. This is because the
potential acquirers have combined the tender offer with a proxy contest. The purpose is to replace some members of the board
to redeem the rights and make it possible for the acquirer to buy a substantial stake in the target without being subject to the
effects of the poison pill).

To what extent a poison pill is desirable?

Positive effects
- If the board is using the strategy to effectively protect the stockholders from an abusive tender offer.
- It may be used as an instrument to empower the board to bargain with potential bidders and extract the maximum premium for
the control-sale.
- The pill is particularly important when the company’s stock is significantly undervalued in relation to its liquidation value. In this
case the company becomes a vulnerable target for hostile takeovers and the stockholders might receive an unfair premium (they
might tender their shares because they don’t recognize that the market price is undervalued)
Negative effects
- The board might be using it as an obstacle to changes in control with the main purpose of entrench itself in office.
- Even if the board acts in good faith in adopting the rights plan to attract the best bid, the results can be adverse to the
stockholders considering the ex-ante costs of scaring potential bidders. Some acquirers will simply not consider the company as
a target because of the poison pill, what will decrease the competition between potential buyers and, ultimately, result in a lower
premium.

The legality of the flip-in has not yet been appreciated by the Delaware Courts. The further it went was to accept the flip-over
rights plan as a legitimate exercise of business judgment by the board.

Moran v Household International, Inc. (As long as the Rights Plan is reasonable in relation to the threat posed by an uninvited
takeover, it should be upheld)
Financial studies showed that Household’s stock was significantly undervalued in relation to the company’s break-up value and
the board decided to adopt a defensive measure to protect the company’s vulnerability against hostile takeovers. Household did
not adopt its Rights Plan during a battle with a corporate raider, but as a preventative mechanism to ward off future advances.
Basically, the Plan provided that Household common stockholders are entitled to the issuance of one Right per common share
under certain triggering conditions. There are two triggering events that can activate the Rights. The first is the announcement of a
tender offer for 30% of Household’s shares and the second is the acquisition of 20% of Household’s shares by any single entity
or group (Household’s issues the Rights). If a merger or consolidation occurs subsequently to the announcement of the tender
offer or acquisition of 20% of the stock, the Rights holder can exercise each Right to purchase $200 of the common stock of the
tender offeror for $100. This flip-over provision of the Rights Plan is at the heart of the controversy. Moran, one of Household’s
own directors and also Chairman of DKM corporation (the largest single stockholder in Household) was interested in pursuing a
leverage buy-out of Household by DKM and, thus, brought this suit challenging the validity of the defensive mechanism.
Three provisions in the DGCL that were used to justify the board’s authority to adopt this Right Plan (DGCL 157 – “every
corporation may create and issue … rights or options entitling the holders thereof to purchase from the corporation any shares of
its capital stock … as shall be approved by the board of directors”; DGCL 151 (g); and DGCL 141 (a)). These provisions were
cleared designed for financing purposes and not as a means of protection against hostile takeovers. The court, however, upheld
the technique considering it was a legitimate reaction to the threat posed in the market place of coercive two-tier tender offers. In
addition, the Plan didn’t entirely preclude the possibility of tender offers, there were still methods around the plan. The acquirer
could tender with the condition that the board redeem the rights, could tender and solicit consent to remove the board and
redeem the Rights or could also form a group of up to 19.9% (does not trigger the rights) and solicit proxies for consent to
remove the board and redeem the rights. The plaintiff contends that the “20% trigger” effectively prevents stockholders from
banding together into a group to solicit proxies if, collectively, they own 20% or more of the stock. The court rejected this
interpretation of the plan, arguing that the holder of a proxy is not the “beneficial owner” of the stock (the grantor can revoke the
proxy at any time) so the mere acquisition of the right to vote 20% of the shares, and not the shares themselves, does not trigger
the rights. The court concluded that if there is no demonstration that the director’s action was taken for entrenchment purposes it
should be treated within the standard of the business judgment rule.

The fact that the court accepted the adoption of the Rights Plan is this particular case doesn’t mean that it can’t reject it in under
other circumstances. The board might have a duty to redeem rights issued under its right plan if their effect no longer appears
reasonable in relation to the threat posed by an uninvited offer. Indeed, the Delaware Court of Chancery forced boards to
redeem their pills in two cases. In City Capital Associates Ltd. Partnership v. Interco, Inc., the court ordered Interco to redeem a
stock rights plan because the hostile all-cash, all-shares offer did not constitute a sufficient threat to Interco or its shareholders to
justify foreclosing the shareholders indefinitely from choosing to accept the offer. Similarly, in Grand Metropolitan Public Ltd. Co.
v. Pillsbury Co., the court required Pillsbury to redeem its right plan after concluding that Pillsbury’s own restructuring proposal
compared unfavorably in value to a hostile all-cash, all-shares offer from Grand Met. The Supreme Court disapproved these
cases in dicta but it continues to assert that boards have an ongoing fiduciary obligation to redeem the pill if it is no longer
reasonable in relation to the threat of an acquisition offer.

Using defensive tactics such as a discriminatory self tender (Unocal) or the adoption of a Rights Plan (Moran) to protect the
corporation’s independence against uninvited offers is the first side of the fiduciary duty of the board at face of a change in
corporate control. The second side is the board’s duty in arranging for the “sale” of a company. Management can obtain a variety
of benefits in “friendly” deals, ranging from a place on the surviving corporation’s board to many compensation-related benefits.
Therefore, the Delaware courts are concerned about incumbent managers selling their company at a low price to a favored
bidder instead of advancing the shareholders interests by selecting the highest bidder.
Selling a “Block of Control” (note: issuing more than 20% of the outstanding shares requires shareholder approval under NYSE
listing rules 312.03)

Smith v. Van Gorkom (In arranging for the sale of a company, the board’s conduct must be analyzed under an enhanced
business judgment rule which requires the gathering of efforts to assure that the highest bidder will be selected)
Shareholders of Trans Union brought a class action against Trans Union’s board of directors seeking rescission of a cash-out
merger of Trans Union into Marmon Group Inc. Van Gorkom, Trans Union’s CEO for more than 17 years, approached Jay
Pritzker with a proposed per share price for sale the of Trans Union and a financing structure by which to accomplish the sale.
Van Gorkom believed that $55 per share would be a fair value which he would be willing to accept for his own 75000 shares.
Pritzker accepted the proposal and made a cash offer for Trade Union at $55 per share which was to remain open for a period
of 90 days (Trans Union could accept a higher offer). Van Gorkom called a special meeting of the Trans Union board and began
the meeting with a twenty minute oral presentation. Copies of the proposed merger Agreement were delivered too late for study
before or during the meeting. Van Gorkom took the position that putting Trans Union “up for auction” through a 90-day market
test would validate a decision by the board that $55 was a fair price. The board approved the merger agreement relying in Van
Gorkom’s twenty minute presentation and submitted the merger agreement for stockholders approval recommending the deal. Of
the outstanding shares, 69.9% were voted in favor of Pritzker merger proposal; 7,25% were voted against ; and 22.85% were
not voted.
Surprisingly, the court concluded that the board had acted in a grossly neglected manner and held the directors personally liable
for the fair value of the plaintiff’s shares in Trans Union. The breach of the fiduciary duty raised from the failure to make an
informed decision: (i) the directors were given no documentation to support the adequacy of $55 price per share; (ii) the board
relied solely upon Van Gorkom’s 20 minute oral presentation of the proposal; (iii) no investment bankers were called to analyze
the offer; (iv) the adequacy of the premium cannot be measured by comparing it to the value of a minority position; (v) the
company was not “shopped” to other potential bidders; and (vi) the merger agreement in fact made it hard for the board to shop
the company.
One might think that this case involves the duty of care because there was no self-interest or fraud involved (the buyer was an
independent third party). But as we saw when examining the duty of care, courts generally defer to the reasonableness of
decisions made by disinterested directors in the board’s regular decision-making process. So why did the court hold the directors
liable for acting in a grossly negligent manner? The violation of the board’s duty in Van Gorkom is much more connected to the
responsibilities triggered by the sale of the company than to the common duty of care. The underlying concern of the court was
the favorable definitive agreement to sell the company to a third party instead of gathering efforts to look after the highest bidder
to further the stockholders interests. The conclusion which can be extracted is that, in arranging for the sale of a company, the
board’s conduct must be analyzed under an enhanced business judgment rule which requires the gathering of efforts to assure that
the highest bidder will be selected.

Revlon, Inc. v. Macandrews and Forbes Holding, Inc. (The board breached its fiduciary duty in arranging the sale to Forstmann
because the lock-up provisions were adopted to protect the noteholders’ interests and ultimately, the directors’ interests, at the
expense of the equity holders who could benefit from the continuity of the intense bidding contest)
Perelman made a hostile cash tender offer for Revlon at a 90% premium. Revlon’s management opposed the Perelman offer with
two defensive tactics. First, it adopted a flip-in rights plan and second, it repurchased 20 percent of Revlon’s stock with
unsecured debts (the Notes) at a premium price. The recapitalization had two effects: (i) capture 20% of the outstanding shares
which can no longer be captured by Perelman; and (ii) was a vehicle for Revlon to subject itself to specialized debt covenants
that restrict the sale of assets making it more difficult for the buyer to finance the transaction (in a typical leverage buyout – LBO
– the buyer borrows cash to buy the equity of the target corporation and secures the debt with the target’s assets). Perelman
reacted to management’s move by raising his bid price and promising even more if the board redeemed the Notes. At this point,
Revlon’s management solicited a competing bid from a “white knight”, or friendly bidder, Forstmann Little & Co. But for the new
strategy to succeed, Revlon had to remove the restrictive covenants contained in the Notes that it had exchanged with its
shareholders since they also precluded Forstmann from financing the new alternative transaction. Stripping the restrictive
covenants from the Notes sharply lowered their value and the noteholders would have a claim against the board for breach of
fiduciary duty. Revlon then concluded a final deal with Forstmann: Forstmann would increase its offer for Revlon’s stock to
$57.25 and support the price of Revlon’s Notes (thus satisfying any claim of noteholders). In exchange, Revlon would assure
Forstmann’s victory against Perelman by giving it a lock-up option to purchase Revlon’s most valuable assets at a bargain price if
a competing bidder were to acquire more than 40% of Revlon’s stock and agreeing not to assist buyers other than Forstmann
(no-shop provision). In response to the new Revlon-Forstmann deal, Perelman increased its offer to $58/share conditional on the
lock-up provision being rescinded. This suit was brought to enjoin Forstmann’s lock-up option as well as the no-shop provision.
The Delaware Supreme Court approved Revlon’s original defensive tactics designed to maintain its independence and avoid an
inadequate offer (the poison pill and the Notes exchange) but rejected Revlon’s final agreement with Forstmann. The board’s
main argument to justify the “asset lock-up” and the “no-shop” provision in Forstmann’s favor, was the protection given to the
noteholders in exchange. The board argued that according to Unocal, it could consider the interests of other corporate
constituencies at face of a change in control. The court rejected such argument alleging that the primary responsibility of the board
at this stage was to promote the equity owner’s interests. Unocal is not about adopting defensive measures to select a friendly
acquirer, but instead, it refers to the protection of the company’s independence by assuring that inadequate offers will not
succeed. The Notes covenants specifically contemplated a waiver to permit the sale of the company at a fair price and the
holders were aware of this risk before accepting them. Thus, nothing remained for Revlon to legitimately protect, especially
because no rationally benefit thereby accrued to the stockholders. To the contrary, the principal benefit went to the directors,
who avoided the threat of personal liability to a class of creditors and pursued through a sale strategy which assured that the
noteholders interests would be protected. This strategy, however, ended an intense bidding contest which would lead to a higher
premium and, thus, further the shareholders interests. Because the board failed to sell the company to the highest bidder,
adopting, instead, a strategy to protect the interest of other constituencies which would, ultimately, protect the directors
themselves (avoiding litigation and the threat of personal liability) the court concluded that the board had violated its fiduciary duty
(a combination between the duty of care and the duty of loyalty).

Is the lock-up clause always illegal under Revlon?

No. The lock-up clause can be structured to promote the highest premium. The company can announce a lock-up offer in
exchange for an audacious premium in the “last round” of the bidding contest. Moreover, the bidding contest could last for ever,
with each of the competitors increasing the offer by one penny, and the company might need a lock-up clause to terminate a
process which would otherwise be infinity. In fact, considering the time value of money, the stockholders would be better off
receiving a good premium straight away rather than waiting a log period for a slightly higher premium. Finally, the company might
agree with a lock-up clause when, after proceeding with some investigation (market check), it concludes that there is a single
bidder at the market.

Unocal X Revlon
Why is the board permitted to take into account the interest of other constituencies under Unocal when adopting defensive
measures to protect the company’s independence, but is not when deciding to sell the company to a selected bidder?
Because when the company decides to sell the company, the stockholders are under a very sensitive position. It is their last
opportunity to extract a control premium. Once the company is sold, they will no longer participate in the long-term strategic
value of the company, no matter how successful it proves to become. On the other hand, when the board is merely adopting
defensive tactics, even though the stockholders might be losing attractive premiums (the defensive tactics might be scaring away
potential bidders), at least they remain in the position of stockholders and are able to benefit from the long-term value of the
company.

Could the board consider the interests of other constituencies in locking-up the deal with a selected acquirer if there is no
conflicted interest, such as the threat of personal liability?
One could argue that the determinant fact in Revlon to prohibit the consideration of other constituencies when adopting lock up
clauses with a selected acquirer to sell the control was the fact that the directors were actually considering their self-interest
(protect the noteholders to avoid the threat of personal liability). If we assume that this conflicted interest was the main reason
why the court invalidated the deal protections, then it would follow that an independent and disinterested board could take non-
shareholder’s interests into account when adopting deal protections. The rule would be the same as in Unocal, without regard to
whether the board is adopting the defensive tactics to protect the company’s independence or adopting lock-up clauses to assure
the success of a potential acquirer. On the other hand, it could be argued that there is a substantial difference between protecting
the company’s independence (Unocal) and selecting an acquirer to sell the control (Revlon) which justifies permitting the board to
consider other constituencies in the first situation but not in the second even if the board is disinterested. This leads us to the
argument above.

Paramount Communications, Inc. v. Time, Inc. (Revlon duties are not triggered under a “merger of equals” agreement because
there will be no breakup or dissolution of the company. Under Unocal duties, the board is allowed to adopt defensive measures
proportionate to the threat posed, and the incapacity of the shareholders to recognize the real benefits of the management-
sponsored alternative is considered a threat)
Time initiated merger negotiations with Warner Communications. As both companies were in the 10-12 billion range, the
proposed combination was to be a “merger of equals”: a stock-for-stock merger where 62% of Time’s common stock were to
be transferred to Warner’s stockholders; the board of the surviving corporation would be expanded to be divided equally
between the old Time and Warner directors; and there would be co-CEOs in the surviving corporation for a period of five years,
one from Time and the other from Warner. Two weeks before Time’s shareholders were scheduled to vote on the Warner
merger, Paramount announced an offer all-cash bid for 100% of Time’s shares up to $200 per share. Time’s board rejected
Paramount’s price as grossly inadequate based on Time’s investment banker opinion that a control market value for Time would
exceed $250/share. Having rejected Paramount’s offer, however, Time’s management faced a dilemma: it had planned a stock-
for-stock merger, which required a shareholder vote. But if Time’s shareholders were to vote, they would almost certainly reject
the proposed merger in the hope of tendering into the higher Paramount offer. Therefore, Time adopted the defensive tactic to
turn the combined merger into a buyout of Warner’s stock, what didn’t require shareholder’s approval. The governance terms in
the new Time-Warner agreement were identical to the original and the only difference was that Time would be forced to borrow
$10 billion to support a cash tender offer for Warner. This strategy would have to effects: proceed with the Time-Warner
combination escaping the requirement of shareholders vote and causing Paramount to give up from buying the heavily indebted
Time-Warner entity that would emerge. Paramount, joined by several groups of Time shareholders, sought to block Time’s
tactic. They contend that the original Time-Warner agreement effectively put Time up for sale, triggering Revlon duties, requiring
Time’s board to enhance short-term shareholder value and not to erect barriers to further bids. In addition, Paramount asserts a
Unocal claim arguing that Time’s board didn’t have reasonable grounds to believe that Paramount posed a threat to Time’s
shareholders and a danger to Time’s corporate policy and effectiveness. According to Paramount, the defense was not
proportional to the threat posed; instead it was a strategy to perpetuate management in office.
To decide whether the Revlon duties were triggered the pivotal question is: did Time, by entering into the proposed merger with
Warner, put itself up for sale? The court concluded that a “merger of equals” does not constitute a “change in control”.
Specifically, the transaction would not cause the dissolution or breakup of the corporate entity. To the contrary, the stockholders
of both companies would remain as stockholders in the surviving corporation, which would be managed by directors and CEOs
of both companies. The danger presented in Revlon that stockholders would be precluded from participating in the long-term
value of the company and deserved a high premium for that does not arise here. The board’s reaction constituted a defensive
response and not an abandonment of the corporation’s continued existence so Revlon duties were not triggered, although Unocal
duties attach.
Under Unocal duties, the defensive measure must be proportionate to the threat posed. When evaluating the threat posed,
directors may consider the “inadequacy of the price offered, nature and timing of the offer, questions of illegality, the impact on
constituencies other than shareholders, the risk of nonconsummation and the quality of securities being offered in the exchange”.
In this particular case, the directors knew that the Time-Warner merger would maximize the long-term value of the company, but
the shareholders might elect to tender into Paramount’s cash offer as a result of a mistaken belief of the strategic benefit derived
from the Time-Warner combination. Because the stockholders were incapable of recognizing the potential benefits of the Time-
Warner merger, the board had to act to avoid Paramount’s offer that was apparently more attractive. In sum, the court found that
the defensive tactic was appropriate in relation to the “substantive coercion”: the risk that shareholders will mistakenly accept an
underpriced offer because they disbelieve management’s representation of intrinsic value. Shareholders shouldn’t be permitted to
decide between the management’s recapitalization transaction and the hostile bidder’s all-cash deal when they don’t have the
ability to recognize the real benefits/costs of each alternative, in which case the board’s business judgment to adopt defensive
tactics shall prevail.

Paramount Communication, Inc. v. QVC Network, Inc. (When the board decides to sell the corporate control held by the public
in exchange for both cash and equity in the surviving company (the shareholders will have no meaningful participation in the
surviving entity) the Revlon’s duty to seek the highest bidder. Any deal protections that might conflict with this duty are invalid
and unenforceable)
Paramount board unanimously approved the Original Merger Agreement whereby Paramount would merge with and into
Viacom. Viacom would be the surviving corporation and the merger consideration to Paramount’s stockholders would be
approximately $70 per share paid with cash and Viacom’s stock (including common and preferred shares). The Original Merger
Agreement also contained substantial deal protections to Viacom, such as a “no-shop” provision (Paramount’s board would only
negotiate with third parties if it was necessary to comply with its fiduciary duties); a “termination fee” (Viacom would receive
$100 million if: (i) Paramount terminated the original Merger Agreement because of a competing transaction; (ii) Paramount’s
stockholders did not approve the merger; or (iii) the Paramount board recommended a competing transaction); and a “stock
option agreement” (if any of the triggering events for the termination fee occurred, Viacom would be granted an option to
purchase 19.9% of Paramount’s outstanding common stock at $69.14/share). Moreover, the stock option agreement contained
two provisions unusual and highly beneficial to Viacom: Viacom was permitted to pay with a senior subordinated note instead of
cash and Viacom could elect to require Paramount to pay Viacom in cash a sum equal to the difference between the purchase
price and the market price of Paramount’s stock. Despite these attempts to discourage a competing bid, QVC jumps into the
deal with an offer to acquirer Paramount for approximately $80 per share paid with cash and QVC’s stock. Viacom realized that
it would need to raise its bid in order to remain competitive and the merger agreement was amended. The new provisions
included an $80/share cash tender offer by Viacom for 51% of Paramount’s stock and Viacom would then merge into
Paramount giving the remaining Paramount stockholders shares in Viacom. Also, the amendment included a “fiduciary-out”
provision where the Paramount’s board was given the power to terminate the Amended Merger if its fiduciary duty required so at
face of a better alternative. The deal protections in favor of Viacom, however, were not amended. QVC responded to Viacom’s
higher bid by increasing its tender offer to $90/share and by increasing the securities for its second-step merger, conditioned on,
among other things, the invalidation of the stock option agreement. The Paramount board determined that the new QVC offer
was not in the best interest of the stockholders and refused to proceed with further negotiations with QVC alleging that the “no-
shop” provision prevented such communication. QVC brought this suit seeking to invalidate the deal protections in the merger
Paramount-Viacom.
The first question before the court is whether the Merger Agreement between Paramount and Viacom triggered Revlon’s duties.
The court considered that Paramount’s board was actually selling the corporate control. Paramount’s voting stock is widely
spread in the market and the control of the corporation is currently vested in the fluid aggregation of unaffiliated stockholders.
Following the consummation of the Paramount-Viacom transaction, Viacom will become the controlling stockholder who will
have the voting power to: (i) elect directors; (ii) cause a break-up of the corporation; (iii) merge it with another company; (iv)
cash-out the public stockholders; (v) amend the certificate of incorporation; (vi) sell all or substantially all of the corporate assets;
or (vii) otherwise alter materially the nature of the corporation and the public stockholder’s interests. The public stockholders will
receive cash and a minority equity voting position in the surviving corporation in exchange for their shares, which together
constitute the control of the company. Because shareholders are excluded from meaningful participation in the governance of
combined company, which will be dominated by the new controller, the board had an obligation to take the maximum advantage
of the current opportunity to realize for the stockholders the best value reasonable available, instead of justifying its action on the
basis of a long-term strategic value which will not accrue to current stockholders but to the selected buyer (the new controller can
even change the strategic vision that shall be adopted by the company). This situation is distinct from the Time-Warner case
because there the merger agreement provided the current stockholders with the opportunity to participate in the long-term
strategic value of the combined company, whereas here the shareholders will be cashed-out and receive a small equity voting
position. Moreover, in Time-Warner, the corporate control will remain in the public’s hand, whereas here the corporate control
will be vested in Viacom (which had Redstone as its controlling shareholder). Where the control of the company is shifted from
the public stockholders to a controlling stockholder, the public stockholder is entitled to the highest premium reasonable available
and the board has the duty to seek the highest bidder. The deal protections granted to Viacom in the Merger Agreement are
inconsistent with such duty and are invalid and unenforceable. When the board noticed that there was a competitor bidder
outside (QVC) it should have renegotiated with Viacom the Merger Agreement to withdraw the counterproductive devices which
were impeding the realization of the best value reasonable available to the Paramount stockholders. The court concluded that the
deal protections are not enforceable since they preclude the board from exercising its fiduciary duty to seek the highest bidder to
buy the corporate control.

Omnicare, Inc. v. NCS Healthcare, Inc. (Even when the transaction is not in the mode of Revlon duties, but instead it is a merger
of equals, the merger agreement cannot contain protections considered “coercive” or “preclusive” because under Unocal and
Unitrin unreasonable defensive tactics are forbidden, regardless if they were adopted by the directors or by the controlling
shareholder).
NCS was in the verge of bankruptcy when Omnicare proposed to acquirer NCS in a bankruptcy sale under Section 363 of the
Bankruptcy Code. Omnicare’s bid reached $ 313.750.000, but still proposed to structure the deal as an asset sale in
bankruptcy. The transaction would provide only a small recovery for NCS’s creditors and no recovery for its stockholders.
Subsequently, Genesis contacted NCS concerning a possible transaction that would take place outside the bankruptcy context.
Although it did not provide full recovery for NCS’s noteholders, it provided the possibility that NCS stockholders would be able
to recover something for their investment. Genesis demanded, however, that before any further negotiations take place, NCS
agree to enter into an exclusivity agreement with it. Omnicare came to believe that NCS was negotiating a transaction, possibly
with Genesis or another of Omicare’s competitors, that would potentially present a competitive threat to Omnicare. Thus,
Omnicare board proposed to acquirer NCS through a transaction which did not involve a sale of assets in bankruptcy. Genesis
reacted by proposing substantially improved terms but requiring that the transaction had to be approved the next day, otherwise
Genesis would terminate discussions and withdraw its offer. Genesis insisted the merger agreement include a section 251 c
clause, mandating its submission for a stockholder vote even if the board’s recommendation was withdrawn and, most
importantly, insisted in a voting agreement by which NCS’s controlling shareholders, Outcalt and Shaw (who were also directors
in NCS’s board), would agree to vote their shares in favor of the merger agreement regardless of eventual superior bids. The
board concluded that “balancing the potential loss of the Genesis deal against the uncertainty of Omnicare’s letter, results in the
conclusion that the only reasonable alternative for the board of directors is to approve the Genesis transaction”. The board then
resolved that the merger agreement was advisable and fair and in the best interest of all the NCS stakeholders. The NCS board
further resolved to recommend the transactions to the stockholders for their approval and adoption. Omnicare filed a lawsuit
attempting to enjoin the NCS/Genesis merger, and announced that it intended to launch a tender offer for NCS’s shares at a
price of $3,50/share. As a result of this irrevocable offer, the NCS board withdrew its recommendation that the stockholders
vote in favor of the NCS/Genesis merger agreement. At that time it was too late. The success of the Genesis merger had already
been predetermined due to the existence of the voting agreement entered into by NCS’s controlling shareholders to vote in favor
of the Genesis merger. The question before the court is whether the NCS/Genesis merger and the voting agreement are valid and
enforceable.
The Court of Chancery concluded that, because it was a stock-for-stock merger which didn’t result in a change of control, the
NCS directors’ duties under Revlon were not triggered by the decision to merge with Genesis. It argue that “even applying the
more exacting Revlon standard, the directors acted in conformity with their fiduciary duties in seeking to achieve the highest and
best transaction that was reasonably available to the stockholders”.
The Delaware Supreme Court reversed. Even though it agreed with the chancery court that Revlon duties didn’t apply because
the transaction was a stock-for-stock merger, it considered that the defensive devices that protected the Genesis merger
agreement were “coercive” and “preclusive”, in violation of Unocal and Unitrin’s doctrine. It argued that “a board’s decision to
protect its decision to enter a merger agreement with defensive devices against uninvited competing transactions that may emerge
is analogous to a board’s decision to protect against dangers to corporate policy and effectiveness when it adopts defensive
measures in a hostile takeover contest”. Considering that the board’s decision to protect the stock-for-stock merger with Genesis
from competing bidders is analogous to the board’s decision to adopt defensive tactics against a hostile takeover, the board’s
conduct mandate “special scrutiny” under the two-part test set forth in Unocal. In the first step of the test, the directors must
demonstrate that they had reasonable grounds for believing that a danger to corporate policy and effectiveness existed. The threat
identified by the NCS board was the possibility of losing the Genesis offer and being left with no comparable alternative
transaction. The second stage of the Unocal test requires the NCS directors to demonstrate that their defensive response was
“reasonable in relation to the threat posed”. In interpreting the second stage of the Unocal test, Unitrin established that the deal
protections devices adopted in response to the threat posed shall not be “coercive” or “preclusive” and must fall within a “range
of reasonable responses” to the threat perceived. Under the circumstances of this case, as a result of the voting agreement, any
stockholder vote would have been robbed of its effectiveness by the impermissible coercion that predetermined the outcome of
the merger without regard to the merits of the Genesis transaction at the time the vote was scheduled to be taken. Finally, the
court concluded that the deal protection devices that result in such coercion cannot withstand Unocal’s enhanced judicial scrutiny
standard of review. It was suggested that even when an offer appears to be the best opportunity, the target’s board doesn’t have
the authority to agree with an absolute lock-up. It should resist through negotiations.
The dissenting vote disagrees with the majority’s opinion that the lock-up was not reasonable in relation to the threat posed.
Instead, it argues that situations will arise where business realities demand a lock-up so that wealth-enhancing transactions may
go forward. In light of Genesis pressure, the lock-up provisions were the only way of securing what appeared to be the only
value-enhancing transaction available for a company on the brink of bankruptcy. The board’s disinterested, informed, good faith
exercise of its business judgment must be analyzed from an ex-ante perspective, at a moment where there was no other attractive
bid. Moreover, the deal protections here were not adopted unilaterally by the board to fend off an existing hostile offer that
threatened the corporate policy and effectiveness. To the contrary, it was a joint decision by the controlling stockholders and the
board of directors through the lens of their independent assessment of the merits of the transaction. It is hard to see why the
controlling shareholders themselves would agree to lock-up the merger with the third party if it was not the best alternative
available in the market. At this point, the controlling shareholder’s interest is perfectly aligned with the minority’s interest: both
want to sell their shares at the highest price possible. Therefore, there was no meaningful minority stockholders vote to coerce.
The dissenting vote also expresses its dissatisfaction with the consequences of the majority’s holding. Under a holding in which a
merger agreement entered into after market search, before any prospect of a topping bid has emerged, which locks-up
stockholder approval and does not contain a fiduciary out provision, is per se invalid when a later significant topping bid emerge,
the universe of potential bidders could shrink or disappear.

Orman v. Cullman (When the deal protection is adopted by the controlling shareholder in his capacity as shareholder and it does
not preclude completely the minority stockholders’ vote, it shall be upheld)
Swedish Match agreed to buy out the minority shareholders of General Cigar for $15.25 per share cash, such that Swedish
Match would own 64% and the controlling Cullman family would own 36% of General Cigar (with the Cullmans retaining control
by virtue of their high-vote stock). The Cullman family agreed to vote their shares for the Swedish Match transaction, and against
any alternative acquisition proposal for 18 months after any termination of the merger. In other words, the minority would be able
to veto the deal, but if they did so they would not be able to see another deal for 18 months. The Delaware Chancery Court
upheld the shareholder lock up agreement: “In Omnicare, the challenged action was the directors’ entering into a contract in their
capacity as directors. The Cullmans entered into the voting agreement as shareholders. Unlike Omnicare, the public shareholders
were free to reject the proposed deal, even though, permissibly, their vote may have been influenced by the existence of the deal
protection measures”.

Summary

Note: Both the minority and the majority shareholders can sue the board to block the “transfer of control” and void the lock-up
clauses. (class action)

There are four main issues that should be considered when the board is conducting a friendly sale of control:
- What are the characteristics of the merger agreement (merger consideration, size of the companies, how is the control exercised
in the acquirer)
- The level of self-interested involved (which could be to entrench in office or to protect the interest of other constituencies which
will, ultimately, protect the director’s interests; who are the directors locking-up the deal and what are their relation with the
selected acquirer?)
- The intensity of the lock-up provision and its ability to preclude the minority’s shareholders vote (even when Revlon duties are
not triggered the lock-up provisions may still be considered preclusive under Unitrin as it was held in Omnicare)

Strategies that can be adopted by the board to assure the friendly takeover:
1) Simply recommend the deal to shareholders (Smith v. Van Gorkom)
2) Deal protections that lock-up the transaction (Revlon) & (Paramount v. QVC)
3) Putting covenants in new loan agreements to make it hard for the acquirer to finance the transaction (Revlon)
4) Turn the merger into a transaction that does not require shareholder’s vote. Buy stock from the other company instead of
merging (Time)
5) Voting agreement between the acquirer, the target and the target’s controlling shareholder by which the controller agrees in
advance to vote his shares in favor of the merger (Omnicare)

Merger characteristics to consider when analyzing if the Revlon duties were triggered:

Revlon Duties Business Judgment

Merger Consideration All-cash All-stock

But for the stock consideration standing alone is not enough to BJR, still depends on:

Size of Target Whale X Merger of equals

versus Acquirer minnow

Control in Acquirer Controlling Shareholder Widely Held

1) Are Revlon duties triggered when:

a – the merger consideration is all-cash?
b – the merger consideration is stock and the acquirer is widely held?
c – the merger consideration is stock and the acquirer has a controlling shareholder?
d – the merger consideration is stock and the acquirer is much larger but widely held?

a - When the stockholders of the target are cashed-out in an all-cash merger it is undisputed that Revlon duties are triggered
(even if the acquirer is widely held) because they will not participate in the surviving company and it is there last opportunity to
earn a control premium. Revlon.

b – When the merger consideration is stock and the acquirer is widely held, it is likely that Revlon duties will not be triggered
because the control of the surviving company will remain in the hands of the public (a combination between target and acquirer
stockholders). In this case, the target stockholders will continue with a proportionate interest in the surviving company and will be
able to benefit from the synergies generated by the merger. Thus, the courts should trust the business judgment of the board in
calculating the long-term strategic value of the combined entity to determine how the target stockholders shall be compensated in
the merger agreement (specifically, how many shares in the surviving entity shall be exchanged per share of the target
stockholders). The board has more expertise and knowledge to calculate the potential benefits of a stock-for-stock merger than
the stockholders, the market or even the courts. Time-Warner.

c – When the merger consideration is stock and the acquirer has a controlling shareholder the courts might be reluctant to
exonerate the board from Revlon duties. In this case, the target stockholders will be subject to a controlling shareholder in the
surviving company (Paramount v. QVC). But why should the board be able to exercise its business judgment in calculating the
synergies of the surviving entity when it is widely held and be denied this deference in calculating the synergies of the surviving
company when it has a controlling shareholder? The answer to this question is unclear. One could argue that it is harder for the
target’s board to determine the long-term strategic value of the surviving company when the combined entity has a controlling
shareholder because the controller might decide to replace the board and change completely the business strategies of the
surviving company, whereas when the surviving company is widely held this change in management is harder to occur (“small”
shareholders have to engage in a costly proxy-contest to try to replace the board). Moreover, when the surviving company has a
controlling shareholder the target stockholders (in the position of minority stockholders in the surviving company) are more
vulnerable to self-dealing transactions engaged by the controller. For these reasons the court should apply a tougher standard in
analyzing the board’s conduct towards a merger where the control of the target moves from the public’s hand to the controlling
shareholder of the acquirer.
In Paramount v. QVC the court found that the transaction was in the mode of Revlon because the merger consideration was
mainly cash (plus a minority equity interest in the surviving company) and the acquirer had a controlling shareholder. Because the
court was inclined to reach this conclusion due to the merger consideration (mainly cash) the question of whether a stock-for-
stock merger where the acquirer has a controlling shareholder triggers or not Revlon duties remains open.

d – When the merger consideration is stock and the acquirer is much larger but widely held there are two factors that suggests
that Revlon duties don’t apply. The fact that the target stockholder will receive stock in a widely held company apparently
indicates that they will continue with ownership interests and, thus, would be able to benefit from the long-term strategic value of
the surviving company. However, because the acquirer is much larger than the target their ownership interest will be extremely
diluted and whatever benefits will result from the synergy gains, they won’t accrue considerably to the target stockholders.
Instead, the target stockholders will be left with a small fraction of ownership interest and their ability to interfere with the
company’s destiny (by voting on the board or in relevant future transactions) will be reduced as compared with their power in the
target company. Therefore, the merger-of-equals doctrine applied in Time-Warner will probably not protect the target’s board
from exercising its business judgment in a transaction where a big entity is the acquirer.

2) What if the merger consideration is 70% stock in the surviving entity and the rest in cash? May the board consider the long-
term value and lock the deal?
When the merger consideration is mixed the question of whether Revlon duties are triggered or not is unclear. Perhaps the court
would look to the other factors of the merger agreement such as the size of the target versus the size of the acquirer and how is
the control exercised in the acquirer company. When the merger consideration is 70% stock in the surviving entity and 30% cash,
but the companies have approximately the same size and the acquirer is widely held, then the courts will be more sympathetic to
the deal and apply a standard closer to the business judgment. In this case, it is easier to argue that the target stockholders will
still participate in the long-term strategic value of the surviving entity with a relatively proportional ownership interest. On the other
hand, when the merger consideration is 70% stock in the surviving entity and 30% cash, but the acquirer is much larger than the
target and has a controlling shareholder, then the courts would more likely apply Revlon duties. In this case, the ownership
interest of the target stockholders in the surviving company will be substantially reduced and they will be subject to the willingness
of a controlling shareholder. The target stockholders lost a considerable power and they should be entitled to the highest control
premium possible.

3) When cash represents a small fraction of the consideration but the major part is preferred stock redeemable and nonvoting,
were the minority cashed out for Revlon duties purposes?
It seems that nonvoting preferred stock is just like debt. Without voting rights, the stockholders will no longer participate in the
corporate governance of the merged entity and, therefore, the control has been sold and they have the right to receive the highest
control premium available.

4) When the merger consideration increase’s the acquirer’s outstanding stock by more than 20%, the acquirer’s stockholders
have the right to vote. In which circumstance can the acquirer increase its outstanding stock by more than 20% (if the Authorized
stock permits) without shareholder’s approval? (two-step mergers, why?)

5) Under Unocal, does the board have the right to adopt defensive tactics to protect the company against inadequate tender
offers or the duty? In other words, could the target shareholders sue the board for not adopting a defensive tactic at face of a
coercive tender offer?

6) When the board agrees with a termination fee with a “white-knight” why doesn’t this affect the reservation price which other
bidders are willing to pay? The termination fee will be paid by the corporation in which the bidder will become the new controller
so it would be reasonable that he would value less the target, right?

Deal Protections

Examples of “lock-ups” generally adopted by the board to assure a friendly deal:

a) Termination Fee – termination fees are often justified as necessary to compensate a friendly buyer for spending the time,
money and reputation to negotiate a deal with the target when a third party ultimately wins the target. Therefore, even when the
transaction is in an auction mode of Revlon, courts have long approved reasonable termination fees. To determine the
reasonableness of the termination fee the factors that should be taken into consideration are the value of the fee (should not
exceed 3% or 4% of the deal) and at which stage of the contest the termination fee was given (if it was to early then it is more
susceptible of ex post attack).
When the transaction is not under the Revlon mode, the courts will be willing to accept larger termination fees as an incentive to
close the deal. But an exceedingly high termination fee would raise some suspicious about the transaction. When the transaction is
not under Revlon there is a presumption that the company is arranging the best possible deal for the stockholders (Time-Warner)
even though they might not recognize the benefits derived from such transaction. But when the termination fee is extremely high,
this presumption can be challenged: why would the merger proposed by the management require such a high termination fee to be
protected? Two possible suggestions might explain the high termination fee: (i) the target stockholders are not able to recognize
the benefits of the management-sponsored alternative and only a very large termination fee might be able to preclude them voting
against it; or (ii) the target board is receiving some compensation by the acquirer (such as assured seats in the surviving
company’s board or consultant contracts) to grant such a favorable clause. In both hypothesis the large termination fee is abusive
and should be unenforceable.
b) Block future deals - if the proposed deal doesn’t close the company will not enter into any other control transaction for a
certain period (say, 18 months)
c) Asset lock-ups – the friendly bidder is entitled with the right to acquirer valuable assets from the target company for a specific
price.
d) Stock lock-ups – the friendly bidder is entitled with the right to acquirer a block of securities of the target company’s stock for
a specific price (usually the deal price agreed in the protected transaction)
e) No-Shop – the board agrees not to shop for alternative transactions or neither to supply confidential information to alternative
buyers. But when the transaction is under Revlon mode and a third party makes a better offer before the shareholders can vote
on the original offer, the board has the fiduciary duty of negotiating with the higher bidder. Generally the Delaware Courts have
declared contracts which preclude the board from exercising its fiduciary duty unenforceable (Paramount Communication v.
QVC). Thus, contracts damages may not ever be available against a corporation that abandons a transaction subject to Revlon
duties on the grounds that a better deal is available. But because it is unclear when the courts will actually consider that the
transaction is in the mode of Revlon and allow the board to breach the lock-up clauses without having to face contractual
damages (the clauses are unenforceable) it is more prudent for the board to include a “fiduciary-out” clause which specifies that,
if some triggering events occurs, then the target’s board can avoid the contract without breaching it.
f) Go-Shop – the board asks for a time to look for other potential bidders (market check) and after this period it negotiates
exclusively with the interested acquirer (if no other interested bidder was found)

What deal protections are accepted by the courts will depend whether the transaction was in the mode of Revlon:

When it is in the mode of Revlon - reasonable termination fees are accepted (3% or 4% of the deal) and also contracts between
the board and the acquirer in which the board is required to submit the merger proposal to shareholders vote (DGCL 251 c).
What is not enforceable are the strategies adopted by the board to influence the minority’s vote.

When it is not in the mode of Revlon – usually the courts will be more sympathetic to the deal protections and analyze them under
the standard of Unitrin (they still cannot be preclusive as argued in Omnicare)

Range of events to trigger the termination fee:

a) Failure of the board to recommend a negotiated deal to shareholders in light of the emergence of a higher offer
b) Rejection of the negotiated deal by a vote of the target’s shareholders
c) Sale of target’s assets to another company

State Antitakeover Statutes

Hostile Takeovers were not only discourage by the defensive tactics adopted by the target’s board (discriminatory self tender –
Unocal, shareholders right plan – Moran), but also by antitakeover statutes enacted by the states. The first antitakeover
legislation enacted was the federal Williams Act (already addressed under the “tender offer” topic).

First Generation of Antitakeover statutes:

- Illinois Business Takeover Act of 1979 – The Supreme Court struck down the Illinois Act as preempted by the federal
Williams Act in Edgar v. MITE Corp.
First it noted that the Illinois statute provided for a 20-day precommencement period. During this time, management could
disseminate its own view on the upcoming offer to shareholders, but offerors could not publish their offers. The plurality found
that this provision gave management “a powerful tool to combat tender offers”. Second was a provision for a hearing on a tender
offer that, because it set on deadline, allowed management to “stymie indefinitely a takeover”. Third was the requirement that the
fairness of tender offers would be reviewed by the Illinois Secretary of State, noting that “Congress intended for investors to be
free to make their own decisions”. The Supreme Court concluded that the Illinois statute operated to favor management against
offerors to the detriment of shareholders.

Second Generation of Antitakeover statutes (attempted to avoid preemption by the Williams Act by maintaining an appropriate
balance between the interests of the offerors and the targets within the policy of investor protection):

- Fair price statute (operates in the freeze-out step) – deters coercive two-tier tender offers by requiring that minority
shareholders who are frozen out in the second step of such a takeover receive no less for their shares than the shareholders who
tendered in the first step of the takeover.

- Control share statute (operates in the acquiring control step) – resists hostile takeovers by requiring a disinterested shareholder
vote to approve the purchase of shares by any person crossing certain levels of share ownership in the company that are deemed
to constitute “acquisition of control”.

- Indiana’s control share statute – allowed the bidder to cross the relevant ownership thresholds without obtaining shareholder
approval but with an automatic loss of voting rights. The offeror could regain voting rights only upon gaining approval from a
majority of disinterested shareholders. Indiana’s statute was upheld by the Supreme Court in CTS Corp. v. Dynamics Corp. of
America. It was held that “the primary purpose of the Act is to protect the shareholders by affording them, when a takeover offer
is made, an opportunity to decide collectively whether the resulting change in voting control of the corporation, as they perceive
it, would be desirable”. Moreover, the Indiana’s statute didn’t block many potential transactions because the offeror can always
make a conditional tender offer, offering to accept shares on the condition that the shares receive voting rights within a certain
period of time. After all, this protection is not so different than when corporations adopt a staggered board, delaying the time
when a successful offeror gains control of the board of directors.

Third Generation of Antitakeover statutes: followed the Supreme Court’s holding in CTS Corp. v. Dynamics Corp. of America
allowing statutes that make the acquisition of shares less attractive:

- Business combination statute (operates in the freeze-out step) – prohibits a corporation from engaging in a “business
combination” within a set period of time after a shareholder acquirers more than a certain level of share ownership. While New
York Business Combination statute bars any substantial sale of assets or merger for five years after the threshold is crossed
without prior approval (NYBCL 912), the Delaware statute covers only transactions between the target and the bidder or its
affiliates (DGCL 203 c 3). Thus, a takeover entrepreneur could still seek to acquire control of a company having a liquidation
value substantially in excess of its stock market value and subsequently dissolve the company and distribute the proceeds of the
assets to the remaining shareholders.

- Delaware Business combination statute (DGCL 203) – the general rule contemplates two exceptions. First the restriction
doesn’t apply if the bidder can acquirer 85% of the outstanding voting stock in a single transaction. Second, its restriction will not
be imposed if, after acquiring more than 15% but less than 85% a bidder can secure a two-thirds vote from the remaining
shareholders (other than itself) as well as board approval. This brings the bidder to a dilemma: try to reach the minimum 85% and
automatically exclude the restriction or try to use the second exception by acquiring a certain level of shares and then asking for a
two-third shareholder approval? The problem is that if the bidder does not acquirer 85% but acquires a substantial quantity (say
80%), it will be hard to gain shareholder’s approval. First because the remaining minority shareholders will probably not be
sympathetic to an acquirer who captured this level of shares and is able to do whatever he wants with the company. Secondly
because the statute requires 2/3 of outstanding shareholders to vote affirmatively, so the lesser is the number of the remaining
shareholders, the harder it will be to gain a 2/3 affirmatively vote. Potentially, this could create an incentive to make a partial bid
for only 50% (if the bidder is uncertain about its ability to acquire 85% and it fears falling just short of that level). Alternatively,
the bidder could protect itself by specifying an 85% minimum tender condition to its obligation to close its tender offer.

- Disgorgement statute (operates in the acquiring control step) – any bidder who acquirer’s a certain percentage of voting rights,
including (in some acts) voting rights acquired by proxy solicitation, is required to disgorge any profits made upon the sale of
either stock in the target or assets of the target. (Adopted in Ohio and Pennsylvania)

- Redemption rights statute (operates in the acquiring control step) – allows shareholders to bring an appraisal action not merely
for freeze-out mergers but also whenever a person makes a “controlling share acquisition”, defined as acquisition of 30% of a
corporation’s stock.

- Constituency statutes (operates in the acquiring control step) – allow the board of a target corporation to consider the interests
of constituencies other than the shareholders when determining what response to take to a hostile takeover offer. This allows the
board to use a broader range of justifications for taking defensive measures followed by the right to be reviewed under the
business judgment standard. Under this statute, the directors are not required to redeem any shareholders right plan or to take or
decline to take any other action solely because of the effect such action might have on a proposed acquisition of control of the
corporation or the amount that might be paid to shareholders under such acquisition. (Ohio and Indiana adopted this statute).
Is this statute consistent with Delaware Law? The statute repeats what Unocal had already stated about allowing the board to
consider the other constituencies when adopting defensive tactics to protect the company’s independence. Revlon, however,
narrowed this conclusion by holding that when the board is putting the “company to sale” it cannot take other constituencies into
account at the expenses of stockholder’s interest. Thus, if the constituency statutes are interpreted to cover even situations where
the board is selling the company (and not only protecting its independence) it is inconsistent with Revlon. But if it is interpreted
narrowly to situations where the board is protecting the company’s independence, then it is consistent with Delaware Law (under
Unocal without violating Revlon).
- Classified Board statute – provides classified boards for all public companies incorporated in the state as statutory default
(adopted in MA, but already invalidated due to its extremeness)

Proxy Contests for Corporate Control

In a world in which a board is empowered by so many antitakeover statutes, including the recognized right to adopt a poison pill,
those seeking an opportunity to acquire control have only two alternatives. The first is to negotiate with the incumbent board and
try to persuade the directors that a change-in-control transaction is a good thing. This open space for “friendly deals” in which the
incumbent management captures a large share of the transaction gains (in the form of compensation payments and other private
benefits). The second alternative is to displace the incumbent management by running both a proxy contest and a tender offer
simultaneously. In this case, closing the tender offer is conditioned on electing the acquirer’s nominees to the board (then the new
board can redeem the target’s poison pill). Contest of this type leave open a variety of further defensive steps that the target may
attempt to take. For example, the target board may attempt to affect the outcome of the proxy fight by (i) changing the date of
the shareholder’s annual meeting; (ii) increasing the size of the board and placing its own candidates; (iii) issuing stock into
friendly hands; (iv) purchase stock selectively from a large shareholder who is otherwise likely to vote for the insurgents; (v)
transferring the target’s assets to a new wholly owned subsidiary and implementing a staggered board structure; or (vi) selling
corporate assets that represent value to the hostile bidder.

Schnell v. Chris-Craft Industries, Inc. (The directors cannot advance the date of a shareholders meeting with the purpose of
frustrating a proxy contest)
In order to frustrate a proxy contest, the incumbent board amended the bylaws to advance the date of the stockholders annual
meeting, thereby restricting the time available for the insurgent stockholders to promote campaigns in favor of their nominees and
solicit proxy materials. Even though the change in the bylaw date is legally possible, management has attempted to exercise its
right with the purpose of perpetuating itself in office. The legal power held by a fiduciary may not be deployed in a way that is
intended to treat a beneficiary of the duty unfairly.

Bylaw Amendments X Fiduciary Duties

Both in Schnell v. Chris-Craft Industries, Inc and in CA, Inc. v. AFSCME Employees Pension Plan, the court rejected bylaw
amendments which could collide with the exercise of the fiduciary duties. Even though, both the directors and the shareholders
have the legal power to amend the bylaws, the exercise of this right has to be under the strict limits imposed by the fiduciary
duties. There are two main differences in these cases that can be pointed. In Schnell the bylaw was amended by the board
whereas in CA the shareholders were proposing the amendment. The rational underlying CA is that the shareholders democracy
does not trump the fiduciary duty owed by the board to the corporation. In other words, the shareholders cannot put the
directors in a situation in which they are forced to breach its fiduciary duties. The second difference is that in Schnell the bylaw
amendment was an actual breach of fiduciary duties whereas in CA the bylaw amendment was rejected based on a mere
possibility of situations where the directors would be forced to breach their fiduciary duties by complying with the amendment. In
the later case, the proposal would be accepted if it included a “fiduciary-out” provision.

Blasius Industries, Inc. v. Atlas Corp. (Defensive measures adopted by the board with the primary purpose of interfering with
shareholder’s democracy are abusive and constitute a breach of fiduciary duty, regardless if they were undertaken with the
subjective good faith to advance the company’s interest)
Blasius Industries, the owner of about 9% of the stock of Atlas Corporation, proposed a restructuring to Atlas’s management.
When management rejected the restructuring proposal, Blasius announced that it would pursue a campaign to obtain shareholder
consent to increase Atlas’s board from 7 to 15 members (the maximum size allowed by Atlas’s charter) and to fill the new board
seats with Blasius’s nominees. The Atlas’s board reacted by immediately amending the bylaws to add two new board seats and
filling these seats with its own candidates. Atlas’s board was classified so the strategy of increasing the board’s seats had the
effect of preventing Blasius’s candidates, if elected, to dominate the board. The question before the court was whether the
board’s decision to amend the bylaws to add two new board seats and fill them with its own candidates was a breach of
fiduciary duty.
The court concluded that the step undertaken by the board had the primary purpose of precluding a majority of the shareholders
from effectively adopting the course proposed by Blasius. By adding two seats in the board, the incumbent directors intended to
strengthen their control over the board and avoid that Blasius plan of dominating the board with its own candidates succeeded.
The court distinguished this case from Unocal by arguing that the defensive measure adopted here was designed for the primary
purpose of interfering with the effectiveness of a stockholder vote. Similarly to Schnell, the argument made here is that a board’s
decision (even when undertaken with subjective good faith to advance the corporation’s interest) which blocks shareholder’s
ability to vote in the way they may think appropriate is considered abusive and shall be deemed a breach of fiduciary duty. The
rational for such conclusion is that the allocation of effective power with respect to governance of the corporation shall rest under
the principal’s (shareholders) control, rather than the agent (board).
Unocal X Blasius
Under Unocal the board has the right to adopt defensive measures (reasonable to the threat posed) against a hostile takeover.
Blasius, however, holds that this right is restricted when it is exercised in the context of a proxy-contest, in which the
shareholder’s democracy shall prevail. The rational to explain such difference is that in the first case the board is protecting the
company against an outside acquirer (a potential shareholder or an actual shareholder who intends to acquirer the control)
whereas in the second situation the board is protecting the company against its current shareholders and limiting their ability to
exercise the most fundamental right conferred by their common stock: the right to vote.

Time-Warner X Blasius (In Time-Warner the board is adopting defensive tactics because the shareholders don’t understand the
danger imposed by a tender offer or imposed by a proxy-contest. The fact that shareholders do not recognize the dangers of a
tender offer can justify the board’s defensive action but the fact that they do not recognize the danger of a proxy-contest cannot).
The Delaware Supreme Court’s Time-Warner opinion seems to authorize a target board to take defensive action if the company
is threatened by “substantive coercion”, this is simply the board’s belief that the tender offer is inadequate and that the
shareholders do not understand this fact. Under Blasius, however, corporate action to defeat a proxy contest cannot be justified
by a parallel belief that the voters simply do not understand the foolishness of voting for the insurgent slate.

Liquid Audio v. MM Companies, Inc. (Even when the shareholders are not actually precluded from voting in favor of the hostile
bidder’s proposals, the defensive measures adopted by the incumbent board with the primary purpose of making it harder for the
hostile bidder to gain control over the board in a proxy-contest are invalidated under Blasius)
LA, which shares were extremely undervalued in the market, rejected a cash offer from MM Companies in favor of a stock-for-
stock merger with Alliance Entertainment. MM then forced LA to hold its annual meeting, at which MM planned to: (i) challenge
the two incumbent directors who were up for reelection; and (ii) propose a bylaw amendment expanding the board from 5 to 9
members. LA reacted by increasing the board’s size from 5 to 7 members and adding two new directors. The outcome of the
shareholder’s meeting was divided. MM was successful in replacing two members of the incumbent board, but the proposal to
increase the size of the board was rejected. The result was that there were 7 members in the board, in which 5 “belonged” to the
original LA team and 2 “belonged” to MM. The question before the court was whether the board’s initial decision to amend the
bylaws to add two new board seats and fill them with its own candidates was a breach of fiduciary duty.
Vice Chancellor Jack Jacobs upheld LA’s defensive tactics under Unocal, and declined to apply Blasius because LA’s actions
would not have prevented MM from achieving board control had its board expansion amendment succeeded. The Delaware
Supreme Court reversed, holding that Blasius applied because the “primary purpose” of LA’s actions was to reduce the MM’s
directors’ ability to influence board decisions. Thus, the defensive tactic adopted by the incumbent directors of expanding the
board from 5 to 7 members was invalidated under Blasius.
This decision can be particularly criticized because the board’s action didn’t actually preclude the shareholders from voting in
favor of the course proposed by MM. Indeed, the shareholders had the option of approving the amendment to increase the
number of seats in the board and fill them with MM’s candidates. The fact that the directors had filled two new seats with their
own candidates did not preclude the exercise of this option. This means that the court excluded Unocal doctrine even without an
actual threat on shareholder’s democracy. The mere possibility of interfering with shareholders vote is enough to exclude Unocal
doctrine and invalidate the defensive tactic under Blasius.

Hilton Hotels v. ITT Corp. (The board’s strategy to transfer the assets to a wholly owned subsidiary and implement a staggered
board structure is preclusive because it blocks the shareholders right to vote in favor of the bidder’s proposed course of action)
Hilton initiated a $55 per share cash offer for all shares in ITT and a proxy-contest to replace the ITT’s board. ITT, in reaction,
delayed calling its annual meeting and then structured a reorganization. The reorganization was basically to transfer ITT main
assets to a wholly owned subsidiary and implement in the subsidiary a full stable of antitakeover mechanisms, including a poison
pill and a staggered board structure (the existing ITT did not have a staggered board and by virtue of law the board is not
permitted to amend the bylaws as to implement such structure). Hilton sought an injunction against effectuation of the
reorganization without shareholder approval.
In determining if the reorganization required shareholder approval, the court compared this situation to a “sale of substantially all
assets”. The difference is that in this case the transferee was indirectly held by the same shareholders in the same proportion as
was ownership in the transferor. Therefore, the transaction cannot be considered a sale for shareholder’s vote purpose.
The court reviewed the defensive tactic adopted by the incumbent board in light of the relevant Delaware precedents – Unocal,
Unitrin, and Blasius. It concluded that the defensive tactic was “preclusive” in violation of Unitrin because “the classification board
provision for ITT Destinations will preclude current ITT shareholders from exercising a right they currently possess – to
determine the membership of the board of ITT”. The court could also used Blasius to argue that the reorganization with a
staggered board structure was undertaken with the primary purpose of blocking the shareholder’s right to vote in favor of
Hilton’s proposed course of action.

In light of the above cases, it is clear that the Delaware courts have rejected the target’s board defensive action undertaken to
frustrate a proxy-contest and interfere with the shareholder’s right to vote in favor of the hostile bidder’s nominees (Schnell,
Blasius, LA and Hilton). As a result, management began looking for alternative strategies to discourage hostile takeovers.

Management’s strategy to entrench the Poison Pill – Dead Hand Pills

There are many variations of the “dead hand pill” but the core idea is simple: once a poison pill is adopted by a company, it
cannot be redeemed by the “hostile” board that is elected in a proxy-fight for a stated period of time. Only the “continuing
directors”, a term defined to mean directors in office at the time of adoption of the pill, would have the authority to redeem the
pill. The Delaware Courts rejected a version of the dead hand pill in Mentor Graphics Corp. v. Quickturn Design Systems Inc.
The Chancery Court struck down the pill on the grounds of a Unocal/Unitrin analysis. The court argued that no abstract threat to
the corporation made reasonable the imposition on the shareholders’ right to have fully functioning directors in place. The
Delaware Supreme Court affirmed Quickturn but did not invoke Unocal/Unitrin principle. Instead, its opinion was based on the
board’s general power conferred by the DGCL 141 a, arguing that the present board did not have the authority to restrict the
power of future boards conferred by the statute. The Delaware Supreme Court’s rationale for striking down this version of the
dead hand pill raises interesting questions. The present board is at all time limiting the power of future boards by entering into
long-term contracts and, nevertheless, they are not deemed invalid. Could we say that present boards may limit the power of
future boards when they have a “business reason” for doing so but not when the purpose is to defend the company against hostile
takeovers?

Protakeovers’ strategy to eliminate the Poison Pill - Mandatory Pill Redemption Bylaws

Shareholders may adopt a bylaw that requires the board of directors to redeem an existing poison pill and to refrain from
adopting a pill without submitting it to shareholder approval. Two main questions arise concerning the validity of this bylaw-
amendment.
First, is a bylaw that mandates the board to exercise its judgment in a particular way a valid bylaw? In CA, Inc. v. AFSCME
Employees Pension Plan the court decided that the shareholders can amend the bylaws as long as the amendment is intended to
regulate the process for substantive decision-making, instead of mandating the decision itself. Here it is hard to argue that the
proposal is a method of regulating formally the procedure of hostile takeovers since the idea is to actually command the board’s
action at face of a hostile takeover, limiting the board’s power to react in the way it considers “reasonable to the threat posed”.
Moreover, as argued in CA, Inc. v. AFSCME Employees Pension Plan, the proposal might put the board under a situation
where it cannot act in accordance with its fiduciary duties. Sometimes, the fiduciary duties of the board would mandate it to react
promptly to a hostile takeover which threats the company and its shareholders (such as a two-tier coercive tender offer). If the
board is forced to submit a poison pill proposal to shareholder’s approval before adopting it, the voting process might take too
long to prevent the threat posed by the hostile bidder. Moreover, the company may be threatened by a “substantive coercion”
(as stated in Time-Warner), which means that the shareholders may not recognize the threat posed by the hostile offer and the
board would be required to act without shareholders consent to protect them from the “misunderstanding”.

Second, is the management obliged to include in the company’s proxy solicitation, materials respecting a mandatory pill
redemption proposal? Indeed, SEC Rule 14a (1)(i) specifically states that a board may exclude a proposal that would be illegal
or invalid under state law. Some provisions in the DGCL can be invoked to argue that such proposal is inconsistent with
Delaware law. First the DGCL 141 (a) confers broad powers to the board to manage the company and its affairs and the
proposal, if adopted, would interfere with the board’s extensive managerial powers, including the right to adopt a poison pill
recognized in Moran. Secondly, section DGCL 102 b 1, contemplates that the certificate of incorporation may contain a
provision limiting the broad statutory power of the directors, suggesting that this is the only adequate way to restrict the board’s
power. In other words, any such reallocation of governance power must be set forth in the corporation’s charter and not in the
bylaws. Finally, the proposal might violate the established common law of fiduciary duty by removing the board’s autonomy to
react to the threat posed by a hostile takeover.
The Delaware Chancery Court was called to rule on this issue in Bebchuk v. CA, Inc, concerning the validity of a proposed
shareholder bylaw which mandates that the CA board could only adopt a poison pill through a unanimous board vote (thereby
reducing the effectiveness of a staggered board as a takeover defense because once the acquirer places at least one director in
the board, the unanimous consent will be deterred), and any pill so adopted would automatically expire one year after it was
adopted, unless ratified by the CA shareholders. The SEC refused to issue a no-action letter, forcing the company to include the
proposal in the proxy materials. The Delaware Chancery Court, however, refused to decide the controversy declaring that
“deciding the question posed in this case now would prematurely resolve a highly contentious and important matter before the
court knows what pertinent facts might develop in the future”.
Some policy questions related to the issue might help to decide the controversy: how costly is it to evaluate a stock rights plan?
Suggests that the board is better informed to make the decision. How likely is it that a pill will deter wanted offers? How likely is
it that management will misuse the pill? See the discussion in the Poison Pill section.
While the question of whether a shareholder’s proposal to retain the power to install/redeem poison pills remains open, the
Delaware Chancery Court already made it clear that when the directors themselves grant this right to the shareholders through a
contract, then the promise is valid and enforceable:

Unisuper v. News Corp. (When the directors themselves empower the stockholders to decide whether the pill shall continue or
not, the contract is valid and enforceable)
New Corp. agreed with certain of its institutional shareholders to a “board policy” that any poison pill adopted by the News
board would expire after one year, unless shareholders approved an extension. When Liberty Media appeared as a potential
hostile acquiror the News’ board promptly installed a poison pill and, subsequently, extended it without submitting the matter to
shareholder’s approval, in contravention with the earlier stated board policy.
The court rejected the argument based on DGCL 141 a by stating that the provision simply describes who will manage the affairs
of the corporation and it precludes a board from ceding that power to outside groups or individuals. However, it does not
preclude a board from ceding such power to the shareholders, who are the ultimate holders of power under Delaware law.
The court also rejected the argument based on a potential breach of fiduciary duty by stating that all other Delaware cases in
which the court invalidated a clause because it would unable the board from exercising its fiduciary duty were situations where the
board removed the power to decide from the shareholder’s hands (Schnell, Blasius, LA and Hilton). Here, to the contrary, the
challenged contract put the power to block or permit a transaction directly into the hands of shareholders. The court concluded
that “Where the principal wishes to make known to the agent exactly which actions the principal wishes to be taken, the agent
cannot refuse to listen on the grounds that this is not in the best interest of the principal”.

TRADING IN THE CORPORATION’S SECURITIES

Trading in the Corporation’s Securities

We now turn to a large topic: the obligation of directors, officers, and issuing corporations when dealing in the corporation’s own
securities. The regulation is concentrated on publicly held companies because the public investors are subject to a high level of
risk and opportunistic behaviors. The Securities Act of 1933 is the principal statute to regulate public distribution of securities and
the Securities Act of 1934 is the primary source to regulate securities transactions in the public “secondary” markets (such as the
New York Stock Exchange or NASDAQ). While the Federal Securities statutes are the major source of law to regulate
securities transactions, the corporate law and fiduciary doctrines are decidedly of secondary significance in this field.
Nevertheless, the common law’s development deserves some attention.

Corporate Law (State)

Strong v. Repide (In a face-to-face transaction the insider is required to disclose any material facts that might be unknown to the
other party)
A shareholder offered to sell his stock for a director who knew, but did not reveal, that the company was about to conclude
negotiations on a highly favorable contract. The director bought the stock, without disclosing this information or counseling delay,
at what soon appeared to be a bargain price. The former shareholder sues to rescind the contract for breach of fiduciary duty of
loyalty. The Supreme Court affirmed judgment for the former shareholder on the grounds that, where special facts exist, a
director has an obligation to disclose these material facts or refrain from buying corporate stock in a face-to-face transaction.

Goodwin v. Agassiz (When the transaction takes place on a stock exchange there is no disclosure obligation)
Agassiz, president and director of Cliff Mining Company, and MacNaughton, director and general management in the same
company, purchased the company’s shares on the Boston stock exchange. They had certain knowledge, material as to the value
of the stock, which the former shareholder plaintiff didn’t have. Because the stock of Cliff Mining was bought and sold on the
stock exchange, where the identities of buyer and seller of the stock in question in fact was not known to the parties, there was
no disclosure obligation. The plaintiff was no novice, he acted upon his own judgment in selling his stock.

Strong X Goodwin and State Law Development

The rationality for treating a face-to-face transaction differently from a transaction in the stock exchange is that in the first situation
there is actual communication between the buyer and the seller and one relies on the other’s word. When the transaction takes
place in a stock exchange there is no such relationship of trust because the parties don’t know each other. Corporate Law,
however, evolved. Nowadays it plays an important role in two situations. First, a corporation can bring a claim against an officer,
director, or employee for trading profits made by using information learned in connection with his corporate duties. In this case,
the corporation or its shareholders as a collectively are able to sue the insider derivatively to capture their profit on behalf of the
corporation (it is presumed that the inside information is a corporate asset and that the corporation is therefore entitled to any
profits made by its agents by trading on it). Second, shareholders can invoke state fiduciary duty to challenge the quality of the
disclosure that their corporation makes to them.

Derivative suit on behalf of the corporation to recover the profits:

Diamond v. Oreamuno (NY)
The New York Court of Appeals held that the officers and directors of a corporation breached their fiduciary duties owed to the
corporation by trading in its stock on the basis of material non-public information acquired by virtue of their official positions.

Brophy v. Cities Service Co. (Delaware)

The confidential secretary to a director of a corporation purchased a number of shares of the company’s stock after finding out
that the corporation was about to enter the market to make purchases of its own stock, and then sold at a profit after the
corporation began its purchases. The Delaware Court of Chancery upheld the complaint in a derivative action on behalf of the
corporation to recover those profits. Here it is easier to see that the corporation suffered an injury.

Freeman v. Decio (The Diamond case shall not be applied because the federal securities law is now the appropriate remedy
against insider trading and because there is no actual injury to the corporation subject to recovery)
The principal question presented by this case is whether under Indiana law the plaintiff may sustain a derivative action against
certain officers and directors for allegedly trading in the stock of the corporation on the basis of material inside information. The
court declined to apply Diamond v. Oreamuno on the grounds that when that case was decided the 10b-5 class action provided
under the Securities Exchange Act of 1934 was not an effective remedy for insider trading, but nowadays it made substantial
advances and it is the appropriate method of challenging an insider trading.
Moreover, the court rejected the characterization of inside information as a corporate asset. It argued that instead of identifying
an inside information as a corporate asset the court must ask if there was any potential loss to the corporation subject to
recovery. In fact, most information involved in insider trading is not a corporate asset (neither a corporate opportunity) because if
the corporation were to attempt to exploit such non-public information by dealing in its own securities, it would open itself up to
potential liability under federal and state securities laws. Therefore, one cannot consider an inside information a corporate
opportunity if the corporation itself is prohibited from exploiting it.

Board disclosure obligations under State Law:

Initially, Delaware’s Court of Chancery attempted to reconcile parallel federal and state disclosure duties by stating that a duty
arose only when the board communicated with shareholders by recommending how to vote or react to a tender offer. Thus, the
Chancery Court indicated that state law retained its traditional focus on corporate governance rather than on the effects of
corporate disclosures on the investment decisions of individual shareholders. The Delaware Supreme Court rejected this self-
imposed limitation and clearly expanded the scope of state disclosure duties to the protection of shareholders in Malone v.
Brincat. According to this precedent, directors are required to exercise honest judgment to assure the disclosure of all material
facts to shareholders. Failure to disclose a material fact, however, is unlikely to give rise to liability unless this failure represented
intent to mislead. Otherwise, the common charter waiver of liability for damages (DGCL 102 b 7) will protect directors from
good faith failure to adequately disclose (even when negligent). An injunction, however, remains available if plaintiff can
demonstrate a failure to disclose a material fact.

Securities Law (Federal)

The first regulation was the narrow provision of section 16 of the Securities Exchange Act of 1934. According to section 16 (a),
the covered persons (directors, officers, and 10% shareholders of any issuer) are required to file public reports of any transaction
in the corporation’s securities. Section 16 (b) imposes a strict liability rule which requires the covered persons to disgorge to the
corporation any profits made on short-term turnovers in the issuer’s shares (purchases and sales within six months). It may be
enforced by the corporation itself or by a derivative suit brought by shareholders on behalf of the corporation to recover the
profits. The SEC is not entitled to enforce the provision. Section 16 (b) is intended to deter statutory insiders from profiting on
inside information, but the provision raises three problematic issues.
First, because it eliminates a subjective intent inquiry, it is both overinclusive and underinclusive. It is overinclusive because short-
swing transactions not necessarily involve insider information; and it is underinclusive because insider trading can occur over a
period longer than six months.
The second problem is that the designation of “covered person” (10% shareholders, directors and officers) could easily be
escaped through creative use of label forms (vice-president or production manager). In Reliance Electric Co. v. Emerson Electric
Co. the court found that plaintiffs could not recover profits made in the second of two successive sales of company stock, even
though the sale had been split in order to avoid application of 16 (b), because at the time of the second sale the defendant was no
longer a covered person under the statute (he owned less than 10% of the company’s stock). The courts, however, have stated
that the relevant inquiry concerned whether the putative person had recurring access to nonpublic information by virtue of his
position.
Finally, the most difficult administrative issue arising under 16 (b) lies in formulating the exact criteria for a “purchase or sale”.
Transactions might have the effects of a purchase or sale without having their forms. Suppose an officer borrows money,
delivering his holdings of company stock as security, and subsequently defaults on his loan, forcing the bank to sell his stock. Was
the original extension of cash a “sale”? What about the treatment of mergers? When target shareholders receive cash in return for
their shares have they sold stock? And when target shareholders receive stock in the surviving company as the merger
consideration?

Kern County Land Co. v. Occidental Petroleum (A merger is not a sale of stock for section 16’s purpose)
Occidental was a 20% shareholder in Kern at the time of the merger between Kern and Tenneco. Occidental received
Tenneco’s shares as the merger consideration and now Kern (which continued to exist as a wholly owned subsidiary of Tenneco)
brought a suit against Occidental alleging that the merger constituted a sale of Kern shares and, therefore, the profits should be
disgorged to the corporation. The court considered whether the defendant was in a position to profit from inside information.
Occidental could not access Kern’s inside information. In addition, the transaction that was claimed as a sale was a corporate
transaction authorized by others, not Occidental alone. Thus, the court concluded that the merger did not give rise to the risks
that Section 16’s remedy was designed to protect against and was not covered by section 16.

Calculation of profits owed to the corporation by the covered person:

(The idea is to maximize the profit you can attribute to the insider – punitive aspect)

Purchases:
Sep 15 – 10.000 shares at $5,00/share = 50.000
Oct 1 – Became a covered person
Oct 30 – 5.000 shares at $5,50/share = 27.500
Dec 15 – 3.000 shares at $5,30/share = 15.900

Sale:
Dec 25 – 2.000 shares at $5,10/share = 10.200
March 1 – Resignation
March 20 – 16.000 shares at $5,70/share = 91.200

Analysis:
The purchase on Sep 15 doesn’t count because he was not yet a covered person under section 16. But the sale on March 20
counts because he was still under the six month period proscribed by section 16. Therefore, the only purchased shares that count
are the 8.000 shares purchased while holding office. In relation to these shares, the insider spent $43.400 (27.500 + 15.900).
Later on, he sold these 8.000 shares for 5,70/share within the 6 months period after his resignation (still a covered person),
receiving $45.600 (8.000 X 5,70). Therefore, his total profits were $2.200 (45.600 – 43.400).

Strategy to calculate:
1) Identify how many shares were acquired during the insider period and calculate their total price.
2) Identify the best sale he made during the insider period and multiply the number of shares purchased during the insider period
for the price per share received in the best deal. Go to the second next best deal if the best one is not able to cover all the
purchased shares.
3) Get the result from step 2 and subtract it from the result from step 1 to obtain the total profits that must be disgorged.

Note: the shareholder with more than 10% ownership only becomes a covered person for the transactions realized after the
transaction that gave him 10% ownership (this transaction itself doesn’t count because the shareholder is only presumed to have
inside information after he is a 10% shareholder).

Rule 10b-5

Because of the weakness of section 16 of the Securities Exchange Act of 1934, particularly the underinclusive and overinclusive
problem created by the 6 months period standard, section 10 b of the same Act broadly empowered the SEC to promulgate
rules regulating the trading of securities on national exchanges. Section 10 b provides that it shall be unlawful “to use or employ, in
connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered,
any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may
proscribe as necessary or appropriate in the public interest or for the protection of investors”.
The most important rule promulgated by the SEC under section 10 b of the 1934 Act is Rule 10b-5. The Rule provides in
pertinent part that it shall be unlawful:
(a) To employ any device, scheme or artifice to defraud;
(b) To make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements
made, in the light of the circumstances in which they were made, not misleading;
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.

Before going through each of the elements of the Rule, there is a preliminary question which refers to the possibility of bringing a
claim under Rule 10b-5 against a fiduciary who breaches his duty to the company’s shareholders by trading with the company’s
securities in possession of confidential information. Isn’t the breach of fiduciary duty issue relegated to state corporate law? The
general rule is that the fiduciary can only be sued in the federal courts under Rule 10b-5 if he used deceptive devices (including
nondisclosure) in connection to the trade of securities. In this case the plaintiff can bring a derivative action in the federal courts on
behalf of the corporation. If there was no deceptive device, the shareholders plaintiff can only sue the fiduciary under state
corporate law claiming a breach of fiduciary duty.

Santa Fe Industries Inc. v. Green (When a fiduciary (controlling shareholder or directors) deals with the company’s stock without
employing a manipulative or fraudulent scheme, there is no violation of Rule 10b-5 and any claim shall be brought in the state
court on the grounds of a breach of fiduciary duty. The available claims would be for violation of the duty of care, violation of the
duty of loyalty (entire fairness action) or the appraisal remedy)
Santa Fe was the controlling shareholder of Kirby Lumber Corp., holding 60% of its stock. Wishing to acquire 100% ownership
of Kirby, Santa Fe first increased its control of Kirby’s stock to 95% through a series of purchases over the succeeding years
and, subsequently, cashed-out the minority stockholders through a “short-form merger” under the DGCL 253. The investment
banking valued Kirby’s assets at $640 per share and valued Kirby’s stock at $125 per share. This discrepancy of values
indicates that the market price of Kirby’s stock is extremely undervalued (the reasons to explain why the market price is
undervalued are that minority shareholders assume the risk to be subject to a controller who could engage in self-dealing
transactions, extract private benefits and even cash-out the minority at any time, with the limitation imposed by the appraisal
remedy and the entire fairness action). Santa Fe sent the valuations of the investment banking to minority shareholders, notified
them about the short-form merger and offered $150 per share. In addition, the minority stockholders were advised of their right
to obtain an appraisal in Delaware Court if dissatisfied with the offer of $150 per share. (Remember that an entire fairness class
action is not possible because the transaction in question is a short-form merger). In order to avoid the high costs of the appraisal
remedy, the minority stockholders challenged the terms of the merger in the federal court claiming a violation of Rule 10b-5. The
action was brought on behalf of the corporation and the rest of minority stockholders seeking to recover what they claimed to be
the fair value of their shares. To sustain a violation of Rule 10b-5, plaintiffs argued that Santa Fe employed a “device, scheme, or
artifice to defraud” and engaged in an “act, practice or course of business which operates or would operate as a fraud or deceit
upon any person, in connection with the purchase or sale of any security”. The plaintiff argued that Santa Fe had obtained a
“fraudulent appraisal” of the stock from Morgan Stanley to mislead the minority that $150 was more than a fair price because it
was $25 above that valuation.
The court rejected a claim under Rule 10b-5 because the transaction was neither deceptive nor manipulative. On the basis of the
information provided, minority shareholders could either accept the price offered or reject it and seek an appraisal in the
Delaware Court of Chancery. Moreover, the court argued that a federal cause of action is inappropriate when the cause of action
is traditionally relegated to state law. Because the Delaware Legislature had supplied minority shareholders with a cause of action
in the Delaware court of chancery to recover the fair value of shares allegedly undervalued in a short-form merger (through an
appraisal remedy), the federal court should not interfere to avoid overlapping between securities law and corporate law and
possible conflicting decisions. Therefore, Rule 10b-5 should not be extended to “cover the corporate universe”. As a response,
the Delaware Supreme Court modernized the appraisal remedy in Weinberg v. UOP Inc, making it a more attractive option for
minority shareholders cashed-out in self-interested transactions (plaintiff may be entitled to rescissory damages)

Santa Fe doesn’t apply: (when the fiduciary uses deceptive devices)

- When a director (fiduciary) persuades by fraud the board to sell him stock.
The company can sue the director for breach of fiduciary duty under corporate law or under Rule 10b-5 for fraudulently trading
in connection to securities. A shareholder could also sue the director in a derivative action (if she can demonstrate that the
board’s judgment not to sue the director is not deserving of business judgment deference) for violation of Rule 10b-5.

- When a controlling shareholder (fiduciary) causes a corporation to issue stock to him at an unfair price by dominating corporate
directors (dominance over the board is regarded as manipulation).
The minority shareholder can bring a derivative action on the company’s behalf under Rule 10b-5 (Schoenbaum v. Firstbrook).
Even though this case was decided before Santa Fe, the court decided in Goldberg v. Meridor that it survived Santa Fe. In
Goldberg v. Meridor the court decided that a derivative action could be brought under Rule 10b-5 on the basis that the
transaction between a corporation and a fiduciary was unfair if the transaction involved stock and material facts concerning the
transaction had not been disclosed to all shareholders. Therefore, in order to succeed under the principle of Goldberg v.
Meridor, the plaintiff must show (i) a misrepresentation or nondisclosure that (ii) caused a loss to the shareholders.
To meet the second requirement of the test, plaintiffs usually argue that if full disclosure had been made the shareholders could
have sought injunctive relief against the proposed transaction under state law and, thus, this foregone remedy was a loss. This
claim is controversial in the courts. The Ninth Circuit held in Kidwell ex rel. Penfold v. Meikle that plaintiff must show that the
shareholders would actually have succeeded if they had brought the foregone suit. In Healy v. Catalyst Recovery, on the other
hand, the Third Circuit held that the plaintiff must show only that there was “a reasonable probability of ultimate success”. The
Seventh Circuit adopts a position even stricter than the Ninth Circuit by completely rejecting the idea that an alleged failure to
disclose a breach of fiduciary duty can constitute an actionable omission or manipulation under 10b-5 (Painter v. Marshall Field
& Co.).

The elements of a Rule 10b-5 cause of action can be summarized as follows: (1) false or misleading statement (2) of material fact
that is (3) made with intent to deceive another (4) upon which that person (5) reasonably relies, (6) and that reliance causes
harm. The two most controversial elements of Rule 10b-5 are the false or misleading statement (the discussion is whether it
reaches “omissions” by anyone who possesses nonpublic information or only reaches explicit false statements) and the reasonable
reliance.

Elements of Rule 10b-5: false or misleading statement (“omissions” included?)

Initially the SEC and the Second Circuit Court of Appeals took the most aggressive position that any possession of relevant,
material, nonpublic information gives rise to a duty to disclose or abstain from trading (“disclose or abstain”). The SEC first
applied this position in its Cady Roberts decision and then the Second Circuit Court of Appeals affirmed such position in Texas
Gulf Sulphur.
Note: the defendants can use the defense provided in paragraph 10b (c)(1)(i) by demonstrating that they had entered into an
agreement to trade securities on specified terms before becoming aware of the material nonpublic information.

SEC v. Texas Gulf Sulphur Co. (Anyone in the possession of material nonpublic corporate information shall disclose it or abstain
from trading since all traders owe a duty to preserve the integrity of the market)
The SEC sued Texas Gulf Sulphur and several of its officers, directors and employees, including TGS’s Vice-President, TGS’s
chief geologist and two independent professionals for trading in the securities market with confidential and undisclosed
information related to TGS’s business. The defendants were the only ones who knew that TGS had discovered a vast mine with
rich drill core in the area of Timmins and, while in possession of such information, they purchased TGS stock in the market before
the official announcement of the Timmins discovery. The court held all the defendants liable arguing that “anyone who, trading for
his own account in the securities of a corporation and has access, directly or indirectly, to information intended to be available
only for a corporate purpose and not for the personal benefit of anyone may not take advantage of such information knowing its
is unavailable to those with whom he is dealing, i.e., the investing public”. If the defendants were disabled from disclosing it in
order to protect a corporate confidence, or they choose not to do so, they must abstain from trading in or recommending the
securities concerned while such inside information remains undisclosed. TGS itself was also held liable under 10b-5 because it
explicitly mislead the public investor.

This aggressive position adopted in Texas Gulf Sulphur Co. is called “the equal access theory”, which is based on the idea that all
traders owe a duty to the market to disclose or refrain from trading on nonpublic corporate information. The rational of this
theory is that exploiting an information advantage over other traders is an “unfair” practice which challenges the presumption that
investors have equal access to important corporate information when trading in the securities market.

Reasons to deny the “Equal access theory”: (Deregulate)

1) The counter-part in the transaction didn’t suffer any injury because it would have purchased/sold securities in the market
regardless of the insider trading, and might even not be able to get the deal it got by trading with the insider.
2) The investor doesn’t have a relationship of trust and confidence with the market to trigger a duty to disclose.
3) Why is information asymmetry alone unfair in the securities market if, in fact, in many other commercial private relationships (a
person who purchases a car from another) there is information asymmetry and it is not regulated?
4) Some academics argue that insider trading leads to more informed prices that may actually increase investor confidence as well
as the allocational efficiency of the market. The argument here turns primarily on the value of insider trading as a mechanism for
signaling the trading value of information that the firm cannot or will not disclose directly: for example, preliminary merger
negotiations or a new product that might be copied by competitors. Such information may find its way into prices only through
insider trading. Thus, the claim is that insider trading ought to be tolerated in the interest of informationally efficient prices that
ultimately lead to a more efficient allocation of capital.
5) The right to trade on inside information might serve as a compensation device. Allowing managers to benefit from prior
knowledge of increases in share prices would motivate them to initiate successful corporate projects. Moreover, the
compensation device reduces contracting costs by automatically adjusting the manager’s trading bonus to his proximity to large,
value-increasing projects within the firm.
6) Prior to legal regulation there were no voluntary agreements to prohibit insider trading, what indicates that insider trading is an
efficient mode of compensation.

Justifications for the “Equal access theory”: (Regulate)

1) Investors who trade in the securities market presume that the market price reflects all the important information. Thus, from an
ex-ante perspective, in the absence of effective mechanisms to punish insider trading, investors will anticipate the risk of dealing
with an insider and will be willing to pay less when purchasing securities and charge higher prices when selling their own shares.
The result would be a decrease in the efficiency of the market to allocate resources (the maximum price that buyers are willing to
pay for securities decreases and the minimum price that sellers are willing to sell increases, creating what economist would call a
“deadweight loss”, that is, a lack of transactions that would otherwise occur) and, consequently, the cost of capital would
increase.
2) The investors who were actually injured by the insider trading were not the ones who traded in the opposite side of the insider.
These ones arguably benefit from the insider because otherwise they wouldn’t be able to deal at the price that they personally
valued the shares. The harmed outsiders are mainly the professional investors who were spending money with informational
researches and would be the “next in line” to make the good deal undertaken by the insider. If it weren’t for the insider, the
professional investor would be able to rely on his informational researches and make the profits that were made by the insider (or
some of the profits). Thus, an effective method to detect and punish all insiders is necessary to give incentives for professional
investors to remain trading in the market.
3) In contrast to the idea that insider trading leads to more informed prices because some information that the firm will not
disclose will find its way into prices through insider trading, some academics argue that the company would be forced to disclose
such information in the near term in any case, so the this argument in favor of deregulation is weak.
4) As a response to the inside information serving as a compensation device capable of motivating managers and reducing
contracting costs, it could be argued that, first, because trading profits depend on control over information, there is no guarantee
that the originators of successful projects will reap the rewards; and secondly there is no reason to believe that managers’
negotiated contracts would correctly anticipate levels of insider trading or that other market controls would operate to check
excessive insider trading.
5) The fact that voluntary agreements prohibiting insider trading were uncommon in the past does not indicates that insider trading
is an efficient mode of compensation because managers, who are the chief beneficiaries of insider trading, wouldn’t have been
motivated to bar such trading given the realistic assessment of the scope of managerial discretion permitted by the markets.

The Texas Gulf Sulphur’s decision, reflecting the “equal access theory”, was overruled by the Supreme Court’s decision in
Chiarella v. United States. The Supreme Court rejected the idea that traders owe a general duty to the market and ruled that,
absent a fiduciary relationship, there is no duty to disclose nonpublic information.

Chiarella v. United States (A trader only violates Rule 10b-5 for nondisclosure when there is a duty to disclose arising from a
relationship of trust and confidence (RETAC) between the corporate insider and shareholders)
Chiarella learned from the confidential documents he handled that one company was planning to acquire a second company. He
learned such information from the documents of takeover bidders, not the target. Without disclosing his knowledge, Chiarella
purchased stock in the target company and sold the shares immediately after the takeover was made public, realizing gains of
$30.000 in the course of 14 months.
The Supreme Court held that a trader is only liable for nondisclosure when there is a duty to speak and such duty arises from a
relationship of trust and confidence. “Such liability is premised upon a duty to disclose arising from a relationship of trust and
confidence between parties to a transaction (…) We hold that a duty to disclose under 10b does not arise from the mere
possession of nonpublic market information”. Because Chiarella had absolutely no relationship of trust and confidence with the
target company or its shareholders, he wasn’t under a duty to disclose and, therefore, there was no violation of Rule 10 b.

Chiarella’s decision adopted the “fiduciary duty theory” to narrow the scope Rule 10b-5. The question that arises under such
theory is: what constitutes a relationship of trust and confidence? The relevant analysis is whether there is an expectation of
confidentiality.
Are corporate directors, officers or employees under a relationship of trust and confidence with the company in which they
work? Yes, certainly.
Dirks expanded the scope of primary insider trading violation by suggesting that market professionals such as “underwriter,
accountant, lawyer, or consultant” may become constructive insiders for purposes of Rule 10b-5 by virtue of entering a fiduciary
relationship with the insider (they are regarded as “temporary insiders”).
By contrast, people who have no such relationship with the company from which they possess confidential information (the taxi
driver who heard a conversation between two CEO’s concerning a merger, the waiter who heard a conversation in the
restaurant) are free to trade in the possession of such information.
It is important to highlight that the “fiduciary duty theory” requires a relationship of trust and confidence between the insider and
the shareholders with whom he transacts. (Stockholders in the target company). Even if there is a relationship of trust and
confidence between the insider and the source of information, that is not enough to trigger Rule 10b-5 liability (in contrast to the
“misappropriation theory”).
Therefore, if one of the “temporary insiders” acquires confidential information concerning the company in which they are working
for, they are precluded from trading in the securities of such company. On the other hand, if they acquire confidential information
concerning another company in the course if their work, they may trade on the securities of this second company because there is
no RETAC (relationship of trust and confidence). (In contrast to the misappropriation theory)
What about tippees, that is, people who receive tips from a corporate insider? Are they under a fiduciary duty to disclose or
abstain from trading?

Dirks v. SEC (For a tippee to be held liable under Rule 10b-5 the tipper must have had breached its fiduciary duty by releasing
the inside information in exchange for some personal benefit – which is understand very broadly, not only as monetary
compensation but also as gift to a friend)
Dirks, a securities analyst, received information from Secrist, a former officer of Equity Funding of America. Secrist alleged that
the assets of Equity Funding were vastly overstated as the result of fraudulent corporate practices. Subsequently, Dirks discussed
the information he had obtained with a number of clients and investors, who then sold their holdings of Equity Fundings securities.
The question before the court is whether Dirks violated Rule 10b-5 by this partial disclosure.
The Supreme Court hold that the tippee, who originally owes no duty, assumes a duty only when the insider’s “tip” constituted a
breach of the insider’s fiduciary duty. Whether tipping is improper in the first instance is said to turn on whether the insider tips to
secure a personal benefit from the tippee. In such case, the insider effectively trades indirectly on his own tip and is in violation of
Rule 10b-5, as well as the tippee who assumed the insider’s duty. “Thus, the test is whether the insider personally will benefit,
directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And
absent a breach by the insider, there is no derivative breach”. The court noted that the personal benefit might be a gift of
confidential information to a trading relative or friend.
In this case, the court concluded that the tipper did not violate his duty to the corporation’s shareholders by providing the
information to Dirks because he received no monetary or personal benefit for revealing Equity Funding’s secrets, nor was their
purpose to make a gift of valuable information to Dirks (what would be a breach of fiduciary duty). It follows that in the absence
of a breach of duty to shareholders by the insiders, there was no derivative breach by Dirks.

Dirks was intended in part to create a safe harbor for security analysts by allowing that corporate managers release material
inside information to a prominent security analysts as a means of assuring accurate reporting on the company without any violation
of Rule 10b-5 by the manager or by the analyst (even if the analyst uses the insider information). Both Chiarella and Dirks’
decisions narrowed the scope of Rule 10b-5 (only fiduciaries owe a duty to disclose confidential information; and a tippee does
not owe such duty unless the tipper breached its own fiduciary duty when releasing the information) and soon the SEC, lower
federal courts and even Congress reacted.

SEC reactions to Chiarella and Dirks:

Regulation Fair Disclosure (FD) – directed only to partial disclosures to specific groups.
This regulation was enacted to deal with the problem of selective disclosure to security analysts, brokers, or journalists who were
given access to inside information before the general public, and they could take advantage of such information because Rule
10b-5 didn’t reach them.
# 243.100 (FD)
(a) Whenever an issuer, or any person acting on its behalf, discloses any material nonpublic information regarding that issuer or its
securities to any person described in paragraph (b) (1) of this section, the issuer shall make public disclosure of that information
as provided in #243.101(e):
(1) Simultaneously, in the case of an intentional disclosure; and
(2) Promptly, in the case of a non-intentional disclosure.
(Paragraph (a) covers brokers, dealers, investment advisors, investment analysts and managers, and shareholders who are likely
to sell. It does not cover persons who owe a duty of trust and confidence to the issuer, such as attorneys, investment bankers,
and accountants – these “temporary insiders” are already precluded from using the confidential information under Rule 10b-5 as
stated in Dirks)
# 243.102 (FD)
No failure to make a public disclosure required solely by #243.100 shall be deemed to be a violation of Rule 10b-5 under the
Securities Exchange Act.

Rule 14(e)-3 – enacted by the SEC to regulate insider trading in the context of tender offers (mergers are excluded)
Rule 14(e)-3 imposes a duty on any person who obtains inside information about tender offers that originates with either the
offeror or the target to disclose or abstain from trading (regardless of a RETAC and a fiduciary duty). In effect, this rule
reintroduces the equal access normal in the limited but important domain of tender offers (note that mergers are not covered by
the rule, so if a person without a RETAC with the company has the knowledge of confidential information regarding a merger he
can still trade on the basis of such information).
The SEC rulemaking authority by adopting Rule 14(e)-3, which proscribes trading on undisclosed information in the tender offer
setting, was affirmed in United States v. Chestman and in United States v. O’Hagan. “To be certain, the SEC’s rulemaking
power under this broad grant of authority is not unlimited. The rule must still be “reasonably related to the purposes of the
enabling legislation” (…). The SEC, however, in adopting Rule 14(e)-3, acted consistently with this authority”. United States v.
Chestman. “We hold, accordingly, that under 14(e), the Commission may prohibit acts, not themselves fraudulent under the
common law or 10 (b), if the prohibition is “reasonably designed to prevent acts and practices that are fraudulent”. United States
v. O’Hagan.

Last Exam: 14e-3 case against Winona and Stephen is possible, although barely. Would Janet’s information about how she will
vote be considered information “relating to” a tender offer? Has Janet’s spouse already taken a “substantial step” toward initiating
his tender offer? (No liability if still in the planning phase.)

Lower federal courts reactions to Chiarella and Dirks, which even persuaded the Supreme Court to slightly change its position:

Adoption of the “Misappropriation Theory”, which provides that “one who misappropriates nonpublic information in breach of a
fiduciary duty and trades on that information to his own advantage violates section 10(b) and Rule 10b-5”. SEC v. Materia.
Rather than focusing on the relationship between the “insider” and uninformed traders this theory focuses on the private
appropriation of information rights that belong to someone else. It differs from the “fiduciary duty theory” because it is enough
that the “insider” has a relationship of trust and confidence with the source of information, regardless if he owes such duty to the
counterparty in the transaction. But still there must be a breach of fiduciary duty (as stated in Chestman) the only difference is that
the duty can be owed to the source of information, instead of requiring a duty to the shareholders with whom the insider
transacts. The Supreme Court adopted the “misappropriation theory” in its O’Hagan decision.

United States v. Chestman (Rule 10b-5 was not triggered because Keith Loeb didn’t breach a fiduciary duty to the source of the
information (Waldbaum’s family), simply because Loeb didn’t owe a fiduciary duty to Susan (his wife) neither to the members of
Waldbaum’s family. Consequently, the tippee is also protected from liability)
Waldbaum Inc. was about to be sold to A&P Company. Ira Waldbaum, the president and controlling shareholder of Waldbaum,
told three of his children, all employees in Waldbaum, about the pending sale, and told also his sister, who, in turn, told her
daughter (Susan Loeb), who, finally, told her husband (Keith Loeb). All of them were advised to maintain the information as a
secret. Keith Loeb, however, contacted Chestman and told him that Waldbaum was about to be sold at a “substantially higher”
price than its market value and asked for advice. Chestman then executed several purchases of Walbaum stock and told Keith
Loeb that “Waldbaum was a buy”. Loeb ordered 1.000 shares of Waldbaum stock. The question is whether Chestman and
Loeb violated Rule 10b-5 and/or Rule 14(e)-3.
The court upheld the Rule 14(e)-3 convictions, because both of them traded on the basis of material nonpublic information
concerning a pending tender offer (A&P would acquire Waldbaum through a tender offer), but reversed the Rule 10b-5
convictions. According to the court, Rule 10b-5 was not triggered because Keith Loeb didn’t breach a fiduciary duty to the
source of the information (Waldbaum’s family), simply because such fiduciary duty didn’t exist. Keith Loeb was not an employee
of Waldbaum and there was no showing that he participated in confidential communication regarding the business with the family.
Moreover, the court held that “Keith’s status as Susan’s husband could not itself establish fiduciary status”. In relation to
Chestaman’s liability under Rule 10b-5, the court also reversed the convictions on the grounds that “Absent a predicate act of
fraud by Keith Loeb, the alleged misappropriator, Chestman could not be derivatively liable as Loeb’s tippee or as an aider and
abettor”.

The SEC, however, overruled the approach in United States v. Chestman by adopting Rule 10b-5-2, which clarified that a
relationship of trust and confidence does exist within family members, giving rise to liability under Rule 10b-5. The enumerated
“duties of trust and confidence” arise (1) whenever a person agrees to maintain information in confidence; (2) whenever two
persons have a history, pattern, or practice of sharing confidences, such as that the recipient of the information reasonably should
know that the speaker expects that the recipient will maintain its confidentiality; or (3) whenever a person receives or obtains
material nonpublic information from his or her spouse, parent, child, or sibling.

United States v. O’Hagan (To trigger Rule 10b-5 it is enough that the trader with confidential information owed a fiduciary duty
to the source of the information – the law firm in which he worked and its client – even though he owed no duty to the
counterparty in the transaction – the shareholders in the target company)
Grand Metropolitan PLC (Grand Met) was about to pursue a tender offer for the common stock of the Pillsbury Company and it
retained Dorsey & Whitney law firm as local counsel. James O’Hagan was a partner in this law firm and, even though he did not
work on the Grand Met representation, he knew about the transaction and made several purchases of Pillsbury stock. The
question before the court is whether O’Hagan is liable under Rule 10b-5.
According to the “fiduciary duty theory” adopted in Chiarella, O’Hagan wouldn’t be held liable because he owed no fiduciary
duty to Pillsbury stockholders, since he had no relationship of trust and confidence with the target company. Under the
“misappropriation theory”, however, it is enough that O’Hagan owed a fiduciary duty to the source of the information (the law
firm and its client, Grand Met). The court concluded that the second theory was more adequate on the grounds that “it makes no
sense to hold a lawyer like O’Hagan a 10 (b) violator if he works for a law firm representing the target of a tender offer, but not if
he works for a law firm representing the bidder. The text of the statute requires no such result”.
Note that even if O’Hagan had told his law firm that he would trade on the basis of the confidential information and the law firm
accepted, he would still be held liable because he owes also a fiduciary duty to its client. “Where, however, a person trading on
the basis of material, nonpublic information owes a duty of loyalty and confidentiality to two entities or persons – for example a
law firm and its client – but makes disclosure to only one, the trader may still be liable under the misappropriation theory”.

Congress reactions to Chiarella and Dirks:

In 1988, Congress passed the Insider Trading and Securities Fraud Enforcement Act (ITSFEA) as a way to increase the
deterrence of insider trading. ITSFEA amended the Securities Exchange Act of 1934 by adding a new #20A, which was
incorporated into Title 15 of the United States Code as a new section, #78t-1.
The rule does not differ from the “misappropriation theory” as the standard to determine if liability under 10b-5 was triggered, but
it gives private parties who were “contemporaneously” buying or selling the securities subject to the violation standing to sue the
insider. Therefore, not only the government is entitled to sue the insider, but also the stockholders who were victims of the inside
information.
§ 21(d): SEC can seek disgorgement of trading profits
§ 20A(a): if SEC fails to act, or if any trading profits left over after SEC has acted, contemporaneous traders can seek
disgorgement as well.
§ 21A(a)(2): SEC can seek civil penalties up to three times the profit gained or loss avoided, in addition to disgorgement.

When you receive a stock “tip” (tippee), and you trade on the basis of such information, you will be held liable for insider trading
depending on:
1) If the tipper had a fiduciary relationship with the source of the information;
2) If the tipper breached such duty by passing the information in exchange for a personal benefit;
3) If you owe a fiduciary relationship to the tipper;
4) If the information passed was material; and
5) If you knew about all the above conditions.

Summary

Liability for insider trading

- Rule 16(a) and 16(b) ---------------------------Company through derivative action
against the statutory insider

- FD --------------------------------------------------SEC against the person who spoke

- Rule 14(e)-3 ---------------------------------------SEC and “traders” against the insider

- Rule 10b-5-2 (to trigger RETAC) --------------SEC and “traders” against the insider

- Equal Access theory (Texas Gulf) --------------SEC and “traders” against the insider

- Misappropriation theory (O’Hagan) -----------SEC and “traders” against the insider

Not Liable for insider trading

- Fiduciary Duty theory (Chiarella and Dirks)

- Misappropriation theory (Chestman but consider 10b-5-2)

Fraud on the market under Rule 10b-5

Elements of Rule 10b-5: materiality

Rule 10b-5 is not only directed against insider information, but also against fraud on the market. The fraud on the market theory
is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the
available material information regarding the company and its business. A fraud on the market takes place not when an investor
who has confidential information trades on the basis of such information, but when the company itself makes insufficient or
inaccurate disclosures to its stockholders causing them to purchase/sell the company’s stock in a way that they wouldn’t
otherwise do if the information was properly disclosed.
The standard of materiality for the purposes of fraud on the market under Rule 10b-5 adopted in the Supreme Court in Basic
Inc. v. Levinson holds that “an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote”. Moreover, in determining whether the “reasonable investor” would have
considered the omitted information significant “will depend at any given time upon a balancing of both the indicated probability
that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity”. SEC v. Texas
Gulf Sulphur Co.
A question that may arise is whether preliminary corporate mergers negotiations are material for the purposes of Rule 10b-5 and,
therefore, should be disclosed by the company to the shareholders. Initially the 3rd Circuit Court had decided that preliminary
merger discussion do not become material until there is an “agreement-in-principle” as to the price and structure of the
transaction. By definition, then, information concerning any negotiations not yet at the agreement-in-principle stage could be
withheld or even misrepresented without a violation of Rule 10b-5. The rationality is that premature disclosures would scuttle
merger negotiations since the acquirer would have to face a “bidding war” for the target and will be discouraged to bid in the first
place. Therefore, officers and directors would be entitled to lie about certain matters to protect ultimately the interests of the
stockholders themselves.
This understanding was partially overruled in Basic Inc. v. Levinson. There, the Supreme Court decided that, even though the
company is not under a duty to disclose preliminary merger discussions, it cannot make untrue statements regarding the matter.
The result is that the company may remain in silence, but once it decided to say anything about preliminary merger discussions it
cannot make false statement.

Basic Inc. v. Levinson (The company is liable under Rule 10b-5 when it makes misleading statements about corporate matters,
even though the subject was confidential. The company could simply remain in silence)
For two years prior to the merger of Combustion Engineering Inc. and Basic Inc., the two companies had engaged in private
merger negotiations. During this period, Basic made three public statements denying that any merger negotiations were taking
place or that it knew of any corporate developments that would account for the heavy trading in its stock. The plaintiffs are
former shareholders in Basic who sold their stock between Basic’s first public denial of the merger and a date just prior to the
public announcement of the merger. They claim that the corporation had made misleading statements about material corporate
information in violation of Rule 10b-5. The court upheld the claim on the grounds that the misleading statements were material to
influence the shareholders in their trading decisions. “We therefore find no valid justification for artificially excluding from the
definition of materiality information concerning merger discussions, which would otherwise be considered significant to the trading
decision of a reasonable investor, merely because agreement-in-principle as to price and structure has not yet been reached by
the parties or their representatives”.

Elements of Rule 10b-5: Scienter (made with intent to deceive another)

In Ernst & Ernst v. Hochfelder, the Supreme Court confirmed that liability under Rule 10b-5 requires specific intent to deceive,
manipulate, or defraud. In applying such requirement, however, the courts have determined that the burden can be met by simply
demonstrating that the defendants were recklessly unaware of the materiality of an omitted statement. In other words, the
requirement of “bad faith” can be inferred from negligent conduct (recall Stone v. Ritter). In response to the aggressive growth of
private securities litigation under Rule 10b-5, Congress adopted the Private Securities Litigation Reform Act, which requires a
tougher standard to infer intention:
“The complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to
a strong inference that the Defendant acted with the required state of mind”.

Elements of Rule 10b-5: Standing in connection with the purchase or sale of securities.

The insider can only be sued by the government or by the counterparty in the transaction, in practice the persons who traded in
the open market during the period when the insider traded on the basis of the confidential information (because of Congress
reactions to Chiarella and Dirks when adopting ITSFEA). And when there is a fraud on the market, who is entitled to sue the
company? In Birnbaum v. Newport Steel Corp. it was held, and subsequently followed, that a plaintiff must have been a buyer or
seller of stock in order to have standing to bring a complaint about an alleged violation of Rule 10b-5.
In Blue Chip Stamps v. Manor Drugs, the plaintiff alleged that the company had made materially false statements concerning an
investment offer and that, relying in such statements, the plaintiff declined the offer. It argued that if the statements had been
truthful, he would have investment. The Supreme Court denied the claim, reflecting its concern that 10b-5 liability might become
too expansive. Therefore, traders who rely on the misrepresentation to “not purchase” or to “not sell” do not have standing to
bring a 10b-5 claim. The purchase or sale requirement to bring a 10b-5 claim does not apply to claims under Rule 14(e)-3: the
plaintiff can sue even if the representation caused him “not to tender”.
Most courts appear to provide more relaxed standing requirements when the plaintiff seeks an injunction. In Mutual Shares Corp.
v. Genesco it was held that deceitfully inducing minority shareholders to sell gives minority shareholder who did not sell standing
to seek an injunction,

Elements of Rule 10b-5: Reliance

Even if a shareholder never hears the false statement made by the company, if he purchased/sold on the stock of such company,
he is entitled to a 10b-5 claim. On the assumption that markets are affected by all public information, we might conclude that the
price that such a person gets or pays in transacting in the stock is affected by the false statement (the plaintiff must only show that
he purchased or sold stock during the period of misrepresentation). There are only to exceptions to the “integrity of the market”
rule.

Basic Inc. v. Levinson (A company’s public material misrepresentation affects the market price and, because traders rely on the
integrity of the price set by the market, they have presumably relied on the misstatement even without expressly hearing it)
As a result of the company’s misrepresentation about merger negotiations, the price of Basic shares was depressed. Persons who
traded Basic shares had done so in reliance on the integrity of the price set by the market, even if they hadn’t heard the
company’s misstatements. Therefore, the traders presumably relied on the public material misrepresentations made by the
company.
The presumption that the traders believed in the “integrity of the market price” and, therefore, were manipulated by the
misrepresentation, can be rebutted in two instances. The defendant may show that the misrepresentation in fact did not lead to a
distortion of price, by arguing that the market would not react if the merger negotiation was properly disclosed; or the defendant
may show that the plaintiff knew that the company’s statements were false (and consequently knew that Basic stock was
underpriced), but sold his shares nevertheless because of other unrelated concerns (political pressures, for example). In such
case, it cannot be said that the plaintiff relied on the integrity of a price which he knew had been manipulated. Both of the
defenses are very hard to demonstrate in practice.

Efficient Capital Market Hypothesis (ECMH) postulates that (i) prices of stock on the market reflect the material information that
is available to the public and (ii) information is quickly assimilated into the stock prices. Some academics suggest that the ECMH
may also be used defensively. The argument is that, if all public information is rapidly absorbed by markets and reflected in
prices, when a deliberate misstatement is made no injury can be caused by that statement since any significant part of the market
knows the truth.

Elements of Rule 10b-5: Causation (transaction causation and loss causation)

For liability to attach, a misstatement or omission must both “cause” the plaintiff to enter the transaction and “cause” the plaintiff’s
loss. In omission cases the plaintiff must prove causation by demonstrating that if the material information had been disclosed, he
wouldn’t have entered into the transaction.
Suppose that a company makes a false statement that it is operating at full capacity and makes a true statement that it doesn’t
have fire insurance. The shareholder plaintiff purchased stock relying in the false statement and, subsequently, the facility burns
and the stock becomes worthless. Even though the transaction causation requirement is satisfied, the loss causation requirement is
not because the misrepresentation about the full capacity didn’t have any relationship to the loss suffered (fire).

Dura Pharmaceuticals Inc. v. Broudo (When the misrepresentation is later on truthfully disclosed but there is no change on the
company’s stock price, the plaintiff cannot claim a 10b-5 violation because there is no loss causation)
Dura Pharmaceuticals made false public statements concerning Dura’s drug profits and the likelihood of FDA approval of a new
asthmatic spray device. Plaintiffs purchased Dura’s stock during the period of the false statements. Later on, Dura announced
that the FDA would not be approving the spray device and the next day Dura’s share price temporarily fell but almost fully
recovered within a week. Plaintiffs brought a 10b-5 claim against Dura for its public misstatements but the Supreme Court
rejected the claim on the grounds that there was no loss on sale after truthful disclosure caused by the misrepresentation. Because
the misrepresentation didn’t cause a loss to the shareholders, the court denied the claim.

Fraud-on-the-market theory (Steps)

1) The company has made a material misstatement (explicitly false or omission);
2) The company should have known that the omitted statement was material;
3) A trader effectively purchased or sold stock from this company;
4) Even if he didn’t have direct access to the misrepresentation, he relied on the integrity of the market price, which was distorted
by the misrepresentation;
5) The plaintiff must show that the misrepresentation caused him to enter the transaction and effectively caused him loss;
Remedies for 10b-5 violations

Private actions against insider traders

Private action against insider trading is available for all investors who traded on the open market during the period when the
insider transacted and when the information was publicly announced. How much are these traders entitled to recover? There are
three possible measures but the disgorgement measure is the one actually adopted to calculate the liability of insider traders
(Elkind v. Liggett & Myers Inc.).

Out-of-pocket measure – the difference between the price paid and the “true value” of the stock when brought. All the investors
who traded on the company’s stock between the period when the insider transacted and when the information was disclosed to
the market are entitled to receive the value of this difference. But to hold the tipper and tippee liable for the losses suffered by
every open market trader of the stock as a result of the impact in the market after the information became public would be
grossly unfair and result in exorbitant damages.
Ex: Tippee sells 5.000 shares at $50 (stock immediately falls to $48 as a result). Plaintiff buys 10.000 shares at $48. Later on,
the inside information is disclosed to the market and the stock falls to $40 (assumed to be the “true value” of the stock at the
moment of the purchase). Out-of-pocket measure: $48 - $40 = $8 X 10.000 = $80.000.

Causation-in-fact measure – only permits recovery of damages caused by erosion of the market price of the security that is
traceable to the tippee’s wrongful trading. Accordingly, the uninformed investors are compensated for the loss in market value
that they suffered as a direct result of the tippee’s conduct. The disadvantage of this measure is the difficulty of proving the time
and extent to which the integrity of the market was affected by the tippee’s conduct. (why would the change in the market price
be attributable exclusively to the tippee’s wrongful act?)
Ex: Tippee sells 5.000 shares at $50 (stock immediately falls to $48 as a result). Plaintiff buys 10.000 shares at $48. Later on,
the inside information is disclosed to the market and the stock falls to $40 (assumed to be the “true value” of the stock at the
moment of the purchase). Causation-in-fact measure: $50 - $48 = $2 X 10.000 = $20.000.

Disgorgement measure - Uninformed investors who traded on the company’s stock between the period when the insider
transacted and when the information was disclosed to the market are entitled to receive the difference between the price paid and
the decline on the price by the time the information became public limited, however, to the amount gained by the tippee as a result
of his selling before the information was publicly announced. Should the intervening buyers, because of the volume and price of
their purchases, claim more than the tippee’s gain, their recovery (limited to that gain) would be shared pro rata.
This alternative offers several advantages. To the extent that it makes the tipper and tippees liable up to the amount gained by
their misconduct, it should deter tipping of inside information. On the other hand, by limiting the total recovery to the tippee’s
gain, the measure bars windfall recoveries of exorbitant amounts bearing no relation to the seriousness of the misconduct. The
disadvantage is that in most class actions the total claim would exceed the wrongdoer’s gain, limiting each claimant to a pro rata
share of the gain, what would discourage plaintiffs to bring class actions against insider traders.
Ex: Tippee sells 5.000 shares at $50 (stock immediately falls to $48 as a result). Plaintiff buys 10.000 shares at $48. Later on,
the inside information is disclosed to the market and the stock falls to $40 (assumed to be the true value of the stock at the
moment of the purchase). Disgorgement measure: $48 - $40 = $8 X 10.000 = 80.000 limited to the tippee’s gains as a result of
the inside information: $50 - $40 = $10 X 5.000 = $50.000. In effect, plaintiffs would be entitled to recover only $50.000 on a
pro rata basis.

Elkind v. Liggett & Myers Inc. (The tipper is liable only to the amount gained by the tippee as a result for trading on the basis of
the inside information)
Shareholders brought a class action against Liggett & Myers Inc. (tipper) for wrongful tipping of inside information about an
earnings decline to certain persons (tippees) who then sold Liggett’s shares on the open market. The tippee sold 1.800 shares at
$55 per share in the possession of confidential information. When the information was disclosed to the market, the price declined
to $46 per share. Under the disgorgement measure, the total recovery would be limited to the gain realized by the tippee from the
inside information, i.e., $55 - $46 = $9, multiplied by the number of shares sold X 1.800.

Private actions against fraud on the market

Note: Class action against the company

Private action against fraud-on-the-market is available for all investors who traded on the open market during the period when
the misrepresentations were made and when the truth statement became publicly announced. How much are these traders entitled
to recover? It would make no sense to apply the disgorgement measure because the company is not earning profits by making
the misrepresentation. Therefore, the measurement applied under a fraud-on-the-market claim is the out-of-pocket measure,
whereby the company is liable to all investors who traded in the open market during the period when the misrepresentation was
made until when it was revealed for the difference in the price of the stock caused by the misrepresentation. The result is that a
company which makes misrepresentations to the public investors will be liable for exorbitant damages and the ultimately injury
will be suffered by its stockholders. To justify such extensive injury to stockholders holding stock in the company which made
misrepresentations, the assumption must be that stockholders had some responsibility for the misrepresentations by arguing that
they could stop the directors or the CEO from misleading the public investors.

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This page was last modified 17:10, 10 Dezembro 2008 by Jo�o Zacharias de S�.