Corporate Organization and Management
1. Corporate Form
Characteristics
Limited Liability
Free Transferability of Ownership Interests
Continuity of Existence
Centralized management
Entity Status
Articles and Bylaws
Articles control over bylaws
Articles give the corporation is authority to operate.
Bylaws govern day to day affairs, but cannot exceed scope of articles.
Pre-Incorporation Contracts
A pre-incorporation contract is a contracts that is entered into before the corporation is formed
Liability for pre-incorporation contracts.
Promoter's Liability: The promoter is personally liable for a pre-incorporation contract.
The promoter is not released from liability when the corporation accepts the contract
The promoter may be released from the contract if there is a novation
The promoter is not bound if the other party knew the corp was not formed and agreed to look solely to the corporation for performance
Corporation's Liability: The corporation is not bound by a pre-incorporation contract until it accepts it.
Express Acceptance: The corporation is bound if it explicitly accepts the contract
Implied Acceptance: The corporation is bound if it impliedly accepts the contract
Accepting the benefit of the contact
With knowledge of its terms
Acceptance by the corporation does not release the promoter unless there is a novation
Defective Incorporation
Defective incorporation occurs when the promoters fail to fully comply with the applicable corporate statute.
The effect of defective incorporation is the promoters and would-be shareholders do not have protection of limited liability
Active participants will loose limited liability if not a de facto or de jure corporation
Passive investors may still claim limited liability
De Jure Corporation
A de jure corporation is in full compliance with all aspects of the corporate statute.
Once the corporation has de jure status, the shareholders have limited liability
De Facto Corporation
De Facto Corporation is a defense to personal liability focusing on the acts of the defendant
There must be a statute under which incorporation is possible
Defendant makes a "colorable" attempt to comply with the statute
Defendant acts as a corporation
Defendant had a good faith belief that the corporation was formed
Corporation by Estoppel
A defense to personal liability focusing on the acts of the plaintiff
Plaintiff dealt with the business as a corporation
Plaintiff never expected to be able to look to the "shareholders" for personal liability.
The defendants must have acted in good faith and not have mislead the plaintiff
Corporation by Estoppel is not valid against non-contract creditors, i.e., tort creditors
Ultra Vires Doctrine
Common Law
Acts done outside the scope of the corporate powers were void
Modern Law
Modern corporate statutes have mostly abolished the doctrine of ultra vires by authorizing corporations to engage in all lawful businesses.
The Objective of the Corporation
The purpose of the corporation is to make money for the benefit of its shareholders.
The corporation is allowed to engage in charitable behavior if it has some benefit to the corporation.
2. Corporate Structure
Shareholders
Shareholders are the owners of the corporation.
Shareholders invest equity in the corporation and share in the profits and losses through increased or decreased value of their shares or through distribution of dividends
Shareholders act by voting at shareholder meetings.
Notice
All shareholder meetings (annual and special meetings) require advance notice
Quorum
Generally a majority of shares represented is required for quorum;
A few states allow the articles of incorporation to set a lower quorum
Voting
Regular shareholder action requires majority of the shares present (some states say a majority of the shares voting)
Fundamental changes require approval of majority shares outstanding
Shareholders can vote by proxy
Shareholders elect the directors
Shareholders elect directors, but cannot tell directors how to act.
Shareholders can remove directors for cause
Some states authorize shareholders to remove directors for no cause
Shareholders approve or disapprove fundamental changes
Directors
Directors are elected by the shareholder
In the absence of a specific statute, the board cannot remove a director with or without cause.
Directors are the managers of the business
Directors set corporate policy and make key decisions
Directors appoint the officers to carry out the corporate policies
Directors only act by voting at board meetings.
Notice
Regular board meetings are set in the bylaws.
Special board meetings require notice.
Quorum
A quorum is a majority of the full board, even if positions unfilled.
Voting
To pass a proposal requires a majority vote of those present.
Board members cannot vote by proxy.
The board can act by unanimous written consent.
Officers
The officers are appointed by the board of directors
The officers carry out the policies determined by the board of directors.
The officers run the day-to-day affairs of the business under the general supervision of the board of directors.
The officers act as the agents of the corporation,
Piercing the Corporate Veil
Under certain circumstances, the court may disregard the corporate entity
Fraud
The court may pierce the corporate veil if the acts of a shareholder amount to fraud
Alter Ego Doctrine
Inadequate capitalization
Inadequate capitalization is the most important factor
Majority of states say inadequate capitalization is just one factor, but typically treat it as the most important factor
Minority of states say that inadequate capitalization alone is sufficient to pierce the corporate veil
Inadequate capitalization is the factor most likely to cause harm
Inadequate capitalization has to exist when corporation is formed—there is no obligation to add more money later
Consider whether insurance is a reasonable substitute for the corporation to meet its expected financial liabilities.
Failure to follow formalities,
Funds siphoned or commingled
Corporation functioned as a façade of shareholders so that they were treating the assets as their own.
There must be some element of injustice that would occur if the shareholder was allowed to avoid personal liability.
Effect of piercing the corporate veil
If the court pierces the corporate veil then the shareholders may be personally liable for the obligations of the corporation
Enterprise Liability
Enterprise liability is similar to piercing the corporate veil.
Instead of finding shareholder personally liable, enterprise liability seeks to hold one or more companies liable for the obligations of an affiliated brother/sister company
Apply the same elements that are used for piercing the corporate veil
Equitable Subordination of Shareholder Claims (“Deep Rock” doctrine)
The corporation is in bankruptcy
An insider (officer, director or shareholder) is a creditor that loaned money to the corporation
The insider committed some misconduct that harmed other creditors to the advantage to the insider-creditor
The court may allow the other creditors to be paid before the insider-creditor is paid.
Must otherwise comply with bankruptcy law
Interference with Shareholder Franchise
Blasius Test
If purpose of board action is to impede or preclude the shareholder franchise, then the board has a “heavy burden to show compelling justification.”
Unocal Test
The board is allowed to take defensive measures in response to a threat to the corporation.
Board must make reasonable investigation into the takeover attempt and determine in good faith that it represents a threat to the corporation.
Board can take defensive actions if the action is proportionate and reasonable in light of the magnitude of the threat.
Revlon Test
When takeover becomes inevitable, management cannot continue to resist takeover attempts.
Management must maximize shareholder value in the takeover.
Management cannot favor one bidder over another, except for the purpose of maximizing shareholder value.
3. Special Problems of Close Corporations
What is a close corporation?
Small number of shareholders
No ready market for corporate stock
Shareholders participate in management, direction and operation of the corporation.
Similar to partners carrying out a joint business for profit.
The corporation may be their only source of income.
Their investment in the business may also represent the majority of their personal assets.
Shareholders depend upon the corporation for their livelihood
Shareholders in close corporations may use various means to change the traditional allocation of corporate control.
Shareholder voting agreements
Classified stock
Voting trusts
Restrictions on share transfer
Super-majority voting or quorum
Fiduciary obligations in close corporation,
Shareholders in close corporations have a duty of reasonable care.
Shareholders in close corporations have a duty to further the interests of each other within the scope of the relationship.
Shareholders in close corporations have a duty not to withhold relevant information regarding the affairs of the relationship.
Shareholders in close corporations have a duty not to use their positions to gain special advantage over the other people involved.
Shareholders in close corporations are susceptible to economic coercion
Freeze-outs
A freeze-out occurs when majority deprives a minority from the economic benefit of owing shares in order to coerce them to sell their shares at an unfairly low price.
This denial is "especially pernicious" in close corporations where the opportunity of employment is one of the basic reasons for investing capital in the business and the shareholder depends on a salary as the principal return on his investment.
Oppression
Oppression occurs when a controlling shareholder in a close corporation causes the corporation to act in some way that frustrates the reasonable expectations of the minority shareholders
A shareholder in a close corporation may reasonably expect ownership will entitle him or her to a job, a place in management, a regular dividend, or some other form of security.
Expectation must be reasonable under the circumstances.
Expectation must be central to the decision to join the corporation.
Reasonable expectations may change over time.
Proper Purpose
Majority has opportunity to show that they took action for a proper business purpose.
The injured shareholder then has the right to show that there were alternative methods to achieve the business purposes that were less harmful to the minority.
Capitalization and Finance
1. Issuance of Stock
Articles determine how many share of stock are authorized.
Board has power to issue stock up to the amount authorized in the articles.
Authorized and Issued Stock
Stock that has been issued by the board. Also known as “authorized and outstanding” stock
Authorized but Unissued Stock
Stock that has been authorized by articles, but the board has not issued
Treasury Stock
Stock that has been issued by the board, and subsequently repurchased by the corp
Preemptive Rights
Common law rule: Each shareholder had the right to purchase a proportion of all newly issued stock to maintain his or her same percentage of ownership.
Modern majority rule: Shareholders have no preemptive rights unless specifically stated in articles.
Modern minority rule: Shareholders have preemptive rights unless denied in the articles.
Subscription Agreements
A subscription agreement is considered an open offer to purchase shares of the corporation.
A subscription agreement is generally revocable at any time prior to acceptance.
Some states make subscription agreements irrevocable for 6 months.
A subscription agreement is always revocable if all other subscribers agree.
2. Watered Stock
Par Value
Par Value is the lowest price at which the corporation can sell its stock
Modern statues allow low-par and no-par value stock
Stock sold for less than par value is generically called “watered stock.”
Bonus Stock: Shares sold for no consideration; given away for free.
Discount Stock: Shares sold for cash, but cash less than par value.
Watered Stock: Shares sold for property or services worth less than par value.
Liability for Watered Stock
Shareholder who holds watered stock may be liable to the corporation or to its creditors for the difference between amount paid and par value
Corporation Solvent
Liability to Creditors: If the corporation is solvent, the creditors have no right to recover for watered stock.
Liability to other Shareholders: In a minority of states other shareholders may recover for watered stock if the holder explicitly promised to pay the full amount; otherwise no liability.
Corporation Insolvent: Split of authority
Majority Rule: “Misrepresentation” theory
Only creditors who become creditors after the watered stock was issued are allowed to recover.
Someone who become a creditor before the watered stock was issued is not entitled to recover because he or she did not rely on the representation.
Minority Rule: “Trust Fund” Theory
Par value of the corporation is treated as a trust fund for the benefit of all creditors.
Board is liable to the creditors for the difference between amount paid and par value
3. Distributions to Shareholders
Dividends
Dividend is a payment to all shareholders pro-rata based on the number of shares owned.
Discretion to Pay Dividends
Courts will not interfere with a corporate policy to pay a dividend, absent breach of a duty or injury to creditors
Limits on Dividends
The corporation cannot pay a dividend if it would harm the rights of its creditors.
Insolvency test
The corporation cannot pay a dividend if it is insolvent
Equity or “Cash Flow” Insolvency Test: The corporation is insolvent if it cannot pay its obligations when they come due.
Bankruptcy or "balance sheet" insolvency Test: The corporation is insolvent if its debts exceed its assets.
Capital impairment test
The corporation cannot pay a dividend if its capital is impaired
The corporation's capital is impaired if it does not have sufficient amount in its surplus accounts.
Stated capital is par value times number of shares outstanding.
Capital surplus (aka paid-in surplus) is the amount that the shares where sold for above par value.
Reduction surplus is created by reducing par value which reduces stated capital.
Revaluation surplus is created by revaluing assets on the books.
Earned surplus (aka Retained Earnings) is the amount earned by the corporation.
All states allow dividends to be paid from earned surplus (aka retained earnings).
In the majority of states, this is the only account that can be used to pay dividends.
Nimble Dividend
A small minority of states also allow a "nimble dividend" to be paid out of current earnings, even if no there is no surplus
Liability for Improper Dividend
Directors' liability
The directors are liable for any harm to the creditor, up to the amount of the improper dividends.
Shareholders' Liability
The liability of a shareholder for an improper dividend depends on whether the corporation is solvent or insolvent.
Solvent Corp: Shareholder is liable only if they knew the dividend was improper.
Insolvent Corp: Shareholder is liable for the amount of the dividend.
Stock Repurchases
A stock repurchase is distribution of funds to shareholders
For stock repurchases, apply same rules apply as for dividends
Corporation cannot repurchase shares if the corporation is insolvent.
Corporation cannot repurchase shares if its capital is impaired
Exceptions: If the corporation's capital is impaired, but it remains solvent, the corporation can repurchase shares in certain specified circumstances.
Eliminate fractional shares
Setoff to shareholder debtor
Pay a court-ordered appraisal remedy
Redeem redeemable shares
Fiduciary Duties
1. Duty of Care
Officers and directors of corporations have a fiduciary duty to the corporation to use reasonable care in conducting its business.
Must act in good faith
Good faith is violated if the decision involves a self-dealing,
Good faith is violated if the director knows that the action violates the law, or involves some form of fraud.
Decision must be believed to be in the best interests of the corporation and its shareholders
This element is satisfied if there is any rational reason why a director would believe that the decision would benefit the corporation.
This is an easy test to pass. The only way to fail this test is for the director to involve the corporation in a no-win situation.
For public policy reasons, an illegal act is never considered in the best interests of the corporation
Must use such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under the circumstances.
Similar to negligence standard under tort law.
Example of specific duties
Duty to understand the business
Duty to keep informed
Duty to attend meetings
Duty to monitor financial status
Duty to inquire further when notice of wrongdoing
Duty to object or resign upon finding wrongdoing
Duty to seek advice of experts
Duty to use any expert knowledge possessed by the officer or director (lawyer, accountant, etc.)
Business Judgment Rule
The business judgment rule is a defense to allegations of breach of the duty of care.
If the elements of the business judgment rule are met, then there is a presumption that officers and directors met their duty of care.
Elements
Decision cannot involve a self-interested transaction
If there is any conflict of interest or breach of the duty of loyalty, the business judgment rule no longer protects the decision.
Decision must be an informed decision
The officer or director must show that he or she has gathered sufficient information to make an informed decision under the circumstances.
The officer or director must reasonably believe that the decision is in the best interests of the corporation.
2. Duty of Loyalty
Self dealing transactions
A self dealing transaction is one where the officer or director is on both sides of a transaction
The officer or director is in a position to influence the corporation in entering into the transaction
The officer or director is in a position to profit from the transaction (often at the corporation's expense, but not always.)
Usurpation of corporate opportunity
Usurpation of a corporation opportunity is a form of self-dealing, but where the officer or director is not on both sides of the transaction.
Usurpation occurs when an insider competes with the corporation
Usurpation occurs when an insider uses corporate property for his own benefit or to the detriment of the corporation
Usurpation occurs when an insider takes an opportunity that “belongs” to the corporation.
Interest or expectancy test: The corporation has existing right or can reasonably expect to take advantage of some opportunity
Line of business test: The opportunity is closely related to existing or prospective business
Fairness test: Measure the fairness of the transaction.
Historical rules
Pre 1900's Rule: Complete prohibition
A self-dealing transaction was voidable even if the transaction was fair to the corporation and fully disclosed
Early 1900s Rule: Disclosure
A self-dealing transaction could be upheld if fully disclosed.
Transaction fully disclosed
Interested party took no part in the decision (majority rule: interested director could not even count for quorum)
Transaction approved by disinterested majority of the board
Interested party took no unfair advantage
Modern fairness test.
Completely fair: transactions will be upheld.
If the transaction is completely fair to the corporation, it will usually be upheld.
Middle ground: shifting the burden of proof.
If the transaction is not completely fair but not so unfair as to be fraud or waste, then the defendant will have the burden to prove fairness.
Defendant can shift the burden of proof to the plaintiff.
The transaction must be fully disclosed.
The transaction must be approved by disinterested board or ratified by fully informed, uncoerced, disinterested shareholder vote
If burden shifts, then the plaintiff will have the burden to show the transaction was unfair
Fraud or waste: transaction is voidable.
If the transaction is so unfair as to amount to a fraud or waste, it will usually voided
3. Duty of Controlling Shareholder
Exercising control over the corporation.
Controlling shareholder is allowed to use controlling interest to exercise control over the corporation
Controlling shareholder must make full disclosure of all facts “germane” to the transaction (or “material” facts)
Self-interested transactions
Controlling shareholder allowed to engage in self-interested transactions as long as intrinsically fair
Intrinsic fairness test
Two elements
Fair dealing
Procedural aspects: How was the transaction was timed, initiated, structured, negotiated, disclosed and approved? Was it rushed by the controlling shareholder?
Fair price
Considering all relevant factors, was the price fair?
Burden of proof
Burden to prove fairness is on the Defendant
Defendant can shift the burden of proof to the plaintiff
Transaction must be fully disclosed
Transaction must be approved by independent, disinterested special committee
Look for relationships between controlling shareholder and members of the special committee
If burden shifts, then the plaintiff will have the burden to show the transaction was unfair
Sale of control for a premium
Controlling shareholder can sell his or her controlling interest for a premium and keep the premium.
Controlling shareholder cannot sell to a corporate looter.
An unreasonably large premium may put seller on notice of intent to loot
Controlling shareholder has a duty to investigate further if on notice of potential looter.
Control premium cannot be a sale of a corporate opportunity or corporate asset.
Cannot be any fraud, or other acts of bad faith.
Liability is the damage to the corporation up to the amount of the premium.
Sale of corporate office
Controlling shareholder generally prohibited from keeping premium paid for sale of corporate office
Split of Authority
Some jurisdictions prohibit sale of corporate office as “per se” illegal
Some jurisdictions allow sale of corporate office if taking control of the office would be a “mere formality.”
Mergers, Acquisitions, and Structural Changes
1. Statutory Mergers
General Rules
Two companies merge together upon filing articles of merger with the secretary of state.
Shareholders have approval rights
The decision to enter into the transaction must be submitted to the vote of the shareholders
Shareholders have appraisal rights.
The objecting shareholders are entitled to have their shares appraised and bought-out by the corporation.
Valuation determined by court
Valuation method must be generally acceptable in the financial community
Any valuation method is admissible as long as evidence is otherwise admissible in court.
Court not limited to "Delaware Block" method
Surviving corporation takes assets and debts of disappearing corporation by operation of law.
May trigger tax issues.
Small- Scale Merger
Typical statute allows acquiring company to increase its common stock by up to 20% to acquire another company.
Does not trigger approval or appraisal rights in the acquiring company’s shareholders.
Short-Form Merger
Typical statute allows parent company to merge with subsidiary company where the parent already owns 90% or more of the subsidiary.
Parent company can use short-form merger to cash out a minority interest.
Does not trigger approval rights for shareholders of parent or subsidiary company.
May trigger appraisal rights for minority shareholders in subsidiary.
2. Sale of All or Substantially All Assets
Corporation may attempt to purchase assets of target company rather than purchasing the company.
Court may give shareholders approval and appraisal rights.
If the assets are "quantitatively vital" to the operation of the corporation.
If the sale is "out of the ordinary" course of business.
If the sale substantially affects the existence and purpose of the corporation.
3. De Facto Merger Theory
Remedy for shareholders when corporations engage in transactions that are not technically mergers, but have same result as a merger.
Does the transaction cause the corporation to lose its essential or fundamental nature?
Does the transaction alter the original fundamental relationships of the shareholders among themselves and to the corporation?
Similar analysis as a sale of all or substantially all assets.
Court may treat transaction as a merger for purposes of triggering shareholder appraisal rights.
Many statutes limit de facto merger remedy to situations where shares of smaller company are used to acquire larger company.
Look for a corporation issuing new shares sufficient to elect a majority of the board of directors
4. Tender Offers
Regulated by Williams Act which amends the Securities Exchange Act of 1934
Must file disclosure with SEC if acquiring or offering to acquire 5% or more shares.
Must keep offer open for 20 days.
Must make offer available to all holders.
Must give best price to all tenders.
Must prorate among all tenders.
Must comply with Section 14(e), anti-fraud provision.
Anti-Fraud provisions for tender offers similar to Rule 10b-5
Cannot make misstatement or omission of material fact in connection with tender offer.
Defensive Measures
Management of target corporation allowed to take defensive measures to resist tender offer.
Defensive measures subject to certain limits.
Unocal
Management must use good faith and reasonable investigation.
Identify the tender offer as a threat to the corporation.
Defensive measures must be reasonable in light of the magnitude of the threat.
Blasius
If the purpose of defensive measure is to interfere with shareholder franchise (right to elect majority of directors) then management must show “compelling justification.”
Revlon
When takeover becomes inevitable, management cannot continue to resist takeover attempts.
Management must maximize shareholder value in takeover.
Management cannot favor one bidder over another, except for maximizing shareholder value.
5. Entire Fairness Test
Majority shareholder has a duty of establishing entire fairness to the minority shareholders.
Fair Dealing
Examine how was the transaction was timed, initiated, structured, negotiated, disclosed and approved.
Duty of “complete candor” – controlling shareholder must disclose all information which is material to the transaction.
Fair Price
Determination of fair value must be based upon "all relevant factors.”
Controlling shareholder must make full disclosure of all material information that would effect the price.
If the transaction does not meet the fairness test, shareholders may be able to get an injunction or appraisal rights.
Burden of Proof
Initial Burden: The burden of proving fairness is on the defendants
Approval by Shareholders: Approval by vote of fully informed minority shareholders shifts the burden to the plaintiffs.
Burden on Shareholders: If the burden shifts to plaintiffs, then the objecting shareholders must prove fraud, misrepresentation or other items of misconduct to demonstrate unfairness of the merger.
Shareholder Lawsuits
1. Direct Suit
Where the harm was to the shareholder directly
Injunction against wrongful acts
2. Derivative Suit
Where the harm was to the corporation or to the body of shareholders
Requirements
No individual recovery
Recovery goes to corporation.
Purpose is to protect corporate creditors.
Contemporaneous ownership rule
Plaintiff must have owned shares at the time the wrong was committed.
Plaintiff must continue to hold the shares throughout the lawsuit until entry of judgment.
Demand on the board
Majority of states require the plaintiff to make a written demand on the board of directors before bringing a derivative suit.
The demand asks that the board bring suit to correct the wrong.
Demand may be excused where it would be “futile.”
Demand is futile if the majority of the board engaged in the wrongdoing and are therefore self-interested.
Not enough that all board members are named in lawsuit, majority must be interested
Must be plead "with particularity"
Plead particularized facts alleging each member of a majority of the board is interested.
Plead that the directors failed to inform themselves to a degree reasonably necessary about the transaction.
Plead that the transaction is so egregious on its face that it could not be sound business judgment.
Possible early termination
The board can appoint a special committee to review the merits of the lawsuit
The committee can recommend early termination of the claim on the grounds that it is not in the corporations' best interest.
Committee must be independent and disinterested
Were members of the special committee were on the board at the time the wrongdoings occurred?
Do they have any prior affiliations with the company or the interested parties?
Are they controlled by interested parties?
Committee must use sufficient processes in making its decision
Did committee engage outside counsel?
Did committee review the work of the auditors?
Did committee interview witnesses; review administrative transcripts?
Did committee question management/non-management directors, etc?
Decision of special committee given protection of business judgment rule
In some jurisdictions (e.g. New York), as long as proper methods were used, courts will not address the merits of underlying action.
Other jurisdictions (e.g. Delaware), courts have discretion to review the decision of the litigation committee.
First step is to review whether proper methods were used.
Second step is for court to apply it own independent judgment and weigh corporate interest in dismissing lawsuit versus continuing lawsuit.
Must post security for expenses
Plaintiff may be required to post security to pay for the corporations expenses, including attorney's fees in pursuing lawsuit.
Generally only required from small shareholders (less than 10%); minority shareholders can aggregate their holdings to avoid requirement.
Shareholders can ask for shareholder list to solicit additional shareholders.
Right to Jury Trial?
Derivative action is an equitable remedy; equitable remedies not normally tried by jury.
In derivative actions, the tight to jury trial depends on underlying right.
If the corporation would have been entitled to jury trial, then the plaintiff in the derivative action will be entitled to a jury trial.
3. Indemnification
Indemnification Required
Corporation is required to indemnify the defendants if they win on the merits or otherwise.
Dismissal without having to pay damages is a “win."
Indemnification Prohibited
Corporation is prohibited from indemnifying the defendants if breach the of duty of loyalty.
Indemnification Permitted
Corporation is allowed to indemnify the defendants if only a breach of the duty of care.
Securities Regulations
1. Shareholder Informational Rights and Proxy Voting (Rule 14a-9)
Common Law Rules
State law generally gives shareholder a right to inspect the corporate book and records as long as they are doing so for a proper purpose.
The shareholder generally must make a written demand, and the inspection must take place during usual business hours.
Inspection generally must be in good faith.
Inspection must be for a proper purpose
Common Law
Proper purpose is to determine the financial condition of the company and ascertain the value of the shareholder's shares.
As long as proper purpose is the primary purpose, any secondary or ulterior motive is irrelevant.
Modern Statutes
To demonstrate a proper purpose the shareholder need only show a credible basis that there are legitimate issues of wrongdoing.
Shareholder does not need to prove actual wrongdoing.
But purpose must be more than just “idle curiosity”.
Shareholder List
A shareholder has the right to the shareholder list to communicate with fellow shareholders for any legitimate issue related to the business.
Scope
The shareholder must show that every class of items request are related to the proper purpose.
Federal Proxy Regulations
Purpose of proxy regulations is to ensure full, complete and accurate disclosure.
Reporting companies
Statutory requirements
Any corporation with shares traded on any national securities exchange.
Any corporation meeting threshold number of shareholders and assets.
500 or more record shareholders of any classification of stock.
Assets greater than $10 million.
Regular reports
Annual: 10-K
Quarterly: 10-Q
Special Events: 8-K
Proxy statement
Proxy solicitation
Soliciting a proxy considered very broadly.
A solicitation is any “communication reasonably calculated to result in the procurement, withholding or revoking a proxy.”
Proxy statement.
Anyone who solicits a proxy file a proxy statement.
Examples
Management must file proxy statement for the annual election of directors.
Non-management must file proxy statement when contact shareholders to challenge management.
Exceptions
Ten or Fewer: A shareholder can solicit up to ten shareholder without invoking the proxy regulations. This allows a shareholder to “test the waters.”
Unilateral Voting Announcement: A shareholder can make a unilateral voting announcement, including the reasons for the decision so long as the shareholder is not otherwise soliciting proxies.
Proxy statement must disclose details of the proposal.
Proxy statement must disclose any conflicts of interest.
Special requirements for management solicitations
Management must disclose compensation of five must highly paid officers.
Management must disclose annual report.
Anti Fraud Provision
Rule 14a-9 prohibits misleading proxy communications false or misleading with respect to any material fact, or omits to state a material fact.
Materiality: Same test as under Rule 10b-5
A fact is “material” if a reasonable shareholder would consider it important in deciding how to vote.
Fact would have a “significant propensity” to affect the voting process.
Fact would have “assumed actual importance” in the deliberations of a reasonable shareholder.
Fact would have “significantly altered the total mix” of information available.
It is not necessary to show that the fact would be the determining factors.
2. Insider Trading (Rule 10b-5)
Common Law Rules
Fraud or intentional misrepresentation
Elements from tort law.
Requires an affirmative misrepresentation of a material fact.
Must be made with the intent that the plaintiff rely upon it.
Plaintiff does rely upon misrepresentation
Plaintiff suffers detriment.
No common law duty to disclose
Most stock trading is an impersonal exchange where the buyer and seller to not know each other.
Silently trading while in possession of material non-public information is not actionable under common law.
Exceptions
Minority Rule required disclosure in face-to-face trading.
Where a director personally seeks out a stockholder to buy shares, the transaction will be “closely scrutinized” if the director does not disclose material non-public information.
Under common law, it is fraudulent to take affirmative steps to prevent the truth from being discovered.
Rule 10b-5
Any person
The defendant does not need to have bought or sold.
Jurisdiction
Instrumentality of interstate commerce
Face-to-face transactions and purely intra-state transactions are excluded.
The mails
The facility of national securities exchange
Act of fraud or misstatement or omission of material fact
Fraud or deceit
Incorporates common law elements regarding fraud or misrepresentation
Misrepresentation of a material fact
Defendant intends the plaintiff rely upon the misrepresentation
Plaintiff does rely upon misrepresentation
Plaintiff suffers detriment
Untrue statement of a material fact
Materiality: Same test as in proxy regulations
A fact is material if a reasonable shareholder would consider it “important in deciding how to vote”
A fact is material if it has a “significant propensity” to affect the voting process.
A fact is material if it would have “assumed actual importance” in the deliberations of a reasonable shareholder
A fact is material if it would have “significantly altered the total mix” of information available
It is not necessary to show that the fact would be the determining factor
Omission of a material fact
Purchasing and selling while in possession of material non-public information.
Defendant must wait until the news could reasonably be expected to appear over the media with the widest circulation.
Connection with purchase or sale of securities
The fraud, misrepresentation or non-disclosure must be connected to the purchase or sale of securities.
Sale of an option was “in connection with” a purchase or sale.
A broker selling his client’s stock and keeping the proceeds was “in connection with” a purchase or sale.
Scienter
The defendant must have scienter for liability on SEC action or in private action.
Scienter is knowledge (sometimes referred to as “guilty knowledge”).
Scienter is the “intent to deceive, manipulate, or defraud.”
Defendants must have scienter at the time of the misrepresentation or omission
Scienter can be proven by motive and opportunity or circumstantial evidence.
Motive and opportunity
Motive and opportunity is a “concrete and personal way” for the defendants to benefit from the purported fraud:
Motive and opportunity is met where corporate insiders make material misrepresentations “to keep the stock price artificially high while they sold their own shares at a profit.”
Not sufficient to show general desire to maintain the company’s stock at a high price unrelated to a personal desire to obtain an unfair or wrongful profit.
Strong circumstantial evidence of conscious misbehavior or recklessness
Conscious misbehavior
Intentional or deliberate illegal conduct.
Recklessness
Highly unreasonable conduct involving an extreme departure from the standards of ordinary care so obvious that the actor must have been aware of it.
Refusal to see the obvious: defendants had knowledge of facts that contract their public statements.
Failure to investigate the doubtful: Defendants had access to information that would lead a reasonable person to inquire further.
Pleading Standard
Scienter must be plead "with particularity"
specifying the statements,
identifying the speaker,
stating where and when the statements were made, and
explaining why the statements were fraudulent.
Insider relationship
The defendant must have an insider relationship for liability in SEC action or private action.
Corporate Insiders.
Officers
Directors
Constructive Insiders.
Individuals who become temporary fiduciaries of a corporation.
Attorneys
Accountants
Consultants
Tippers and Tippees
A "tipper" is an insider who discloses material non-public information to a tippee.
Tipper owes a fiduciary duty to the corporation.
Tipper breaches fiduciary duty by disclosing insider information to the tippee.
Tipper expects a direct or indirect benefit by making the tip, or uses information to make a gift to a relative or friend.
A "tippee" is an outsider who receives material non-public information from the tipper.
The tippee must know that the tipper breached fiduciary duty owed to the corporation.
Misappropriators
The "misappropriation theory" prohibits trading on non-public information in breach of a duty owed to the source of the information.
The misappropriator does not have to be an insider.
Misappropriator owes a duty of confidentiality to the source of the information,.
Misappropriator might not have any duty to the corporation or its shareholders.
Trading by misappripriator
Misappropriator breaches duty of confidentiality by trading on the information.
Misappropriator is liable under rule 10b-5 for trading on the information.
Disclosure by misappropriator
Misappropriator breaches duty of confidentiality by disclosing information to a tippee.
Misappropriator intends that disclosure will lead to misuse of the information.
Misappropriator's knowledge of his or her own breach establishes own expectation of some kind of misuse.
Does not need to know exactly what type of misuse will occur.
Misappropriator does not need to expect any benefit by making the disclosure
If tippee or any subsequent tippee trades on information, then the misappropriator is liable under Rule 10b-5
If the tippee has knowledge of misappropriator's breach, then the tippee will also be liable under Rule 10b-5.
Distinguish misappropriation theory from "traditional" insider trading liability.
Misappropriation theory does not require any relationship with the corporation.
Misappropriation theory does not require an unbroken chain between disclosure and trade.
Misappropriation theory does not require the intent to benefit or intent to make a gift.
Purchaser or seller
The plaintiff must be a purchaser or seller to bring a private action. (Not required for SEC action.)
The plaintiff must have purchased or sold company stock during the time of the misrepresentation or non-disclosure.
Merely declining to purchase or sell is not sufficient.
Purchasing an option to buy securities is a “purchase.”
Exception: A private plaintiff may request an injunction without being a purchaser or seller.
Reliance
The plaintiff must have reliance to bring a private action. (Not required for SEC action.)
Reliance is presumed if the misrepresented or omitted fact is shown to be material.
The question is not whether any particular investor was mislead, but whether the market was mislead.
If the misrepresentation was “material” then market is presumed to have been mislead.
The presumption of reliance can be rebutted.
The presumption can be rebutted by showing that the individual investor did not in fact rely (e.g. plaintiff bought or sold for some other reason).
The presumption can be rebutted by showing that market makers knew the truth or did not react to misrepresentation, therefore the market price was unaffected
Causation
The plaintiff must show causation in a private action. (Not required for SEC action.)
Plaintiff must prove that the act of fraud, misrepresentation, or omission was the cause of the loss.
Plaintiff must show both transactional causation and loss causation.
Transactional causation is shown where the defendant's act induced the plaintiff to enter into the transaction.
Defendant's fraud, misrepresentation, or omission was the reason why the plaintiff’s bought or sold the securities.
Loss causation is shown where defendant’s act directly caused the economic loss.
The test for loss causation is whether the specific loss is one of the “foreseeable consequences” of the wrongdoing.
Are there other causes for the loss?
Would the loss have occurred anyway?
3. Short Swing Trading (§16b)
Elements
Insider
Officer
The president and principal financial or accounting officer.
Any Vice President in charge of a principal unit, division or function.
Any policy-making officer.
Any person who performs similar policy-making functions.
Director
Director also includes any person who performs similar functions.
A controlling shareholder can be a "deputized directors" if the actual directors are under his or her control.
10% beneficial owner
Must be 10% shareholder at time of purchase and sale.
The purchase that brings a shareholder up to 10% does not count.
Purchase and a sale
Does not have to be the exact same shares that were bought and sold
Does not have to a purchase followed by a sale
Within six months
Any two transactions within six months of each other are subject to Section 16b.
You can look forward and backwards to find a matching transaction.
Bright line rule.
No intent required
Exception for involuntary transactions.
First step: test whether transaction was involuntary.
Did insider have control over purchase or sale?
Did insider have control over timing of the transaction?
Second step: test whether insider had access to inside information.
Only applies to “reporting companies”
A corporation with shares traded on any national securities exchange.
A corporation meeting threshold number of shareholders and assets.
500 or more record shareholders of any classification of stock.
Assets greater than $10 million.
Effect
Insider must disgorge all profits to the corporation
Match up lowest purchase price with highest sale price to maximize profits.
Do not allow offset for losses incurred.
Losses avoided are considered a profit.
Shareholders can enforce through derivative action if corporation fails to enforce.
4. Tender Offers (§14e)
Must file disclosures with SEC if acquiring or offering to acquire 5% or more shares
Must keep offer open for 20 days
Must make offer available to all holders
Must give best price to all tenders
Must prorate among all tenders
Must comply with Section 14(e), anti-fraud provision
Anti-Fraud provisions for tender offers similar to Rule 10b-5
Cannot make misstatement or omission of material fact in connection with tender offer.
Alternative Forms of Business Organization
1. Agency
Rule
Agency is a relationship between 2 parties.
One party (the agent) is authorized to act for the other party (the principal).
Actual Authority
The principal actually authorizes the agent to act on his or her behalf.
Authorization can be either express or implied.
Apparent Authority
The words of the behavior of the principal would cause a reasonable person to believe that the principal has authorized the agent to act.
Agency by Estoppel
A third party has changes his or her position believing that the agent is acting on behalf of a principal.
Principal intentionally or recklessly caused the belief.
Principal had knowledge of the belief but did not take reasonable steps to dispel it.
Agency by Ratification
The principal either affirms the conduct or engages in conduct that would only be justifiably if the principal intended the affirm the conduct.
Receiving the benefit of the contract with knowledge of how it was obtained.
Agency by Acquiescence
The agent acts and principal fails to object.
Inherent Authority
An inconsistent rule, but a great quote.
It is inevitable that in doing their work, either through negligence or excess of zeal, agents will harm third persons or will deal with them in unauthorized ways.
It would be unfair for an enterprise to have the benefit of the work of its agents without making it responsible to some extent for their excesses and failures to act carefully.
Elements
Manifestation of intent by the principal that the agent shall act on the principal's behalf
Acceptance by the agent to act on behalf of the principal.
Effect
Principal is liable for the obligations of the agent created within the scope of the agent’s authority.
Agent has duty of loyalty to principal.
Fiduciary duty to act with the utmost good faith and fair dealing.
An agent cannot take a secret profit.
2. Partnership
Rule
A partnership is an association of 2 or more people.
Carry on as co-owners of a business.
For profit.
Elements
Intent to share profits.
Intent to share losses.
Intent to share mutual right to control.
Intent to share community interest in the venture.
Effect
Joint and several liability
Liability under Uniform Partnership Act
Tort Liabilities - Joint and several liability (the partners can be sued either jointly of separately).
Contract Liabilities - Joint liability but NO several liability (all partners must be joined in the same suit).
Liability under Revised Uniform Partnership Act
All liabilities are joint and several.
But creditors cannot collect against individual partners until collection against the partnership assets have been exhausted.
Duty of Loyalty
Partners have a fiduciary duty to each other to act with the utmost good faith and fair dealing
Partners cannot take a secret profit.
Partners cannot take a partnership opportunity.
Operation and Management
Transfer of Partnership Interests
Partners can assign their rights to receive profits, but cannot transfer their right to be a partner without unanimous consent of the partners.
Partners can change the default rules through a partnership agreement.
Control
Ordinary matters decided by majority.
Certain changes require unanimous consent.
Accepting new partner
Partners can change the default rules through a partnership agreement.
Dissolution
At-will partnership
An at-will partnership can be dissolved at any time by the request of any partner.
Partnership for a "particular undertaking”
Partnership can only be dissolved after the accomplishment of the undertaking.
Attempt to dissolve can be wrongful dissolution.
Distribution of Assets
First: discharge the debts of the partnership
Second: repay debts to partners
Third: repay capital contributions
Court can find an agreement to treat cash or services in the same way as capital contributions
Last: Divide any surplus divided among all partners.
The partners do not have the right to have the assets divided in kind
3. Limited Partnership
General Partner
General partner has management responsibility.
General partner has personal liability.
Must be at least one general partner.
General partner has same fiduciary duties to limited partners as in an ordinary partnership.
Limited Partners
Limited partners have no voice in management.
Limited partner looses protection from liability if they participate in management.
Limited partners are protected from liability beyond their investment in the LP.
Modern limited partnership typically have a general partner that is a corporation, so no individual has unlimited personal liability.
4. Limited Liability Partnerships
Similar to a general partnership - there are no limited partners.
Partners may have shield from certain partnership liabilities.
Partial Shield LLPs
Partners have personal liability for all contractual obligations of the partnership.
Partners have personal liability for their own negligence and the negligence of their subordinates.
Partners do not have personal liability for negligence of their partners or employees they do not supervise
Full Shield LLPs
Same protections as partial shield LLPs
PLUS partners also have limited liability for contractual obligations of the partnership.
LLP form popular with "professional" partnerships: lawyers, doctors, accountants.
5. Limited Liability Companies
Hybrid business organization with similarities to partnerships and corporations.
Pass through taxation like a partnership.
Limited liability like a corporation.
Flexible management rules allows organization to function like a partnership or like a corporation.
Owners are “members”
LLC is governed by an “operating agreement” similar to a partnership agreement and corporate bylaws.
“Member Managed” LLCs are managed by members directly, like a partnership.
“Manager Managed” LLCs are managed by elected managers, like a corporation.
6. Close Corporations
Elements
Small number of shareholders
No ready market for corporate stock
Shareholders participate in management, direction and operation of the corporation.
Similar to partners carrying out a joint business for profit.
The corporation may be their only source of income.
Their investment in the business may also represent the majority of their personal assets.
Shareholders depend upon the corporation for their livelihood
Effect
Shareholders in close corporations may change the traditional allocation of corporate control.
Shareholder voting agreements
Classified stock
Voting trusts
Restrictions on share transfer
Super-majority voting or quorum
Shareholders in close corp have fiduciary duties to each other.
Shareholders in close corporations have a duty of reasonable care.
Shareholders in close corporations have a duty to further the interests of each other within the scope of the relationship.
Shareholders in close corporations have a duty not to withhold relevant information regarding the affairs of the relationship.
Shareholders in close corporations have a duty not to use their positions to gain special advantage over the other people involved.
Shareholders in close corporations are susceptible to economic coercion
Freeze-outs
A freeze-out occurs when majority deprives a minority from the economic benefit of owing shares in order to coerce them to sell their shares at an unfairly low price.
This denial is "especially pernicious" in close corporations where the opportunity of employment is one of the basic reasons for investing capital in the business and the shareholder depends on a salary as the principal return on his investment.
Oppression
Oppression occurs when a controlling shareholder in a close corporation causes the corporation to act in some way that frustrates the reasonable expectations of the minority shareholders
A shareholder in a close corporation may reasonably expect ownership will entitle him or her to a job, a place in management, a regular dividend, or some other form of security.
Expectation must be reasonable under the circumstances.
Expectation must be central to the decision to join the corporation.
Reasonable expectations may change over time.
Proper Purpose
Majority has opportunity to show that they took action for a proper business purpose.
The injured shareholder then has the right to show that there were alternative methods to achieve the business purposes that were less harmful to the minority.
About
Course
Business Organizations
Description
Course Description
Syllabus
2005 Fall Syllabus
Author
Professor Eric Roring Pesik
Comments
© Copyright 2005, Eric Roring Pesik
Eric Pesik