Corporations Outline: Wonnell


Wonnell Master Notes


Powerplays of corp. 3

o       RMBCA- 7.02- calling shareholder meetings. 3

o       Shareholders have the power to amend the bylaws. 4

·Shareholder voting and agreements. 5

· Types of voting. 7

o       Straight line – minority shareholders can get frozen out 7

o       Cumulative voting - technique to allow minority shareholder to become involved. 7

· RMBCA-7.28. 8

o       How to amend articles. 8

§ RMBCA 10.03. 8

· Buy/Sell agreements. 11

o       Delectus personae. 12

Corporate Social Responsibility- 12

Berle and Means theory. 13

Proxy... 13

1. Proxy contests... 13

2. Capital Markets... 13

3. Product Markets... 13

4. Nature of executive compensation... 13

5. Market for corporate control- 13

6. Voluntary mergers- 13

7. Corporate law... 13

8. Reputation/Market for Managers... 14

Mark to Market accounting. 14

Sarbanes-Oxley Act: 14

Proxy solicitation... 15

Federal Securities Acts. 15

§14(a)—it doesn’t say an awful lot. 15

§12(g)— 10 million dollars, 100 or more shareholders. 16

Efficient Capital Market Hypothesis (ECMH)—... 18

§21E of the 34 Act... 18

In the Matter of Caterpillar, Inc. 18

J.I. Case Co. v. Borak—... 19

Duty of controlling shareholders: 20

Debaun v. First Western Bank and Trust co. 20

Perlman v. Feldman page 527. 20

Express actual authority. 21

Implied actual authority. 21

Apparent authority. 21

Inherent authority... 21

In the matter of Drive-In Development Corp: 21

Lee v. Jenkins Brothers—... 21

Mills v. Electric Auto Light Co. 22

Materiality under 14(a)-9. 23

TSC Indus., Inc. v. Northway, Inc. 23

Virginia Bank Shares, Inc. v. Sandberg: 23

Shareholder proposals: 24

Rule 14(a)(8)- 24

Rauchman v. Mobil Oil 648: 25

How do I get my materials in the hands of shareholders?. 25


Litwin v. Allen.. 26

Shlensky v. Wrigley. 27

MBCA of Directors Treatment of Duty of Due Care--§8.30 and §8.31. 27

Business Judgment Rule. 27

ALI §4.01... 27

Smith v. Van Gorkom.. 28

RMBCA 2.02(b)(4)-Director Indemnity. 29

Francis v. United Jersey Bank. 29

Cede & Co.,Cinerama, Inc. v. Technicolor, Inc. 29

Emerald Partners v. Berlin: 30

In Re Caremark Intern. Inc. Derivative Litigation.. 30

Allison Chalmers... 31


Stone v. Ritter 32

Malone v. Brincat 33

Fraud on the Market theory- 34


Gall v. Exxon Corp. 35

Zapata Corp v. Maldonado: 35

Aronson v. Lewis: 36

In Re Oracle Corp. Derivative Litigation.. 37


Marciano v. Nakash.. 38

Delaware §144 on page 721 break down: 39

WASTE.. 39

Heller v. Boylan: 40

Brehm v. Eisner—... 40


Sinclair Oil Corp v. Levien case: 41

Weinberger v. UOP, Inc. 42

2 component fairness test: 43


Northeast Harbor Golf Club, Inc. v. Harris. 44

ALI test: 44


§10b and §10b-5. 45

Kardon v. National Gypsum Co. 45

Ernst & Ernst case: 46

Santa Fe v. Green: (page 824): 46

In Re Enron Corporation Securities, Derivative & ERISA Litigation.. 47


Cady Roberts case: 48

SEC v. Texas Gulf Sulpher Co. 49

§21(e) of ’34 Act... 49

Chiarella v. United States. 51

Carpenter v. United States. 52

United States v. O’Hagan—... 52

Santa Fe v. Green: 52

Dirks v. SEC—... 53

Famous footnote 14: 54

Remedies: 55

What happens when you engage in insider trading—... 55

§21A of the ’34 Act. 55

§16(a) of the ’34 Act—... 55

Basic v. Levinson—... 56



Management and Control of Corporation

Traditional Roles of Shareholders and Directors

  Powerplays of corp

o       One fraction in control of shares vs. one fraction in control of board

o       Matter of Auer v. Dressel

§ Facts

·Request by shareholder that board hold a special meeting

·Plaintiffs have a majority of shares

·Bylaws- president shall call a special shareholder meeting upon demand of the majority of shareholders

o       RMBCA- 7.02- calling shareholder meetings

§Board can call meeting (no help here, b/c you don't control board)

§Through bylaws (this would be here, b/c it is in bylaws)

§10% shareholders have right to call meeting

·President has refused to call meeting

· Shareholders take president to ct

·Why did the president refuse?

o       He says the topics intended for the meeting were not proper subjects for shareholder meeting

§The plaintiffs wanted to vote on a resolution approving the tenor of the previous president of corp

·Understand why current president doesn't like this

§Amend bylaws to state that vacancies will be filled by the shareholders

§Vote on charges of existing board

·Remove current members and replace them with new directors

· Its possible for shareholders to act w/o a meeting

o       RMBCA- if unanimous support of shareholders

§Are these subjects legitimate for a shareholder's meeting

·Shareholders can't just order to fire president

o       b/c of centralized control of corp

·but to say that shareholders wish that previous president was still here

o       Ct: this is okay

§Non-binding resolution

·Amend bylaws to state that vacancies will be filled by the shareholders

o       Shareholders have the power to amend the bylaws

§RMBCA - §10.20

·Can you boot directors

o       Yes – shareholders can remove for cause

o       RMBCA – more liberal

§If you don't provide for it article of corp for cause, default rule is that shareholders can fire w/ or w/o cause

o       What is cause?

§Needs to be some kind of mismanagement or misdeeds

§Not simply policy decisions

o       Ct: need to give existing directors notice of what they are charged w/ and give them an opportunity to respond

· Ct says this is fine

o       Majority of shareholders can use this to take control of corp

·Shareholder voting and agreements

o       Default rules of corp

§Centralized management

·Board and to whom the board delegates

§Limited liability

§Free transferability of shares

§Separate entity

o       Default rule of free transferability of shares is someone problematic

§If shareholder of IBM, who cares

§But if you are shareholder in a mom and pop, it's more problematic

·If shareholder sells to your bitter enemy, you are in bad situation

§ Liquidity concerns

· Suppose 3 shareholder w/ each a 1/3

· Concerned that other two will gang up on you

o       Out vote you on board for every director


o       This board appoints other two as officers/directors

o       Board doesn't decide to give out dividends

·So what can you do?

o       Can sell shares, but who are you going to sell it to

§There's no stock market here


o       Who gets to vote particular shares

§29K shares owned by pioneer

· Owner on record

§Pioneer was in bankruptcy and receivership and been appointed

·TX ct had ordered receiver to give shares to two people for proxy contest

o       Proxy contest

§Takeover – going to have solicit proxies

·Management of firm will give their own recommendations

· If you want change, you are going to have to submit your own slat for board(expensive to do)

§There is a fight of the shares of Pioneer

o       Corp decides to disallow these votes

§b/c some other entity had been given beneficial owner of these shares

· techincally, they argued that person should vote

o       Ct: record owner of shares is entitled to vote

§Its up to election inspector to verify that the proxy has the authority to act for pioneer

·Here the inspector did not care about pioneer, b/c the benefical wants something else

·Ct: this was improper for the inspector

o       Reasoning

§There are actions beneficial owners can do

· Demand a proxy from the legal owner

o Once you have proxy you can cast shares

· Can go to corp and have the records of corp change to reflect your ownership

o Would have to demonstrate that you are beneficial owner

§ But here, the beneficial owner did neither of these

§ Therefore, as date of election there was  record owner, Pioneer

· Types of voting

o       Straight line – minority shareholders can get frozen out

§ Ex. 5 spots to vote for

·A- 10 shares

· B- 20 shares

§ In all situations A is going to lose

o       Cumulative voting - technique to allow minority shareholder to become involved

§ Ex. 5 spots

· Under straight could only cast 10 votes per position, but has 50 votes total

· Cumulative allows to use this figure

·A- 50 votes for one position

§ Formula p. 451

· Number of shares need to elect n director under cumulative voting

o       (nS/ D+ 1)   +1

§ N – number of directors desired

§ S- number of shares voting

§ D- number of directors to be elected

· Ex. if five person board and goal is to elect one, and I own 10 shares and others own 20

o       Can I guarantee one spot

§ 1(30)/ 5+1

· 30/6

o       5 +1 = 6

o       Need 6 shares to guarantee position

§ He has 10, so its okay

o       Cannot get 2 positions on board

· RMBCA-7.28

o       Cumulative voting is not default

o       Only get if in articles of incorporation

§CA had different rule for small corp

·Cumulative voting is default in CA for small corp

o       Humphrys v. Winous

§ Facts

· Board classified into 3 classes of directors

o       1/3 would be reelected

§ Staggered election

· Technique which can be used to undermine cumulative voting

o       Creates bigger fraction = more votes need to garner position

·Ct: allows classified boards

o       RMBCA – allows different classes of directors with staggered voting its okay

o       Cumulative voting is okay, but not default

o       Classified directors is not default, needs to be in articles

o       How to amend articles

§ RMBCA 10.03

·Articles can be amended only by joint consent of board of directors and shareholders

o       If you don't control them both, you cannot change it

·So staggered terms has to be in articles

o       Have to get approval from shareholders

§In public company takeovers

· Staggered board make it more difficult to have hostile takeovers

o       In first year, won't have opportunity to use new majority of shares to elect new board right away

o       So two reasons for classified boards

§ Weaken cumulative voting

§ Make it tougher for hostile takeovers

·Ringling Bros.

o       Facts

§ 3 owners

· Ringling – 315 shares

· Haley owns 315 shares

·North – 370 shares

§ Situation where any two could go against the other one

· But unstable

§ Concept

· Ringling and Haley would enter into shareholder agreement w/ each other and promise to always vote together

o       Agree to consult each other and vote together

o       If they can't vote together, they will go to an arbitrator

§ They are upset with each other so go to arbitrator

· But one refused to go with arbitrator's decision

o       Cast vote separately

§ Chairman decides to register vote as arbitrator would have decided

o       Issue

§ Are these shareholder agreements valid

§ Remedy?

·Even if it were valid, as a shareholder don't you have power to cast vote

o       May have breached contract, but still should have legal power to cast that vote

o       Ct

§Agreement is valid

·Shareholders can enter into agreement w/ each other

§ But as  remedy, Ct does not count arbitrator's votes

·Ct says that since one voted against arbitrator, her vote doesn't count

o       Got disenfranchised

o       This was a shareholder agreement on shareholder issues (i.e. how they would vote their shares)

§Contrasted with shareholder agreement which attempts to determine how board makes decision

·Under RMBCA- need unanimous shareholder agreement

o       Specific performance of agreement would have required to follow arbitrator's decision

§ Ct: not going to enforce

§ RMBCA- is going to allow it

o       Issue of remedy

§ Ct respects agreement but doesn't follow intent of the agreement

o       Effective devices for enforcing shareholder agreement (3)

§ Voting trust

·  Have two women transfer shares to arbitrator, they remain as beneficial owners, in trust instrument can instruct arbitrator how to vote

§ Revocable Proxies

· Give a proxy to arbitrator

o       But not a method of enforcing a shareholder agreement

o       b/c one could just revoke proxy

§ Irrevocable Proxy

· RMBCA – 7.31

o       Proxy coupled w/ an interest

· Buying votes

o       NY does not allow

o       DE – not so clear

§ Institutional votes were purchased

· Buy/Sell agreements

o       Oppression concern

§ Minority fears being frozen out

§ Liquidity concern

· What if I die and kids don't want to be in business

§ Remedy

· Upon certain events, someone must pay something to shareholder

o       What events

§ Upon death, retirement

· Anything you are worried about

o       Who pays for shares

§ Corp

§ Or other shareholders

o       How much (4 ways)

§ Give fixed amount

· Pros- w/o litigation

· Cons – stuck w/ number which can be way off from value

§ Book value

· Value share as percentage of book value of company

·         Pro- naturally updated, determinate (not arguable)

·         Expert Appraisal

·         Adjusted Amount

o       Delectus personae

§ Choice of colleagues

· In small corp, people care who their fellow shareholder's are

§ Remedy

· Put restrictions on sale, pledge, gift, bequest

o       Control the shares

· Right of first refusal

o       Before you sell shares to 3rd party, you must offer at same terms to X

§ Options

· Give right to corp

· Offer them to other shareholders

o       Not absolutely forbidding sale to 3rd party

· Permission to sell

o       No sales w/o permission

The Public Corporation—


Corporate Social Responsibility-

Against—Milton Friedman—what is it that authorizes the corporate managers to take the money—argument for the elimination for private property.  The story is really this isn’t what we want.  We want corporate managers to be faithful to the public, but that is not what they are elected for.  They are elected by the shareholders, so they aren’t really accountable for the public interest.  What we want is for corporate managers to be faithful agents of their owners, to use their money within the laws to maximize profit.


There isn’t very much social responsibility in corporations—corporations maximize their profit very well.


Article on page 540—William Allen Article-professor thinks it is nonsense and self interest rationalized by thinly veiled concerns of other people. Professor argues that we would be much better off with a law that says that we are accountable to the shareholders.  


Page 548-Lack of accountability of corporate directors to shareholders.


Berle and Means theory

—wrote a book in the 1930’s called the Modern Corporation and Private Property.  Thesis—corporate managers are an out of control class.  They are a plutocracy.  Private property is supposed to be a good thing, for instance a farmer has an incentive to maximize the profits of the land.  Corporations, the people who own the corporations are the shareholders, but the shareholders do not manage the corporation.  The top officers manage the company, but they are unaccountable.  Shareholders elect the directors, and the directors appoint the officers.  But shareholder elections are a joke. 


There are very, very few proxy contests.  Out of the top thousand corporations, there were three—essentially the corporate elections were rigged.



Give me your shares to vote.  The problem with this is that they are expensive, and the directors can hold proxy votes on the corporate dime.  Individual shareholders have to pay for proxy solicitations, but usually nobody fills out proxy statements. 


More constraints holding management accountable than Berle and Means initially suggested:


1. Proxy contests

Berle and Means were right to some extent that these were a largely useless constraint. 


2. Capital Markets

How did you get control of hundreds of billions of dollars?  You have to do well in your investments to get more money, so in a sense, the capital markets are somewhat of a restraint.


3. Product Markets

You produce something that people want to buy.  You must continue to produce products that people can buy, or you won’t be able to stay in business and you will run out of money.  You are operating within a constrained environment.  You provide lots of wealth for yourself by producing goods that other people want to buy.


4. Nature of executive compensation

Officers we can assume are self interested creatures, but how do you become wealthy, it depends somewhat on your compensation structure.  Most are compensated in some part to the performance of the firm.  Much of the compensation is in the form of stock options or bonuses tied to performances.  Problem, it also creates an incentive to lie.


5. Market for corporate control-

If you get a majority of the shares, you can kick out the management and run the company better, it is the fear of this that drives the managers to do well, you want to drive the price of the stock up, so that it costs more to take over.  A lot of what has been done at the state level has undermined this.


6. Voluntary mergers-

Won’t be deterred by a bid, since this is voluntary.  Suppose that you are running the company badly and there is another company with a different management team that can run your assets better, another company will want to buy your assets from you.  Bad companies will tend to be merged into good companies because the assets are worth more to the good companies to the bad companies. 


7. Corporate law

Imposes some fiduciary duties of care and loyalty on the managers.  Shareholders can bring derivative suit (a suit brought in the name of the corporation by a shareholder).


8. Reputation/Market for Managers

What will make you an attractive commodity in the market for corporate managers?  I.e. if you spent your time playing golf you lose your value as a commodity. 


Huge trend toward institutional ownership of shares.  1930’s most shares owned by individual shareholders and subject to collective interest problem.  Today, the vast majority of shares are owned by institutions—pension funds, banks, insurance companies, foundations, and so on.  So shareholder voting is not as big as a joke as it once was. 




Hamilton Article—the reality of corporate boards—they have very little to do with the corporate management of the firm.  They only meet a few times a year, members of the board are CEOs of other organization, officers inside the company, etc.  They aren’t really paid that much money. 


Power structure:

-diversified leadership now.


Board elected, they create a compensation committee, an audit committee, the nomination committee and these directors are more and more independent. 


We don’t want to legislate the optimal control structure of a corporation. 

Boards are more willing to control officers.


Land article on page 566—basically this was a chummy kind of place, the board of directors was a bunch of rubber stamps. 


Section 3.02 of The Principles of Corporate Governance-569


Independent directors have become more numerous.  These committees, board audit.


Corporate Governance in 2007


Enron created about 1000 SPVs (separate purpose vehicles that could hold separate assets and liabilities and the like).  Enron used these SPVs to create a lot of fraud. 


Mark to Market accounting. 

Adjust asset to current market value.  A lot of the instruments that Enron traded in were new, so nobody knew what they were worth, whereas historical costs were a fact, you knew what you paid for it, and you wrote it down. 


What did Congress do about this?  They passed the Sarbanes-Oxley Act:


What was the diagnoses of the problem?  Top executives were determined to perpetrate fraud by manipulating accounting data and everybody else kind of went along or they stuck their head in the sand.  The board of directors did nothing. 


Sarbanes-Oxley Act:


§101-new agency to regulate accounting—Public company accounting oversight board.


§201-Deals with other activities of auditors—accounting firms shouldn’t be performing other services besides the audit—logic, you don’t want a conflict of interest, you don’t want a firm that is making so much on side deals that they don’t want to say—hey, where does this number come from?


§301-Deals with audit committees—audit committee of the board must supervise the outside audit and the audit committee must be independent.  There are also some rules about competence in this section.  If you want to list on the NYSE you have to have an outside audit by independent directors and it must be competent (must be an expert).


§302- (corporate responsibility for financial reports) CEO and CFO must certify the financial information—this is the kind of thing that makes people scared.  What motivated this was that people went to Congress and said, “I don’t know what was going on, it’s a big company, etc.”  This has a lot of people terrified, it may be that this is too hard in some ways, it may be too hard to know what is going on in a large corporation.  As a result a lot of companies are going private to get out of the Sarbanes Oxley.  We don’t want people to say that they don’t know what is going on when they did know or should have known, this is all about accountability at the top.


§307-Rules for others—professional responsibilities of attorneys.  Attorneys who are aware of a material fraud or breach of fiduciary duty (law violation) must report it to the CEO or the Chief Legal Officer, and then (if it didn’t work because the CEO and CFO were in on it) you are supposed to report it to the audit committee (which is designed to be independent).


§402-Loans to executives—used to be that loans made with little interest or collateral or if they would be paid back—the rule now, the Sarbanes rule is that by in large loans to executives were disfavored.


§404-System of internal control, also a controversial one-you are supposed to create a kind of structure where information is supposed to flow so that the right hand knows what the left hand is doing.  These are very expensive.  Has caused existing number of public firms to go private, the idea was to have a free flow of information


§806-Protection for whistleblowers section--


§903—increase in criminal penalties—increase the penalties for white collar crime. Increasing terms of prison times for ERISA fraud, mail fraud, wire fraud.


§906-Corporate responsibility for financial reports—want top executives to certify accuracy of information.  Whoever certifies any statement knowing it does not comport with all requirements, will be subject to fine and possible imprisonment.



Proxy solicitation


Federal Securities Acts


1933 Act-regulates initial issuance of securities, first time you are issuing a security, a new issuance of stock that you will sell for the first time to the public, it is not a necessarily a company.  Once the stock reaches the public, it is covered by the ’34 Act.


1934 Act- regulates subsequent trading and proxy statements.  Specifically §14(a).


§14(a)—it doesn’t say an awful lot. 

The statute doesn’t make anything illegal, all it says is that some day the SEC will make regulations to solicit proxies, and when that happens you are going to follow the rules. Quoted in book at page 589. 


Says with respect to registered securities—raises a different issue, what companies are regulated by such an act.


§12(g)— 10 million dollars, 100 or more shareholders

Was 1 million dollars plus 500 or more shareholders. 


Now it is 10 million dollars of assets and 100 plus shareholders.  Bottomline is 10 million dollars in assets or 100 plus shareholders.  If the company is that size then they are required to participate in the regulatory scheme of the ’34 Act.


If you have a company that is that size, then they are required to participate in the regulatory scheme of the ’34 Act.  One of the requirements is proxy solicitation. 


The problem is that there aren’t any proxy contests.  Corporate voting is a bit of a joke.  You don’t really have a choice, either you vote for them, or you don’t vote for them, but there is no rival slate that you can vote for instead so really there is no alternate choice. 


This is why you end up with a self perpetuating board.


The ’34 act makes this perpetual board worse instead of better.  They makes rules and things that make it difficult for you to receive these things.


Regulations that the SEC has adopted under §14 (a)


Studebaker case on page 592—the corporation is suing is stock holder, and this is a bit jarring right off the bat. 


A shareholder wanted to inspect the list of shareholders.  In order to obtain access to that list, you have to have the authority of 5% of the existing shareholders.  The defendant had done that, he had talked to other shareholders and gotten authorization from enough of them that he had the requisite amount.  Of course if you get the shareholder list you can send out proxy statements.


What was the problem?


The problem was that the company said, “how did you get these authorizations?”  In order to get these authorization, you must have gone out and talked to other shareholders, and asking them for the authority to represent them, and this was part your plan to ultimately seek proxy solicitation with the other shareholders.  All this communication with your co-shareholders was calculated in a plan to ultimately ask for a proxy solicitation.  Therefore it was itself a proxy situation.


One of the rules that the SEC adopted was Rule 14(a)-3.



No solicitation shall be made unless the shareholder is provided also with statutory information.  Who are you, what is your background, and so on. 


What is a solicitation?


14(a)-1 definitions, solicit-


§(l)-defines solicitation—the term solicit and solicitation includes any request for a proxy…under circumstances reasonably calculated to result in a proxy. 


Any communication reasonably calculated to result in a proxy.  The court says here, as long as your communication is the start of a plan that will likely result in a proxy, then it is a solicitation.   No solicitation unless you have the statutory information, and the statutory information is very expensive.  In Studebaker they didn’t have it, so the court said that what they did was illegal. 


After the Studebaker case, there has been some attempt to deregulate this area and to allow certain things to be not solicitations or solicitations that don’t trigger 14(a)-3.  It is not completely obvious how this helps (to the professor). 


amended rule 14a-1-- new definition of solicit (citizens post ad). 

-In response to the citizen problem (of where citizens posted an ad in the paper saying they wanted control and were denied by the court).


You are allowed to answer questions, communicate to persons of which you have a fiduciary duty, or answer an ad. 


14a-2—rule which exempts you from all but lying.

is a new rule which is solicitation for which rules 14a-3 and others apply. 

14a-2(b) which says that rule 14a-3-14a-6 and rules…do not apply to the following. 


Important thing is that at does not exempt you from 14a-9, which is the most important of the rules, and 14a-9 says that you can’t lie when you solicit proxies and we aren’t exempted from that.


Does not exempt you from 14(a)(9)—14(a)(9) is the most important of the rules, it essentially says that you can’t lie when you are soliciting proxies. 


14(a)(1) you are not held to this, nothing in 14(a) applies to you, since you are not soliciting proxies.


14(a)(2)-even thought you are soliciting a proxy, you will be exempted from a lot of rules, but you will not be exempted from 14a-9. 


If it is not a solicitation then you are exempted from everything, if it is a solicitation and it comes within 14a-2, you are exempt for a lot of stuff, but not lying.


If you are within 14a-2 you are exempt from the Studebaker requirements.


One thing that has been proposed is that to get elected you have to have a majority of the stockholders, this would help the problem, but only slightly.  Usually you can’t win without proxy solicitation. 


14a-2(b) is quoted in the book—page 595. 


SEC is protecting us from a problem that doesn’t really exist.  The problem is having an election on the ballot for something we can vote on.


14a-3—you are not supposed to solicit proxies without certain statutory information.  Example on page 599, independently ratify public accountant, and disclose certain information about the accountant. 


Management’s Discussion of Financial Condition and Results of Operation (required information under 14a-3). 

- Traditionally a company submitted a proxy statement to the SEC, and the SEC got back to them.  Now the SEC staff doesn’t read these things.  If nothing is controversial, just send in the standard vote.


One thing you have to disclose is the MDA the Management Discussion and Analysis of financial conditions.  Don’t just present the data, but talk about it.  What are the future prospects for the company, what does accounting data show. 


SEC was really concerned that you don’t mislead shareholders, so for the longest time the SEC took the position that the management may not discuss the future.


SEC rule denied the shareholders the only new information that they could get. 


Efficient Capital Market Hypothesis (ECMH)—

Says that you cannot systematically profit from information of type X. 


Weak version:

Can’t profit by systematic analysis of past pricing data.


Semi-strong version—

You can’t profit by all publicly available information, this includes information on so called fundamental analysis.  You can’t systematically profit by reading the wall street journal. 



You can’t systematically profit from any information, public or non public, that even if you have access to private information you can’t beat the market. 


There is a lot of evidentiary support for the weak and semi strong theory.  The strong theory is not supported by evidence, i.e. if you have inside information you can beat the market. 


Historically SEC just wanted you to restate in your proxy the information that would be in the WSJ.  The economists said this was no good, and useless.


§21E of the 34 Act

Forward looking statement—this is a safe harbor, going to create a safe harbor for certain forward looking statements.  If you include cautionary language that your prediction might be false and it is not knowingly false, the mere fact that it is wrong won’t be held against you. 


Back to 14(a)(3)—don’t solicit proxy unless you have information—a requirement that the management talk about the future as opposed to 21E, which is just a safe harbor—we will protect you against fraud claims…


In the Matter of Caterpillar, Inc.


SEC brought an administrative action against Caterpillar, Inc., alleging that it had failed to comply with section 13a of the ’34 act.  13a deals with falsities in the reports.  Caterpillar has a big operation in Brazil, and in 1989, they made a lot of money and 23% of their profits were from their Brazilian operation and they had a practice of consolidating all of their money from all of their operations into one big balance sheet. 


1989 report, it showed that they were doing well and it didn’t break it down by which operation was doing what, in 1990, there were a lot of political changes in Brazil.  For the first time in a proxy statement they were going to break down the Brazilian operations and make a negative future statement about the future Brazilian operation.

SEC said that what you said in 1989 and first quarter of 1990 were misleading because they didn’t break things down, because you didn’t notify the shareholders that the reason the company was doing so well was because of the Brazilian operation. 


When they finally broke it down and said Brazil looked negative, the SEC said that they should have broke this down earlier.  Criticize you for not making the statement that would of helped explain the material risks of the company for the future. 




Prohibits material falsities and omissions necessary to keep the statements you made from being misleading.



J.I. Case Co. v. Borak


Supreme Court at it’s worst in interpreting SEC law. 


Plaintiff is a shareholder.


Case of company being merged, Borak believed the merger was unfair to the shareholders and the shareholders are asked to vote. 


ISSUE:  Is there an implied private right of action for shareholders?  There were also some other issues—is this a direct or derivative suit, can you have damage remedies or just injunctions? 


14(a)(9) doesn’t spell out the remedial consequences if you lie. 


Is there an implied private right of action for shareholders.  How did the reach that conclusion? By a number of different things—they looked at §27 of the 1934 Act, quoted at the bottom of page 613. 


Direct suit is a suit brought by the shareholders to enforce a certain right.  Simplest example would be if you were a holder of preferred stock that entitles you to 10 dollars per share before dividends to common stock.  If the company pays dividend to the common stock, and you didn’t get any money for your shares, then you have a direct right to sue.


Derivative suit is a suit the shareholders initiate on behalf of the corporation.  Corporation itself is a victim.  The right is a right of the corporation, the shareholder just initiates the suit.  The plaintiff is technically the corporation, not the shareholders, against the directors. 


14a-9 is concerned with individual shareholders.  Court says that it is also a derivative suit, because this was a merger and the merger may have been unattractive for the corporate entity to move.  Because of the false solicitations it went through.  In that sense, the entity itself was the victim and the shareholder can bring a derivative suit against the directors. 


Direct—shareholders have individual right not to be lied to.


Derivative because corporation itself is hurt.


Supreme court says that there is both injunction and damages.



Main issue is whether or not there is an implied right of action.  If there is, what happens? 14a-9 doesn’t say.


Holding, yes, there is an implied private right of action.


The court uses that to show substantive private rights of action. 


This is a very weak demonstration of the claim that there is an implied right for shareholders. 


There is no federal common law, so what is the court doing here?  Are they just interpreting a federal statute?  Arguably they are, but this isn’t really in the statute.  There are all kinds of different rights of private action, so what Congress wanted a private right of action, they knew how to provide for one.  It is very hard to interpret the statute as calling for a private right of action, but you can do what the court did and say that it would be helpful to have this and by general common law reasoning to supplement the statute to read this right into the statute.  This is a weak demonstration of a claim that there is an implied right of action. 


The court doesn’t really believe in interpreting things this way, they only find a private right of action when it is supplied by a statute, BUT Borak has been grandfathered in.


Duty of controlling shareholders:


Controlling shareholder is somebody who controls a corporation.  I.e. if you control 51% of the shares. 


Why do you owe any duty to anybody?  It is not as obvious as if you were a director. 


Debaun v. First Western Bank and Trust co.


Majority shareholder sold shares of corporation to people who basically looted the corporation and they depleted the assets of the corporation into their own pockets.  The problem is that the crooks are insolvent.  They are in Tahiti, etc.,


The question here is does a controlling shareholder have a fiduciary duty to sell his shares to a reputable person, such as if they sell their shares to a crook they have violated their duty to their shareholders. 


Court said that the bank was liable.  The particular person who was buying the shares didn’t exist.  The related entities had all sorts of bad omens, bankruptcies, criminal convictions, etc.  If you made some inquiry you would have found this out.  Court said that given this, you should have made some inquiries.


You can’t unload your stock where you should have known. 


Perlman v. Feldman page 527.


Feldman owns controlling block of shares in Newport Steel Corporation. Controlling block being sold to purchaser, and purchaser was somebody who wanted to use steel and lock in their supply of steel by vertical integration with the steel company.  They sold the controlling stock at a considerable premium.  Court said that this isn’t wrong, it is okay to sell the stock for a premium price. 


-Nevertheless the court said that there was a violation, Feldman did violate his duty as a controlling shareholder.  The steel company was in an excellent position to exploit the price of steel.  What they could have done was get special deals like low interest loans for exchange of locking in the price of steel, this would have benefited the whole corporation.  The controlling shareholder just acted in a way that benefited the controlling shareholder only and not the corporation as a whole.  If they had held onto the steel company but entered into a contract, that would have been for the benefit of the whole corporation, so the court saw it as some sort of usurpation of corporate opportunity.  Discussion of golf course case. 



Actual Authority



Apparent Authority


Inherent Authority


When is a corporation legally bound by a contract?

-Under what circumstances can a principle be bound by the actions of an agent?


Actual authority is the manifestation of principle to the agent.  Principle made it appear to the agent that the agent can enter into a contract on behalf of the principle. 


Two types of actual authority.


Express actual authority

-is expressed in words—you have the authority to enter into this contract on my behalf.


Implied actual authority

-is where the principle conveys the same message to the agent, but this is by conduct rather than words.


The alternative is apparent authority.


Apparent authority

-is a manifestation from a principle to a third party.  Trying to protect 3rd party from being mislead by believing that agent has authority. 


Ratification—a person can be unauthorized at the time they enter into the contract, but the corporation can subsequently ratify this contract by its action.  Corporation can ratify the unauthorized action by the agent. 


Inherent authority

kind of a certain type of agent has by their status has inherent authority to do certain types of things.  Professor thinks this is better explained by actual and apparent authority.



Page 511—


In the matter of Drive-In Development Corp:


Case where you have a company that is in bankruptcy (drive in corp), and the bank has asserted a claim against the corporation but also against the officers who executed a guarantee of payment.


Question—whether the officers had the authority to enter into a contract to certify this corporation.


The corporation is denying that there ever was such minutes.  The court says it doesn’t make any difference whether there really was such a board meeting or not, the corporation is estopped from denying this.  The board created a secretary, whose job was to certify the minutes.  The secretary did certify the boar minutes as being valid, so it doesn’t make any difference if there was minutes or not, they were certified, so there was.


This case is an illustration of the right way to do it.


One way to have express actual authority is by having modern by-laws, another is by having an express resolution.


Lee v. Jenkins Brothers

more typical of cases you might encounter.


Yardley wants to induce Lee to stay at the plant.  Lee brings suit saying that he is entitled to a pension—but the Jenkins Brothers said that Yardley didn’t have the authority.


Lee says okay,  but gets fired at age 55 and brings suit against the company, claiming that he is entitled to a pension.  Company says that Yardly is not authorized to enter into such a contract.  Does he have this authority, or doesn’t he?


Court: the president has the power to enter into ordinary course transactions, employment contracts are ordinary transactions, but a lifetime contract is extraordinary.  Pension more ordinary than extraordinary—what is the court doing here?  They are either looking at implied apparent authority. 


Ordinary-Extraordinary principle can be given an economic rationale. 


Giving a person a title can give a person apparent authority.


§14(a) of the 1934 SEC Act.  When you are soliciting proxies, you will follow our rules.


Rule 14(a)(9)-when you are soliciting proxies, you don’t make false statements of material fact.  No material half-truths (you must not make an omission to make the statement misleading—given what you did say, you must say more as to not be misleading). 


Borak case—there is an implied private right of action under 14(a)(9).  If you are a shareholder and somebody lies to you, you can sue them under 14(a)(9) 


The Mills case—page 615:


Mills v. Electric Auto Light Co.


You have a merger between corporation number 1 and corporation number 2.  The two firms are going to merge.  Corporation number 1 owns a good stake in corporation number 2.  If corporation 1 has a majority interest in corporation 2, then you can push through the merger at terms favorable to corporation number 1.  Every dollar moved from corporation 1 from 2 is bad.  Want to move as much value from corporation 2 to 1.  Who is harmed by this?  it is the other shareholders of corporation number 2, they are harmed when the terms of the merger favor corporation number 1.  The other shareholders are bringing suit against the corporation that has an interest in corporation number 2. 


You have to get shareholder approval for a merger.  Please give us proxy to vote you shares at the meeting.  Shareholders often claim that they were lied to, the whole point is to move value from one company to the next. 


Claim:  Proxy statement failed to disclose that 54% of the shares were owned by the other party in the merger.


The court addressed the question of causality.  Did the fraud cause harm?  Is there a causal relationship between that lie and the harm.


Defendant made an argument that merger was on fair terms:

-Argument-you were lied to, but you got a fair deal anyway, so you weren’t really harmed—and the court rejects this argument.  Court said that it was Congress’ purpose to have shareholders decide for themselves if they liked the merger, it is the shareholders decision to make.  If we bought this argument, it would allow solicitors to lie to shareholders and then just say that the transaction is fair. 


Court says that it is not relevant that this is fair or unfair, what is relevant is the solicitation of the proxy.


Court says that lies were material.  Given that it is a material statement and the solicitation was essential, that is enough causality. 


If a shareholder would consider it important and if it was necessary for the transaction to go forward, that is all the causality you need.


You don’t need but for causality, you just need material statement in a necessary proxy statement is cause enough.


One other point, issue of attorney’s fees: attorney’s were entitled to attorney’s fees for the work they had already achieved.  Exception to rule, if you are representing a broad class, you get attorney’s fees.  Shareholders are a class benefit and we allow attorney’s fees. 


Materiality under 14(a)-9


TSC Indus., Inc. v. Northway, Inc.


Raised the question of the definition of materiality under 14(a)-9.


Facts are similar, National is acquiring TSC corporation, and National owned 34% of TSC shares.  Victim’s are other shareholders of TSC (besides National).  Other shareholders feel that terms favor National to the other shareholders detriment.


What was wrong with the proxy statement?  It doesn’t disclose that TSC is controlled by National.  It discloses other things, like National owns 34% of the stocks, but really, not that TSC is a puppet of National, it is not an independent entity.


Question: Whether this omission was material.


Rejected a “but for” test and a might be material test.


Court embraces a test which is toward the bottom of page 621:


An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.


This definition is objective, focus is on the reasonable shareholder, not individual shareholder.  This is important to class action suits. 


Mix of information on which this was based. 


Virginia Bank Shares, Inc. v. Sandberg:


Here you have a situation—same facts, merger—VBI is a wholly owned subsidiary of FABI—VBI owns 85% of a bank’s shares and the bank is going to be merged into VBI.  You also have minority shares of the bank. 


There is a worry—yes, the VBI board has voted for it, so it is probably good for VBI, but is it good for the bank?  Who knows?  Although the bank voted for it, the bank’s board is doing the bidding of the people that elected them.


One difference is that because they owned 85% of the shares, they were able to take advantage of a short form merger statute.  This statute said that this merger can occur without any vote by the minority shareholder, and you can do this because you own so many of the shares.


The company made the decision that they were going to seek shareholder votes, but why even bother?  They sought to push this merger through by soliciting shareholders… but the claim is that the proxy statements were lies.


Several issues:


1. Can an opinion be a material fact?  I.e when they said there was a high value for shares and that this was a fair price for the bank shareholders and it would earn them a high price for their shares. 


And so informed by their board of directors the bank shareholders decided that they would vote for this thing.


Is there a false statement of a material fact here, or is this just puffing and opinion? 


Court says that there is.  There is a fact that you hold the opinion.  There is also a fact that there is a basis for the opinion, underlying facts that back up the opinion, especially given who the opinion came from, the board of directors, who would know better than anybody.


The holding is that the two of them together is enough to create a claim of false material fact.  If you can demonstrate that the price is not fair and that the board of directors did not actually have this belief/hold this opinion, that is enough to create a basis for a breach of a material fact. 


The other issue is the causality question, the same question that was presented in Mills, but here it was a little bit different.  Here, the transaction did not actually require the shareholder vote. 


It really was not required for the shareholders to vote, so is there causality, what difference does it make that they were lied to?


Can you make a causal claim that what difference does it make?  They could have passed this regardless.  Because a proxy solicitation was not legally required, there is no causal link between the false statement in the proxy materials and the harm done to the plaintiffs.


Plaintiff says that they are doing this to look good to their shareholders.  Maybe there is a causal link afterall.  If there wasn’t a causal claim, then why did they do this?


Court feels guilty about Borak.  Page 629…a really subtle way of saying that Borak was not well.  Court doesn’t want to expand on these private rights, especially since Congress has never expressly even stated these rights exist.


Scalia in his separate opinion is a little more cynical.  This thing never should have been created in the first place—just read it narrow.


The dissent sort of says, no, once you adopt it, you should either repeal it, or give it its fair scope.  You should be reasonable and allow it to flourish, or get rid of it, one or the other, don’t just leave it there and chip away at it.


Holding of the case is—we aren’t going to go that far.  In Mills you needed the shareholder vote.  In this case, you just don’t need it.  This would be expanding on Borak. 


Mills case and this case establish a causality requirement.  You have to show that the solicitation of proxies was legally essential to the transaction. 


Remedies: injunction, damages, or void sale (voiding sale is rare).


Shareholder proposals:


Rule 14(a)-8—This is an SEC rule interpreting Rule 14(a).  This is called the shareholder proposal rule.  This rule basically requires the company in certain cases to include a shareholder proposal in the companies proxy materials.  If I have something I would like the shareholders to vote on, I can communicate to the shareholders via the proxy materials and this will allow the shareholders to vote yes or not.  Can put it in the company’s materials and they have to pay for it. 


Rule 14(a)(8)-


Who is eligible to submit a proposal?

-You must have held at least $2,000 in market value of shares or 1% of the company’s securities (shares) entitled to vote…see page 638.  If you qualify it requires the company to include a shareholder proposal in the proxy statement.


Grounds for exclusion:

Improper under state law (page 641 heading 1):

Can exclude a proposal because it is not a proper proposal for shareholders to act on.  I.e. this matter is a board of directors prerogative.  Under state law it is improper and can be excluded. 


Violation of proxy rule, 14a-9- your proposal can’t include false statements of material fact.


Rule 14(a)(8)-we weren’t really serious about this—don’t want you to make an argument against a company proposal.  Don’t want you to submit a shareholder proposal to oppose a merger.  This wasn’t meant to be an affront to corporate authority, it was supposed to allow you to vent, so serious stuff is not permitted.


Ordinary business transactions.  Company can exclude a proposal if it opposes ordinary business transactions. 


Court—anything relating to a significant policy issue is not an ordinary business transaction.  By enlarge policy proposals are able to get through (since ordinary business can encompass a lot of stuff).


Labor is ordinary business, even when a proposal was extended by a shareholder to end discrimination in labor.  The SEC under pressure changed their mind and now employment policies are not ordinary business and so can’t be excluded.


Amending the bylaws:


Rauchman v. Mobil Oil 648: 

Ask for bylaws to be amended and provide that no member of an OPEC country can be on the Mobile board of directors.  Mobil wants to exclude because it concerns the election of directors.  The court accepts this argument.  There was an OPEC member running for the board, and court says you can’t affect this directly.  IF somebody wasn’t running would it come out different?  We don’t know what the court would do if there was no election issue.  Court read this as a targeted response, and viewed it as using the 14a-8 in a way that wasn’t allowed.


14a is not really a serious threat to directors at this point. 


Small shareholders are going to get screwed because they can’t pay for it.


Rule 14(a)(7)—page 653—


How do I get my materials in the hands of shareholders?


If you make a request for this service, the company has to mail your materials at your expense to the shareholders, or they have to give you the list of the shareholders so that you can mail them out yourself.  The shareholder list will list institutional owners but not the beneficial owners. 


NOBO (non objecting beneficial owners): list-non objecting beneficial owners, people owning stock who do not object to their name being included. 


This rule essentially says that the company has to choose between giving a list or mailing, but you have to pay for it.


Regulation FD. 

If you spill something in a meeting to a financial analyst, you have to release it.  If you intended to release it at the meeting, you have to release it to the public at the same time.  If it was an accident, THEN you have to release it to the public.


Two main duties owed by directors of corporations to their shareholders:

Duty of care (guy who buys a boat); and

Duty of loyalty (deals more with self dealing).


Solution to the Berle-Means (economic theory) problem, people who run the corporation don’t have incentives to run it well.




Litwin v. Allen


Allegheny corporation, and it owns some Missouri Pacific Railroad bonds.  These are convertible bonds, i.e. if you own it you have the option to convert it to another instrument for a fixed rate.  In this case, it is stock in Missouri Pacific.  They want to borrow money, but they can’t due to their corporate charter, so they come up with the idea of selling bonds to JP Morgan, and JP Morgan in turn has an arrangement to pre-sell the bonds to the Trust Company and Guaranty Co., but they have an option to be bought back within 6 months. 


The shareholders are bringing suit on behalf of the corporation, so this is a derivative suit.  Shareholders bring suit on behalf of the Trust and Guarantee company against the directors. 


The court does find that the directors violated due care.  Court: these banks were forced to hold these bonds for six months, after the six month period was up, they were forced to make a sale of these bonds if they wanted to.  The losses you incurred in that six month period were inherent in the transaction itself, so the court focused on the losses during this time period of the suit.


Rare case because it did find that there was a violation of due care.


Why did they rule this way and find that the directors were personally liable?  The court said that there was no upside to this transaction.  If the prosperity returns it goes back to Allegheny, if things go sour, the bank ends up holding the bad.


A lot of people think that what the bank did here wasn’t particularly startling. 


Looking at the law:

-“good faith, skill diligence and prudence.”


Some degree of skill, diligence, and prudence is required, so you can  be sued for essentially negligence if you don’t behave.  The court says that banks are held to a higher standard.


Three is a policy question of whether or not we want the courts to be doing this thing.  The court is saying that these directors are bad business people and that the courts could have done a better job running the business.  But is the court the one to judge this? 


It is not really desirable to have the courts evaluate this.  If we were to take this duty of care more seriously, and people would sue directors left and right and there would be a temptation upon the directors to be very conservative in the decisions that they make.  This is bad from a shareholder perspective.


Even if you thought the courts were competent to evaluate, there would still be a concern over instilling conservatism—i.e. a director has two choices, A and B, and B has more risk but will make more money and might result in a lawsuit.  A has a much less chance of making money, BUT the director knows that choosing it won’t result in a lawsuit.  Argument: The fear of a lawsuit pushes director to make a more conservative decision.  Most shareholders are risk neutral, they own shares in several companies, so while one may fail, it is not likely that they all will.


Shlensky v. Wrigley


Directors of the company are deferring to Wrigley.  They have this vision that baseball should be played in the daytime.


Not really any self dealing here, Wrigley is probably losing money too since there are no lights.


The court says that this is not a violation of duty of due care.  Court says that this is a good faith decision, but usually good faith is more of a duty of loyalty question, not duty of care. 


Even if there isn’t bad faith, there is a question of prudent judgment.  Could a person of reason do what he is doing and believe that what he is doing is in the best interest of the corporation.  The court says yes,


Two arguments: he is concerned about the neighborhood for his sake, my responsibility to the world to make sure neighborhood doesn’t deteriorate.  Or he doesn’t want the property value to decrease around Wrigley field. 


Interesting question if you said, “I don’t care if the shareholders make money, I want this to be a good neighborhood.”  Public interest, the court doesn’t get into this.


The court says that they won’t second guess the second judgment. 


MBCA of Directors Treatment of Duty of Due Care--§8.30 and §8.31.

Page 670.


§8.30-standard of conduct and §8.31 deals with the standard of liability. 


Language of ordinarily prudent person was deleted in the most recent version of the Revised MBCA.  Prudence conveys a connotation of being conservative. 


Current §8.30(b)

When becoming informed in connection with decision making function or or voting attention to oversight function act with care that a person in like position would reasonably believe appropriate.


Business Judgment Rule


You have an obligation to become informed and pay attention.  You don’t necessarily have an obligation to make a good decision.  The substance of your decision won’t be attacked, but you will be in trouble if you are not informed and don’t know what you are doing—i.e. the business judgment rule.


Also, notice that the prudence language is deleted, reasonable belief means both actually believe and have reason to believe.  You have to actually believe that you have studied enough to be informed of the subject. 


Obligation to become in formed

Obligation to pay attention

Act with a reasonable belief that they were informed and paid attention when they acted.


Policy-why do judges care about procedure of decision, but not the substance of decision? Judicial efficiency, courts aren’t good at judging decision, but they can judge the process.


ALI §4.01

As long as you follow the guidelines on page 671, you should be okay.  If you meet these requirements, you are okay, even if it turns out that your judgment was bad.


Business judgment rule:

You will see this a lot in the case law.  This is a rule of deference to decisions made by the board that under certain circumstances the court will not second guess a corporate decision on the merits.  If you make a judgment and you meet these three elements, then you have done what is legally required of you as a director and if you have done what turns out to be a colossal mistake, it doesn’t matter.


You can’t attack a decision on the merits itself.  BUT you can claim that you approved a decision without being well informed and without believing it was in the best interest of the company.  Those are ways in which you can attack a judgment. 


Smith v. Van Gorkom


Trans Union was a corporation that had kind of a problem.  It had these investment tax credits that could be used to help offset income that you made, however, they weren’t making enough income to make use of these credits.  What they really needed was to merge with some other company that was making income so that their tax deductions could be written off. 


CEO of TransUnion was Van Gorkom, and goes to speak to Pritzker.  Discuss whether or not Pritzker would buy the company for $55 a share.


Pritzker wants options to purchase the Transunion stock.  Van Gorkom and Pritkzer agree, but the merger needs to be approved by the board.  They call a meeting.


9/20 meeting:

Van Gorkom gives a 20 minute presentation to the board about the merger.

Legal advice—you may be sued if you don’t approve this transaction (merger price was at a significant premium to the current share value).

Report by CFO stating that $55 a share was a fair price at the beginning range of the price of the shares.


The board approves the transaction subject to a 90 day market test.  90 days go buy and they receive a few nibbles, but Van Gorkom thought that these offers weren’t serious and ultimately the transaction goes through.


Shareholders approve the transaction. 


A derivative suit is brought by the shareholders claiming that the directors breached their duty of care, because they approved this transaction.  To everyone’s shock, the Delaware Supreme Court agreed.


What was wrong, why was this so bad.  The court said that “you were selling the whole company, it’s the end of the line,” couldn’t you have done more to prepare?  The court stressed things that weren’t there.  They didn’t see the merger agreement, there was no outside opinion.  A lot of it was that there was too little information available for this type of bid decision.


Directors took the position that they were allowed to rely on such reports.  §8.30(f) states that an officer can rely on an officer or employee of the corporation, or counsel…etc.  Arguing that we were advised that we would have to do this transaction, or we would be sued, we were relying on legal advice.  The court rejects this.  If they would have voted against it then they would have been protected from the business judgment rule.


The 55 dollars a share, where was the inquiry?  No questions asked as to why this is the beginning of the range, is this reasonable, where is the independent test.  The court was just saying that you were being a passive rubber stamp to what Van Gorkum tells you.  The board did try to shop the company for 3 months, so it wasn’t a total rubber stamp, but the court just wasn’t convinced that this 90 day test was real.


Dissent:  The people on the board had many, many years of experience, they knew the company well. 


-The court says that experience doesn’t substitute for transactional development.  In the end the directors just devoted far too little time to the transaction for the amount of money things were worth. 


Were all the directors equally responsible?  During oral arguments, the Delaware court dropped a hint that they were willing to exonerate some of the directors (those that weren’t there), but the directors made a decision that they would stand and fall together, they were represented the same attorney, etc.   The court did not allow the lesser directors to get a rehearing because they initially chose to stand with all of the directors.


Court: when there is gross negligence, there is not business judgment rule. 


Result of this case:


Idea that a corporation might be able to insulate its directors for liability. 


RMBCA 2.02(b)(4)-Director Indemnity

(page 688) articles of incorporation may set forth provisions that limits the liability of the director except for liability for financial benefit received by the director or illegal harms.


-you can put in a clause that limits liability except for liability based upon intentional wrongs or personal profits.

-Can put a clause in articles of incorporation that insulates the directors, but the shareholders must approve this. 


Happy story-you give the shareholders a chance to get rid of it, and they did.  They don’t want the directors to constantly worry about being sued, they want them to focus on overseeing the corporation.


Unhappy story is the Berle-Means (economic theory)-shareholders like this case.  They are ignorant of what they are giving away.


Legislature ended the Van Gorkom, the revolution was short lived due to the legislative response.


Also see Delaware is §102(b)(7)—page 687


Francis v. United Jersey Bank

Case where there was a housewife director, but she didn’t do anything, and her sons who were running the company were robbing it blind.  She was an alcoholic, and so she got sued for violating the duty of due care, and she lost.  Van Gorkum changed this and terrified people. 


Fiduciary duties owed to corporations:


Van Gorkom terrified people—it wasn’t in all that bad of a business decision. 


One of the responses was that you could add a charter provision to protect the directors.  I.e. don’t worry about Van Gorkum, you can get add this charter amendment, as long as the board members and shareholders sign onto it. 


Cede & Co.,Cinerama, Inc. v. Technicolor, Inc.

On page 688—suppose that you have a violation of the duty of due care, the question is the consequences.  The traditional view is that you have to have some sort of causality.   


In a lot of cases there won’t be causality—what if directors go to the meetings and everything would be the same.


Delaware court—we don’t want to bring into the duty of care the tort notion of proximate cause.


Court wants to make a fairness inquiry—a question of whether the transaction is sensible for the corporation.  Fairness also applied to the duty of care.  It was the aftermath of the violation of the duty of care.  Once you breach the duty of care it removes the business rule deference, and the court must scrutinize the transaction to see if it makes sense for the corporation. 


Case stands for the proposition that a fairness inquiry is what follows from a violation of the duty of care.  No more business judgment rule deference, we are going to look at this decision and ascertain de novo whether this transaction makes sense from the corporation’s point of view.


Emerald Partners v. Berlin: 

Issue is suppose you’ve got one of these charter provisions in a Delaware corporation that insulates the directors from liability.  Now somebody sues the directors, the question is, can you dismiss the case on the pleadings?  Say, you aren’t allowed to get any damages from us because our charter prohibits it, so the suit should be dismissed.  These suits are very expensive suits to defend.  You can’t insulate the directors from everything.  The problem is that until we try the case we don’t know whether there was a breach of loyalty by the directors.  So you can’t dismiss the case earlier than that. 


In Re Caremark Intern. Inc. Derivative Litigation

(case on page 690):


FACTS: Shareholder derivative suit, against the director claiming that the director violated a duty to the company.  The company had violated some medical care statutes, and as a result brought on large fines and civil penalties. 


The claim is who was minding the store?  The employees were out there committing crimes, and the directors of the company wasn’t minding the store.  There was also a claim relating from a settlement the corporation had entered into. 


Why is the court saying—I want to review this settlement—once there is a settlement, the case is done and off the court’s docket.  Why would the court want to examine this settlement?  The court thinks it is looking after the shareholders.


The worry is that you will have a settlement agreement that is favorable to the directors because they don’t have to pay that much, favorable to the attorney’s because they get a fee, but not favorable to the shareholders (plaintiffs) as a class).  The worry is that the settlement will go through favorably to the directors, favorably to the attorney’s, but not favorable for the corporation, which isn’t really represented.  I.e. sell out the corporation for the benefit of the directors and the attorneys. 


The court does approve the settlement, they think it is fair.  One of the arguments that has to be made in favor of the settlement is that we want to make sure that this is fair to the plaintiff.  If you didn’t get much money, a way to rationalize this is to say that the claim was very weak.


Plaintiff and defendant both want the settlement approved.  Really, the court says “why was this settlement so low,” and the plaintiff says, because our claim was weak, they can’t really do this.  This is all the weird procedural background. 


Underlying case, the employees were out there committing crimes and the directors weren’t out there doing anything, and we need to know how strong the case against the directors was.


The only reason lack of good faith is necessary—it is required to get around the charter amendment insulating the directors from liability. 


The court thinks that there is very little evidence that the directors were that awful, or that they never even attempted to do anything.


Allison Chalmers

(precedent) a similar case involving and anti-trust violation—i.e. directors were asleep at the switch.  Directors took the claim that they didn’t know what was going on.  Court says that you have to be proactive and to try to ferret out information about what is going on.  Plaintiff’s argument was that you have to be proactive and establish procedures that give you information.  The court said, you don’t have any such duty.  There were no red flags, you don’t have a duty to commit corporate espionage and spy on your employees.  You DO have a duty to heed red flags, if somebody calls something to your attention that is wrong, you have to investigate it.


This case, says that we reject Allison Chalmers.  They said that we think the Delaware court would not follow Allison Chalmers today and that Chalmers is out of date. 


The court relied on the federal sentencing guidelines for white collar crimes, took the position that a corporation could be treated more seriously if it failed to implement law compliance programs. 


Odd thing about this case—there is a tension between Allison Chalmers and the holding of the case.  The holding is that the court approved the settlement because the plaintiff’s case against the directors is so weak.  All of this is based on the fact that the case against the directors is fairly strong. 


Chalmers is obsolete, you do have a duty to be proactive. 


The only way that plaintiffs can recover is to demonstrate bad faith, the only way to show this is to show that not only did they fail to implement a system, but that they didn’t even try to implement reporting system.


The evidence that you didn’t try to implement these systems is weak, therefore the settlement is not selling them out, it is fair given that they have got this weak case. 


Enron case has heightened the worry about directors being asleep at the switch.  The claim is how could you not know there was a multibillion dollar fraud going on? 


Notes 2 and 3 (page 699)—reliance. Can’t a director rely on reports they receive from inside the company?  Directors can rely on reports that they reasonably believe to be reliable or accurate.


Reasonable belief means 2 things:

1. Do you actually believe the report is reliable; and

2. Do you have objective reason to back up your belief.


Page 700—Ford motors-dismissal on demurer.  Haven’t plead what was required to overcome the business judgment rule.


Francis v. United Jersey Bank—doing nothing is not good enough (drunk lady case).  Court says that there is no such thing as a corporate director, if she would have read the reports, then she would have know.  All directors must meet a certain minimum standard.


What if there is an upside, such as having a director how is a lawyer or an accountant, is there an upwards side?  There is some case law to support this. 




Stone v. Ritter


Similar to the previous case in claiming that the directors were asleep at the switch while the company was behaving in ways that caused the company to get fines. 


You either have to do 1 of 2 things.  You either have to make a demand on the corporation to sue, or you have to show that demand is excusable.


This is an idea of exhausting intracorporate remedies.  Let’s assume that the director did something terrible, the rest of the board may be able to bring suit against the director.  The board of directors should be given a chance to exercise corporate power.  Even if you have a suit against lots of directors maybe the corporation could set up a committee of independent directors not accused of any wrongdoing and leave the decision of whether to start the suit to them.  The corporation could then make a business decision, to either bring the suit or not bring a suit.


In some cases we will make the demand excusable, because nobody would heed it. 


1) make demand on corp to sue—exhausing intracorporate reaches




2) show demand is excusable—that it is just so obvious that it would bring a demand because there is nobody to heed it.  All the current directors are tainted equally.


Did the plaintiff make a demand in Stone v. Ritter-No. 


Can try to dismiss the case for failure to make a demand, unless plaintiff could show the latter (2).


This is a 12(b)(6)-motion to dismiss claim for failure to state claim for which relief can be granted.


Court dismisses this case, the court takes Caremark as correct and as the law.  In order to show bad faith, you must show this utter failure to attempt anything.  Your complaint doesn’t plead a complete failure of an attempt, so we don’t think that your suit should prevail.


Case is saying that the plaintiff did not ask for a demand.  Must ask if demand is excusable.  Demand is excusable if a majority of the directors are involved in actual wrongdoing for which they could be liable and if the case has merit.


Court—you are not excused from making a demand because all the directors are tainted.  Even if the board is tainted, the court can still dismiss the suit for lack of merit. 


One issue—some people argued that there were 3 duties in Delaware.  The court states that there are not 3, there are only 2.  Bad faith is just an aspect of the duty of loyalty so there isn’t a third thing called bad faith, it is just one way that you can violate your duty. 


You might have thought that this isn’t a duty of loyalty case.


Demand excusable if majority of directors are involved in actual wrongdoing for which they could be liable. 


2 duties—care and loyalty, bad faith is a subset of duty and loyalty.  You have to bring the suit as a bad faith/loyalty case.  The plaintiff doesn’t plead that, they don’t show that this is the case, therefore they don’t demonstrate that the board could do the right thing. 


Can exculpate for duty of care, but not duty of loyalty.


Malone v. Brincat


Suit against Mercury finance—breach of duty of disclosure by overstating earnings. 


Not a shareholder derivative suit, it is a class action suit.  If we would have known the true state of the company, we would have sold our stocks earlier. 


Direct suit—you claim that you as the shareholder have an individual right that is violated by the defendant’s wrong.  A preferred shareholder who is entitled to receive a dividend before common shareholders receive something and the corporation doesn’t do this.  You can bring a lawsuit individually on your own behalf.  You can also bring a class action upon yourself and all other shareholders.  Still a direct suit but just a class action.  Not just corporation that was harmed, but it was I who was harmed.  That is why this suit is brought as a class action suit.


Derivative, I as the shareholder am not directly technically wronged, I am derivatiley wronged by you harming the corporation.


In this suit the claim is that were personally lied to, we have a right to be told the truth, and we would have sold our stock if we had known what was going on.


Does Delaware state law recognize this claim that you are trying to bring against the directors?  I.e. that the directors misstated the financial statements, but not in a proxy statement.


Plaintiff says this is more than a failure to disclose, this is affirmatively lying. 

What is it that is lacking in the current complaint that you could fix in the current complaint? You could refile it as a class action with appropriate remedies or as a derivative suit.


Routine damage claim is going to have trouble because we are talking about what happens with each individual person, each individual damages.  Want you either to bring suit as a derivative suit, or refile in a class action with a remedy that doesn’t make an individual determination.  Dismiss the case as currently pleaded and allow them to replead.


Not on test, just on bar:


The issue is indemnity and insurance.


Can a corporation indemnify its directors against:





MBCA 8.50-8.55.


We don’t want you indemnifying directors against terrible wrongs that they have committed.  If it is a slip up or mistake, then you can get insurance.  Acted in good faith and in a manner you reasonably believed to be good for the corporation. 


Exception for derivative suits and settlements (even if director did make goof faith, etc.)


Corporation must indemnify a director if wholly successful on the merits or otherwise.


Permissive indemnification, standard of care.  In shareholder derivative suits then you cannot indemnify for your judgments or settlements.


Special Legal Counsels:


Who decides whether the standard of care is met?  When we articulate a standard of care that your behavior has to be in good faith, etc., who gets to decide that question?


RMBCA §8.50 and subsequent sections, §8.55 says that determination should be made if there are two or more qualified directors by a majority vote of all the qualified (i.e. disinterested directors).


Or by a majority vote of a special committed which is enacted by the disinterested board.


Qualified director equals disinterested director.  9 members of a board 4 of whom are accused of wrongdoing.  Disinterested board is one option. 


Special legal counsel—another idea selected in a manner prescribed in subsection 1. 


Third option is the shareholders. 


In total there are 3 options, the board itself, special legal counsel, or the shareholders.


Advances, when you are sued you don’t know whether you will be vindicated.  Can get a loan, but if you don’t meet the standard of care, you can’t get reimbursed. 


Can you get an advance to cover the legal expenses?  No, you can’t, you can get a loan, and if you fail to meet the standard of care, you must pay back the loan. 


Does Sarbanes Oxley block this?  It does prohibit loans from corporations to executives, does it apply in this case?  Most people say that it doesn’t, and that being advanced the money to defend yourself from a lawsuit is not the same thing.


Back to things that will be on the test:


Brincat case-Delaware court spent some time talking about the fact that Delaware state law doesn’t want to duplicate Federal law. 



§10(b)-no deceptive or fraudulent devices contrary to SEC rules.


10b-5-no false statements or half-truths in connection with purchase or sale of securities.  You can’t say one thing and then omit another thing, you can’t omit something in order to mislead people. 


Fraud on the Market theory-

Anybody who bought stock, whether they were aware of a false statement or not have been victimized because they bough based on the market price which in turn reflects the price of the stock.


Market price is based on public information. Person who bought stock, whether they were aware of it in any sense, were affected by the fraud.  The fraud on the market theory permits class action lawsuits damages. 


Under 10(b)-5 in connection with purchase or sale of securities, the only people who have standing to complain are people who have purchased or sold securities.  The court relied on that as a reason why we should recognize this in state law. 10b-5 doesn’t give standing to these people, but we do allow standing for these people. 


In connection with purchase or sale of securities—if all you have done is hold stock, then you don’t have standing under 10b-5 in federal court.  You must have sold or bought it.  The court relied on this as a reason for why we should recognize this in state law.


Congress passed a law that said we don’t want to have duplicative state and federal law, we want fraud to be federal.


Moving on past duty of care to the mysteries and vagaries of the shareholder derivative process:



Gall v. Exxon Corp.


Gall brought a derivative action because Exxon had given money for campaign contributions to people in Italy.  Exxon corporation creates a committee, but who created the committee?  It was the board of directors who created the special committee.  There were certain board members who are named in the suit. 


All the members of the committee not named as defendants, the committee was created of these new directors.


Fundamental question: should we sue the corporation?  There is a corporate decision to be made whether or not they should sue.  Is it in the best interests of the corporation to sue?  What would it cost to bring suit, etc.


Committee says that it is not in the best interest of the corporation to bring suit.  This isn’t really surprising. 


Corporation has moved for summary judgment.  For this purpose they are treated as the defendant and they are saying that since we have decided not to bring the suit, we are now the adversary of the plaintiff. 


Does court grant summary judgment?  No, they do not, they deny it for now and they say that discovery is needed to decide whether summary judgment is appropriate. 


What needs to be discovered, what are the factual questions that remain?  Want to know in a sense what people are on the committee, etc.  Plaintiff must be given a bona fide opportunity to test whether the committee is independent and also to determine the bona fide good faith of the committee. 


“It is clear that absent allegations of fraud, collusion, self-interest, dishonesty or other misconduct of a breach of trust nature, and absent allegations that the business judgment exercised was grossly unsound, the court should not at the instigation of a single shareholder interfere with the judgment of the corporate officers.”


Who has the corporation’s interest at heart?  Not really the committee or the named plaintiff has the corporation’s best interest at heart. 


You have a bunch of bad choices here because there aren’t any good ones.  Insurance is subject to contractual limitations, and they will have exclusions in their policy that will say that we won’t cover willful or intentional conduct.  Insurance law will sometimes say that it is against public policy to insure against a willful wrong. 


You can purchase insurance for a director, although you can’t purchase indemnity. 


Zapata Corp v. Maldonado:


When demand is excusable.  Tainted board can excuse demand, but tainted board elected independent directors, court says it is okay if they past the test.


Zapata board had a stock option plan where directors could buy stock at certain dates.  Around the time of the final date they had a plan to issue a tender offer and they knew that it would move up the price, so in order to avoid tax liability they wanted to exercise the options before the tender offer.  Not really an insider trading situation, but there are tax premium considerations. 


The members of the board are charged with a self dealing type of operation.  They are all being accused of a breach of duty of loyalty, since it is a self interest transaction.  It is a shareholder derivative suit against these directors.


Make a demand, i.e. bring this suit on behalf of the corporation.  The corporation then makes a decision whether to bring the suit.  This doesn’t happen, the shareholder just brings a suit.  So is this direct?  Well a majority of the board is tainted by self interest.  Not only are they defendants, but they are defendants for their own self interested behavior and this is enough to excuse demand and plaintiff can go ahead and proceed with the suit. 


I hereby demand that you bring this suit on behalf of this corporation.  There is a question of whether that is correct, and the court assumes that it is correct.  A majority of the board is created by self interest.  This is enough under Delaware law to excuse demand. 


The plaintiff proceeds with the suit and the corporation in response establishes a committee.


We are applying standards for a specific situation, where the board is so tainted that you cannot even make a demand.


Set up a special litigation committee with two outside directors.  Were these outside directors on the board of directors at the time the suit was filed?  No, they were brought in. 


The issue is whether the committee had the power to seek dismissal, and the court says yes, it has the power to dismiss the suit, but it must pass the test.  The board can create a committee which has these powers, but there is a question of whether or not the committee’s decision will stand the test of the court. 


There must be an objective and thorough investigation and there are two parts of the test after that:



First element (2 parts to this suit): court should inquire into the independence and good faith of the committee and the bases supporting its conclusions. 

-do you have a stake in the claim?

-are you beholden to other people you are being asked if you should sue


Second element—court impose own independent business judgment to see whether the decision to dismiss the suit was in the best interest of the corporation.

-Does it make good business sense for the corporation to pursue?


Derivative suits are generally bad for corporations and you can always make this argument.  Think though, if this argument would defeat the suit then there is no deterrence.


There may be a narrow set of circumstances where it is in the company’s benefit to bring the suit and in the best interest of the public.


Aronson v. Lewis:


Company Prudential and Meyers is a wholly owned subsidiary.  And Prudential distributes the Meyers stock to the shareholders.  Now there is a bunch of public shareholders of Meyers, and the plaintiff is one of them.  We are going to pay this guy a bunch of money for consulting, he is 75 years old.  Is this in the best interest of the Meyers corporation?


Shareholder derivative suit, what happens then?  Was there a demand made for the corporation to bring suit?  No, the plaintiff is claiming that the demand would be futile since they are all friends with the old guy. 


Lawsuit brought claiming that this is a conflict of interest. 


There was no special litigation committee, the corporation just moved to dismiss. 


How does the plaintiff try to get around the issue of demand?  He claims that all the directors were selected by Fink.  Claim that it would be futile to bring a demand because the people are all under Fink’s thumb.  You would just be making a demand on Fink, and that would be just like Zapata.  They want to show that these other directors are puppets of Fink. (this is what the plaintiff is saying).


Does the plaintiff plead enough facts to plead a motion to dismiss—Supreme court says that they didn’t plead enough facts so we are going to dismiss the pleading.  Procedural posture is-you should have brought a demand on those facts.  You have to make a demand and get a determination from the corporation before you can proceed.  The corporation has to dismiss the demand before you can bring such a suit. 


Tradition in these suits is to plead particularlized facts because of the strike suit worry, these suits brought just for nuisance. 


What the courts want to know is, are you capable of making a good faith decision for whether or not this suit should proceed?


Court does not accept the fact that he is old and getting paid a lot and not really contributing as enough.


In Re Oracle Corp. Derivative Litigation

-Case on page 735: Case involving creation of special litigation committees. 


Shareholder derivative suit brought against the directors of Oracle alleging insider trading and Oracle creates a special litigation committee consisting of professors from Stanford.  The special litigation committee decides that it is not in the best interest for the company to bring a derivative suit against the shareholders.


What is the court going to make of this, will they accept this determination, and so on. 

Committee must prove that it is independent, it acted in good faith, and reasonable basis.


This was one of those typical elaborate reports, 1100 pages long.  Hard to argue that it is not thorough and careful.  Good faith does mean that you are honestly trying to figure out what you purport to figure out.  Also, independence, are we going to say that this committee is independent, is it capable of making an objective observation.


The court decides that it is not independent.  There are quite bit of ties between the Stanford people and Oracle. 


The court said that there were too many ties between the Stanford people and the directors, we don’t think that it can be independent.


This issue comes up a lot, one question is how broad the ruling of this case is.  This charge (insider trader) is a pretty serious claim against the directors. 


Most cases have taken an economically independent review—are you hurt monetarily, etc.  In this case the court seems to be saying something else here, i.e. we need to broaden our inquiry here—


Can you realistically be independent given these social pressures? 


You are in this bay community, there is social pressure, you guys are all in the same club.  It might be that these Stanford professors aren’t financially dependent on Ellison, but it is just that they will feel pressure and the easy thing is to just get along and don’t make waves.  This is a break, as the normal approach is to just look at economic ties, but this court suggests that Delaware should go further and take a broader view of what is involved.




Concerns the duty of loyalty, and this is the other large category of fiduciary duty (other than duty of care).  This was thought of as putting your own interests above the firm that you are supposed to be representing.  A classic case would be theft or embezzlement from the firm, but what we are dealing with here is a transaction between the firm.  You have a transaction between the firm and the director individually.


The question is whether when you caused the corporation to engage in the transaction, did you have the corporation’s value in heart? 


Case law has expanded the duty of loyalty a little bit to include callous indifference to what you are doing, and that may be driven in part due to the exculpatory provisions.  Exculpatory provisions protect against due care, traditionally the duty of loyalty has been expanded because people argue breach of loyalty to get around breach of due care (which there are indemnity provisions for).



Conflicting interest transaction.


Marciano v. Nakash

(case on page 756):


Deadlock, situation where you can’t maintain continuity—the corporation is under bankruptcy because these two families can’t get along. 


Nakash family makes a loan, and we want to know whether the transaction is valid.  In a sense the Nakash family is on both sides.  They cause the corporation to accept a loan and then repay, so they get the benefit of the corporation.


The worry is over whether Nakash causing the corporation to make a transaction that benefits them, or that benefits the corporation. 


Delaware §144— On page 721 footnote

Transaction between a corporation and an officer or director.  This encompasses a lot of things, the first thing it encompasses is salaries. 


What transactions are regulated—transactions between a corporation and an officer or director.  This encompasses a lot of things, including salary.  This would also encompass the corporation borrowing money from one of the directors.


Corporation in which the A corporation director has a financial and then also a business in which A corporation director is a director or officer.  This would be a case where you transact with a corporation in which your director has a 50% shareholder interest, so they benefit when the corporation does well.  Or where the director has no financial state, but is the director of the other corporation. 


If you have these situations—no contract void or voidable solely for this reason (reason of the conflict). 


Statute is the opposite of what you thought it would say.  The common law rule, was supposedly a rule of per se voidability. 


If we have members of the board of directors that are conflicted (Nakash on both sides of transaction) we don’t want them to approve it, the court is looking for disinterested parties.  The Nakash family would be interested, you would have to be outside family.  Also, can’t be under the thumb or dominated by the people that have a conflict. 


To be disinterested, you must not benefit directly from the transaction, and the other point would be that you are not dominated by people who are interested.  The Nakash’s benefit directly from the transaction, so they are an interested party.


Delaware §144 on page 721 break down:


No contract or transaction shall be voidable solely because …see page footnote on page 721…


1. Material factor disclosed and is authorized in good faith

2. Disclosure and approval by shareholders

3.  Fair to corporation, makes good business sense.


If you don’t go through 1 or 2, then it is clear that the director has to prove that the director has to prove the transaction was fair.  The plaintiff has the burden of proof on 1 or 2.  It is much better to run it through 1 or 2 and get it cleansed so that the plaintiff has to prove that there is something wrong. 


If 1 of these three things happens, we won’t go with the common law rule of per se avoidability.


Was this transaction approved by a majority vote of the disinterested directors? No.  Was it approved by the shareholders?  No.  


What should we be doing in these conflicting interest transactions.  Common law rule is per se avoidability. 


What is the holding, the court holds that the intrinsic fairness is out there anyway, we aren’t really relying on §144, but we really are, if it is intrinsically fair, then it is good enough.  144 leaves open what happens when a transaction occurs outside of these things.

Delaware court says that they reserve the right to judge the transaction on intrinsic fairness anyway.  This transaction is intrinsically fair so it is good.


What makes the common law rule bad (per se voidable if there is conflicting interest) is that you may be blowing very useful situations, where the insider is the most natural party.  I.e. who would give a deadlocked corporation a loan?  Now we have 4 bad situations and we must decide which one is the least bad. 


The Delaware approach is the one that is common in most states. 


Page 760:


See note 3(a), and 3(b):


-If the court feels the transaction to be fair to the corporation, it will be upheld;

-If the court feels the transaction involved fraud, undue over-reaching or waste of corporate assets, the transaction will be set aside.



What is waste?  Waste is getting rid of corporate assets and not getting anything in exchange. 


Courts do not treat donations to charity as waste, although this would otherwise be a typical example of waste.  Corporations do get good will/word of mouth in tern.


Waste is that you get so little back that no rational person would have done what you did.  You paid $1,000,000 for a boat that doesn’t work. 


Duty of Care v Duty of Loyalty—page 761.


Easterbrook—it is not true that loyalty breaches self interest but care does not, both breaches are based on personal self interests.   


Duty of care the court is very deferential, duty of care taken more seriously. 


A good argument can be made for keeping courts out of judging decisions of corporations.  I.e. bad corporations will fail under the market and go under.  The market forces will be powerful enough to get people to pay attention. 


Duty of loyalty and conflicting interest transactions.


Corporation in which the director or officer is has a stake. 


Heller v. Boylan:


Tobacco company that has an incentive plan.  Great depression and the directors are being paid millions of dollars.  Shareholders bring a derivative suit.


Is this is conflicting interest?  Yes, sure it is.  The officers and directors are parties to this transaction and so is the corporation.  If you applied Delaware §144, would ask if it is approved by directors or shareholders.


The interesting thing was that the stock option plan was created by a bylaw of the corporation, and the bylaw was created by the shareholders.  Every time there was a vote, the majority said that liked the status quo.  Could always argue that the corporation is doing well because of this incentive. 


Shareholder derivative suit, are we going to validate this transaction?


Gift in part—and that was an interesting line, that is what the doctrine of waste traditionally was, to give assets away. 


First thing that the court pointed out was that the shareholder voted on it.  In terms of waste the court said that this was a lot of money, but they throw up their hands and say, what type of standards do we apply?


Court: What type of standard would we apply, how would we know if a salary was to high if we saw it?  There is no answer to this question.


The restriction to deduct salary of up to 1 million dollars.  Congress didn’t like high salaries and intervened in the market.  Wonnell thinks that this intervention is probably a mistake, because you create an incentive to circumvent the rule with other compensation (such as stock options).  Stock options only have value if the corporation goes up in the future.  Sometimes corporations will back date these options to increase the incentive.  This is fraud, but it is a backdoor way of creating additional compensation for the executives.


It is nice to have an incentive to raise the share price. 


The hard way is to increase the value of the company, the easy way is to cook the books.


Brehm v. Eisner


Disney board, Michael Ovitz is a big wig in Hollywood.  Eisner decided that it would be a good idea to hire him as the president of the corporation.  They go to the board recommends a plan that is very lucrative for Ovitz.  Incentive that says, if he leaves (except for good cause), then he will be entitled to all of these stock options. 


Ovitz makes $150 million in severance pay.  This was a disastrous corporate experiment.  He is a big shot, somebody who had a lot of talent at what he did, but for whatever reason his talents didn’t mesh with Disney’s corporate needs. 


Shareholder derivative suit brought against the directors of the Disney corporation for approving the package in the first place and also making the subsequent determination that Ovitz was not in breach of contract and hadn’t done anything wrong so he was entitled to the package.


Claim: original board should not have approved package, and subsequent board should not have found no breach of contract.


Interesting in that Ovitz didn’t fall into self dealing, because he wasn’t on the board and wasn’t an officer when the deal was made.  This is not an obvious conflicting interest transaction.


The court says that we can’t really say that this is gross negligence via Van Gorkum, and with the exculpatory provision it would take more than gross negligence, it would take bad faith.


Bad faith requires a willful contempt for corporate duties.  If you just thumb your nose at the corporate duties, that is willful bad faith even though you are not profiting. 


Plaintiffs contend that Eisner was conflicted, he dominated the board and the board was full of Eisner’s puppets.


Conflicting interest because you are trying to hire your friend (Ovitz knew Eisner), the court is not moved by this. 


Another story was that Eisner may have wanted to hire Ovitz and pay him a lot of money to raise the bar for corporate compensation.  So this may be a conflicting interest because he wants to set the bar for when he has to renegotiate his contract.  Court said that this was too vague, Eisner has way too much stock, and his incentive is to hire good people, and we don’t buy the claim that Eisner is conflicted.


Court: if you are really rich, you don’t care about the director salary and so you are not under the influence of being on the board.  But then there is the teacher, whose board salary is 3 times what her normal salary, is, but the court finds her independent as well.


Court does not intervene, it was just a terrible business decision.  It would have made a better case than Van Gorkum for intervening.




Sinclair Oil Corp v. Levien case:


Transactions between a parent and a subsidiary are not per se conflicted.  You need to show confliction.


Case involving a parent and subsidiary company.  Sinclair is a parent company and it has a whole slew of subsidiaries.  One of the companies it has is Sinven, a subsidiary in Venezuela.  Sinclair owned 97% of the shares, but 3% were owned by public shareholders.


Subsidiary parent interaction causes a potential problem, all the interactions between the subsidiary and the parent tend to favor the parent.  If you take a dollar away from the subsidiary and give it to the parent, this is good.  In this case where they own 97% of the stocks, taking 98% would be good.  So if Sinven makes one dollar, 97 cents go to Sinclair and 3 cents go to shareholders...inefficient.


The plaintiff is complaining that the transactions engaged in between Sinclair and Sinven were detrimental to Sinven.


Directors have a fiduciary duty, but so do majority shareholders.




1. Payment out of excessive dividends. 


2. Sold oil to international, which was a wholly owned subsidiary of Sinclair.  Breach of contract, there was a minimum amount that they were supposed to take, which they didn’t take. 


Plaintiff would be the minority shareholders of Sinven. 


Should the court be deferential to the decisions of the directors? 


Business judgment rule vs. Intrinsic fairness.


Paying out of dividends was equally, and this was fair, so we will defer to the corporation in this respect.  Would be a problem if you were favoring the parent corporation in respect to somebody else.  I.e. if you were purchasing Sinclair shares and no other companies, but there you are just paying dividends and you have to pay dividends equally on all shares.   


Breach of K, do we apply the business judgment rule or intrinsic fairness test?    You sold your oil to Sinclair as opposed to selling it elsewhere. 


Intrinsic fairness is usually an inquiry into both the process and the substance.  Does this transaction make sense in Sinven’s point of view?  Would this be a rational decision to maximize the profits of Sinven. 


Intrinsic fairness, the burden is on the defendant to show that the transaction was fair.  Look into fair price and fair dealing.  I.e. does this contract make sense from Sinven’s point of view?  Did Sinclair meet its burden or proof to show fairness in this transaction?  No, they did not. 


For the payment out of excessive dividends, we defer to the business judgment rule.


For the breach of contract use the fairness. 


Weinberger v. UOP, Inc.


Plaintiff was forced to sell his shares.  He is a former shareholder of UOP.  First they purchase shares on their own, then they tender offer to buy a majority shares, and then they try to initiate a merger.  There was a cash out merger that compelled the guy to sell, at least not on the terms that were offered. 


Merger transaction between UOP and signal, and it will result in the former shareholders of UOP getting compensation, so the grievance is that the minority shareholders did not get enough money for their shares. 


Plaintiff claimed that the merger transaction didn’t offer enough money to buy out the remaining shares.  The outside directors weren’t really brought into the nature of the transaction.  Signal puts a lot of directors on the board, and the non Signal directors weren’t well informed.


There was a report that said that $21 dollars per share is a good price, but the report also said that it would be favorable for Signal to sell with anything up to $24 dollars per share. This report was not given to the non Signal directors of UOP. 


It would be a favorable investment for Signal at anything up to $24 dollars per share.  Typical report you would give your own corporation when it is going to deal with an adversary. 


The report was treated as if they were working for signal. 


Signal people said that $21 dollars a share is favorable to the independent directors and the shareholders and then they left and said, discuss this and vote on it.  The non signal shareholders voted and the independent directors voted and they both approved it.


Why do we apply the intrinsic fairness test?


This is a direct cashing out of the minority shareholders and from signal’s point of view, the lower the price the better.  This is a conflicting interest transaction.  Is this a conflicting interest transaction?  Definitely a conflicting interest transaction.  From Signal’s point of view the lower the price is better. 


Are we going to apply the intrinsic fairness test even though it is approved by the disinterested directors of UOP and the minority shareholders?


Why wasn’t this enough to move the court?  The court thought that there wasn’t any information going on here.  Did they have anything to go on?  They had an independent form, and they also had the market price.   


Could it really be a duty to disclose your reservation price, the top dollar that you would be willing to pay, that is a very odd thing.  If you do have a duty, you aren’t going to create this document in the first place.  Nobody discloses the top price that they are willing to pay. 


What really bugged the court was that if Signal had its own independent people, the court wouldn’t have a problem.  What bothered the court was that common directors to both companies prepared the report and they prepared the report as if they were working for Signal alone. 


People who purport to be minding their store weren’t.  UOP did almost nothing in the way of negotiating.  The CEO of UOP had been installed by Signal. 


Court doesn’t think that independent directors matter much because they weren’t informed.  There is a duty of candor with the shareholders, here they weren’t candid.  They thought what they told the shareholders was misleading.  They certainly weren’t told with the 24 dollar requirement.


Intrinsic fairness test—can still validate if the process is entirely fair. 


2 component fairness test:


Process—(procedural) if they acted as if they were adversaries in making the deal.  Not fair: The directors of UOP didn’t act as an adversary in the bargaining test, and there wasn’t disclosure to the Signal directors.


Substantive—you need to figure out what the fair price of the shares is:  The Delaware block method, or the weighted block method—These are the kinds of things that would go into valuation:


What is a company worth? 

Book value, the book value of the shares, is assets-liabilities.  Book value is in many ways a crude method of determining the value of the corporation.  Not reflective of true value.


Delaware block method hard to impose, the court doesn’t say that they are getting rid of the Delaware block method, they are just accepting other valid, generally acceptable methods.  Requires a lot of information, court does rely on it, but it doesn’t insist on it.


Market value—how much have other companies like this sold for in the past?


Page 797: notes—


Court getting rid of that test, it doesn’t serve a useful function.  What is an intrinsic fairness test, it is basically saying, does this transaction make good sense?  Other than that, what is the business purpose test? 


Common to use independent directors.  Subsidiary has non parent directors who are permitted to act as a non negotiating committee. 




Another subset of the duty of loyalty.  Duty as director to present the opportunity to the corporation before you take the opportunity yourself. 


Northeast Harbor Golf Club, Inc. v. Harris


Harris was offered some land and she buys it.  Did she discuss these issues with the golf club? 


The corporation gets upset when Harris starts to make plans to develop the land. 


There is this doctrine that says if there is a corporate opportunity that is presented you must present it to the board and they must deny it before you can pounce on it.


Question is this a corporate opportunity?  This is the first question.  


ALI test: 

Become aware of it in connection with performing functions.


§5.05 (b) (see page 804 of book)—become aware of it in connection with performing functions as a director or senior office, either:


(A)Become aware in a connection with performing functions person offering opportunity expects it to be offered


(B) Through use of corporate information or property


(2) Any opportunity to engage in a business activity of which a senior executive becomes aware and knows is closely related to a business in which the corporation is engaged or expects to engage.


Other tests to be aware of:

“Interest of expectancy “ test

“Fairness” test.

Line of interest”-if the opportunity is closely related to the business.


There really are only two ideas.  These tests are rather vague, they may incorporate both and they make go back and forth between the two. 


Land adjacent to the golf course, is this a corporate opportunity?  Is it in a business that the corporation is closely related?  That is what they argued, they said that they were in the golf course business, not the real estate business.


Must disclose the fact of the conflict—“I’ve been told about this land, I am interested in purchasing it, and I will purchase the land if the corporation doesn’t.”


We want a rejection from the corporation, and once it is rejected somebody may come along and challenge it because the board is a bunch of yes men. 


ALI is clear on this, they say that director must first offer to the opportunity to the corporation.  Then they give 3 options.  See §5.05 (a)(3) on page 804.


If you want to avoid litigation, present the opportunity to disinterested board members and have them reject and you should be fine, business judgment rule. 


If you don’t have a disinterested party reject, you must prove that it is fair.


Common law--doesn’t say there is not breach if the corporation couldn’t afford this.  The case law does.  ALI says that if they reject it, you can defend on grounds of fairness and one of the defenses is that they can’t afford it.  But under the ALI you must present it anyway, the corporation must say, “we can’t afford it.”




§10b and §10b-5.


It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) to employ any device, scheme, or artifice to defraud,

(b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not by misleading, or

(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.


§10b of the 1934 SEC Act—Shall be unlawful for any person to use or employ in connection with the purchase or sale it is unlawful to use any manipulative or deceptive devices or contrivances, contrary to SEC rule.  (Someday the SEC will come up with rules in this area, and when it does, you’re going to follow them).


Rule 10b-5 is also quoted on page 813.  False statements or half truths, in connection with purchase or sale. 

What does 10b-5 add?  The rule sort of pretty much covers the ground, we don’t want you in connection with a purchase or sale to engage in fraud or put forth half truths. 


I.e. you can’t go up to somebody face to face and say your corporation is doing well when it isn’t. 


First question on 814—whether there is a private right of action.  Suppose you have been lied to in a securities transaction, does this mean you can bring a private suit for damages?  Well 10b and 10b-5 doesn’t spell out any action (doesn’t say what happens to you if you do engage in fraud).


Kardon v. National Gypsum Co.

Private right of action is “implicit under general principles of law.”


60 years of private right of action under 10b-5.  When new cases of private action come up the courts are much tougher, they want to


Argument that you aren’t supposed to have these federal common law.  Congress knew how to make a private right of action, they had done it before, but not with the SEC.  A lot of recent cases have expressed a lot of regret over the proliferation of private right of action.  Court has said that if the statute doesn’t say there is a private right of action, then there isn’t one.  The private right of action for 10b-5 has been grandfathered in however.


Cutting back a bit on the scope of 10b-5

Page 817—1975, start to get cases that cut back a little bit on the scope of 10b-5.  First case is Blue Chip stamps:


In Blue Chip Stamps, you had a class action suit brought by people who failed to purchase stock due to overly pessimistic statements.  Court said that this was a false statement or half truth, but the question is whether this is with the purchase or sale of securities.  Your claim is that you would have purchased, but you didn’t purchase. 


You must be a purchaser or a seller under rule 10b-5.


Court says that we feel responsible for the 10b-5 universe.  The things that are policy arguments are inappropriate to consider because the court’s job is to think through the statute as written.  Whatever you think of policy arguments generally they are more relevant here since the court created this policy.  We will entertain policy arguments here.


Actual purchase or sale provides evidence that you are affected by the statements.  The claim of I would have purchased, we don’t know if you were paying attention or you would purchase the stock.  Policy arguments in equipoise--


Blue chip: holding, you must be a purchaser or seller, and also the fact that the court opened up the realm to straight forward policy arguments since the court opened up the case.


Ernst & Ernst case:


Accounting firm fails to discover a fraud.  Question: Could you base a 10b-5 cause of action on mere negligence?  The court said no.  You have to have scienter for a 10b-5 cause of action (this is a mental state in regard to the falsity).  Language of 10b is the language of active deceits, the language does not mean to be careless. 


Language of 10-b said no manipulate, the language is talking about actual decit, manipulative or deceptive advice, to trick somebody purposefully is not to be careless.


SEC can’t exceed its statutory authority.  If the SEC wanted to be on that they could pass a rule.  Idea that this statute was designed to deal with calculated fraud.


Scienter is a broad term.  Is recklessless enough to be scienter?  Lower courts have said yes, negligence is not enough, but recklessness is enough.  If you know a statement is false and you make it anyway.  Reckless, you knew that the statement has a substantial chance that it is false.  


Santa Fe v. Green: (page 824):


Merger between a parent corporation and a subsidiary.  The parent has this tendency to want the terms of the merger to favor the parent and to disfavor the minority shareholders.  Instead of suing under state law claiming a breach of fiduciary duty they went to federal court and alleged that an unfair merger should represent a violation of rule 10b-5, since this is a manipulative or deceptive device or contrivance.  The second circuit jumped on this.


Alleged that a merger on unfair terms should be a violation of rule 10b-5, but they didn’t exactly claim any false statements, they just did this.  They merged out our firm under the Delaware statute with a short merger.  The second circuit jumped on this and agreed and said we don’t think any false statement is required under 10b-5, this type of transaction should be enough.  People thought that the court was federalizing corporate law.


Supreme court says, “no.”  The statute is concerned with fraud.  Manipulative is a term or art, this is beyond the scope.  Said that we the courts created 10b-5 and it is clear that we don’t extend it.  Congress created it to prevent fraud, and that is what we are going to hold it for.


Must be fraud, can’t be unfairness.


Finally in this case there is some discussion here that this is traditionally relegated to state law (page 826). The idea that corporate law is state law is something Congress accepted, Federal overlay is that we don’t want anybody to be deceived.


Page 827: statute of limitations—statute of limitations for 10b-5 is the federal statute of limitations.  Previous was that state law governed the statute of limitations (created a lot of forum shopping), but the court said it is the Federal statute. 


Aiding and abetting, in general you are not liable in private suits for aiding and abetting.  You can be charged by the SEC, but not by a private right of action.


In Re Enron Corporation Securities, Derivative & ERISA Litigation

page 829:


Companies that the allegations were against, citigroup, Vinson and Elkins, and Arthur and Anderson.


1. Bank defendants

2. Attorney defendants

3. Accounting defendants.


Want to sue these people instead of Enron, because Enron is bankrupt.


Who are the plaintiffs?  Purchasers of Enron shares.  Remember that under 10b-5 you must be a purchaser or seller.  The purchasers claim that they bought the shares because they thought Enron was a reputable company.  We thought it was reputable because you said it was okay (bank accountant, etc.)


Banks: They knew that Enron had a lot of debt, and they let Enron borrow money to try to hide the debt. 


This case hasn’t gone to trial, it is on the pleadings.  You have to allege particularized facts. 


What about the attorneys?  Do they face liability?  Yes, they do.  They violated both 10b-5 and the disciplinary rules.  What did they do wrong that violated both things?  This was a whitewash investigation, interview only the people who they knew would deny things.  They weren’t making an effort to investigate.  Disciplinary rules is to say that it is one thing to know your client is doing something wrong, but another thing to HELP your client do something wrong, i.e. if you knew those press releases were going out and you were creating the special purpose vehicles, if you knew this was a scam you are doing a lot more than just not disclosing information about your client.


Ernst v. Ernst: You can’t be liable for merely failing to cover a fraud, no liability in a private suit for aiding and abetting, so the fact that you are aiding somebody else’s fraud is not enough.  But if you had your own knowledge and did your own acts that harmed them, then you can be liable.  Does the plaintiff plead a good case against the attorney?  Yes, the attorney’s did much more than uncover the Enron fraud.


One thing to know your client is doing something wrong, but it is another thing to help the client perpetrate the wrongdoing. 


Arthur Anderson:

This is what really bothered the Congress.  Arthur Anderson was getting fees for lots of services that they performed (not just the audit).  We’re making so much money from them that we can’t ditch them.  This is a conflict issue.


Take over situation: following material will not be on the exam (but will be on the bar exam).  Takeovers are chapter 15.


Delaware case law on takeovers:


Unical and Revlon:  issue whether board of directors is violating its fiduciary duty by the use of defense tactics.  A lot of these cases involve poison pills. 


Unical: 2 tiered tender offer, company responded with a selective purchase of shares.  The merger will result in the shareholders receiving securities which we estimate the value to be $51 dollars.  Pressure put on shareholders to tender.  Company responds to this by borrowing a bunch of money to purchase shares by somebody other than a bidder and they get sued for violation of fiduciary duty.


Court: there was a problem and that was coercion.  They were being coerced into selling. 


Revlon case: Board responding to a takeover attempting by trying to respond with a white knight.  Somebody who is willing to merge with us who is willing to offer the existing board more power in the surviving company than the bidding company will.





Cady Roberts case:

Page 841—


They prosecuted and tried the case. 


In Cady Roberts there was a broker who was in possession of material non public information and he tipped his clients, there was a board meeting and it was decided that dividends would not be paid that year.  Half way through the meeting a guy calls his broker and says there won’t be a dividend, and the broker calls all his clients and tells them to sell.


SEC brings an administrative proceeding against the broker.


Material non-public information.


“Court” (SEC) articulates a rule, a test for insider trading.


2 elements:


1. A relationship giving access to information intended for a corporate purpose, and not a personal purpose. If they use it for personal purposes, such as tipping friends, that can be a violation.  Trusted with copy machine not the steal.


2.  Inherent unfairness, trading knowing that the information is not available to the other party. 


These two elements kind of cut in different directions once you think about it.  The first idea is a corporate property idea, you were entrusted this information the same way you are entrusted with the Xerox machine, so you are taking corporate property when take the inside information.


What if the company let you trade on inside information?  I.e. this is in the charter as part of your compensation.  Then it is no longer a violation of corporate property.  Can they opt out of it, it is their property under theory #1.  This is an interesting question.  You aren’t betraying the corporation, but it is juts as bad from the point of the market. 


Second element looks to the market and says you know the information the other person does not, and these two elements are in some tension.  You know the information and the other person does not.


Common law said that you can’t lie, but it did not say that you can’t disclose information you knew to the other person.  Laidlaw K case.  In general you don’t have a duty to disclose information to person you are bargaining with.  Common law, we want to encourage for people to invest in information.  If you had to disclose, person who made the survey doesn’t profit from his information, so what incentive would there be to discover?


SEC v. Texas Gulf Sulpher Co.


Duty to disclose, or a duty to refrain from trading.


SEC sues Texas Gulf Sulpher plus its officers directors and employees.


Suing certain officers directors and employees for 10b-5 violation. 


§21(e) of ’34 Act

Suit brought by SEC under administrative duty for jurisdiction.

§21(e)-upon application of a commission (not necessarily the SEC), SEC is in power to create federal jurisdiction, they can bring action against parties.


3/59—anomalies discovered in aerial survey.  What do they do to confirm this result?  They sent the core sample out to a lab and the lab confirms that it is potentially lucrative. 


10/63-ground surveys confirm the find and it is all coming back positive.  They cover up the hole that they discovered and they decide that they should acquire the land confidentially. 


We know that Texas Gulf is in on good times, so they are buying up shares, they tipped other friends to buy up shares. Group of defendants goes from owning 1000 shares to 8000 shares in a short time span.  What happens in March and April of 1964.  There were stock option plans granted in February of 1964. 


Things started to leak out about this.  The company downplayed the reports, by issuing a press release in April of 1964 downplaying the find.  The market price of Texas Gulf Sulfur is going up, partly because of inside trading and partly because of rumors leaking out.


MP (market price) is 17 and 3/8 on 11/63, and then by 3/64 the price was 26 and then on 5/15 the price hit 58.


Then they issued a press release confirming the discovery.  This really causes the market price to ratchet up. 


The court says that the people who traded were liable under 10b-5.  Embraces the Cady Roberts idea, they say you were entrusted with this purpose, you had a relationship giving you access to this information and you traded with information not given to other parties.  If you have a relationship conferring access…you are liable under rule 10b-5.  If you are not saying anything, it is not completely certain this is bad, this is anonymous trading on the stock market.  The company making a press release is making a false statement (i.e. no big deal) the problem with this is that they aren’t trading.


What about the fact that the company wanted the information kept confidential?  The argument that if we had disclosed the information it would have been bad for the company.


The company said that you either had a duty to disclose or a duty to refrain from trading. 


Who is harmed by insider trading?  May depend on what happens.  There are two possible right things you could have done, you could have disclosed information and traded, or not disclosed and not traded, either one would be a right action, but both would have different consequences.


What about the stock options—were the people who received the stock options liable for 10b-5 violations? The ones that appealed were.  The people that were receiving these options knew about the finding.  Court said that they had an obligation to turn down the options (yet at the same time remain silent about the finding).  The court said that those who knew of the finding and accepted the options were liable.


Texas gulf sulphur was found liable for issuing the false press release (not in book).


Liability both for the trading and the tipping.  Unlawful to tip others and to trade based on inside information.


What about people who bought stock right after the disclosure?  This was not okay.  They bought after, but it was before the information was released or processed by the market.  Court said that you have to give the market time to process the information.


Statement must me materially false.


Information you have to have must be material.  Directors argued it wasn’t material, but then how do you explain the trades, they bought, their actions are the evidence of materiality.


Henry Manne—Wrote a book called Insider Trading and the Stock Market. Page 856 (note 2):


One argument was that insider trading was ubiquitous, it was everywhere and it is essentially standard operating procedure.  There is no real way of stopping, it should be tolerated. 


Opposition argument, people benefit either way.  They can sell both bad and good information.  Creates incentives to shock the market.


Carlton & Fischel—insider trading may actually be a good thing. 


Insider trading is a form of compensation.  May inspire you to merge, discover things, etc., so that there is a lot of information and so that you get the advantage of all this information and it is an incentive.  The argument is that it encourages you to be entrepreneurial.


Also there is a motivation because if the company tanks, I will sell, if it succeeds, then I will buy.  I have an incentive to manage the company in a way that conducts a lot of events.  Manne says that--Executives naturally don’t want to take as many risks as shareholders want them to, mainly because they are diversified.  Executive faces a lot more risk, a lot of their capital is tied up in the company.  Manne, if you want people close to the top to be entrepreneurial, then you want insider trading.  (ask why this is).


Carlton and Fischel—insider trading is not as bad as people think it is.  Which corporation would do better, one with insider trading or one without insider trading?  Insider trading deters information disclosure.  It may increase the cost of capital because investors pay less hearing insider information.  If the company wants to raise a million dollars of capital, the thought is that if people are fearful they are trading with insiders it will be more difficult to attract capital.  You would think that a company that banned insider trading would do better than one that allowed it.


Other arguments for insider trading:


Speculative training moves present prices toward future values.  Speculation moves price gradually toward market price.  Rather than have the price crash, it will go down gradually.  You have adaptations to future prices.


Why this is bad, private benefit might be better than public benefit.  Laidlaw case—where the guy knew the war of 1812 was over and sold tobacco.  Helps the private guy, but not the overall public prices.

-creates incentives to overinvest in information, and creates inefficiencies in the market.


Law of conservation of securities.  Bill Wang- Oftentimes it is hard to know who is victimized by insider trading.  Sometimes the victim is a preemptive trader on your side of the market.  I.e. you want to buy at 20 dollars a share and you outbid somebody who wanted to buy at 17.75.  You outbid them.


Chiarella v. United States


Chiarella worked for a printing company, and his printing company was employed by a law firm, which was in turn employed by a company that was making a tender offer for shares.  The documents he was given companies to had the names redacted, and he deduced from the information in the documents what the companies are and he figures out the target company, so he buys shares in the target company.  The SEC picks up this and books him on a criminal prosecution.  He appeals conviction and the Supreme court reverses. 


It is illegal to act as fraud with the connection of the purchase and sale of securities.  It is not fraud, rather, it is a mere non disclosure.  Common law—for non disclosure to be fraud, there has to be a duty not to speak. 


Chiarella didn’t owe any duties to the shareholders of the target company (the people whom with he traded).  Chirarella did not have an affirmative duty to speak, so his conviction can’t be upheld. 


Issue of duty to your employer.  Cady Roberts is a two part test.  He is betraying the confidence of the acquiring company (i.e. he knew something the other side didn’t).  The court said that this theory of liability wasn’t presented to the jury, so they get around this on a technicality, so they haven’t rejected this theory.


SEC responds by adopting rule 14(e)-3—which says that if you are given information about an upcoming tender offer, you must disclose the information or refrain from trading.  The SEC is trying to supply this duty that was missing in the case. Question of whether the SEC could do this, are they going beyond their authority. 


Hypothetical on page 864:

1. (a)—it has to be a material fact that you hear.  Chiarella talks about a duty to speak, they are buying shares of their company, so they do have a duty (buys shares from employer). 


(b)-Hard to find a violation under the duty, you have no expectation that you are looking out for the XX company, in terms of duty to my source of the information, this doesn’t fit either.  Person at the restaurant is not employed by the company.  Seems like this is okay.


(c)-beneficiary of public information, but information hasn’t been processed by the market.  Under Chiarella, does he have a duty to disclose?  He is a member of the press.  It takes more than the fact that you know and the other party doesn’t, sometimes that little extra is a duty.


Carpenter v. United States

-Case where the guy worked for the Wall Street Journal and had a column called “heard on the street.”  Information belongs to company until you are released.  The author got in trouble for publishing rumors, even though he didn’t work for the company.  Until publishes it is private information.  Author told other reporters he worked with the contents of his articles before they were published.


United States v. O’Hagan


O’Hagan works in a law firm, finds out through his firm that Grand Met making a tender offer for shares of Pilsbury.  O’hagen was an attorney for the Dorsey firm, he didn’t work on the file and so being an entrepreneurial guy, he buys options in Pilsbury stock.  He makes a lot of money, but he also gets in trouble with the SEC.  They criminally prosecute him and he is convicted.


Then it goes to the circuit court and they reverse his conviction, and the US Supreme court reinstates the conviction.


Misappropriation theory.  Entrusted to him for his lawfirm.


What is the story here?  If you reason from Chiarella, you might say that he is alright.  He did not have any relationship with the Pilsbury corporation.  He did not have any duty to the Pilsbury shareholders. 


If you read Chiarella you may think everything is alright.  He had no duty to Pilsbury.  In Chiarella there was an issue of misappropriation theory.  You may be liable to your source of information.


Issue still open and in O’Hagan they accept the misappropriation theory.  Theory is that O’Hagan defrauded his employer and his employer’s employer for information.  This was entrusted to him for a corporate purpose.  To obtain the information with an assumption of confidentiality is a type of deception. 


In O’hagan, the court accepts the misappropriation theory.  O’hagan defrauded his employer and his employer’s employer that was entrusted to him in confidence.  To get this information and then turn around and use it for your own gain is deceptive.


You have fraud, you have securities trade, but you don’t necessarily have fraud in securities trade.  May not have the requisite connection between securities trade and fraud (dissent).  There is an issue about the requisite connection here.  You could have fraud, you could have securities trade, but are the two connected?  The dissenters are moved by this.


The wrong is the use of information in the stock market transaction.  You’ve got the information, but it is not like you used it until you have traded on it.  So there IS a connection.


A few questions to ask:

1. Is this case compatible with other precedents of the court?  Chiarella—literally it is compatible, even if it is an intentional spirit.


Santa Fe v. Green:


There wasn’t really any deception, they just did it.  The grievance was that the transaction wasn’t fair and the Court overturned saying that 10(b)-5 is only concerned with fraud.  It is specifically not intended to federalize corporation law. 


Can see a potential argument that Santa Fe v. Green is a misappropriation (type of theft).  Have to have deceit in a 10b-5 claim.


Dirks v. SEC


There was a tip from the insider about fraud in the insurance industry.  Was Dirks committing a breach?  One issue was that this was not given to Dirks in confidence.  He was not deceiving his source, there was no such promise to keep this information silent. 


Issue of rule 14(e)(3)—this came up in O’Hagan.  14(e) deals with tender offers.


14(e)(3)—no fraud in connection with tender offers. 


-It shall be unlawful to make untrue statements with respects to tender offers.


-The commission shall design and prescribe means reasonably designed to prevent such practices.


Self executing part in section 14(e)—even if the SEC never adopted any rules it is illegal.


Section 10b doesn’t by its terms make anything illegal.  Section 14(e) does.


If and only if the SEC some up with rules that deal with deception and manipulation of securities does it violate rule 14(e)(3). 


14(e)(3) Designed to deal specifically with the Chiarella type of situation.  If you acquire confidential information from you employer, you have a duty to disclose or not buy.  It is induced to overturn Chiarella.


There was a question whether the SEC could legislate via 14(e).

-Supreme Court says that it was okay for Rule 14(e)(3), SEC did have authority to adopt this rule.  They also adopt a lot of deference to this rule.


Trading “on basis of inside information”—can always argue, that you were going to trade anyway and that the information was not the basis of your trading.


O’Hagan goes to jail.


“Trading on the basis of inside information.”  You can always argue that you knew about the information, but you were going to trade anyway.  SEC did not want to allow this, so they adopted a new rule, 10b-5-1.


Rule 10b-5-1:

Defining “on the basis of”—rule says that if you are in possession of information then you are held to be trading on the basis of that information.  In possession of = on the basis of.


Rule goes on with some exceptions for pre-programmed trading—stock options and what not.  If you want to sell 1000 shares a month for 6 months and at the time you had no insider information, this is okay.


Rule 10b-5-2: Question of confidential relationships in non business settings.  Information entrusted to you in confidence and you sell, then it is still a violation.  When do you have the requisite relationship or expectation of confidentiality to trigger the misappropriation theory of O’Hagan.  Things like, what if you hear it from a spouse, friend, or business associate—are you given that information in confidence?


If you tell somebody, “I will keep this a secret” it is enough to create that relationship.


History practice of sharing confidential information (course of dealing).  Not explicit agreement, but it is our course of dealing and understanding. 


Spouse, parent, child, or sibling—close family member is presumed to be a relation of confidence, unless you can demonstrate otherwise. 


Dirks v. SEC page 881


Insurance company called Equity Funding—the Enron of its day.


The books were cooked and the company was not as solvent as it suggested. 


Seacrist knew this information and called an investment analyst (Dirks).  Dirks goes and interviews people at Equity funding.  Goes to the WSJ and tries to get them to write an article about this.  He thinks it is good enough, so he tips his clients, tells them to sell their Equity funding stock.  They eventually find out, he was right, there really was a problem, and the SEC decides to come after Dirks. 


Supreme court finds for Dirks.


Was he liable as a tipper for these clients?  He didn’t trade anything, but he helped his clients to avoid losses. 


Did he help Seacrist to violate his duty?  If Dirks was aware that Seacrist was disclosing something he shouldn’t have disclosed.  This argument is possible, but the court rejects it.  Court rejects the idea that Dirks could be liable for breaching fiduciary duties.


You are not supposed to put yourself above the people you are supposed to be a fiduciary for. 


Seacrist did not derive any personal profit from his tip from Dirks.  He wasn’t paid for information, he wasn’t trading himself, if anything he was trying to blow the whistle.  So since Seacrist didn’t breach, then Dirks couldn’t.


O’Hagan—misappropriation idea.  Could Dirks be liable because he misappropriated information?  No he didn’t violate any expectation of confidentiality.  He was given the information to spread it, not with an expectation to keep it quiet.


Famous footnote 14:

Footnote 55—known as footnote 14—call it footnote 14, page 883: Temporary insider, somebody who is not normally an officer, but they become a temporary insider when they are entrusted with insider information. 


Back to benefits…

Benefit, there is no benefit to Seacrist.  Take this with a grain of salt, why did he do this?  It could be that there was no benefit to him, but who knows.  He might have done it because he was public spirited, he might have done it because he was angry with his employer, etc.  He probably benefited from this.  He is party of the tipping club.  If he was getting money or return favors, then there would be a breach of fiduciary duty and Dirks would be liable.


Court stresses the role of investment analysts.  They perform an important function of moving companies stock prices in the right direction.  If this is true, then the whole Cady Robert situation is wrong (Cady Roberts is a duty to refrain from insider trading). 


Holding: if the insider derives a benefit from the tip, then they are breaching fiduciary duty and then tipee is furthering the breach.


On the other hand if the investment analyst thing is a point, we want the market to go on and the case is potentially broader. 


There is a tension between these two ideas.  No profit, vs. role of invenstors.


The court doesn’t really hold much deference to the SEC in this case, it is a different attitude than in O’hagan.



What happens when you engage in insider trading—

Page 902—


§21A of the ’34 Act. 

Provides for civil penalties. Something between damages and criminal penalties.


These are SEC proceedings, not criminal proceedings brought by Department of Criminal Justice.


People who violate these insider trading rules can be liable for up to 3 times the amount of profit they make. 


Controlling person can be liable for 3 times the profit up to a million dollars.


Controlling person not held liable if they didn’t know about the trade or they adopted a policy or procedure that –attempt to encourage corporations or others that have authority over individuals to institute policies that make it clear that you aren’t supposed to trade on insider information and have law compliant programs.  This encourages law firms setting up policies saying don’t trade on company information. 


What if they allowed it, what if they tolerated it?  Would you then be violating any confidentiality rule?  It seems that you would not be, by logic.  Here it goes the other way, we want corporations to lean on people to not trade, and we reward them by making them immune from the penalties.


Page 904—Reward for whistleblower.


Try to get you to rat people out for insider trading and you get rewarded for that by a bounty.


Then of course there is criminal prosecution, give you up to 10 years in jail.  Reminder that you have a scienter requirement in 10b-5.


Page 907:


§20A of the ’34 Act—private suits for damages stemming from insider trading. 


Cross reference of Bill Wang’s article, issue about who exactly is victimized by insider trading?  It is really not that easy to tell. 


Contemporaneous traders on the other side are artificially given standing.  If I was selling the class of people are those who are contemporaneously buying, and vice versa.  Liable only to the amount of profit you make.  Not clear how broad the class is.


Today’s assignment—


§16(a) of the ’34 Act—


§16(b) short swing trades rule—you match the lowest buy to the highest sell, treat that as a profit, this belongs to the corporation. 


Any profit made by purchase and sales less than 6 months apart, belong to the corporation.  Match highest price with lowest price.  Match lowest purchase with highest sale.


Basic v. Levinson

Merger between two corporations, company releases a press release saying that there was no merger.  People say that they would not have sold the stock if they did not know that there was a merger.


I wouldn’t have sold if I knew what was going on.  Court had to address two questions—First question: is this a proper class action?  Reliance argument against class action, but court rejects this.  The court talks about the integrity of the market price, the common question dominates. 


The other question is materiality.  The issue is whether the statement is material.  No agreement in principle, but still we are going to apply the general TSC standard of materiality—would the shareholder consider this significant when deciding whether or not to buy or sell.  Company made a common sense argument that the shouldn’t have to disclose that they are in merger negotiations.  Court: yeah, but you LIED about it, you denied merger negotiations were going on.  If you do speak up, you can’t lie about it in material ways.


Page 932—discussion of some NYSE rules that say that when there is a false rumor circulating you need to negate.  Not an affirmative duty to speak, but you do have an affirmative duty to come forward during some occasions.