• • •
Characteristics of all corporations:
• • • • • •
legal entity Can only be formed by observing formalities perpetual existence limited liability—key advantage! “Shares” reflect ownership Centralized management in the officers, not the shareholders Corporate law not very uniform Shareholder relations controlled by statute double taxation--key negative
Public corporations only:
Ownership base very large; Shareholders are passive investors Often, no one has e nough shares to have majority control shares are liquid Closely held corporations only: Only have a handful of shareholders Controlling shareholder owns the majority of shares—very powerful Stock is not traded on the open market Common to have some or all owners active in management owners will draw salaries—decreases double taxation problem
• • •
“Public” vs. “Closely Held:
• • • • •
•
All owners are equal More common form of partnership
•
Not a legal entity—it’s a relationship
•
No limited liability— all assets are liable (including personal assets)
•
Key disadvantage--Partners are jointly and severally liable
•
No formalities required to form partnership
•
Rel. bet. partners is contractual —there’s —there’s statutory statutory default rules rules
•
(Mostly) Limited life of partnership
•
Characteristics of a General Partnership
•
Management not required to be centralized (but they can choose it) Major decisions require unanimity
•
No double taxation —key advantage (can be very significant) significant)
•
Substantial uniformity of law—governed by RUPA and UPA
•
Ownership interest is not freely transferable
•
two classes of partners—General (run the business), limited (passive)
•
•
declining in importance a special species of general partnership
•
Formalities are required
•
Management is centralized
•
Limited Partnerships
•
Limited partners have limited liability and limited control (like shareholders); general partners do not have limited liability Must have at least one of each type Trend: give limited partners more control while maintaining limited liability Governed by separate statutes (ULPA, RULPA); UPA and RUPA cover the gaps
•
Born in the last 10 years
•
Hybrid between corporation and partnership; best of both worlds
•
• •
LLC’s
• • • •
• • •
The LLC is a legal entity ≈ corporation Has perpetual existence ≈ corporation No taxation of the entity ≈ partnership Relationship can be contractual Limited liability ≈ corporation Owners are called “members” Most states allow choice of two management models: o Member managed Owners actively participate in managing ≈ partnership Appropriate for a small LLC o Manager managed
•
1
Management authority centralized in managers elected by members Common for larger LLCs
Problems of LLCs (larger companies are less interested in this form)
o o • • •
•
LLP’s
• • •
Important, relatively new development in partnership law Subset / variation of general partnership Particularly important for law firms—no reason not to elect it Claims against the entity limited to the assets of the entity ≈ corp Every other aspect of partnership structure remains Governed by UPA/RUPA Requirements: o Must affirmatively elect this form o
•
Which makes a creditor happier: a debt ratio
•
of 5:1, 1:1, or 10:1? • •
Explain the reasons behind limited liability
• • •
Must file with the state
1:1 = creditors are covered by the firm’s assets 5:1 = creditors’ claims are extended to virtually all of the assets; nearly all of the assets are needed to cover claims If the debt ratio is lower, corp is less at risk for bankruptcy, payoff potential is also lower Facilitates investment / proper allocation of capital Decreases the need to monitor managers Decreases the need to monitor other shareholders’ wealth Permits optimal management decisions
•
For personal liability to attach to shareholders, it must be shown that the shareholders where actually carrying on the business in their individual capacity rather than for corporate ends.
•
The corporate veil can be pierced where the shareholders undercapitalize the corporation and actively participate in the conduct of corporate affairs.
•
In contracts cases, the veil may be pierced if (1) there was a unity between the individual and the corporation and (2) an inadequate result would occur if the acts are treated as
When can claimants “pierce the corporate veil”?
May make investors nervous New form: no case law / precedent
those of the corporation alone. •
What is “book value”? What is a “fixed asset”? Distinguish between income statements and balance sheets
•
•
When might shareholders who loaned money to the corporation have their claims “equitably subordinated”?
amount at which various assets and li abilities are recorded / “booked” on financial statements. a real object; something you can stub your toe on
•
Income statements: Reflects net income generated over a period of time. Cannot tell what liabilities or assets exist
•
Balance Sheets: Tells us what corp has and what claims against assets are at this moment. It is a snapshot.
•
•
Retained earnings:Profits from the date of starting the corporation that have never been distributed to shareholders o Describe as “cash” on the left side, and “retained earnings equity” on the right side. If this amount ever goes below zero, put negative amount in parentheses to reflect the loss.
•
Money put in by shareholders goes in on both sides (cash on left, equity on right)
•
Basic rule: Creditors get first dibs on assets. Shareholders next in line
•
Shareholders who loan money to the corporation: claims may be equitably subordinated
Explain how retained earnings are reflected on a balance sheet Explain how shareholder contributions to the corporation are reflected on the balance sheet
If directors of a parent corporation are also directors of a subsidiary, there is no piercing issue as long as the directors keep their proper “hats” on.
•
to those of real creditors. Factors: o Was corporation adequately capitalized at the time of loan? o Was loan made in same ratio that stockholders own stock? o o
Explain the difference between “inside” and “outside” directors: What can / can’t shareholders generally vote on?
•
Inside directors: Sits on board and is a top officer of the corporation
•
Outside directors: Part time; are not employed with the corporation
•
Vote on such issues as: o Election of directors (usually once per year)—most important power they have o o
2
If yes on (i) and no on (ii), view as creditors rather than shareholders. Otherwise, treat as shareholders, and equitably subordinate claims
Removal of directors (easier to wait for the next election) Article / Bylaw amendments
Major (“organic”) changes (mergers, sale of corp assets)
o •
Generally do not vote on the identity of corp officers or their salaries
•
Audit committee: Decides who will audit the corporation’s financial statements o Now required of all public corp under Sarbanes-Oxley. Must consist of entirely outside directors o Is responsible for integrity of financial records—issue: did corp follow GAAP
•
Compensation Committee: Establish compensation packages of officers o ALI recommends that this consist of outside directors (most do this)
•
Nominating Committee: Nominates people for the board of directors and officer positions o Should consist of outside directors
Name the three key committees a board of directors should have:
•
What duties does a director have? What duties does an officer have? Explain how cumulative voting works
•
Duty to exercise care of ordinary prudent and diligent person; not responsible for mere bad business judgment Owe duty of care and loyalty to the corporation
Operates only at the shareholder level Only really matters in close corporations--public corp too large This is the exception, not the normal method of voting Not required in many states, but allowed in most Only applies to election of directors (cannot be used in making merger decisions, for example) Allows shareholders to cast votes equal to the total number of shares that Formula to know how many shareholder owns, multiplied by the number of seats being voted on. seats you can Shareholder can cast all shares/votes on one director. elect: N = {x(D+1)}÷S May allow minority shareholder to elect director they would ordinarily be kept N = Total # of from electing directors you will be able to elect No such thing as a “no” vote in cumulative voting; directors with the most votes X = Your total # of shares overall win. D = Total # of How majority can limit the value of cumulative voting: directors being voted on a. Stagger terms of directors: S = Total # of b. Majority can remove minority elected directors shares being voted at the c. Smaller board limits minority ability to elect directors • • • • •
•
•
•
•
meeting
Who bears the burden of showing a proper / Must alwaysShareholder mailing lists: •
round down
improper purpose in a shareholder’s request to inspect corporate records and/or
•
Corporate records:
a. Burden on shareholders to show proper purpose
shareholder lists? What is the general focus of the Securities Act of 1933?
a. Burden on corporation to show improper purpose
•
Securities Act of 1933 (“Securities Act”)
a. b. •
Securities Exchange Act of 1934 (“Exchange Act”)
a. b. c.
What is the general focus of the Securities Exchange Act of 1934?
d.
What is a “reporting company”? What 3 reports must a reporting company provide?
•
• • • •
Explain how Section 14(a)(7) works
Explain how Section 14(a)(8) works
•
Deals with primary transactions Focus: full disclosure via registration statement Deals with Resale or Secondary Transactions Regulates stock exchange and securities professionals Goals: ensure level playing field, prohibit market manipulation, fraud in transactions, and insider trading Sets up requirements for ongoing disclosure statements from “Reporting Companies”
have at least $10 million in assets and 500 shareholders 10K: annual report 10Q: quarterly report 8K: significant events report § 14(a)(7): applies where shareholder is willing to bear the costs a. Management has a choice: i. Can mail the proxy solicitation at shareholder expense, or ii. Management can give the shareholder list to the shareholder b. Cost may be extremely prohibitive, unless this is a large shareholder with a lot at stake § 14(a)(8): applies where shareholder is not willing to bear the costs
a.
Free-ride Solicitation: Corp is obligated to include the shareholder’s proxy
solicitation with its own solicitation, including supporting statement of 500 words at
3
no expense to shareholder. •
What exclusions can a corporation assert to avoid paying under Section 14(a)(8)? • •
Exclusions: (shareholder must bear costs if these apply)
a. b.
De minimis shareholder exclusion : must own 1% of shares / at least $1,000 stock
c.
Personal grievance against the corporation / any of its employees:
d.
Beyond the power of the corporation to implement:
e.
Relates to ordinary business operations : (see below)
f.
Relates to the election of directors:
g.
It is counter to a proposal by management:
Not a proper subject for shareholder action : outside shareholder powers
If SEC agrees with management about the exclusion, it issues a “no action letter” Ordinary business expense exclusion:
a. Trend : SEC will require inclusion under § 14(a)(8) when shareholder proposal relates to a major ethical / social policy issue that has a tangible link to the corp •
Explain what an “irrevocable proxy” is
• • •
Explain what a “voting trust” is
•
•
Galler stands for the idea that a shareholder
agreement concerning matters in discretion of the directors (in a close corp) will be upheld if:
A and B agree to elect each other and give X the signatory (X votes for A and B) Principal grants right of vote to agent, agent votes / serves principal’s interest Termination: can terminate at any time, unless proxy is coupled with an interest Strongest type of shareholder agreement Shares of participating shareholders are transferred to a trustee; trustee becomes the le gal holder of the shares. Established to gain control of a close corporation. StatStatutes limit duration of trust, require that trustee voting be disclosed
•
No complaining minority shareholder No fraud to public or creditors No clear statutory prohibition
•
Delaware rule for statutory close corporation:
• •
o
Distinguish DE and CA treatment of shareholder agreements concerning matters
o •
in the discretion of directors in a statutory
Approves management agreement as if it were a partnership. Shareholder agreements involving a majority of shares will be enforceable, even if they take away board powers. Would hold the agreements in McQuade and Galler enforceable
CA rule: o
Approves of shareholder agreements in a close corporation, but d efines
o
agreement as being among all shareholders. Would hold the agreement in McQuade not enforceable, but would distinguish
close corporation:
between shareholder voting agreements and management agreements in Galler (voting agreements always okay; management agreement must be approved by all shareholders). •
Right of first refusal: o Gives corporation or identified person the right to match any offer by a third party Not a direct impediment, but can dampen marketability of shares First option right: o Must first offer to some identified party before offering elsewhere o Must establish what first option price will be in advance of sale o
•
Explain the four main restrictions on transferability of shares:
•
•
Consent restraint: o Requires consent of another party before transfer. Purpose: compatibility o Reduces marketability Absolute prohibition: o Not an actual absolute prohibition o Identifies groups shares may be sold to, or groups that shares may not be sold to
•
Allen v. Biltmore : Low price is not sufficient disparity to establish unreasonableness.
What requirements must be met for a
•
Delaware : restriction must be obvious on the certi ficate
restriction on transferability to be valid
•
CA: only reasonable restrictions are enforceable and they have to be set forth in the articles of incorporation and referenced on the certificate
Explain the scope of the duty of care in
•
Duty of care: refers to duty of management when discharging responsibilities—duty is to
management •
shareholders and the individuals within the corporation Includes the duty to: o Monitor the corporation and other employees o Inquire into corporate practices upon receiving notice of i mpropriety o
4
Make reasonable decisions
o
Factors to look for in a fiduciary case:
Use a reasonable decision-making process
•
Uniqueness of transaction : Common transactions are less suspect than new method
•
Nature of the benefit: Are they getting cash? (Worst of all cases)
•
What is the effect on the minority? Neutral vs. harmful
•
Position of controlling shareholders once transaction is done : Better if controlling shareholder leaving corp.
•
Defense to duty of care
•
ALI definition of the business judgment rule: § 401(c): A director of or officer who makes a business judgment in good faith fulfills the duty of care if the director or officer: o Is not interested in the subject o f the business judgment o Is informed to the extent they reasonably believe is necessary o Rationally believes that the business judgment is in the best interests of corp
What are interested and interlocking
•
Interested director: e.g., selling real estate to the corporation
directors?
•
Interlocking director: Corporations doing business together share one or more directors.
•
Rule: contracts involving either intere sted or interlocking directors are valid if they are fair and they are approved by a disinterested majority of directors.
•
Note: there is a detailed chart showing DE, CA, and CL approaches
When may a director or officer pursue a
•
Key issue : is the business oppo rtunity closely related to the business?
business opportunity without first offering it to
•
If the corporation is insolvent: Director can pursue any opportunity
the corporation?
•
If the corporation has no cash on hand : conflict could arise because the CEO might put personal interests ahead of the corporation’s interests
•
Communicated to officer / director where person offering it views it as a corporate opportunity; or Learned through use of corporate resources where it is reasonable to expect that it is of interest to the corporation, or The opportunity is closely related to the business. If completely unrelated to the business, no need to report it
Explain the business judgment rule and its 3 requirements
What is the basic rule for conflicts of interest involving directors?
When is there a “corporate opportunity”?
•
What are the main principles to know from Zahn?
•
•
•
Most cited case in corporate law, for the principle that the majority owes a fiduciary duty to the minority shareholders . But Traynor’s “control is material” framework is not widely followed.
•
Held: Controlling shareholders must act in good faith and inherent fairness towards minority in any transaction in which control of the corporation is material. ( Traynor )
•
Fiduciary duty: seller (board/shareholders) cannot sell controlling shares to purchaser if seller knows / has reason to know that purchaser intends to loot the corporation. Basically, if all assets are liquid and the buyer is willing to pay more than net asset value, management should be suspicious. (Gerdes) In situations where ∆ knows or should have known that the purchaser intended to use control to prevent the corporation from realizing profits it would have obtained, ∆ has breached fiduciary duty. (Perlman)
What is the commonly cited principle from Jones v. Ahmanson (by Traynor)? What is the less widely followed framework?
What fiduciary duties does a controlling shareholder have upon leaving?
Basically, as fiduciary, you can grab a little of the overall put, but you can’t grab the majority (or all of it) to the detriment of the minority. Shareholders can’t misuse their control of the board. (self dealing, gross overreaching, or disproportionate benefit) Shareholders can vote their own interest as shareholders.
•
•
What SEC rule is the primary source of
Rule 10(b)(5): It is unlawful (in connection with the purchase of any security) to: o Employ any device, scheme, or artifice to defraud o
regulation of insider trading? o • •
What does Rule 10(b)(5)(1) say? Who can sue under Rule 10(b)(5)? Who is subject to the requirements of 10(b) (5)?
• • • • •
5
Make untrue statements of a material fact or omit material facts necessary to make statements made not misleading Engage in any act or practice that operates as fraud or deceit upon any person
Problem: Does not clearly define insider trading
It is unlawful to trade “on the basis of” material inside information in breach of a duty. o “On the basis of” satisfied if a person is aware of the information when trading Affirmative defense : a pre-existing binding contract to sell/plan o Must be an actual purchaser or seller of stock— Birnbaum The corporation itself Insider with a fiduciary duty: Obligation to refrain from trading or disclose information Tipee who gets info from an insider and trades on info obtained thereby Law firm who learns inside information
• • •
What does Rule 14(a)(3) govern?
Possibly an investigator Applies to reporting companies Prohibits a person in possession of non-public information about a tender offer derived from: o The offering person, or o o
•
•
To what degree does 10(b)(5) require scienter?
The target corporation or others acting on their behalf To purchase securities in the target corporation
Tender offer: offer by bidder to shareholders of a certain corporation to sell shares to the bidder in exchange for cash or securities More than negligence—implies awareness o Need intent to deceive, manipulate, misrepresent, act under fraud Therefore, gross negligence is probably sufficient for a 10(b) charge o
•
•
§ 16(b) actions: applicable only to reporting companies Designed to capture short term profits: Any short term (6 month) profit realized by insiders from purchase or sale of stock is recoverable by the corporation. o Does not matter whether or not they used inside information o o
How does Section 16(b) of the ’34 Act relate
•
to insider trading?
•
The idea is to stop short term speculation by insiders If you are a member of the relevant group, do not sell or buy short term—
otherwise, the corporation will confiscate your profits Certain people must file reports with the SEC, indicating ownership of stock in reporting companies and most importantly, changes in their ownership of stock in reporting companies. o Applies to officers, directors, and shareholders with a 10% or greater stake. Narrower than 10(b) This is a mechanism to find out what stockholders are doing
•
§ 16(b) is a bright line rule: Applies whether measured in a l inear fashion or measuring highs against lows. Applies whether looking at salepurchase or purchasesale direction. Can work in conjunction with 10(b).
•
No. Santa Fe.
•
Keyed to efficient market theory—integrity of info is central to the theory
•
Basic v. Levinson : Plurality
•
Can you sue under 10(b)(5) if there is no
Example: making a misstatement with total disregard for truth or falsity
deception?
o
o
Rule 10(b)(5) applies to misrepresentations and non-disclosures only if the misrepresented or omitted fact is material. New standard for materiality : “magnitude / probability test”
An omitted fact is material if there is substantial likelihood that a reasonable shareholder would consider it important in deciding on her course of action. Materiality depends upon a balancing of the indicated probability that an event will occur and the anticipated magnitude of the event in light of the totality of the corporate activity. (Not a bright line) Irrebuttable presumption for purposes of class action: o Doesn’t make a difference whether individual investor is aware of the misstatement, because the misstatement went to the market. Market is efficient in responding to information, which establishes a presumption which, for practical purposes, is not rebuttable, that in a 10(b) action based upon misrepresentation, the investor relied upon market interpretation of stock pricing.
What is “fraud on the market”?
•
•
Other than a public offering, how can a
•
corporation raise capital?
• • •
What are the three big ideas related to the
•
regulation of sales of securities? •
What is a “prospectus,” and what is it for?
• •
6
At formation: founder’s investment Third party financing (banks) Venture capital firms Public financing No offers of a security can be made until the Registration statement is filed with the SEC Definition of what securities are included: determines how broad the registration mandate is, how many types of transactions this will cover Exemptions from registration (see 504, 505, and 506) SEC controls; wants this to be the only document investors read Tells story of business; details what the business does / plans to do; provides a detailed description of risk. Includes management discussion and analysis, financial information about the corp.
•
Protects underwriters and other sellers from liability
•
If incomplete, creates big problems—the prospectus is otherwise like an insurance policy. This is distributed as part of the registration statement before public offering
•
No registration filed : No securities can be offered or sold
•
Waiting period: registration is filed with the SEC, but not yet effective o Still cannot make any sales or written offers (Can make oral offers, send copies of
•
What are the three stages of a public offering?
o
What defines a “security”?
•
Registration effective / Waiting period over: This is the critical d ate—sales permitted
•
Section 2 of the ’33 Act
•
Elements of an investment contract: o Investment of money o
In a common enterprise With an expectation of profit
o
Solely (aka “largely”) from the efforts of others
o
What is an “investment contract”? •
Basic idea : turning over money to someone else and relying on them to produce profits
•
Pyramid scheme ? Probably an investment contract
•
If investment contract it’s a security
•
What are the exemptions from registration
•
under ’33 Act?
• •
7
the prospectus) Can form a firm commitment contract with an underwriter
Intra-state offering exemption: (3)(a)(11) of the ’33 Act Private placement exemption: § 4(2) of the ’33 Act (Private offering) Limited offerings (Regulation D) (includes Rules 504, 505, and 506) Regulation A: § 3(b) “Short form registration”
•
Explain the intra-state offering exemption (3) (a)(11) of the ’33 Act:
•
•
•
Explain the private placement exemption— Section 4(2) of the ’33 Act:
Requirements: o The offer must be extended only to residents of a single state where the issuer corporation is incorporated and is doing (substantially of its) business. o Definitional problems may arise for “doing business in the state”, “resident,” etc. Exemption is strictly construed--is lost if security is offered to out of state resident even if no sale occurs . Safe Harbor: Rule 147: o Defines residency with objective standards—a checklist o Standards for resale: must wait 9 months Provides exemption for a transaction by issuer that is not a public offering. Applies to an offering involving a small number of subscribers who are sufficiently experienced or informed. o
Explain the idea behind restrictions on
•
Regulation D / Rule 506 provides safe harbors
Want to assure that the purchaser is a true investor, not a conduit
transferability Explain the doctrine of “securities coming to
•
rest” •
What is an “accredited investor”?
• •
•
Explain Rule 506
Securities must come to rest with the initial buyer before they can be sold to a third party that the issuer could not have sold to originally. Accredited investor : (See 505 and 506)—don’t need prote ction o Institutional investor (e.g., banks)—investors with substantial access to info and bargaining power. o Wealthy person: you have more than $1 million in assets or annual income of $200,000 o Insiders: Already have key i nformation; not laypersons Safe harbor for private offering exemption. See § 4(2). Bright line rule—this is the most difficult option to comply with. Issuer can sell an unlimited amount of securities to: o An unlimited number of accredited investors, and o
Up to 35 non-accredited investors—must be sophisticated and get disclosure
•
•
•
Explain Rule 505
•
• •
Explain Rule 504
(small issue administrative exception) Relates back to § 3(b), which is a blanket authorization for the SEC to develop administrative exemptions for offerings up to $5 million. No more than 35 non-accredited purchasers; unlimited accredited purchasers o No sophistication requirement for non-accredited purchasers Disclosure documents required for non-accredited purchasers Restricted stock: New purchaser must also have exemption to resell. See Rule 144 or § 4(1).
•
(small issue administrative exception): See Section 3(b)
•
•
Good for offerings of less than $1 million total sold No obligation to disclose, no sophistication requirements, no cap on non-accredited purchasers Easiest to comply with, so long as sale is very small Restricted stock: New purchaser must also have exemption to resell. See 144 or 4(1).
•
Regulation A: § 3(b) “Short form regi stration”
•
•
Explain Regulation A
Sophisticated: capable of evalu ating the risks and merits. See Rule 501(h). Restricted stock: New purchaser must also have exemption to resell o Not under § 4(1): § 4(1) cannot follow private placement sale.
o o
o
This is a § 3(b) exemption, so the cap is $5 million. Must have disclosure document called an “offering statement” Statement is simpler than an ordinary registration statement Must be filed with the SEC before the transfer occurs Advantage over Regulation D: stock not restricted as to resale No sophistication standard or limitation on number of investors, accredited or otherwise Problems with Regulation A:
8
Formalized disclosure document still requires attorney; it’s complicated
•
Explain how Regulation D controls resales of securities
Will need accountants. But not nearly as expensive as a registration statement More expensive than a 505 o ffering Caps amount of sale at $5 million
Davis Hardware sells securities to A. A sells the securities to B. o Must make sure A is an investor, not a conduit. Restrict transferability But don’t prohibit transfer forever o Unlawful to sell securities unless a registration statement is in effect If Davis Hardware will never have a registration statement, A must find an exemption to cover the resale. § 4(1) Exempts transaction not involving issuer, underwriter, or dealer •
9
•
Creates an exemption for controlling shareholders who have restricted stock and want to sell it. Can be shareholder of any size. With valid exemption, no registration necessary. Must have consent of issuer. Applies to all Regulation D resales. o Rule 144 gives controlling shareholders safe harbor; defines size of transaction which will negate distribution classification (large scale sales). If satisfied, Rule 144 will characterize stock as a resale or restricted stock transfer.
• •
Note: Rule 144 will not be available for most resales Requirements to satisfy Rule 144: o
Explain Rule 144
o
o o o
•
•
Explain Exemption 4(1):
Limit on amount of sales: Sales must be made gradually May not be over 1% of outstanding shares Holding period (critical!): Must be for at least 1 year Public corp: No Rule 144 for closed corp (but can be analogized for closed corp) Notice of sale must be filed with the SEC Issuer cannot solicit orders to buy stock; must be product of demand of stock
purchaser Legal imprint: stock will have a stamp which states that stock can’t be transferred without registration or unless approval received from issuer and exemption is established for resale. Resale of smaller amounts (no issuer involved) o If a person can show that he is neither an issuer, underwriter, or dealer, he does not have to worry about the registration requirement Proof that purchaser is not an underwriter: hold stock for at least 1 year; small sale o Cannot follow a private placement transaction. o In order to use § 4(1), must pass restrictions along to buyer; in effect, § 4(1) carries out a series of consecutive restrictions as to size and holding period
•
Section 11: Bad registration statement liability o
§ 11 buyers have private right of action for material misstatements or omissions in a registration statement Liability applies only to those securities issued under the registration statement in question
§ 11 does not require a showing of actual reliance on the misstatement
What is the potential source of civil liability for a false registration statement?
o
o
minus and losses ∆ can show to be caused by something other than the misstatement Potential defendants: Issuer, All directors / top officers, Underwriters, Accountants In other words, all who sign registration statement and certify its truth Corporatio n is strictly liable : no defense unless buyer knew statement was wrong
o
at time of purchase Barchris: High threshold for underwriters—must be an aggressive investigator
o
What defense does a corporation have
•
against a Section 11 claim? What defense do officers and directors have
•
against a Section 11 claim? How does due diligence work for non- experts?
•
Affirmative defense : buyer shown to know the statement was wrong at the time of the purchase Damages: Original offering price minus value of securities at the time of suit and
None (strictly liable) unless the corporation can show that the purchaser knew the statement was wrong at the time of the purchase Due diligence defense : All persons (aside from the corporation) to whom liability extends may avoid liability by proving that they exercised due diligence with respect to the information in the part of the registration statement for which they are liable. Due diligence for non-experts: o
Expertised part: satisfied if no reason to believe it is not accurate
o
Ex: financial statements, valuations by appraisers Non-expertised part: satisfied only if had reason to believe it was accurate after a proper investigation Difficult to satisfy because you can only have a reasonable belief after a proper investigation has occurred •
10
E.g., Underwriter cannot simply take info that corporation has given to them; they have an independent responsibility to
investigate all information given to them by the corp. •
What does Regulation FD prohibit?
•
•
What are “pre-emptive rights”?
Prevents corp from revealing certain public info to analyst before revealing to public at large Rationale: analyst would absorb the information and distribute to their customers, giving those people an advantage Pre-emptive rights—relevant to closed corporations o Right of a shareholder to purchase his proportionate interest in a new issuance of stock by the corporation Example: Davis Hardware. Hillman owns 60%; we own 40%. Hillman has first right to purchase 60% of the stock being offered, and we have first right to purchase 40% of the stock being offered. o If you cannot exercise your right because you lack money, you waive your right
o
Pre-emptive rights are usually laid out in the Articles of Incorporation; exist in some state statutes as well They usually exist because they were bargained for at the outset
o
Otherwise, the majority shareholder can decide to issue n ew stock, and only issue to himself. You cannot sell your pre-emptive rights
o
o
•
Bonds: pays out at a fixed rate of interest o
What are the basic characteristics of bonds? o
•
Not relevant in a public corporation because there is an open market, so you can purchase as many shares as you want and keep your percentage of ownership. Obligations of the bond: Pay interest on the principal on an annual or semi-annual basis Repay the principal at the end of the term Return on bond affected by two variables: Change in credit risk (Change in rating by rating companies) Changes in interest rates
Characteristics: Fixed dividend preference vis a vis the common stock holders o o
No right to receive the dividend
o
Sold around par value
o
Typically no voting rights
o
What are the basic characteristics of o
preferred stock?
Zahn had a provision where if no dividends paid for a certain period of
time, preferred stock had voting rights Normally not cumulative unless bargained for and placed in Articles of Incorporation Typically has liquidation preference (like Zahn )—usually close to par
Preferred stock holder looking for risk averse fixed rate of return and value security. However, different from bond holders because preferred stock holder may not get any dividend at all (directors are not required to pay dividends). Convertible stock: o Preferred stock can be convertible to common stock o Risky because common stock can be worth more or less than preferred stock o
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Compare / contrast bonds and preferred stock?
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Greater initial sale price for preferred stock o Trade-off for conversion characteristic because common stock wants the initial higher income from the sale of preferred stock. Bonds: o
Debt
o
Interest : Cumulative: it is a legal obligation to pay a defined amount of interest. If a
o
payment is missed, that obligation remains in existence. It does not go away until payment is made. Priority to stock : They have priority over the equity holders. This means they get
o
paid before the stock holders. Annual return fixed : Mandatory—return on the bond is a legal obligation. This is a
o
mandatory payment. Defined duration : Usually 30 year bonds, but can be something else. There is a
o
defined point in future when they will be repaid. Interest deductible : The interest is deductible for the corporation; this means this may be a better source of financing for the corporation because they are in effect
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What are “senior securities”?
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Why would a corporation issue senior
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securities instead of common stock?
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Explain recapitalization
subsidized by the g overnment. Preferred stock: Equity o o
Dividend : Not cumulative unless bargained for; lost if it is not paid
o
Subordinate to a bond
o
Annual return fixed : Discretionary; corporation doesn’t have to pay. If the
o
corporation doesn’t have any money or wants to keep the money in the corporation, it can. Indefinite duration : There is no time for the “repayment” of preferred stock
o
Dividend not deductible : Corporation cannot deduct the interest from taxes
Bonds and preferred stock Way to bring in new investors without giving them equity interest in the corporation (bonds) Investor might like the priority given to preferred stock and bonds over common stock Existing shareholders like the options because they do not give up their ownership rights Can be issued to existing investors, and do not effect relative ownership interests. Recapitalization (generally) is an adjustment in relative rights and preferences of stock holders. Can occur in many different situations. Commonly arises when preferred stockholders have not been paid dividends in a long time
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Become an employee of the company—draw a salary Lease land to the corporation—get rent Dividends Stock repurchases
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Equitable limitation:
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What are the ways you can get money out of
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a corporation?
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o
What are the two exceptions to the general rule that payment of dividends is discretionary?
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is in bad faith or so unreasonable as to amount to an abuse of discretion, a court of equity may intervene. Only applicable where there is a huge surplus and the board refuses to issue a dividend. Closed corporation: o
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What is the “insolvency test”?
If complaining shareholders can show that the board’s refusal to declare dividends
Majority shareholder’s decision whether or not to issue dividends is subject to fiduciary duty.
Rule: a corporation cannot distribute dividends if they would be unable to pay debts as they
become due in the usual course of business This is the overriding test for lawfulness of a dividend payment. Exists in every jdx. o A corporation not in bankruptcy may still be considered insolvent for purposes of distribution of dividends. o Must look at known and future obligations (some speculation involved). Courts will look at reasonable exercise of judgment by the board of directors.
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Explain the “balance sheet test” •
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dividend may be paid only to the extent that assets exceed the sum of liabilities and stated capital. Dividend = assets – (liabilities + Stated Capital) o Example: $100K in assets (cash and real estate), $50K liability; $50K Stated Capital—Dividend = Zero Change par value amount: If you amend par value, your stated capital will be lower, which will allow for greater dividends Problem: You can manipulate the balance sheet however you want Revaluation: o If you revaluate the land because the land has appreciated, you may be able to garner more assets; but then you must show that added value as a “revalue surplus.” Problem: how often can you do it? Plus, if reevaluation is of property, property is not liquid—can’t pay creditor debts with that. Most jdx do not allow revaluation analysis in balance sheet tests
Explain “revaluation” and the Klang rule: •
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Walkovsky v. Carlton
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Klang : (Minority view)--Corporation has not yet realized or reflected on its balance sheet the
appreciation of its assets is irrelevant to creditor concerns. An actual, though unrealized appreciation reflects real economic value of the corporation that can be borrowed. Majority view: Can’t manipulate reflection of assets to create surplus account by showing appreciation of real estate. π
injured by taxi; the corporation that owned the taxi was judgment proof. π went after the
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sole corporate shareholder. ∆ had 10 cab corporations, each with 2 cabs in it (why not 1 corporation with 20 cabs?). π's failed attempts to pierce the veil: o Alleges a fragmented corporate entity--Not grounds to pierce the veil, even if true Undercapitalization: π argued that ∆ intentionally undercapitalized, and thus should be personally liable Court holds that ∆ is not req’d to exceed minimum limits of insurance as required by statute Dissent argues this should have been grounds for piercing the veil Why not get a lien on the cabs? o Probably already attached to specific creditors, who will have priority. o
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Moral hazard problem: if you let insurance suffice, no incentive to be careful—insurance will pay damages (CA—Traynor opinion): π’s daughter dies in pool leased by ∆ (director of a CA
corporation). There are articles of incorporation, but no stock ever issued, no assets in the corporation. π gets a wrongful death judgment—corporation is judgment proof. π seeks to pierce the veil, sues director, secretary, and treasurer. Rule: pierce the veil when Shareholders: o Treat the assets of the corporation as their own, adding / withdrawing capital at o
will; or Hold themselves out as being personally l iable; or
o
Provide inadequate capitalization and actively participate in the conduct of
Minton v. Cavaney
corporate affairs. •
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United States v. Best Foods
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In this case, records kept in ∆’s office suggests active involvement in the business. (Not a very high threshold) o Reality: in CA, undercapitalization is enough to pierce the veil in tort claims Suit brought against Best Foods (parent) because BF used the subsidiary to carry out improper conduct (toxic tort). The offending facility was operated directly by BF. π claims that the subsidiary is just the agent of the parent, who is using the subsidiary. Plaintiffs are trying to reach the parent corporation, not the underlying shareholders; not a traditional piercing the veil case. If the “veil” is pierced, the “person” who pays is another corporation, rather than individual officers or shareholders. The two had overlapping management teams, indicating board members of BF were directing the actions of the subsidiary. Overlapping board members is not a problem if they can keep their “hats” separate. o There was someone who worked only as an officer for parent, not subsidiary, and he was directly involved in the tortious conduct. Therefore, parent is exposed, for direct action. Not really a PTV case.
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Dodge v. Ford
AP Smith v. Barlow:
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Ford made lots of money; instead of paying out large dividends, Ford wanted to keep the money in the corporation to employ more people, with the goal of helping society. Court allowed shareholders to block this move, forced dividends: “A business corporation is organized and carried on primarily for the profit of the stockholders. The power of the directors are to be employed for that end.” President makes $1,500 charitable contribution to Princeton. He justified the decision saying it was a business d ecision: good for the corporation’s reputation to be philanthropic. Rule: corporations can contribute reasonable sums to charity; no shareholder vote required
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Battle over incumbent management keeping their post vs. shareholders electing new management. Should insurgent expenses be reimbursed? Plurality decision: o Froessel (3 votes): policy vs. power [this is Del.’s approach] If over policy and shareholder approves, the shareholder may be reimbursed, and so can management Desmond (concurring): notice
Fairchild Engine and Airplane Corp. v. Rosenfeld :
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Says that reimbursement should be limited to costs of notice Van Voorhis (3): notice Distinction between policy and power is ridiculous. Everything is about power. Only reimburse notice expenses.
o
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Donohue •
Issue: buy-back of stock from non-participating minority shareholder Facts: Controlling shareholder transferred a majority of his shares to his children, and sells some to the corporation for $800 per share. Refuses to allow the minority shareholder to sell any shares back at that value. Held: apply strict fiduciary duty (like partnership); corp must give other shareholders equal opportunity Rule: a corporation may repurchase its own shares if: o Done in good faith without prejudice to creditors and minority shareholders; and o o
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Ringling Bros.
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McQuade v. McGraw •
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Clark v. Dodge
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If a closed corp, must use utmost good faith and loyalty to other stockholders To meet this test, the corporation must offer each shareholder an equal opportunity to sell a ratable number of shares to the corporation at the same price.
Pooling agreement 2 of 3 shareholders pooled their votes so that they could elect 5 of 7 b oard members. They use an arbitrator to facilitate this p rocess. Ringling follows the direction of the arbitrator, but Haley doesn’t. Court disregards Haley’s votes, because he had to follow the arbitrator. Majority shareholder (Stoneham) and two minority shareholders (McQuade and McGraw) agreed that they will use their best efforts to keep each other on the board and to keep each other employed. Stoneham and McGraw bailed on McQuade, who sues for specific performance under the agreement. Held: agreement is void—shareholders can’t agree to manage the corporation; can’t have side deals involving a control block of shares binding the corporation to certain practices. Employment decisions are made by the board, not by officers. Dodge owns 75%; Clark owns 25%, but runs the corporation as long as he is “faithful, efficient, and competent.” Clark’s salary is 1/4 of corporate income. Held: the contract is enforceable because it harms no one, even though i t impinges on statutory norm. The agreement involves all of the shareholders. Impairment of the board’s powers is insignificant—so shareholders here can contract for management positions. The agreements: o Vote to amend the bylaws (4 directors and a quorum of 3 for a board meeting). o They agree to vote for each other as directors Agree to a minimum $50,000 dividend payment (role of directors) o Agree to a salary continuation for surviving spouses (role of directors) When one of the parties says the agreement is void, the court upholds it—says that close corporations are different—uphold the agreement so long as: o No complaining minority shareholder o
Galler v. Galler
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o o
Francis v. United Jersey Bank
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Basic concept: you have a duty to do more than nothing Sons of predecessor make corporate loans to themselves and drain the assets of the corporation. Mother and Sons were directors. Suit was brought against Mom’s estate. Held: standard = degree of diligence that someone in like position would exercise; must exercise the care of ordinary prudent and diligent persons in the like positions under similar circumstances o Objective standard: sick, drunk, dumb, unsophisticated ≠ defense o
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No fraud to public or creditors No clear statutory prohibition
“A director is an essential component to corporate governance; a director cannot protect himself behind a paper shield bearing the motto, ‘Dummy Director.’”
Kamin v. AMEX
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Options for someone like Mom: Tell the bad actors to stop. Seek ju dicial relief, resign, and put in writing that you disapprove of the actions of the wrongdoers
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AMEX buys BLJ stock. The value drops significantly in 3 years. AMEX gives the BLJ stock as a dividend instead of cash. π sues, claiming D should have sold shares on the open market and received a tax write-off for the corporation.. Held for D: More than a mistake or imprudence must be shown. Court will not interfere when there is no showing o f fraud or self-dealing. The directors considered the tax write-off but made a reasoned decision to go another way.
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Corp buys up public shares with internal stock. It is going through leveraged buyout (essentially becoming close corp). Corp can afford to buy public shares for $55 per share, but shares are trading at $32 per share. CEO approaches friend to take over corp instead. Manages deal, but needs quick board approval. Board approves, but says they need 90 days to accept other offers; board won’t solicit other offers. Basically, directors followed charismatic boardmember rather than doing their own research. They also failed to create written record of relevant meetings, and caved to pressure to decide far too quickly.
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Held: Facts allege board did not do their duty; 36 hours not enough time to review deal. Directors knew they were making material decision without adequate information, nor adequate time to deliberate. Implies they did not care about decision that caused injury / loss to corporation / its stock. Business judgment defense invalid. Duty of inquiry: duty to b e informed if circumstances suggest need
Smith v. VanGorkin
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Malpedies v. Fredericks •
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Northeast Harbor Golf Club v. Harris •
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Board put Fredericks’ up for sale; deal to buy Fredericks included severe restrictions on directors’ ability to negotiate with different buyers. This made sense because buyer’s offering price was high—didn’t want sellers to use offer to shop around for better offers. Sued for breach of fiduciary duty of care / loyalty. All claims dismissed because not pled to satisfy DE law. (DE law has no claim for breach of duty of care.) If intentional tort, insurance won’t cover; if negligence, insurance covers, but state law doesn’t allow a negligence claim. So no viable claim in DE. If brought in CA, he would have claim for gross negligence. Harris (president) buys properties adjacent to the golf course. Tells other directors she has no plans to develop the property. They sue Harris, who says the corporation was financially unable to purchase the property. Held: Harris breached fiduciary duty—the golf club wasn’t in the business of purchasing real estate, but it was in the business of preventing development around the golf club. Tobacco company. During WWII, price of tobacco soared. Directors know the worth of tobacco has risen from $6 million to $20 million. Directors call and buy up 2/3 of Class A stock, converting to Class B. The directors purchase the rest of stock with the intent to sell the corporation and reap the benefits. Why? They know stock is worth more than market knows. There were three classes of stock: Class A: Defined dividend of $3.20. Callable (corporation can redeem for $ or o
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Zahn v. Transamerica •
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different stock). Non-voting stock. Liquidation preference: double Class B. Convertible at a 1:1 ratio Class B: Dividend: $1.60. Not callable. Has voting rights. Liquidation value: 1/2 of
Class A. Not convertible Problem: these are shareholders also acting as the board of directors. When this happens, shareholders must act under corporate restraint of the board of directors role. o Wrongful to call the Class A stock, denying them of the liquidation preference without informing them of the plan. Common shareholders were injured by this action. The true wrong is the failure to disclose the plan, rather than the call itself. Held: board can use its control of the board to wipe out double liquidation preference. Must share the game with other Class A shareholders, but can deprive them of full expectation. Damages: Measure is the difference between what they got o n redemption vs. what they would have gotten if they converted upon receiving notice. •
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Sinclair
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Sinclair Oil owns 97% of Sinclair Venezuela. Minority owns 3%. Minority claims Sinclair is mismanaging Sinclair Venezuela (Sinven), especially that the dividend payment is excessive —thinks money should be kept in Sinven to assure future growth and profits. Court looks to see if the controlling party is getting some benefit that it is not sharing with the minority shareholder. o If it is, courts will look closely at transaction; if not, defer to business judgment. o
Jones v. Ahmanson
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Majority not grabbing benefit disproportionately, so defer to business judgment.
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This is the most cited case in corporate law, for the principle that the majority owes a fiduciary duty to the minority shareholders . But Traynor’s “control is material” framework is not widely followed.
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S&L association owned by Jones (13%) and ∆ control group (87%). The majority shareholders (∆) are a coalition. The S&L was a thinly traded company. While other S&L stock price was going up, this one wasn’t because of the high cost per share. Price per
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share is not determined by the market, but by total value divided by the number of shares outstanding. The majority did nothing to create more market interest in the company (such as a stock split). Instead, ∆ decided to exclude Jones by creating a holding company. (A holding company simply holds the stock of another company. It doesn’t do any business of its own.) ∆ transferred control to the holding company (“United”) and then sold some shares of United to the public to get some cash. The majority controlled United, and did not let Jones in on the action. This effectively created a stock split at the level of United that didn’t exist for Jones. Jones is excluded from this development of a market in the S&L. The United shares became valuable, as the S&L shares dropped in value. Jones wanted to exchange his shares for shares in United. Ruling: all shareholders must be benefited proportionately by actions of controlling group.
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Distinguish from Zahn : This is action by shareholders, not corp—no corp action at issue.
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Held: Controlling shareholders must act in good faith and inherent fairness towards minority in any transaction in which control of the corporation is material. ( Traynor ) (Distinguish “materiality” of control from the “use” of control.) Therefore, ability of majority to put controlling shares into United meant control was material, even if United did not actually enter into the business operations of the corporation, and the control was not actually used.
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Gerdes v. Reynolds
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Majority shareholders also board of directors. Corporation’s only assets are cash and securities; has little liability. Buyer offers $2 per share; only worth $0.75 per share. Seller did not get cash—only note. Minority shareholders sue seller for not properly safeguarding corporate assets. Held: board cannot resign if it would leave corporation without proper care and protection. Must check references of buyer to see if responsible / qualified buyer. Clear fiduciary duty: seller (board/shareholders) cannot sell controlling shares to purchaser if seller knows or has reason to know that purchaser intends to loot the corporation. o Basically, if all assets are liquid and the buyer is willing to pay more than net asset value, management should be suspicious.
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Holds: looting case. F sold stock at a premium for control, and corporation should have benefited from increased stock price. F deprived the corporation and shareholders of the ability to sell for $175 by taking premium for stock because he was looting value that belonged to the corporation. o In situations where ∆ knows or should have known that the purchaser intended to use control to prevent the corporation from realizing p rofits it would have obtained, ∆ has breached fiduciary duty.
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Premium stock price: usually belongs to shareholders, but exception here—control involved potential value to corporation that corp lost and should have been shared by all shareholders. That is, corp profit from sale of steel at true price (gouging during the war). π must show that the corporation lost something of value because of the terms of the sale. ∆ had to pay portion of price that exceeded fair value of his stock back to the corporation.
Perlman v. Feldman
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SEC v. Dirks
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F sells stock for $20/share; market value is $12/share. Buyer is willing to pay more for stock because he gains benefit of control. F sells to syndicate (e.g. buyers/users of steel). Purchaser saw benefit of obtaining controlling amount of shares—could then purchase steel at an artificially low price. Minority shareholders’ problem: loss of true value sale price of steel. War = unethical price i ncrease. Court doesn’t want to say breach of fiduciary duty. Disallowance of charging unethical $.
Corporation built financial records on fraudulent practices. Dirks (∆) gets information from an insider. ∆ investigates the information, concludes fraud existed, and tells clients to get out of the corporation. ∆ then tells the Wall Street Journal (who does nothing). Once fraud is made public, SEC says ∆ committed fraud because he had a duty to expose the information or else refrain from trading. Held: Tippee may not have a duty, but may still be restrained from using the information because he is participating in a breach by the insider after the fact. o Test: duty that arises by virtue of a relationship between the tipper and issuer corporation that prohibits an individual from acting on the basis of non-public information. Do not want to discourage investigation of good/bad information about corporations Obligation of tippee: liability is derivative (depends on motive of tipper). If insider was expecting to profit in some way from the tip, then he breached his duty, and the breach
extends to the tippee. •
Santa Fe RR
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SF acquires 95% of public stock in corporation that is its subsidiary. Decides to get rid of minority shareholders via short form merger. Almost like absorbing the subsidiary into itself. {Short form merger different because you do not need shareholder approval if one corporation owns 90% or more shares i n another corporation—but must pay off shareholders in the acquired company for their shares.} De minimis shareholders got paid $170/share (determined by 3 rd party expert). Real value was $640, but shares for like corporations were being sold on the market for $170. Minority can fight for recovery of fair value. Instead, minority files 10(b) claim. SCOTUS: 10(b) is not replacement for state law on fiduciary responsibilities. Minority shareholder arguments are mostly fiduciary arguments. 10(b) is about disclosure, not fiduciary duty. Here, no fraud or failure to disclose. This case thus bars 10(b)(5) suits where there is no deception Two corporations negotiate a merger. Combustion to take over. Rumors in the market about the merger, so stock rose. Management issued three separate releases falsely denying merger agreements. Their attorney advised them that most circuits say press releases before speculation becomes fact okay to deny merger, but when agreement reached, from that point forward cannot issue false statements.
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Rule 10(b)(5) applies to misrepresentations and non-disclosures only if misrepresented or omitted fact is material.
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New standard for materiality: “magnitude / probability test” o An omitted fact is material if there is substantial likelihood that reasonable
Basic v. Levinson
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shareholder would consider it important in deciding on her course of action. Materiality depends at any given time upon balancing of indicated probability that an event will occur and anticipated magnitude of event in light of totality of corp activity. (Not a bright line) Greater magnitude of event, less probability necessary for it to be material. o As applied in this case: magnitude of merger is huge, so the probability of it occurring needs to be much less for it to be immaterial; therefore, false press releases were untrue statements of material fact under 10(b). Dissent: (White / O’Connor) o Do not buy the market efficiency theory. It was not clear that the market really responds to false information in the way we assume it does. There is a conceptual problem because our entire system of securities regulation is based upon diligent and knowledgeable investors. We assume that investors read these statements.
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Ann Taylor
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9th circuit is the most difficult place to file suits against corporations—would have killed this case in the pleadings
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2nd circuit looks at pleading in terms of motive and opportunity standard (only need to prove motive and opportunity to plead circumstantial evidence supporting state of mind) 2 nd circuit doesn’t feel PSLRA did anything new.
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BarChris •
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Allegation concerned misleading financial statements specific to inventory. Corporation states inventory not sold at full price rather than discounting it. Clearly the corporation was trying to defer putting negative number in the reports. Rule: must find requisite scienter with intent to deceive
Material statements tied back to the registration statement Liable parties: CFO, attorney / board member, CEO, President, VP Court: does not matter how educated the individual board member was, or how long they’ve been on the board—they had more knowledge as to the corporation and should have read and amended any defects in the statement. Only a small portion was expertised. Underwriter’s liability: underwriters are just as responsible for the corporation if the prospectus is false; prospective investors rely on the reputation of the underwriters in deciding whether to purchase securities High threshold for underwriters—must be an aggressive investigator
