ࡱ > " # ! ܥh c e |8 ( ( ( ( ( ( ( P v s7 V " 5 5 5 5 % 5 6 U7 7 X !8 [ s7 ( s7 t3 ( ( t3 t3 t3 ( ( 5 @P < L * ( ( ( ( 5 t3 t3 CORPORATIONS OUTLINE Stacy Aronowitz Professor Daines Fall 1997 OVERALL THEMES: Its all about wealth maximization Formation: Incentives are clear, so Ex ante: key time to look at legal rules Information: What parties knew & when Necessary for consent (K view) Courts require K: what parties specified if K doesnt cover, look to what parties would have done- default structure Default rules: implied K terms reduces K costs Costs: Agency & Monitoring align incentives vote threat of lawsuit monitoring or bonding up front Institutional Competence: Courts: good at ex post Markets: good at valuation Parties: good at ex ante Tension between preventing opportunism & respecting discretion Eg: Page, Meinhard, Tarnowski (THREE CONSTRAINTS ON AGENCY COSTS: limit managements ability to take or grab (Fiduciary Duties (Voting (Takeovers AGENCY LAW & THE PRINCIPAL-AGENT PROBLEM tort or K Principal (P) --------- Agent (A) ======== 3rd Party Agency law: almost entirely a matter of K Less dependent on what law requires b/c parties free to do a lot via K. Enabling: lets people make own decision Need agency law when: 3rd parties effected; their rights not covered by K 3rd parties affected in tort: look to vicarious liability 3rd parties affected in K: look to authority doctrines other K problems: externalities asymmetric info high K costs Vicarious Liability in Tort P------ A ===(tort)=== 3rd party P liable if both: Master/Servant Reship (respondeat superior triggered) [gas station cases] P ------- A ------- Servant ===(tort)=== 3rd party Agent? liability clear here 220: Master/Servant v. Independent Contractor Factors: Control: P can control As behavior: M/S P has less control over As behavior: IC Skill required: Less skill- easier for P to monitor A: M/S Higher skill- easier for A to monitor self, less effective & more expensive for P to monitor A: IC Work part of regular business: Yes- P more likely to know stuff b/c knowledge base: M/S No- P unlikely to know answers: IC Method of payment: By time- P more likely to monitor b/c A less concerned w/ own productivity: M/S By job- P less likely to monitor: IC Other factors: Hours (who sets?- points to control) Ability to sever P-A contract: Easier to sever reship: M/S Tougher to sever reship: IC Control over subordinates: P controls As subordinates: M/S A controls As subordinates: IC Where risk of profit & loss placed? P bears risk- A less incentives, needs monitoring: M/S A bears risk- A incentive to avoid loss, needs less monitoring: IC Policy: Who should be monitoring? Should place liability on one in better position to deter (cheapest cost avoider). Parties can K, find efficient allocation. If party has right to control & bears portion of operating cost, probably a lot of actual monitoring &/or screening. 2. Deep pockets M/S or IC? Advantages to M/S: Can control how products are sole & distributed Can better protect product & co. reputation Disadvantages to M/S: Liability Administrative costs- monitoring is expensive Alternatives to Monitoring: Insurance Screening W/in Scope of Employment [drunken seamen cases] M ------ S ===(tort)=== 3rd party Actuality: this prong of test ignored Requirements (attempt to get at control): A does work hired to do A does work w/in time & space authorized A does work w/ intent to benefit P dont need sole intent to benefit, okay mixed motives (Nelson) Can look beyond intent to benefit: which party can deter, cheaply monitor activity level; externalities (Ira S. Bushey) Activity level- if dont find P liable for the tort, might encourage too much of the activity. P should have to pay if the tort is one of the costs of doing business But this assumes that can figure out what the harmful activity is, who is hurting who. (apple & cedar trees) Overall reasons for holding P liable: Deterrence by cheapest cost avoider: Nitty-gritty control (gas station cases) Screening (Humble) Adjustment of activity level (Ira S. Bushey) Authority Doctrines (K) P ------ A ===(K)=== 3rd party ( (authority doctrines) Types: Actual Authority: based on Ps communication to A: if from that, a reasonable A would believe A had authority Actual Express Authority (AEA): Actual Implied Authority (AIA): incidental Efficient: saves transaction costs between P & A so dont have to go through every possible option Apparent Authority: based on Ps communication (direct or indirect representation) to 3rd party: (eg: P putting own name on As actions) Efficient: reduces transaction costs b/w P & 3rd party Enables P to work through an A; A easily binds P. Mistakes can be avoided at low costs. Consensual If P is putting person in position to do harm, P better monitor Inherent Authority: (Rest. 161) based on power of As position: if P appoints A to a standard role, 3rd parties can rely on traditional authorities associated with that role. If extraordinary transaction for A to partake in, & 3rd party knows this, 3rd party will bear cost of transaction. Authority doctrines : help to delineate when P will be liable for As actions 3rd parties want to get to P b/c A often judgment proof Degree to which P wants to be easily bound to Ks b/w A & 3rd parties: Ex ante (b/f K): P will want A to easily bind P to Ks b/c easier to make credible commitments and get customers Ex post (after K): P will not want A to easily bind P to Ks; if A had no authority to act, P can avoid liability. P will want to break K OR P will keep K, but not bear cost (3rd party or A will bear cost) Incentives to minimize costs: ( Costs: Transaction costs: b/w P & A & b/w P/A & 3rd party Monitoring costs Bonding costs (to make 3rd parties trust P) Bind cheapest cost avoider if no actual authority: Bind P- If symmetrical info Ordinarily, P cheaper cost avoider b/c control, screening. Often situated to deter violations (Asme) P can be bound even if A had no intent to benefit P Law wants to make expected value of breach of K equal to amt. it would cost to deter the breach. Need to ( risk of low visibility offenses- b/c of the lower cost (b/c low probability of being caught). Bind 3rd party- when unusual transaction (for P or A)- if 3rd party should have known A had no authority (Jennings) COSTS3rd PartyPextraordinary transactionlow costshigh costsordinary transactionhigh costshigh costs Prevent parties w/ superior information from acting opportunistically: stop Ps- Ratification: If P discovers that A has exceeded authority, & signals it was okay, P held to ratify the authority stop 3rd parties- Inherent authority: if A does not have inherent authority, if nature of As position does not traditionally authorize actions, 3rd parties penalize If asymmetrical info: cost on party w/ superior info party who did not disclose could have prevented will likely be 3rd party in an usual transaction will likely to P in ordinary transactions P on Notice YesNo3rd Party on NoticeYes(symmetrical info) P pays (asymmetrical info) 3rd party paysNo(asymmetrical info) P pays(symmetrical info) P paysThe Agency Contract & Fiduciary Doctrines Importance of K: Most important set of restraints NOT fiduciary duties, but is K: parties free to K around the law. If default rule, can K around. If non-optional can sort of be Ked around by making irrelevant But, not complete freedom of K; 2 restrictions: Termination: cannot make an irrevocable K But, can make this rule irrelevant via K: Eg: in employment: Severance payment (makes it harder for P to fire A) Give A some ownership in co. b. Fiduciary Duties: Still have K basis in sense of K defines whether or not & when a fiduciary duty will intervene Fiduciary Duties Types: Duty of Care (DOC) & Duty of Loyalty (DOL) Breach: result will depend on K Form: P ---- A === 3rd party ( fiduciary duties Generally: ex post application common law development strong moral flavor broad statements- little evidence of tailoring Need agency law if K problems- fiduciary duties as a solution Goal: (Making $; wealth maximization; efficiency Use law to ( size of pie Agency Problems: Separation of ownership & control: use of A enables division of labor (( output), but Agency costs reduce size of pie may benefit A less than P is harmed P must invest in monitoring P & A - divergent interests (how youre paid matters): A gets wage P gets residual interest (profit) P & A want lower agency costs: P & A want to be bound ( size of pie P & A invest in reducing agency costs to optimal level GoalWealth maximizationProblem (for P & A)Agency costs (costly to align incentives, monitor defections, & pre-commit to avoid defections)Solutions:K or common law Alternative Solutions Contractual solutions: parties free to alter fiduciary duties via K by tailoring default rules Problems w/ Ks: As obligations often cannot be neatly specified obligations change Ks are costly: need info & consent negotiation implementation rigidity costs (hard to change) imperfect measures residual loss evidence of K (rare to custom tailor fiduciary duties-except to K out of DOC) Hard to improve: Work hard & be loyal may be as good as you can do. Common law solutions: What can law do to ( size of pie? Use of common law: usually- cooperation; law only solves problem cases ex post Can choose rules parties would have chosen if they could have easily negotiated; fiduciary duties apply ex ante b/c K costs to spell them out too high: saves transaction costs where K costs high Gets right answer when K costs high Allow parties to customize obligations: offers off the rack default rules that parties can tailor to their needs via K Restatement: Scale: Respect for K that purports to authorize As conflict: Minimal Respect (quality of info poor) Maximum Respect I----------------------------------------------------------------------------------------------------------------------------------------------I ( ( ( A violates duty even Given dependent P, If independent P, if consent from if no secret profits, no inquiry into fairness beneficiary & then fair. (388-390). principal (Gleeson); As conflict okay. Fiduciary duties free A Per se rule- A violates from liability. duty even if no showing of actual damages (Tarnowski) 387: A has duty to act solely for benefit of P in all matters connected w/ his agency Default (unless otherwise agreed) 388: A must account for profits arising out of employment (A can enjoy no secret profits (Tarnowski) (A must account for profits if exploits confidential info acquired in course of job does NOT look to whether P harmed Default 389: If A acts as adverse party w/out Ps consent, voidable Looks at disclosure, NOT fairness Hard to do fairness inquiry if no readily observable mkt price. Consent as ready substitute for fairness Default 390: A can act as adverse party w/ Ps consent Mandatory If P is dependent: (In Re Gleeson b/c of concern about Ps being taken advantage of: bright line rule eliminates potential conflict of interest; costs of rigid rule may be low here. b) Fairness scrutiny What is DOL? (Meinhard v. Salmon) : Must consider P/joint venturers interests, so owe: information disclosure (so chance to compete) opportunity to participate on same or = grounds Rationale: Joint venture (j.v.) Managing co-venturer- higher duty to look after others interests Objection: j.v. is more limited than pship; this is new project Fiduciary duties apply ex ante when K costs too high to spell out what reship the parties would want. parties did not clarify intentions 3 possible rules they would have agreed to: If new opportunity, will be j.v. under same terms (Cardozo) DOL?: fiduciary duty on new projects but unlikely that new terms applicable penalty default & info forcing rule forces party to K b/c this is bad option Competition (must disclose, so can compete) DOL?: fiduciary duty to disclose But, might not want to agree ex ante to compete ex post (know each others ability to compete too well?) Each party has option to do what it wants DOL?: no fiduciary duty on new projects Private wealth maximization; gives parties incentives to find new opportunities Unblurs line b/w partner & j.v.; parties can still K for a limited purpose. vi) (If the court cites Meinhard, ( loses The Problem of Agency Costs Agency Problems: Separation of ownership & control: use of A enables division of labor (( output), but Agency costs reduce size of pie may benefit A less than P is harmed P must invest in monitoring P & A - divergent interests (how youre paid matters): A gets wage P gets residual interest (profit) P & A want lower agency costs: P & A want to be bound ( size of pie P & A invest in reducing agency costs to optimal level How to reduce: give A has ownership interest give P control over & monitoring of Ps actions Problems: want to give As some degree of discretion so that can perform jobs Agency costs in other, non P----A reships? Agency problems b/w partners as have b/w P ---- A b/c each partner is an agent. PARNTERSHIP LAW Relationship to corporations: Comparison w/ corporations: ISSUEPARTNERSHIPCORPORATIONLiabilityUnlimited (limited only by extent of loss)Limited (to extent of investment)Life of EntityLimited: terminate at event or death (can K around, eg: that business will continue upon death or partner)UnlimitedControl/ ManagementDefault rule: each partner is an A w/ equal control- proportional to # voting Can use executive committee & limit authority w/ notice & agreement by othersCentralized management But poses risks to minority s/hs (freeze-out)Governing LawOften UPA; some mandatory rules; conflict of lawsparties choose state law which seems to include more mandatory laws- although even those are chosen b/c parties choose which stateDefault RulesExtensiveMore extensiveFlexibilityGreatOften acceptable (especially if private)TransferabilityUnanimity to sell- UPA 18(g) default- can K around (eg: can delegate to executive committee)Freely transfer shares (but often K for restrictions)Tax single tax2 taxes (corp. taxed on earnings & individual taxed on dividends) Miscellaneous1) Some think it is complicated entity/aggregate distinction entity: separate thing aggregate: nothing of itself lawyers like it; others think its seedyEasier (at first) Sounds better on business card Hybrids: Limited Liability Partnership (LLP): pship w/ some limited liability; filing required Limited Liability Company (LLC): hybrid; flexible; can achieve pship taxation Limited Partnership: limited liability for limited partners, if they do not participate in control; can use corporation for general partner Introduction: Law creates entity status (cant be created by K b/w partners alone) Background Rules: Partnership (inter se) rules: Default Types: control (majority rule) 18(h): ordinary matters decided by majority or partners 18(c): equal rights in management of business 18(g): need every partners consent to bring someone new into pship (thus cant just sell shares) profits 18(a): share equally in profits most pships K around this this is penalty, info-forcing default rule b/c most times wouldnt want = profits b/c rarely have = contributions 3rd party rules: Immutable: set by law; not really alterable by K b/w partners need 3rd party disclosure Types: agency (9: every partner has power to bind pship via apparent authority) unlimited liability (15: personal liability for pship debts) jointly liable for all contractual debts jointly & severally liable for all tort debts (100% of debt could fall on 1 partner) Why Joint Ownership?: equity capital (instead of debt capital) ( amount of funds cheaper to get $ in form of equity than debt (financing effects size of pie) equity = a piece of the action/ownership interest incentives bonding: partners have power to bind pship moral hazard: if equity low enough, moral hazard to take more risks agency cost less b/c less incentives to take risks less b/c when one contributes equity (as opposed to lending $), give them an ownership interest, which reduces agency costs if equity interest, desire to work harder Formation The Potential Significance of Formation Questions pship can be inferred from parties acts even if did not intend for reship to be pship- can still infer one; parties intent not despositive harder to tell if pship formed than if corp. formed potential personal liability in tort & K potential claim on pship assets a. partners have power to bind partnership via K What indicates parties formed a pship? 6:intent does matter 7:means of payment matter joint ownership does not establish a pship sharing of gross returns (income) does not establish a pship sharing of profits (income - costs) is prima facie evidence of pship (costs matter when sharing profits; incentive to manage costs stronger when share profits than when just share income (profit as proxy for control ((b) if sharing of profits was just wages, defeats presumption Courts will look beyond intent to actions (Vohland v. Sweet- nursery) Was ( partner or commission salesperson? UPA: 7(4): net profit presumption (since shared profits, presume pship). 18(a): each partner shall be repaid his contributions & share equally in profits & surplus 7(4) + 18(a): If parties share profits, shows intent to be partners, so each party will get a share of the profits. On facts here: b/c parties shared profits pre-inventory, each will get a share of the profits, which includes the inventory Inventory: if not a partner, then no reason to build up inventory: If want to maximize inventory, then want to give person who controls inventory an incentive to maximize it. If profits include share of inventory, giving this to person who controls the inventory an incentive to maximize it. Would make no sense to compensate ( from post-inventory # unless ( is a partner- otherwise not giving person who controls the inventory an incentive to maximize it. but do partners always want inventory? In some industries, inventory expensive- want to minimize it. Interpret the ambiguity against (/owner, who may have wanted it both ways: Owner wanted ( to maximize inventory, work hard, & mind costs- but didnt want pay him share of inventory. Dont want owners manipulating employees like this. Problem w/ this rationale: companies often pay employees out of profits reduces agency costs b/c gets employees to act like owners. Want to encourage firms to pay out of profit like this dont want firms to have to fully share profits If interpret all profit-sharing as an indicator of a pship, firms will be less likely to use this method of payment employment Ks should reduce agency costs Creditors Rights General: who can creditors pursue? Type of debt: K debts: partners jointly liable Tort debts: partners jointly & severally liable W/drawl of partner 36(1): dissolution of pship does not of itself discharge existing liability of any partner default rule liable for debt pre-w/drawl, even after w/drawl had control b/f w/drawl, so liable for debts NOT liable for debt pship incurs after w/drawl rationale for NOT letting exiting partners escape liability: would create opportunism; encourage exit would five incentives for extra risky behavior would enable exploitation of 3rd parties Opting out (occasionally, will let exiting partner escape liability) means: 36(2): not liable if creditors agree (info + consent) 36(3): not liable if material amendment to debt after exit Munn v. Scalera rationale: not active member- no longer has control prevent other partners & 3rd parties from exploiting exiting partner 3rd party might be in good position to monitor & know best if change in risk or change in behavior Make party who should have known better bear the cost Partnership property Property is ownership of pship, not the individuals leans toward entity view (separate thing) 25: partners can pledge their pship interest b/c its an identity apart from pship. pship bankruptcy Old rule (jingle rule): pship creditors privileged; have 1st claim on pship assets (prevent race to court house- which would be inefficient & destroy going concern value) now: pships can file for bankruptcy (In Re Comark) 28: partners interest subject to charging order: creditor can go after share of profits creditor can sell interests of partner This breaks apart the pship (dissolution) Authority: Ordinary decisions decided by Majority Rule: 18(h): majority rules, absent decision to contrary (default rule) agency: all partners bound if majority rules (Nabisco v. Stroud) minority partners can not opt out (& avoid liability) by informing 3rd parties rationale: protects 3rd parties, who may be unclear as to who is in charge valuable for pship b/c partners able to pre-commit allows for credible commitments (3rd parties can rely) need to allow a partner to act otherwise, give a virtual veto power to each partner over affairs, which would de-stabilize pships & thus impose large costs good rationale? pships are unstable anyway; this rule does little to stabilize stunts definition of what constitutes action: placing orders privileged over canceling them (Nabisco) misses broader conception of action neglects that equal importance for co. to act & to stop an action Possible rules for tie-breaker b/w partners: partner who does not want to pay trumps partner who does want to pay trumps the buying partner can bind pship unilaterally law chose this rule Steps than can protect partner from liability ex ante: structure different regime; inform creditors & suppliers ex post: dissolve pship (not great alternative) Partnership Accounting & Dissolution Accounting: Balance sheets: snapshot of finances at any one time (so doesnt show overall value) must balance: Assets = liabilities + equity definitions: assets: what co. has liability: what co. owes equity: what co. really has 3. If expenses (, equity will ( Income (flow) statement: portrays financial condition over a period of time more important financial measure than balance sheet Dissolution ways to break up a pship: Dissolution: aggregate definition covering change in reship of members Winding-up: liquidation & paying everyone (partners & creditors) Termination: everything is over (death certificate) dissolution does NOT necessarily lead to termination winding-up does lead to termination 29: if any partner exits it is a dissolution 38: dissolution leads to wind-up leads to instability b/c 1 partner can dissolve & it ends pship, but default: can otherwise agree that a w/drawl of 1 partner, for example, will not lead to wind-up. If K around this instability: every partner still has power to start dissolution but now lacks right to start dissolution would owe damages to pship (liability rule protection) agreement trumps statute (Adams v. Jarvis) continuum: one end: respect for discretion of parties (respect K) other end: minimize opportunism & agency costs Dissolution & Wind-up: 29-38 IssueBackground RuleMutable?How?RationaleWhen is a wind-up triggered? Adams v. Jarvis38(1): statutory dissolution triggers wind-up. Default (K trumps statute; easy to opt out of default)Mutable via K, if agreement: provides for continuation sets forth how to pay w/drawing partner his share doesnt jeopardize rights of creditors is enforceable (equal bargaining)want to avoid losing going-concern value avoid start up costs makes everyone happy ex anteHow will wind-up occur? Dreifuerst(trial ct: probably through sale (appellate ct: 38; saleDefault: (trial ct: can change it to in-kind (appellate ct: mutable(trial ct: probably if majority wants it (can opt out by- appellate ct: ex ante agreement OR ex post unanimous vote no debts, fair, only interested parties are partners (appellate ct rejects) allow a majority of partners to continue business w/out winding-up if majority repurchases disassociating minoritys interest at fair values. (trial ct: dont want to avoid sale interests may diverge (appellate ct: sale is objective test to see what co. is worth- so make it hard to change. Better for cts. Maybe also better for partners- dont have to break-up business & lose its value. (to allow majority to repurchase minority interest: saves transaction costs Why may wind-up be triggered? (limits) PageNot going to imply a term; can wind-up (but allows for opportunism & breach of fiduciary duty owed to partner)Not clearDont want to imply term that parties didnt K for b/c disincentive to others to enter pship if cts will imply term making it hard to get out Limited Partnership (controlled by Uniform Limited Partnership Act) Features: Shields from unlimited liability (liable to extent of investment) Passive investment; lack control Creature of statute Often for a specified term Agency problems: b/c limited partners lack control, place control in hands of general partners control devices (limited partners can use to prevent agency costs): limit by term require access to info specific roles written into K align incentives (tie pay of general partner to $ limited partners receive) voting by limited partners fire general partners (but, might hurt limited partners ex ante b/c if general partners know can easily be fired, may not enter into the agreement or may charge more) Liability of limited partners If do participate in management of the pship, risk being deemed general partners & losing their limited liability protection Old rule: If limited partners are controlling general partner (if limited partners have control), they should have unlimited liability. (Delaney) Good rule?: yes: if choose pship form (& not corporate form), must be liable no: dealing w/ K (not tort) creditors; knew what they were getting into; could have gotten personal guarantees on loans who cares?: as long as clear ex ante, let parties K for whatever 303(a) & (b): limited partners have double protection- to be liable must Exercise control AND be held out as a general partner Formation: ex ante; incentives are clear, so key time to look at legal rules & K around Combines limited liability & single tax characteristic of pships CORPORATE FORM Introduction (Basic Attributes: entity theory (separate existence) centralized management bd of directors that controls corp. bd technically doesnt have to listen to s/h, but have fiduciary duty to s/h (Jennings) limited liability corp. is liable for all of its debts, but creditors cant get to s/h P(s/h) ---- A(corp) ==== 3rd party ( limited liability puts thick wall here (corporate veil) freely transferable easy to exit or enter solves pship problem that each can threaten dissolution via exit unlimited life (Acts only through people: players: SHAREHOLDERS (((((((((((( DIRECTORS/OFFICERS ( distributors ( ( ( service creditors ( CORPORATION ( employees customers ( ( suppliers Directors & officers: job is to maximize s/h wealth Director: a s/h on the board 1. voted by s/h Officer: management may or may not be a s/h may or may not be on board Formation: DGCL 101: sets up statutorily what has to be done & by who (establishes right, powers, obligations) Stocks & Dividends: how $ gets paid to s/h s/h: b/c own stock, own share of corporation entitled to profits get $ via dividends (which are controlled by board) stock transfers: DGCL subchapter 7- when & to whom s/h can sell to Charter & Bylaws: Bylaws: Amending: easier to change than charter s/h can amend directly Charter (Articles of Incorporation): Amending: tougher to change than bylaws DGCL: must put include in charter if going to allow Bd to change it Whats Included: Name (mandatory- DGCL 102(a)(1)) Address (mandatory- DGCL 102(a)(2)) Purpose of corp. (mandatory- DGCL 102(a)(3)- but optional as to whats stated) # of shares common stock (mandatory- DGCL 102(a)(4), 151) preferred stock (mandatory- DGCL 102(a)(1), 151) what directors are not liable for (mandatory- DGCL 102(b)(7)) can not excuse directors from liability for certain acts (mandatory) breach of DOL acts not in good faith acts for personal benefit of director can excuse directors from liability for certain acts (default) breach of DOC Basic Concepts of Valuation (( (Note: market is better at valuation than judges Time Value of Money: Present Value (PV) (PV = amount of $ 1 + discount rate (discount rate (r) (PV ( as r ( For 1 year period: (PV = FV (1 + r) For t year period (if same interest rate for all years): (make more each year b/c earning interest on interest & principle) (PV = FV (1 + r)t Future Value (FV) For 1 year period: (FV = PV(1 + r) For t year period (if same interest rate for all years): (make more each year b/c earning interest on interest & principle) (FV = PV(1+ r)t For t year period (if different interest rates): (make more each year b/c earning interest on interest & principle) (FV = amount of $ + interest in year 1 + interest on interest + interest in year 2 + interest on that interest + interest in year t. Net Present Value (NPV) NPV = PV- Costs Determines if it is worth it if NPV > 0, then invest. if NPV ( 0, dont invest. Example One dollar to bank for one year (r = 10%) PV = FV 1 + r 1 = FV 1 = FV FV = 1 X 1.10 FV = 1.10 1+.10 1.10 FV = PV (1 + r) FV = 1 (1 + .10) FV = 1.10 Review session valuation problems Risk & Return Uncertainty Expected Value (EV) value of outcomes weighted by the probability theyll occur EV = (Probability of A X Value of A) + (Probability of B X Value of B) EV = (VA)(%A) + (VB)(%B) More times you do something, closer it will come to EV If EV is more certain, willing to pay more for a risk Risk measures: Risk: Difference b/w actual outcomes & EV bigger the difference b/w outcomes & EV, greater the risk Default risk: chance of default eg: chance that debtor will not pay back loan Variance volatility: how much an outcome can deviate from the EV Risk premium: difference b/w EV & certainty equivalent (how much need to be paid to take a risk) Risk matters: Risk neutral: VA = EVA Risk loving: VA > EVA If risk loving, going to pay more for opportunity to make more $ Risk averse: VA < EVA Risk premium: difference b/w EV & certainty equivalent Diminishing marginal utility of money: $ matters more or less- depends on how much you have more risk averse if have more $ if risk averse, going to pay less for opportunity to make more $ risk aversion can go away w/ via diversification & insurance Risk affects discounting & PV: Discount certainty equivalent Convention: adjust discount rate Discount rate ( as risk aversion ( b/c risk premium (need to get paid to bear risk) Problems (pg III-15.) Diversification: not all eggs in one basket; can act more risk neutral Implications for price (value) of financial assets & for risk aversion If EV is more certain, willing to pay more for a risk Diversification makes EV more certain- willing to pay more for risk Risk aversion matters less if can diversify Diversifiable risks - can ensure return should trade right near EV investors cant charge risk premium idiosyncratic risk (b/c can diversify b/c can invest in different co.) Undiversifiable risks - market risk (b/c whole mkt is effected) investment of human capital undiversifiable Managers invest human capital- cant fully diversify S/h invest $- can fully diversify arises to tension b/w s/h & management Market Prices of Securities Can perform a valuation 2 ways discounted cash flow analysis (smart way) (mkt price of securities: worth = stock price X # of shares outstanding (lazy way) Efficient Capital Market Hypothesis: mkt does better job at valuing mkt price as objective value Capital Structure & the Incorporation Bargain Capital Structure: Debt (fixed claim) Senior Secured (eg: mortgage) Senior (unsecured) (eg: visa charges) Subordinated (eg: parental loan) Equity (residual claim- gets what is left over after debt) 1. Types of Stock: Preferred Stock: dividend typically no vote convertible to common stock (so can exercise some control) 1st in line b/f common stock liquidation preference- get back what invested Common Stock a) gives control via vote Equity owners: get % of co. profits DGCL 151: Incorporation bargain- do all of this in certificate of incorporation (c) allows for flexibility to structure incentives control Differing incentives Equity owners: more incentive to maximize value b/c will get more $ might want to take risks that debt ppl (creditors) dont, b/c creditors get all of the down side & limited upside. less risk averse than creditors Debt owners (creditors): get all downside, so more risk averse. Capital Structure & Leverage Leverage: Debt financing is providing some capital The higher the ratio of a corp.s debt to equity, the more leveraged corp. is (corp. is called thinly capitalized) High debt financing ( potential for large returns (& large losses) on the equity investment B/c debt obligation is fixed, high earnings will produce a high return on equity (ROE) To calculate ROE, subtract the fixed debt obligation from the earnings Note: if debt is held by same persons who hold the equity, the effect of leverage is meaningless b/c the overall return on investment doesnt change Debt: doesnt change worth, but can change value of corp. Discipline of debt: makes corp. work harder, so changes incentives & reduces agency costs Bankruptcy costs: if default on debt, bankruptcy bankruptcy is expensive & lowers value of corp. Taxes Limited Liability: (Rule: 3rd parties can only get to what s/h invested Default?: K creditors: could structure it so not limited liability Tort creditors: can NOT structure it differently (b/c no b/f the fact) limited liability on part of corp. for torts leads to high agency costs Efficient: in most corp., even if unlimited liability, high collection costs s/h could evade liability (eg: could sell shares to someone whos judgment proof) monetary advantages people (investors) prefer limited liability Creditors need protection: s/h, if not constrained, would put themselves 1st in line limit how much debt corp. could take require corp. to insure pay $ out via dividends or share repurchase Creditors hurt by: dilution of creditor claim (making other claims more senior) dilution of assets (sending $ out the door) Tension: creditor protection v. s/h control creditors: 1st in line (1st claim on assets), BUT s/h have control, can take out assets Whos hurt by tension & opportunity for s/h opportunism: ex post: creditors ex ante: s/h (b/c creditors will charge more interest) inefficient- pie is smaller Does it matter? for K creditors- Maybe not ex ante: parties can K for a different outcome eg: s/h can offer securities problems w/ K here expensive to K; default rule is cheaper Ks cant perfectly constrain s/h opportunism Ks can be too rigid- s/h need flexibility Ks can deter valuable transactions ii) for tort creditors- YES Best Rule: prevents s/h from advancing place in line when $ owed to creditors allows s/h to take $ when not in debt Creditor Protection Devices (Checks on Limited Liability) Pre-insolvency Measures (Regulatory Measures) Ex Ante Creditor Protection DevicesHow it protects creditorsCapitalization Requirementsmakes sure corp. has enough $ to start w/Distribution Constraints- Dividend Tests insolvency limits trust fund protection RMBCA 6.40prevent s/h from distributing all corp.s $ via dividends bars dividends if corp. insolvent bars dividends that reduce a cushion bars dividends if insolvent- based on balance sheet or some other valuationFiduciary Duties to Corp.prevents s/h from opportunistically taking $ out of corp Capitalization Requirements: make sure corp. has enough $ to start w/ done in Europe, not in U.S. Good idea? Pros: efficiency gains: can save K costs b/c dont have to put requirements into every K protects tort creditors Cons: easier for corp. to get out of the business too blunt of an instrument; hard to tell what amount corp. needs to start off w/ doesnt make much difference as long as people know ex ante what theyre getting- will charge the right price Distribution Constraints: prevent s/h from sending all $ out of corp. These tests can depend on definitions set in charter & bylaws; but s/hs can change charter & bylaws Stockholders equity: total ownership interest that all s/h have in corp. represents corp.s net worth (amount by which assets exceed liabilities) 3 equity accounts/categories (DGCL 153, 154): Stated or legal capital: s/hs investment: value that s/hs transferred to the corp. in exchange for shares (par value of stock) X (# of issued & outstanding shares) Capital surplus: initial purchase price less the par value of stock Earned surplus: accumulated retained earnings (Dividend Tests (ex ante) (Insolvency limits: bars dividends to s/h if corp. insolvent balance sheet insolvency: if s/h equity is (+), can pay dividends functional insolvency (repay debt) or equity insolvency: corp. insolvent if cant repay someone cant always use test b/c: might be short-term barriers to access of $ could have debt due later, but no current mkt for debt c) appraisal option (Trust fund protection: bars dividends that reduce a cushion Ways to define fund/cushion: StatuteCushionMutabilityNYBCL 510stated capital (traditional)mutable (so collapses into insolvency test)MCBA 45earned surplusmutable (notice to creditors not required)DGCL 170stated legal capital OR profits earningsNOT mutable If standards are mutable: Rationale: want s/h to have value- instead of having that $ sit in trust fund creditors know bd can opt out of this requirement; can K for some other protection Risks: accounting is poor measure of value creditors can be hosed RMBCA 6.40(c) & (d) (modern approach) Equity: insolvency/ balance sheet test: if s/h equity is (+), can pay dividends OR other valuation allows for appraisal by experts to get to true value can skip accounting NOT mutable Generally: Main theme: protect s/hs flexibility rather than creditors flexibility. rationale: s/h flexibility allows for valuable transactions that might otherwise be deterred most rely on K alternatives (eg: s/h offers securities) Turns on valuation: relies on accountants, creditors, bankers, legislators to value corp (unlike fid. duties, where bd or ct values corp.) What about info? (i.e. notice 1st?) Fiduciary Duties to corp. Prevent s/h from opportunistically taking $ out of corp. Interests b/w maximizing corp.s value v. s/h wealth may diverge b/c s/h dont bear full down side eg: in leveraged corp. near insolvency Duty to maximize value of corp- new (traditionally, duty was to s/h) implied duty of bd to corp itself, separate from duty to s/h; duty of bd jumps from s/h to corp. as co. nears insolvency exception to usual trend to maximize duties to s/h Good idea? Pros: efficient- value maximizing (( size of pie) Cons: K: s/h v. creditors bds duty should be to s/h, not creditors goes against idea that should maximize s/h wealth disincentive to ppl to be s/h Info: usually, complicated to know values so clearly- not clear whether close to insolvency Relies on ct to decide value of co. Agency Costs (: bds dont know whether duty to creditors or s/h if bd has 2 bosses, likely that beholden to neither (no man can have two masters) Post-insolvency Measures (Ex Post Creditor Remedies) Fraudulent Conveyance: ( pool of assets: ( must put $ back creditors can set aside certain transfers by debtors when no equivalent value was received & the debtor was left w/ unreasonably small capital (UFCA 4, 5, UFTA 4) law seeks to prevent fraudulent conveyances designed to protect against debtors acting in own self interest & currying favor w/ certain creditors when corp. close to insolvency Scope: long history of regulating all creditor reships application to corporations (dividends) implicit sale or loan gift to s/h? Clark says yes Relevance: applies mainly in leveraged buy out (LBO) area: LBO: ( use of debt (( debt to equity ratio) Use: to protect creditors of corp. b/f it was leveraged: thought it was low risk investment; now theyre pissed Negligence (UFTA) v. per se rule: per se rule prohibiting LBOs all together: might deter valuable transactions but would protect creditors Equitable Subordination: (only when corp. in bankruptcy) Limits claims by s/h (s/h cant cut in line) s/h cant come b/f creditors if what they are doing is making their equity look like a loan (Costello v. Fazio) Formation: cant intentionally set up undercapitalized corp. & misrepresent self to creditors Good rule? Benefits: want to encourage creditors to give loans protects creditors if their space in line is secure Risks: will discourage s/h loans if theyre always subordinate loans from s/h are good- lower interest rates Inequitable conduct? Guiding principle? (fraud? egregious mismanagement?) Piercing Corporate Veil (PCV): Opens up s/h to liability ignores entity status places unlimited liability on s/h remedy for something a corp. or s/h did wrong Ostensible principles- PCV if: Lack of separateness b/w s/h & corp. domination capitalization co-mingling formalities sham Use of corporate form may be wrong, unfair or inequitable bad debts, no clear boundaries wild card- cts can do anything here Actual principles- if a public corp., no PCV if s/h passive, no PCV if corp. follows formalities, no PCV doesnt seem to be about info, b/c no requirement of reliance on info Reverse Piercing (RCPV) : get s/h, then get other corp. s/h are also s/h of (Sea-Land Services) RPCV? Or is taking the stock sufficient? Pros to RPCVCons to RPCV(s/h may be hiding assets (may be only way to get damages(other s/h or creditors may get hurt; shouldnt be able to cut in line ahead of legit creditors ( monitoring costs: dont want corp. to have to look at whether other corp. are acting okay (2 prong test: (Sea-Land Services; Kinney Shoe Co.) Unity of Interest (2 corps not really separate) Factors: absence of corp. formalities co-mingle funds or assets under-capitalization s/h domination 1 corp. treating assets of another corp. as its own Why does lack of separateness matter? if it was geared at requiring info, thered be a causation requirement (require reliance on info) you want to be treated like a corp., you better act like one idea Fraud OR injustice (inequitable result if dont PCV) sneakiness or implicit misrepresentation (eg: shifting assets liabilities; changing forms) reducing these reduces the cost of K-ing ex ante. under-capitalization not enough to be fraud or injustice reason no PCV Sea-Land wild card- allows ct to do whatever it wants if this prong was really about sketchy behavior, it would limit damages to amt of $ s/h took from corp. Protection of Involuntary Creditor (Tort Creditor) What about ppl who use corp. to externalize costs of doing business? under-capitalization is problematic possible theories of liability: (Walkovsky v. Carlton) enterprise liability (get to whole corp, not to s/h) agency theory: but s/h can w/draw all the $ PCV not distinguished from agency, so not PCV but should insufficient capitalization allow PCV? Policy analysis: Choices: insurance (corp. should insure to cover claims of tort creditors) do nothing (Walkovsky v. Carlton) PCV (& allow tort creditors to get to s/h-owner) Efficiency: Impact on activity level: if allow ppl to externalize costs via corp. form (ie: limited liability), will have too much of the activity. if force internalization, correct amount of activity. Impact on raising capital: 3 Possible Rules for Tort Creditors: NOT PCV: (Easterfish & s/h like) Good rule? Costs: externalities: corp. doesnt bear full cost Benefits: PCV promotes corp. disaggregation b/c PCV gives small corp. an advantage (violates economies of scale) PCV doesnt help; corp. still has to buy minimal insurance legislature should decide, not activist cts instead of PCV,: insurance subordination of K creditors to tort creditors (good rule for K creditors) Partial PCV (Walkovszky) can go sideways to other corp.s assets cant PCV solely on grounds of inadequate capitalization Full PCV separateness requirement where most differs from Not PCV Should under-capitalization be enough to PCV in tort? Keating thinks under-capitalization enough to PCV unless: if under-capitalized b/c times are tough, but started out okay ??? Costs: institutional competency: hard to determine under-capitalization cts not well suited legislature did not choose to have a capitalization requirement- judges shouldnt but maybe legis. didnt b/c background of activist cts in corp. law (Keating) deters investment in under-capitalized corps. but maybe this is good thing doesnt go far enough- why distinguish b/w new co. & old co. (good rule for tort Have unlimited pro rata s/h liability in tort? (Hansman & Kraackman) will ( monitoring will adjust activity level & thus ( amount of torts Centralized Management & the Public Corporation Players: s/h: equity interest; get residual claim on assets Vote: (to protect equity interest) to elect directors to the Board to approve extraordinary transactions adopt, amend, & repeal bylaws remove directors (for cause OR if right to remove via K) adopt s/h resolutions ratify board actions OR request the board take certain actions DGCL 271: s/h can authorize sale of assets or dissolution via resolution, but Bd must deem it in best interests of corp. Majority s/h- actually have power over bd Typically- passive s/h in public corp. Board: statutorily- run the corp. power to manage corp. but usually just supervise the management hire & fire management not employed by corp; get fee for giving advice Management (Officers): reality- run & manage the corp. nominate people to board- power to pick Bd important control info disseminated to board employees of corp., in trenches doing the dirty work Why do s/h give up control to Bd (eg: K that s/h prevail only in super-majority vote)? s/h havent given up complete control: b/c majority s/h can replace board have safety net of super-majority vote to overrule board rationale for relinquishing control: protects minority (from self-dealing on part of majority) co. harder to dissolve officers have greater job security can pay officers less (job security is part of compensation pkg) board is in touch w/ whats going on- so better decision makers s/h avoid temptation to overrule bd by requiring super-majority vote to overrule Ct will only interfere w/ this charter/K if fraud (Automatic Self-Cleansing Filter) Close Corporations: in Tension w/ the Corporate Form Characteristics: small # of s/h majority s/h participate in management majority s/h get returns from dividends & salaries leaves minority s/h vulnerable (to freeze out) restrictions on share transferability no open mkt for shares (mkt restrictions) Restricted transferability of shares: (K restrictions) rationale: its a small room- dont want just anyone in there w/ you enforceable: enforceable if reasonable (Allen v. Biltmore Tissue) rationale: ct avoids having to do valuation close corp. reflect high customization & quirky Ks techniques TechniquesFeaturesRights of 1st refusal(b/f can sell to 3rd party, must offer to corp. &/or other s/h (price set by terms offered to 3rd party1st options(b/f sell to 3rd party, must offer corp. &/or other s/h (price set in agreement creating the option -can be problematic if set price at time when corp. had very different valueconsent powersbuyback rightsbuy-sell arrangements(s/h agree to buy or sell shares (specifies qualified events when can exit (provide means & terms of repayment (provide for method of valuation [appraisal OR accounting (income or assets) OR fair division] Reship to other forms: Similar to partnership BUT Some characteristics of corp. (limited liability; unlimited life; centralized management) (Majority S/h Opportunism Corporate QualityProblemReship to other FormsContractual Response (Ex ante)Cts Response (Ex Post)Eg:Limited transferability of shares: (no mkt; K restrictions)Lock In (cant sell; no exit)(pship: any can exit, leads to dissolution (corp: sell shares on mkt(improve s/h exit power sell option; buy-sell agreementImprove s/h exit power via forced dissolution (RMBCA 14.30(2): oppression remedy if: (fraudulent, illegal, or oppressive director conduct (wild card for cts) Bd deadlock causing irreperable harm s/h deadlock wasted corp. assets (problems w/ forced dissolution: kills corp., risks going concern valueWhite v. Perkins dissolve if oppressive Centralized management (majority s/h opportunism: -dividends -employment -share repurchase (minority has no voiceFreeze Out (must sell b/c majority made life so bad)(pship: all have voice (corp: only Bd has voice(customize allocation of control give s/h veto power, DGCL 218, 151 give s/h bd position (( voting power (employment K (tie salary to mngemnt salary)(fiduciary duties remedy (DGCL) -UGFAL (utmost good faith & loyalty): not default *only pro rata share repurchase [Note: may hurt minority s/h ex ante: (majority will pay less for shares (will discourage investment non pro rata share repurchase can be valuable may want to kick out some managers & want to be able to buy out shares ((parties probably would K for non- pro rata share repurchase (Easterfish)Donahue v. Rodd - UGFAL Ex Post Response to Freeze Out: Fiduciary Duties (fid. duty to limit oppression) tricky b/c s/h-manager has conflicting duties: s/h expected to be greedy, but manager expected to look after s/h METHODS to get $ to s/hCOMMON LAW NORMDividendEqual treatment across classes of securities (everyone gets pro rata)Employment/SalaryUnequal treatmentShare Repurchase(b/f Donahue: unequal treatment (after Donahue: equal treatment UGFAL- BUT, majority s/h be a little selfish can get around UGFAL via employment or severance pkgs, which do not need to be evenly distributed if (Wilkins) Legit business purpose & least harmful way of doing it not so much selfishness that hurts corp. (Smith v. Atlantic) FIDUCIARY DUTIES & SHAREHOLDER LITIGATION (Fiduciary Duties Intro: constraint on agency costs- limits managements ability to take or grab Different from fid. duties in agency law b/c: Principal: not really the s/h, but the corp. sheer # of s/h- collective action problems- no s/h has incentive to enforce fid. duties response: s/h derivative suits & class actions to give incentives (2 doctrines: (Duty of Care (must pay attention & not be grossly negligent) (Duty of Loyalty (must be honest) Fiduciary Duty ( ( DOC DOL ( ( Self-Dealing Corporate Opportunity Opting Out: charter provisions & amendments insurance indemnification Source- main function of corp.: facilitate collection of capital & specialization of labor S/h have priority over management, but management has control agency costs to ensure that management keeps s/h interests in mind DOC & DOL: response- limit managements ability to do fraud/self-dealing PRIORITYREALITYDOCTRINEs/h should have control- not managementmanagement has control- not s/hDOC & DOL creditors 1st in line b/f s/hs/h 1st in line b/f creditorsPCV Business Judgment Rule (BJR) (BJR) BJR insulates business decisions by Bd from legal attack in s/h suits if Bd entitled to protection of BJR, then cts shouldnt interfere or 2nd guess rebuttable presumption that: Bd is better equipped then cts to make business decisions & Bd acted w/out self-dealing & exercised reasonable diligence & acted w/ good faith party challenging the bd bears burden of rebutting the presumption (BJR as long as Bd looked at all its options (AmEx v. Kamin) process oriented rule, doesnt pay attention to substance of decisions just get advisers (lawyer, investment banker) to point out all options (create paper trail) okay even if choose stupid option BJR as long as fulfill prerequisites- DOL & DOC Rationale: s/h can fire Bd, dont need to sue Justification of BJR Role of Bd in governance concentration of decision making authority in Bd Makes it very hard for s/h to get to managers i. DOC & DOL- thin protections for s/h- not very protective Duty of Care (DOC) Generally: must pay attention (cant be lazy or grossly negligent) cant miss out on a business opportunity that can earn corp. $ OR cant overlook something that loses corp.s $ Default rule Opt out or not? DOC keeps directors from being grossly negligent BUT DOC can hurt- judges make wrong decisions, wasteful litigation 90% of corporations have opted out- most think DOC is hurtful Breaches of DOC: liability turns on negligence (or gross neg.) standard compared w/ breaches of DOL less morally troublesome less profitable to breacher c. Cts rarely find breaches of DOC Origin of problem: division of labor & problem w/ centralized management DOC- tries to get best of specialization of labor w/out downside ( When evaluating DOC, ask 4 questions: ( What did Bd do? ( Why did Bd do it? ( What else could Bd have done? ( What happened? Any damages? (Requirements under DOC (to avoid liability): (Must Look: (AmEx) If Bd looks at all options, cts excuse dumb decisions (BJR if look) (Must Look when Red Flag (actual notice of problem) (Graham v. Allis Chalmers): Bd must look if theres a warning or actual notice of a problem How hard does Bd have to look?: Only part of Bd has to look: their knowledge imputed to rest of Bd Do not have to do much monitoring BUT inefficient: Bd clearly in control could be cheapest cost avoider So why doesnt Bd monitor here? s/h K w/ managers- no externality or 3rd party who will bear the costs other costs- s/h want to minimize lots of costs Good rule? too lenient: worry about setting up corp. ex ante to relieve self of liability ex post shouldnt let Bd get off b/c set up broad, sprawling co. where easier to avoid monitoring too strict: s/h might be better off if management allowed to do some bad stuff- might make pie bigger not purely wealth maximizing objective (b/c need to be in conformance w/ law) no liability for Bd may benefit s/h b/c can hire experience ppl (who usually have more $) if liability for Bd, will get ppl w/ less $ & probably less business acumen If hold Bd liable, should Bd reimburse s/h? if activity benefited s/h, should s/h get it? if s/h get $ via damages, not clear that better off (Must Open Eyes & Look (Francis v. United Jersey Bank): No willful blindness (like the good widow Pritchard) basic duties of a director 3 basic duties learn basics of business keep current on developments read financial statements 4th implied duty? duty to respond exit- stop being director voice- talk to other members of Bd inform- tell authorities sue- other members of Bd look further NOT a normal DOC case b/c Cts rarely find breach of DOC as did here Why here? industry here- higher level of trust corp. near insolvency- so duty runs to creditors (Allen) case brought by creditors, not s/h- odd sons are not sympathetic characters (good widow is dead) (Must Look around some (or hire someone to look) (In re Caremark) Bd does have to look & set up a compliance system Not liable if Bd has implemented info gathering systems where reasonable to conclude, in good faith, that corp. is in compliance w/ law: gathered info looked into law- inside & outside counsel internal auditors disseminated policy enforced policy Twin difficulties of DOC & DOL: DOC case difficult for ( (b/c hard to win) Ct looks at good faith & actions DOL case difficult for ct Policy Justifications: Non-Diversification Assumption generally assume s/h diversified & wants Bd taking risk but, if reasonableness standard, Bd wont take risk Here, rule assumes: reasonable s/h is risk averse & is not diversified duty to corp., not to s/h dont want Bd taking risk that may kill corp. Blame the Victim s/h picks these directors- so tough on them no externalities, only harm is to corp. could have K for different result Labor Mkt for directors would have to pay much more if directors held liable (Must Not Act Quickly W/out Full Info (Smith v. Van Gorkom) (Duty of Bd owed to s/h when evaluating an offer to buy corp. Ends: must get fair price Means: take a long time & hire a lawyer- Get full info: independent investigation & valuation dont trust info & price of acquirer hire investment bankers & lawyers DGCL 141(e)- Bd not liable if reasonably & in good faith rely on them can rely on advisers if theyre informed get reasonable assessment of assets & worth of shares Take time: written (not just oral) proposals; long meetings Bd liable here Terms of offer Bd accepted short-fuse rule (offer only open for a few days) target cant shop around to get better deal b/c if acquirer loses deal, lose $ invested in getting the deal together (eg: search costs) Financing option out for acquirer (buy only if can get $) offer price 50% above stock mkt price cash out merger (so s/h voted) Lock-up: if someone else buys other than acquirer, acquirer gets option to buy shares at cheap price compensates acquirer- found target, put it on mkt makes someone else less likely to buy Shocking: reasonable directors usually not held liable Good rule?: Impacts on parties: not clear that s/h helped future Bds helped- now have clear guidance on how to act helps them if want to resist offers lawyers & investment bankers helped- who will get hired Bd not hurt- have director & officer (D & O) insurance Info limited & expensive- must allow Bd to act w/out full info (DOC now mutable for directors (protect Bd) DGCL 102(b)(7): DOL still mandatory DOC is now DEFAULT still the background rule but can opt out via charter or charter amendment DOC still mandatory for officers K out of personal liability: DOC has always been mutable, even b/f 102(b)(7) : D & O insurance OR Indemnification (sometimes) BREACHES OF DOCB/f Van GorkumResponse after Van Gorkum- Bd Liability for breaches of DOCYesYes, but default Bd Insulated from paying if liable? insurance 2) indemnification Yes No- not in s/h derivative suit Yes No Duty of Loyalty (DOL) Generally: i. (Duty of Loyalty: must be honest- cant take $ from corp. cash register Mandatory Agency law: corps. use A, who may look after selves instead of P If A (director) cheats P (s/h) by breaching DOL, whos hurt? ex post: s/h hurt ex ante: Director also hurt by potential breaches of DOL b/c s/h less willing to trust director, so pay less Both want to do away w/ breaches of DOL- better off aligning incentives Who cares if breaches of DOL? who cares: P- if anticipate DOL breaches, will reflect that in price paid to directors/officer s/h- will pay less for a share if director/officer allowed to breach DOL incentives to do this privately (K) not via cts Breaches of DOL: 1. liability framed under 1 of 3 conflict of interest standards basic self-dealing misappropriation of corp. opportunity waste of corp. assets compared w/ breaches of DOC more morally troublesome more profitable to breacher DOL to whom? s/h probably- should maximize long term profits of corp., but other constituencies (management? employees?) some states say Bd can consider more than s/h interest but no man can have 2 masters so DOL to none Why Fraud & Self-Dealing are Wrong: Objections to Fraud: Makes mkt imperfect- mkt relies on ppl w/ full & correct info ( transaction costs b/c undermines credulity & trustworthiness leads to costly investments in checking & verifying info must obtain & pay for guarantees of trustworthiness OR insure against losses from untruthfulness Objections to Self-Dealing: Unilateral rather than bargained for taking of property create unproductive uncertainty ( cost of capital (pay less for share if expect self-dealing) un-diversifiable b/c anticipate unfair self-dealing by managers of all corps. Types of DOL: Self Dealing & Corporate Opportunity DOL ( ( Self-Dealing Corporate Opportunity ( ( ( ( Disclosure Approval D/O Parent/Subsidiary ( ( S/h Bd (ratification) (authorization) Self-Dealing: Arises when directors favor own interests over those of s/h. Transaction b/w director & corp: ((Non)Disclosure: (If dont disclose, more likely to be liable for breach of DOL) C/L rule: non-disclosure is per se violation of DOL, regardless of fairness of transaction (Hayes Oyster) rationale: if dont disclose, likely something fishy is going on institutional competence: cts not good at evaluating whether fair price or not Remedy for failure to disclose: punitive- disgorge secret profits ALI 5.02(a): non-disclosure is per se violation of DOL DGCL 144(a)(3): undisclosed transactions subject to entire fairness review (will look at price & process) must have s/h or Bd authorization, approval, or ratification rationale: want to encourage valuable transactions- sometimes that will be w/ directors RMBCA 8.61: Fairness review for undisclosed transactions, but directors must have had a good reason for failure to disclose (Approval by s/h or Bd Ratification (usually s/h, approval ex post): must be disinterested to ratify Ratify b/c may be too costly to switch if deal already done Authorization (Director approval ex ante) must be disinterested to authorize Policy Considerations How beneficial to corps. are self-interested transactions by directors? How well does authority or ratification cure things? How well can cts do this if Bds cant do it via authority or ratification? Matter of compensation: allow some self-dealing, pay Bd member less Standards of Review: a. BJR- lowest standard of review looks to process to see if fair rationale: institutional competency & will chill valuable transactions if threaten liability RBF (reasonable belief by Bd in fairness of transaction): looks to price to see if fair rationale: a bit suspicious of directors Entire Fairness: highest standard of review looks to price & process to see if fair (Wheelabrator) SELF DEALINGDGCL 144RMBCA 8.60-8.63ALI 5.02(a)Burden of ProofAuthorization by Disinterested Bd members + disclosureBJR [look at process] 8.61(b): BJR [look at process]RBF (reasonable belief by Bd in fairness of transaction)- [look at price/substance](Ratification by Disinterested S/h or Bd + disclosure BJR8.62(a): BJRentire fairness- look at price & process (, but burden may shift to ( (eg: if ( could have gotten authorization b/f the transaction, ALI 5.02(a))NO Approval by Bd or s/h + NON-disclosure disclosure violation of DOL 2) entire fairness violation of DOL entire fairness violation of DOL 2) entire fairness violation- no burden of proof 2) ( Corporate Opportunity Doctrine: (Rule: D/O can only take opportunity if they disclose to corp. & corp. declines Director/Officer (D/O) Corporate Opportunity: Must disclose (Tests: (Broz v. Cellular Info Systems) in line of business of co. OR look at nature of opportunity: Factors: how it came to D/O via individ. capacity? via corp.? D/O offer opportunity to corp.? D/O have influence & power over corp.? financial capability of corp. to exploit opportunity? Not very predictable test no factor despositive & dont know how heavily to weigh each Rationale for rejecting bright line test: factors as proxies for intent line of business rule is dumb: want ppl on Bd who are in same field as corp. is in better to rely on mkt forces & imperfect judicial tests then have directors from diff. field Matter of compensation: pay D/O less, but let them have some corp. opportunity Shareholder/Parent (controlling s/h) Background rules: transactions b/w controlling s/h & subsidiary are subject to intrinsic fairness test controlling s/h has burden of proof test only applies when s/h getting something out of corp. Parent owes fiduciary duty to its subsidiary (Sinclair Oil) If non pro rata distribution (dont distribute to minority s/h)- maybe corporate opportunity Self-Dealing in Executive Compensation i. Management Compensation: cash/salary bonuses allow some self-dealing & stolen corp. opportunity (breaches of DOL) golden parachutes stock options percentage of earnings Management compensation pkgsABCPay$1$100,000$60,000 w/ bonus tied to profitsDOL breaches No DOL breachesDOL breachesDOL breachesKGrab-bagSome K restraints on management behaviorFew K restraints on management behaviorExplanationhigher salary, more K restraints, compensation less tied to performancecompensation tied to performance (align incentives) so need less judicially enforced constraints Who gets thismid-managementCEO Ks favored (salary, bonus) over permitted breaches of DOL by cts Doctrinal reasons: employment Ks easy to approve by Bd S/h can only complain of Bds: gross negligence waste (no reasonable reship b/w compensation & value of services given) easy to do via K (Economic reasons: monitoring reasons (harder to monitor breaches of DOL) can monitor breaches of DOL if disclose, BUT higher monitoring costs if compensate managers via wide array of transactions- hard to get their true value agency costs: easier to align interests via K (tie bonus to performance) Ways to Pay Management: Golden Parachutes: K creation cons: Management entrenching effects harder to fire, but usually can quit for any reason triggers generous severance pkg prevents takeovers b/c ( cost acquirer usually wants to fire management may ( agency costs: harder & more expensive to fire manager manager may not behave in way that ( s/h wealth pros: S/h wealth enhancing effects (despite ( agency costs) ( ability to attract best managers ( management resistance of takeovers (which are good for s/h) Percentage of Earnings: (bonus tied to performance of corp.) pros: for manager to ( compensation, must ( earnings of corp. ( agency costs cons: earnings of corp. depend on a lot, not just what management is doing can get out of whack if corp. does really well Stock Options (right to buy shares): (Michelson v. Duncan) profit if market price is greater than exercise price (EP) pros: aligns incentives (make manager act like owner) ( monitoring ( agency costs cons: can change EP mid-stream (Michelson) via centralized management- (insiders on Bd or management petition of Bd) if reduce EP, ( incentives to work harder Allow waste claim if change EP mid-stream? No- waste claim is bad: need to re-align incentives if mkt wide decline (not idiosyncratic to this corp.) DGCL 157: Bd decision conclusive Yes- waste claim is good: ex ante: ( management incentive to work hard if can go to Bd & get new EP ex post: dont want management influencing Bd like this Options are noisy signals as to value of corp. reflects mkt wide effect & management effort solutions Change options- so linked to firm value, not mkt value Tie to mkt share & revenue options if out-perform peers Give s/h more discretion ex ante (Enforcing fiduciary Duties & Shareholder suits Generally: Types: Derivative Direct (class action) Type of suitHarm toLaw or Equity?( & (path of $DERIVATIVEcorp.equity( (s/h)(( (corp)(3rd party $ to D/O(s/hDIRECTs/hlaw( (s/h)(( (D/O)$ to corp.(s/h (to extent that have shares) Differences: Classification Economic (who pays whom) Procedural what procedures apply whether suit can be dismissed by itself Derivative Suit: Generally: Response to collective action problem: w/out derivative suits: s/h pays for all litigation BUT s/h recovers only pro rata share of benefits reduced incentive to sue derivative suits altered (s compensation but creates problem of strike suits In S/h interests? can ( corp. value: allows recovery for past harms or enjoin prospective harms deters director wrongdoing can ( corp. value: direct cost of litigation ( cost of hiring managers- b/c corp. must buy D & O insurance ( Compensation S/h have little incentive to bring suit, so law rewards (s attorney fees: ( Attorney Fees if: common fund (s/h won settlement, $ went to corp.) OR corp. enjoyed substantial (non-monetary) benefit (Fletcher v. AJ) governance changes must be a (+) thing s/h want to pay for, but problems: governance changes dont have to be related to cause of problem & the suit valuation problems- hard to tell how much governance changes worth if (s attorneys settle (& save corp. litigation expenses) but this encourages more strike suits Objections: corp. might have to liquidate assets to pay attorneys fees- lose going concern value Strike suits brought just for settlement value (97% settle) create bounty hunter settlement Settle b/c no one really looking after s/h rights: S/h: collective action problem, not looking after own rights Attorneys: if settle, get fees Interested directors (ones being sued): if loyal- DOL to look after s/h, so may settle to save s/h $ if not loyal- if Bd settles, attorneys fees indemnified by corp. if lose at trial, attorneys fees not indemnified Independent directors: structural bias- look out for other directors Cts: cant really reject settlement that all parties agree to it D & O insurance: dont really care, b/c as long as things are predictable, can alter the premiums Bd may settle w/ ( who can be bought off more easily (Kahn v. Sullivan) Attempted Solutions to Strike Suits Standing/Technical Requirements: Beneficial owner: Continuing interest: s/h for duration of action. RMBCA 7.40-41 internalizes costs & benefits- if still a s/h, deterred from doing something that will ( stock price but rule doesnt work as well if s/h can own just 1 share Contemporaneous ownership: s/h at time of alleged wrongful act. RMBCA 7.41 prevents going in & buying a share when see a problem but this is not necessarily bad: drives price up- not so bad price of stock reflects corp. assets, which include expected value of litigation doesnt matter- (s attorneys own stable client portfolio Able to fairly & adequately represent s/h interests (no conflict of interest) Bond requirements- so lose $ if suit is frivolous- but judges get around it 1st try to obtain satisfaction from Bd (demand requirement) Screening Doctrines derivative suit is corp.s asset; Bd must 1st get a chance to take it over Bd Action (sue, get $, ct reviews w/ BJR- or no action; usually no action) ( usually loses ct discretion- ( SLC review standards (Auberach, Zapata, Joy v. North) Yes ( ( Yes Recommend ( DEMAND Dismissal? ( ON ( No BOARD? Yes ( Bd establishes ( Case proceeds w/ corp. as ( (which never happens) ( SLC? ( No ( No ( Yes ( Demand ( Case proceeds Futile? ( ct discretion No ( Dismissed b. (Demand Requirement: (Futility of Demand- Cts discretion whether it was useless to ask Bd to solve problem (Test: (Aronson; Levine v. Smith - Perot) Reasonable doubt that Bd couldve exercised BJ? Bd (dis)interested? Bd (in)dependent? OR Look at specific transaction- reasonable? really a 1 part test this just a proxy for whether Bd couldve exercised BJ (Rales v. Blasband) (Special Litigation Committee (SLC)- SLC made up of independent directors decide whether or not corp. should take over case Cts discretion to defer to SCL decision to proceed or not Standards of review: (review under BJR (Auerbach- NY) (two step review (Zapata- Del.) SLC must be independent look to procedure good faith? good try? Ct own BJ is litigation is NPV or not? replicate decision of loyal Bd (Joy v. North) NPV= recovery - costs - reputation costs (+)- dont dismiss (-)- dismiss factors: corp.s best interest law public policy anything it wants (eg: employees interests) VOTING (S/h vote: Purposes: s/h means of direct participation keep managers in line ( agency costs align incentives mechanism for takeovers For what: for directors- when- DGCL 211 at least annually, some directors elected default- can vote more often if opt out via bylaws at special meeting for any reason Bd determines b. staggered Bd- vote annually, but only for part of Bd- DGCL 141(c) for extraordinary transactions- DGCL 251, 271 which transactions: mergers sales of assets dissolution amendments of articles of incorporation b. rationale- (Easterfish): more is at stake for management for s/h proposals (which management usually proposes) for charter amendments charter is K b/w corp. & s/h charter could say, ex ante, that management can change charter w/out s/h vote, but this will ( share price Bd can have s/h vote on anything: if self-dealing by director, s/h ratification thwarts future litigation repeat players, concern for reputation Can vote by proxy- DGCL 212 One Share - One Vote- default rule Approval & Quorum- DGCL 151 directors must be approved by majority of shares cast charter amendments must be approved by majority of shares entitled to vote Which law? substantive rights- state law how state law rights are exercised- federal proxy rules if public co. Books & Records: Access to S/h list Need proper purpose- economic concern (Pillsbury v. Honeywell) very hard to opt out of , but default, can K out of rationale- reasonable for majority to expect that corp. is there to make $ if management has too many purposes, hard to monitor; easier to monitor if looking out for only economic concerns prevents corporate waste Proxy Expenses: proxy fights: to solicit votes (only other way to get a vote is to buy share) (Compensation of proxy expenses (usually $5-10 million): (Rosenfeld v. Fairchild) Incumbents reimbursed if: reasonable expenses (reviewed under BJR) good faith about policy (not personnel) Insurgents reimbursed if: s/h authorize in practice- must win management must propose for s/h to authorize management will only do this if insurgents are on Bd Problems w/ compensation: over-compensates: incumbent rule- b/c hard to distinguish policy fight from personnel fight proxy fights- not useful- if compensate might encourage under-compensates: incumbent rule- might also want to compensate for personnel changes insurgent rule- might benefit co. even if lose stock prices ( during proxy fight ppl pay attention monitoring of management ( collective action problem for insurgents lack incentives to bring proxy fight if lose, pays own expenses if win, get pro rata share of benefit change bring proxy fight might have (+)NPV, but might not be brought under current rule, have too few proxy fights Alternative rules: Alter the payoffs: pay all insurgents but then would have too many (like strike suit problem) incumbents pay own way if lose (like insurgents) corp. will have to pay directors more b/c will have to compensate Bd for anticipated expenses of proxy fights would pay directors via indemnification, not via salary over-compensate successful insurgents only pays for non-frivolous proxy fights Screening doctrines: different standards if proxy fight over issue v. control screening based on major s/h view wealth-maximizing s/h wont approve value destroying proxy Restrictions & Regulations on Voting Manipulation of Voting System: Bds power over agenda, meeting dates delegate to management management can manipulate to entrench themselves Okay to manipulate? (eg: move up election date at last minute): Yes- its in bylaws, s/h know Bd & management can do this NO- voting is special, will scrutinize more closely (Schnell v. Chris Craft) Allowed to do some things to keep selves in power can refuse if s/h vote to sell corp. if they dont want to s/h delegate this power to management rationale: s/h can not be trusted to sell can authorize super voting shares & give to friendly grp can buy back shares of enemies Even if technically okay, can not manipulate if in bad faith- will look to purpose (Schnell) eg: cant fiddle w/ bylaws opportunistically not even if good business reason (b/c can always come up w/ one) even if independent Bd, might not be okay too strategically- will look at effect & purpose (Atlas) if impedes s/h vote, not okay, even if in good faith screens out defense protection takenen today; carves back attempts to entrench self- slightly allows offensive moves- taken in advance only influences poorly advised bds trying to entrench selves Line b/w what can do & cant do to keep self in power is fuzzy. rationale: s/h can be trusted to vote, but not to sell Problem w/ treating voting rights as special- s/h can exit Circular Voting Structure DGCL 160(c): corp. cannot vote the shares it owns cant misalign investment & voting power (Speiser v. Baker) economic interests should align w/ voting interest rationale: want person in control to have right incentive Vote Buying- S/H Collective Action Problem Cannot separate vote from economic interest: Can not buy vote alone, separate from equity interest avoids unnecessary agency costs Can give vote alone (via proxy), separate from economic interest Vote buying not illegal per se: (Schreiber) purchase of vote voidable (can be approved by s/h ratification) illegal if intent is to disenfranchise s/h (not if intent is to benefit corp.) 3 problems vote-buying causes: Fraud (of corp.) or Disenfranchisement (of s/h) Distorted choice - less ability to rely on s/h judgment now rejected justification for ban on vote buying info-forcing rule- if one s/h knows why vote should go 1 way, ban on vote buying prevents buying of that s/hs silence forces info to be disclosed Collective action problem: Hold-ups (Schreiber v. Carney) threat from s/h to hold-up vote credible threat? Might not be if vote will ( stock price hold-ups always harm corp. (make pie smaller) ex post: if hold-up, vote-buying will always benefit corp. so vote-buying here is allowed under Schreiber ex ante: better to prevent hold-ups via making vote buying illegal per se Collective Action Problem: b/c of splintered ownership collective action problem make voting a weak check on management individually- rational to sell vote separate from equity interest wont sell if vote hurts equity interest individual considers that vote wont matter value of vote = gain X share interest X probability vote matters all s/h will think individual vote does not matter so all s/h will sell votes If all s/hindividual s/h will sell voteselldont sellsellcollectively, irrational to sell vote if less splintered ownership: if ppl had more shares (i.e. institutional investors), more willing to monitor & less collective action problem Federal Regulation: Proxy Rules (one response to collective action problem) 1. General purpose: proxies- so can inform s/h cheaply & enable them to act collectively reduce collective action problem so voting is stronger tool to check management determines how state substantive voting rights are exercised for public corp. Critiques of proxy rules: Easterfish: no one listens to them, so they are a waste Black: create legal obstacles to institutional investors b/c management friendly can rely on institutional investors to monitor & act own more shares, so bigger expected gain economies of scale, so less costs Why solicit proxies if dont have to? if self-dealing & conflict of interest, s/h ratification prevents later liability if repeat players, concern for reputation 14(a): cant solicit proxy unless comply w/ SEC regulations in 14A: what needs to be disclosed process 14a-8: town meeting rule (via proxies, can participate in governance) get ideas to other s/h cheaply- send proposals w/ managements proxy requirements: own $1000 worth of stock proposal <500 words file w/ management 120 days b/f its proxy proposal cant run afoul of restrictions must be proper subject for s/h vote relate to something worth more than 5% of business not ordinary business decision not management proposal related not related to elections 2 types of s/h proposals social proposal (to raise consciousness) proposal about corporate governance 14a-9: anti-fraud rule implied right for s/h to sue if make misstatement in proxy (Va. Bank) elements of c/a: false misleading statement or omission must misstate belief & misstate facts (Va. Bank Shares) material (if material, presume reliance) causation (causes damages) if Bd thinks X & says Xif Bd thinks Y & says Xif really X( loses- no misstatement of belief( loses- no misstatement of facts if really Y( loses- no misstatement of belief( may win critique of liability rule: allows Bd to be: negligent (stupid) or even stupid & dishonest if Bd dishonest, probably lying about other stuff but: no damages to s/h makes it very hard for s/h to have federal c/a if co. lied, have a state ct suit no ratification if Bd lied if co. told truth, no c/a ACQUISITIONS MARKET Corporate Combinations & Appraisal Rights Corporate Combinations Forms - goal of all the forms- end up w/ 1co. differences b/w forms: protection of s/h tax implication liabilities & form of surviving co. transactions costs Why offer prices > stock mkt prices: stock mkt has undervalued tax credits control premiums: current management is value destroying plan to loot Statutory Merger- DGCL 251(c) A takes over T if give stock of A (classical): s/hT & s/hA now s/hA if give $: s/hT have $ Features: S/h Rights: a. Voting Rights- s/hT & s/hA Appraisal Rights- s/hT & s/hA 2. A acquires Ts liabilities- but can K around K liabilities Asset Purchase- A buys assets of T s/hT get any remaining assets & $ A paid Features: Voting Rights: s/hT 2. Transaction costs: must make deed & K for each asset If close corp., s/hA may have veto rights or buy-sell agreement Statutory Share Exchange- RMBCA (not available via DGCL) A gives shares of A for shares of T: s/hT & s/hA now s/hA T becomes wholly owned subsidiary of A Features: Limits liabilities b/c leaves T as separate subsidiary unless PCV to s/h, which is A (100% s/h of T) Voting rights: s/hT Same result as DGCLs triangular merger Triangular Merger A creates subsidiary to acquire T S gives some shares to A for shares of A S acquires T, exchanging its shares of A for shares of T T/S becomes wholly owned subsidiary of A Reverse triangular merger- if T left standing Non-reverse triangular merger- if S left standing Features merger b/w S & T looks like statutory merger Limits liabilities b/c T as separate subsidiary unless PCV to s/h, which is A (100% s/h of T) Short Form Merger- DGCL 253 A owns at least 90% of stock of T, can just merge easily probably part of 2 step take-over: (a la Timberjack) tender offer b/f merger to accumulate the 90% short-form merger Features no other bidders have time to come in Voting: neither s/hT & s/hA for merger S/h Protection: Voting & Appraisal Rights FORM OF Acquirer S/h ProtectionsTarget S/h Protections MERGERVoteAppraisalVoteAppraisalStatutory Mergers (DGCL 251(c) (RMBCA (DGCL: Yes (RMBCA 11.03, .04: Yes (DGCL: Yes (RMBCA 13.02: Yes (DGCL: Yes (RMBCA 11.03, .04: Yes (DGCL: Yes* (RMBCA 13.02: YesSmall Scale (<20% new shares) (DGCL 251(f) (DGCL: No (DGCL: NoShort Form Merger (A owns >90% of T) (DGCL 253 (DGCL: No (DGCL: No (DGCL: No (DGCL: Yes*Triangular Merger (DGCL (RMBCA (DGCL: No (RMBCA: No (DGCL: No (RMBCA: No (DGCL: Yes (RMBCA 11.03: Yes (DGCL: Yes* (RMBCA 13.02: YesStatutory Share Exchange (RMBCA 11.03: No (RMBCA 13.02: No (RMBCA: Yes (RMBCA: YesAsset Purchase (DGCL 271 (RMBCA (DGCL: No (RMBCA: No (DGCL: No (RMBCA: No (DGCL: Yes (RMBCA 12.02: Yes (DGCL: No (Hariton) (RMBCA 13.02: Yes Stock Purchase (tender offer)NoNotender shares?tender shares?( *: no appraisal rights under DGCL if publicly or widely traded) S/h need more protection than Bd negotiating (cant rely on fiduciary duties) Voting: majority rule (no hold out problem as would if needed unanimity) s/hT almost always vote s/hA rarely vote (only DGCL 251(c) or if management lets them) rationale: corp.s buy lots of stuff; cant always go for s/h approval Appraisal rights: if vote against merger, can force corp. to buy shares, cts appraise worth rationale: minority s/h in bad position if future A owns 51% of Ts stock protect minority s/h, get them right price especially if A is s/hT (if A on both sides of table, can act to detriment of T & minority s/hT) if A not s/hT (A not on both sides) then Ts Bd might protect s/hT: unless directors figure they are out of there anyway, so no concern for s/h best interest encourages investment by supporting ppls expectations ex post s/hT can exit & sell shares, but stock price will be lower b/c will reflect As ability to exploit minority s/h voting offers very little protection protect against collective action problem Fischels prisoners dilemma such as in 2 tiered freeze out merger problems w/ appraisal rights: institutional competence, cts not good at valuing avoided via sale of assets (DGCL 271; Hariton v. Arco) some cts will call sale of assets a de facto merger b/c same functional result, & grant appraisal rights to s/hT under-used: collective action problem in getting s/h to bring: similar to collective action problem w/ derivative suits individual s/h must bring suit, but doesnt get all benefit DGCl 262(h),(j): ct can redistribute costs a bit, so alleviates somewhat doesnt deter T from accepting low price for s/hT appraisal rewards value of share (make s/h whole) no punitive damages if only must pay value, will try to screw s/h, b/c most s/h dont use appraisal rights b/c of collective action problem better to have class action remedy like in derivative suits? if voting rights ( appraisal rights 3 exceptions: DGCL 253, short form merger (s/hT get appraisal rights, but no voting rights) voting right would be useless here b/c A owns 90% of Ts shares DGCL 262(b): publicly or widely held co. (s/hT get voting rights, but no appraisal rights) if stock s/h gets in A is publicly traded or if stock s/h owns in T is publicly traded widely held. rationale: already a mkt for shares protects against unfair prices of opportunism problem: stock mkt price might not be a fair price- might reflect As bad treatment of s/hT RMBCA does not have this exception sale of substantially all assets of T (s/hT get voting rights, but no appraisal rights) (Hariton v. Arco) rationale: $ from sale of assets gets paid pro rata, dont need protection of appraisal rights (majority s/hT not going to screw the minority s/hT, b/c theyd just screw themselves) problem: if s/hT also s/hA, & has greater interest in A, will send more $ to A & screw over T & s/hT.. Valuation of the share: method: old Del. method: avg. asset value, mkt value, & earnings modern approach: use whatever investment bankers use (Weinberger) value: DGCL 262(h): ignore value that arose from merger valuing of assets: consider assets as used under T or A? old assets at old uses? OR old assets at new uses? OR new investment at new uses? projections? actual results? new investment at new uses (Cede & Co.v. Technicolor) s/hT invested in T b/c ripe for new investment ex ante, s/hT will pay more if think an A will come in & get rid of Ts bad management valuing of debt (In Re Vision) face value or liquidation (mkt) value if corp. near insolvency, then face value want to give incentives for value maximizing transactions (Friendly Acquisitions Freezeout Transactions: Appraisal rights Exclusive? Or Class Action Remedy? Freeze-outs: self-dealing by controlling s/h high risk of self dealing (vote, mkt for corp. control, & bargaining offer little protection) Policy: cases focus on risk of s/h being paid too little but s/h get more than mkt value- just dont get as much as A willing to pay *debate about whether s/h of parent or s/h of subsidiary get the surplus Class actions permitted if parent or controlling s/h on both sides of transaction?: Cts have flipped flopped: Traditionally: appraisal is exclusive remedy Class actions authorized in 1970s (Singer v. Magnavox) limited freeze-outs to legit business purpose expanded remedies: recissiory damages Class actions not always prohibited (Weinberger v. UOP) very vague as to when class actions okay class actions under only strict conditions (Rabkin) Appraisal rights are significant screen b/f class action allowed s/h cant just pass on appraisal rights & get a class action Weinberger class actions possible in freeze out merger: available if: no bargaining no full disclosure of facts no independent committee w/ real bargaining power (Kahn) remedy: legal fees & recissory damages (which are > appraisal damages) Policy: Appraisal rights are problematic for ct institutional competency- cts not good at valuation particularly bad at valuing surplus (difference b/w mkt price & reservation price- highest price A willing to pay) Penalty default- impose class action costs try to push parties to do it themselves Opt out via various screens (which give minority s/h some power): fairness opinion minority s/h vote independent committee w/ real leverage c. penalty- class action much more so than appraisal Try to manage controlling s/h opportunism same class action problem as w/ derivative suits CLASS ACTIONS Weinberger (class actions might be okay)Rabkin (class actions okay under strict conditions)Kahn (content to when class actions okay)Preclusion of Class Action (Class action not precluded if: (fraud or overreaching (unfairness (Ambiguity as to when precluded: (yes if breach of fiduciary duty (probably no if cash-out merger- go to appraisal rights(Class action precluded if: (only problem is w/ price (only get appraisal rights) (Class action not precluded if: (problem w/ process (particular incidents of fraud, etc.)Fiduciary Duty(Might breach DOL if: (use info from T to help parent (bargain w/out independent committee (move too fast (not candid (Avoid breach of DOL if: ( fairness opinion as to price for Ts shares (independent committee made up of T/subsidiarys directors not affiliated w/ A/parent (Might breach DOL if: (sharp conduct (bad attitude(Might breach DOL if: (special independent committee has no bargaining power (must have committee w/ real leverage & bargaining power)Remedy -valuations?(Liberal valuation method: (all relevant factors (anything ct of equity could say is ok (recissory damages (what would have been if transaction never occurred) grants more than appraisal, which gives what stock worth at time rationale: so s/h dont hold up transaction; option value (this is very bad for (/A/parent Sales of Control Control blocs can be < 50% of co. worth more than minority blocs costly to aggregate: buy from someone who has it (more typical) create control (via tender offer) source of control premium: 2 sources: value adding shares might be more valuable in As hands new management might better handle corp. looting (will loot from corp.) can tell which source: look to mkt (Easterfish): if going to loot: stock price will ( if going to be value adding: stock price will ( But, stock price reflects assets & expected remedies/damages avoid this problem & judicial valuations if can figure out what part of stock price is assets v. expected remedies Mkt Rule: (If sell control block, dont have to share control premium (Hanson Holdings) 2 Exceptions: Corporate Opportunity (Perlman v. Feldman): if control premium reflects value of corp. or collective opportunity that rightfully belongs to all s/h, must share premium (eg: a plan) exiting controlling s/h must share what is above true value, if not for control premium Looting if looting transaction, must share premium ( cost of transferring control, so deters all sales of control (will deter looting (if must pay premium to everyone, everyone will tender, no one left to loot) (also deters value creating transactions (Easterfish) is value creating if mkt price ( If sell control bloc after saw reasonable threat of looting that didnt avoid, liable (Harris v. Carter) cant shut eyes or ignore red flags sue sellers of control bloc, not looters (better for deterrence) Tender Offers & Williams Act: Tender Offer: offer of cash of securities to s/h of public corp. in exchange for their shares at a premium over mkt price usually, attempt to acquire control bloc in diffusely held corp. w/out controlling s/h not defined under Williams Act: SEC 8 factor test (Brascan)- gives judge lots of flexibility active & widespread solicitation of public shares solicitation made for a substantial % f the issuers stock premium over prevailing mkt price terms of the offer are firm rather than negotiable whether the offer is contingent on tender of a fixed minimum # of shares whether the offer is open only for a limited period of time whether the offerees are subjected to pressure to sell their stock whether public announcements of a purchasing program precede or accompany a rapid accumulation Williams Act: protects s/h from coercion Early warning system: 13(d): must file w/ SEC if cross 5% ownership line 13(d)(3): applies to ppl acting in concert if together, amass 5% Disclosure requirements: 13(d), 14(d)(1): must disclose what plan to do if launch a tender offer Im going to maximize s/h value is okay gives management time to get defenses ready Anti-fraud provision (14(e): cant lie Substantive regulations of tender offers (14(d)(4-7): (Hostile Acquisitions (cts see when a would-be A or s/hT challenges defensive tactics of Ts Bd OR T seeks to enjoin As bid (4 sets of rules govern behavior of T when T faced w/ unsolicited merger: Fiduciary duties K: i. ex ante: defenses in charter (eg: poison pill) ex post (after offering): install defenses mid stream (eg: staggered Bd, poison pill) Williams Act raiders/buyers- forced disclosure procedural rules force an auction: (w/drawl rights; open for 20 days; must offer same price to all s/h (cant do what Unocal did) & best price to all s/h) 4. State Anti-Takeover statutes Defensive Tactics & Fiduciary Duties Tender Offers One-Tiered (no back-end merger) Free-rider problem: (incentive to not tender) if tender offer does not succeed: get same price (mkt value) whether tendered or not if tender offer succeeds: better off not tendering b/c can & wait for everyone else to tender & free ride on value A adds Tender offer price ( Yes ( Tender Offer Succeed? ( ( Yes No ( ( Mkt price TENDER? > tender offer price (A wouldnt do it if didnt expect) ( ( No Yes ( ( Tender Offer Succeed? ( No ( Mkt value Two-Tiered Tender Offer 2 tiers: front end: tender offer back end: freeze out remainder of s/h for < tender offer price structurally coercive; s/h pressured into tendering ex ante: better off tendering b/c not going to be worse off will tender regardless of what think outcome will be if low price: s/h on front end harmed; s/h on back end harmed even more Coercive tender offers not allowed coercive tender offer outlawed in Unocal 13e-4 & 14d-10 prevent discriminatory, non pro rata tender offers (by As & by issuing corp.) Defensive Tactics (when faced w/ takeover(s)): Examples: Greenmail: selective repurchase by T of a potential bidders stock, usually at premium over the mkt price DGCL: greenmail okay; default (opt out via charter) Bd can buy back shares for business purpose (Cheff v. Mathes) can not do it to entrench selves okay if takeover presents danger to corp. policy can always come up w/ some policy reason policies that justify: save jobs; liquidation threat low burden on Bd- good faith & reasonableness hard for s/h to challenge Cts standard of review: >BJR if potential conflict Fiduciary Duty: to s/h to maximize profits takeover usually good for s/h; ( aggregate wealth s/h might make more $ if A comes in & liquidates assets (eg: if Ts management is really bad) to other constituents? (community, employees) if Bd has duty to more than one, duty to no one Good for s/h? ex post: s/h worse off (corp. paying more than getting) ex ante: maybe good (agency costs: management owns more shares, aligns incentives for long run ( monitoring costs: rewards raiders who search for under-valued or badly managed corp.; management works harder to avoid Poison Pills: Right distributed to s/h that becomes valuable when someone acquires specified portion of shares s/h can buy stock cheaply OR s/h can sell stock at expensive price back to corp. deters takeovers no takeover will succeed w/ pill in place b/c A be diluted no one has ever trigged a poison pill takeovers always conditional on Bd pulling the pill Pulling the Pill: A can force Bd to pull pill: proxy contest & get control of Bd OR compel T bd to pull the pill do not require s/h vote to pull Reasonable to adopt in advance of threat (Moran) do not require s/h vote to adopt Restructuring Defenses Discriminatory self-tender: offer to buy to non-A s/h to tender to corp. for price even higher then tender offer price (Unocal) scorched earth policy; assures Bd will win 13e-4, 14d-10: now forbid such discriminatory non pro rata share repurchases (by issuing corp. or by A) Giving of debt notes (IOUs) for some of the shares thwart takeover by placing restrictive covenant on notes that corp. cannot borrow any more debt (Revlon) ties hands of future As: A must borrow $ to make bid, but cant secure loan on T b/c T cant take on any more debt d. Golden Parachute 2 questions to be asked when reviewing defensive tactics: (>BJR (intermediate level of review) b/c Bd has conflict of interest (want to entrench themselves) ( Bd has enhanced duty that calls for judicial exam (reasonable grounds that danger to corp. policy (Cheff) (good faith (Smith v. Van Gorkum, Unocal) (defensive measure must be reasonable in relation to threat (Unocal) (When Bd faced w/ takeover, what constitutes a threat? What is a reasonable response? -Unocal, Paramount I (Time-Warner), Moran- (Response Reasonable in relation to threat? (Unocal) Exactly what is a threat is an open question. ThreatIs Threat Valid?Low price(Valid (Unocal, especially if 2-tiered tender offer & back-end freeze out)Coercion(Valid (Unocal, s/h may get too little; raider shouldnt be able to buy in) (Not valid if all s/h getting same price (Time-Warner)Greenmail (Valid (Unocal) (critique: scorched earth is sledgehammer to kill a fly no real threat of greenmail in freeze-out, b/c A wants all stock or none Threat to corp. enterprise Valid (Unocal) (critique: corp. does not need own protectionThreat to community/employees (other constituents)(Valid (Cheff) (critique: employees dont lose jobs after takeovers only lost jobs are top management can help employees w/out thwarting takeover via employment Ks & severance pkgs. Liquidation(Valid (Cheff) (critique: s/h might make more $ if corp. liquidated, especially if Ts management was value destroyingBond holders (debtors) may not get paid(Not valid (Revlon, cant favor debt holders over s/h) (critique: sometimes cts find a fiduciary duty to debtors, but Bds can not anticipate when (strikes like lightening)Threat to corp. policy/strategy cant do what was planning to do *if plan in place b/f hostile offer threat to corp. culture (Valid (Cheff) (Valid (Time-Warner) (critique: lets anything count as threat seems to gut Unocal Misunderstanding/confusion by s/h (s/h might be short-sighted)(Valid (Time-Warner) (critique: treats s/h as dumb, unable to see long-term (Not valid if concern is that s/h might tender into excessively conditional offer (QVC) (Once Bd has decided to sell corp., what transactions trigger auction duty (where cant use defensive tactics)? -Revlon, Paramount II (QVC)- (Once corp. will inevitably be sold/broken up, Bd can not just defend anymore (Revlon) must act like auctioneer & sell to highest bidder (Revlon) cant resolutely favor 1 bidder over another why Bd might favor 1 bidder: side payments protect s/h from low freeze-out so favor bidder offering s/h same price at front & back end putting directors on new Bd might bring added value if keep some directors or management ways Bd will favor 1 bidder over another lock-up sell favored bidder big asset or option buy shares cheaply if other A acquires (Van Gorkum) no-shop K (wont look for other As) termination fee to favored bidder if other A acquires give greater access to books lock-ups not illegal per se must look what give v. what get dont want to give lock-up to bidder whos already winning (doesnt benefit s/h) lock-ups ok to tempt a bidder into auction can favor to tempt a bidder into auction (Scope of auction duty (when is corp. inevitably sold?): if hostile tender offer & white knight (Revlon) if sale of control/control shift (QVC) if diffuse ownership & control b/f, but controlling s/h after, then sale of control (QVC) minority s/h now vulnerable; only fiduciary duties to protect them must conduct auction to ensure takeover premium to compensate s/h for this harm if diffuse ownership & control b/f & after acquisition, then no sale of control (Time-Warner) BUT, distinction makes no sense. S/h actually probably better off if controlling s/h (( agency & monitoring costs. (Auctions Good or Bad? (auctions ( premium paid to s/hT from 20% to 50% (Williams Act: essentially forces an auction BAD: (Easterfish) takeovers are good: (*but only winners are s/h) efficient (synergy gains) threat of takeover is good discipliner of management (( monitoring costs) auctions ( amount of takeovers auctions ( amt As must pay to takeover (auctions ( returns to search (will have ( searches & ( takeovers Revlon & Williams Act prevent takeovers ( chance of getting any premium b/c ( chance of a takeover. empirically- auctions ( amt of takeovers, but premiums to s/hT dont ( much probably would rely on mkt to screen defenses GOOD: (Bebchuck) auctions only ( search a little - - ( search muted by fact that A hold shares of T (<5%) society better off w/ auctions takeovers not necessarily value-creating (only clear winners are s/hT takeovers b/c: tax savings better management monopoly gains mkt inefficient exploit labor auctions & Williams Act will likely deter these inefficient takeovers auctions- ensure bidder who values T most gets it but 2nd buyer can acquire from the 1st bidder if 2nd one values it more, auctions (*transaction costs of bidding & auctions) No Defense/No Auction No Defense/Yes Auction Yes Defense/NO Auction ( ( ( -------------------------------------------------------------------------------------------------------------------- (Easterfish) (Bebchuck, Gilson, Kraackman) State Regulation of Takeovers Constitutional Rationale protect s/h: low price; coercion protect management protect employees (if this was goal of statute, it would deny takeovers that pose threat to employees, but allow others. Not what statutes do, so not true concern) PA (very honest) anti-takeover statute: Bd can consider anything it wants; can leave poison pill in place for any reason disgorges profits from raider who buys block & later sells protects employees: (severance pkg; all labor Ks remain in play after takeover) default: many have opted out of at least some PA corps. have lost $4 billion (( agency costs b/c no fear of takeovers) Impact of anti-takeover legislation: winners: top management (keeps jobs) losers: s/h who currently hold stock when law passed DGCL 203: bars interested s/h (crossed 15% threshold) from any merger for 3 years unless: Bd approval b/f acquires 15% OR Bd & s/h approval OR crossed 15% in transaction (ie: tender offer) in which got 85% of shares deters potential As: interferes w/ debt financing; A must share all synergy gains can get around: proxy contest to replace Bd, then make takeover bid; tender offer for 85% of stock; wait 3 years; negotiate deal w/ incumbent management VII. SECURITIES MARKET & INSIDER TRADING Anti-fraud provision: Rule 10b-5, under 10(b) of Securities Exchange Act of 1934 like anti-fraud provisions in proxy rules (14a-9) & Williams Act (14e) 10(b): prohibits use or employment of any manipulative or deceptive devise in sales of securities 10b-5: prohibits, in connection w/ purchase or sale of security: device, scheme, or artifice to defraud untrue statement or omission of material fact fraud or deceit SEC & private c/a private c/a: Ct carved back on implied right of action (to limit # of claims) doesnt govern s/h & management reship- thats state law But if lose ability to get some remedies (eg: injunction) in state ct & controlling s/h breaches fiduciary duties, may be able to get to fed ct (Goldberg) SEC: 3 remedies civil injunctive action disgorgement administrative proceedings to bar ppl from business criminal actions (U.S. Attorney) 2 contexts: Securities fraud- overt misstatement or omission Insider trading Outright Misstatement or Omission Elements of c/a: Misrepresentation or omission (Santa Fe) Okay as long as tell truth (sharp dealing okay if dont lie about it) no requirement that business purpose for freeze-out; just cant lie Materiality (TSC) whether reasonable investor would view matter as significant (balance probability of event & price impact of event (Basic) Not when reach agreement in principle Scienter (knowledge or recklessness) (Ernst) Causation (Goldberg) Damages Reliance (but might not have to show actual reliance) (Basic) 10b-5 can be enforced in a class action (Basic) Reliance can be presumed (if mkt believed the deception) enables class action (not required to show individual reliance) even if s/h didnt know of deception, the mkt did Fraud-on-the-Mkt Theory misstatement deceived the mkt (mkt as agent of s/h) s/h rely on mkt (which knew of the deception) if mkt believed the deception, influenced the stock price mkts are speculatively efficient (reacts quickly to info) Rebuttable presumption rebut by showing no reliance by s/h or no change in price Traditional RulePost-Basic RuleFalse statementReliancePresumption of RelianceSilence/omission Presumption of reliance C. Insider Trading (I.T.) History: permitted at C/L (permitted at time 1934 act passed) Old approach to combat I.T. under 1934 act (can still use): 16: must disgorge of profits if insider buys & sells w/in 6 mo. period 10b-5: does not explicitly prohibit I.T. does not define insider trading Whats wrong w/ I.T.? Corp. concern: insider shouldnt control destiny of corp. Societal concern: dont like ppl who cheat Mkt concern: need foundation of integrity (otherwise, disincentive to invest) 3 Theories- Liability for I.T.? Equal Access Theory: buyers & sellers entitled to level playing field 2 principles (Cady v. Roberts) general DOL to s/h inherent unfairness if have more info (TGS) cant trade w/out disclosing insiders subject to materiality standard (probability X magnitude) view whether misleading from perspective of investor corp. liable for deeds of insiders even if corp. didnt trade If have superior info- cant trade on it unless disclose (TGS) all investors should have = access managers & employees: disclose or abstain from trading Good rule? AdvantagesDisadvantages can reach all I.T. conduct, even if info originates outside corp. victims of I.T. easily identified: all uninformed traders to whom insiders should have discloseddiscourages search & research b/c cant capture gains 10b-5 requires fraud: if non-disclosure, must have duty to disclose. If no duty, ppl are not hurt. There are always ppl w/ more info- shouldnt have to disclose unless have a duty. (REJECTED (Chiarella) ( access is not fraud: must be fraud or deceit to be violation Fiduciary Duty Theory a. RETAC (pre-existing reship of trust & confidence) (Chiarella) Must find breach of RETAC to person on other side of trade if owe no RETAC (to s/h of corp. that have info about), then owe no duty to disclose no general duty to mkt duty must be independent of 10b-5 Who has a RETAC? Officers & Directors Investment banker or lawyer on deal (temporary insider) (Dirks) not person who overhears Tippee liability (Dirks) tip must constitute a breach of a duty eg: traditional insiders duty breach only if tipper reaped a personal benefit by providing tip if no personal benefit to tipper, then RETAC doesnt stick tippee must know or have reason to know of the breach Good rule? AdvantagesDisadvantagesavoid liability for security analysts (imp. investigatory efforts); s/h better off w/ some ( info (better off w/ security analysts) b/c so vague, even more of a deterrent good if diversified, b/c RETAC obligates disclosure of things that will ( stock price (eg: fraud); good b/c if diversified, likely to be on other side of transaction in another situationUnder-inclusive: does not get to person who trades in corp. that dont have RETAC to. only gets ppl who owe duty to selling s/h must owe duty to X & trade Xs shares if A plans to buy T, & insider of A buys stock in T, not I.T. under fiduciary duty theory Very vague, hard to structure behavior ex ante not good if not diversified, b/c RETAC obligates disclosure of things that will ( stock price Misappropriation Theory (OHagan) abuse of some relationship property rights theory (dissent, Chiarella) Must deceive- no liability if disclose that trading Can misappropriate the good reputation of employer journalist cant trade on inside info b/c would sully reputation of newspaper for which he works Good rule? AdvantagesDisadvantagesmore inclusive: dont have to have duty to selling s/h if owe duty to X but trade on securities of Y, can be liable here generally, corp. owe duty to will be source of info can reach almost all forms of I.T., regardless of whether traditional insiders are involved. isolates a real duty & a real frauddoesnt really fit language of 10b-5 employers can opt out of liability for its employees 14e-3(a): pure liability rule liable if: *tender offer context got inside info trade on inside info PAGE PAGE 54 /=8 \ } 1 2 C D K L V ) + 6 z { " ' . / L U e r , . B D R T . / U V b d W [ b J J ^ J c h c c J Uc Uc J %Uc V UVb d " $ ! ! " " " *" " " # !# # # $ $ ' ' ( ( ) ) ) y* * * * * * * W+ ^+ + + + + , z, ~, , , , , , , `- d- 2. 6. . . 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