Corporations
Prof. Hempel, Rm. 8; 2:30 – 4:20 pm, MW
Principals and Agents: like the master and servant in Torts. Deals with issues of control and liability. Agency is more about contract law than tort. Employees are servants or agents of their employer. The is always consent in order to have some kind of relationship between principal and agent. One issue is how much authority an agent has to act on behalf of the principal. When one party controls another, that makes the controlled an agent.
Morris Oil v. Rainbow Oilfield: a contract cannot make an agent out of a 3rd party without the 3rd party’s consent. RULE: Undisclosed principals are liable for the acts of the agent if there is a legitimate agency and the act is done on behalf of the principal, and that act is usual or necessary.
There are three types of disclosure of principal: disclosed, partially disclosed (ident. Unknown), and undisclosed. All three types of principals are liable for the agent if the relationship was created.
The principal is liable for acts that are done by the agent under the principal’s authority. There are two types of actual authority: express and implied.
Implied authority is derived from:
o the words that are used,
o customs, past relationship of the parties (course of dealing), and
o incidental authority.
Apparent authority is derived from words or conduct of the principal that would lead a reasonable person to believe that the principal authorized the act.
Agency by estoppel happens when a 3rd party changes her position based on the belief that there was an agency and the principal intentionally/carelessly caused the belief or failed to correct the 3rd party’s false belief.
Inherent authority is a concept of equity/fairness that protects persons harmed by dealing with agent.
Ratification is when the principal affirms the agent’s conduct after-the-fact. It can be express or implied.
Acquiescence occurs when the principal fails to object, and thus gives rise to actual authority.
Remember these theories of liability of principal to 3rd person (AAA-IRA):
o Actual authority
o 
Apparent
authority
o Agency by Estoppel
o Inherent Authority
o Ratification
o Acquiescence
An agency relationship can be cancelled at any time, even if the K says that it is irrevocable. However, there may be a breach of K claim.
A 3rd person may be liable to principal if an agent and a 3rd person enter into a K under which the principal is liable to the 3rd person. (i.e. switch it around and test liability to see if liability is mutual).
An agent may be liable to a 3rd party if the principal was undisclosed; the agent is jointly liable with the principal to the 3rd party if the principal was partially disclosed. The only time the agent is not liable to the 3rd party is when the agent discloses the principal.
General Partnerships
– Formation and Obligations
Martin v. Peyton: partners can be held personally liable for the debts of the partnership. Partnerships can arise whether people intend to be partners or not. A partnership for a single task is called a joint venture. Partnerships are modifiable by mere conduct and can also be modified orally. They can be formed explicitly or implicitly. Written Ks are examined carefully. Just because you say it’s a partnership doesn’t mean it is a partnership.
Meinhart v. Sammer: the fiduciary duty between partners is to be honest with one another – the duty of the finest loyalty (including disclosure of things that should be disclosed). Do not misappropriate a partnership opportunity for yourself. You only have to disclose the same opportunities that are in the same subject matter as the partnership.
Uniform Partnership Act and the Revised Uniform Partnership Act (UPA / RUPA) are what govern most partnership rules. Each partner is an agent of the partnership. An agent (each partner) can bind all the other partners when acting in the ordinary course of business. If not done in the ordinary course of business, it must be authorized by the other partners. If partners disagree on something ordinary, the majority of partners can decide. If not ordinary, there must be unanimous consent among the partners. Modifying the partnership also require unanimous consent.
Creppers v. Juliane: if a partner hires someone else without the consent of the other partner(s), then this is not allowed without a majority+ of consent. In a two person partnership, there is no authority if only one objects.
NBC v Stroud: you can’t change an established business practice without a majority 50%+. This means that if one disagrees in a two person partnership, there cannot be a change to the established business practice.
Page v. Page: ending a partnership is called a dissolution. Creditors are paid first before the partners get anything. Any partner can dissolve the partnership by saying dissolution, unless they have agreed to continue the partnership for a particular period of time. This is called an at-will partnership. No partner is bound to stay in a partnership.
When a partner leaves from a multiple-partner partnership that stays in-tact, it is called dissociation. Departing partner still owes the debts that are owed by the partnership unless the creditor/lender gives that partner a release or if there is a change the terms. The disassociating partner should notify the partners and the creditor to protect himself from future partnership debts.
Question: can a dissociating partner pay the creditor (a bribe?) to give him a release, or is this illegal? E.g. X, Y, and Z owe $99 to C. X disassociates. X owes C $33, and Y & Z owe $66? Does the creditor send out separate bills to X and to (Y & Z)? Can X pay C $10 for a release?
A partnership may be liable for the acts of a dissociated partner if they would have been liable when a partner and the other party reasonably believed the dissociated was still a partner.
A promoter is the one involved in the formation of a corporation. They become a promoter from the time they start talking or thinking about creating the corporation. The one who signs the articles of incorporation is then called the incorporator.
Creditors can only take assets from the corporation and not from the owners of the corporation unless they are somehow separately liable. The amount the stockholder paid for stocks is the limit of their liability. “The liability of shareholder is limited to his investment.” Creditors should not be able to get to the owners of the corporation.
A properly formed corporation is called de jure (a corporation in law). It becomes a corp when the articles of incorporation are filed with the secretary of state. There are three issues on p. 74:
Debts incurred before the corporation is formed (pre-formation Ks): promoters are personally liable for Ks made with knowledge that corp not yet formed and where 3rd party does not know. K does not automatically bind corp when formed unless corp adopts it by resolution, by act, or by failure to act.
A novation is a specific agreement between corp, promoter, and 3rd party to release promoter from personal liability.
PRACTICE POINTER: See http://ss.ca.gov for the CA secretary of state website. Click on corporations. You can check name availability here. You can also reserve a name. Prof says it’s best to do this in person because it takes too much time to do by correspondence. It costs extra to do hand-deliveries, but do it anyway because it’s worth it.
Fraudulent sale of shares by the promoter before incorporation:
Defective Corporation: a de facto corporation occurs when there is substantial compliance with the statute but still has a technical defect. Must be in good faith. CA requires typical exercise of corporate powers along with good faith.
Corporation by Estoppel: occurs when a 3rd party who deals with business, believing it to be corporation, is estopped from denying its corp status to avoid contracts.
Shareholder Liability: Shareholders have no liability if there is a de facto corporation. An outside party seeking to enforce personal liability on shareholders cannot collect if there was a good faith de facto corporation (a good faith bona fide attempt to comply).
Financing: Corporations have owners and lenders. It gets money by borrowing it from a bank or human, or it gets money from selling stock. Corps have open accounts, or accounts payable. Corps may have credit cards. Corps can borrow from the public in the form of a bond, which is a promissory note. Companies owe money to their bondholders. Bonds are known as debentures. They have a fixed interest for a fixed amount of time. Shareholders (i.e. stockholders) share in the profits of the company called dividends.
Bankruptcy: if a corp fails financially, the creditors (i.e. lenders) are paid in full before the shareholders receive anything.
Common Stock / Preferred Stock: represent an ownership interest in a company. A preferred stock costs more per share and has certain advantages. The holders of preferred stock are paid back first (before the common stock holders) if the company fails financially. There are also different classes of stock that carry different weight as to voting.
Piercing the corporate veil: the corporation is the “veil” over the human. A corporation can own another corporation. This is called parent / subsidiary.
Minton v. Cavaney: corporations will shield their owners from personal liability. A person in control of the litigation is bound by the judgment. Inadequate capitalization and actively participating in the conduct of corporate affairs is one way to pierce the corporate veil. Commingling funds may also pierce the corporate veil. You will need under-capitalization + some other factor before the veil will be pierced. To date, no publicly owned corp has had its veil pierced for lack of capitalization.
Walkovszky v.
1) they treat the assets of the corp as their own and add or withdraw capital from the corporation at will
2) when they hold themselves out as being personally liable for the debts of the corporation
3) when they provide inadequate capitalization and actively participate in the conduct of corporate affairs
Other factors include:
1) commingling funds (corporation w/ shareholders)
2) Corp funds on non-corp uses
3) Failure to maintain corp formalities
4) Personal representation that personally liable for debts of corp
5) Failure to maintain corp minutes or records
6) Identical equitable ownership in two entities
7) Failure to adequately capitalize for the reasonable risks
8) Absence of separate corp assets
9) Using a corp as a shell to do the business of another
10) Sole ownership of all stock by one individual or single family
11) Same office used by corp and shareholders
12) Same employees by corp and shareholders
13) Conceal identity of ownership in corp
14) Using the corp to assume the existing liabilities of another person or entity
There are three ways to look at piercing the corp veil: the instrumentality doctrine (corp controlled by owner), the alter-ego doctrine (corp an alter-ego of the owner), and the identity doctrine (unity of interest and ownership so that there’s no separate identity).
Equitable Subordination:
E.g. Corp A and Corp B are corps that sell widgets. X and Y own shares in A, and L and M own shares in B. When corp A issues its shares, x and y buy shares for $100,000 à $200,000 total capitalization. When corp B issues its shares, L and M each pay $10,000 for their stock, and each loan $90,000 to the corp à $200,000 total capitalization. Each corp cannot pay their creditors. Time to liquidate, and creditors get paid first. Creditors of A is paid in full, leftovers given to X and Y. Shareholders get any leftovers. There is not enough money to pay all the creditors of corp B, therefore all creditors share in proportion to the amount of their debt. A court will look at a creditor-shareholder differently than a shareholder when dealing with debt; acting in equity, outside creditors are paid first in full before the shareholder creditors are paid for their debt at all. This is called equitable subordination. Debts are subordinated to the outsider / non-shareholders.
Ultra Vires: if a corporation does something that is outside its power, it is called an ultra vires act. A complaining stockholder can enjoin a corporation’s act if it is ultra vires. The charter/articles of incorporation may give the power for the company to do what’s set out in the charter.
Courts may look to see whether something is necessary or convenient in order to declare something ultra vires. i.e. bylaws must be reasonable and germane to the purposes of the corporation. Many articles of incorporation have all-purpose clauses to get around the ultra vires problem.
Implied power: if the conduct in question was neither specifically nor generally authorized by the statement of purpose in the articles of incorporation, courts sometimes imply the power to engage in conduct that furthers the state purpose.
Question: Can a corporation put restrictions in their articles that would be unconstitutional if it were state action?
Giving away corporate property is an act that may be ultra vires. The MBCA says that a corporation may make donations.
Corporate Responsibility: ch. 5
Management of Corporations: The function of shareholders is to elect directors. The directors run and advise “the corporation.” i.e. the board of directors form the policies and point the direction of the company. Officers are employees of the company who have management duties. Examples of officers are CEO, COO, President, CFO, treasurer, VPs, etc.
Board of Directors: the shareholders cannot tell the board of directors who the board has to work with (e.g. an outside consulting firm). The board is in control of these decisions. Directors are not the agents of the shareholders. Nobody is an agent of the shareholder. The corporation is the principal that acts through the board, who then hires officers.
Writ of mandamus action is a writ to get a director to do something.
Stockholders have the power to remove directors with or without cause after following a procedure. “Cause” is something that unduly burdens a corporation.
Proxy statement:
Board members set their own compensation, which is disclosed.
Corporate Housekeeping Requirements: this is important to avoid piercing. Meetings need to be in regular intervals. Only those present can vote. Some states allow electronic presence for voting; it’s all about meeting and conferring. The board may act without a meeting if they get unanimous written consent from the board. There must be notice given for when/where meetings will be. Notice can be waived in writing.
A quorum is a majority of the members of the board, but the articles / bylaws can specify either a super-majority or a no fewer than 1/3 quorum. Once there is a quorum, a majority of those present carry the vote.
Board Committees: certain board actions cannot be delegated to committee – e.g. fill vacancies on board, or change by-laws.
Most of the authority of officers if given as apparent authority. A corporate resolution is a resolution of the board that authorizes an officer to do something.
There are three fiduciary duties for directors:
1) Duty of Care
2) Duty of Good Faith
3) Duty of Loyalty
A shareholders derivative suit occurs when one or more shareholders bring an action in the name of the corporation against the board of directors. Any judgment is paid to the corporation.
A receiver is a disinterested party that acts on behalf of a corporation that is liquidating.
In CA, directors can rely on corporate books and records so long as they act in good faith after a reasonable inquiry. If this standard is met, then there is no liability under CA law.
Misprision of office is a tort where one may be held liable if a director falls below the standard of care; there is a duty to keep informed in some detail. It is hard to prove because π has to prove that but-for improper conduct by ∆, things would not have gone wrong. Burden of proof is on π, because there is a presumption that any director has acted in the best interest of the corporation.
Business Judgment Rule: Courts will not step in unless there’s a showing of fraud, illegality, or a conflict of interest. It’s not negligent to not do something just because 19 out of 20 others do it. Judges are not business experts. The judgment of the directors of corporations enjoys the benefit of a presumption that it was formed in good faith and was designed to promote the best interest of the corporation they serve. The process employed must be either rational or employed in a good faith effort to advance corporate interests. To rebut this rule, the π has to rebut this presumption by showing break of a fiduciary duty.
Leveraged buy-outs require a corporation to borrow money in order to take over another company.
The director violates the duty of care if the director is grossly negligent. You can violate the business judgment rule by arriving at a conclusion without being informed. The board has a duty to inform the shareholders of material facts – or, all the facts germane to the issue.
Sometimes you must show exculpation by shareholders of all three fiduciary duties to exculpate a director from liability.
Duty of Loyalty:
A self-dealing transaction may be rescinded if it is unfair.
An interested director’s duty is to:
1) disclose all material facts about the transaction and his interest in the transaction, and
2) the K must be approved by a majority of the uninterested directors or
3) a majority of the shareholders.
4) ∆ then must show that the entire transaction is fair and reasonable to the corporation so it is not void.
The majority of a quorum can approve a transaction (not counting the interested director); however, in CA it still must be fair.
When directors are deadlocked and the company is in liquidation, the court will determine whether a transaction is fair to the corporation. i.e. the intrinsic fairness test. Court will look to see if there were bona fide intentions.
Corporate Opportunities - Guth v. Loft: officers and directors are not permitted to use their position of trust and confidence to further their private interest. There shall be no conflict between duty and self-interest.
The rule of corporate opportunity demands an officer or director to the utmost good faith in his relation to the corporation which he represents. The intent of the offeror is not important; what’s important is how the offer is received.
The burden of proof is on the director to prove that the offer was given to him on a personal, non-corporate basis AND that the entire transaction is fair / reasonable. Courts will look to reasonable ways for corporations to expand. A director will have to disgorge his profits if he takes a corporate opportunity.
Ask whether the opportunity is within the current scope of the corporate operations (line of business test). Then ask if the opportunity was offered to the officer personally (but-for president?).
There is also a “complimentary business” test; A fundamental fairness test; the line of business + fundamentally fair test; full disclosure test; interest or expectancy test (corp may have K rights)
Using employees of the corporation to investigate a personal business opportunity is bad.
Competition and the Duty of Loyalty: officers of a corp are not, by reason of the fiduciary relationship, necessarily precluded from entering into a business competition with the corp, but they must act in good faith.
While you’re still on payroll, you have the duty of loyalty. You can’t steal all your corporation’s clients and start a new company without breaching your duty of loyalty. The duty not to compete ends when you’re no longer employed unless there’s a valid non-competition agreement. Customer lists, stealing clients, are all big no-nos.
At some point compensation can be so big as to constitute corporate waste.
Shareholder Suffrage: majority control is 35% or more of company stock; management control is usually 5-10%; minority control holds between 10-35%.
A ballot, where shareholders vote, is a proxy.
Voting: unless the articles of incorporation state otherwise, a plurality wins. A plurality means that if there are 8 positions open, and 10 people are running for the position, then the highest 8 people get the job. Formula = vote * shares * (seats to be elected)
Straight Voting: determines how many votes any given shareholder has. It is one vote for every share owned for each position. E.g. one vote for position A, B, etc….
Cumulative Voting: helps minority shareholders elect people to the board. The point is to make it possible for minority shareholders to elect somebody to the board. It allows you to vote all of your share votes on whoever they want. Not limited to one-to-one straight voting.
A bond is a promissory note – a loan with a promise to pay interest. The U.S. Gov’t issues treasury bonds in which the gov’t borrows money. Bonds have a principal amount and it has interest. You can buy them directly from the gov’t online. These are supposed to be very safe investments. Bonds get rated as to their safety by groups such as “Moodys” and “Standard & Poors.” AAA is top-rated. BBB is “good luck getting your money back.” These are based on credit ratings. Because interest rates fluctuate Paying for more than face value on a bond is called a premium. Less than the face is at a discount. TIPS bonds are inflation-protected bonds. Bearer bonds are anonymous bonds.
Closely held corporations (i.e. close corporations): there are heightened fiduciary duties in closely held corporations. A closely held corporation is typified by:
1) a small number of stockholders (in CA < 35)
2) No ready market for the corporate stock
3) Substantial majority of stockholder participation in the management, direction, and operations of the corporation.
The shareholder agreement determines what happens insofar as whether a close corporation. Shareholder ratification can also be an exception to the heightened fiduciary duties to minority shareholders.
Liquidation may be reasonably necessary for the protection of rights or interests of the complaining shareholder.
It’s not easy to change – it requires a 2/3 vote – unless the articles provide for less; but at least a majority must vote to change from a closely held corporation to a general corporation.
In a close corporation, there is a special duty to a minority shareholder.
A freeze-out causes the minority to sell out at an unfairly low price to the majority. There is no open market for the shares in a closely held corporation. If the majority offers to buy stock from the majority, it must also offer to buy from the minority. Otherwise it is a preferential transfer of corporate assets.
Reasonableness is an objective standard, but each case is decided case-by-case. In order for liquidation to occur, it must be reasonably necessary to protect interests.
A company may order dissolution if it is necessary to protect rights and interests. Alternatives to dissolution include: 1) Buyout, 2) Arbitration, 3) Provisional directors appointed to break deadlock, 4) Custodian appointed to run business, 5) Receiver appointed to liquidate.
Courts are very reluctant to deal with employment issues of hiring and firing; courts are also reluctant to payment of dividends.
Owning minority stock in a close corporation is not that great an asset.
If the court is supposed to interfere with internal affairs, the court must look at:
Reasonable Expectations (of complaining shareholder)
Voting agreements can completely eliminate the board of directors, how dividends will be paid, who will be officers/directors, and how they’re selected. The agreement has to be either in the articles/bylaws, or written and signed by all the shareholders and filed with the corporation. Any amendment has to be made unanimously unless the agreement states otherwise. An agreement can restrict the transfer of sales for any reasonable purpose. E.g. it can restrict the shares from being sold if it would no longer make it a close corporation.
The right of first refusal says that shares must be first offered to the corporation or other shareholders on the same terms and conditions.
Proxies are always revocable, unless there is an intent for it to be irrevocable, or if there is a proxy coupled with an interest.
The test for a voting trust is (all elements are required):
1) the voting rights of the stock are separated from the other attributes of ownership
2) the voting rights granted are intended to be irrevocable for a definite period of time
3) the principal purpose of the grant of voting rights is to acquire voting control of the corp
Restrictions on transfers: one way to restrict transfer is with an Option. An option says that shareholders have the option to purchase other stock at a specified price before it may be sold to a 3rd party or if someone leaves/dies. An option to purchase is where one party decides whether to buy another party’s stock, which is triggered by some event. A right of first refusal is different, in that sales of stock must first be offered (with the same terms) to the one who holds the right of first refusal. Consent restraints are the most restrictive (and most disfavored) which requires the approval of other shareholders before the stock may be sold. In CA, you are allowed to have reasonable restrictions on transfers of shares. Restrictions must be noted on the actual stock certificate to be valid. Treasury shares are shares that have been bought back by the corporation.
If the situation involves a death or divorce, then the court may say this is not a transfer restriction – it is a transfer by operation of law.
DUTIES OF CONTROLLING
SHAREHOLDERS
Fiduciary Duties of Controlling Shareholders: the traditional view is that a regular shareholder may act in his own self-interest. However, a controlling shareholder may owe a duty to a minority shareholder. The intrinsic fairness test says that the burden is on the ∆ to prove the intrinsic fairness to the minority shareholder of a self-dealing transaction by the controlling shareholder -- is not controversial and generally represents the law elsewhere.
Calling the shares is the same thing as redeeming the shares – the shareholder must sell back to the corporation (plus dividends). i.e. a security that is callable means that the corp may purchase or redeem the security from the holder at the corp’s option for a specified price (take-backs).
Majority shareholders have a fiduciary duty to the minority, judged by the intrinsic fairness rule.
Convertible securities are where bonds can be converted into stock.
Warrants are an option of a specified time duration that entitles the holder an option to purchase a security of the corp at a specified price, which is usually above the existing market price.
Where control of the corp is material, the rule of good faith and inherent fairness to the minority is the duty owed by the controlling shareholders.
Dow Jones is a company – a financial company. See http://www.motleyfool.com to learn more. See also http://www.etrade.com
Is it permissible for shareholder to receive a premium above the market price for selling a controlling block of stock. The only exceptions are sales to a looter, sales of a corporate office, and sales of corporate assets.
It’s illegal for officers and directors to loot the corporation’s treasury; the penalty is personal responsibility for any losses.
It’s ok to pay a premium for control. Look at for what happens after the sale on part of the buyers. If they liquidate or loot the company, this is bad. It’s also improper if the premium was paid for the purpose of getting the board of directors to resign.
A K for the sale of a directorship is an illegal K. However, you can pay more if a company is under priced. Management of a corp is not the subject of trade and cannot be bought apart from actual stock control.
Once disloyalty has been established, a fiduciary must not profit personally from his conduct, and the beneficiary must not be harmed by the conduct.
Corporate Asset Theory of Control: the premium above the per share market price that the seller realizes in return for a controlling block of stock is a corporate asset because it arises out of the ability which the holder has to dominate property which in equity belongs to others. The premium should then go to the corporate treasury.
Big Picture: the SEC was created to protect the shareholder public, increase the public’s trust in American corporations, and to promote disclosure.
Publicly Traded Stocks & SEC Regulation: publicly traded stock are available to the general public.
The rules promulgated by the SEC are called Rules, which are passed by Congress.
Section 14 is about Proxy regulations. Proxies are about shareholder votes. There are four aspects of section 14:
1) Full and fair disclosure of all material facts with regard to any management submitted proposals
2) Prohibits material misstatements, omissions, and fraud in connection with the solicitation of proxies
3) Management must submit shareholder proposals and allow proponents to explain their position in the face of any management opposition.
4) Mandates full disclosure in proxy materials that come from non-management.
NOBO lists are lists of shareholders given by brokerages to the company of the said shareholders so that companies can know who holds shares of the company. A court may require NOBO list to be compiled for other shareholders, depending on the state’s law; If the corp already has a compiled list, it must turn it over.
Solicitation: any request for a proxy (vote) whether or not accompanied by or included in a form of any request to execute or to revoke a proxy; and furnishing any communication to security holders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy. i.e. any time you try to change a shareholder’s mind on a vote, it is a solicitation.
“The question in every case is whether the challenged communication, seen in the totality of the circumstances, is ‘reasonably calculated’ to influence the shareholders’ votes.”
A statement by a person who does not otherwise engage in a proxy solicitation stating how that individual will vote is exempted if the statement is made by means of speeches in public forums, press releases, publications or broadcast opinions, statements, advertisements appearing in a broadcast media, or newspaper, magazine or other bona fide publication disseminated on a regular basis.
If something falls in the category of a solicitation, then one must file with the SEC and any false or misleading statements are subject to criminal penalties.
Proxy solicitations must include: date, time, place of meeting; deadlines; revocability; name of solicitor.
Shareholder Proposals: if a shareholder gives notice to management of a proposal before a meeting, management must include the proposal in its proxy statement and let shareholders vote for or against it in the management’s proxy.
If a proposal is significantly related to the business, it must be included in the proxy statement.
There are 13 reasons that permit management to exclude a proposal from a proxy statement:
1) Impropriety under corporate law
2) Violation of law generally
3) Contrary to SEC proxy rules
4) Redress of a personal claim or grievance
5) (Non)Relevance
6) Beyond the company’s power to effectuate
7) Ordinary business operations (relates to day-to-day management decisions)
8) Relating to election to office
9) Contradicting management proposals
10) Mootness (already been done)
11) Duplication (already on the statement)
12) Resubmissions
13) Dividends (Specific dividends improper)
FRAUD CLAIMS UNDER
THE FEDERAL SECURITIES LAWS
SEC Rule 10(b) makes it unlawful for any person to use the mail in interstate commerce to be deceitful in regards to securities.
10b5 makes it unlawful to (1) employ any device, scheme or artifice to defraud; (2) to make an untrue statement of material fact or to omit a material fact; or (3) to commit fraud or deceit upon any person. These are only illegal if made in connection with the purchase or sale of any security.
These rules can be used by the SEC as enforcement against a person, to prosecute as criminal or as civil, or to use to provide help for harm to individual victims as a private right of action. 10b5 applies to everyone – no exceptions (closely held, big corps, etc).
There are private remedies for securities fraud (under theories of negligence per se). One can get damages and/or an injunction, and this is called a “private right of action.”
Every violation must be about something material. This determination is on a case-by-case basis. An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote.
The “Materiality” Requirement: For a merger, analyze (probability of occurrence) * (magnitude) to calculate materiality. To find probability of occurrence, look to interest in the transaction at the highest corporate levels (e.g. in board resolutions instructions to investment bankers, and actual negotiations). Magnitude should consider the size of the two corporate entities, and potential premiums over market value. Look to effects on the reasonable investor.
The “In Connection With” Requirement: “in connection with” does not apply to someone who does not buy due to a materially misleading statement. 10b5 Actions are limited to actual purchasers and sellers. In shareholder derivative suits, the purchaser/seller standing is satisfied if the corp is a purchaser or seller of securities.
The “Scienter” Requirement: if there is no scienter – an intent to deceive, manipulate, or defraud – then there is no private cause of action for damages. Mere negligence is not enough to aid and abet a violation of 10b5. One can be held civilly liable for reckless omission of material facts upon which the π put justifiable reliance.
The “Deception” Requirement: in order for there to be liability under 10b5, there must be a deception.
“Congress by 10-b did not seek to regulate transactions
which constitute no more than internal corporate mismanagement.”
The “Causation” Requirement: there are two kinds of causation that must both be shown by π:
1) transaction causation (fraud/misstatement/omission causing shareholder to enter transaction to buy/sell) and,
2) loss causation (the transaction caused the loss to the π; it does not have to be an exclusive cause, but can be a significant contributing factor to the loss).
Where there has been a finding of materiality, a shareholder has made a sufficient showing of causal relationship between the violation and the injury for which he seeks redress if he proves that the proxy solicitation itself, rather than the particular defect, was an essential link in the accomplishment of the transaction. If materiality is found, then there is per se loss causation.
The “Reliance” Requirement: π does not have to show direct reliance on misinformation because there is a presumption of reliance in nondisclosure cases brought under SEC Rule 10b-5. The fraud-on-the-market theory prevents material misstatements that affect the open market. One can rebut a reliance presumption by showing that 1) misrepresentation did not lead to a distortion of price or 2) the π would have traded despite knowing the statement was false. Reliance must be reasonable.
Short form merger: 90% or more majority shareholder does not need to vote in order to do a merger with a subsidiary. However, after the merger takes place, the majority must still notify the minority of the merger.
Projections: projections are guesses based on facts. Safe Harbor Rules are rules that describe behavior that does not create liability. There is no liability for projections of revenues, income or loss, earnings or loss per share, financial items (dividends), management plans and objectives, and projections of future economic performance made in good faith. SEC encourages projections. There is a duty to correct material errors in projections.
A stock analyst collects information for its investors. The analyst always tries to get more information than anyone else has. If a company entangles itself in a false projection made by a 3rd party analyst, then this could subject the company to liability (duty to correct error). If uninvolved with a statement of fact, then there’s no duty to correct.
Bespeak caution: e.g. “No guarantee” may protect from liability by making a misstatement immaterial. A bespeaks caution must be substantive statement (directly address the material issue), and tailored to the specific future projections. i.e. a blanket disclaimer will not do it.
Look at statement to determine 1) materiality (reasonable shareholder finds important), 2) fact or opinion/belief. There is liability if an opinion is untrue and that the one making the statement of opinion doesn’t believe it. There’s no liability for true statements. Recklessness is an open question (undecided).
Selective Disclosure: “regulation FD” says that whenever “an issuer, or any person acting on its behalf, discloses material nonpublic information to any other person outside the issuer, the issuer must simultaneously or promptly make public disclosures of that same information. i.e. once disclosed, disclose to everyone simultaneously. i.e. FD is all about “fair disclosure.”
Secondary Liability under 10b-5: SEC can prosecute aiders and abetters if they knowing provide assistance to another person in violation of the Act, but there is no private right of action. E.g. of aiders and abetters are accountants, lawyers, or anyone else drawing up the projections.
Statute of Limitations: π must sue within 2 years of discovery of the violation, or 5 years from the date of violation itself.
Summary:
A proxy is a request by management for a vote. Full and fair disclosure of all material facts is required in all management proposals. Material misstatements, omissions, and fraud are prohibited. Shareholders also have to give full disclosure in their proposals. Solicitations are any requests for a proxy. If it is a solicitation, it must be filed with the SEC. False or misleading statements in a solicitation is criminal, and can result in criminal penalties.
What’s required in proxy solicitations? Dates, deadlines for shareholder proposals; revocability of proxies; who is soliciting; who is paying the cost; nominees relationship to the corp and their interest in the corp; a proxy solicitation has to include the record date (the date when shareholders can vote, and nobody else); whether cumulative voting; senior management compensation & method of arriving at; company’s annual report (specifying earning, financial prospects, etc).
Shareholder proxy proposals: under rule 14, if the shareholder gives timely notice of an intent to make a proposal at a meeting, then in the proxy statement, management has to include the proposal itself, and some way to vote for or against it. Investor must have at least $2,000 or 1% of corp securities in order to have their proposal at the meeting.
INSIDER TRADING
Overview: officers, directors, or 10% shareholders must report to the SEC as soon as there is any change in ownership. Violation of rule 16(a) is a crime, but there is no private right of action for violations.
Insider Trading at Common Law: at common law, the purchaser of an article is under no obligation to disclose facts unknown to the opposite party that may affect the value of the property. Even though there is no common law duty to make an affirmative disclosure, the parties may not make misrepresentations. Insofar as securities,
Officer: it is the actual functions of an employee – particularly his access to inside information – and not his corporate title that determine whether he is an officer within the purview of 16(b). Merely having the title of vice-president does not necessarily make on an officer. An officer is anyone with policy-making functions.
Deputization Theory: is when a person is authorized to act in place of another. A deputy is an agent authorized to act on behalf of the principle, which can bring someone into the scope of 16(b) as a director. Once a director, you have to follow the reporting rules of 16(b). If one ceases to be a director/officer, he has to report any transactions that follows 6 months after the last transaction he had before his resignation.
16(b) is a strict liability statute, and the ∆ has to give back to the corporation any profit that was a result of a purchase or sale of stock within a 6 month period (disgorgement of short swing profits). This person need show no actual inside information or scienter in order to be found liable.
Short Swing Profits: profits made by insider through buying and selling of shares within a 6-month period. Prohibited by SEC rules and is enforced by private shareholder actions.
Short Sales: 16(c) prohibits short sales. A short sale is a transaction in which stock is sold without owning it.
Insider Trading as Fraud: must be:
1) nonpublic
2) material (reasonable likelihood that a reasonable shareholder would find important)
3) obtained from a special relationship with the company
4) connected to a purchase/sale of a security
10b-5 is applicable to a defrauded buyer, and there is no face-to-face requirement. Therefore, any sales by an insider must await disclosure of the information (to the public).
Disclose or abstain from trading. Mandatory Disclose means that an insider is under a duty to disclose material, non-public information pertaining to the securities being transferred.
Not even insiders, but other people who have inside information can be liable under 10b-5 (these are called tipees).
The relationship between an insider and shareholders gives rise to a duty to disclose or abstain from trading because of the necessity of preventing a corporate insider from taking unfair advantage of uninformed stockholders. This applies to any fiduciary, or fiduciary-like relationship, with a corp.
Misappropriation: because trading on misappropriated information undermines the integrity of, and investor confidence in, the securities markets, it is forbidden under 10(b) on deception grounds. Confidential information is property, and taking it is akin to embezzlement. It hurts both the source of the information and members of the investing public.
Look to 1) whether there is a special fiduciary relationship, then 2) whether info was misappropriated
MERGERS AND
ACQUISITIONS
Reasons to Merge: synergy is a big reason to merge. Mergers are a fundamental change to a corporation. Shareholders vote on fundamental changes. Mergers must be approved by a majority of the shareholders of each corporation.
CA Rule: in CA, these are called reorganizations. There are 1) mergers, 2) exchange-reorganization (this is same as share acquisition), and 3) sale-of-assets reorganization.
Short form merger: if parent owns 90% of subsidiary, then no shareholder approval is required for merger (no notice to shareholders is required before the merger – only after it takes place).
Successor Liability in a de facto Merger: There is successor liability when a merger occurs; but usually not when merely a sale of assets. Ff there is a sale of assets, the buyer is not liable for the sellers debts unless:
1) express or implied agreement to assume obligations
2) done only to eliminate liabilities (fraud)
3) De facto merger
FAIRNESS IS CORPORATE
COMBINATIONS –
APPRAISAL RIGHTS AND
JUDICIAL CONTROLS
General rule: if a shareholder disapproves of a fundamental change, then this doesn’t mean that the shareholder can stop it from happening, but he is entitled to compel the corporation to buy his shares at a fair value. These rights are called appraisal rights.
Exceptions to
Appraisal Rights:
1) market-out
exception – if share listed on a national exchange, then you have to
sell on the public market
There is a right to vote on pending fundamental changes. Notice must be given. Short-form mergers require notice after it takes place. Shareholder has to give notice of dissent. The corp then says how much the corp will pay for the shares. Rights to dividends then cease. Shareholder can then specify a different price for the shares. Corp then pays the price, or files in court.
APPRAISAL RIGHTS – FAIR VALUE: fair market value is determined by how much a willing buyer and a willing seller will sell for on the open market.
To calculate a fair value, value the company as a whole, then take the % that the dissenter’s own, and then pay them.
FEDERAL AND STATE
TAKEOVER AND TENDER OFFER LAWS
Overview: in a takeover, the buyers go directly to the shareholders and offer to buy their shares (usually for a premium over the market price). This is called a tender offer. A tender offer means offering a price to the shareholders in return for their stock. A company can also offer to buy back shares from its shareholders – this is called a tender offer too. Both Federal law and State law governs tender offers.
Federal Law: the Williams Act says that anyone who acquires more than 5% of any class of equity ownership (i.e. non-bonds), you have to file with the SEC and the filing calls for 1) the person’s background, 2) the source of funds, 3) any plans for major changes in the target company, 4) relations with others concerning the target.
Typical Tender Offer: a letter comes in the mail to all the stockholders as an offer for the shares. This must go to all stockholders. It will usually say that the buyer will pay cash for all outstanding shares in target company. The same price has to be offered to everyone. There is usually a revocation clause where the buyer may revoke the offer & return the shares if less than X shares are tendered. The shareholder (seller) has a right to withdrawal the tendered offer (in case someone else makes a better offer).
Poison Pill: one of the most popular defensive tactics to a hostile takeover,
Disclosure by tender
offeror: if the purchase would result in more than 5% ownership, a tender
offeror must disclose the information in addition to the purpose of the tender
offer and his plans for the target. (Rule § 14(d)). This is a Federal law that applies to
companies across the
State Regulation of Tender Offers: so long as legislation does not (1) alter the Williams Act’s basic neutrality between tender offerors and target management, or (2) impose burdens that conflict with the Williams Act regulations, the state statute can survive
DERIVATIVE ACTIONS
AND INDEMNIFICATION OF OFFICERS AND DIRECTORS
Derivative Action: when the shareholder sues on behalf of the corporation being harmed. There is a pre-condition that the directors refuse to act after a suitable demand (unless the demand would be futile). There is also a standing requirement in which the complainant must have been a shareholder at the time of the wrong (with the exception of by operation of law – inheritance).
Attorney’s Fees: one can get reimbursed for attorney fees if one wins. Most places have a bond requirement for the π to post in case the π loses.
Derivative vs. Personal Actions: ask 1) who suffered more direct and immediate damage?, 2) where/who did the duty run to?
Standing Requirements: if brought in Fed ct, must be a stockholder at time of wrong. Must allege efforts to get board of directors to act (unless futile). One way to get rid of a derivative suit is to say that the π is not an adequate representative of the shareholders (a personal vendetta).
Demand Requirement: requires the shareholder to tell the company to bring the lawsuit first (unless futile).
Indemnification: There is a duty not to commit an illegal act, and doing so means that the business judgment rule is no shield. Cannot be indemnified if liable to the corporation. For indemnification, one must 1) act in good faith, 2) not unlawful, and 3) reasonably believed in best interest to the corp – then you can get permissive indemnification. The wrong has to have been done to an outside party – cannot get covered if wrong done to the corp. There has to be an agency relationship in order for there to be indemnification. Indemnification agreements for claims arising from SEC violations conflict with public policy. There must not be indemnification if the person benefited improperly from bad conduct.
Sarbanes-Oxley Act of 2002: applies to companies traded on the national securities exchange, or have at least 500 record shareholders and more than 10 million in assets.
Accounting companies that do audits of these companies have to register; only registered firms can audit publicly trade companies. There is an increased duty of the board of directors in publicly traded companies. There must be an audit committee; its members must have no connection to the company – making them completely disinterested directors. The audit committee oversees the accounting firm that audits the corps books. Auditors uncover any fraud or theft that is going on. It establishes procedures for whistleblowers. See Barbri pp. 66-68.
Attorneys who appear & practice before the SEC are subject to SOX rules. Also, dealing with Federal securities will also subject an attorney to SOX requirements. The lawyer has to be providing legal services to an issuer where there is an attorney-client relationship (even to a subsidiary).
Lawyers have an obligation to report material violations “up the ladder” (to chief legal officer, or to both the CLO and the CEO). When a report comes in, the CLO/CEO has a big duty to conduct a reasonable investigation to determine whether there is any wrongdoing. If the CLO/CEO concludes that there was a material violation, they must take reasonable steps to make sure that the corp takes remedial measures. The CLO then has to report up the ladder as to what took place. If there is no material violation, then this should be reported back to the person who reported the violation.
QLCC: qualified legal compliance committees looks into allegations of wrongdoing. If no response, then attorney may report out to the SEC confidential information that the attorney believes reasonably necessary to prevent material violations or to rectify the consequences of a material violation.
Calbar.org has old exam questions and answers.