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LLM Law Outlines > Corporation Outlines

Management Powers And Duties Outline

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This is an extract of our Management Powers And Duties document, which we sell as part of our Corporation Outlines collection written by the top tier of NYU School Of Law students.

The following is a more accessble plain text extract of the PDF sample above, taken from our Corporation Outlines. Due to the challenges of extracting text from PDFs, it will have odd formatting:

A. The Business Judgment Rule

Basic Power Structure:

  • director runs co.,

  • directors owes duties to shareholders in the manner they run the co.

  • shareholders elects directors and approve major changes of co.

Conceptual Framework

  • Agency Costs (of Equity) Paradigm

  • Conflicts of Interests: how divergent and how important

    • Financial

    • Effort

    • Job Retention

    • Profitability versus other goals (growth?)

    • Compensation

  • Potential Constraints on Conflict

    • Voting (shareholders or elected board)

    • Fiduciary Duties (court)

  • Are constraints effective? For which conflicts? Do they have downsides?

Agency Costs of Equity

  • Shareholders and directors/managers creates agency costs of equity: managers may pursue their own personal interests, and which may be bad for the shareholders

  • Constrains effective?

  • E.g. Andrea, a CEO/ chairperson of a company would rather

    • Rest than to work long

    • Raise her own salary

    • Sell real-estate to co. owned by his brother

    • Promote people she prefers

    • oppose a group of shareholders who run against Andrea for election to XYZ's board of directors

    • approve of a charter amendment making directors removable only for cause

    • have XYZ sell stock of Alpha Inc. which have a (historic) book value of $5 million, but a market value of $7.5 million

    • not to have XYZ sell stock of Beta Inc. which have a (historic) book value of $5 million, but a market value of only $2.5 million

  • How would any of the following factors affect the degree of conflict and/or Andrea's inclination to pursue her own, rather than XYZ's shareholders', interests?

    • Andrea owns no stock of XYZ

    • Andrea owns 50% of the stock of XYZ

    • XYZ has no large shareholder

  • Bill (who is unrelated to Andrea) owns 51% of XYZ's stock.

  • The other two directors of XYZ are personal friends of Andrea.

  • The other two directors of XYZ are CEO's of large companies.

  • The other two directors of XYZ are personal friends of Bill (from 4 above).

  • The other two directors of XYZ are XYZ's outside legal counsel and the dean of a law school to which XYZ makes major contributions.

  • XYZ is in sound financial shape.

  • XYZ is close to insolvency.

  • XYZ has two classes of common stock. Voting class A stock, all of which are held by Andrea and non-voting class B stock held by all other shareholders. (In all other aspects, the two classes are identical.)

The Business Judgement Rule, Fiduciary Duties, and Shareholder Suits

  • Elements: If the decision by board is

    1. Disinterested,

      • No conflict of interest

      • Court categories conflict of interest into categories, some are categorized as no conflict of interest

    2. Independent,

      • Directors were not dependent on somebody else who have a conflict of interest, linked to disinterested (no other person who you are dependent on, who had a conflict of interest)

    3. Informed, and

    4. [Good faith]

      • Did not used to be an independent element, now starting to develop and still revolving

Court would not intervene such decision

  • Not required: intelligent

    • Going to court and arguing that board made a “stupid” decision that resulted in big losses does not get you anywhere.

  • Court uses business judgment rule in 3 different meanings, depending on the context

    1. Evidentiary presumption (burden of proof on P) Cinerama

      • ‘Independent’ not mentioned, but doesn’t matter

      • Cinerama: The rule is a rebuttable presumption that directors … acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith. A party challenging a board of directors' decision bears the burden of rebutting the presumption that the decision was a proper exercise of the business judgment of the board.

    2. Substantive decision rule to certain claims for breach of fiduciary duty courts will not pay much attention to [core meaning] if not rebutted court should not interfere

      • Gries: If the directors are entitled to the protection of the rule, then the courts should not interfere with or second-guess their decisions.

      • Cinemara: If a shareholder plaintiff fails to [rebut the BJR presumptions], the business-judgment rule attaches to protect corporate officers and directors and the decisions they make, and our courts will not second-guess these business judgments.

      • Caveat: For claims other than claims for breach of fiduciary, one does not need to rebut BJR presumptions. Examples

        • Company declared dividend and paid everyone but me.

        • Company did not hold annual meeting when required.

        • “Waste”

    3. Characterization of the legal conclusion that P loses (without the court substantively reviewing the fairness of the board decision) even though P did rebut the presumptions of the Business Judgment Rule

      • No substantive review = no assessment of the fairness of the transaction

  • What happen if the Business Judgment Rule is rebutted?

  • Complicated, Topic of Many More Classes

  • Generally: Court will make further inquiries as to whether there was a breach of fiduciary duty.

    • Gries: If a director fails to pass muster as to any one of these three, he is not entitled to the business judgment presumption. This does not mean that the director's decision is necessarily wrong; it only removes the protection provided by the business judgment presumption.

  • If (merely) “uninformed”, generally inquiry as to whether there was a breach of duty of care.

  • If interested/ independent is rebutted, inquiry as to whether there was breach of duty of loyalty.

  • Complications: “informed” considerations are often also relevant when some directors were interested and others are disinterested.

  • Complications: what about breach “good faith” complicated

  • This doctrine is guidance of judges’ preferred outcome, reflection of what the court think is right

    1. Unlike normal doctrine, which imposes constrain on the judges’ judgment judges had to follow what doctrine tells them to

  • Substantively – issue of whether board is informed

  • Fiduciary duty owed by directors and officers

  • Shareholders are the parties who benefit from and seek to enforce fiduciary duty

  • Court should take care to define and enforce fiduciary duties, so directors retains discretion in managing the company

  • Business judgment rule: insulate the board from shareholders suits

    • Defines broad set of circumstances which court will refuse to doubt the board’s decisions, so is to protect directors’ decisions from shareholder’s attack

    • If decision falls outside the business judgment rule, court will examine the actions of directors more closely to determine whether there has been a breach of fiduciary duties

  • Shareholder derivative action or shareholder class action

    • Public corp. often have thousands/ ten thousands of shareholders

    • Will have no incentive to bear the costs of brining suit to enforce the fiduciary duties of officers and directors – since single shareholder gain only a tiny fraction of the benefit from a meritorious suit

    • Most non-US jurisdictions doesn’t allow class actions

    • Shareholders in the US can recover generous compensation for legal costs (if their suits succeed) by framing their suits as

      • shareholder derivative actions: suits brought on behalf of the corp., or

      • shareholder class actions

    • Hence, small shareholders in the US has powerful incentives to bring suit, despite the business judgment rule.

  • Typical definition of the common law Business Judgment Rule

    • Gries Sports Enterprises, Inc. v. Cleveland Browns Football Co.

      • A shield to protect directors from liability for their decisions

      • court should not interfere their decisions if directors are entitled to its protection.

      • But if director is not entitled to such protection, court would scrutinize the decisions as to its intrinsic fairness to the co. and co.’s minority shareholders

      • The rule is a rebuttable presumption: directors are better equipped than the courts to make business judgments + directors acted without self-dealing or personal interest and exercised reasonable diligence and acted with good faith.

      • burden of rebutting lies on the party challenging the board’s decision, to prove that the board’s decision was not a proper exercise of business judgment

      • Shareholders, in a derivative action, challenging the fairness of a transaction approved by a majority of directors of a corporation, a director must be

        • (1) disinterested,

        • (2) independent and

        • (3) informed in order to claim the benefit of the business judgment rule.

      • If any of these 3 is not satisfied, the director is not entitled to the business judgment presumption

        • protection of the business judgment decision presumption would be removed

        • (but doesn’t mean its decision is wrong/ director becoming personally liable)

        • court must then inquire into the fairness of the director’s decision

    • Cinerama, Inc. v. Technicolor, Inc. The business judgment rule operates as

      1. a procedural guide for litigants

        • a rule of evidence that places the initial burden of proof on P

        • In Cede II Court described the rule's evidentiary, or procedural, operation as follows

          • If a shareholder P fails to meet this evidentiary burden, the rule protects the corporate officers/ directors and their decisions – court would not second guess their business judgments

          • If rule is rebutted, burden shift to D directors to prove the entire fairness of the transaction to the shareholder P yet it doesn’t create per se liability on directors but a “procedure which the Delaware courts of equity determine under what standards of review director liability is to be judged”

          • Weinberger v. UOP: the entire fairness standard requires the board of directors to establish "to the court's satisfaction that the transaction was the product of:

            1. fair dealing: when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were
              obtained; and

            2. fair price: economic and financial considerations of the
              proposed merger, including all relevant factors: assets, market value, earnings, future prospects,
              and any other elements that affect the intrinsic or inherent value of a company's stock

            • All aspects of the issue must be examined as a whole since the question is one of entire fairness

      2. a substantive rule of law

        • Even if the procedural presumption has been rebutted, it does not necessary mean that substantive liability would be established

        • Burden of proof on the Board to demonstrate entire fairness by presenting evidence of the cumulative manner, by which it otherwise discharged all of its fiduciary duties

        • Weinberger stresses on whether the director disclosed to shareholders all material facts bearing upon a vote.

        • In Delaware, the law/ policy have evolved into a virtual per se rule of awarding damages for breach of the fiduciary of disclosure

B. The Duty of Care

Graham v Allis-Chalmers Manufacturing Co. (1963)

  • P argued that the Board violated its duty of care in permitting the co. to engage in anti-trust violations P losses Board not involved in the violation: D not liable as a matter of law merely because, unknown to them, some employees of Allis-Chalmers violated the anti-trust laws thus subjecting the corporation to loss

  • Board has 11 meetings a year, each for several hours – but AC is a big corp.: 31k employees, 24 plants, decentralized management

  • Large publically traded co. are ran by the Board – the hours they meet do not permit directors to have deep knowledge of the company [normal: low standard of being informed]

  • 5 board members are part of management [nowadays usually only 2/10 directors] “inside directors” – work every day; “outside directors” – only once a month to attend Board meeting

  • P alleged that Not sufficiently informed about what is going on in the company violation of duty of care (should have paid more attention)

  • Duty imposed on directors personally Director may protect themselves by:

    • Put in more process to reduce liability

      • e.g. by hiring antitrust monitors costs co. the money

        • Don’t do enough directors pay

        • Do enough [hiring monitors] co. pays increase cost

    • Hold more meetings

      • e.g. enough to know what is going on in the co.

      • But vague + more time = more compensation for directors = co. spend more $

      • [for outside directors, as inside directors are already working everyday]

      • Outside directors would then become inside directors.

      • But if we want outside directors, who are more detached, maintain on Board usually bring outsider perspective to the situation and monitor the inside directors

      • More meetings imposing more burden/time/compensation on outside directors eliminating the role of outside directors, who would become CEOs/ inside directors

    • [Provide insurance – but absurd since director hurts the co. insurance pay the company but co. paid insurance]

  • Shareholders would want the co. to make profit, and would not care about antitrust

    • Penalized the company to compensate gov and victim

    • Penalized the specific individuals who violate the antitrust law: $ to gov or victim/ prison

  • Supplementary mechanism: Penalize the board by failing to monitor antitrust make them to give money to shareholders

    • But shareholders are the ones paying money to victim/ gov

    • If the shareholders would receive money because co. is violating antitrust law would defeat the purpose of the antitrust law

    • Co. violates antitrust law to make money for shareholders shareholders were the one who would benefit from antitrust breach [they are not victims of the violation] should not be rewarded

    • Would not work for private companies

  • Co. doesn’t violate the antitrust law (since it is not a human being), it is the management/ employees who violate the law

    • Management violate the law for the company (which benefit shareholders)

      • But management can also get additional compensation form company through right incentives [Management should not get this additional $]

      • It would benefits shareholders and hurt other people in the market place

    • Management can steal money from company, if unsanctioned

      • it would benefit the managers and hurt the shareholders

      • violating antitrust law is doesn’t harm the shareholder should not allow shareholders to benefit from that

      • Directors are not in breach of their fiduciary duty violating antitrust law

    • Company $ to gov/ victim

    • Individual $ to victim/ gov/ imprisonment

  • Derivative action on behalf of Allis-Chalmers against its directors and 4 non-director employees

    • Complaint based on 8 indictments charged violation (including the co. and its directors) of the Federal anti-trust laws

    • Suit seeks to recover damages which AC claimed to have suffered by reason of these violations

    • P alleges D directors had actual knowledge (or knowledge of facts which should have put them on notice) of the anti-trust conduct

    • But no evidence that any director had any actual knowledge of the anti-trust activity, nor should have notice that anti-trust activity was being carried on by some of their co.’s employees

    • Ps then shifted into arguing that D are liable as a matter of law, by reason of their failure to take action to learn and prevent anti-trust activity on the part of any employees of AC

  • AC is a large manufacturer of variety of electric equipment.

    • Operating policy is to decentralize by delegating authority to lowest possible management level capable.

    • Price set by particular department manager, but general manager of the division set prices for product that is large and special.

    • Products of repetitive manufacturing process are sold out of a price list, established by a price leader for the electrical equipment industry as a whole

    • The board conduct annual review on profit goals budget, and sometimes consider general questions on price levels (but doesn’t participate in decisions fixing the prices of specific products

  • Indictment which AC and 4 non-director Ds pled guilty charge that the co. and individual non-director Ds, conspired with other manufacturers and their employees to fix prices and to rig bids to private electric utilities and governmental agencies, in violation of the US anti-trust law

    • None of the directors were named as D in the indictment – Federal Gov acknowledged there is no probative evidence that could lead to the conviction of the directors

    • First actual knowledge of the directors had of anti-trust violation by co.’s employees was from newspaper in 1959 in 1960, the boar issued a policy statement to eliminate possibility of further/future violations of the antitrust laws

    • P argue that 1937 FTC decrees should have put directors on notice of their duty to prevent antitrust problems

    • But none of the director Ds were director in 1937. Though 3 of the Ds later learned of the decree, all 3 satisfied themselves that AC had not engaged in antitrust violation + consented to the decree merely to avoid expense and necessity of defending co.’s position

    • knowledge by 3 of the directors that in 1937, the co. had consented to the entry of decree enjoining it from doing something they had satisfied themselves it had never done, did not put the Board on notice of the possibility of future illegal price fixing

    • P failed to establish that the Board had actual/ imputed notice

  • P then argue directors are liable for losses suffered by their co. by reason of their gross inattention to their common law duty of actively supervising and managing the corporate affairs Briggs v Spaulding:

    • Directors are bound to use that amount of care which ordinarily careful and prudent men would use

    • Duties are those of control, whether by neglect they have made themselves liable for failure to exercise proper control depends on the circumstances and facts of the particular case

    • But Briggs expressly rejected: Even though they had no knowledge of any suspicion of wrongdoing on co.’s employees, they still should have put into effect a system of watchfulness, so misconduct would be detected and put to an end.

    • Briggs: directors are entitled to rely on the honesty/ integrity of their subordinates until something occurs to put them on suspicion that something is wrong. Without suspicion, there is no duty upon the directors to install and operate a corporate system to find out wrongdoings which they have no reason to suspect exists

    • Duties of the AC directors were fixed by the size of the company – since its so big, directors could not know personally all the company’s employees – they are confined to their broad policy decisions (which Ds did)

  • Whether a corporate director has become liable for losses to the corporation through neglect of duty is determined by the circumstances

    • If he has recklessly reposed confidence in an obvious untrustworthy employee, has refused or neglected cavalierly to perform his duty as a director, or has ignored either willfully or through inattention obvious danger signs of employee wrongdoing the law will cast the burden of liability upon him

    • But not the case at bar, for as soon as it became evident that there were grounds for suspicion, the Board acted promptly to end it and prevent its recurrence

    • No rule that requires a corporate director to assume, with no justification that all corporate employees are incipient law violators who, but for a tight checkrein, will give free vent to their unlawful propensities.

  • Held: D not liable as a matter of law merely because, unknown to them, some employees of Allis-Chalmers violated the anti-trust laws thus subjecting the corporation to loss

Questions

  1. What function would imposing liability for breach of the duty of care serve in
    Allis-Chalmers? When might it be in the narrow economic interest of shareholders and when not?

  2. To the extent that one is tempted to impose liability on the board for purposes of
    enforcing the antitrust laws, what alternative enforcement strategies are available? What about increased penalties against the company?

  3. Assume the directors authorized the actions which were later found to have violated the antitrust laws. At the board meeting, legal counsel had informed them that such actions may (but are not certain to) be illegal but the directors concluded that the potential profits are high enough to justify the risk of violating the law. Should the directors be personally liable for violating the duty of care? What if the directors were told that the actions are clearly illegal, but that the probability of detection is low? What if the directors were told that the actions are clearly illegal, but that the government generally does not prosecute such kind of offenses?

Smith v Van Gorkom (1985)

Facts

  • Trans-Union, a Chicago public car leasing co., doesn’t have enough income to use the Investment tax credits (ITCs) to reduce tax

  • July 1980, its management proposed 4 alternative use of the projected 1982-1985 equity surplus, but the sale of Trans Union was not considered

  • In August 1980 Van Gorkom suggested to Senior Management, to sell the Trans Union to a co. with a large amount of taxable income

  • Senior meeting on 5 September 1980, Romans, Chelberg and VG met Donald Romans (CFO of Trans Union) announced his preliminary study on the possibility of a leverage buy-out (LBO) + possible being bought by the Management

    • Romans brought up leveraged buy-out and ran the numbers at $50 and $60 a share.

    • $50 would be very easy to do, but $60 would be very difficult, very rough calculations.

    • VG stated that he would be willing to take $55/share for his own 75,000 shares

    • VG banned the suggestion of a LBO by Management due to conflict of interest

      • Conflict of interest 1: management would be the buyers and sellers are shareholders management wants to buy a low price; shareholders would want to sell the high price. Managers has fiduciary duties to the shareholders they have the best info of the company (knowing the lowest price $55) Managers buying the company are the one who supposed to help shareholders to get the best price [people who know best are the buyers]

      • Conflict of interest 2: VG was then approaching 65 years of age and mandatory retirement he won’t be a buyer in the Management buyout, but a seller as he is the CEO. [VG could negotiate the deal to the best interest of the shareholders as sellers reduce the conflict]

      • $55 seems to a good price to sell his shares

  • VG contacted Trans Union’s Controller Peterson – secretly ask Peterson to calculate the feasibility of a LBO at $55/share

    • VG didn’t want a LBO by management

    • Roman ran the numbers 5 days ago, but VG asked Peterson to calculate the feasibility of a leverage buy-out for $55/share [as CFO told VG the range is $50-60] and told him not to tell anyone nor reason why

    • VG should’ve asked Roman CFO (no.3 in the hierarchy), and not Peterson (lower in the hierarchy) to do the calculations VG wants to keep it confidential from Roman

  • Few days later, VG met Prizker (corporate takeover specialist)

    • Prizker is a potential buyer (rich, well-known corporate takeover specialist) and VG’s social acquaintance

    • VG told Prizker $55 (middle of $50-60)

  • 13 September 1980, Prizker suggested $50 VG: $55 is better

    • Lockups

    • P to serve as a stalking horse for an auction contests, but Prizker wants to buy 1.75M shares at $55 so he can sell to any higher bidder

    • Auction is there in case someone is willing to pay higher

  • 15 Sep: P interested to buy, met VG + Peterson + Chelberg [but not Romans]

  • 18 Sep: VG met again with Pritzker

    • No further discussion on $55 price

    • Amount subject to auction reduced to 1M

    • P wants the deal to be done by Sunday night, before opening of the English stock exchange (3 days later)

    • P in a rush [the actual merger would take several months] because he wants the merger agreement signed as he is worried that someone else would make a higher bid

      • P’s reaction indicates that P thinks it is a great deal [in rush + worried about higher bid + worried VG would negotiate more]

      • Seller should be worried that the price is not high enough

  • 19 Sep, VG called a special meeting on 20 Sep (Saturday)

    • Without agenda, no one was told the purpose of the meetings

    • VG didn’t invite Trans Union’s investment banker, Salomon Brothers (who should have been invited to the meeting)

  • 20 Sep board meeting 2 hours

    • VG disclosed the offer at $55

    • Roman redid calculation: $55 to 65/ share $55 would be a bad deal

    • Senior Management negative reaction to Pritzker’s proposal

    • VG should have tried to leverage for a better price with Prizker, but he did not do so

    • If Roman was involved earlier, won’t have such issue

    • The board did not read the merger agreement, but the lawyer summarized it (but unknown whether it ever existed, may still be negotiating – how did the lawyer summarized it if it is not written?)

    • After 2 hours, agreement was signed

      • VG signed the 700M merger agreement at a party that the hosted for the opening of Chicago Opera – highlights the unprofessionalism of VG

      • Without he/any other member of the Board having read the instruments

  • All board members are very high prestige executive board in Chicago, but none of them are investment bank/ financial analyst

    • But their experience are not valuation of companies

  • Shareholders of Trans Union approved Pritzker merger proposal – 69.9% in favor, 7.25% against

Court:

  • Business judgment rule

    • Protect and promote full and free exercise of managerial power granted to directors

    • Aronson v Lewis Presumed that in making a business decision, the directors of a corporation acted

      1. on an informed basis,

        • Whether directors have informed themselves “prior to making a business decision, of all material info reasonably available to them”

          • [in the nature of a duty of care, not loyalty]

        • concept of gross negligence is the proper standard for determining whether a business decision is an informed one

          • [have to significantly deviate from proper course of conduct]

        • director P has duty to act in an informed and deliberate manner in determining whether to approve an agreement of merger before submitting the proposal to the stockholders

      2. in good faith and

        • presumed, as there is no allegation of fraud, bad faith, self-dealing

      3. in the honest belief that the action taken was in the best interest of the co.

    • Certainly in the merger context, a director may not abdicate that duty by leaving to the shareholders alone the decision to approve or disapprove the agreement. [Director’s duty to make affirmative recommendation to shareholders]

      • Largely broad centric vision of corporate law – board is not to collect all info and provide to shareholders. Board need to give their business judgement to shareholders – as long as the board acts appropriately, court would insulate from shareholders and court’s second guessing their decisions.

Analysis

  • What went wrong? Everything

  • Counterarguments and how court deals with them - Court rebutted D’s arguments:

    1. Premium

      • Board: 50% of the premium of the market price - market price is supposed to reflect the true value of the co.

      • Court: the board cannot just say it is a good premium

        • The board did not take the position that the market price reflects the rue value they believed that the market price is undervalue more than the market price doesn’t mean it is a good deal

        • Market price is the price of the share – not what representative of the whole value of the company

        • Shareholders would want to sell the co. for a high price (at least a fair price)

        • The efficient market hypothesis is not a good evaluation: Prizker is willing to overpay others may also be willing to overpay (unknown) $55 is not the true value of the company

    2. Reliance on reports by officers

      • VG made 20 mins presentation – other board members could not have relied on, but they have not seen the agreement, only have the summary of the agreement indicate rushing (indicate it may not be carefully done), the officers should have ask more questions

      • Boston Consulting Group’s report is not a report on valuation

    3. Board accumulated knowledge

      • No experience regarding valuation

      • Romans have experience but

      • Investment bankers (Saloman Brothers) also have experience but was never asked to the meeting

    4. Market test

      • Didn’t need to know whether $55 is a good price if $55 is too low, someone would come in (need not ask others) and bid a higher price

      • Board not permitted to solicit/ share non-public info to other bidder – under the agreement, unsure whether the co. can accept another bid if another bid came forward

      • Merger Agreement section 2.03: “The Board of Directors shall recommend to the stockholders of Trans Union that they approve and adopt the Merger Agreement ('the stockholders' approval') and to use its best efforts to obtain the requisite votes therefor. GL acknowledges that Trans Union directors may have a competing fiduciary obligation to the shareholders under certain circumstances.”

        • Not saying that the directors can accept another bid

        • Whether GL acknowledge is irrelevant, it is the court who determine whether the board has competing fiduciary

        • Board would want GL to say in the agreement “this contract doesn’t obligate you to act in a manner that is in consistent with your fiduciary duties.”

      • Why did VG not increase the price after hearing Roman’s report?

        • Unusual – supposed to act in the interest of the shareholders – should’ve tried harder

        • Delaware amended rule, adding S.102(b)(7) to permits company to include provision in their charter, in eliminating the personal liability of directors for monetary damages for breach of duty of care [not duty of loyalty] shareholders can have Injunctive relief as remedies

          • But need to act fast - before the merger, once merger is done nth to ask for

    5. Lawyer’s advice

      • Can always get sued, should not be worried about whether they would get sued, but whether they would win (whether they breached their duties)

    6. Shareholder approval

      • Rectification

      • Cannot have misleading statement

  • This case is a window into the mind of the Delaware Court (what did VG do that annoyed the court)

  • Lock-up Options (and Termination Fees)

    • Option to buy 1 million shares at $38

    • Deal Price is $55 per share

    • Profits from Lock-Up depend on whether competing bidder offers a higher price (and amount), but any competing bid would have to be at least $55 per share

    • Minimum profits are thus $17 million

    • Assume instead of lock-up, Pritzker would have received a fee of $17 million (termination fee) if Transunion accepts a higher bid

    • If someone bid $60 P can sell his $38 shares and make a profit

    • Option to close

    • If someone buys it at a higher price, P would get 17M termination fees

    1. If There is Competing Bid

      • Assumptions:

        • Deal Price = $700 million

        • Fee = $17 million

        • Pritzker values Transunion at X (X>$700 million) [in absence of any termination fee]

        • Competing Bidder (CB) values Transunion at Y (assume also >$700) [in absence of any termination fee]

        • If needed, in an auction, Pritzker and CB would bid up to their reservation prices (break-even points)

[P offer 700M deal price, gets 17M fee infer that P thinks the company worth to him for more than 700M (but don’t know how much more). Competing bidder also value this company is more than 700M]

  • Without termination fee

    • Pritzker would be willing to bid up to X

    • CB would be willing to bid up to Y

    • In an English auction, if X>Y, Pritzker would acquire Transunion for Y (since CB will not bid any higher)

    • In an English auction, if Y>X, CB would acquire Transunion for X (since Pritzker will not bid any higher)

    • Generally, higher valuing bidder will acquire company at lower valuing bidder’s reservation price

  • With Termination Fee

    • CB would be willing to bid up to Y - $17 million

      • Reason: If CB succeeds, Transunion has to pay Pritzker $17 million, which comes out of CB’s pocket (as new owner)

    • Pritzker would be willing to bid up to X - $17 million

      • Reason: If Pritzker loses auction, he makes $17 million in profits from fee. So he only wants to win if his profits from buying Transunion exceed $17 million

    • Same party will win auction as in absence of Termination Fee (since relative reservation price is not changed)

    • Amount of winning bid is $17 million lower (since lower valuing bidder’s reservation price is $17 million lower)

[17M Paid by Trans union to P if third party wins auction

17M less cash in trans union when third party buys i.e. 700M-7M

Third party will no longer be willing to bid to as high as P

Make P more likely to win? But P would only be willing to bid only 17M less, for P, losing the auction becomes profitable if P lose auction, he will get 17M – would only want to acquire Trans Union if he can earn more than 17M in profit by acquiring Trans Union]

  • Hence:

    • Termination fee will not affect the identity of winning bidder: both parties valuation goes down by 17M

    • But price paid in auction by 17M hence termination fee given is adverse to shareholders

  1. Will An Auction Ensue?

    • Previous analysis assumed that there was a competing bid, but termination fee may affect WHETHER there is a competing bid.

    • Deal Price = $700 million

    • Fee = $17 million

    • Pritzker would be willing to bid up to X

    • CB would be willing to bid up to Y

    • Initial Assumptions: Assume that Y = $715 million

      • CB will make bid if no fee

      • CB will not make bid if there is $17 million fee

        • 715-17=698M

    • If: Deal Price < Y < Deal Price + Fee then term fee will “foreclose” competing bid [termination fee induce the bidder not to bid an otherwise good bid]

    • If, in addition, X < Y, then term. Fee will affect identity of winning bidder

      • Only the directors care about who is to win the bid

      • But shareholders only care how much money they will get from the auction, would rather get 17M more. But here, shareholders would get 17M less due to the termination fee

  2. Effect on Initial Bid

    • Conclusion so far is that term. fees reduce amount of winning bid if there is an auction but only affect identity of winning bidder if foreclosing [in our example $700<X<Y<$717 million]

    • But term. fees presumably benefit targets by serving to induce bids that would otherwise not be made (if not, why pay them if they reduce winning bid?)

      • If Pritzker make a bid, others will make a bid too (since he is famous for buying co. and making money), Pritzker would not make a bid without the fee if Pritzker doesn’t make a bid, others would not make a bid

      • Fee is necessary to induce the first bid first bid then induce other bids

    • So let’s assume that both Pritzker and CB are only willing to make INITIAL bid (or explore possibility) if promised a term. fee.

      • Then ability to decide whether Pritzker or CB get the fee also affects identity of wining bidder.

  • Held: directors of Trans Union breached their fiduciary duty to their stock holder:

    1. By their failure to inform themselves of all info reasonably available to them + relevant to their decision to recommend the Pritzker merger; and

    • Board of Directors did not reach an informed business judgment in voting to sell their Co. for $55/ share because:

      1. Did not adequately inform themselves as to VG’s role in forcing the sale of the Co. + in establishing the per share purchase price;

      2. Uninformed as to the intrinsic value of the Co.; and

      3. Given these circumstances, at a minimum, were grossly negligent in approving the sale of the Co. upon 2 hrs consideration, without prior notice + without exigency of a crises/ emergency [decision relied entirely upon VG’s 20 mins oral presentation, no written summary of terms of merger, no document to support adequacy of $55/ share, nor agreement]

    • Under 8 Del.C. s.141(e) directors are fully protected in relying in good faith on reports made by officers [including informal personal investigation by corporate officers].

      1. But none presented in the Board on Sep 20

      2. Board of large co. may rubber stamp – rely a lot of the officers

    • s.141(e) directors were entitled to rely upon their chairman’s opinion of value and adequacy, provided that such opinion was reached on a sound basis – directors did not inform themselves as to all info reasonably available to them

    • court rejected applicant’s arguments

      1. The board did not inquire into why Romans put $55/share Roman would have testify that his calculations were preliminary and was not designed to determine the fair value of the Co.

      2. No evidence that the Merger Agreement was effectively amended to give the Board freedom to put Trans Union up for auction sale to the highest bidder

      3. Director’s unfounded reliance on premium and the market test as the basis for accepting Prizker proposal undermines D’s remaining contention that the Board’s collective experience was a sufficient basis for finding that it reached its decision with informed, reasonable deliberation

      4. Mere threat of litigation (if suit might result from the rejection of a merger offer), acknowledged by counsel, does not constitute either legal advice or valid basis to pursue an unformed course

    1. Shareholders were not fully informed of all facts material to their vote on Pritzker Merger:

    • Burden on D to establish the shareholder approval resulted form a fully informed electorate

      1. Board had no reasonable adequate info indicative of the intrinsic value of the Co., other than concededly depressed market price, was without questions material to the shareholders voting on the merger

      2. Board of Directors’ characterization of the Romans report in the Supplemental Proxy Statement was false and misleading preliminary report: value of co. is $55-65/share

      3. Board’s references to the substantial premium offered is misleading

      4. Board’s recital in the Supplemental Proxy of certain events preceding Sep 20 meeting is incomplete and misleading.

        • Reasonable stockholder would have considered material the fact that VG suggested $55 to Pritzker + chose the figure to make it feasible for a leveraged buy-out.

        • by Jan 26, directors knew but did not disclose that VG chose $55 because it would enable Pritzker to fiancé the purchase through leveraged buy-out, and within 5 years, substantially repay the loan out of the cash flow generated by the Company’s operations

  • Dissent

    • Disagree on the majority’s assessment of the directors’ knowledge of the affairs of Trans Union & their combined ability to act in this situation under the protection of the business judgment rule

    • Directors are all super experienced – would not do transaction without being fully informed and aware of the state of art

The decision single-handedly sent the price of directors' insurance through the roof & sent the Business Roundtable running to state legislatures all over the country to lobby for the enactment of "director liability statutes."

Questions

  1. Why wasn't the premium offered for Trans Union -- 45%-50% over market price -- a sufficient defense for the board? What could account for such a large discrepancy between shareholders and asset values?

  2. Consider the actions of van Gorkom up to the board meeting. Does anything strike you as unusual?

  3. Why did the court find it “noteworthy ... that [van Gorkom] was then approaching 65 years of age and mandatory retirement” in connection with van Gorkom vetoing the suggestion of a leveraged buy-out by Management as involving a potential conflict of interest for Management.

  4. Commentators are divided as to whether the liability imposed in Trans Union ultimately helped or harmed shareholders. For what reasons may shareholders be helped or harmed? What other groups in society are the winners from Smith v. Van Gorkom? What groups are the losers?

  5. You are working for a law firm that represents XYZ Corp.. ABC Inc. has just offered to acquire XYZ Corp. at a 65% premium over the market price. The board is generally open to the offer. Prepare a little speech, to be delivered by you to the board, outlining how the board can best meet its obligations under Smith v. Van Gorkom. What real-life effect would you expect your advice to have?

  6. As of the early 1990s, most states had adopted statutory provisions limiting the liability of directors for breach of duty of care. Most of these statutes are modelled after Del. §102(b)(7). In Delaware, well over 90% of public corporations in a large sample had, by 1990, passed charter provisions eliminating liability to the full extent permitted by the statute. Roberta Romano, Corporate Governance in the Aftermath of the Insurance Crisis, 39 EMORY L.J. 1155 (1990). Revisit the Certificate of Incorporation of XYZ Corp in the Introductory Part, Article Sixth, for an example of such a charter provision. How would the analysis and the outcome of the case been affected if Transunion’s charter had contained a provision authorized by that section?

In re the Walt Disney Company Derivative Litigation (2003)

  • Case deal with the facts in a peculiar, abnormal way

  • Derivative action against Directors for breaching their fiduciary duties when they blindly approved an employment agreement with D Michael Ovitz.

  • Facts: Events leading up to the hiring of Ovitz

    • Eisner (CEO of Disney) chose Ovitz as new president for Disney.

    • Ovitz had never been an executive for a publically owned entertainment co., but close friend of Eisner. other people in co. disagreed but Eisner decided to hire Ovitz unilaterally

    • July 7, 1995 concerns about no. of stock options to be granted to Ovitz was far beyond normal

      • Purpose of granting options (right to buy stock): director’s estate in the company incentive to act in the interest of shareholders

      • Price to be paid in exercising the option for executives are always set at the market price of the day of grant

    • Sep 23, 1995 draft employment contract, not provided to compensation committee

    • Sep 26 1995 compensation committee met, spent least amount of time discussing Ovitz’s hiring. Received rough summary of employment contract

      • employment contract is incomplete, didn’t state exercise price of the options to purchase 5M shares of stock

      • Did not receive any info as to how the draft agreement compare with similar agreements throughout the industry

      • Did not have a compensation expert to provide info

        • Experts can provide info on the most suitable candidate for CEO for that price

          • [Like investment bankers missing in VG case for valuation and market for companies, potential buyers]

        • But: how much Ovitz is worth to Disney, how much Disney would have to pay for Ovitz to move to Disney, whether Disney is willing to pay - expert on this would be Eisner (It is customary to pay an amount, but it doesn’t mean Ovitz would have to accept it.)

        • Also: not an equivalent scale transaction

        • Outcome of the meeting: committee approved the general idea and let the CEO Eisner to work out the details

        • Ordinary for the board to delegate the CEO to work on the details, Board can handle the detail or to let management to do so

        • But it is extraordinary to delegate in this case:

          • Making the deal with the CEO Eisner CEO is the highest post in the company, and not just president (2nd highest)

          • Practicality: no one to balance the decision board have to do it by necessity – cannot make president to make deal with CEO and drive a hard bargain in hiring its future boss president is subordinate to the CEO obvious conflict of interest

          • No bother else to balance the decision board should have done it

      • Note the board spend time on more time was spent on discussions of paying 250,000 to Russell for his role in securing Ovitz's employment than was actually spent on discussions of Ovitz's employment [though 250k is a small amount for Disney]: because payments to board members for other services is problematic should spend time discussing

  • Events leading up to the firing of Ovitz

    • Ovitz was unsuccessful and wanted to leave Disney. But if he resigned outright, he might have been liable to Disney for damages + would not receive benefits of the non-fault termination Eisner agreed to help Ovitz

    • If fired without fault, Ovitz would get his salary, 7.5M bonus, gets right away all options over the next 2 years Ovitz would get a lot of money for short period of work that wasn’t unsuccessful

    • Dec 12, 1996 Ovitz successfully got no-fault termination New Board of Directors nor the compensation committee had been consulted/ approved

  • Analysis

    • In mindset/ conceptual of duty of care: high standard for violation + no claim for personal liability

    • Duty of good faith:

      • Directors may be personally liable for damages

      • Duty of good faith can be violated if - super gross negligent

        • directors consciously and intentionally disregarded their responsibilities, adopting a "we don't care about the risks" attitude concerning a material corporate decision

        • Knowing or deliberate indifference by a director to his or her duty to act faithfully and with appropriate care is conduct

        • knew that they were making material decisions without adequate information and without adequate deliberation, and that they simply did not care if the decisions caused the corporation and its stockholders to suffer injury or loss

    • Held: breach of director’s obligation to act honesty and in good faith in the co’s best interests conduct fell outside the protection of the business judgement rule

      • Director’s actions are either ‘not in good faith’ or ‘involve intentional misconduct’.

      • D knew they are making material decisions without adequate info and deliberation, simply didn’t care if the decision caused the co. and its stockholders to suffer injury/loss

      • P proved the facts in favor of P

    • Why did the alleged deficiencies relating to the hiring of Ovitz rise to “conscious and intentional disregard” as to

      1. Eisner

        • If in fact Eisner gave Ovitz this deal because of his personal friendship Eisner would be consciously and intentionally disregarded their responsibilities

          • But marginal for the compensation committee and the rest of the board

      2. The members of the compensation committee

        • Decided to hire Ovitz because Committee went alone with Eisner (thought the Committee’s preference may be different)

        • But the Committee has decided to delegate the details to Eisner – Eisner is experienced, should know best who to hire should have a president that gets along with the CEO (one of the qualification)

        • Eisner and Ovitz are close friends for 25 years – Committee should be a more careful, but Committee is reasonable to trust the CEO

      3. The rest of the board?

        • Board acted as a rubber stamp of the company compensation committee trusted the committee and assumed the committee did their job

        • Bylaw requires Board approval to fire the president

        • Board members should have called Eisner and GC to check the bylaw but:

        • Prof: Committee exist so the board can trust them and need not second guess their holdings not intentional and conscious disregard of their responsibilities

    • Why did the alleged deficiencies relating to the firing of Ovitz rise to “conscious and intentional disregard” as to

      1. Eisner

      2. The members of the compensation committee

      3. The rest of the board?

        • Why had the Board disregarded responsibility? What should have the board done?

        • Board had done nothing the Board should have ask to approve the firing

        • Board doesn’t know that the Bylaw says that the Board has to approve the firing

        • Board members are not responsible to know what the Bylaw knows what decisions CEO can take/ what to approval the general counsel is responsible to tell the Board what the bylaw requires not conscious and intentional disregard of their responsibilities

  • Disney By-Laws

    • The CEO/Chairman “shall, subject to the provisions of the Bylaws and the control of the Board of Directors, have general and active management, direction, and supervision over the business of the Corporation and over its officers.…” … The President shall report and be responsible to” the Chairman

    • The Board of Directors … shall elect the officers of the Corporation who shall hold their offices for such terms and shall exercise such powers and perform such duties as shall be determined from time to time solely by the Board of Directors, which determination may be by resolution of the Board of Directors or in any bylaw provision duly adopted or approved by the Board of Directors; and all officers of the Corporation shall hold office until their successors are chosen and qualified, or until their earlier resignation or removal. Any officer elected by the Board of Directors may be removed at any time by the Board of Directors with or without cause. Any vacancy occurring in any office of the Corporation may be filled only by the Board of Directors.

  • Final Resolution: Having considered these documents, I come to the following conclusions:

    • 1) the board of directors has the sole power to elect the officers and to determine the “duties” of the officers of the Company (either through board resolutions or bylaws); …

    • 3) the Chairman/CEO has “general and active management, direction, and supervision over the business of the Corporation and over its officers,” and to manage, direct and supervise the lesser officers and employees of the Company;

    • 5) the board has the right but not the duty to remove the officers of the Company with or without cause, and that right is non-exclusive; and

    • 6) because that right is non- exclusive, and because the Chairman/CEO is affirmatively charged with the management, direction and supervision of the officers of the Company, together with the powers and duties incident to the office of chief executive, the Chairman/CEO, subject to the control of the board of directors, also possesses the right to remove the inferior officers and employees of the corporation.

  • Limit of this case [wrongly decided cases]

    • If you take the case as face value (how doctrine is applied to the case), it is problematic – with hindsight, this is a bad decision, P should show more to dismiss the good faith standard

    • We cannot deal with all bad decisions, as there would be too much work + lack the ability to do so due to the business structure, managers have prime responsibility to run the company and they make business decisions, court only step in a limited no. of cases where they believe they can bring expertise in a fruitful manner

      • Note: Delaware Court is special - it doesn’t clear up doctrines, but shift directions in different cases, knowing that they would have opportunity to change it when the next case come in

    1. Differences between super gross negligent (Disney) and gross negligent (Van Gorkom)

      1. If you are better than gross negligent no breach of duty of care

      2. Before Disney, we thought that if you are below gross negligent breach but no liability for damages

      3. Below super gross negligent breach + personal liability

      • Prof: what is in between gross negligent but not super gross negligent?

        • The situation of the two cases are similar but if there is no case in between the super gross negligent and gross negligent, when will directors be personally liable?

    2. What is the material decision: is it the hire Ovitz or the terms of hiring Ovitz

      • With benefit of hindsight, the initial employment agreement was poorly drafted for giving so much money to Ovitz [though can also counter argue that Ovitz is giving up a lot to go to Disney]

      • If things unfold in a certain way, it can cost the co. a lot of money, but not foreseeable that it would happen + entitled to decision making

  • Questions on In re Walt Disney

  1. Why did the board’s action rise beyond gross negligence to conscious and intentional disregard of its responsibilities? What is the relation of the board’s actions (or lack of actions) with regard to the hiring of Ovitz and its actions with regard to Ovitz’s termination? Could actions of the board in Smith v. van Gorkom be similarly characterized as conscious and intentional disregard of its responsibilities?

  2. After Disney, can a board be sued for any material decision made by the board without adequate information and without adequate deliberation? How does the board know whether a decision is material?

  3. What kind of information does an investment bank convey to a target company that is up for sale (as in van Gorkom) and how does this information help the board. What kind of information does a compensation consultant convey to a board about to hire a new president?

  4. The opinion notes that the board delegated the authority to approve the final terms of the contract with Ovitz to Eisner, Disney’s CEO. Is this delegation proper under Sections 141(c) or 142(a) of the DGCL? If it is, why is the board accused of conscious and intentional disregard of its responsibilities?

  5. What is the significance of the allegation that Eisner and Ovitz were personal friends?

  6. What is the significance of the allegation that the by-laws require board approval for a no-fault termination?

C. The Duty of Loyalty

  • Which doctrinal level is the court talking about – steps of doctrinal analysis (though not explicit in the case)

    • Step 1: pigeon-hole category of conflict

      • E.g. Self-dealing transaction

      • In what legal cognizable category of conflict does this economic conflict fit in

      • If conflict is not recognizable no recognizable conflict = not interested + everyone would be independent

    • Step 2: determine initially applicable legal standard

      • Entire fairness

      • E.g., Self-dealing transaction review under standard of entire fairness

    • Step 3: check for presences of proper “cleansing act”

      • Sth that changes the initially applicable legal standard

      • Has to be done the right way

    • Step 4: if there was cleansing act, determine ultimately applicable legal standard

      • Whether standard satisfied

        • If not breach of fiduciary duty

        • If satisfied, no breach of fiduciary duty

    • Step 5: apply legal standard to facts

  • Step 3 and 4 involve same factors, all steps are interconnected court would not care about the doctrinal standards

  • Legal Standards for Now

    • Business Judgment Rule

    • Entire Fairness (with burden of proof on the defendant)

      • “Intrinsic” or “full” fairness and other formulations involving fairness refer to the same standard

    • Entire Fairness (with burden of proof on the plaintiff)

  • As we proceed, we will see other standards

  • Corporate officers and directors (and controlling shareholders) must not exercise their discretion over corporate policy to benefit themselves at the expense of their co-investors

  • Duties owe to the corporation

  • Directors are ordinarily authorised to define the corporation’s interests – typically includes individuals whom shareholders most frequently charge with breaching a duty of loyalty to the corporation

  • Two problems:

    • How should the corporation’s interests be defined for the purpose of duty of loyalty – as the common economic interest of its shareholder or something else?

    • What should the role of the board of directors be in determining when particular conduct by a corporate officer or director counts as a breach of the duty of loyalty in the first instance?

  • Basic example of duty of loyalty:

    • the bar against self-dealing and against taking jointly owed opportunities, with particular emphasis on the role of the board in determining when a breach of duty has occurred

  • In Delaware and most states, the duty of loyalty of corporate directors and officers

    • owe to the corporation and its shareholders

    • which implicitly treated as loyalty to the interests of shareholders

    • But law often unclear on the primacy of shareholder interests vs. interest of the corporation

  • 25 states (but not Delaware) have added ‘constituency’ or ‘stakeholder’ amendments to their corporation statues, which expressly allow corporate boards, when establish corporate policy, to consider

    1. the interests of constituency groups (e.g. employees, creditors, community) and

    2. the interest of shareholders in establishing corporate policy

    • undermining traditional legal controls over corporate managers to a certain extend

  • Corporate Laws Committee of the ABA voted to exclude a constituency provision on the ground that

    • it would represent a radical break with past case law; and

    • would have uncertain consequences for much of traditional corporate law

    • “court sometimes appear to recognise that co. have responsibilities that go beyond shareholders and embrace creditors, employees, communities and other constituencies

    • But no case appear that the court countenanced director action which favoured one or more of the other constituencies at the expense of shareholders,

    • No case were the statements of the court acknowledging such responsibilities

    • But clear that a co. may properly expend corporate funds, e.g.

      • for employee outings or other benefits,

      • for charitable and community purposes in areas where it had operations,

      • to assist suppliers in staying in business,

all at the expense of the shareholders on the theory that such expenditures advanced the long-term interests of the co.”

  • In Dodge v Ford Motor Co directors had subordinated shareholder interests to other interests

    • Directors refused to pay dividends as co. made too much money and a sharing of the co.’s profits with the public by reducing the price of the output of the co., ought to be undertaken

    • Court affirmed primacy of the shareholder’s interest:

      • Primary purpose of lawful power of board to share and conduct affairs of a co. is to benefit shareholders (not just incidentally)

      • If D director’s avowed purpose to sacrifice the interests of the shareholders court would have duty to interfere

    • However, Chancellor Allen of the Delaware Chancery Court has argued that: ambiguity of ‘purpose’ of co. and primacy of shareholder interest should remain a persistent feature of American corporate law

    • If directors of an insolvent corporation owe a fiduciary duty to creditors Is this inconsistent with asserting the primacy of shareholder interests?

The Self-Dealing Paradigm

  • Directors and corporate officers are not entitled to favor their own interests in self-dealing transactions with the corporation

  • Doctrine gradually relaxed over the past century [from flat prohibition of trust law to now a mix of judicial review and statutory safe-harbor of uncertainties in self-dealing transactions

  • What constitutes self-dealing?

  • By what legal standards are self-dealing transactions judged?

  • What is the effect of cleansing acts?

    • E.g. obtaining approval of a self-dealing transaction by disinterested members of the board of directors/ shareholders

    • The effect of statutory provisions on self-dealing transactions (which have been adopted by a large majority of states)

    • Almost all statutes contain language to the effect that a self-dealing transaction will not be voidable, ‘solely’ because it involves a conflict of interest, if it is adequately disclosed + approved by a majority vote of disinterested directors/ shareholders, or if it is fair

    • E.g. Del §144 Interested directors


Marciano v Nakash 535 A.2d 400 (1987)

  • 2 families: Marcianos and Nakashes, each own 50% of Gasoline and elects same no. of board directors

  • Do not get alone, evenly split when issues come up no majority = cannot make decisions

  • Gasoline has a bank loan and the bank wants a guarantee from the Marcianos and Nakashes Nakashes gave guarantee but Marcianos doesn’t want to give a guarantee

  • Without guarantee, Gasoline has to repay the money

  • Without consulting the Marcianos, the Nakashes advanced ~$2.3M peronal funds to Gasoline to pay the outstanding bills for the co. (the loan replace the bank loan under the same terms)

  • Marcianos complain that it is a self-dealing transaction: Nakashes are standing on both sides of the transaction - between Gasoline co. (director acts as fiduciary) and the co. Nakashes own

  • Fiduciary duty

    • Del §144(a) No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers… have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such director's or officer's votes are counted for such purpose, if:

      1. The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or

[Facts are disclosed and approved by disinterested directors]

  1. The material facts as to the director's or officer's relationship or interest and as to the contract or transaction are disclosed or are known to the stockholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the stockholders; or

[Approved by fully informed stockholders in good faith stockholders]

  1. The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the stockholders.

[Transaction fair at time it is approved by board/ stockholders]

  • [Breach of fiduciary duty court may award damages, declare void (not common but a potential remedy for breach)]

  • Court: Valid and enforceable debts notwithstanding their origin in self-dealing transactions

    • The transaction is fair so there is no problem – in arranging for the loan, the interested directors were not depriving the corporation a business opportunity but were instead providing a benefit of the corporation which was unavailable else where

    • The transaction is fair because it’s the same term as the bank (outside party, satisfy market test).

    • (3) is not satisfied, though not approved by the board of directors or shareholders loan was approved by the board [directors never act in individual capacity no power to sign as a board unless there is a board resolution]

    • Officers can act in individual capacity in a corporation – Nakashes are officers of the company and Marcinaos are not

    • No deadlock between officers: the CEO have power can sign on behalf of the co.

    • Not all actions by officer requires approval by board as bylaw granted power to officers to do so

    • Doesn’t satisfy (1), (2) and (3) conditions doesn’t mean the transaction is void

    • Meeting (1), (2) and (3) conditions also doesn’t mean the transaction must be valid

    • S. 144 – is a reflection but not a great reflection

  • Dicta of Delaware court: footnote 3 [step 4 legal standard as changed by cleansing act]

    • On the other hand, approval by fully-informed disinterested directors under section 144(a)(1), or disinterested stockholders under section 144(a)(2), permits invocation of the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction.

    • (2) The material facts are disclosed or are known to the stockholders and the contract or transaction is specifically approved in good faith by vote of the stockholders approval by fully-informed … disinterested stockholders under section 144(a)(2), permits invocation of the business judgment rule .

    • Different kind of court system – what technically binds you and what doesn’t binds you

    • Whether the court is serious or not

    • Things that isn’t necessary to decide the case dicta

    • Use the case as opportunity to adjust the course

    • “On the other hand, approval by fully-informed disinterested directors under section 144(a)(1), or disinterested stockholders under section 144(a)(2), permits invocation of the business judgment rule and limits judicial review to issues of gift or waste with the burden of proof upon the party attacking the transaction.”

      • Doesn’t describe the statute correctly, but added:

      • 144(2) only requires ‘in good faith’ (and not ‘disinterested stockholders’)

      • Court think the test is ‘disinterested stockholders’ (and not ‘in good faith’)

      • 144 only talks about violability and not business judgment rule

  • S.144 imperfectly reflects 2 kinds of cleansing acts

  • Two generic types of cleansing act:

    1. Fully informed approval by disinterested directors and

    2. Fully informed approval by disinterested stockholders

  • Dealing with a self-dealing transaction, the court change the applicable legal standard from ‘entire fairness’ to business judgment rule P loses for breach of fiduciary duty because of the cleansing act

  • Member of the Board is interested in the transaction business judgment not presumed can no longer trust the boar d court would second guess substance of fairness of transaction

    • But if the disinterested board members approved the transaction still have structural bias: the disinterested board members are still members of the same board (along with interested board members), they may be friends (before/ after becoming member of the board), have other business dealings in common, be in the same social circle…

    • Would want to be in good relationships with the interested board members would be biased (judge in the same situation who would have recused)

    • How and why Delaware court takes into account concerns over structural bias, why does it choose to deal with concerns about structural bias

The Effect of Approval by Disinterested Directors or Shareholders

  • Commonly (though not in Marciano), interested directors will attempt to comply with one of the two prongs of s.144(a) and seek approval, after full disclosure, by disinterested directors or shareholders

  • Melvin Eisenberg, Self-Interested Transactions in Corporation Law

    • Duty of loyalty under corporate law is rooted in the duty of loyalty under agency law

    • Agency example in a corporation is usually more complex:

      • e.g. senior executive enters into a self-interested transaction may deal with a subordinate, an equal, a superior, the board, or the shareholders. E.g. compensation

    • To satisfy the duty of loyalty, director/ senior executive must

      1. make full disclosure (on conflict of interest and the transaction) to the corporate decision maker who authorises the transaction, and

      2. the transaction must be fair to the corporation

    • Approval of a self-dealing transaction after full disclosure is not always suffice to satisfy the duty of loyalty

      1. Substantive unfairness may suggest that even if the self-interested director/ senior executive made full disclosure of all material facts, he withheld the counsel that he would have given if the transaction had been with a third party Blobe Woolen v Utica Gas & Electric Co

    • Approval by disinterested director

      1. should not insolate a self-interested transaction from judicial review of fairness

        • but this approval shifts the burden of proof. Without approval, self-interested directors/ senior executive would have to show that the transaction was fair.

      2. changes the standard by which the self-interested transaction is measured:

        • Complainant must show that disinterested directors could not have reasonably believed the transaction to be fair to the corporation [easier test for director to satisfy than a pure fairness test, but harder than business judgment standard]

      3. Must be given in advance

        • encourage them to seek advance board approval of self-interested transactions

        • gives disinterested directors opportunity to negotiate with the senior executive/ director

    • if director/ senior executive doesn’t seek approval of his self-interested transaction until it has been consummated question would be whether a consummated transaction is so disadvantageous that a colleague should be exposed to a lawsuit

Kahn v Lynch Commun. Sys. (1994)

  • Different approach from Marciano v Nakash

  • Alcatel owns 43.3% of Lynch, 5/11 members of Board, 2/3 members of executive committee, 2/4 members of the compensation committee

  • Lynch wants to buy Telco, but Alcatel disagree, proposed Lynch to buy Celwave but it would be a self-dealing transaction

  • Lynch board adopted a resolution establishing an Independent Committee

    • Consisting Kertz, Wineman, Berinnger. Alcatel people are not on the Committee as they are interested [they are directors of the co. that owns Celwave]

    • CEO of Lynch who has expertise on whether Lynch should buy Celwave, but was not on the Committee because he is not independent and acts in favor of Alcatel (who owns 40% and is powerful in the company, CEO would want to keep his job)

    • [independent is one of the elements of the business judgment rule]

    • Independent committee hired the investment advisor (advised by their lawyers) Delaware court cares about the process

  • Alcatel withdrawn proposal on Celwave and propose to buy Lynch through a merger

    • All non-Alcatel shareholder of Lynch get paid $14 per share

    • Independent Committee determined that $14/share was inadequate and asked for $17

    • Alcatel suggested $15.25 but Committee rejected the offer Alcatel final offer $15.50 [threats IC to accept it or would make an unfriendly tender offer – ask shareholders directly at a lower price]

    • Committee approved the merger

  • Rosenblatt: in a parent-subsidiary merger, approval by informed vote of a majority of the minority stockholders is not a legal prerequisite, but shifts the burden of proving the unfairness of merger entirely to the Plaintiffs

    • Initial burden of establishing entire fairness party who stands on both sides of the transaction

    • BUT: approval of transaction by an independent committee of directors/ informed majority of minority shareholders shifts burden of proof from controlling/ dominating shareholder to challenging shareholder-Plaintiff

  • Evidence that the transaction meets the test of fairness

    • Each of the contending parties had exerted its bargaining power against the other at arm’s length

  • 2-part test for determining whether burden shifting is appropriate in an interested merger transaction Rabkin v Olin Corp

    1. Majority shareholder must not dictate the terms of the merger Rosenblatt v Getty Oil

    2. Special committee must have real bargaining power that it can exercise with the majority shareholder on an arm’s length basis

      • Majority stockholder’s attitude toward the minority + apparent absence of any meaningful negotiations as to price did not manifest the exercise of arm’s length bargaining by the independent committee

      • In this case, ability of the Committee effectively to negotiate at arm’s length was compromised by Alcatel’s threats to proceed with a hostile tender offer if the $15.50 price was not approved by the Committee + lynch board

  • 5 Steps

    1. Type of conflict

      1. Controlling shareholder [Alcatel]

        • Owe fiduciary duties to the minority shareholders

          • Shareholders owe fiduciary duty only if it owns a majority interest in/ exercise control over the business affairs of the corporation Ivanhoe Partners v Newmont Mining Corp.

        • Plaintiff wants money can sue Alcatel for money

        • To become controlling shareholder in Delaware – test:

          1. Majority interest (own more than 50% of shares); or

            • Citron v Fiarchild Camera & Instrument Corp

            • Alcatel only own 43.3% equity

          2. Control the board

            • But Alcatel exercise control over Lynch’s business affairs/ decisions

            • Alcatel director told the board members “you must listen to us. We are 43$ owner. You have to do what we tell you.”; “Alcatel, with its 44% equity position, would not approve such an acquisition as it does not wish to be diluted from being the main shareholder in Lynch”

            • Independent director said to the board “if management wants the contracts renewed under these circumstances… think twice” board members voted not to renew the contracts

            • The non-Alcatel directors deterred to Alcatel because of its position as a significant stockholder and not because they decided in the exercise of their own business judgment that Alcatel’s position was correct

          • Since Alcatel controlled the board it is a controlling shareholder (despite 43.4%, less than 50% equity) owe fiduciary duties to other Lynch shareholders

      2. Self-dealing

      3. Involve a merger: Big transaction with more scrutiny

    2. Initially applicable legal standards: Entirely fairness, burden on D

      • Controlling/ dominating shareholder standing on both sides of a transaction, as in a parent-subsidiary context, bears the burden of proving its entire fairness Weinberger v UOP Inc

    3. Was there proper cleansing act

      • 2 types of cleansing act:

        1. Shareholder approval done right

        2. Disinterested directors approval done right

          • Depends on the context, Kahn v Lynch uses a higher standard (than in Marciano): also need bargaining power

          • Kahn v Lynch involved controlling shareholder; and Marciano doesn’t have controlling shareholder

          • [Controlling shareholders involved higher standard need bargaining power?]

      • What is approval of disinterested directors not enough to get back to BJR? What about s.144 and Marciano footnote 3?

        1. S.144: Approved in good faith by vote of the stockholders approval by fully-informed disinterested stockholders and directors + need bargaining power

      • Why was there no proper cleansing act?

        • Higher hurdle of what constitute a cleansing act – need to show more

        1. Was there problem with disinterestedness/ independence?

          • What was wrong with how Alcatel acted?

            • Alcatel told Committee that they were giving serious consideration to make an unfriendly tender toke away committee’s real bargaining power Committee has no ability to say no (committee was pragmatic and accepted a deal that is not fair) no proper cleansing

            • Court: should have say no/ ask help from court, should never accept a deal that is not fair

            • If stimulating arm’s length transaction (same position), controlling shareholders cannot do what third party could do, because third party doesn’t have such power (discussed later)

          • What was wrong with how committee acted?

            • Should only say yes when it is the final price

            • The committee dictated the merger and had real bargaining power – it rejected $14 to $15 and $15.25 but approved $15.50

            • But member of committee Kertz, testified that, he did not believe $15.50 was a fair price but he voted in favor of the merger because he felt there was no alternative [but should not accept if it is not a fair price]

            • Kertz ultimately decided that ‘although $15.50 was not fair, a tender offer and merger at that price would be better for Lynch’s stockholders than an unfriendly tender offer at a significantly lower price

            • Should try to get the best possible price + should reject if the best possible price is not a fair price

            • The power to say no is a significant power – it is the duty of directors to only approve transaction that is in the best interests of the public shareholders.

      • Court: 1) Alcatel should not dictate term of merger; 2) committee should have real bargaining power

    4. If yes, ultimate legal standards? Entire Fairness, burden of prove on P

      • Different standard: Entire fairness with burden on P (and not D)

        1. Why:

        2. When does Lynch rule apply in effect of cleansing rule vs. Marciano rule

      • Not BJR – which P would lose

        1. Scrutinize transaction more closely

        2. Controlling shareholder has the power to retaliate, and the committee would be afraid of retaliation even without controlling shareholder doing anything

        3. Controlling shareholders can get the directors off the board and get someone else on the board, knowing that they may be kicked off the board by controlling shareholder directors are not entirely independent and would do what the controlling shareholders want

        4. Controlling shareholders would appoint people to the board who qualify as independent but spineless/ would listen to them

        5. Court formulate mechanism to ‘give spine’ to those directors e.g. in Eisenberg BJR is too soft. Structural bias is pervasive in the context of controlling shareholders transaction. Cannot trust independent directors fully even though no issues was found not BJR but entire fairness with burden on Plaintiff

        6. Entire fairness involves evaluate of substantive fairness of the transaction

      • Weinberger: Exclusive standard of judicial review in examining the propriety of an interested cash-out merger transaction by a controlling/ dominating shareholder is entire fairness, because

        • Parent subsidiary mergers are proposed by a party that controls and will continue to control the co., whether or not the minority stockholders vote to approve or reject the transaction.

        • Controlling stockholder has potential to influence the vote of minority stockholders (unlike in truncation with a non-controlling party)

        • Even without coercion, shareholders voting might perceive their disapproval could risk retaliation by controlling stockholder. Court gave e.g.

          • controlling stockholder might stop dividend payments to all shareholders [but also affects controlling shareholders, but also affects controlling shareholders]

          • effect a subsequent cash out merger at a less favorable price (remedy would be time consuming and costly litigation)

        • Independent committee is not really that important

        • Court cannot be certain whether transaction terms fully approximate what truly independent parties would have achieved in an arm’s length negotiation shareholders who have ratified a merger need procedural protections beyond those afforded by full disclosure of all material facts e.g. to adhere to more stringent entire fairness standard of judicial review

      • If standard is entire fairness, difficult to dispose case before trial

        • Involves review of substantive fairness – fact heavy - need trial to resolve them

        • Court started a 2 prong attack: 2 rules (Kahn v Lynch and Marciano)

          1. Confine the circumstances which Kahn v Lynch would apply

            • Court settled on: 1 cleansing act burden shifting; 2 cleansing act BJR [in another case 20 years later]

            • Controlling shareholder that is alleged to have breached its duty of loyalty

          2. To urge the court to change the law changed in 2014

  • What transaction were breach of duty of loyalty is not entirely clear

  • Doctrinally different from other duty of loyalty transactions

Kahn v Tremont (1997)

  • Plaintiff shareholder (Kahn), appeal from a decision which approved the purchase by Tremont of 7.8M shares of Common Stock of NL (15% of NL’s outstanding shares), from Valhi (90% owned by Simmons)

  • Simmons – controls Valhi – controls: Tremont and NL

    • Simmons

      • Owns 90% of Valhi

        • Owns 44% of Tremont

        • Majority owner of NL

  • P alleges that D willingly participated in a series of improper transactions,

    • including the purchase of NL shares by Tremont, where Simmons was able to shift liquidity from several of his controlled companies to Valhi

    • 2 preceding transactions (repurchase program + self-tender offer) were initiated to artificially inflate the price of NL shares

    • By increasing NL’s per share price, Simmons was able to divest himself, at the expense of Tremont, of the stock in a failing co. for above market prices

  • Valhi wants to sell their NL stocks

    • So it can receive tax savings + can deconsolidate NL from its financial statements

    • Approached 2 outside companies, but would be illiquid (difficult to buy and sell stocks)

      • Liquidity is a very valuable attribute – will get 20% less if the shares is illiquid

  • Valhi then approaches Tremont, Tremont formed a special committee: supposed to have disinterested directors

    • Interested persons that cannot be on this Committee

      1. Simmons

      2. Valhi’s directors/ officers

      3. Officers of Tremont (afraid of retaliation/ being fired by controlling shareholders of Valhi and Simmons)

    • The Committee consists of Tremont’s 3 outside directors Boushka, Stafford, Stein

      • deemed independent,

      • but all had significant prior business relationships with Simmons, they are directors of a company controlled by Simmons and Valhi

      1. Stafford: employed by NL in connection with Simmons’ proxy contest to acquire Lockheed and received 300k in fees

      2. Broushka: initially named to Simmons slate of directors in connection with the Lockheed proxy contest and was paid $20k

        • Being an independent directors cannot count as extra, as it is true for everyone

        • But Stafford and Broushka may try to be nice to Tremont, because they may want to be hired by Simmons again

          • Stafford (who received 300k) would be more worrisome than Broushka (who only received 20k)

      3. Stein: was lawyer affiliate with the law firm which represented Simmons, left firm to promote various business venture, and NL offered consulting position at $10K/ month + bonuses to be paid at Martin’s discretion…

    • Whether Committee is independent if not, need not go further

      • Need a properly functioning Independent Committee

      • Look at how independent committee function

    • Hired

      • Continental (banker):

        • earned significant fees from Simmons operated co. would be nice to Simmons as they would want to earn fees from Simmons in the future

        • Stein recommended Continental – but doesn’t matter whether Stein and Continental are related, as Stein is supposed to be independent

      • C. Neel Lemon of Thompson & Knight (Special Committee's counsel)

        • Tremont gets financial benefit

        • Simmons wants to get a high price to Tremont wants a low price

        • Fiduciary duty of Tremont people is to get the lowest price

        • Counsel of Tremont boss: CEO of Tremont ‘boss’: Simmons

        • But worried that Tremont’s people may pay a high price, because they would want to make their boss (Simmons) happy lack independent

        • Worried that the counsel will not do a good job in giving Committee ‘spine’ would do a good lawyer in Simmons’ perspective – won’t push the committee to get a price so low that the deal may not happen

        • Tremont officers cannot be trusted shouldn’t go to Tremont’s counsel for advice

        • Doesn’t matter that the Counsel previously represented a Special Committee of NL with a proposed merger between NL and Valhi + underwriter for Valhi – Counsel represented the other side (and not Simmons)

        • [Inherent problem that the Special Committee of Tremont would consist of directors of Tremont, which was picked by Simmons (at some point) cannot be avoided hence not considered here]

    • Meeting between Special Committee, NL, Valhi

      • Participated by Stein only [Stafford in Paris – conferencing; Broushka only in the morning]

      • NL mines titanium dioxide the price of titanium dioxide is very important

  • Applicable legal standard

    • Whether subject to Kahn v Lynch; What is required to have a properly formed committee to approve transaction which function as a cleansing act

    • Ordinarily, in a challenged transaction involving self-dealing by a controlling shareholder: Entire fairness with the burden on D

      • Burden may be shifted from D to P through the use of a well-functioning committee of independent directors (cleansing act) Kahn v Lynch

    • But Court held in this case that: the Special Committee did not operate in a...

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