Business Associations Kim Spring 2018 PDF

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Spring 2018

BUSINESS ASSOCIATIONS Introduction Features of a Corporation Legal Personhood Corporations are legal entities with rights, duties, etc. They can be liable for damages or be owed a judgment in the same way an individual can. Centralized Management A corporation is managed by an Executive Officer or a group of such officers that can comprise a Board of Directors or some other structure as outlined in the corporation’s charter. Capital Lock-in Parties that invest in a corporation are relinquishing control of that investment to the Directors of the corporation and can only divest themselves from the corporation through the mechanisms outlined in the charter or as determined by the Directors. (Investors choose when and how to invest, Directors choose when and how dividends are paid or to otherwise divest shareholders). Limited Liability Assets of individual shareholders are not collateral to the debts of the corporation Entity Shielding Assets of the corporation are not collateral to the debts of the individual shareholders Asset Partitioning Limited liability and entity shielding are collectively known as asset partitioning Permanence Life of the corporation is disconnected from the lives of the founders or individual shareholders Free Transferability Shares of a corporation may be freely bought or sold by investors or shareholders Capital Lock-in Ability of shareholders to liquidate invested capital is limited by the discretion of the board/management. Centralized Management Control of the corporation is centralized in the hands of the board, who are elected by the shareholders. Features of a Partnership Unlimited Liability All members are liable for debts of the partnership, and the individuals. 1

Spring 2018 Equal Rights to Participate in Governance Each partner has an equal right to participate in the governance of the business and in most cases business decisions can be vetoed by any one partner. Any Partner May Demand Dissolution Similar to above, a single partner can dissolve the entire partnership (regardless of how many partners are party) at any time. Not Transferable Partnership rights are not freely transferrable in the same manner as stocks or shares. Generally, a transfer of partnership rights requires the approval (or acquiescence) of each and every other partner. Historical Development Early 19th Century Incorporation required a special statute 1811 First general incorporation statute for private corporations (NJ) 1888-1913 Companies could own the stock of other companies (NJ) 1899 Delaware begins to copy the corporate code of NJ 1965 35% of companies listed on NYSE were incorporated in DE 2017 2/3 of publicly-traded companies are traded in DE Default Delaware Corporation ● Shareholders elect the board (DGCL 211(b)) ● Shareholders can remove directors (DGCL 141(k)) ● Board manages the corporation (DGCL 141(b)) ● Board distributes available funds to shareholders (or not) (DGCL 170(a)) ● Each share confers one vote and pro rata share of distributions (DGCL 212(a)) ● Shareholders can act by written consent (DGCL 228(a)) ● Special meetings (DGCL 211(d)) ● Amending bylaws (DGCL 109(a) and 102(b)(4)) and charters (DGCL 242(b)(1)) Focus particularly on DGCL 141 et seq. for the rules of corporate governance. eBay, Inc. v. Newmark et al. Rule for fiduciary duties: A. Of Directors: The Directors of the corporation have a fiduciary duty toward the shareholders (including minority shareholders). 2

Spring 2018 B. Of controlling shareholders: The controlling shareholders of a corporation have a fiduciary duty to the minority shareholders. Fiduciary duty towards shareholders of for profit corporations: Fiduciary duty requires the directors or controlling shareholders of for-profit corporations not act in ways that are intentionally designed to not maximize the economic value of a corporation for the benefit of the shareholders. Rule for how rights plans are limited by fiduciary duties: It violates fiduciary duty for Director’s to implement a rights plan that would limit future corporate policy (of a for profit corporation) specifically from maximizing profitability unless such action is reasonably related to a legitimate goal. Here, craigslist majority shareholders (and directors) implemented a rights plan that prevented eBay from gaining control of the company after their deaths. The court found the implementation was a violation of their fiduciary duties towards eBay as a minority shareholder of craigslist (goal was not legitimate) and further found that even if it had been proven to be a legitimate end, the rights plan was not a reasonable way to achieve that end. Exception: Defendant may justify such an action if they prove the act serves a legitimate corporate purpose and that act was a reasonable way to achieve that purpose. Here, the court opined the preservation of a distinctly protectable company culture could be a legitimate end. Rule for attorney’s fees: Ordinarily, parties are responsible for paying their own attorney’s fees. The court may shift fees to a party who has acted in bad faith in connection with the prosecution or defense of the litigation. Fees may also be shifted to a losing party whose pre-litigation conduct was undertaken in bad faith and “was so egregious as to justify an award of attorneys’ fees as an element of damages.

VOTING Shareholder Voting Rights of the Shareholder (mechanisms for controlling the Board) 1. Vote Can vote for directors, board members etc. Can vote to amend charters and bylaws; and Can vote to approve fundamental transactions. 2. Sell Vote with your feet 3. Sue For breach of contractual duties 3

Spring 2018 For breach of fiduciary duties a. Loyalty b. Care c. Good Faith and Fair Dealing The Voting System: Key Features What do shareholders vote on? 1. Election of directors 2. “organic” or “fundamental” changes, e.g. mergers, sale of all assests, corporate dissolutions, charter amendments, and 3. Any shareholder resolutions When do you vote? Annually, other than special meetings or written consent solicitations How do you vote? Proxy voting system Shareholders typically vote by mail. The board solicits “proxies” on behalf of, and paid by, the corporation. Shareholders vote by granting or withholding proxies (proxies are essentially proposals or nominations). SEC proxy rule 14a-8 allows shareholders to submit certain proposals for the corporation’s proxy card without director approval. How are votes tallied? Straight (first past the post) v. cumulative (each shareholder gets votes equal to the number of shares owned times the number of seats to be filled) What do you need to win? Plurality v. Majority (See DGCL § 216) (1) A majority of shares present constitutes a quorum, but the charter or bylaws may specify otherwise. (2) In all matters other than the election of directors, the affirmative vote of the majority of shares present shall be the act of the stockholders. (3) Directors shall be elected by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of directors Who do you vote for? Either all the directors (unitary board) or 1/3 of the directors (staggered board). How do you remove directors? With or without cause (special rules for staggered and cumulatively voted boards). 141(k). See slides for DGCL citations

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Spring 2018 How do you vote? Proxy Voting System Proxy voting system: Key Features 1. Proxy is a power of attorney which instructs the company to vote a shareholder’s shares as indicated 2. Proxies are used to satisfy the quorum and count as votes 3. The Board prepares and solicits proxies on behalf of, and paid by, the company. 4. Company must file a proxy statement with the SEC 5. Rule 14a-8 requires companies to include shareholder proposals in the company’s proxy materials certain precatory resolutions and bylaw amendments. 6. Some companies give shareholders owning 3% or more for 3 consecutive years the right to nominate directors for up to 25% of board seats. [D.C. Circuit struck it down on an APA claim] Blasius Indus. v. Atlas Corp. (Del Ch 1988) Lubin and Delano gain control of Blasius Industries “with the assistance of Drexel Burnham’s well noted junk bond mechanism.” Blasius buys 9% of Atlas and proposes a leveraged restructuring. Atlas (through its CEO Weaver) rejects the proposal. Rule for fiduciary duty to respect shareholder authority: 1. It is inconsistent with fiduciary duties to shareholders for a director to act with the primary purpose of preventing or impeding the exercise of stockholder voting power 2. (here, the power of an unaffiliated majority of shareholders to expand the board and elect new directors) even when the directors act in good faith and with appropriate care. 3. Board may still succeed if it shows the impeding action had a “compelling justification.” Rule for removing Directors of a staggered Board: Directors on a staggered board may only be removed for cause (unless the charter provides otherwise). DGCL §141(k). MM Companies v. Liquid Audio Rule for extent of Blasius “Compelling Justification” doctrine: A board may violate its fiduciary duties under Blasius even in cases where the boards actions have not entirely precluded the shareholders from exercising their voting power on an issue (“dilute the substantial presence of insurgent directors”) Here, MM Companies sought to take control of Liquid Audio by 1) running candidates against two board members that were up for reelection and 2) proposing a bylaws amendment that would expand the size of the Board from 5 to 9. The Liquid Audio Board expanded the size of the Board by two seats before the annual meeting, thereby making it more difficult for MM to seize control of the Board. MM won the elections, but lost the proposed bylaw amendment and therefore was unable to seize control. 5

Spring 2018 The Court found the Liquid Audio Board’s expansion of the Board must have a compelling justification under Blasius, even though it did not entirely preclude MM from seizing control (still had primary purpose of impeding exercise).

Conflicted Behavior: Duty of Loyalty Fiduciary Duties: The Basics Who owes fiduciary duties in corporations? Officers and directors, and also controlling shareholders. To whom are fiduciary duties owed? To the corporation and its shareholders. They will be plaintiffs in fiduciary duty lawsuits. What are these duties? The duty of care and the duty of loyalty. We will also encounter a duty of good faith and fair dealing, but it has substantially less bite. Why do we need fiduciary duties? What is the difference between shareholders and regular contracting parties? Shareholders receive few explicit rights/promises from the corporate agents. However, they get the right to vote and the protection of fiduciary principles: the duty of loyalty and the duty of care. Shareholders are also residual claimants to the corporation’s assets. Holders of residual claims bear the marginal risks of the firm and so have the best incentives to make the optimal investment and management decisions. Because of the very open-ended nature of how agents are supposed to act, a more flexible standard (duty of care) is more effective. Meinhard v. Salmon Rule for fiduciary duties: A trustee or other party entrusted with the financial well-being of another owes that party a duty of care. It is a violation of this fiduciary duty for a partner to avail themselves of a financial opportunity that was only made possible because of the partnership, without disclosure of the availability of the opportunity to the other partner. The Punctilio Paragraph: “Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.” Cardozo suggestion: Duty requires Salmon to inform Meinhard about opportunities. Meinhard is then free to compete for, or renegotiate over, any new opportunity. Here, Meinhard and Salmon were partners in a joint-venture that held a 20-year lease at a location in New York where they operated a hotel. Salmon was responsible for the dayto-day management. Salmon, through his operation of the hotel, became aware of an opportunity to lease the whole block on which the parcel was located. He took this 6

Spring 2018 opportunity individually, and Meinhard alleged Salmon’s failure to disclose the opportunity to enter the lease to him was a violation of his fiduciary duty to him. Corporate Opportunity Doctrine (Guth v. Loft (1939)) See page 80-81 of textbook Directors & Officers may not personally take a business opportunity if: 1. 2. 3. 4.

The corporation is financially able to exploit the opportunity The opportunity is within the corporation’s line of business The corporation has an interest or expectancy in the opportunity; and By taking the opportunity for her own, the corporate fiduciary will thereby be placed in a position inimical to her duties to the corporation

D & O may take a business opportunity for their own if: 1. The opportunity is presented to the D&O in his individual, and not his corporate, capacity. 2. The opportunity is not essential to the corporation; 3. The corporation holds no interest or expectancy in the opportunity; and 4. The D&O has not wrongfully employed the resources of the corporation in pursuing or exploiting the opportunity. This can be waived by the corporate charter: See e.g. Corporate Opportunity at Dreamworks SKG (charter allowed star directors to use corporate opportunities to incentivize their employment with Dreamworks). Hayes Oyster Co. v. KeyPoint Oyster Co. Rule for director’s fiduciary duty to deal fairly with the company: A transaction involving corporate property in which a director has an interest is voidable by the corporation if the interested director fails to prove that the transaction was fair to the corporation. Nondisclosure by an interested director or officer is per se unfair. Here, the court found Hayes failure to disclose the possibility for secret profit (from the sale of the Allyn and Paulsbo oyster beds to Keypoint, a company in which he had an interest) is a violation of the fiduciary duty. Cookies Food Products v. Lakes Warehouse (1988) Rule for director enrichment and self-dealing (DGCL 144(a) Safe Harbor: A corporation’s contracts with its directors or officers are not automatically voidable if any of the following occur: 1. The material facts as to the director’s interest in the contract are disclosed or are known to the Board/Directors and the Board 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 2. 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 7

Spring 2018 3. 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. And, the interested director can prove that they acted in good faith, honesty, and fairness. Pappas et al. v. Tzolis (2011) Rule for waiver of fiduciary duties: Parties may waive fiduciary duties through contract, partnership agreement, or charter provision. However, an agreement to eliminate fiduciary duties must do so explicitly. Exception: A fiduciary cannot by contract relieve itself of the fiduciary obligation of full disclosure by withholding the very information the beneficiary needs in order to make a reasoned judgment whether to agree to the proposed contract.

Unconflicted Behavior: The Duty of Care Duty of Care: A director or officer has a duty to the corporation to perform the director’s or officer’s functions: (1) in good faith, (2) in a manner that he or she reasonably believes to be in the best interests of the corporation, and (3) with the care that an ordinarily prudent person would reasonably be expected to exercise in a like position and under similar circumstances. ALI § 4.01(a) Smith v. Van Gorkom (Del. 1985) (duty of care to be informed) Rule for director liability under the Business Judgment Rule: Under the Business Judgment Rule, director liability is predicated on gross negligence Rule for director’s duty to make informed business decisions (duty of care): A director has made an informed decision under the Business Judgment Rule if, prior to making a business decision, they have informed themselves of all material information reasonably available to them. This inquiry has two steps: 1. Was the board informed at the time the business judgment was made; and 2. If not, did the board take sufficient steps to cure any infirmity in their business judgment after it took place? (e.g. a proper market test can cleanse) Here, the board should have demanded: a. More information about the $55 valuation 8

Spring 2018 b. c. d. e.

A copy of the merger agreement A meeting agenda A better understanding of the motivations of the deal A better understanding of how the deal was reached and what senior management team and/or financial advisers’ thought about it.

Director liability for monetary damages for a breach of the duty of care may be waived in the charter of the corporation (DGCL 102(b)(7)

Entire Fairness Review v. Business Judgment Rule Entire Fairness Review (EFR) 1. Triggered by a conflict of interest 2. Can be avoided by disclosing, obtaining approval, and cleansing the conflict 3. If EFR, transaction must be fair as to both process and terms e.g. Van Gorkom facts: end price of the shares was fair but the process by which the Board determined the price was unfair. Business Judgment Rule (BJR): A director or officer who makes a business judgment in good faith fulfills the duty under this section if the director or officer: 1. Is not interested in the subject of the business judgment 2. Is informed with respect to the subject of the business judgment to the extent that the director or officer reasonably believes is appropriate under the circumstances; and 3. Rationally believes that the business judgment is in the best interests of the corporation. ALI §4.01(c) What is the Business Judgment Rule? 1. A rebuttable presumption that a director or officer who makes a business judgment in good faith has fulfilled fiduciary duties 2. Rebut by showing the director or officer is either a. Interested b. Not informed c. Did not act with honest or rational belief that their actions will benefit the corporation. Cleansing Conflicts – Standards of Review 1. Is there a conflict of interest? 2. If so, is there full disclosure of the conflict to the board or the shareholders? If no, EFR 3. If so, has the board or shareholders determined that the transaction is in the best interests of the corporation? If no, EFR 4. Is there some way to cleanse the “taint of the conflict?” If no, EFR, but with better footing. If yes, BJR 9

Spring 2018 See DGCL 144(a) for more on Cleansing Conflicts In re Walt Disney Co. Derivative Litigation Rule for bad faith corporate fiduciary conduct – Intentional Dereliction of Duty: In order for a director to act in bad faith such that it violates their fiduciary duties (and renders them personally liable to the shareholders), they must a. Act with subjective bad faith; or b. Intentionally disregard their responsibilities. Mere gross negligence on the part of a director or officer does not constitute bad faith such that it is a violation of their fiduciary duty. This would constitute a violation of the duty of care, but director liability for the duty of care is typically waived under DGCL 102(b)(7).

THE DUTY TO MONITOR Stone v. Ritter (2006) Why no business judgement rule in this case? The issue in Stone was the absence of a decision. So, issue is whether Defendant violated their duty to monitor. Rule for duty to monitor; implementation of reasonable control system: Boards must have a reasonable control system that will bring problems to their attention. In order to prevail on a...