You are the Chairman of the Board of a well-known, publicly traded corporation. You are personally responsible for convincing the Board to fund a new produc

Understanding Corporate Law

CAROLINA ACADEMIC PRESS UNDERSTANDING SERIES

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Understanding Corporate Law

FIFTH EDITION

Arthur R. Pinto PROFESSOR OF LAW EMERITUS BROOKLYN LAW SCHOOL

Douglas M. Branson W. EDWARD SELL CHAIR IN BUSINESS LAW UNIVERSITY OF PITTSBURGH SCHOOL OF LAW

CAROLINA ACADEMIC PRESS Durham, North Carolina

Copyright © 2018 Carolina Academic Press, LLC

All Rights Reserved

Library of Congress Cataloging-in-Publication Data

Names: Pinto, Arthur R., author. | Branson, Douglas M., author. Title: Understanding corporate law / Arthur R. Pinto and Douglas M. Branson.

Description: Fifth edition. | Durham, North Carolina : Carolina Academic Press, LLC, [2018] | Series: Understanding series | Includes bibliographical references and index.

Identifiers: LCCN 2018011007 | ISBN 9781531010003 (alk. paper) Subjects: LCSH: Corporation law–United States. Classification: LCC KF1414 .P56 2018 | DDC 346.73/066–dc23 LC record available at https://lccn.loc.gov/2018011007

eISBN 978-1-53101-001-0

Carolina Academic Press, LLC 700 Kent Street

Durham, North Carolina 27701 Telephone (919) 489-7486

Fax (919) 493-5668 www.cap-press.com

Printed in the United States of America

Contents

Preface

Chapter 1 · Introduction and Formation § 1.01 Introduction § 1.02 Sources of Corporate Law § 1.03 Historical Background § 1.04 Choice of Form

[A] Sole Proprietorship [B] Partnership vs. Corporation

§ 1.05 Limited Partnerships § 1.06 Limited Liability Company § 1.07 Taxation

[A] Double Taxation [1] Subchapter S Corporation [2] Limited Liability Companies

§ 1.08 Incorporation and Organization § 1.09 Choice of Law

[A] Delaware's Dominance § 1.10 Ultra Vires

[A] Corporate Social Responsibility and Philanthropy § 1.11 Social Benefit Organizations

Chapter 2 · Promoters' Liability and Defective Incorporation § 2.01 Introduction § 2.02 Promoters' Liability on Preincorporation Contracts

[A] Overview [B] Liability of the Promoter [C] The Strict View of Promoters' Liability [D] Reliance on the Intent of the Parties [E] Liability of the Newly Formed Corporation or LLC [F] Promoters' Fiduciary Duties

§ 2.03 Defective Incorporation

[A] The Problem [B] The De Facto Corporation Doctrine and Corporation by Estoppel

[C] Statutory Abolition of the De Facto Corporation Doctrine [D] Does Corporation by Estoppel Survive the Model Business Corporation Act?

[E] Model Business Corporation Act Compromise [F] Corporate Death

Chapter 3 · Piercing the Corporate Veil § 3.01 The Concept of Limited Liability § 3.02 The Limited Liability Debate § 3.03 Grounds for Piercing the Corporate Veil

[A] Introduction [B] Intermixture of Affairs [C] Lack of Corporate Formalities [D] Veil Piercing in Limited Liability Companies (LLCs) [E] Inadequate Capitalization

[1] Overview [2] What Is Capital for These Purposes? [3] When Is Capital Adequate? [4] Is Inadequate Capitalization Alone a Sufficient Ground? [5] Does a Duty Ever Arise to “Top Off” the Original Capital?

[F] Evasion of a Contract or Statute or Use of a Corporation Solely to Work a Fraud

[G] Instrumentality Theories [H] Torts Versus Contracts

§ 3.04 Equitable Subordination § 3.05 Piercing the Corporate Veil: Procedural Contexts § 3.06 Statutory Liability Under Environmental Laws § 3.07 Successor Corporation Liability in Products Liability § 3.08 Piercing the Corporate Veil — Structural Settings

[A] Personal Shareholder Liability [B] Parent-Subsidiary Settings [C] Brother-Sister (Sibling) Corporation Settings [D] Enterprise Liability

[E] Reverse Piercing [F] Participation [G] Summary

Chapter 4 · Financing the Corporation § 4.01 Introduction § 4.02 Securities

[A] Debt [B] Common Shares [C] Preferred Shares

§ 4.03 Leveraging and Capital Structure § 4.04 Legal Capital Rules

[A] Preemptive Rights [B] Par Value [C] Dividends and Repurchases of Shares

§ 4.05 Valuation [A] Liquidation Value [B] Book Value

[1] Cost Based Accounting [2] Depreciation [3] Intangible Assets

[C] Earnings Approach [1] Capitalization of Earnings [2] Cash Flow as Earnings [3] The Rate

Chapter 5 · The Legal Model and Corporate Governance: Themes and the Allocation of Power Under State Law § 5.01 Introduction § 5.02 Themes

[A] Focus of Corporate Governance and Stakeholders [B] Publicly Held Corporation [C] The Stock Markets

[1] Benefits of Stock Markets [2] Shareholder Protection and Stock Markets

[D] The Efficient Capital Market Hypothesis [E] Role of Ownership

[1] The Berle-Means Corporation — Separation of Ownership from Control

[2] Institutional Investors [3] Political Significance of Share Ownership

[F] Independent Directors [G] Gatekeepers [H] Federalism [I] Publicly Held vs. Closely Held Corporations

§ 5.03 Theories of the Firm [A] Regulatory Approach [B] Management, Director, or Shareholder Approach [C] Law and Economics Approach

[1] Agency Costs [2] Markets [3] Nexus of Contracts [4] Critics of Contractual Approach [5] Behavioral Economics

§ 5.04 The Legal Model § 5.05 Shareholders

[A] Right to Vote [1] Cumulative Voting [2] Right of Expression

[B] Shareholder Meetings and Proxy Voting [C] The Proxy Fight

[1] Change or Influence Management [2] Replace Directors to Facilitate an Acquisition [3] Change Policy

[a] Shareholder Proposals [b] Withholding Votes [c] Nominating Directors in Management's Proxy Statement

[4] Collective Action Problem [5] Proxy Expenses

[D] Shareholder Democracy [1] Fiduciary Duty

[E] Vote Buying

[F] Right to Information § 5.06 Board of Directors

[A] Board Structure [B] Meetings

[1] Actions Without a Meeting § 5.07 Officers

[A] Authority § 5.08 Financial Scandals

[A] The Sarbanes-Oxley Act of 2002 [B] Dodd-Frank Act of 2010

Chapter 6 · Mergers and Acquisitions § 6.01 Introduction § 6.02 Mergers

[A] Triangular Merger [B] Reverse Triangular Merger [C] Short Form Merger

§ 6.03 Sale of Assets § 6.04 Tender Offer § 6.05 Other Legal Issues § 6.06 Appraisal Remedy

[A] Delaware Block Approach [1] The New Delaware Methodology

[B] Stock Market Exception § 6.07 De Facto Mergers

Chapter 7 · Introduction to Federal Regulation and the Proxy Rules § 7.01 Introduction and Overview § 7.02 SEC Jurisdiction and Periodic Reporting by Publicly Held Corporations [A] SEC Jurisdiction [B] Periodic Reporting — An Overview [C] Certifications, Code of Ethics Disclosure, and Penalties for Earnings Restatements

[D] Private Securities Litigation Reform Act (PSLRA) Safe Harbor for Forward Looking Statements

[E] Management Discussion and Analysis (MD&A)

[F] Earnings Management and Revenue Recognition Issues § 7.03 Securities Issuance

[A] The Federal Disclosure Philosophy [B] Registration Requirements [C] The Registration Process [D] Exemptions From Registration

[1] Scope [2] The Intrastate Exemption [3] The Private Offering Exemption [4] Regulation D Exemptions [5] Crowdfunding

§ 7.04 Proxy Regulation [A] Introduction [B] A Proxy Solicitation Hypothetical [C] Proxy Contests

[1] The Shareholder's Role [2] Inadvertent Solicitation and Other Problems [3] Regulatory Burdens and Costs [4] Proxy Contest Procedures and Further Costs

[D] Use of Shareholder Consents [E] The Internet and the “Notice and Access” Proxy Regime

§ 7.05 The SEC Shareholder Proxy Proposal Rule: SEC Rule 14a-8 [A] Proposals [B] Eligibility and Procedure [C] Background on the Nature of the Proposals [D] Mechanics of the Shareholder Proxy Proposal Process [E] The 14a-8, Question 9(7), Ordinary Business Operations Exclusion

[F] Other Rule 14a-8 Exclusions [G] Proposals to Amend Corporate Bylaws [H] CA, Inc. v. AFSCME Employees Pension Trust

§ 7.06 The Proxy Rules' General Antifraud Rule: An Introduction to General Disclosure Law Concepts [A] Introduction [B] SEC Rule 14a-9 [C] Implication of Private Rights of Action

[D] Standing to Sue [E] Materiality of the Omission of the Misleading Statement [F] State of Mind (Fault) Required [G] Causation [H] Remedies

Chapter 8 · Introduction to Fiduciary Duty: The Duty of Care, the Business Judgment Rule and Good Faith § 8.01 Introduction

[A] Overview of Duty of Care and Loyalty [B] Sliding Scale

§ 8.02 Policy Issues [A] Law and Economics Approach

§ 8.03 Duty of Care [A] Nonfeasance [B] Malfeasance and the Business Judgment Rule [C] Causation

§ 8.04 The Smith v. Van Gorkom Case § 8.05 The Demise of the Duty of Care

[A] Delaware General Corporation Law § 102(b)(7) § 8.06 Good Faith

[A] Disney Litigation and Good Faith [B] The Duty to Monitor and Stone v. Ritter

§ 8.07 Duty of Disclosure § 8.08 Duty to Act Lawfully

Chapter 9 · The Duty of Loyalty and Conflicts of Interest § 9.01 Introduction § 9.02 Policy § 9.03 Interested Director Transactions

[A] Common Law [B] Statutory Responses

[1] Weak Form Approach [2] Semi-Strong Approach

[a] The New York Approach [b] The Current California Approach

[3] Strong Form Approach

[a] Delaware Approach [b] The MBCA Approach

§ 9.04 Executive Compensation [A] Stock Options [B] Good Faith and Compensation [C] Waste

[1] Delaware's Waste Standard § 9.05 Corporate Opportunity and Abuse of Position

[A] Legal Tests [1] Interest Test [2] Line of Business Test [3] Fairness Test [4] The ALI Test

[B] Financial Inability [C] Multiple Boards [D] Use of Information and Competition [E] Undisclosed Profits

§ 9.06 Shareholder Voting — Ratification and Optional Voting [A] Effect of Optional Disinterested Shareholder Voting

Chapter 10 · Controlling Shareholders § 10.01 Introduction § 10.02 Use of Control

[A] The Zahn Case [B] Parent-Subsidiary Dealings [C] Sale of Corporation

§ 10.03 Freezeouts [A] Policy Issues [B] State Law [C] Cases

[1] The Weinberger Case [2] Post-Weinberger Cases

[a] Appraisal versus Equity in Delaware [b] Fair Dealing

[i] Negotiating Committee of Independent Directors [ii] Majority of Minority Shareholder Voting

[iii] Both Independent Board and Shareholder Approval

[c] Business Purpose [d] The Controlling Shareholder's Tender Offer

[D] Federal Law [1] SEC Rule 13e-3 [2] SEC Rule 10b-5

§ 10.04 Sale of Control [A] Looting [B] The Perlman Case [C] The California Approach [D] Sale of Office

Chapter 11 · Special Problems of the Closely Held Corporation § 11.01 Introduction and Overview

[A] Definitions of a Close Corporation [B] Illiquidity and Exploitation [C] Corporate Law Responses to the Illiquidity and Exploitation Situation

§ 11.02 Obtaining and Maintaining a Measure of Control [A] Preview [B] Shareholder Voting Agreements [C] Irrevocable Proxies [D] Voting Trusts [E] Class Voting [F] Cumulative Voting [G] Summary

§ 11.03 Protecting Shareholder Expectations in Closely Held Corporations Ex Ante [A] Contract [B] Long-Term Shareholder Tenure and Salary Agreements [C] Less Than Unanimous Shareholder Agreements [D] Other Agreements Affecting Directors' Discretion [E] Comprehensive Shareholder Agreements

§ 11.04 Restrictions on Share Transferability [A] Introduction [B] Umbrella Test — Unreasonable Restraint Upon Alienation?

[C] Other Legal Aspects of Share Transfer Restrictions [1] Legal Capital and Funding [2] Procedural Aspects [3] Disparity Between Buy-Out Price or Formula and Fair Price

[4] Implied Covenant of Good Faith and Fair Dealing [5] Notice

§ 11.05 Other Governance Features of the Closely Held Corporation [A] Overview [B] Greater Than Majority Quorum and Voting Requirements [C] Informal Action by Shareholders and Directors

§ 11.06 Close Corporation Statutes § 11.07 Protecting Shareholder Expectations in the Close Corporation Ex Post [A] Resetting the Problem [B] Heightened Fiduciary Duty in the Close Corporation Setting [C] Heightened Fiduciary Duty in Other Jurisdictions [D] Two Worlds Collide: The Donahue Principle Meets Employment at Will

[E] Involuntary Dissolution Statutes [F] Cases of Deadlock [G] Oppression Grounds [H] Remedies in Involuntary Dissolution Cases [I] Valuation Issues in Court Ordered Buyouts [J] Conclusion

§ 11.08 Limited Liability Companies [A] Introduction

[1] Hybrid Nature [2] Manager-Managed [3] Comparison with Limited Partnership [4] Comparison with the Limited Partnership Hybrid

[B] Background [C] Formation of an LLC [D] Finance [E] Veil Piercing in LLCs [F] Authority of Members and Managers

[G] Fiduciary Duties of LLC Managers and Members [1] Introduction [2] Implied Covenant of Good Faith and Fair Dealing [3] The Duty of Loyalty [4] Competition with the LLC [5] Opting out of Fiduciary Duties [6] Exculpatory Provisions

[H] Dissolution of an LLC [I] Limited Liability Partnerships [J] Series [K] Social Enterprises, Mission Driven Companies, and the Low Profit Limited Liability Company (L3C)

Chapter 12 · Hostile Tender Offers § 12.01 Introduction § 12.02 The Rise and Fall of Hostile Tender Offers § 12.03 Policy Issues

[A] Proponents [B] Opponents

§ 12.04 Tactics [A] Bidder Tactics [B] Target Tactics

[1] Poison Pills § 12.05 State Law

[A] Delaware Approach [1] The Cheff Case [2] The Unocal Test [3] The Revlon Test [4] The Time Case [5] The QVC Case [6] The Unitrin Case [7] Shareholder Voting and Tender Offers [8] Judicial Scrutiny of Deal Protection

[a] The Omnicare Case (Using Unocal) [b] The Lyondell Case (Using Revlon)

[9] Summary

§ 12.06 Federal Securities Law — The Williams Act [A] History [B] Disclosure Rules [C] Other Rules [D] Section 14(e)

§ 12.07 State Takeover Statutes [A] Introduction [B] Policy Issues [C] Constitutionality

[1] The Edgar Case [2] The CTS Case

Chapter 13 · SEC Rule 10b-5 Disclosure and Insider Trading § 13.01 SEC Rule 10b-5 Disclosure and Insider Trading § 13.02 Disclosure Concepts and Elements of a Cause of Action Under Rule 10b-5 [A] Implication of Private Rights of Action [B] Standing to Sue [C] Materiality [D] State of Mind [E] Pleading State of Mind [F] Reliance (Transaction Causation) [G] The Fraud on the Market Theory Reliance Substitute [H] Loss Causation [I] The “In Connection With” Requirement [J] Privity [K] Secondary Liability for Disclosure Violations [L] Statutes of Limitation

§ 13.03 The Prohibition of Insider Trading: Is It Good or Bad? § 13.04 The Law of Insider Trading

[A] Common Law Background [B] The Nature of the Insider Trading Prohibition [C] Who Is an Insider? [D] Tipper-Tippee Liability [E] The Misappropriation Theory [F] The Misappropriation Theory in the Supreme Court

[G] Tippees of Misapporiators [H] Remedies and Enforcement [I] SEC Regulation FD

§ 13.05 The Insider Trading Prohibition Under State Law [A] Common Law [B] Common Law Exceptions: The Kansas Rule [C] Common Law Exceptions: Special Facts Doctrine [D] Modern Expansion of the Special Facts Doctrine [E] Finding Harm to the Corporation from the Insider's Trading

§ 13.06 Regulation of Insider Trading Under Section 16 of the Securities Exchange Act of 1934 [A] Statutory Provisions [B] Parties Plaintiff and Calculation of Damages [C] Who Is an Officer for Section 16 Purposes? [D] Insider Status at Only One End of a Swing [E] Takeover Players and Section 16(b)

Chapter 14 · Corporate Litigation § 14.01 Introduction § 14.02 The Nature of the Derivative Suit: Direct Versus Derivative, Pro Rata Recovery, and Other Preliminary Issues [A] The Nature of the Derivative Suit [B] Direct Versus Derivative — Special or Distinct Injury Rule [C] Direct Versus Derivative — Denial of Contract Rights Associated With Shareholding

[D] Direct Versus Derivative — Closely Held Corporation Exception

[E] Pro Rata (Individual) Recovery in Derivative Actions [F] The Tooley Test in Delaware

§ 14.03 Qualifications of a Proper Plaintiff-Shareholder [A] Record Ownership [B] Contemporaneous Ownership

[1] Introduction [2] Basis for the Rule [3] Possible Exception: Undisclosed Wrongdoing [4] Exception: Continuing Wrong [5] Exception: Double Derivative Actions

[C] Continuous Owner [D] Clean Hands Requirement [E] Adequate Representation Requirement [F] Selection of Lead Counsel

§ 14.04 Reforms of the Earlier Strike Suit Era [A] Overview [B] Verification Requirement [C] Security for Expenses Requirements

§ 14.05 The Demand Rule [A] Overview [B] Demand Refused [C] Demand Accepted [D] Demand Excused

[1] Introduction [2] The Futility Exception

[a] Introduction [b] Legal Tests for Demand Futility [c] Disabling Conflicts of Interest [d] Lack of Independence

[3] Threat of Irreparable Harm [4] Closely Held Corporations [5] Delay [6] Neutrality

[E] Demand on Shareholders § 14.06 Termination of Litigation: The Advent of the Special Litigation Committee Device [A] Background [B] Application of the Business Judgment Rule [C] Delaware and the Zapata Second Step [D] Structural Bias and Other Criticisms [E] Recent Cases

§ 14.07 Proposed Reforms of the Modern Strike Suit Era [A] The ALI Proposals Briefly Considered [B] The American Bar Association (Model Business Corporation Act) Proposals

[C] Derivative Action Summary

[D] Bylaw and Contractual Impediments to Shareholder Litigation

§ 14.08 Right to Trial by Jury, Attorneys' Fees, and Miscellaneous Issues [A] Right to Trial by Jury [B] Attorneys' Fees in Derivative Actions

[1] Entitlement: Common Fund Versus Common Benefit Cases

[2] The Cosmetic (Collusive) Settlement Problem [3] Computation of Fee Amounts: Lodestar Versus Percentage of Recovery Methods

[4] Objectors and Intervenors [5] The WorldCom Case

[C] Statute of Limitations or Laches? [D] Who Pays?

§ 14.09 The Reprise of the Shareholder Class Action [A] The Death of the Derivative Action and the Rise of the “Stock Drop” Class Action

[B] The Private Securities Litigation Reform Act (PSLRA) of 1995

[C] Particularized Issues Under the PSLRA [1] Pleading [2] Loss Causation [3] Selection of the Most Appropriate Plaintiff

[D] The Securities Litigation Uniform Standards Act (SLUSA) of 1998

[E] Mail and Wire Fraud Government Criminal Prosecutions § 14.10 Lawyering Problems in Corporate Litigation

[A] Attorney-Client Privilege [B] Attorney-Client Privilege in Derivative Litigation [C] The Corporation as Client [D] Sarbanes-Oxley Act (SOX) § 307: The Conflict Between “Reporting Up” and the Prohibition on Disclosure of Client Confidences

§ 14.11 Indemnification and Insurance [A] Overview [B] Indemnification Statutes

[C] Advance of Fees and Other Expenses [D] Fees on Fees [E] Implementation by Contract [F] Non-exclusive Versus Exclusive Statutes, Public Policy Limits, and Consistency Limitations

[G] Overriding Requirement of Good Faith (Statutory) [H] Insurance [I] Summary

Table of Statues & Regulations Table of Cases Index

Preface

Understanding Corporate Law is intended to assist law students and lawyers with a basic understanding of the law of corporations as taught in most corporations courses. Significant business, economic and policy issues are highlighted in connection with a thorough analysis of the important cases and both state and federal statutory provisions used in the study of corporations. It includes the major theoretical approaches used in current corporate law literature. In each chapter, the authors identify important policies and discuss the relationship of the law as it has developed to those policies. The rise of institutional shareholder ownership and its effect on legal developments is highlighted. Statutory issues are covered under both the General Corporation Law of the State of Delaware and the Business Corporation Act. In addition, significant sections from the Principles of Corporate Governance of the American Law Institute are covered. The corporate scandals of 2001 and 2002 and the enactment of the federal Sarbanes-Oxley (2002); the financial crisis of 2008 and enactment of Dodd-Frank (2010); and JOBs (2012) Acts are also covered. Chapter 11 now incorporates material on limited liability companies (LLCs). This book is designed to be used with all of the major corporate law casebooks. We also have written this volume so that non-lawyers who desire to progress

beyond a rudimentary knowledge of corporate law may do so by reading this book. Although the book was a collaborative effort, Professor Pinto wrote Chapters

1, 4, 5, 6, 8, 9, 10 and 12. Professor Branson wrote Chapters 2, 3, 7, 11, 13 and 14. Professor Pinto would like to acknowledge his partner Stephen J. Bohlen for

his constant support. Professor Branson dedicates this book to Elizabeth, Clare and Annie. The book is dedicated to our students past and present who have inspired this

project.

Arthur R. Pinto Douglas M. Branson

Chapter 1

Introduction and Formation

§ 1.01 Introduction The corporation is one of several ways to structure a business. Partnerships,

limited liability companies and sole proprietorships, as forms of business, far outnumber corporations. However, the economic impact of the corporate format is significant, since it is the form chosen by most large enterprises. Although there is no standard definition for the term “corporation,” the United States Supreme Court in the Dartmouth College case described it as follows:

A corporation is an artificial being, invisible, intangible, and existing only in contemplation of law. Being a mere creature of law, it possesses only those properties which the charter of its creation confers upon it, either expressly, or as incidental to its very existence.1

A corporation is a separate legal entity2 which owes its existence to the state. Its owners, called shareholders (sometimes “stockholders” by some state statutes) because they own shares of stock, elect a distinct group, known as the board of directors, to oversee the management of the business and select officers to run it (the directors and officers are often called the “managers”). A significant aspect of the study of corporate law (which includes state corporate law and federal securities law) involves corporate governance and the means by which the relationships between shareholders and managers are governed.3

Experiences vary widely in business formation, but we will describe one that may help the reader relate to some of the material in this book. A business often starts with an idea or invention but requires capital (money or contribution of goods or services is also possible) or other people to get started or expand. The initial business can be formed as a corporation, partnership, limited partnership or limited liability company. The capital can be invested in the business in two general ways.4 If capital is lent, then the relationship between the lenders and the business creates a debtor-creditor relationship where the creditor is looking

for eventual repayment plus some current return usually in the form of interest on the loan. If the capital is provided for an ownership stake, then the investors are w

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