Duties of Officers, Directors, & Other Insiders

Question 1

What happens when there is a violation for breaching fiduciary duties?

Answer 1

Personal liability.

Question 2

What is the Duty of Care?

Answer 2

• Involves the directors’ obligation to apply the appropriate standard of care when making corporate business decisions.
• A director has a duty to act in good faith (be honest, not have a conflict of interest and not approve or condone wrongful or illegal activity), reasonable belief and reasonable care, on the basis of the best information as they manage the corporation.
• Duty of care is analyzed under the business judgment rule.
  
  • Material information: the board must only gather and consider all material information that is reasonably available
  • Directors may rely on experts, legal counsel, accountants, or other officers or employees that director believes to be reliable and competent.
  • If order to comply with the duty to care, a director must:
    
    1. Continue to monitor the company
    2. Obtain at least a rudimentary understanding of the business and the industry or walk away, and
    3. Know how to read basic financial statements.
  • If a director discovers illegal course of action, he has a duty to inquire and investigate, object to the behavior, resign, seek advice of counsel and threaten to sue.
  • Examples: issuing dividends, too high of salary to corporate officers, corporate waste, not maximizing income, reorganization, etc.

Question 3

What is the Business Judgment Rule?

Answer 3

• Rebuttable presumption that in making business decision the directors of a corporation
  
  1. Acted on an informed basis
  2. In good faith and in the
  3. Honest belief that the action taken was in the best interest of the company.
• Plaintiff-shareholder must show the director acted fraudulently or with gross negligence to overcome the presumption.

Informed basis: corporate directors must have informed themselves of all reasonably available material information about a proposed business decision before making that decision. Corporate directors do not need to personally investigate all information possibly available.

Question 4

What is the Duty of Loyalty?

Answer 4

• It involves the directors’ obligation not to place their own interest ahead of those of the corporation and its shareholders and to avoid engaging in self-dealing activities.
• Because a breach of the duty of loyalty implies a conflict of interest, the business judgment rule does not apply to a breach of the duty of loyalty. A Defendant Director has the burden of proving the transaction was inherently fair and reasonable from the perspective of the corporation (ie. Made in Good faith).

Question 5

Approaching Corporate Opportunities…

Answer 5

• Two Approaches
  
  • ALI Approach:
    
    • _​_A corporate opportunity is any opportunity to engage in a business activity that a director or senior executive learns of:
      
      1. During performance of his functions as director or senior executive or under circumstances where reasonable to believe the offeror expects it to be offered to the corporation or
      2. Through use of corporate information or property. Or any opportunity for business of which a senior executive becomes aware and knows is closely related to the business in which the corporation is engaged. Under the ALI approach, a director or senior executive may not take advantage of a corporate opportunity unless the individual first offers the opportunity to the corporation with full disclosure and allows the corporation to reject it first, and that rejection must be fair.
  • Delaware:
    
    • Has a narrower approach where in determining whether a corporate opportunity exists, the court looks to whether
      
      1. The corporation is financially capable of pursuing the opportunity,
      2. The opportunity is within the corporations line of business
      3. The corporation has an interest or reasonable expectancy (i.e. the opportunity is not presented to the director or officer in their individual capacity), and
      4. Whether the director engaged in self-dealing or self-interest (they have not wrongfully utilized corporate resources to take advantage of the opportunity). These are factors to consider when determining if there is a potential corporate opportunity.
  • If there is a corporate opportunity, the director should formally submit the opportunity to the board, and have them reject it.
  • Remedy: disgorgement

Question 6

What is a Dominant Shareholder?

Answer 6

• Like a director, a dominant or controlling shareholder has a fiduciary relationship to the corporation and the minority shareholders.
• Their dealings with the corporation are subject to strict scrutiny, and the burden falls upon them to prove not only good faith, but the inherent fairness of their dealings as well.
• Such self-dealing occurs only when a transaction is to the detriment of the minority shareholders.
• The fiduciary duties attach to dominant shareholders because they have the control to elect the board, which owes such duty to the shareholders.

Question 7

Insider Information - Rule 10b-5…

Answer 7

• Requires that one in possession of material inside information (information a reasonable person would consider important in making an investment decision) must either disclose it to the investing public or if he is unable to disclose it in order to protect a corporate confidence or chooses not to do so must abstain from trading in or recommending the relevant securities while such inside information remains undisclosed.
• The rule only applies to material information, which is information a reasonable person would consider important in making an investment decision (i.e. would affect the desire of investors to buy, sell, or hold the securities).
  
  • With speculative information, the test balances the probability the event will occur and the magnitude of the event.

Question 8

Insider Trading: Classic Insiders

Answer 8

Directors and officers are always prohibited from trading on insider information. They must either disclose or abstain from trading.

Question 9

Insider Trading: Temporary Insiders

Answer 9

• May become fiduciaries of the shareholders because they have entered into a special confidential relationship with the corporation and given access to inside information.
• Examples include:
  
  • underwriters, lawyers, or consultant working for the corporation. They have the same prohibition against trading, they must either disclose or abstain.

Question 10

Insider Information - Tippees

Answer 10

• Can also be liable if
  
  1. The tipper breached his/her fiduciary duty to shareholders by disclosing the information to the tippee in order to derive a direct or indirect personal gain; and
  2. The tippee knows or reasonably should know that there had been a breach.

Question 11

Under 10b-5(2), what is the Misappropriation Theory?

Answer 11

• Misappropriation theory holds that a person commits fraud in connection with a securities transaction when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.
• Rule 10b5-2 further stretches this misappropriation theory and states that a person has a duty of trust or confidence for purposes of the theory:
  
  1. When a person agrees to maintain such information in confidence,
  2. When the person communicating the material non-public information and the person to whom it was communicated have a history of sharing confidences, or
  3. Whenever a person receives a material nonpublic information from his or her spouse, parent, child or sibling. The agent would have to get the principal’s consent to trade on the information or engage in self-dealing, so this prevents the trade from happening at all.

Question 12

Under 10b-5(2), what is the Aider/Abetter Theory?

Answer 12

To be liable as an aider or abetter, the tipper must owe a fiduciary duty of confidentiality to the corporation and the aider and abetter must know of the tipper’s breach of fiduciary duty. (SEC used the aider/abetter theory—but not an actual type of 10b-5; criminal law)

Question 13

Under 10b(5)-b, what are False or Misleading Statements?

Answer 13

• False or Misleading Statements: One must also refrain from making false or misleading statements or omissions of material fact with the intent to deceive one who relies on such statements to their detriment causing damages.
  
  • Fraud on the market theory: creates a rebuttable presumption of reliance. Stockholders rely on the integrity of the stock price as being the true and accurate reflection of all publicly-available information. While the corporation has a duty to correct false or misleading statements or omissions of material fact, it has no such duty to correct third party misinformation.
    
    1. False/ misleading statement
    2. Material
    3. Scienter: intent to deceive
    4. Plaintiff relied on the statement
    5. Fraud on the market theory is the presumption of reliance
    6. Caused harm
• Avoiding liability: To avoid liability under a misappropriation theory, a tippee must disclose his intent to trade to the source of the information (i.e. tipper). Whereas to avoid liability under a class theory, a tippee must disclose material, nonpublic information to the public.

Question 14

What is the Tender Offer Rule under 14e-3?

Answer 14

• It prohibits anyone in possession of material information relating to a tender offer that has been commenced (or will be commenced) which he has reason to know is nonpublic and which he has reason to know has been acquired directly or indirectly from
  
  1. The offering person
  2. The issuer of the securities sought, or
  3. Any officer, director, or employee acting on behalf of the offering person from purchasing or selling such securities, unless within a reasonable time prior to such purchase or sale such information and its source are publically disclosed.

Question 15

What is the Short Swing Profits Rule under 16b?

Answer 15

• Under Rule 16(b) of the Securities Exchange Act of 1934, any beneficial owner, director or officer who profits from any low purchase and high sale transaction sequence within a period of less than 6 months must disgorge such profit to the issuer of the securities.
• A beneficial owner is someone with more than 10% of a corporation’s outstanding shares and must be a beneficial owner at the time of BOTH the time of the purchase and sale (e.g. a purchase transaction that newly qualifies one as a beneficial owner is not eligible for matching against any corresponding sales transaction).
• Everyone is strictly liable under this rule and intent doesn’t matter, even applies if there has been a net loss, so long as there is a “buy low and a sell high” transaction.

Question 16

What are Proxies & Proxy Fights?

Answer 16

• Through the use of proxies shareholders may authorize someone else to vote their shares at a shareholder meeting so that things can get accomplished. Each year, shareholders must elect the board, at which time the proxies are often dispatched. A proxy voting relationship gives rise to an agent-principal relationship. Occasionally an insurgent group may seek to oust an incumbent board and seeks proxies to vote consistent with the ouster at the shareholder meeting. Soliciting proxies may cost substantial money.
  
  • The incumbent board may use corporate funds to keep itself in power so long as there is a bona fide policy dispute (there must be a dispute over business policy, as opposed to the board’s mere self-interest in maintaining their director position). The incumbent board may be reimbursed whether they win or lose, because they have a right to defend against attacks.
  • The insurgent group may recover reasonable and proper expenses from the corporation, only if they win (because such a win essentially validates the merit of their efforts).

Question 17

What are Shareholder Proposals?

Answer 17

• Shareholder Proposals is a shareholder’s recommendation or requirement that the company and/or its board of directors take action, which the shareholder intends to present at a meeting of the company’s shareholders.
  
  • Presumption is that the corporation must include the proposal in its proxy statement unless there is a proper exclusion. The burden falls to the company to demonstrate it is entitled to exclude a proposal.
  • Eligibility: To be eligible to submit a proposal a shareholder must have continuously held at least $2,000 in market value or 1% of the company’s securities for a least one year by the date of submission and through the date of the meeting. The proposal may not exceed 500 words, and must be received at least 120 days before the date the proxy statement is released.
  • Exclusion of Shareholder Proposals: A corporation may exclude a shareholder proposal in 13 circumstances. It may exclude a shareholder proposal where the proposal is
    
    1. Improper under state law
    2. Violation of law
    3. Violation of proxy rules
    4. Personal grievance/special interest
    5. Relevance: Proposal relates to operations that account for less than 5% of company’s net assets and not significantly related to the company’s business (economic, ethically, or socially)
    6. Absence of Power or Authority
    7. Management Functions: relates to company’s ordinary business operations
    8. Director Elections: proposal relates to election
    9. Conflicts: proposal conflicts with one of the company’s own proposals
    10. Substantially Implemented: company has already substantially implemented the proposal
    11. Duplication: the proposal substantially duplicates another proposal that will be included in the proxy materials
    12. Resubmission: the proposal deals with substantially the same subject matter as another that has within the previous 5 calendar years (so long as the proposal received less than 3% of the vote if proposed once in the last 5 years, less than 6% if proposed twice in the last 5 years, or less than 10% if proposed three or more times, or
    13. Specific amounts of dividends.

Question 18

What are Close Corporations?

Answer 18

Corporations in which shareholders are also managers of the business (integration of ownership and control), tend to have a smaller number of shareholders, and there is typically no ready market for the shares.

Question 19

Close Corporations - Cumulative Voting

Answer 19

to ensure minority shareholders are guaranteed some representation, each shareholder is allowed to vote by the number of shares he holds times the number of directors to be elected. They can divide them equally or use them all at once.

Question 20

Close Corporations - Vote Pooling Agreements

Answer 20

In a close corporation, shareholders can agree to pool their votes and request that a third party intercede when there is a disagreement about how to vote said shares. These voting agreements will be enforced so long as the agreement is not fraudulent or harmful to the public.

Question 21

Close Corporations - Voting Trust

Answer 21

The shares are transferred into trust and the only person allowed to vote them is the trustee, who is instructed to vote in a certain way. The trust must be in writing and it becomes a public document because could lead to a supermajority. Trustee has a fiduciary duty and shareholder can sue the trustee for breach of fiduciary duty. They are self-enforcing and good for giving stock to children.

Question 22

Close Corporations - Class Voting

Answer 22

Dividing up shares of the corporation into classes-some have voting rights, others do not. This divides power.

Question 23

Close Corporations - Voting Agreements

Answer 23

• Shareholders can agree to pool their votes and request that a third party intercede when there is a disagreement about how to vote said shares.
• Elected directors are supposed to choose officers who will act in the best interst of all shareholders, so an agreement to bind each other at the director level traditionally constituted a violation because it sterilized the board.
• However, in close corporations, shareholders can bind each other at the director level if such an agreement is unanimous, or there is no objecting minority shareholder interest (Clark v. Dodge* and *Galler v. Galler).
  
  • Furthermore, a shareholder agreement in close corporations that controls board voting and management decisions should still be enforced so long as the agreement is not fraudulent or harmful to the public (Galler v. Galler).

Question 24

Close Corporations - Fiduciary Duties of Shareholders

Answer 24

• Shareholders in close corporations owe one another more significant fiduciary duties because the close corporation shareholders are more like partners and owe each other a fiduciary duty of the utmost good faith and loyalty.
  
  • Freeze out test: When there is a majority shareholder oppressing a minority shareholder and they are trying to freeze-out the minority, then it is the majority’s burden to demonstrate that business decisions were made for a legitimate business purpose. The court affords the majority deference to determine a legitimate business purpose for what it did. Then the minority has the burden to show there was a less harmful alternative.
    
    • Majority Oppressing a Minority: duty of loyalty claim which is inherent fairness test
    • Majority Oppressing a Minority and looks like a Freeze-out
    • Freeze-Out in Close Corporation:
      
      • Majority’s burden to demonstrate that business decisions were made for a legitimate business purpose. The court affords the majority deference to determine a legitimate business purpose for what it did
      • Court also place a burden on minority shareholders to demonstrate there was a less harmful alternative

Question 25

What is Involuntary Dissolution?

Answer 25

• MBA JX
  
  • _​_Court may dissolve a corporation in a proceeding by a shareholder if the shareholder proves that
    
    1. Corporate assets are being misapplied or wasted,
    2. That the directors are deadlocked and the corporation has subsequently suffered or will suffer irreparable injury,
    3. Have failed to elected directors at two consecutive annual meetings or
    4. That the directors in control have acted in a manner that is illegal, oppressive or fraudulent.
• In CA
  
  • _​_The statute is broad and liberal and allows either one-half or more of the directors, at least a one-third shareholder or any shareholder in a close corporation may file a complaint for involuntary dissolution and must show
    
    1. Corporation abandoned business
    2. Even number of directors equally divided
    3. Even number of shareholders deadlocked and failed at two meetings to elect directors,
    4. Those in control are guilty of personal fraud/mismanagement or persistent unfairness toward the shareholders or
    5. Reasonably necessary to protect the shareholders.

Question 26

What is a Transfer of Control?

Answer 26

• One may transfer a controlling block of shares for a premium price.
• A controlling shareholder may not however transfer control at a premium if there is
  
  1. Looting of corporate assets,
  2. Conversion of a corporate opportunity or
  3. Fraud or other acts of bad faith

Question 27

What is the Approach to Shareholder Suit?

Answer 27

• What claim can she bring, and how likely is it that she will succeed:
  
  1. Direct or derivative
  2. Procedural necessities of derivative suit
     
     • Posting security/ security for expense statute
     • Demand
     • Special litigation committee: any time a derivative suit is gaining steam, a corporation can at any moment make a special litigation committee. But they aren’t required.
  3. Merits of the claim: breach of fiduciary duty