legal personality archive
Week 9: October 15-19
There will be no classes on Thursday 25 October and Friday 26 October.
For this week please read to p 332.
I’m providing a link here to SSRN for an article by Myron Steele of the Delaware Supreme Court on Fiduciary duties in LPs and LLCs in Delaware (this is not required reading).
Comment: cstruluck – October 16, 2007: Should the judicial standard for court involvement allow interference in the case of arbitrary refusals or gross negligence as suggested in Dodge? I would argue that the nature of economic theory should preclude judicial involvement barring fraud and/or directorial incapacity. Even with incapacity, the nature of economics suggests that the corporation will fix itself with the aims of stabilizing input and output.
WEEK 8: 8-12 October 2007
Here is an example of a complaint in a shareholder derivative suit relating to allegations of backdating of stock options in Advanced Micro Circuits Corporation (AMC Corp). See especially pages 11-12 for demand futility allegations. This is one of Wolf Haldenstein’s cases.
In its most recent form 10Q (quarterly report) AMC stated:
We have been named as a party to several derivative action lawsuits arising from our internal option review, and we may be named in additional litigation, all of which could require significant management time and attention and result in significant legal expenses and may result in an unfavorable outcome which could have a material adverse effect on our business, financial condition, results of operations and cash flows.
We are subject to a number of lawsuits purportedly on behalf of Applied Micro Circuits Corporation against certain of our current and former executive officers and board members, and we may become the subject of additional private or government actions. The expense of defending such litigation may be significant. The amount of time to resolve these lawsuits is unpredictable and defending ourselves may divert management’s attention from the day-to-day operations of our business, which could adversely affect our business, results of operations and cash flows. In addition, an unfavorable outcome in such litigation could have a material adverse effect on our business, results of operations and cash flows.
As a result of our option review and restatement, we are subject to investigations by the SEC and Department of Justice (“DOJ”), which may not be resolved favorably and have required, and may continue to require, a significant amount of management time and attention and accounting and legal resources, which could adversely affect our business, results of operations and cash flows.
The SEC and the DOJ are currently conducting investigations relating to our historical stock option grant practices. We have been responding to, and continue to respond to, inquiries from the SEC and DOJ. The period of time necessary to resolve the SEC and DOJ investigations is uncertain, and these matters could require significant management and financial resources which could otherwise be devoted to the operation of our business. If we are subject to an adverse finding resulting from the SEC and DOJ investigations, we could be required to pay damages or penalties or have other remedies imposed upon us. The restatement of our financial statements, the ongoing SEC and DOJ investigations and any negative outcome that may occur from these investigations could impact our relationships with customers and our ability to generate revenue. In addition, considerable legal and accounting expenses related to these matters have been incurred to date and significant expenditures may continue to be incurred in the future. The SEC and DOJ investigations, and any negative outcome that may result from such investigation, could adversely affect our business, results of operations, financial position and cash flows.
The process of restating our financial statements, making the associated disclosures, and complying with SEC requirements was subject to uncertainty and evolving requirements.
We worked with our independent registered public accounting firm and the SEC to make our filings comply with all related requirements. The issues surrounding the historical stock option grant practices are complex and the regulatory guidelines or requirements continue to evolve. There can be no assurance that we will not be required to further amend our filings with the SEC. In addition to the cost and time to amend financial reports, such an amendment may have a material adverse effect on our investors’ confidence and our common stock price.
If we do not maintain compliance with Nasdaq listing requirements, our common stock could be delisted, which could have a material adverse effect on the trading price of our common stock and cause some investors to lose interest in our company.
As a result of our option investigation, we were delinquent in filing certain of our periodic reports with the SEC, and consequently we were not in compliance with Nasdaq’s Marketplace Rules. As a result, we underwent a review and hearing process with Nasdaq to determine our listing status. Once we filed the delinquent periodic reports with the SEC, Nasdaq permitted our securities to remain listed on the Nasdaq Global Select Market, but our securities could be delisted in the future if we do not maintain compliance with applicable listing requirements. Being delisted could affect our access to the capital markets and our ability to raise capital through alternative financing sources on terms acceptable to us or at all and could cause our investors, suppliers, customers and employees to lose confidence in us.
For this week please read to page 298 of the case book.
The Delaware Supreme Court held in Gentile v Rossette (Aug. 2006) that where shareholders complained that the CEO/controlling stockholder converted debt owed by the corporation to him into stock, and that this wrongfully reduced the cash-value and the voting power of the public stockholders’ minority interest, and increased correspondingly the value and voting power of the controller’s majority interest, that claim was both a direct claim and a derivative claim. The Chancery Court had held that to give rise to a direct claim, a dilution must result in a “material decrease” in voting power, and that plaintiffs who were minority shareholders of SinglePoint both before and after the debt conversion had not suffered a material decrease in voting power.
The Delaware Supreme Court identified two harms: the corporation was caused to overpay for the debt owed to the CEO and “minority stockholders lost a significant portion of the cash value and the voting power of their minority stock interest”. The Court described the dual character of the claim:
A breach of fiduciary duty claim having this dual character arises where: (1) a stockholder having majority or effective control causes the corporation to issue “excessive” shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders. Because the means used to achieve that result is an overpayment (or “over-issuance”) of shares to the controlling stockholder, the corporation is harmed and has a claim to compel the restoration of the value of the overpayment. That claim, by definition, is derivative.
But, the public (or minority) stockholders also have a separate, and direct, claim arising out of that same transaction. Because the shares representing the “overpayment” embody both economic value and voting power, the end result of this type of transaction is an improper transfer—or expropriation—of economic value and voting power from the public shareholders to the majority or controlling stockholder. For that reason, the harm resulting from the overpayment is not confined to an equal dilution of the economic value and voting power of each of the corporation’s outstanding shares. A separate harm also results: an extraction from the public shareholders, and a redistribution to the controlling shareholder, of a portion of the economic value and voting power embodied in the minority interest. As a consequence, the public shareholders are harmed, uniquely and individually, to the same extent that the controlling shareholder is (correspondingly) benefited. In such circumstances, the public shareholders are entitled to recover the value represented by that overpayment—an entitlement that may be claimed by the public shareholders directly and without regard to any claim the corporation may have.
The Court rejected the idea that the reduction in voting power must be “material”:
the requirement of a “material” reduction in voting power should play no part in any analysis of whether a claim is direct, derivative, or both. Such a requirement distracts from—and obscures—the nature of the harm inflicted upon the minority … and denigrates the seriousness of the breach of fiduciary duty causing that harm…. A rule that focuses on the degree or extent of the expropriation, and requires that the expropriation attain a certain level before the minority stockholders may seek a judicial remedy directly, denigrates the gravity of the fiduciary breach and condones overreaching by fiduciaries—at least in cases where the resulting harm to the minority falls below the prescribed threshold for “materiality.” No principle of fiduciary law or policy justifies any condonation of fiduciary misconduct, even where the resulting harm is not “material” in the sense used by the trial court.
The Court also addressed the application of the rule in Tooley (see CB p 240):
..the minority shareholders .. suffered a harm that was unique to them and independent of any injury to the corporation. The harm to the minority shareholder plaintiffs resulted from a breach of a fiduciary duty owed to them by the controlling shareholder, namely, not to cause the corporation to effect a transaction that would benefit the fiduciary at the expense of the minority stockholders. Finally, in this specific case the sole relief that is presently available would benefit only the minority stockholders. Because SinglePoint no longer exists, there are no “overpayment” shares that a court of equity could cancel, and there is no corporate entity to which a recovery of the fair value of those shares could be paid. The only available remedy would be damages, equal to the fair value of the shares representing the overpayment by Single Point in the debt conversion. The only parties to whom that recovery could be paid are the plaintiffs. Hence, although under Tooley the claim could be brought derivatively or directly, as a practical matter, the only claim available after Cofiniti was liquidated is a direct action by the plaintiffs.
cstruluck October 9, 2007: It appears as though the removal of the “material” requirement for stockholder claims will allow individuals to seek a remedy whenever there is a derivative claim. Where is the line distinquishing derivative from individual? It seems probably that anytime a corporation suffers a harm the stockholder is likely to suffer at least a very minor individual harm.
Frank Menendez October 9, 2007: Side Note: There was an article on the WSJ about Shareholders rights to sue third parties: http://online.wsj.com/article_print/SB119163353051650981.html
If that doesn’t work, try: http://jurist.law.pitt.edu/paperchase/2007/10/supreme-court-hears-securities.php
Although this has to do with securities law, it is still very interesting!
Joy Harrison October 10, 2007: Regarding Eisenberg v. Flying Tiger Line, Inc., I am still unclear why the remedy in that case went to the corporation, making the claim a derivative claim. Having his voting rights taken away harmed the shareholder. It seems that if his voting rights were restored he would be receiving the benefit of the remedy.
Brandon Forgione October 10, 2007: In cases like Auerbach v. Bennett, does the number of votes needed for a majority change when the wrongful directors are excluded? For example, would the board in Auerbach still need 8 votes (15 total members) to appoint the committee or only 6 (excluding the 4)?
Also, does this case involve the decision of a special committee (representing the board) after a demand has been made on the board to act? If not, how could the committee (board) stop the action of the shareholder?
To respond to #3, someone correct me if I am wrong, but I think the court found that the action was representative, not derivative, for that very reason. The plaintiff did not have to post a bond because it was not a derivative suit (i.e. the statute did not apply to representative actions).
Bradley October 10, 2007:The remedy the shareholder is asking for which would restore the shareholder’s original voting rights is an unwinding of the merger transaction and the resuscitation of a corporation which no longer exists because it has been merged into another corporation.
Frank Menendez October 12, 2007: Great timing! “Mattel board sued for breach of fiduciary duties in wake of massive toy recalls” http://jurist.law.pitt.edu/paperchase/2007/10/mattel-board-sued-for-breach-of.php
Week 7: 1-5 October 2007
On Tuesday we will finish up with LPs, and then move on to the promoters and veil piercing material (CB pp 200-231) which we will continue with on Thursday. We will also start the derivative suit material this week, so please read in the CB to p 269. In this part of the course we are exploring the implications of a separation between the corporate entity and its owners (shareholders). Note that the issues we consider in the context of derivative suits arise not just because of this separation but because management of the corporation’s business is confided to directors and officers rather than to owners. In some corporations, but not in all, the owners are also the managers.
The issue of what duties a promoter owed to a corporation arose in the context of the Access Cardiosystems bankruptcy. Fincke, an inventor of defibrillation systems, set up the corporation with Baletsa. Fincke arranged for patents for his inventions which listed him as the sole inventor, although the corporation paid the costs of the patent applications. Subsequently other investors were brought in. Fincke left the corporation and argued that he owned the patent rights and that the corporation had no right to use his proprietary information and know-how. The investors argued that Fincke had breached his duties, including his duties as a promoter of the corporation. The Court agreed, saying:
…. in order to retain the benefit of transactions with the corporation, a promoter must disclose in full the particulars of any transaction for prior approval or, at the very least, obtain subsequent ratification by an independent board…
…As a promoter of Access… Fincke owed fiduciary duties of care and loyalty to the company at all times relevant to this litigation…Fincke’s fiduciary duties toward Access began prior to incorporation, during the development of the intellectual property. The intellectual property clearly represented an essential opportunity for the corporation, since Access’s sole purpose was to exploit the resulting inventions.
Fincke was required to assign all rights in a pending patent application to the corporation.
Note that the court pointed out that the Massachusetts Supreme Judicial Court had stated in 1977 that “the problems of the common law liability of promoters as fiduciaries have been largely dormant since the enactment of federal securities legislation in the 1930’s.”
Week 6: 24-28 September 2007
We will start on Tuesday with the question whether the result in Page v Page would be different under RUPA. According to the syllabus for this week we should be reading CB pp 197-231, however we only reached page 163 on Friday, so we’re unlikely to get quite this far this week. I’d like to get to page 187 on Tuesday and start on limited liability on Thursday.
The purpose of this bill is to repeal the special partnership provisions of the Partnership Act 1908 and to establish a modern regulatory regime for limited partnerships that -
* gives the business community in New Zealand the option of a flexible and internationally recognised business structure similar to limited partnerships in use in overseas jurisdictions; and
* facilitates the development of the venture capital industry in New Zealand.
Interestingly the competitive legislation seems to include the control rule which is in the process of being eliminated in the US (the 2001 RULPA does away with the control rule in s 303). This statute has been adopted in Arkansas, California, Florida, Hawaii, Idaho, Illinois, Iowa, Kentucky, Maine, Minnesota, Nevada, New Mexico, North Dakota, and Virginia.
cstruluck, October 2, 2007: It’s seem as though the holding in Access reaches a bit too far in stating that “Fincke’s fiduciary duties toward Access began prior to incorporation, during the development of the intellectual property. The intellectual property clearly represented an essential opportunity for the corporation, since Access’s sole purpose was to exploit the resulting inventions.” Unless the court found that Fincke had entered into a partnership prior to the development and patenting of the intellectual property because of the co-existence of partnership contribution and intent, it seems premature to hold him to the high standard of fiduciary duty before incorporation.
Does the holding in Access Cardiosystems suggest that a promoter is held to corporate fiduciary duties from the moment of intent/purpose to enter into a partnership? Would fiduciary duties exist if a partnership was not properly established but where the interested parties invested in the promoter’s intellectual property? Will the investment in the intellectual property establish the partnership so that fiduciary duty is presummed upon contribution?
Bradley, October 2, 2007: It is probably helpful here to move away from the term partnership. Although that term is often used in a general sense for the purposes of this class we should probably try to limit its use to circumstances where people agree to carry on business together for profit as co-owners and where they do not set up business in another form. Access Cardiosystems was incorporated, and the role Fincke had in its creation was the role of a promoter. The promoter’s liability does not depend on any idea of partnership but on the status of being a promoter.