1.2.3.4.5.352Part IV Business Management and.docx

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Part IV Business Management and Governance
Chapter 18 Governance and Regulation: Securities Law
361
CHAPTER 18
GOVERNANCE AND REGULATION:
SECURITIES LAW
For up-to-date legal and ethical news, go to
mariannejennings.com.
LECTURE OUTLINE
Use opening CONSIDER 18.1 to pique students' interest.
18-1
History of Securities Law (See PowerPoint Slide 18-1)
· Initially Regulated at the State Level
· 1929 Stock Market Crash Precipitated Federal Regulation
18-2

Primary Offering Regulation: The 1933 Securities Act (See
PowerPoint Slide 18-2)
Regulates Primary Offerings (First‑Time Offerings) of
Securities
18-2a
What is a Security?
· Investment in a common enterprise with profits to come from
the efforts of another (SEC v. Howey)
· Includes stocks, bonds, warrants, debentures, voting‑trust
certificates, oil wells, and so forth
· Pension plans are not covered
ANSWER TO CONSIDER 18.2: Walk students through first
example tutorial and then move on to the next examples.
1.
Limited partnership interests – security.
2.
Whether sales of memberships in LLCs are securities would
depend upon whether members participated in operation and
management or delegated such duties.
3.
Same with LLP.
4.
Oil and gas leases are security.

5.
LLP in an oil field – see #2 above.
6.
Real estate investment trust interests – security.
7.
World Series tickets – not security.
18-2b
Regulating Primary Offerings: Registration (See PowerPoint
Slide 18-3)
· Securities and Exchange Commission (SEC)
· SEC – issue injunctions, institute criminal proceedings, enter
into consent decrees, handle enforcement and promulgate rules
· First time public offering is called an IPO
18-2c
Regulating Primary Offerings: Exemptions
· Exempt securities (from registration) (See PowerPoint Slide
18-4)
· Securities issued by federal, state, county, or municipal
governments
· Commercial paper (less than nine months)
· Banks, savings and loans, religious and charitable
organization securities
· Insurance policies

· Annuities
· Common carriers (ICC regulates)
· Stock dividends and splits
· Charitable bonds
· Exempt transactions (See Exhibit 18.1 and PowerPoint Slide
18-5 for summary)
· Intrastate offerings (See PowerPoint Slide 18-6)
· Issuer must be domestic business in state where offering is
made
· Offerees must all be residents of the state
· Triple 80 requirements
· 80 percent of its assets in the state
· 80 percent of its income earned in the state
· 80 percent of sale proceeds will be used on operations in the
state
· Transfer restrictions apply (Rule 147 – 9 months)
· Regulation A – small offering exemption (See PowerPoint
Slides 18-7 and 18-8)
· Shortcut method of registration
· S‑1 filed
· Issues of $5,000,000 or less during any twelve month period
· Up to $50,000,00 in JOBS audit requirements met
· SEC can use integration – can group offerings in a year and

then exemption is not met
· Regulation D (See PowerPoint Slides 18-9, 18-10, 18-11, and
18-12)
· Rule 504 – $1,000,000 or less only transfer restrictions (up to
$2,000,000 if blue-sky registration)
· Rule 505 – $5,000,000 to limited number and types of
investors (up to $7,500,000 under JOBS provisions)
· Rule 506 – no amount limit but limits on types of investors
· Limits on types of investors – accredited investors
· Private business development firm
· Directors, officers, partners (general) of issuer
· Banks
· Purchasers of $150,000 or more
· Natural persons with net worth greater than $1,000,000 (Dodd-
Frank: residence is excluded from determining net worth)
· Persons with income of greater than or equal to $200,000/year
or joint spouse income of $300,000 per year and, with Dodd-
Frank changes, expectation that those funding levels will
continue
· Limits on advertising
· All must carry restrictions on transfer
· "Bad actors" cannot be involved in Reg D offerings UNLESS
SEC-approved
· Crowdfunding under JOBS – up to $1,000,000
·
Stock issued pursuant to corporate reorganization is also exempt
· Escrow required

· Background checks
· Portal is registered
ANSWER TO ETHICAL ISSUES (Goldman Sachs): Goldman’s
point was that it did not owe a duty of disclosure to
sophisticated investors, but the SEC based its charges (and the
charges were eventually settled for $515 million) on the fact
that Goldman at least owed a duty to disclose that it sometimes
took positions contra to their clients’ positions and investments
in the market. The regulatory cycle is important here because
Goldman was operating in a gray area or in a loophole area –
that loophole has now been closed so that Goldman will be
unable to make money from secretive positions that their clients
knew nothing about. The ethical issue is whether you would
want to know, being on the other side, and most folks do want
to know when their investment adviser is positioned against
them.
Use Exhibit18.3 and PowerPoint Slide 18-13 to give overview
of exemptions and registration.
18-2d
What Must Be Filed: Documents and Information for
Registration (See PowerPoint Slides 18-14 and 18-15)
· Issuer/offeror files a registration statement
· SEC has 20 business days from date of filing to act
· If no action, effective after 20 business days
· Can issue a comment or deficiency letter during that time
· Must remedy deficiencies

· First-time offerings generally take six months for approval
· SEC follows full disclosure standard
· Materials include:
· Description of securities
· Audited financial statement
· List of assets
· Nature of business
· List of management and their shares
· Before registration statement is effective
· Can run tombstone ad – see Exhibit 18.2
· Can issue red herring (sample prospectus)
· Cannot make offers to sell
· Can do shelf registration
· File and get approval
· Can go to market any time within a 2-year period
· Must update information in filing
18-2e
Violations of the 1933 Act (See PowerPoint Slide 18-16)

· Section 11 Violations – civil liability for inaccurate
information in registration statement
· What is required for a violation?
· Failure to make full disclosure
· Registration statement contains a material misstatement or
omission
· Who is liable for a violation? (See PowerPoint Slide 18-17)
· Officers
· Directors
· Anyone who signed registration statement
· Experts (lawyers, accountants, appraisers, geologists)
· Defenses for Section 11 violations (See PowerPoint Slide 18-
18)
· Immaterial misstatement
· Investor knew of misstatement and bought anyway
· Due diligence – acted with prudence and had no reason to
believe there was a problem
See PowerPoint Slide 18-19.
CASE BRIEF 18.1
Escott v. BarChris Construction Corp.
283 F. Supp. 643 (S.D.N.Y. 1968)
FACTS: BarChris was an expanding bowling alley firm. Its
rapid expansion necessitated the sale of debentures it registered

with the SEC. The financial disclosures in the registration
statement were full of errors (see summary in text). Various
purchasers filed suit for 1933 Act violations (false materials in
the registration statement). The court dealt with each defendant
separately.
Russo: CEO – knew all facts; liable
Vitolo: President – limited education; liable
directors
Pugliese: VP – limited education; liable
Kircher: Treasurer – liable
Trilling: Controller, but not director – liable
Birnbaum: Lawyer – young but did not investigate; liable
Auslander: New outside director; liable for failure to ask
questions
Peat, Marwick: Liable; failure to ask questions
Answers to Case Questions
1.
How much time transpired between the sale of the debentures
and Bar Chris's bankruptcy? BarChris sold the debentures in
1961; bankruptcy was filed in early 1962.
2.
Give a summary of the types of items that were materially
misstated. BarChris omitted the debt disclosure as well as a

multitude of other pieces of material information. The summary
in the book shows that loans to officers were not disclosed and
assets were not valued correctly.
3.
Who was sued under Section 11? Who was held liable? Those
held liable were those who signed: BarChris’ auditor – Peat,
Marwick, Mitchell & Co.; nine directors; the controller; one
attorney; two investment bankers serving as directors; and all
others who assisted in the preparation of the registration
statement. Signers of the statement, underwriters, and auditors
were held liable.
· Penalties for violations of Section 11 (See PowerPoint Slide
18-20)
· $10,000 and/or five years
· Injunctions to stop sales
· Civil suits
· Securities Litigation Reform Act of 1995
· Limits attorneys’ fees
· Addresses “professional plaintiff”

· Allows “safe harbor” protection for financial predictions
· Section 12 Violations (See PowerPoint Slide 18-21)
· Selling without registration (unless exempt)
· Selling before the effective date
· False information in the prospectus
· Same penalties as Section 11
· Due diligence and Sarbanes-Oxley (See PowerPoint Slides 18-
22, 18-23, 18-24, 18-25, and 18-26 and FOR THE MANAGER’S
DESK − A PRIMER ON SARBANES-OXLEY AND DODD-
FRANK)
· Auditors’ independence
· Public Company Accounting Oversight Board (PCAOB) (Peek-
a-Boo)
· Consists of five presidential appointees
· Nonprofit organization
· No more than two members who are CPAs
· Will develop registration system for public accounting firms
· Establish rules to ensure quality, ethics and auditor
independence
· Will inspect firms to determine compliance with Sarbanes-
Oxley

· Will investigation violations and impose discipline
· Will encourage high standard in the accounting profession
· All firms must register if doing audits for publicly traded
companies
· Auditor independence – cannot do audits of company and do
its
· Bookkeeping
· Information systems
· Appraisals
· Actuarial services
· Management or human resources services
· Broker, dealer services
· Legal services
· Expert services
· Other as PCAOB dictates
· Must rotate audit partner every five years
· Audit firms must have internal systems to monitor conflicts
(Section 404)
18-3
The Securities Exchange Act of 1934

Regulates Secondary Market (See PowerPoint Slide 18-27)
18-3a
Securities Registration
· All traded securities on exchanges must be registered
· All securities of firms with over $10 million in assets and 500
or more shareholders must be registered
18-3b
Emerging Growth Companies (EGCs) and 1934 Act Exemption
· JOBS Act has given EGCs a grace period before the 1934 act
reporting requirements apply
· EGC is defined under JOBS as
· Less than $1 billion in annual gross revenues
· Publicly traded for less than five years
· A public offering of $700 million or less
· Have not issued $1 billion in debt in the immediate past three
years
18-3c
Periodic Filing Under the 1934 Act: Those Alphabet Reports
(See PowerPoint Slide 18-28)

Same firms – national stock exchange and/or 500 or more
shareholders and $10 million or more in assets
· 10‑Q – quarterly financial report
· 10‑K – annual report
· 8‑K – unusual events, spin‑offs
· Periodic filings must be certified under Sarbanes-Oxley
· Both CEO and CFO must sign
· Certify that they have reviewed the report
· Certify that the report contains no untrue statements
· Certify that the financials represent fairly all material aspects
of the company’s financial performance
· Certify that they are responsible for sufficient controls on
company financial systems
· Penalties of $10 million and/or ten years
18-3d
The 1934 Act Antifraud Provision: 10(b) (See PowerPoint
Slides 18-29 and 18-30)
· Fraud or misrepresentation in the sale of securities
· Application of 10(b): applies to all firms (only requires
interstate commerce)
· Proof of Section 10(b): corporations running afoul

· Failure to give information or giving overly pessimistic
information results in violation
· Examples: Failure to disclose pending merger – Texas Gulf
Sulphur, failure to disclose a rich mineral strike
· What should be disclosed? (See PowerPoint Slide 18-31)
· Pending takeovers
· Drops in quarterly earnings
· Pending large dividend
· Possible lawsuits
·
When to disclose?
CASE BRIEF 18.2
Siracusano v. Matrixx Initiatives, Inc.
563 U.S. 27 (2011)
FACTS: Matrixx Initiatives, Inc. (“Matrixx”) is a
pharmaceutical company that sells Zicam through its wholly-
owned subsidiary, Zicam, LLC. One of its products, responsible
for 70% of its sales, is Zicam Cold Remedy, a homeopathic
product marketed as stopping or minimizing cold symptoms.
In December, 1999, Matrixx began to get questions from
physicians whose patients were developing anosmia (loss of the
sense of smell). Researchers at medical facilities contacted
Matrixx in 2002 to offer access to studies showing that zinc

sulfate (present in Zicam) was linked to anosmia.
During this time, Matrixx’s public disclosures did not discuss
these inquiries and studies. In fact, on October 22, 2003,
Matrixx issued an optimistic press release announcing that its
net sales for the third quarter of 2003 had increased by 163%
over the third quarter of 2002.
On an October 23, 2003, earnings conference call, executives
for Matrixx expressed their “enthusiasm for the most recently
completed quarter” and “optimis[m] about the future.” At one
point during the call, Zicam executives were asked to “make
any comment on the litigation MTXX or its officers are
involved in, or whether or not there is any SEC (Securities and
Exchange Commission) investigation.” They replied that “[t]he
officers of this company are not involved in any litigation,” and
that they were not aware of any SEC investigation. In fact, a
lawsuit alleging that Zicam caused anosmia had already been
filed at this time.
By January 30, 2004, the FDA was “looking into complaints
that an over-the-counter common-cold medicine manufactured
by a unit of Matrixx Initiatives, Inc., may be causing some users
to lose their sense of smell.” Matrixx's stock declined after this
report, “falling from $13.55 per share on January 30, 2004 to
$11.97 per share on February 2, 2004.”
DECISION BELOW: NECA-IBEW Pension Fund and James
Siracusano (plaintiffs/appellants) brought a class action suit
against Matrixx and three Matrixx executives (Appellees)
alleging a violation of the Securities Exchange Act of 1934 by
their failure to disclose material information regarding problems
with Zicam. The district court granted Matrixx’s motion to
dismiss the complaint. The court of appeals reversed. The
shareholders appealed.
ISSUES ON APPEAL: Was the information about Zicam and

anosmia material? Was there intent on the part of Matrixx
executives to withhold the information?
DECISION: Yes, the information on the evolving questions and
studies was material. Even if not statistically significant, this
kind of information was likely to influence consumer decisions
to buy Zicam. If they are influenced, then it affects the
company and investors would also likely be influenced by the
decision. The fact that the executives did not release the
litigation information and questions makes the case – it was not
disclosed because they feared the impact.
Answer to Case Questions
1. Based on this decision, if you had been the executives at
Matrixx, what would you have disclosed and when would you
have disclosed it? The information that affects a company’s
products – affects how investors perceive the company. Also,
holding back on the information only loses trust in the
company. If Zicam had dealt with the issue publicly, it might
not have been its demise.
2. Why is it relevant that consumers would be affected by the
studies, whether significant or not? Because the whole picture
moves the market, not the exactness of the science on the data.
If customers are influenced, the company, and hence, investors,
are affected.
3. By 2009, the FDA required that Zicam be removed from
stores and warned consumers about the risk of losing their sense
of smell. What happens to the company as a result? What will
be the impact on Matrixx investors? What will their damages
be? The company has lost 70% of the revenues because the
product cannot be sold. The company cannot continue without
its major product. The investors have lost their investment and
could not recover the loss in value of their shares.

· Running afoul of 10(b): how soon can you trade after
corporate disclosures? (See PowerPoint Slide 18-33)
· Must allow information to go public
· Texas Gulf Sulphur case and adequate disclosure
· Proof of a violation: how individuals run afoul of 10(b)
· Trading too soon before information is disseminated
· Passing along inside information to friends, relatives, etc. –
tippees are also trading on inside information until the
information is fully disseminated
ANSWER TO ETHICAL ISSUES (Insider Trading): Discuss
Mr. Rajaratnam's comments and the prosecutor's response.
· Who runs afoul: the extent of section 10(b) liability
CASE BRIEF 18.3
U.S. v. Salman
792 F.3d 1087 (9th Cir. 2015); cert. granted, 136 S.Ct. 899
(2016)
FACTS: In 2002, Maher Kara joined Citigroup's healthcare
investment banking group. Over the next
{ "pageset": "S80c
few years, Maher began to discuss aspects of his job with his
older brother, Mounir (“Michael”) Kara. Maher began to suspect
that Michael was trading on the information they discussed,
although Michael initially denied it. As time wore on, Michael
became more brazen and more persistent in his requests for
inside information, and Maher knowingly obliged. From late
2004 through early 2007, Maher regularly disclosed to Michael
information about upcoming mergers and acquisitions of and by
Citigroup clients.

In 2003, Maher Kara became engaged to Salman's sister,
Saswan (“Suzie”) Salman. Salman and Michael Kara became
fast friends. In the fall of 2004, Michael began to share with
Salman the inside information that he had learned from Maher,
encouraging Salman to “mirror-imag[e]” his trading activity.
Rather than trade through his own brokerage account, however,
Salman arranged to deposit money, via a series of transfers
through other accounts, into a brokerage account held jointly in
the name of his wife's sister and her husband, Karim Bayyouk.
Salman then shared the inside information with Bayyouk and
the two split the profits from Bayyouk's trading. From 2004 to
2007, Bayyouk and Michael Kara executed nearly identical
trades in securities issued by Citigroup clients shortly before
the announcement of major transactions.
As a result of these trades, Salman and Bayyouk's account grew
from $396,000 to approximately $2.1 million.
The Government presented evidence that Salman knew full well
that Maher Kara was the source of the information. Michael
Kara (who pled guilty and testified for the Government)
testified that, early in the scheme, Salman asked where the
information was coming from, and Michael told him, directly,
that it came from Maher. Michael further testified about an
incident that occurred around the time of Maher and Suzie's
wedding in 2005. According to Michael Kara, on that visit,
Michael noticed that there were many papers relating to their
stock trading strewn about Salman's office. Michael became
angry and admonished Salman that he had to be careful with the
information because it was coming from Maher. Michael
testified that Salman agreed that they had to “protect” Maher
and promised to shred all of the papers.

Maher and Michael Kara enjoyed a close and mutually
beneficial relationship. Michael helped pay for Maher's college.
Maher, for his part, testified that he “love[d] [his] brother very
much” and that he gave Michael the inside information in order
to “benefit him” and to “fulfill [ ] whatever needs he had.” For
example, Maher testified that on one occasion, he received a
call from Michael asking for a “favor,” requesting
“information,” and explaining that he “owe[d] somebody.” After
Michael turned down Maher's offer of money, Maher gave him a
tip about an upcoming acquisition instead.
{ "pageset": "S80c
Michael gave a toast at Maher's wedding, which Salman
attended, in which Michael described how he spoke to his
younger brother nearly every day and described Maher as his
“mentor,” his “private counsel,” and “one of the most generous
human beings he knows.” Maher, overcome with emotion, began
to weep.
DECISION BELOW: The jury found Salman guilty on all five
counts of insider trading.
ISSUE ON APPEAL: Was the furnishing of the information to
a family member insider trading under Section 10(b) of the 1934
Act?
DECISION: Yes. Despite differing views around the circuits,
the court held that the information was proprietary and was
passed to someone with the intent of benefiting them. The
tipper need not gain financially to be guilty of insider trading
and the information was used to make money.
1. Explain the differences between and among the Dirks,

Newman, and Salman cases.Dirks involved a whistleblower
telling an analyst that he suspected a fraud at his company. The
analyst used the information to warn clients, and it was still
insider trading. In Newman, it was a case in which analysts
were getting tips from friends about a company and then
offering advice based on that information, although it was not
clear that they knew the information was inside information. In
Salman, there was a mergers expert who was not with the
companies involved, but was assisting the companies with
mergers and acquisitions and was passing information along to
relatives and they were making money. They all involved
inside information, but the sources and purposes were different
in terms of usage.
2. List the elements the court requires for proof of insider
trading. There has to be someone in the inside who discloses
information that should not be made public. Then the person
tipping has to have some benefit and the person tipped must
have a benefit from that information.
3.
What should those who have inside information learn from this
decision? Those inside the company need to be very cautious
about discussing their work. Those who are in the securities
field need to understand where information is coming from.
And, if you gain inside information, don’t trade on it.
BUSINESS STRATEGY: HUDDLES WITH ANALYSTS OR
STRATEGISTS − DOES IT MATTER?: Goldman came up with
a way to have candid discussions internally without having to
disclose to its clients its real views by having strategists, not
analysts, meet to discuss. The SEC rules covered analysts and
so Goldman developed a specific group that would find a way
around the SEC requirement. Revisit Goldman’s sophisticated
investor position and loophole strategies and the risks of its
approach.

· Running afoul with e-commerce
· Pump and dump facilitated by internet
· Posting of false information can be very damaging
· Aiders and abettors (See PowerPoint Slide 18-35)
· Stonebridge Investment Partners LLC v. Scientific American
case was troublesome to regulators and investors
· Vendors helped a company paint a rosier picture of its
financial condition and performance than was really true and
they were complicit in concealing the deal
· Court held that they were not liable unless there was some
underlying illegal conduct, despite the fact that the company
and its vendors duped the auditor
· Dodd-Frank has expanded liability to cover such situations
FOR THE MANAGER’S DESK: WHAT'S ETHICAL IN
INSIDER TRADING?
1. Because the information about their company is already
public, the employees would not be doing anything wrong by
buying more shares. The only information they have that is not
available to the public is their belief that the company can come
back from the regulatory sanctions. Investor belief in a
company is different from inside information.
2. This was held to not be insider trading, but the case is being
revisited and Mr. Cuban is still under investigation. The issue
is dilution and advance notice of dilution. There is always a
risk of dilution because a company can always sell more shares.
· Sarbanes-Oxley and disclosure
· Must use caution on classification of revenues and expenses

· “Earnings Management” issues present concerns under new
standards
· Must work for honest and ethical conduct
· Give full, fair, accurate, timely and understandable
information
· Must comply with all laws, rules and regulations
· Standing to sue – must have been an actual seller or purchaser
to sue (See PowerPoint Slide 18-36)
· Mental state – need scienter – intent to defraud
· Penalties include $100,000 and up to 25 years per violation
(Insider Trading and Securities Fraud Enforcement Act of 1988)
ANSWER TO CONSIDER 18.3: Yes, he entered a guilty plea
because he was passing along proprietary information that
should not have been disclosed.
18-3e
Insider Trading and Short Swing Profits (See PowerPoint Slides
18-38 and 18-39)
· Applies to officers, directors, and 10 percent shareholders
· Liable to corporations for profits made on sales and purchases
or purchases and sales during any six month period
· SEC matches highest sale with the lowest purchase
· Sarbanes-Oxley era: two-day notification of activity in stock

18-3f
Regulating Voter Information – Section 14 (See PowerPoint
Slides 18-40, 18-41, 18-42)
· Idea is to have full disclosure
· Proxy materials must be registered with the SEC
· Who is soliciting
· How the materials will be sent
· Dodd-Frank requires that company send out shareholder
materials; this change will make it easier for shareholders to
submit proposals for a vote and also to nominate their own
directors
· How much has and will be spent
· Purpose of proxy – an annual meeting
· Shareholder proposal (See Exhibit 18.4)
· Management must include proposals if subject matter is
appropriate
· Shareholders can also get list for solicitation but with
company now handling proposals, this expense is covered
· Dodd-Frank provides for expanded inclusion in proxy
materials
ANSWER TO ETHICAL ISSUE (Wal-Mart): A shareholder can
submit proposals for inclusion in the corporation’s proxy
materials and on the shareholder ballot if the shareholder has
held at least $2,000 (market value) in the corporation’s shares
or 1% of the corporation’s voting securities for at least one
year. Trinity Wall Street Church owns 3,500 Wal-Mart shares.

Under 17 CFR §240.14a-8, a company can refuse to include a
shareholder proposal for a number of reasons that it can provide
to the SEC including personal grievances, management
functions (ordinary business operations), or that the proposal is
not related to the corporation’s business.
The SEC held that Wal-Mart was correct and could exclude the
proposal. Trinity filed suit in federal court seeking a
preliminary injunction against Wal-Mart from printing, issuing,
or mailing the proxy unless it contains the Trinity proposal on
guns. The federal district court denied Trinity’s preliminary
injunction request concluding that the proposal “deals with guns
on the shelves and not guns in society.”
However, after the case went to a full hearing, the federal court
granted an injunction holding that the proposal dealt with a
proper societal issue of the sale of guns. Trinity had originally
filed the proposal following the massacre of the children at
Newtown, Connecticut in December 2013.
Wal-Mart has appealed the decision and the Court of Appeals
has an expedited hearing scheduled because the latest date for
the printing of the Wal-Mart proxy, if it is to meet the federal
and its own bylaw standards for proxy notification to
shareholders, is April 17, 2015. Trinity Street v. Wal-Mart
Stores, Inc., 2015 WL 1905766 (3rd Cir. 2015).
See Exhibit 18.5 for summary of 1933 Act, 1934 Act, and state
regulations.
· Shareholders and executive compensation (see also Chapter
17)
· Major concern
· Compensation committees are now comprised of independent
directors (Sarbanes-Oxley)
· Remedies for Section 14 violations

· Invalidate proxies
· Invalidate actions at meeting
18-3g
Shareholder Rights in Takeovers, Mergers, and Consolidations
· Definitions (See PowerPoint Slide 18-43)
· Merger
Combination of two or more corporations
Example: A Inc. + B Inc. = B Inc.
· Horizontal mergers – merger of two competitors
· Vertical mergers – merger of two firms in the chain of
distribution

Examples: Manufacturer and wholesaler, wholesaler and
retailer
· Conglomerate mergers – merger between two unrelated
companies
Example: Burger franchise and jewelry retailer, generally done
to diversify
· Consolidations
Two or more companies form a new firm
Example: A Inc. + B Inc. = C Inc. (See PowerPoint Slide 18-
44)
· Tender offer (See PowerPoint Slide 18-45)
· Not a business combination
· Method used to get a combination

· Publicly advertised offer to buy stock
· Generally offer is higher than market to make it attractive
· Takeovers
· Can be friendly – management favors
· Can be hostile – management opposes
· Asset acquisitions
· No change in corporate structure
· Shareholder approval not required
·
Filing requirements under the Williams Act (See PowerPoint
Slide 18-46)
· Passed in 1968
· Enforced by SEC
· Applies to all offers to buy more than 5 percent of another’s
securities
· Filing requirements
· Tender offer statement filed with SEC
· Disclosure information to shareholders
· Target company opposing the takeover (hostile) must file its
materials with the SEC

· Required to be disclosed
· Name of offeror
· Source of funding
· Plans for company if takeover is successful
· Number of shares now owned
· Time requirements so shareholders aren’t forced into action
· Definition of tender offers done by courts
· Penalties for violations
· Failure to disclose
· Fraudulent information in the materials
· Proposed changes – Congress is debating more regulation (see
supplemental readings for selection of articles)
· Hostile takeovers
· Management must do the following (within ten days of offer)
· Recommend acceptance or rejection
· No opinion (remains neutral)
· Unable to take a position

· Can take action to stop
Examples: White knight, Pac‑man, etc.
ANSWER TO ETHICAL ISSUES (Dillards):The problems may
have been caused by Horne’s inexperience in takeovers.
Dillard’s took advantage of that lack of experience. The lawsuit
between the parties was settled. They needed further details in
their contract regarding due diligence.
· State laws affecting tender offers (See PowerPoint Slide 18-
47)
· States are enacting statutes to protect their companies
· Types
· Voting‑right restrictions – can accumulate shares but don’t get
voting rights: Hawaii, Indiana, Minnesota, Missouri, New
York, Ohio, Wisconsin
· Redemption‑rights laws – raiders subject to same redemption
price: Maine, Utah, Pennsylvania
NOTE: Pennsylvania passed a new antitakeover statute that has

been called the most restrictive of any of the statutes to date;
many institutional investors are demanding that companies opt
out of its protections so that management is not entrenched
· Fair price laws – all shareholders get a fair price:
Connecticut, Georgia, Illinois, Kentucky, Louisiana, Maryland,
Michigan, Mississippi, Virginia, Washington
· Third generation statutes (Wisconsin and Pennsylvania)
require three‑year waiting periods before a merger can take
place (see above note on PA)
·
Future of State Antitakeover Statutes
· Seventh circuit has stated economic arguments do not
invalidate the statutes
· U.S. Supreme Court refused to grant certiorari – impliedly
approved the decision
· Many shareholder proposals deal with opting out of these
antitakeover provisions
· Proxy regulations (See PowerPoint Slide 18-48)
· Must follow SEC regulations
· If not, action at meeting can be set aside
· Proxy costs can be reimbursed by directors
18-4
State Securities Laws(See Figure 18.5 and PowerPoint Slides
18-49, 18-50, 18-51, and 18-52 for summary of law)
· Blue Sky Laws (state registration requirements) (See

· Can Follow a Merit Review Standard – Securities Reviewed
for Their Merit Must Be “Fair, Just, and Equitable”
18-5
International Issues in Securities Laws (See PowerPoint Slide
18-54)
· United States Has Most Stock Exchanges
· European Union Has Regulations on Disclosure
· Insider Trading Becoming More Vigorously Regulated in
Other Countries
· Only United States Has Proxy Disclosures
BIOGRAPHY − BERNIE MADOFF: THE LARGEST AND
LONGEST PONZI SCHEME IN HISTORY ($50 BILLION AND
18 YEARS)
Discuss these key points:
1.
Respected member of the financial community; chairman of
NASDAQ.
2.
Operations were isolated from scrutiny.
3.
The ongoing, absolutely consistent returns were a clue.
4.
Those who knew Bernie refused to believe that he could do such
a thing.
5.
He started small and then had to grow to keep the whole thing
going.
ANSWERS TO CHAPTER QUESTIONS AND PROBLEMS

1.
The notes were held to be securities. They were investments in
a common enterprise with profits from others’ efforts. Reves v.
Ernst & Young, 494 U.S. 56 (1990).
2.
Yes, they were tippees who violated section 10(b). The broker
did not invest on the basis of the information and is not liable.
They used proprietary information obtained in a doctor/patient
situation. SEC v. Mervyn Cooper and Kenneth E. Rottenberg,
No. 95-8535 (C.D. Cal. 1995).
3.
The Commission has determined not to pursue an enforcement
action in this matter. The SEC held as follows:
The use of social media has proliferated and the Commission is
aware that public companies are increasingly using social media
to communicate with shareholders and the market generally.
The ways in which companies may use these social media
channels, however, are not fundamentally different from the
ways in which the web sites, blogs, and RSS feeds addressed by
the 2008 Guidance.
The SEC held that the company could use Facebook for
announcements, but not the personal accounts of executives and
directors. However, the SEC also noted that the formal
disclosure must then be made promptly after the Facebook
posting.
4.
The court held that Mr. O’Hagan misappropriated information
from his firm and then used it in a way for which it was not
intended and was controlled by the firm’s obligation to the
client. Misappropriation is a breach of fiduciary duty and
involves the use or disclosure of information that was not
intended to be made public. United States v. O'Hagan, 521 U.S.

657 (1997).
5.
The SEC did not require the proposal, but Pepsi pulled the ads.
The ads can affect income, but were more of a social issue.
6.
The proposal was included because the animal treatment
affected reputation and sales. Lovenheim v Iroquois Brands,
Ltd., 618 F. Supp. 554 (D.C. 1985).
7.
The advance knowledge of the attacks would not be inside
information because it is not proprietary to any particular
company. These are individuals who are, in effect, betting on
world events and the impact those events will have on the prices
of the stock of different companies, depending upon their
position with respect to the political (or even weather in some
cases) event.
8.
No, Chiarella did not violate 10(b). He had non-public
information but was not engaged in fraudulent activity.
Chiarella v. United States, 445 U.S. 222 (1980).
9.
He can serve on the board, but he does not qualify as an
independent director. He, therefore, cannot serve on the audit
committee.
10.
Yes, the proxy vote can be rescinded if the proxy materials
contained misrepresentations. Pavlidis v. New England Patriots
Football Club, 737 F.2d 1227 (1st Cir. 1984).
11.
The test for whether a particular scheme is an investment
contract was established in our decision in SEC v. W.J. Howey
Co., 328 U.S. 293, (1946). We look to “whether the scheme

involves an investment of money in a common enterprise with
profits to come solely from the efforts of others.” Id., at 301.
This definition “embodies a flexible rather than a static
principle, one that is capable of adaptation to meet the countless
and variable schemes devised by those who seek the use of the
money of others on the promise of profits.” Id., at 299.…
…[W]hen we held that “profits” must “come solely from the
efforts of others,” we were speaking of the profits that investors
seek on their investment, not the profits of the scheme in which
they invest. We used “profits” in the sense of income or return,
to include, for example, dividends, other periodic payments, or
the increased value of the investment. There is no reason to
distinguish between promises of fixed returns and promises of
variable returns for purposes of the test, so understood. In both
cases, the investing public is attracted by representations of
investment income, as purchasers were in this case by ETS’
invitation to “‘watch the profits add up.’” Moreover,
investments pitched as low-risk (such as those offering a
“guaranteed” fixed return) are particularly attractive to
individuals more vulnerable to investment fraud, including
older and less sophisticated investors. Under the reading
respondent advances, unscrupulous marketers of investments
could evade the securities laws by picking a rate of return to
promise. We will not read into the securities laws a limitation
not compelled by the language that would so undermine the
laws’ purposes.… We hold that an investment scheme promising
a fixed rate of return can be an “investment contract” and thus a
“security” subject to the federal securities laws. SEC v.
Edwards, 540 U.S. 389 (2004).
ETHICS, PUBLIC POLICY, & THE LAW: GOLDMAN SACHS
– THE GOLD (?) STANDARD OF WALL STREET
Discuss the following key points:
1. Partnership structure meant partners’ personal assets were on
the line so the firm engaged in less risky behavior.

2. The laddering process was a form of trading against clients
by ensuring that an IPO was hyped through inside sales.
3. Changing the underwriting standard is fine as long as
investors are aware that the standard has been changed and that
there is more risk associated with these IPOs.
4
The Abacus deal was set up to decline in value but Goldman
distanced itself so that it did not have to make disclosures about
the portfolio.
5.
Discuss what happens to market trust when there are these types
of behaviors from your investment advisor.
INTERACTIVE/COOPERATIVE LEARNING EXERCISES
1.
Have students write a publicly held company and obtain a proxy
statement and then answer the following:
a.
How many directors were up for election?
b.
Were there any shareholder proposals?
c.
What disclosures are made in the proxy materials?
Reiss v. Pan American World Airways
711 F.2d 11 (2nd Cir.1983)
WINTER, Circuit Judge: Irving Reiss appeals from a judgment
granting defendant Pan American World Airways, Inc.’s (“Pan
Am”) motion for summary judgment dismissing his class action

complaint. The complaint alleged violations of section 10(b)
and Rule 10(b)‑5 of the Securities Exchange Act of 1934.
Plaintiffs, holders of Pan Am convertible debentures which
were being called, sold the debentures rather than convert them
into capital stock. They allege that if they had known at the
time that Pan Am was attempting to negotiate a merger with
National Airlines, Inc. (“National”), they would have converted
the debentures into stock rather than selling them. In granting
summary judgment upon a detailed stipulation of facts, Judge
Broderick held alternatively that Pan Am was not obligated to
disclose the existence of the negotiations in question and also
that the failure to disclose was not knowingly misleading.
Background. Pan Am had been interested in acquiring National
since May 1977. By January, 1978, it had secured a
$50,000,000 loan commitment from Citibank, N.A. and Pan
Am’s Chairman, William T. Seawell, and Executive Vice
President for Finance and Development, James H. Maloon, had
met with National’s Chairman, L. B. Maytag. However, Maytag
advised Seawell that National was not interested and Pan Am
allowed the Citibank loan commitment to expire. Throughout
these negotiations confidentiality was preserved. During the
next few months, Seawell and Maloon made other fruitless
overtures to National. Meanwhile, Texas International Airlines,
Inc. began purchasing National stock and petitioned the Civil
Aeronautics Board for permission to acquire control. In
response, Pan Am began purchasing National shares on its own,
acquiring .4% of National’s stock by August 15.
On August 8, 1978, Pan Am’s investment banker, Lehman
Brothers Kuhn Loeb Inc., submitted a report to Pan Am
recommending a call of debentures prior to September, 1978.
One objective of the proposed call was to induce holders to
convert debentures into capital stock, since at that time the

stock was trading in excess of the so‑called “effective
conversion price” – that stock price equal to the amount due
debentureholders upon redemption. Other objectives of the call
included savings on interest payments, tax savings due to
loss‑taking, simplification of the company’s capital structure,
and a strengthening of its equity base.
On August 15, 1978, Pan Am’s Executive Committee adopted
two resolutions. The first authorized acquisition of up to 10%
of National’s stock and further negotiations for the acquisition
of National. The second authorized the call of $25,000,000 of
10 1/2% convertible debentures for redemption on September
29, 1978, at 110% of face value plus accrued interest from
August 14 to September 29. The particular debentures called
were to be determined randomly and were redeemable either in
cash or through conversion to capital stock. On August 15, a
press release announced the redemption but did not mention Pan
Am’s intentions toward National. On the same day, Pan Am
secured a second loan commitment from Citibank. Between
August 15 and August 23, Pan Am negotiated with National,
while increasing its share of stock holdings in National to 4.8%.
No public announcement of the negotiations was made.
On August 23, both National and Pan Am issued press releases
reporting that a firm merger offer was under consideration.
Subsequent press releases on the merger negotiations were also
issued and, on September 7, the merger was announced at
$41/share. On August 29, Pan Am announced that it was
expanding the call to all debentures. At all relevant times, Pan
Am common shares were traded at prices exceeding the
conversion price of the debentures. However, the price of Pan
Am stock rose even higher after the August 23 announcements.

Plaintiff Reiss and the other members of the class sold their
debentures between August 15 and August 22. They claim that
Pan Am’s failure to disclose the merger negotiations with
National between those dates amounted to an intentional
withholding of material information in violation of section
10(b) and Rule 10(b)‑5 of the Act. We affirm Judge
Broderick’s decision.
Discussion. Reiss argues that Pan Am’s August 15 decision to
renew negotiations with National, its second loan commitment
from Citibank, and the statutes of these negotiations between
August 15 and 23 were material facts which were not timely dis
closed to the debentureholders. His claim is based on the
following facts: (1) the August 23 announcement affected the
value of the debentures by causing Pan Am’s stock to rise in
price; (2) Pan Am’s Form 8‑k for August, 1978, reported the
relevant events; and (3) the circumstances on August 15 did not
differ significantly from the circumstances on August 23, when
the first press release disclosing the merger negotiations was
issued. Essentially he argues that since the merger information
affected the value of the debentures when announced, it should
have been disclosed at the earlier rather than later date.
Finally, he contends that scienter is present because Pan Am’s
decisions as to the timing of the various announcements was
conscious.
We consider first Pan Am’s obligation to disclose various
events. Assuming that the partial call of the debentures
constituted a “purchase or sale” for purposes of section 10(b)
and Rule 10(b)‑5, Pan Am’s August 15 announcement of the
partial call of debentures was not misleading. Liability thus
must rest on a showing that additional information should have
been released so as to avoid “assertions . . . so incomplete as to
mislead” the debentureholders. Since such a claim must be

viewed “in the light of the facts existing at the time of the
release . . .,” hindsight is of limited value and the fact that
ultimate disclosure of the negotiations affected stock price is
not compelling. This is particularly so since that price was at
all times greater than the effective conversion price.
The Form 8‑k is entirely irrelevant since the events it in fact
describes occurred after August 23. Thus, even if the contents
of an 8‑k constitute an admission of Rule 10(b)‑5 materiality, a
conclusion which is anything but self‑evident, this 8‑k was no
such admission.
Reiss attempts to supply the missing link by asserting that the
facts on August 15 differed in no relevant respect from the facts
on August 23, when Pan Am announced its merger offer.
Arguing that the fact of an offer on August 23 is no more or less
relevant than a loan commitment on August 15 or than Pan
Am’s overtures to National between August 15 and 23, Reiss
argues that since the status of the negotiations on August 23
was disclosed, the earlier events of supposed equal stature
should also have been given to the investing public.
Even assuming these various events were of comparable
relevance, however, the preferred conclusion confuses
materiality under section 10(b) with consistency in corporate
public relations decisions. Disclosure is a matter of corporate
discretion where legally material facts are not involved, and,
absent a finding of materiality, disclosure at one time does not
imply a legal obligation to disclose at a different time. It does
not serve the underlying purposes of the securities acts to
compel disclosure of merger negotiations in the not unusual
circumstances before us. Such negotiations are inherently fluid
and the eventual outcome is shrouded in uncertainty.

Disclosure may in fact be more misleading than secrecy so far
as investment decisions are concerned. We are not confronted
here with a failure to disclose hard facts which definitely affect
a company’s financial prospects. Rather, we deal with complex
bargaining between two (and often more) parties which may fail
as well as succeed, or may succeed on terms which vary greatly
from those under consideration at the suggested time of
disclosure. We have no doubt that Pan Am disclosed the
existence of negotiations on August 15 and had those
negotiations failed, we would have been asked to decide a
section 10(b)‑5 action challenging that disclosure.
The district court also held that Pan Am lacked scienter, an
independently dispositive grounds for summary judgment. To
prove scienter, more than a conscious failure to disclose must
be shown. Rather, there must be proof that the non‑disclosure
was intended to mislead. Reiss’s argument itself rebuts any
inference to that effect. His contention is that Pan Am called
the debentures in order to encourage debentureholders to
convert to common stock. He also argues, however, that he and
the class he represents sold rather than convert as a result of the
nondisclosure. Since conversion would improve Pan Am’s debt
structure even more than redemption by retaining investment
capital while at the same time securing the interest and tax
savings from the call, Pan Am had every reason to disclose
information which would have increased the trading price of its
common stock, for the higher the stock price, the greater the
incentive for debentureholders to convert. The non‑disclosure
was thus counterproductive so far as the underlying purpose of
the partial call was concerned and can hardly be labeled
knowingly misleading.
Plaintiffs will at best be able to prove that Pan Am failed to
disclose the negotiations with National because it feared that
disclosure would be misleading under the circumstances or

would adversely affect the negotiations themselves. In neither
case are investors well served by a rule compelling disclosure.
Affirmed.
2.
Have students search business periodicals to find a merger,
consolidation, or acquisition in the past two years. Have them
describe the transaction.
SUPPLEMENTAL READINGS
Alvey, Thomas W. III, “Puncturing the RICO Balloon: The
Judicial Imposition of the 10b-5 Purchaser-Seller Requirement,”
41 WASH. U. J. URB. & CONTEMP. L. 193 (Spring 1992).
Bebchuk, Lucian A., "The Wages of Failure: Executive
Compensation at Bear Stearns and Lehman 2000-2008," 27
YALE J. ON REG. 257 (Summer 2010).
Cardilli, Maria Camilla, “Regulation Without Borders: The
Impact of Sarbanes-Oxley on European Companies,” 27
FORDHAM INT'L L.J. 785 (January 2004).
Cherry, Miriam A., “Whistling in the Dark? Corporate Fraud,
Whistleblowers, and the Implications of the Sarbanes-Oxley Act
for Employment Law,” 79 WASH. L. REV. 1029 (November
2004).
Cole, Christopher W., "Financing an Entrepreneurial Venture:
Navigating the Maze of Corporate, Securities, and Tax Law," 78
UMKC L. REV. 473 (Winter 2009).
Davis, Kenneth B., Jr., "The SEC and Foreign Companies – A
Balance of Competing Interests," 71 U. PITT. L. REV. 457
(Spring 2010).
Dunn, Michael B., “Pleading Scienter After the Private
Securities Litigation Reform Act: Or, a Textualist Revenge,” 84
CORNELL L. REV. 193 (November 1998).

Elofson, John, “Should Dead Hand Poison Pills Be Sent to an
Early Grave?”, 25 SEC. REG. L. J. 303 (1997).
Gara, Stephen C. and Craig J. Langstraat, “The Sarbanes-Oxley
Act of 2002: A New Ballgame for Accountants,” 34 U. MEM. L.
REV. 73 (Fall 2003).
Goergen, Marc and Luc Renneboog, “Why are the Levels of
Control (So) Different in German and U.K. Companies?
Evidence From Initial Public Offerings,” 19 J.L. ECON. &
ORG. 141 (April 2003).
Goforth, Carol R., “The Efficient Capital Market Hypothesis:
An Inadequate Justification for the Fraud-on-the-Market
Presumption,” 27 WAKE FOREST L. REV. 895 (1992).
Hamilton, Robert W., “The Crisis in Corporate Governance:
2002 Style,” 40 HOUS. L. REV. 1 (Spring 2003).
Hansen, Aron, “The Aftermath of Silicon Graphics: Pleading
Scienter in Securities Fraud Litigation,” 34 U.C. DAVIS L.
REV. 769 (Spring 2001).
Hansen, Steven W., “The Securities and Exchange
Commission’s Use of Cease and Desist Authority: A
Preliminary Appraisal,” 20 SEC. REG. L. J. 339 (1993).
Heenan, Palmer T., Jessica L. Klarfeld, Michael Angelo
Roussis, and Jessica K. Wash, "Securities Fraud," 47 AM.
CRIM. L. REV. 1015 (Spring 2010).
“HSBA Bar Convention 2003 Update,” 7-OCT HAW. B.J. 24
(October 2003).
Ingber, Adam F., “10b-5 or Not 10b-5?: Are the Current Efforts
to Reform Securities Litigation Misguided?,” 61 FORDHAM L.
REV. S351 (May 1993).
Jennings, Marianne M., “A Glass Walkway, a Pipeline, an
Easement, and a Tree,” REAL ESTATE LAW JOURNAL 41(1):
79-86 (2012).

Jennings, Marianne M., “Accountability When Deceit Is In the
Air: The “Under the Bus” Theorem,” CORPORATE FINANCE
REVIEW 18(2): 30-34 (2013).
Jennings, Marianne M., “Are They Good or Are They Greedy?
JP Morgan Chase, Ina Drew, and the Dangers of Misguided
Character Measurements,” CORPORATE FINANCE REVIEW
17(3): 37-41 (2012).
Jennings, Marianne M., “Bribery, Britain, and Basic Business,”
CORPORATE FINANCE REVIEW 16(1): 40-44 (2011).
Jennings, Marianne M., “Could the Ethics of Regulators Be Part
of the Problem?” CORPORATE FINANCE REVIEW 17(2): 33-
37 (2012).
Jennings, Marianne M., “Does Dodd-Frank Countermand
Sarbanes-Oxley? On Whistleblowers and Internal Controls,”
Jennings, Marianne M., “It’s Not the PR That’s Bad: The
Ethics May Be the Problem,” CORPORATE FINANCE
REVIEW 15(5): 38-41 (2011).
Jennings, Marianne M., “Let’s Have Liability, More Liability,
and No Case Law: Due Diligence,” 22 SOUTHWESTERN U. L.
REV. 373 (1993).
Jennings, Marianne M., “MF Global: How Many Times Must
We Live Through the Same Scenario,” CORPORATE FINANCE
REVIEW 16(4): 36-41 (2012).
Jennings, Marianne M., “RESPA Fee Splits and Other Things
That Go Bump in Escrow,” REAL ESTATE LAW JOURNAL
41(4): 491-498 (2013).

Jennings, Marianne M., “SAC: Using Your Gut and Not a Legal
Standard When Assessing Ethics and Character,” CORPORATE
FINANCE REVIEW 17(5): 41-44 (2013).
Jennings, Marianne M., “The Bystander Effect in Finance: The
Goldman Public Resignation,” CORPORATE FINANCE
REVIEW 16(6): 40-42 (2012).
Jennings, Marianne M., “The Ethics of Willful Ignorance,”
Jennings, Marianne M., “The Irony of Complicity: Lehman
Brothers, Ernst & Young, and Repo 105,” CORPORATE
FINANCE REVIEW 15(6): 36-41 (2011).
Jennings, Marianne M., “The Real (and Ethical) Lessons From
JP Morgan Chase and the Facebook IPO,” CORPORATE
FINANCE REVIEW 17(1): 39-43 (2012).
Jennings, Marianne M., “The Story of Olympus: Missing
Internal Controls and a Culture of Fear, Oddities, and
Reluctance on Governance Reforms,” CORPORATE FINANCE
REVIEW 16(5): 34-36 (2012).
Jennings, Marianne M. “The ‘Who Knew’ Syndrome,”
Jennings, Marianne M., “What HP Missed About Ethical Culture
in Acquisition of Autonomy,” CORPORATE FINANCE
REVIEW 17(4): 36-38 (2013).
Jennings, Marianne M., “You Cannot Talk Your Way Out of a
Situation That Your Conduct Got You Into: Lessons in Ethics
From the Murdoch Events,” CORPORATE FINANCE REVIEW
16(2): 37-41 (2011).
Jensen, Nancy J., “The American Corporation in the Twenty-
First Century,” 31 UNIV. RICHMOND L. REV. 1497 (1997).

Johnson, Lyman P.Q., “(Not) Advising Corporate Officers
About Fiduciary Duties,” 42 WAKE FOREST L. REV. 663
(2007).
Johnson, Lyman P.Q. and Mark A. Sides, “The Sarbanes-Oxley
Act and Fiduciary Duties,” 30 WM. MITCHELL L. REV. 1149
(2004).
Johnson, Marilyn F., Karen K. Nelson and A.C. Pritchard, “In
Re Silicon Graphics, Inc.: Shareholder Wealth Effects Resulting
From the Interpretation of the Private Securities Litigation
Reform Act's Pleading Standard,” 73 S. CAL. L. REV. 773
(May 2000).
Kaufman, Michael J., "Resolving the Continuing Controversy
Regarding Confidential Informants in Private Securities Fraud
Litigation," 19 CORNELL J.L. & PUB. POL'Y 637 (Summer
2010).
Kershen, Drew L., “Sarbanes-Oxley and the Oklahoma Rules of
Professional Conduct,” 28 OKLA. CITY U. L. REV. 413
(Summer-Fall 2003).
Klausner, Michael, “Institutional Shareholders, Private Equity,
and Antitakeover Protection at the IPO Stage,” 152 U. PA. L.
REV. 755 (December 2003).
Kohn, Robert E., “Civil Liability for Primary Securities
Distributions in the United States and the United Kingdom,” 55
LAW & CONT. PROBLEMS 399 (1992).
Kopel, Jared L., "Recent Developments in Securities Law
Leading Lawyers on Understanding Recent Decisions,
Navigating New SEC Initiatives, and Establishing Compliance
Policies Key Securities Law Litigation: Supreme Court, SEC,
and FCPA Cases," 2010 WL 2832729 (July 2010).
Langevoort, Donald C., “On Leaving Corporate Executives
‘Naked, Homeless and Without Wheels’ Corporate Fraud,

Equitable Remedies, and the Debate Over Entity Versus
Individual Liability,” 42 WAKE FOREST L. REV. 627 (2007).
Lee, Hyun-Chul, “The Hidden Costs of Private Benefits of
Control: Value Shift and Efficiency,” 29 J. CORP. L. 719
(Summer 2004).
Lehman, Kathryn Stewart, “Executive Compensation Following
the Sarbanes-Oxley Act Of 2002,” 81 N.C. L. REV. 2115 (June
2003).
Levy, Ely R., “The Law and Economics of IPO Favoritism and
Regulatory Spin,” 1.33 SW. U.L. REV. 185 (2004).
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World and the International Ricochet of Sarbanes-Oxley,” 67
ALB. L. REV. 211 (2003).
McCollam, Douglas, “Mergers and Acquisitions,” 20
AMERICAN LAWYER 514 (1998).
McCormack, Gerard, “Tort and Takeover Bids,” 14 BUS. L. R.
31 (1993).
Moberly, Richard E., “Unfulfilled Expectations: An Empirical
Analysis of Why Sarbanes-Oxley Whistleblowers Rarely Win,”
49 WM. & MARY L. REV. 65 (2007).
Morrissey, Joseph F., “Catching the Culprits: Is Sarbanes-Oxley
Enough?,” 14 2003 COLUM. BUS. L. REV. 801 (2003).
Muir, Dana M., “Fiduciary Constraints: Correlating Obligation
With Liability,” 42 WAKE FOREST L. REV. 697 (2007).
Noe, Thomas H., “Insider Trading and the Problem of Corporate
Agency,” 13 J. OF LAW, ECONOMICS & ORGANIZATION
287 (1997).

Oldham, Jeffrey L., “Taking ‘Efficient Markets’ Out of the
Fraud-on-the-Market Doctrine After the Private Securities
Litigation Reform Act,” 97 NW. U. L. REV. 995 (Winter 2003).
Paredes, Troy A., “Foreword,” 81 WASH. U. L.Q. 229 (Summer
2003).
Paulsen, Erik, “Imposing Limits on Prosecutorial Discretion in
Corporate Prosecution Agreements,” 82 N.Y.U. L. REV. 1434
(2007).
Pazicky, Luke A. E., “A New Arrow in the Quiver of Federal
Securities Fraud Prosecutors: Section 807 of the Sarbanes-
Oxley Act of 2002,” 81 WASH. U. L.Q. 801 (Fall 2003).
Prentice, Robert A., “Sarbanes-Oxley as Quack Corporate
Governance: How Wise is the Received Wisdom?,” 95 GEO.
L.J. 1843 (2007).
Rosenblum, Robert H., “An Issuer’s Duty Under Rule 10(b)-5 to
Correct and Update Materially Misleading Statements,” 24 SEC.
L. R. 175 (1992).
Schreiber, Scott B. and Andrew T. Karron, “Back to the Future:
The New Focus on Predictions as a Basis for Securities Fraud
Claims,” 1 STAN. J.L. BUS. & FIN. 73 (Fall 1994).
Steinberg, Marc I., "A Prolonged Slump for 'Plaintiff-Pitchers':
The Narrow 'Strike Zone' for Securities Plaintiffs in the Fourth
Circuit," 88 N.C. L. REV. 1923 (September 2010).
Thompson, Robert B., “Exit, Liquidity and Majority Rule:
Appraisal’s Role in Corporate Law,” 84 GEORGETOWN L. J. 1
(1995).
Veliotis, Stanley, "Rule 10b5-1 Trading Plans and Insiders'
Incentive to Misrepresent," 47 AM. BUS. L.J. 313 (Summer
2010).
Wallace, Perry E., “Accounting, Auditing and Audit

Committees After Enron, et al.: Governing Outside the Box
Without Stepping Off the Edge in the Modern Economy,” 43
WASHBURN L.J. 91 (Fall 2003).
Wyant, Christopher, “Executive Certification Requirements in
the Sarbanes-Oxley Act of 2002: A Case for Criminalizing
Executive Recklessness,” 27 SEATTLE U. L. REV. 561 (Fall
2003).
360
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© 2017 Cengage Learning®. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole
or in part, except for use as permitted in a license distributed
with a certain product or service or otherwise on a password-
protected website or school-approved learning management
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© 2015 Cengage Learning. All Rights Reserved. May not be
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_1532958318.unknown
_1532958319.unknown
_1532958317.unknown
336
Part IV Business Management and Governance
Chapter 17 Governance and Structure: Forms of Doing
Business

329
CHAPTER 17
GOVERNANCE AND STRUCTURE:
FORMS OF DOING BUSINESS
For up-to-date legal and ethical news, go to
mariannejennings.com.
LECTURE OUTLINE
Use opening CONSIDER 17.1 to pique students' interest.
See Exhibit 17.1 and PowerPoint Slides 17-1, 17-2, and 17-3 to
help students compare the various organizations.
17-1
Sole Proprietorships (See PowerPoint Slide 17-4)
17-1a
Formation
· Done by an individual
· May have a fictitious name
Example: Ralph Jones d/b/a Spuds Brewery
· No formal requirements for formation
· May have to publish d/b/a name

17-1b
Sources of Funding (See PowerPoint Slide 17-5)
· Loans
· Government help
17-1c
Liability (Full Personal Liability of Owner)
17-1d
Tax Consequences
· Owner claims all income and losses
· No separate filing requirement
17-1e
Management and Control (All Assets With One Person)
17-1f
Transferability of Interest (See PowerPoint Slide 17-6)
· Business can be sold – property, inventory, and goodwill
· Owner will usually sign a noncompete agreement
17-2
Partnerships (See PowerPoint Slide 17-7)

· Governed by the Uniform Partnership Act (UPA)
· Adopted in 49 of 50 states
· In absence of agreement UPA controls
· Revised Uniform Partnership Act (1994) – adopted in most
states now
· Definition – Voluntary Association of Two or More
Persons/Co‑Owners in a Business for Profit (See PowerPoint
Slide 17-8)
17-2a
Formation
· Voluntary formation: by agreement
· Draw up articles of partnership
· See lists in Exhibit 17.2 and PowerPoint Slide 17-9 for
requirements and suggestions
· Involuntary formation: partnerships by implication (See
· Sharing of profits
· Constitutes prima facie evidence that a partnership exists
· Exceptions – rent, wages, annuity to widow or estate, payment
for goodwill

Examples: Shopping center leases with percentage of profits
(landlord is not partner), employee profit sharing plans (they
are not partners)
CASE BRIEF 17.1
Blumberg v. Ambrose
2015 WL 5604474 (E.D. Mich. 2015)
FACTS: During the summer of 2004, Roberta Blumberg
(plaintiff) and Michael Ambrose (with LLC referred to as
defendants) worked together at the health clinic of Tamarack
Camps. Blumberg was a registered nurse and the Director of
Health and Safety at Tamarack, while Ambrose was an
undergraduate student and a clinical assistant. Blumberg and
Ambrose collaborated to create and market a for-profit web-
based electronic medical records program called “CampDoc”
that would allow camps to input and access the medical records
of their campers. This program was expanded to allow parents
the ability to fill out health forms and medical histories on-line,
as well as electronically submit information regarding allergies
and medications. Blumberg participated in both the design and
the development of the CampDoc system, including its
prototype, and Ambrose wrote the code for the CampDoc
software.
In the summer of 2009, Blumberg and Ambrose were able to
pilot the software program at Tamarack. With the success of the
pilot program, the two decided to market and sell the CampDoc
program to other camps across the county.
In October 2009, Ambrose filed articles of incorporation for

CampDoc as a Michigan limited liability company and,
unbeknownst to Blumberg, included himself as the sole member.
As part of organizing the company, Ambrose told Blumberg that
she needed to sign several documents, including an employment
agreement, which she did in May 2010. However, Blumberg did
not believe that these documents altered her relationship as a
partner with Ambrose. Ambrose also had conversations with
Blumberg in 2011 about her interest in the profits of CampDoc,
and he told her that “she would receive some percentage of the
profits from the business.”
From 2010 to March 2012, Blumberg attended conferences for
CampDoc. Blumberg “brought several dozen camps on board in
2011,” but she was not paid for that work. In 2012, Blumberg
quit her job “as a registered nurse to devote [her] attention to
CampDoc.” Blumberg never received compensation for her
services in 2009. Blumberg was paid $100 in 2010, $1,000 in
2011, $6,250.02 in 2012, and $18,750.06 in 2013. Ambrose
believed Blumberg's services in 2010 and 2011 were worth more
than what she actually received, and that it was his intention to
make Blumberg “a millionaire.”
In September 2012, Ambrose provided Blumberg with four more
documents to sign − a consulting agreement, a participation
plan agreement, a non-compete/non-disclosure agreement, and a
confidentiality agreement. Although Blumberg claims that
Ambrose considered her a “co-founder,” and called her “the
heart and face of the company,” Ambrose's lawyers advised him
that she should not be listed as an owner of CampDoc. Rather,
Ambrose suggested that Blumberg own a “phantom” interest in
the company, which would be “the equivalent of real equity.”
After reviewing the documents, Blumberg informed Ambrose
that she intended to seek legal advice. Ambrose then terminated
Blumberg's “employment” with CampDoc the following day.

Blumberg filed suit seeking to have the association between
herself and Ambrose declared a partnership under Michigan's
Uniform Partnership Act.
ISSUE: Had the parties created a partnership?
DECISION: There were enough factual issues that the court
could not grant summary judgment. The parties worked
together as a team. They intended to share profits from the
company. Blumberg worked without compensation. They had
formed the idea together and worked to develop it and then sell
it.
Answer to Case Questions
1. If an LLC was created, how is this case about the formation
of a partnership? The LLC was formed unilaterally by Ambrose,
without permission. The issue is the interest that Blumberg
holds and whether the intention was to create a partnership.
2. What are the indications that there was a partnership created?
The two had talked about sharing and making millions.
Blumberg went without compensation as they built the business.
They split the work assignments between administration and
selling and marketing, but they both participated equally.
3.
What list of lessons could you develop for two people who are
starting a business based on what happened in this case? Put
your interests in writing. Determine what type of entity you
want and create it together. Don’t do too much business before
you have properly formed an entity. Watch employment
agreements and other documents between the two of you before
the entity is created.
ANSWER TO CONSIDER 17.2: A partnership agreement had
been executed. Income was to be split and all final decisions

were to be made by Chaiken. The three were not sharing
profits, and there was no intent to create a partnership. The
Commission’s decision that there was not a partnership was
upheld. Chaiken was liable for unemployment taxes. Chaiken
v. Employment Security Comm'n, 274 A.2d 707 (Del. 1971).
· Involuntary formation: partnership by estoppel (or ostensible
partner) (See PowerPoint Slide 17-12)
· Results when someone allows the inference to be made that
he/she is a partner
· Allowing name to be used to get a loan
17-2b
· Capital contributions of partners
· Loans by partners
· Outside loans
ANSWER TO CONSIDER 17.3: Yes, Pope was an ostensible
partner; credit was extended on that belief. There was the
appearance of a relationship. Pope v. Triangle Chemical Co.,
277 S.E.2d 758 (Ga. 1981).
17-2c
Partner Liability (See PowerPoint Slide 17-14)
· Mutual principals and agents
· Partnership assets reachable by partnership creditors
· Personal assets reachable by partnership creditors when
partnership assets are exhausted

CASE BRIEF 17.2
Vrabel v. Acri
103 N.E.2d 564 (Oh. 1952)
FACTS: Stephen Vrabel and a companion went into the Acri
Café in Youngstown to buy alcoholic drinks. Without
provocation, Michael Acri shot and killed the companion and
seriously injured Vrabel. Michael was convicted of murder and
sentenced to a life term. Florence and Michael Acri had owned
the Acri Café as partners since 1933. From the time of their
marriage in 1931 until 1946 (the shooting occurred in 1947),
Michael had been in and out of hospitals, clinics, and so on for
mental disorders. Michael did beat Florence during their
arguments but had no other history of violence. He had been in
exclusive control of the café at the time of the shooting since
1946 when Florence had obtained a legal separation. Vrabel
brought suit against Florence seeking damages.
DECISION BELOW: The trial court awarded Vrabel $7,500.
ISSUE ON APPEAL: Was Florence liable as a partner to
Vrabel for the injuries inflicted by Michael?
DECISION: No. The act was wrongful and malicious and not
within Florence’s control since she had been excluded from the
café for some time.
1.
What was the nature of the business? The nature of the business
was a café.
2.
Why was Mr. Acri not a defendant? He was in jail.

3.
Explain why Mrs. Acri is or is not liable for the injuries. No,
Florence is not liable because the shooting was outside any
scope of partnership responsibility.
17-2d
Tax Consequences in Partnerships (See PowerPoint Slide 17-15)
· Partnership does not pay taxes
· Partnership files informational return
· Partners report income and losses on their returns
17-2e
Management and Control (See PowerPoint Slides 17-16 and 17-
17)
· Partnership authority
· Unless otherwise agreed, each has equal management authority
· May delegate day‑to‑day authority to one partner
· Each partner is mutual principal and agent of the others
· Borrowing – done routinely in most partnerships
· Unanimous consent required for:
· Confession of judgment

· Selling goodwill
· Admission of another partner
· No compensation for work unless agreed
· Partner fiduciary duties (See PowerPoint Slide 17-18)
· Mutual principals and agents
· Each is to act in the best interests of the partnership
· Partnership property
· Property contributed to the firm or purchased with partnership
assets
· Own property as tenants in partnership
· Equal rights to possession and use for partnership purposes
· Upon death of partner, rights automatically transfer to
remaining partners
Example: A, B, and C are partners. B dies. A and C own
property. B’s widow has right to value of B’s interest but not
the property.
· Partner’s interests
· Personal property
· Transferable
ANSWER TO CONSIDER 17.4: The theory is a simple one –
the Facebook shares were partnership property and could not be
distributed. The partnership owned the shares and they had to
either be sold and the proceeds distributed or the shares had to
be allocated by investor interest. The case turned on the simple
concept of partnership property.

An excerpt from the court opinion appears below:
The Favored LPs argue in the first instance that they had an
ownership interest in the Partnership's underlying Facebook
shares. That is wrong.
By claiming an ownership interest in particular Facebook
shares, the Favored LPs are claiming an ownership interest in
specific Partnership property. By statute, a limited partnership
is a separate entity, and individual partners do not have any
rights in specific partnership property. The LP Act says just
that: “A partner has no interest in specific limited partnership
property”. What a partner instead owns is a “partnership
interest.” The LP Act defines that term as “a partner's share of
the profits and losses of a limited partnership and the right to
receive distributions of partnership assets”. Ownership of a
partnership interest does not carry with it any rights to specific
limited partnership property.
Although clear as a matter of statutory law, the Partnership
Agreement reiterated these propositions. Section 1.4 of the
Partnership Agreement, titled “Purposes, Business and
Objections,” confirmed that investors in the Partnership were
not obtaining an ownership interest in Facebook shares. It
stated:
The purpose of the Partnership and the business to be carried on
and the objectives to be attached by it are to invest its funds in
the stock of Facebook. Notwithstanding the foregoing, each
Limited Partner hereby acknowledges and agrees that he is
investing in the Partnership and will acquire an equity interest
in the Partnership, and will not, in connection with this
Agreement or related investment, own nor acquire any shares of
stock in Facebook. ESG Capital Partners II LP v. Passport
Special Opportunities Master Fund LP, 2015 WL 9060982 (Ct.
Chancery 2015).

17-2f
Transferability of Interests (See PowerPoint Slides 17-19 and
17-20)
· Partner’s interest is personal property
· Can be pledged to creditors and transferred
· Transferee does not become a partner
· Admission of new partner requires unanimous consent
· Transferring partner is not relieved of liability
· Some partnership agreements require partners to offer it first
to remaining partners
17-2g
Dissolution and Termination of the Partnership (See PowerPoint
Slides 17-21 and 17-22)
· One partner no longer associated with the partnership
Examples: Retirement, death
· Need not result in termination; can just be a change in
structure or can proceed to termination
· Termination
· Assets are liquidated
· Distribute in this order: outside creditors; partners’ advances

(loans); capital contributions; profits
· Dissolution by agreement
· Dissolution by operation of law: death of a partner,
bankruptcy of partnership or partner
· Dissolution by court order
17-3
Limited Partnerships
· Governed by Uniform Limited Partnership Act (ULPA) (See
Recent revision is called Revised Uniform Limited Partnership
Act (RULPA)
· Adopted in nearly all states
· Use ULPA or RULPA when no agreement
· RULPA has limited adopters but will see more
· ULPA was drafted at a time when limited partnerships were
not popular and size was smaller
· RULPA addresses the needs of the larger limited partnership
· Structure (See PowerPoint Slide 17-24)
· Must have at least one general partner
· Must have at least one limited partner
· Liability of limited partner is limited to capital contribution

· Liability of general partner is all personal assets are subject to
attachment
17-3a
Formation (See PowerPoint Slides 17-25 and 17-26)
· Must meet statutory requirements; if not met a general
partnership is created
· Must file certificate of limited partnership; see text for list of
requirements and note differences between ULPA and RULPA
· RULPA is much briefer
· Corrections can be filed by limited partners
17-3b
· Limited partners provide most of the financing
· Limited partners can contribute services under RULPA
· Loans are used – called advances when made by partners
· Under RULPA, limited partners can use services already given
as a contribution
17-3c
Liability (See PowerPoint Slide 17-28)
· Limited partners have limited liability

· Cannot participate in management
· Cannot use their names in partnership name
· Must file correctly
· Under RULPA, can do the following and still retain limited
liability status:
· Can be an employee
· Can consult with and advise the general partner
· Can act as a surety or guarantor for the limited partnership
· Can vote on amendments, dissolution, sale of property, and
debt assumptions
17-3d
Tax Consequences (See PowerPoint Slide 17-29)
· Taxed the same as general partnerships
· Partners report profits and losses on individual returns
· Limited partners get direct tax benefits with limited liability
· IRS scrutinizes to be certain it is a partnership and not a
corporation
17-3e
Management and Control (See PowerPoint Slide 17-30)

Management is responsibility of general partner
· Profits and distributions
· Authority belongs to general partner to make decisions here
· Profits and losses are allocated on the basis of capital
contributions
· RULPA requires agreement for splitting profits and losses to
be in writing
· Partner authority (See PowerPoint Slide 17-31)
· General partner has same authority as in general partnership
· Can restrict by agreement
· Consent of limited partners required for:
· Admitting a new general partner
· Admitting a new limited partner (can give authority in the
agreement)
· Extraordinary transactions (selling assets)
·
Limited partners have right to inspect books and records
17-3f
Transferability of Interests (See PowerPoint Slide 17-32)
· ULPA allows transfer of interests

· May have significant restrictions on transfer to prevent
liability under federal securities laws
· The more easily an interest can be transferred, the more likely
the IRS is to label it a corporation
· Transfer of a limited partner’s interest does not dissolve the
partnership
· Under RULPA, assigning limited partner can be given the
authority to make the assignee a limited partner
17-3g
Dissolution and Termination of a Limited Partnership (See
· RULPA provides for the following means:
· Expiration of time period in agreement or event as provided in
agreement
· Unanimous written consent of all partners
· By court order
· Withdrawal of general partner
· If termination is elected, assets are distributed as follows (See
· Outside creditors
· Partners’ distributions
· Return of capital contributions

· Remainder split according to agreement
17-4
Corporations
· Characteristics (See PowerPoint Slide 17-35)
· Unlimited duration
· Free transferability of interest
· Limited liability
· Centralized management
· Legal existence
· Can hold title to property
· Can sue or be sued
17-4a
Types of Corporations (See PowerPoint Slides 17-36 and 17-37)
· Profit
· Not for profit
· Domestic – in the state of incorporation
· Foreign – everywhere else
· Government corporations – like Fannie Mae (until its collapse)
· Professional corporations – limited liability on everything
except professional malpractice

· Close or closely held corporations
· Limited number of shareholders
· Subject to less formality
· Subchapter S or S corporation
· IRS election to be treated as partnership for tax purposes
· Still have limited liability
· Limits on size for this election
BUSINESS PLANNING TIP (Corporation Requirements):
Cover the Small Business Protection Act and requirements for
Subchapter S Corporations.
17-4b
The Law of Corporations (See PowerPoint Slide 17-38)
· Model Business Corporation Act (MBCA)
· Liberal statute
· One-third of the states have adopted
· Revised in 1984
17-4c
Formation (See PowerPoint Slide 17-39)
· Must comply with statutory requirements
· Where to incorporate
· Status of state’s corporation laws

· State tax laws
· Ability to attract employees
· Incentives
· File articles of incorporation (See PowerPoint Slides 17-40
and 17-41)
· Name
· Names and addresses of all incorporators
· Capital structure of the corporation
· Types of stock
· Classes of stock
· Rights of shareholders
· Voting rights
·
Statutory agent
· Incorporators (See PowerPoint Slide 17-42)
· Idea people – also called promoters
· Will be personally liable for contracts entered into before
incorporation
· Corporation can ratify contracts – promoter is secondarily
liable
· Corporation can enter into a novation with the third party –

promoter or incorporator is released from liability
· Postformation
· Must hold initial meeting after incorporation (See PowerPoint
Slide 17-43)
· Elect new directors
· Adopt bylaws (day‑to‑day procedures)
17-4d
Capital and Sources of Corporate Funds (See PowerPoint Slides
17-44 and 17-45)
· Short‑term financing – loans from banks
· Debt financing – bond market
· Equity financing – shareholders
· Common stock
· Usually most voluminous
· Get dividends
· Voting shares
· Preferred stock
· Priority for payment of dividends and liquidation of corporate
assets
· Cumulative preferred – guaranteed certain amount for
dividend (if not paid one year, carried over to the next year)

17-4e
Liability Issues (See PowerPoint Slides 17-46 and 17-47)
· Must make full payment for shares – if not, there is liability
Examples: Promising to pay, paying with undervalued property
· If corporate veil is pierced, there is shareholder liability
· Means corporate immunity from liability is set aside
· Reasons for piercing
· Inadequate capitalization – must put enough money at the risk
of the business
· Alter ego theory – separate nature of corporation is
disregarded; no formalities – personal and corporate properties
are mixed together
· Ignoring corporate formalities
· Forming to perpetrate a fraud on creditors
CASE BRIEF 17.3
U.S. v. Bestfoods, Inc.
524 U.S. 51 (1998)
FACTS: In 1957, Ott Chemical Co. manufactured chemicals at

its plant near Muskegon, Michigan, and both intentionally and
unintentionally, dumped hazardous substances in the soil and
groundwater near the plant. Ott was sold to CPC International,
Inc.
In 1965, CPC incorporated a wholly owned subsidiary (Ott II)
to buy Ott’s assets. Ott II then continued both the chemical
production and dumping. Ott II’s officers and directors had
positions and duties at both CPC and Ott.
In 1972, CPC (now Bestfoods) sold Ott II to Story Chemical,
which operated the plant until its bankruptcy in 1977. Aerojet-
General Corp. bought the plant from the bankruptcy trustee and
manufactured chemicals until 1986.
DECISIONS BELOW: The District Court held both CPC and
Aerojet liable. After a divided panel of the Court of Appeals
for the Sixth Circuit reversed in part, the court granted
rehearing en banc and vacated the panel decision. This time, 7
judges to 6, the court again reversed the District Court in part.
ISSUE ON APPEAL: Can a parent be held liable for the
CERCLA violations of a subsidiary?
DECISION: The case is remanded for a determination of
whether the parent companies were sufficiently involved in
operations to warrant liability under a corporate veil theory.
1.
Describe the corporate ownership history that surrounds the
Muskegon facility. Ott owned the chemical plant that originally
operated the Muskegon plant. Ott sold to CPC (eventually
became Best Foods). CPC incorporated Ott II to run the plant.
Ott II was sold to Story. Story went into bankruptcy. Aero-Jet
purchased the plant in bankruptcy.

2.
What must be shown to hold a parent liable for the actions of
the subsidiary? Is CERCLA liability determined under the same
corporate veil standards as other issues? No, the silence makes
it clear that there is only the common law corporate doctrine
and not any special CERCLA veil piercing standard. There
must be something more than joint directors and control of the
company – here there must be control of the operations and
involvement.
3.
Are joint directors of parent and corporate subsidiaries evidence
of a need to pierce the corporate veil? No, the court makes it
clear that such is one of the necessary functions of corporate
accountability and that a conclusion of liability from such
cross-directorships is not appropriate under common law or
CERCLA. There is some evidence that an officer of the parent
had hands-on involvement with the facility and it is that level of
control and involvement that is necessary to establish liability.
17-4f
Corporate Tax Consequences (See PowerPoint Slide 17-49)
· Double taxation
· Corporation pays on income
· Shareholders pay tax on dividends
· S Corporation is an alternative
17-4g

Corporate Management and Control: Directors and Officers
· Election of directors
· Board – hires officers and sets policy
· Executive Committee – delegated authority in between board
meetings
· Role of directors (See PowerPoint Slide 17-51)
· Dodd-Frank Wall Street Reform and Consumer Financial
Protection Act requires that a vote be held on officer pay – at
least once every three years for shareholders to approve officer
pay packages
· Compensation committee members must be independent
· Claw-back provisions are required for compensation earned
through fraud or other illegality
· Limited deductibility of $1 million of pay continues
· Shareholders continue to make proposals on compensation and
some corporations now mandate shareholder approval EVERY
year – not just an affirmation vote
FOR THE MANAGER'S DESK − CEO COMPENSATION:
Review with the students the various levels of compensation.
Discuss levels of compensation relationships with performance.
There are two schools of thought on executive compensation.
The first school, an economics-based one, is that CEOs should
be paid whatever the market will bear. A second school of
thought maintains that CEOs are paid too much and their pay
should be tied to the wages of the employees and the
performance of the company.
The argument has been made that large CEO salaries are
subsidized with taxes because they are deductible. There have
been congressional proposals to place a cap on the amount of
CEO pay that would be deductible.

Many follow the philosophy that CEO pay should be tied to
maximums above worker compensation and that the payment
should not go up unless the company’s financial health is
improved.
Currently the compensation committee of the board of directors
of a company establishes officer pay. Their independence has
been called into question in recent cases since these directors
are often doing business with the company.
Institutional investors have been demanding more say in board
matters and have raised objections about CEO pay. However,
there are some questions about having outside investors set the
management pay incentives in a company. These investors
would then be involved in micro-managing the company which
is not the role of either the board or the shareholders. The issue
that also arises is at what point do the shareholders simply sell
their shares and move onto other companies that pay officers
within reasonable bounds? Traditionally, the market has
functioned as shareholders move from stock to stock depending
upon the performance of the company. Shouldn’t these
investors express their dissatisfaction with the pay system via
the market, with sales?
Dodd-Frank imposes new independence requirements on those
who sit on compensation committee of the board. Dodd-Frank
also gives shareholders a “say on pay.” That is, they have a
vote on approval of compensation. It is not an action vote, but
it reflects shareholders’ position on pay. Some companies have
had shareholder resolutions that changed their articles of
incorporation to require shareholder approval – their standards
go beyond the law.
· Director liability
· Fiduciary

· Business judgment – must give time and effort
CASE BRIEF 17.4
Brehm v. Eisner
746 A.2d 244 (Del. 2000)
FACTS: Michael Eisner, then-CEO and Chairman of Disney,
hired Michael Ovitz as his second-in-command at Disney. Mr.
Eisner had a history of not working well with powerful second-
in-commands, and Mr. Ovitz was a powerful Hollywood talent
agent and producer. In less than one year, Mr. Ovitz and Mr.
Eisner were at such odds, that Mr. Eisner and the board agreed
to pay Mr. Ovitz over $38,000,000 in cash compensation and
3,000,000 in Disney stock to leave the company. The
shareholders brought suit against the Disney board alleging that
the board’s supervision of Eisner was lax, that the hiring was a
poor business decision, and that the amount paid to end the
arrangement constituted waste. The board says it just made a
mistake.
The Delaware Court of Chancery dismissed the shareholders’
complaint because of the business judgment rules. The
shareholders appealed
ISSUE ON APPEAL: Was the decision to hire and terminate
Mr. Ovitz protected under the business judgment rule?
DECISION: Yes. The pay-out was outrageous, the processes of
the board were not crackerjack, and the shareholders were
justifiably upset, but they had not established that the board did
not have its reasons for just getting rid of Ovitz with the pay-
out. There were downsides to litigating with Ovitz and
dragging the company through the process.

1.
What must the shareholders prove to recover? They must prove
that there was not sufficient consideration of the issue and that
no reasonable person could have reached that decision or would
have reached that decision if they had put in sufficient time in
considering the pros and cons of the severance package for
Ovitz.
2.
What does the court say is the relationship between good
corporate governance, liability, and business judgment? A
company need not have perfect corporate governance processes
in order to enjoy the protection of the business judgment rule.
Aspirational is the description for perfect corporate governance,
but a board need not be there in order to enjoy the liability
protections of the business judgment rule.
3.What alternatives to litigation do shareholders have? The
court notes that shareholders can sell shares or vote out
management, but the standard for liability is high enough that
the processes of a company are both disrupted by courts second-
guessing their decisions.
ANSWER TO CONSIDER 17.5: Shlensky felt the directors
were missing the opportunity to make money. However, the
court held in the case that the directors had considered all the
factors and just decided differently than Shlensky would.
Directors can be wrong so long as their decisions are
researched, experts are consulted, and appropriate time is spent
on the final decision. Shlensky v. Wrigley, 237 N.W.2d 776
(Ill. 1968).
NOTE: Lights and night games were eventually added by the
Cubs.
· Corporate opportunity doctrine

· Director has duty to give opportunities first to corporation
· If they do not, profits belong to corporation
· Officer liability (See PowerPoint Slide 17-53)
· Increasing personal liability
· Increasing prosecutions
· Shareholder litigation against boards and officers: derivative
suits
· Officers, boards, Sarbanes-Oxley, and Dodd-Frank (See
PowerPoint Slides 17-54 and 17-55)
· Sarbanes-Oxley brought substantial reforms
· Reforms go beyond MBCA
· Dodd-Frank requires disclosure about combination of CEO and
chairman’s job into one job
· Prohibitions on loans to officers
· Code of ethics for financial reporting
· Separate from regular codes
· 97% of publicly held companies have codes
· Stiffer penalties for false financial information
· Role of legal counsel for corporations
· Must investigate whether violations have occurred
· Lawyer must inform the CEO of the investigation

· Lawyer must report material violations to CEO
· If no action is taken, lawyer must go up the ladder to the
board (independent members)
· Company must create a legal compliance committee
ANSWER TO ETHICAL ISSUES (Officers’ Personal Lives and
Problems for Companies): While we would like to argue that
our personal lives are no one’s business, the reality is that the
behavior of CEOs affect companies and affect share prices of
publicly traded companies. Leadership demands accountability,
both from a business and personal perspective. The company is
vulnerable for many reasons – markets don’t like uncertainty
and evidence of poor judgment makes markets uncertain about
companies. Also, there is a fine line between office romances
and harassment. There can be big judgments and lots of bad
press coverage when a harassment suit hits. The tips on
controlling conduct provided here are important for companies
and officers to follow.
· Role of the chairman and CEO − chairman and CEO job being
split remains an open and debated question
· Role of the compensation committee − compensation
committee must be independent
· Board membership − majority of directors must be
independent
17-4h
Corporate Management and Control: Shareholders (See
PowerPoint Slides 17-56, 17-57 and 17-58)
· Board is governing body

· Can have executive committee for day‑to‑day issues
· Board elects officers and decides salaries
· Shareholder rights: annual meetings
· Elect the board
· Can demand an annual meeting if one not held in thirteen
months
· Shareholder rights: voting
· Can give a proxy
· Voting authority
· Good for eleven months
· Pooling agreements – group of shareholders agrees to vote a
certain way
· Voting trust
· Title to shares signed over to trustee
· Trustee does the voting
· Shareholders still have dividends
· Trust agreement must be filed in corporate office
BUSINESS STRATEGY − GOVERNING CORPORATE
GOVERNANCE: When companies get into legal or ethical
difficulty, government monitors often step in to change
behaviors. The list of changes that E*Trade made after the
revelations about compensation of its CEO are good ones to

illustrate how a board can take back control from management.
Curbing perks, advance preparation for board meetings,
orientation, and open access to management are all principles of
good corporate governance.
· Shareholders rights in business combinations
· Board resolution required for
· Merger
· Consolidation
· Asset sale
· Notice given to shareholders of resolution and meeting
· Each shareholder gets notice
· Even nonvoting shares will vote in these major changes
·
Shareholder approval
· Majority under MBCA
· All shares vote
· Not required for short-form mergers – merger between
subsidiary and parent that owns 90 percent of the subsidiary
· Shareholder rights: the dissenting shareholders
· Those who don’t vote for the merger
· Entitled to appraisal rights

· Demand value of their shares
· Must have filed a written objection to the merger before the
sale
· Given fair value of shares as of the day before the vote
· Freeze-outs – mergers undertaken to get rid of minority
shareholders
· Courts require business purpose for freeze-out (other than
getting rid of minority shareholders)
· Majority shareholders owe fiduciary duty to minority
shareholders
· Shareholders have access to books and records (See
· Under revised MBCA, no ownership requirements
· Must have proper purpose
· Business motivation
· Not political or philosophical motivation
· Transfer restrictions (See PowerPoint Slide 17-60)
· Must be noted or referenced on stock certificates
· Must serve a necessary purpose
· Must be reasonable
FOR THE MANAGER’S DESK − THE BATTLES FOR
SILICON VALLEY CONTROL: The battles in high-tech

companies continue because founders often hold a majority of
the stock, but they often reach a peak in terms of their business
skills and often cannot carry the company forward. the result
has been significant wrestling for board control and hence the
ability to name new CEOs, other than controlling shareholders.
The tricky part is keeping the company running as the board and
control disputes continue.
17-4i
The Dissolution of a Corporation (See PowerPoint Slide 17-61)
· Voluntary
· Board resolution
· Shareholder approval
· Involuntary
· Forced by court or state agency
· Example: Fraud
17-5
Limited Liability Companies
· History (See PowerPoint Slide 17-62)
· Been in existence internationally for some time
· GMBH – Europe
· Limitada – South America
· LLC – U.S.
· Nature

· Aggregate organization
· Liability shield
· Income flows through
17-5a
Formation (See PowerPoint Slide 17-63)
· Articles of organization
· Filed centrally
· Name must disclose status
17-5b
Sources of Funding
Members Contribute Capital (See PowerPoint Slide 17-64)
17-5c
Liability
Members stand to lose capital contributions, but their personal
assets are not subject to attachment

CASE BRIEF 17.5
Martin v. Freeman
272 P.3d 1182 (Colo. App. 2012)
FACTS: Dean C.B. Freeman managed Tradewinds as a single
member LLC. Tradewinds contracted to have Robert C. Martin
construct an airplane hangar. In 2006, Tradewinds sued Martin
for breaching the construction agreement. In 2007, while the
litigation against Martin was pending, Tradewinds sold its only
meaningful asset, an airplane, for $300,000, and the proceeds of
that sale were diverted to Freeman, who paid Tradewinds'
litigation expenses. The trial court declared Martin the
prevailing party and awarded him $36,645.40 in costs.
Because the proceeds of the sale of Tradewinds' only significant
asset, the airplane, went directly to Freeman, the LLC was
without any assets. Martin filed suit to pierce the LLC veil.
DECISION BELOW: The trial court pierced the LLC veil and
found Freeman personally liable for the cost award entered
against Tradewinds. Tradewinds and Freeman (defendants)
appealed.
ISSUE ON APPEAL: Could the LLC be pierced to pay the
creditor?
DECISION: Yes, the LLC could be pierced like a corporate
veil. The judge held: (1) LLC was sole member's alter ego for
purposes of piercing the corporate veil; (2) LLC's sale of its
sole asset during litigation was an attempt to defeat potential
creditor's rightful claim for purposes of piercing the corporate
veil; and (3) in a matter of first impression, a party seeking to
pierce the corporate veil did not have to show wrongful intent.
1.
Give the list of reasons the court finds that piercing the LLC is
necessary.

· Tradewinds maintained negligible corporate records;
•
The records concerning Tradewinds' substantive transactions
were inadequate;
•
The fact that a single individual served as the entity's sole
member and manager facilitated misuse;
•
The entity was thinly capitalized;
•
Undocumented infusions of cash were required to pay all of
Tradewinds' operating expenses, including its litigation
expenses;
•
Tradewinds was never operated as an active business; legal
formalities were disregarded;
•
Freeman paid Tradewinds' debts without characterizing the
transactions;
•
Tradewinds' assets, including the airplane, were used for
nonentity purposes in that the plane was used by Aircraft
Storage LLC, without agreement or compensation;
•
Tradewinds was operated as a mere assetless shell, and the
proceeds of the sale of its only significant asset, the airplane,
were diverted from the entity to Freeman's personal account.

1.2.3.4.5.352Part IV Business Management and.docx

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