Chapter 43 – Management of Corporations
CHAPTER 43
MANAGEMENT OF CORPORATIONS
I. OBJECTIVES
This chapter is intended to acquaint students with the management structure of corporations and
the duties and liabilities of those who manage corporations. A student should know:
A. The objectives and powers of corporations.
B. The functions of boards of directors.
C. The process by which directors are elected.
D. The formalities of valid board actions.
E. The various proposals for changing corporate governance.
F. The corporate governance rules imposed by the Sarbanes-Oxley Act of 2002 and Dodd-Frank
Act of 2010.
G. The authority of officers.
H. The special rules for managing close corporations.
I. The fiduciary duties of directors and officers.
J. The operation of the business judgment rule and how directors can comply with it.
K. The tactics directors can adopt to fight hostile takeovers of the corporation and the legality of
the directors’ tactics.
L. The rules that apply to decisions of the board of directors when a director has a conflict of
interest.
M. The reasons corporations freeze-out minority shareholders, the freeze-out methods, and the
legal rules that apply to freeze-out transactions.
N. The liability of the corporation for its agents’ torts and crimes.
O. The rules for insurance and indemnification of directors and officers.
II. ANSWER TO INTRODUCTORY PROBLEM
A. The board of directors should comply with the business judgment rule. The board must make
an informed decision and have a rational basis to believe that the decision is in the best
interests of the corporation. The rule applies because the board has no conflicts of interest.
KRNP can help the board meet its duty by making a reasonable investigation into the
acquisition of Ballmax, including the value of Ballmax and its fit with the products and
strategy of Clestra. KRNP should investigate connections between the board members and
the Ballmax to ensure than no board member has a conflict of interest. KRNP must inform
the board of its findings prior to the board’s consideration of the acquisition to give the
directors time to read and digest the report. At the board meeting, KRNP should make an oral
presentation and take questions from the directors. KRNP should advice the board to take
adequate time to evaluate the facts provided by KRNP. When the board makes its decision, it
should ensure not only that the decision fits with the facts revealed by the reasonable
investigation but also with the firm’s strategy. The decision should be rational and not
grossly negligent.
B. The board should comply with the intrinsic fairness standard because one of Clestra’s
directors has a conflict of interest due to his family’s ownership of the Virginia Hatchets.
The decision to acquire naming rights to the stadium must be fair to the corporation, that is,
one that would be made by reasonable persons acting at arm’s length. KRNP’s role in this
decision is virtually identical to its role under the business judgment rule, including making
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Chapter 43 – Management of Corporations
a reasonable investigation and informing the board of the facts. In addition, KRNP should
investigate the extent of the director’s conflict of interests and ensure that the conflict is fully
disclosed to the board. KRNP should advise Clestra that only the disinterested directors
consider the decision to obtain naming rights, which at least will shift to the corporation the
burden of disproving unfairness if there is litigation. It may result in some courts applying
the business judgment rule. In addition, the KRNP should ensure that the decision of the
board so closely fits with the facts revealed by the reasonable investigation and the firm’s
strategy that the decision to acquire naming rights is fair to the corporation.
C. The board should adopt the tactics in Figure 1 on page 1131 that deter a hostile bid. These
include putting shares in the hands of friendly shareholders, incorporating in a state with a
control share law, having a stock trading surveillance program, and perhaps having a poison
pill, although shareholder’s rights plans are typically found invalid when challenged by
hostile bidders. An important tactic is the board’s adopting a long-range acquisition strategy,
because it will justify virtually any hostile takeover defense and help the board meets its
fiduciary duty under the Unocal test, which applies when a board is taking steps to oppose a
hostile takeover bid. If Clestra has, for example, a long-run strategy to be an independent
consumer products company that can nimbly respond to consumer demands, the board may
oppose an acquisition by a company that threatens that strategy. Having an acquisition
strategy, like Time, Inc. did in the Paramount v. Time case (page 1132), will help Clestra’s
board prove that it had a reasonable grounds to believe that the acquisition posed a threat to
corporate policy and effectiveness and that its defense tactics were reasonable in relation to
that threat, two elements of the Unocal test.
III. SUGGESTIONS FOR LECTURE PREPARATION
A. Introduction
Preview the material in this area by explaining that a corporation is managed by its board of
directors, which often delegates much authority to board committees and the officers. Next,
note that corporation law restricts the managerial discretion of directors and officers. Such
restrictions exist in the objectives and powers of the corporation, the authority of
management, and the fiduciary duties of management.
B. Objectives of the Corporation
1. Compare the profit motive and the other motives of corporations. Note that a corporation
may be acting socially responsibly yet be maximizing profits simultaneously.
2. Note that the courts have allowed corporations to act socially responsibly for many years.
Dodge v. Ford (which appears on page 1165 in Chapter 44), a 1919 case, evidences only
one of the judicial attitudes toward socially responsible conduct as of that date. Courts at
that time permitted management to act socially responsibly in ways other than
maximizing shareholder profit. You may point out that the first corporations in the
United States were permitted to exist only because they served socially important
functions, such as providing water or operating toll roads. It was only after general
corporation laws proliferated in the late 19th Century that the profit maximization
objective dominated.
3. Ethics in Action: Corporate Constituency Statutes (p. 1114): Discuss the corporate
constituency statutes that were passed in response to the Revlon, Inc. v. MacAndrews &
Forbes Holdings, Inc., 506 A.2d 173 (Del. S. Ct. 1986). Check whether your state has
such a statute. Isn’t it essential that corporate managers consider the interests of many
corporate constituencies when making an important decision? All the ethical theories
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Chapter 43 – Management of Corporations
we studied in Chapter 4 require consideration of many constituencies. A profit maximizer
must consider shareholders, employees, clients, customers, suppliers, and the community,
at a minimum, to determine which action will be received well by these groups and lead
to firm profitability. A utilitarian must consider the costs and benefits to everyone in
order to optimize social utility. A rights theorist must weigh the rights of different
constituents. A person who acts according to Kant’s categorical imperative must consider
the impact on others in order to determine how he would will others to act. A justice
theorist has to consider which of many constituents is most needy.
4. Mention Section 2.01 of the ALI’s Principles of Corporate Governance: Analysis and
Recommendations. The ALI Corporate Governance Project recommends that during the
conduct of business a corporation may take ethical considerations into account and may
devote resources to public welfare, humanitarian, educational, and philanthropic
purposes, whether or not corporate profit and shareholder gain are thereby enhanced.
The ethical considerations taken into account must be reasonably regarded as appropriate
to the responsible conduct of business by a significant portion of the community.
Excluded are ethical considerations that are likely to violate the fair expectations of the
shareholders taken as a whole. The Corporate Governance Project is an important work
and has appeared to have potential to impact significantly the development of corporate
law in the area of social responsibility. However, the Revlon case and the state
legislatures’ reaction to that case have stolen much of the limelight from the Corporate
Governance Project.
C. Corporate Powers
1. Distinguish corporate powers from corporate objectives: a corporation has the objectives
of maximizing profits and acting socially responsibly; a corporation has the power to do
certain acts, such as manufacture computers or contribute to the United Way, which aid it
in its accomplishment of its objectives.
2. Note the sources of a corporation’s powers and the sources of limitations on a
corporation’s powers: state statutes and corporate documents, especially the articles of
incorporation.
3. Tell students that few limitations exist on a corporation’s powers today. Modern statutes
empower a corporation to do anything legal. The articles of incorporation rarely limit a
corporation’s powers.
4. Briefly review the history of the ultra vires doctrine.
a. Note that ultra vires problems rarely exist today for two reasons:
1) Modern statutes do not permit a party to a contract to use ultra vires as a defense
to a contract. Explain the reason for not allowing either party to a contract to use
ultra vires as a defense: each party intended to be bound by the contract; it is
merely fortuitous that the contract was ultra vires.
2) Nearly every corporation has a purpose clause that allows it to engage in any
lawful act. For example, a coal mining corporation’s articles may have a purpose
clause that states the following: the corporation is organized for the purpose of
mining coal and engaging in any other lawful activity. Such a corporation is not
limited by its purpose clause.
b. Explain the situations in which ultra vires may be asserted. Note the reasons for
allowing ultra vires to be asserted in these situations.
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Chapter 43 – Management of Corporations
1) Shareholder suit to enjoin an executory ultra vires contract, when the party
dealing with the corporation knew the contract was ultra vires. This rule allows a
shareholder to force the corporation to comply with its purpose clause.
2) A corporate suit against management for causing damages to the corporation by
committing an ultra vires act.
a) Such suits are usually derivative actions or suits initiated by nonmanagement
shareholders of the corporation. Derivative actions are covered in Chapter
44 on pages 1168-1171. The corporation must prove that it was harmed by
management’s ultra vires act.
b) Note that management is not automatically liable. A manager who has
committed an ultra vires act may escape liability by proving that she
exercised the care normally expected of corporate managers.
3) Action by the attorney general. You may want to mention this. We let the
students cover this material themselves during their reading of the book.
5. Note that the powers of nonprofit corporations are not limited by the Model Business
Corporation Act but may be limited by the articles. Ask your students why it may be
wise for a nonprofit corporation to limit its purpose. Point out that such a clause would
encourage managers to act within the limited scope of the enterprise. Nonetheless, the
corporation may not use the ultra vires defense to avoid liability on a contract exceeding
its purpose clause.
D. The Board of Directors
Much of the material here can be learned by a student by himself. We recommend devoting
little time to the formalities here, saving time for more important issues, such as corporate
governance proposals and management’s duties to the corporation.
1. Function of board
a. Note that boards in large publicly held corporations mostly only oversee management
by officers.
b. Name the common board committees and define their functions.
c. Note that the Sarbanes-Oxley Act of 2002 requires audit committees comprising
independent directors for public companies.
2. Election and removal of directors. You may wish to assign or to refer to Chapter 44’s
discussion on this subject at pages 1151-1153.
a. Number of directors. Note that the modern rule is to permit corporations to have
only one director. Many statutes, however, require a corporation to have at least
three directors, unless the corporation has fewer than three shareholders, in which
case, it may have as few directors as it has shareholders.
b. State that directors are elected and removed by shareholders.
1) Distinguish between straight voting and cumulative voting. Refer to the
discussion on straight voting and cumulative voting in Chapter 44 at pages 1151-
1152. Note the purposes of cumulative voting: to allocate control among
shareholders and to allow minority shareholders to obtain representation on the
board of directors.
2) Discuss class voting. Refer to the discussion on classes of shares in Chapter 44
at page 1152.
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Chapter 43 – Management of Corporations
3) Note that shareholders may remove directors with or without cause at any time,
absent a contrary provision in the articles. They may also petition a court to
remove a director.
Example: Problem Case # 1.
c. Indicate that all directors may be elected yearly or that they may be elected in classes,
allowing them to serve terms of up to three years. Note that having classes of
directors reduces the effectiveness of cumulative voting, as is discussed in Chapter
44.
d. Proxy solicitation process
1) Explain the mechanics of proxy solicitations, taking care to define the two uses
of the term proxy.
2) Explain why a corporation and its management will solicit proxies: to ensure that
a quorum of the shares are present and to ensure that management will obtain
shareholder approval of management’s slate of directors.
3) Note the practical effect of management’s solicitation of proxies: it ensures
management’s perpetuation in office. Ask your students whether the proxy
solicitation process upsets the traditional corporate model that shareholders elect
directors.
4) Note that sometimes shareholders opposed to management will solicit proxies,
which they will vote for director nominees opposed to present management.
When management and opposing shareholders solicit proxies in competition with
each other, we have a proxy fight (or proxy battle or proxy contest).
Management nearly always wins a proxy fight, because most shareholders
opposing management sell their shares rather than fight management. This is an
application of the Wall Street rule, which is defined on page 1118.
5) Improving Corporate Governance.
a) Review the proposals for changing (improving) corporate governance on
pages 1118. You may want to review or assigned Chapter 4’s material on
corporate governance at this time. See pages 99 and 106-112. Ask the
students to criticize each proposal. Ask students whether they have other
proposals to change corporate governance.
b) Attempt to define the goals of corporate governance rules. Ask students
whether corporate governance rules should increase the efficient
management of business, promote increased profitability, increase
shareholder participation in management decision-making, or make
management more responsible to shareholders, employees, customers,
suppliers, other business constituents, or the general public. Ask students
whether they can think of any other goals. Can and should corporate
governance rules attempt to achieve several goals at once? For example, can
some corporate governance rules increase shareholder participation and
promote increased profitability at the same time?
c) Ask students why they think the traditional corporate governance model
withstood the heavy criticism mounted against it during the 1970s and
survived with few changes. The answer probably lies more in the pragmatic
than in the philosophic: investors recognized that they could realize larger
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Chapter 43 – Management of Corporations
profits by investing in the most profitable businesses and selling unprofitable
investments rather than interfering with the management of corporations.
That philosophy may change after the ethical debacles of the early 2000s and
the poor investment and loan decisions that led to the credit crunch of 2008-
2012. We’ll watch that closely.
d) Log On (p. 1118): This website is a good source of best practices in
corporate governance.
e) The Global Business Environment: Corporate Governance in Germany (p.
1120): Some critics laud Germany’s corporate governance structure as a
model. American corporations are not required by statute to have labor
representatives on their boards of directors, and few have chosen voluntarily
to place labor representatives on their boards.
f) Grimes v. Donald (p. 1119). The court held that the board of directors had
not illegally delegated the board’s duties and responsibilities to Donald, the
CEO, by agreeing to make a high severance payment to Donald if the board
interfered with his management of the corporation.
Points for Discussion: What reasons did the court give to support its
holding? First, the contract did not foreclose the board from exercising its
statutory powers and fulfilling its fiduciary duty. The court likened the
delegation of duties to Donald to a decision to engage in a certain business,
which preempts the corporation from entering other businesses, but
nonetheless is reasonable. Second, the market for business executives
requires the board to compete for top executives by paying large salaries and
giving them high termination payments, which are legal unless excessive.
Third, and most important, the board may choose to breach the contract and
interfere with Donald’s duties and responsibilities, constructively or actually
removing him from office. Even though the cost of breaching the contract
with Donald may be high, the board has final say whether to allow Donald to
pursue his course of action or to pursue the action desired by the board. The
court concluded that the cost was not so high in relation to the size of DSC
that the board would be unlikely to interfere or terminate Donald if it wished
to do so.
e. Vacancies on the board. Note the power given to the board here. There is no need to
seek shareholder approval between annual shareholders’ meetings. Instead, directors
may fill vacancies, even if they create the vacancies themselves by increasing the size
of the board.
3. Meetings
a. Need for formal meetings. Note that directors may take actions at a meeting,
including one by telephone. Or they may take actions without a meeting if each
director consents in writing to the action taken.
b. Notice of Meetings
1) Note that a director is entitled only to notice of special board meetings, which
under most statutes (but not the MBCA) must state the purpose of the meeting.
Under the MBCA, the notice must be given two days before the meeting. Note
that if notice is defective to any director, the action taken at the meeting is
invalid.
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Chapter 43 – Management of Corporations
2) Waiver of notice. A director may waive her objection to defective notice in either
of two ways: attendance at the meeting without objection or written waiver
delivered to the corporate secretary either before or after the meeting. (Some
states require the written waiver to be obtained before the meeting is adjourned.)
c. Quorum requirement. Usually, a quorum is a majority of the directors.
E. Officers of the Corporation
1. Appointment of officers. Note that officers are selected by the directors. List the officers
of the usual corporation; note that the MBCA permits flexibility in determining the
officers a corporate may have.
2. Authority of Officers. State that officers—who are agents—have only the powers
conferred upon them. Therefore, like agents, they may have express, implied, or apparent
authority. And a corporation may ratify officers’ previously unauthorized actions. Unlike
other agents, they may have inherent authority by virtue of their offices. [You may want
to note that such inherent authority is comparable to the implied authority that an agent
has by virtue of her title. In fact, you may want to analyze inherent authority as a subset
of implied authority.]
F. Managing Close Corporations
Compare the roles of shareholders in close corporations with shareholders’ roles in publicly
held corporations. Note that many close corporations are essentially incorporated
partnerships, in which each shareholder wants to participate in management, or at least be
employed by the corporation. In addition, shareholders of close corporations often wish to
dispense with the traditional formalities of management, such as having regular board
meetings. Such management formalities may be unnecessary to protect the rights of close
corporation shareholders, since close corporation shareholders are involved in the day-to-day
management of the corporation. Yet, close corporations create opportunities for a majority
shareholder to dominate the corporation to the detriment of minority shareholders. Although
domination or oppression may sometimes provide a legal right of action for the dominated
shareholders (as is explained at page 1137 in this chapter and at page 1172 in Chapter 44),
often domination is legal, even if detrimental to minority shareholders. The management
formality and shareholder domination problems may be anticipated by good business and
legal planning.
1. Reducing Management Formalities. Many statutes now permit close corporations to
dispense with the board of directors and to allow the shareholders to manage the
corporation as if it were a partnership. Such statutes recognize that many close
corporations are merely incorporated partnerships. Note that dispensing with the board is
an election: a close corporation may choose to use a board of directors.
2. Preventing Domination of Close Corporation Shareholders. You may want to assign and
cover Chapter 44’s material relevant to close corporation planning at this time, which will
allow you to cover all the major issues regarding the allocation of power in closely held
corporations. See pages 1151-1153 and 1167-1168.
Note the two ways to prevent domination when a close corporation has a board of
directors: restricting board discretion and requiring supermajority votes for board actions.
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Chapter 43 – Management of Corporations
a. Restricting board discretion. Explain that modern statutes grant shareholders
unlimited power to limit board discretion. Give a few examples of restrictions:
1) Requiring mandatory annual dividends.
2) Prohibiting the termination of a shareholder’s employment.
3) Requiring shareholder approval to hire employees.
b. Requiring supermajority votes. Explain how supermajority votes protect minority
shareholders. Note that it is imperative that the minority shareholders have
representation on the board, unless they have other rights that ensure they will obtain
a return on their investments. Supermajority voting requirements can be used to
protect the same interests as restrictions on board discretion:
1) Unanimous approval to change the dividend rate or amount.
2) Unanimous approval to terminate a shareholder’s employment.
3) Unanimous approval to hire new employees.
c. Log On (p. 1121): California’s secretary of state provides assistance to those forming
close corporations. Does your state?
G. Managing Nonprofit Corporations
Legally, managing nonprofit corporations is very similar to managing for-profit corporations.
Practically, nonprofit corporations are usually managed far more informally that for-profit
corporations. However, as liability concerns increase for all business organizations, including
nonprofit businesses, it becomes prudent for nonprofit businesses to be more deliberate in
their decision-making, especially with regard to important decisions. This means that the
day-to-day managers should involve the directors in all decisions that are not ordinary and
fully inform the directors prior to or during to their consideration of a matter.
Note the purpose of the MBCA’s optional provision requiring that no more than 49% of the
directors of a public service corporation may be financially interested in the business of the
corporation: to reduce the risk that the directors win run the corporation for their personal
benefit, not the public benefit.
H. Directors’ and Officers’ Duties to the Corporation.
1. Introduction. Start by stating the three duties that managers owe to the corporation:
a. To act within their authority.
b. To exercise due care.
c. To be loyal to the corporation.
Expand upon each of these, especially the last two.
2. Duty of care
a. Prudent person standard. Note that the MBCA standard refers to the prudent person,
not the prudent businessperson. Note also that the standard may be increased, but not
decreased, because of the special skills of a particular manager.
Examples: Problem Cases # 2 and 3.
Note that managers will not be judged in light of the 20-20 vision of hindsight.
Everyone knows what to do after history reveals one’s mistakes. A manager need
merely consider the information available at the time the decision was made.
b. Good faith and reasonable belief
1) Reasonable investigation. Before making a decision, managers must make a
reasonable investigation in an attempt to discover the material facts that affect a
business decision. For some decisions, such as hiring a low-level employee, very
little is required. For other decisions, such as selling a profitable product line, an
extensive investigation is required. Note that management is permitted to rely
upon corporate staff and outside consultants. Such reliance is common,
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Chapter 43 – Management of Corporations
especially when the corporation is buying or selling product lines and
considering proposed mergers and other business combinations. In such
situations, the board will rely upon financial reports audited by independent
accountants and valuations of investment bankers.
2) Best interests of the corporation. The good faith standard requires the managers
to believe honestly that they are acting in the best interest of the corporation. If a
manager believes that she is acting contrary to the corporation’s best interests,
she should not engage in the activity. This requires the directors to act in
accordance with the firm’s strategies.
c. The Business Judgment Rule.
1) Note the consequence of the applicability of the business judgment rule: a court
will allow management’s decision to stand; it will not substitute its judgment for
the judgment of management.
2) Indicate the difficulty courts have judging the wisdom of business decisions
made by corporate managers. Judges and jurors are often not trained or
experienced in business. Their only knowledge of the business of the corporation
is based upon evidence presented in court, which is sketchy and incomplete. We
like to say, “Judges have no business education, no business experience, and no
business making business decisions.” Note the effect on business managers if
they had to fear liability for every business decision that lost money for the
corporation: the managers would be more concerned about liability than about
doing what is best for the corporation in the long run. They would take fewer
risks, turning down projects that are likely to return huge profits even though
there is a small risk that project may generate large losses. The result is that the
law would encourage managerial decision-making that would not maximize the
total wealth of society.
3) Review the elements of the business judgment rule. Note that the rule is
essentially a restatement of the duty of care discussed earlier. Note especially the
role consultants can play in helping the board meets the requirements of the
business judgment rule. We cover this in the text in a subsection on page 1124.
a) Informed basis. This requires the board to make a reasonable investigation
prior to making a decision.
b) No conflicts of interest. There should be no self-interest. For example,
self-interest exists if there is self-dealing. There must be no doubt that the
manager is acting only with his corporation’s interest in mind.
c) Rational basis. Note the apparent contradiction in the business judgment
rule: in determining whether the manager has a rational basis for the
decision, the court is second-guessing the manager: the court applies a gross
negligence standard in determining whether the decision is reasonable.
Hence, the business judgment rule does not absolutely forbid judicial inquiry
into the reasonableness of a manager’s decision. A low-level review of
reasonableness is required by the rule.
d) Because many of our students will be consultants, we spend most of
class time covering how to help clients comply with the business judgment
rule. The material on page 1124 matches what we tell our students to do
when advising corporate clients.
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Chapter 43 – Management of Corporations
e) Brehm v. Eisner (p. 1125). Disney CEO Michael Eisner and other Disney
directors were found to have complied with the business judgment rule both
when hiring new COO Michael Ovitz and when firing him a year later.
Points for Discussion: This is a high profile and highly interesting case with
great facts and even better lessons for students. It is a very long case, but
easy reading, because it is mostly about the facts of how Eisner worked to get
Ovitz hired and why Ovitz later had to be fired. It is a good example of how
directors can act less than ideally yet not be liable under the business
judgment rule.
Ask students what is the greatest learning from this case? It is that the
business judgment rule protects about any decision that is honestly motivated
when there is no conflict of interest. While Eisner’s domineering led to flaws
in the process of getting board approval to hire Ovitz, and while the cost of
firing him was enormous, both decisions were protected by the business
judgment rule. We usually point out at this time that the business judgment
protected the decisions of the Chicago Cubs both to refuse to install lights
and then later to install lights at Wrigley Field. See Problem Case # 4.
Additional Points for Discussion: This litigation was part of an effort by Walt
Disney nephew Roy Disney to oust Eisner from Disney, a battle that went on
for years, motivated by Disney’s stagnant stock price and Eisner’s
management style, which chased away a number of very talented executives.
Note that Disney has entered a new era of management calm since Robert
Iger took over as CEO in 2005. Under Iger, the company has reconciled with
Roy Disney, who dropped his “Save Disney” campaign and agreed to work
with Iger. Roy Disney was named a director emeritus and consultant.
f) Additional Examples: Problem Cases ## 4, 5, and 6.
4) Criticism of the business judgment rule
Critics of management argue that the business judgment rule unduly isolates
management from liability for their bad decisions. It is true that very few
directors are held liable in the absence of self-dealing. This explains why the
Trans Union case (discussed on page 1124) surprised some people. Review this
case with your students. You may wish to look at the case in its original; it is a
long opinion. Ask your students whether they think the directors should have
made a more extensive investigation. Tell them that directors almost always
obtain an investment banker’s report before approving a merger. Note that the
court indicated that the board did not look at information concerning the intrinsic
value of the corporation. Should a board always be required to look at such
information? Clearly it should if there is no regular market for the corporation’s
shares. But what if the corporation’s shares are publicly traded on the New York
Stock Exchange? Is not market value the best determinant of the value of shares?
Economic and finance theory hold so, yet such thinking has not been generally
accepted by lawyers and judges.
5) Changes in the Duty of Care
Note the changes that make it even more difficult to hold directors and officers
liable under the duty of care. Some states have changed the standard to a
willfulness or recklessness standard. Other states such as those that have adopted
the MBCA permit shareholders to amend the articles to reduce the liability of
directors and officers.
6) Opposition to Acquisition of Control
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Chapter 43 – Management of Corporations
A boards’ use of tactics to defend against hostile tender offers has created special
problems for courts’ deciding whether to apply the business judgment rule.
Although most enlightened commentators believe that self-preservation is the
primary motivation for using defense tactics, courts nearly always find that the
boards have no conflict of interest. The Delaware decisions, beginning with the
Unocal case, represent a middle ground.
a) Go over the defense tactics in Figure 1 on page 1131.
b) Note the large number of constituencies that the board may consider in
choosing to oppose a hostile tender offer. In part, the judicial attitude
favoring defense tactics may reflect the judges’ disdain for hostile tender
offers. [You may wish to refer here to the materials on tender offer
legislation, especially the federal law, whose purpose is to promote an
auction market for corporate shares. This is covered in Chapter 45 at pages
1224-1226.] Often, the few tender offer defense cases in which the business
judgment rule was not applied involved boards that acted quickly to oppose
the tender offer without first carefully considering whether the offer was in
the best interest of the corporation. In such cases, either the board lacked an
informed basis for its decision or the lack of a reasonable investigation
proved the board preferred its self-preservation interest over the best interests
of the corporation.
c) Cover the three elements of the Unocal test on page 1130.
Paramount Communications, Inc. v. Time, Inc. (p. 1132). The court refused
to apply the business judgment rule to the decision to oppose Paramount’s
takeover offer unless the board proved 1) reasonable grounds for believing
that a danger to corporate policy and effectiveness existed and 2) the
defensive measure adopted was reasonable in relation to the threat posed.
Points for Discussion: Ask your students whether they are persuaded by the
court’s reasoning that there is reasonable grounds for believing that a danger
to corporate policy and effectiveness existed. Is the court applying the
business judgment rule prematurely by stating that the court can’t substitute
its judgment regarding what is a better deal? Has the court provided a
“trump card” for all directors opposing a takeover by validating the directors’
concern that shareholders might be ignorant or mistaken as to the strategic
benefits of the combination with another company? Can this concern always
be raised by directors? Note that the court stated that directors are not
obliged to abandon a deliberately conceived plan in exchange for short-term
shareholder profit unless there is clearly no basis to sustain the corporate
strategy. Does this give too much latitude to directors?
Additional Points for Discussion: How important to the court’s decision was
Time’s having negotiated a combination with Warner prior to Paramount’s
initiation of its takeover? It was the most important fact, for it proved that
Time’s directors were motivated to combine with Warner for honest business
reasons, not merely to defeat a hostile takeover.
Additional Example: Problem Case # 9.
7) The business judgment rule and derivative suits. You may want to cover this
important issue at this point. It is discussed in Chapter 44. In states in which the
business judgment rule applies to a shareholder litigation committee’s decision
not to sue wrongdoing managers, it is nearly impossible to hold managers liable
to the corporation, even if they have engaged in self-dealing. Applied in such a
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Chapter 43 – Management of Corporations
situation, the business judgment rule nearly absolutely protects managers against
liability.
3. Duties of loyalty
a. Introduction
1) Explain the general duty of loyalty, as expressed by Judge Cardozo on page 1134.
A manager must not have divided loyalties; she must do what is best for the
corporation even if doing so is detrimental to her own financial interests.
Example: Problem Case # 7.
2) List the duties of loyalty and explain them carefully.
b. Conflicting Interest Transactions
1) Explain the conflict of interest that arises when a manager deals with his
corporation. Note the divided loyalties that exist and the risk that the manager
will prefer his own interests to those of the corporation.
2) Explain the intrinsic fairness standard and how it protects the corporation.
3) Note the burden-shifting effect of a manager obtaining board or shareholder
approval of a self-dealing transaction. Approval by itself is not enough to
legitimize the transaction. It merely shifts to the corporation the burden to prove
the absence of intrinsic fairness. Without approval, the self-dealing manager has
the burden of proving intrinsic fairness. Note that unanimous shareholder
approval conclusively legitimizes the transaction: intrinsic fairness becomes
irrelevant.
Note the variety of statutory schemes that dictate the formalities to be followed to
obtain board or shareholders approval of a self-dealing transaction. Some
statutes permit an interested director to be counted toward a quorum of the board;
others do not. Some statutes permit interested directors to vote, but do not count
their votes; others prohibit interested directors from voting. Some statutes permit
an interested shareholder to vote; others do not. Some statutes require disclosure
of only the manager’s interest; others require disclosure of all material facts as
well.
4) Example: Problem Case # 8.
5) Ethics in Action: Sarbanes-Oxley Act of 2002 Prohibits Loans to Management
(p. 1135): The jury is out on the need for and effectiveness of the Sarbanes-
Oxley Act. The Act’s ban of most loans to management is one reason. For many
years, loans have been a part of a manager’s compensation package. The Act
doesn’t ban other types of compensation, just loans. Why is a loan any more
problematic than a high salary? The ethical justification is to prevent
management from looting the corporation, yet other ways of looting the
corporation are not banned.
A rights theorist would consider the ranking of various rights, including a
manager’s right to receive a loan as a form of compensation, the corporation’s
right to compete for executive talent by offering loans, a corporation’s right not
to have its assets looted, and a corporation’s right to protect itself from looting
through internal corporate policies rather than by a law banning loans. There are
other rights to be considered. A utilitarian will consider the law’s effect on total
social welfare and consider whether the negative effects of the law (eliminating a
form of executive compensation) will be overcome by the benefits (making
looting harder). A profit maximizer will probably point out that the law
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Chapter 43 – Management of Corporations
interferes with the free market for corporate talent and argue that the board of
directors can make loans to manager and at the same time protect the corporation.
Note that SOA does not prevent banks and other financial institutions from
making loans to their management.
c. Usurpation of a corporate opportunity
Give the essence of this breach: it is theft or conversion of corporate property. While
an opportunity may be intangible, it has value. It can also be understood as
competing with the corporation.
Discuss the three elements of usurpation:
1) Opportunity received by a director or officer in her corporate capacity.
2) Opportunity has a relation to corporate business.
Examples:
a) An opportunity to buy a toll bridge that takes people to a recreational island
owned by the corporation. While operating a toll bridge is a new line of
business, it does relate to property in which the corporation has an existing
interest.
b) An opportunity to buy one-half acre of prime commercial real estate. This
opportunity would be in the line of business of a real estate investment
business. As for another corporation, it would relate to property in which the
corporation has an existing interest if the corporation is looking for land on
which to build its corporate office. It would have no relation to the business
of a corporation operating a small restaurant and having no plans for
expansion.
3) Corporation able to take advantage of the opportunity.
4) Guth v. Loft, Inc. (p.1136). List and go through the elements of usurpation with
this case.
Points for Discussion: What facts prove that Guth received the opportunity in his
corporate capacity? That Megargel contacted Guth about the opportunity when
Guth was president of Loft. Nothing in the facts suggests that Megargel
contacted Guth other than in Guth’s personal capacity; nonetheless, since Loft
was interested in buying Pepsi syrup, Guth should have considered the
opportunity as having been presented to Loft. This reasoning exhibits that
high-level officers are almost always acting in their corporate capacities when an
opportunity of interest to the corporation comes to their attention. The
justification for this reasoning is that high-level officers are hired and paid to be
on the lookout for opportunities useful to the corporation.
What facts prove that the opportunity had a relation to Loft’s business? Loft was
in the business of manufacturing syrups. Therefore, manufacturing Pepsi was in
its line of business. Also, Guth knew that Loft needed a steady supply of cola
syrup to allow it to offer its customers a cola drink. Hence, Loft had an interest
or expectancy arising out of Guth’s knowledge of Loft’s need for a supply of cola
syrup.
What facts prove that Loft was financially able to take advantage of the
opportunity? The trial court found that Loft had the resources to develop the
Pepsi business. Also, and more importantly, Guth had used Loft’s funds,
facilities, and employees to develop the opportunity. Guth’s misappropriation of
Loft’s property placed the equities clearly in Loft’s favor, making it easier for the
court to find for Loft.
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Chapter 43 – Management of Corporations
Additional Point for Discussion: Note the effect of the court’s decision. Loft gets
all of Guth’s Pepsi shares and all of his dividends received from Pepsi. In other
words, Guth is not permitted to benefit at all from his usurpation. He must give
the corporation all the benefit he has received. The corporation need merely pay
him what he paid for the opportunity.
Additional Point for Discussion: You might mention that Guth is the single most
important person in the history of Pepsi. He made Pepsi what it is today,
transforming it from a failing company to a profitable behemoth. Was the court
willing to give Guth a break because he was a brilliant businessman? No. Read
the last sentence of the case.
d. Oppression of minority shareholders
1) There are many forms of oppression, but they share either of two characteristics:
the minority shareholders are singled out for detrimental treatment or the
majority shareholders are singled out for beneficial treatment. Phrased this way,
oppression looks very much like self-dealing, and the rules applied to oppression
cases are similar to those applied to conflict-of-interest cases.
2) You may want to cover at this time Chapter 44’s material on oppression by
majority shareholders on page 1172-1174.
3) Freeze-outs. Some of the most interesting oppression cases in recent years have
been the freeze-outs cases, especially going private transactions. Going private
transactions increased between 2008 and 2009 as the stock market took a tumble.
For many small corporations, the negatives of public ownership outweigh the
benefits.
a) Freezeout Methods. Go though the methods in the textbook: the reverse
stock split and the freeze-out merger. The latter was the technique used in
the Coggins case on page 1138. Use schematics to explain the techniques.
In addition, dissolution of the corporation and sale of assets to a corporation
owned by the majority shareholders will effect a freeze-out. The minority
shareholders receive part of the cash proceeds of the sale. This could be
done in reverse, with the sale of assets predating the dissolution. The effect
is the same.
b) Purposes of freeze-outs. Usually corporations freeze out minority
shareholders to eliminate the burden of public disclosure required by the SEC
and to eliminate minority shareholders, whose concerns must be addressed
when the corporation acts. Being relieved of the prohibitions and
requirements of Sarbanes-Oxley are important reasons today.
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Chapter 43 – Management of Corporations
c) Legality. By itself, a freeze-out is not wrongful. However, it can be
accomplished in a wrongful way. Note that although Delaware has
abandoned the business purpose test as unworkable, other states follow it.
Note the two elements of the intrinsic fairness test: fair dealing and fair price.
Ask your students which test they like better. What are the problems with
each test? The difficulties are determining a proper business purpose,
deciding whether the minority shareholders are lying about the purpose of the
freeze-out, and calculating a fair price.
Note that neither test allows a shareholder to remain a shareholder if the
freeze-out transaction is structured legally. These tests make it clear that no
one has the right to remain a shareholder unless she has taken contractual
precautions to prevent a going private transaction.
Coggins v. New England Patriots Football Club, Inc. (p. 1138). The court
reviewed both the business purpose test and intrinsic fairness test as applied
to a freeze-out and decided to apply the business purpose test and the fairness
test.
Points for Discussion: Why did the court decide that the business purpose
test was needed in addition to the fairness test? “[T]he duty of a corporate
director must be to further the legitimate goals of the corporation. . . .
Because the danger of abuse of fiduciary duty is especially great in a freeze-
out merger, the court must be satisfied that the freeze-out was for the
advancement of a legitimate corporate purpose.” Why was there no
legitimate corporate purpose here? Because only Sullivan was served by the
freeze-out, which would allow him to pay and secure his personal
obligations.
Ask your students whether the court would have legitimized the freeze-out
had it applied only the intrinsic fairness test.
Additional Example: Problem Case # 10.
d. For an excellent new case on valuing shares, see the MCHC case in Chapter
44 on page 1157.
e. Trading on inside information. We cover this area only briefly at this point. The
state law of insider trading is largely of only historical importance. The more
important law is federal securities law, which applies to nearly every insider trading
transaction. You may wish to cover all the law of insider trading at this point. The
federal law of insider trading is covered in Chapter 45 at pages 1216-1219.
4. Ethics in Action: Sarbanes-Oxley Act Imposes Duties and Liabilities on Management (p.
1140): Note the duties imposed on management of public companies: certifying financial
statements and disgorging compensation and profits.
Example: Problem Cases ## 8 and 11.
5. The Global Business Environment: Directors’ Duties around the Globe (p. 1140): Not
surprisingly, directors worldwide owe duties of care and loyalty to their corporations.
6. Capstone Example: Chapter Introductory Problem (p. 1114): This problem requires
students to determine which standard of director conduct applies in each conduct. It is a
good problem to test their knowledge of the contexts in which the business judgment
rule, intrinsic fairness standard, and Unocal test apply and the manner in which the board
complies with those standards.
I. Disclosure of Merger Negotiations
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Chapter 43 – Management of Corporations
You may wish to refer to the Securities Exchange Act Rule 10b-5 discussion of merger
negotiation disclosure, which appears at pages 1216 of Chapter 45.
J. Director Right to Dissent
Note how directors who disagree with an imprudent or otherwise improper decision of the
board may escape liability for damages caused by the decision: the director may not vote to
approve the transaction and must attempt to dissuade the rest of the board.
K. Duties of Directors and Officers of Nonprofit Corporations
Note the similarities in for-profit and nonprofit corporation law, including the ability of a
nonprofit corporation to limit or eliminate director liability for breaches of the duty of care.
Ask your students whether they would be willing to be an uncompensated director of a
nonprofit public benefit corporation–such as Big Brothers, Big Sisters–if the corporation’s
articles did not limit their exposure to liability.
L. Tort and Criminal Liability
1. Torts. Agents are always liable for their own torts. Corporations are liable for their
agents’ negligent and intentional torts if committed within the course and scope of
employment. Refer to the principles of respondeat superior in Chapter 36.
2. Crimes. Review the evolution of the law to its present state of imposing criminal liability
upon corporations for criminal acts requested, authorized, or performed by the board, an
officer, a policy making employee, or a high-level administrator. Also, corporations are
liable for the crimes of their mere agents when the agents act in the course of their
employment. In addition, the corporation can be liable without regard to its intent when
the corporation violates a criminal statute designed to protect the public welfare.
United States v. Jensen (p. 1141). This long case will help your students appreciate the
facts and issues regarding options backdating, a huge issue in 2006 and 2007. It also
allows students to understand better some of the sentencing guidelines for corporate
officers who engage in criminal conduct. This case also is a cautionary tale for officers,
like Jensen, who don’t benefit directly from their criminal conduct, but are guilty because
they enable others, like her CEO, Reyes, to engage in criminal activity. It shows how
aggressive federal prosecutors are.
Points for Discussion: Why did the court conclude that Jensen knowingly violated an
SEC rule? The evidence showed that she knew her conduct was wrongful, because she
tried to conceal the date options were really issued, and she directed employees not to
communicate about options by phone or email. Those are not usually actions of someone
who thinks she is acting honestly or rightly. However, that was not enough. She had to
know that her conduct violated an SEC rule. The court agreed with the trial court that
Jensen knew that stock options pricing affected financial statements, because she
shepherded the options through the pricing process by ensuring that stock options pricing
forms went from her department, HR, to the finance department. The court found that a
reasonably intelligent corporate officer would understand that if the forms are routed to
the finance department, the forms must have some affect on the company’s financial
statements. A reasonable officer would also know, therefore, that falsifying option grant
forms would impair the integrity of the company’s financial statements, a violation of
SEC rules.
Additional Points for Discussion: On the sentencing issue, the court considered several
enhancements that would increase the length of Jensen’s prison sentence. Why did the
court refuse to enhance her sentence on the grounds she owed a heightened fiduciary duty
to shareholders? The court found that while Jensen was an important internal officer,
externally as far as shareholders were concerned she was not making policy decisions
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Chapter 43 – Management of Corporations
that showed she owed a heightened duty to shareholders. Nonetheless, the court
enhanced her sentence because she occupied a position of trust regarding the company’s
books and records, which she misused by causing financial records to be falsified. She
also received an enhanced sentence for obstruction of justice by allowing her lawyer to
state a falsehood in court that she knew to be false. The courts don’t look kindly on
obstruction of justice.
Additional Point for Discussion: Ask students how much prison time Jensen was
awarded. Six to 12 months. Ask them how few months she might serve. As few as one
month. The rest she should could spend under community confinement or home
detention.
Additional Example: Problem Case #12.
M. Insurance and Indemnification
1. As if the business judgment rule and recent changes in the duty of care were not enough,
insurance and indemnification exist to isolate directors and officers from the financial
burden of being found liable to the corporation for mismanaging the corporation.
Insurance and indemnification can compensate a manager for other liabilities incurred as
well. All large publicly held corporations buy liability insurance for their directors and
officers. Insurance should be purchased by any corporation with directors having a
liability risk.
2. Go through the indemnification rules. We deleted Figure 2 that was in the 11th edition,
but have included it in this instructor’s manual at the end of this manual chapter. You
may want to reproduce it on the whiteboard and go through it. Note the different
treatment and rationale for limits on the power of the corporation to indemnify managers,
depending on who is the plaintiff and whether the action is criminal. Note that a director
who acts in good faith will be able to escape financial detriment nearly entirely. Only
those who receive a financial benefit will suffer nearly certain financial loss.
Example: Problem Case #13.
3. Ethics in Action: News Corporation and Its Directors Agree to Largest Shareholder Suit
Settlement (p. 1146): It seems that new records are set at least yearly. Track more recent
shareholder actions to update in class the material in this ethics box.
4. Ethics in Action: Expanding Indemnification (p. 1146): The ethics questions in this box
place students in the positions of shareholder and director, showing that one’s viewpoint
may affect one’s decisions, unless one is well grounded ethically. A rights theorist will
probably have difficulty justifying expanded indemnification of directors on the grounds
that the corporation’s right to be protected from poor judgments by a director is more
important than a director’s right to avoid financial liability when she acts carelessly and
in bad faith. Applying the categorical imperative, would one not will others to act at least
in good faith? Would one want others merely to be held to a standard that they not intend
to harm the corporation and not receive an improper financial benefit? Utilitarian
analysis would probably conclude that society loses when directors escape the financial
burden of their imprudent and bad faith decisions. A profit maximizer would probably
come to the same conclusion. It is hard to see why the market for corporate executive
talent would require extending protection to a director who acted in bad faith. A director
should not fear promising that minimal amount of due care. A shareholder would argue
that the corporation will not maximize its profits if it selects as a director someone who
wants protection from careless and dishonest errors in judgment.
IV. RECOMMENDED REFERENCES
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Chapter 43 – Management of Corporations
See the references in Instructor’s Manual Chapter 41.
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