978-1285427003 Chapter 29 Lecture Note Part 2

subject Type Homework Help
subject Pages 9
subject Words 4448
subject Authors Jeffrey F. Beatty, Susan S. Samuelson

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Additional Case: Northeast Harbor Golf Club, Inc. v. Harris1
Facts: Nancy Harris was the President of the Northeast Harbor Golf Club in Maine for nearly 20 years.
The club's only major asset was a golf course in Mount Desert. Harris was definitely a generous
President. She not only mowed the grass and did the gardening, she also used her own money to purchase
equipment for the club. Twenty years ago, a real estate broker informed Harris that three parcels of land
next to the golf course were for sale. The agent contacted Harris because she was the President of the club
and he believed that the club would be interested in buying the property to prevent development. Harris
immediately agreed to purchase the property in her name. Afterwards, she informed the club's board that
she had made the purchase and that she did not intend to develop the land. Again, 15 years ago, Harris
purchased a parcel of land contiguous to the golf course. Again she informed the board of directors after
the purchase.
The club continually experienced financial difficulties, operated annually at a deficit, and depended
on contributions from the directors to pay its bills. There was evidence, however, that the club had
occasionally engaged in successful fund-raising and had $90,000 in a capital investment fund.
Five years after her last purchase, Harris began the process of obtaining approval for a five -lot housing
development. The club sued her for violating the corporate opportunity doctrine. The trial court found that
Harris had not usurped a corporate opportunity because the acquisition of real estate was not in the club's
line of business, and the corporation lacked the financial ability to purchase the real estate. The club
appealed.
Issue: Did Harris violate the corporate opportunity doctrine?
Holding: Judgment for Harris reversed. Instead of determining on her own that the club could not afford
the land, Harris should have given the board the opportunity to make that decision. Although the club was
in the business of operating a golf course, owning land was an inherent part of that business. Harris’s new
development could have infringed on the value of the club’s land and its ability to operate the course.
However, the SJC ordered the case dismissed because the statute of limitations had run out before the
club filed suit.
Question: Did Harris compete with the golf course?
Answer: The trial court held that she did not, because real estate was not in the club’s line of business
and the club couldn’t have afforded it anyway. The SJC disagreed, holding that:
Question: To what damages would the club be entitled?
Question: Is that what the club wants?
Answer: Probably the club would prefer that the property not be developed at all. In other words, it
Duty of Care
The duty of care requires officers and directors to act in the best interests of the corporation and to use the
same care that an ordinarily prudent person would take in a similar situation.
1 1999 ME 38, 725 A.2d 1018, 1999 Me. LEXIS 36 Maine Supreme Judicial Court, 1999.
Rational Business Purpose
In the Wrigley case, the court held that the company did have a rational business purpose. One
commentator suggested that finding a case in which a court held that a board decision did not have a
“rational business purpose” was like looking for a very small number of needles in a very large haystack.
Some writers suggest that one should not even pretend that the rule exists since it exists only in theory.
Other writers argue that, while there are few reported cases, many of the cases settle out of court. The
mere existence of the rule keeps managers honest.
Legality
Courts are generally unsympathetic to managers who engage in illegal behavior, even if their goal is to
help the company.
Informed Decision
Generally, courts will protect managers who make an informed decision, even if the decision ultimately
harms the company.
Additional Case: RSL Communications v. Bildirici2
Facts: Ronald S. Lauder founded RSL, Ltd. A multinational telecommunications corporation that
provided voice, mobile, and data/internet services. RSL Plc was a subsidiary of RSL Ltd. The subsidiary
began issuing $1.4 billion of bonds. A few years later, in July, Lauder provided RSL Plc with a $100
million line of credit. The company’s board did not hold a meeting to approve the line of credit, but in
August drew down $25 million from the loan. The following March, the company’s board held their first
meeting in a year. Five days later, RSL, Plc filed for bankruptcy.
The issue before the court is whether the members of the board of directors of RSL Plc breached their
duty of care to the company when they failed to hold a meeting for a year at a time when the company
was in such a precarious financial position.
Issue: Did the directors of RSL Plc violate their duty of care to the corporation?
Holding: Yes, the board violated its duty of due care. According to the court, under New York law, a
director shall perform his duties as director, in good faith and with that degree of care that an ordinarily
prudent person in a like position would use under similar circumstances. This duty requires that a
director’s decision be made on the basis of reasonable diligence in gathering and considering material
information.
When faced with allegations of misconduct, a director may raise the business judgment rule as a
defense. The business judgment rule applies even where conclusions were stupid or irrational, as long as
the process employed was either rational or employed in a good faith effort to advance the corporation. A
director must show an exercise of judgment, not simply the existence of a business decision. Thus, where
the director’s methodologies and procedures are so halfhearted or restricted in scope as to constitute a
pretext or a sham, their acts are not protected by the business judgment rule.
RSL Plc did not hold board meetings on behalf of RSL Plc during the time period relevant here.
Despite this, RSL Plc still operated and took actions such as drawing down $25 million from the loan,
apparently at the direction of RSL Ltd. However, no independent board meeting or discussions regarding
the propriety of this and other business decisions were held on behalf of RSL Plc.
The law does not tolerate inaction of this sort. RSL Plc allegedly failed to consider any information
regarding the company’s financial health and allegedly failed to make a business judgment as a board
regarding any financial decisions on behalf of RSL Plc.
RSL Plc argues that closely held corporation with directors who are frequently in contact with one
another do not have to abide by such formalities as board meetings when making business decisions.
2 2006 U.S. Dist. LEXIS 67548, United States District Court for the Southern District of New York,
2006.
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However, RSL Plc is not a small company; it has accrued $1.4 billion in debt. Although some of RSL
Plc’s board members had some contact, there were no behind the scenes meetings where the business of
RSL Plc was discussed.
Lastly, RSL Plc argues that its board members were fully informed about the financial situation of the
company because some RSL Plc board members were also RSL Ltd board members, and thus they
exercised their judgment on behalf of RSL Ltd, the parent of RSL Plc. However, individuals who act in a
dual capacity as directors of parent and subsidiary corporation owe the same duty of good management to
both corporations.
Question: The board members of RSL Plc and RSL Ltd overlapped. RSL Plc claims that because of
this overlap, both boards were aware of what was going on with RSL Plc. Shouldn’t that make a
difference when determining whether the board of RSL Plc was making an informed decision?
Answer: The court does not think so. The court expressly rejected that argument, stating that it makes
Question: Does the fact that the board did not formally meet to discuss the loan or the draw down
mean that the members acted improperly?
Answer: Not necessarily. What the court said was that because the board did not meet, the directors
failed to follow proper procedure. Because the directors are faced with allegations of misconduct, in
Role of Shareholders
In many ways, this chapter is as much about ethics as Chapter 2. Corporate managers have a great deal of
power and, as the Enron case and other corporate scandals have illustrated, some have abused this power.
Research: Board of Directors
If students performed this assignment on boards of directors, they could discuss what they found.
General Questions:
What percentage of directors were insiders versus outsiders?
How many directors have industry experience?
How many directors have close ties to the company CEO?
How many also service as directors on other corporate boards?
How would students evaluate this board of directors?
Rights of Shareholders
Shareholders have neither the right nor the obligation to manage the day-to-day business of the
enterprise.
Right to Information
Under the Model Act, shareholders acting in good faith and with a proper purpose have the right to
inspect and copy the corporation’s minute book, accounting records, and shareholder lists.
Additional Case: You Be The Judge: Chopra v. Helio Solutions3
Facts: Facts: Paul Chopra was a minority shareholder and former director of Helio Solutions, Inc. Both
he and Helio were in the business of reselling Sun Microsystems hardware and software. Chopra
suspected that: (1) some of Helio’s majority shareholders had purchased a building and leased it to Helio
at an excessive rent, (2) the company had broken a lease so that it could rent this building, (3) some
shareholders had used assets of the corporation to secure a personal loan, (4) Helio had permitted
ex-employees to take away substantial business, and (5) the company had not collected a $1 million debt
it was owed. In addition, he wanted to know if Helio was planning to issue stock and thereby dilute his
ownership. Finally, he felt that his dividend of $1952.55 was unreasonably low, given that Helio had $88
million in revenue. Chopra hired a forensic accountant to help him investigate Helio’s finances. At the
accountant’s request, Chopra asked Helio for these documents:
1. articles of incorporation
2. minutes for meetings of the board of directors and shareholders
3. all financial statements
4. all tax returns
5. the general ledger with accompanying journals
6. income and balance sheets
7. schedule of accounts payable and received and inventory
8. depreciation schedule for fixed assets
9. supporting documents including bank loans, lines of credit, accrued payroll liabilities, sales tax
liabilities, other receivables, loans to officers and owners, significant prepayments or deposits, and
equipment lease agreements
10. monthly bank statements
11. company credit card statements
12. compensation records
13. the following contracts: life insurance policies for officers and/or stockholders; pension plan and
profit sharing plans; stock purchase plans; equipment and building leases; employment and bonus
agreements for owners or key employees; covenants not to compete; loan agreements and credit
information, documents connected with the company’s real property; option grants and each owner's
curriculum vitae
14. a list of patents
15. budgets projections for the current year
16. company brochures and/or marketing information
17. a list of key management personnel with job title
18. an overview of company positions and objectives for each department manager
19. information regarding contingencies and lawsuits
3 2007 Cal. App. Unpub. LEXIS 5909, Court of Appeal of California.
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Helio gave Chopra items 1-6 but refused to turn over the other materials. Chopra filed suit. The trial court
found for Helio and Chopra appealed.
You Be The Judge: Which of these documents must a company provide to its shareholders?
Holding: For Helio, the trial court’s ruling was affirmed. According to Chopra, the documents he
requested were necessary for assessing the value of Chopra’s investment in the company and determining
whether his interests as a minority shareholder were being protected. The records previously provided by
Helio were insufficient to make this determination.
According to the court, a shareholder has an interest in the assets and business of the company and
inspection of the company’s books may be necessary for the protection of his interest or for information
as to the condition of the company and the value of his interests. However, the inspection rights of the
shareholder are limited. Shareholder status does not, by itself, entitle an individual to unfettered access to
corporate information. The right does not extend to records not reasonably related to the proper purpose
for which they are sought.
According to the Appellate Court, the trial court was correct in ruling that Chopra’s stated reasons for
inspection were vague and lacking in support. In addition, Chopra was asking for information about
certain shareholders rather than information about the company. Chopra was engaged in a fishing
expedition in which he was asking for information to support his unsubstantiated claims of corporate
wrongdoing rather than seeking information to support his interest as a shareholder.
Question: What was Chopra’s role at Helio?
Question: As a shareholder, isn’t he entitled to information about the company?
Question: What type of information do shareholders have a right to receive?
Question: Was Chopra’s request broader than this?
Answer: Chopra’s request was much broader. Chopra requested, among other information,
Question: Why was he not entitled to receive this information?
Answer: According to the court there were a number of reasons why Chopra was not entitled to this
information. First, the court did not believe he was making the request with a proper purpose. The
court believed Chopra was looking for more than just information that would help him assess the
Question: Why is this wrong?
Answer: Although board members have a duty to shareholders to maximize shareholder value,
shareholders have no duty to the corporation. Thus, shareholders can use the information they seek
Right to Vote
A corporation must have at least one class of stock with voting rights. Annual shareholder meetings
are the norm for publicly traded companies.
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Shareholder Proposals
Under Securities and Exchange Commission (SEC) rules, any shareholder who has continuously owned
for one year at least 1 percent of the company or $2,000 of stock can require that one proposal be placed
in the company's proxy statement to be voted on at the shareholder meeting.
The SEC traditionally recommended that shareholder proposals be in the form of non-binding requests
because state laws sometimes prohibit binding resolutions. However, shareholder activists have become
angry that companies continue to ignore non-binding shareholder proposals that receive hefty votes. In
one recent year, shareholders of 29 companies voted in favor of non-binding proposals. Only four
companies made the changes recommended by shareholders.
In response, shareholders have begun to offer binding proposals although the validity of these proposals is
not clear.
Question: Should shareholders be allowed to pass binding resolutions?
Answer:
Arguments in favor:
Shareholders own the company. Why shouldn’t they be allowed to have some say?
The interests of managers and shareholders often conflict; binding proposals can keep
managers honest.
Election and Removal of Directors
Congress began its reform effort by passing the Sarbanes-Oxley Act (SOX), which applies to all publicly
traded corporations in the United States as well as to all foreign companies listed on a U.S. stock
exchange. Among other provisions, SOX stipulates that all members of a board’s audit committee must be
independent and at least one of these members must be a financial expert.
Majority Voting Systems. Because of pressure from shareholder activists, two-thirds of the S&P 500 (large
companies) now refuse to seat a director if fewer than half of the shares that vote tick off her name on the
ballot. However, among smaller companies – those in the Russell 3000 Index – three-quarters still permit
plurality voting – where one vote is often sufficient to insure election.
Shareholder Activists. Proxy advisors, such as Institutional Shareholder Services, Inc. (ISS) are a new
development in corporate democracy. They advise institutional investors on how to vote their shares.
Proxy access. By a 3-2 vote of the Commissioners, the SEC approved proxy access rules that require
companies to include in proxy material the names of all board nominees, including those selected by large
shareholders (who have owned three percent of the company for three years).
Compensation for Officers and Directors – The Problem.
Between 2001 and 2003, public companies spent 9.8 percent of their net income on compensation for top
executives. Executives also get many non-cash perks such as stock options, termination benefits,
retirement benefits, luxury perks, and sometimes illegal use of insider information. Additionally, the
power to set compensation and make other important decisions lies very close to the ones who benefit
from those decisions (directors and executives) but not with the ones who bear the risk (shareholders).
Corporate executives are not the only people to earn fabulous salaries. Some athletes earn more even than
CEOs. What is the difference between athletes and executives (besides a hook shot)? Athletes’ salaries are
indeed negotiated at arm’s length with the team owner who will actually be paying the bill. This
negotiation process means that (1) athletes’ pay is not camouflaged; (2) they do not receive enormous
severance packages on their way out the door; and (3) their retirement pay ranges from modest to
nonexistent. Also, an athlete’s performance is transparent and easy to measure.
Compensation for O%cers and Directors – A Solution?
The federal government has begun to respond to these perceived abuses by amending proxy rules, and by
passing the Sarbanes-Oxley, Dodd-Frank, and the Jumpstart Our Business Startups acts. Even with these
new protections in place, shareholder influence over executive compensation is far from guaranteed.
Case: Brehm v. Eisner4
Facts: Michael Ovitz founded Creative Artists Agency (CAA), the premier talent agency in Hollywood.
As a partner of this agency, he earned between $20 and $25 million per year. He was also a longtime
friend of Michael Eisner, Chairman and CEO of the Walt Disney Company. Disney hired Ovitz to be its
President. Upon the advice of Graef Crystal, a compensation consultant, the Board approved Ovitz’s
contract.
After 14 months, all parties agreed that the experiment failed, so Ovitz left Disney with a $130
million severance package. Shareholders of Disney sued the Board, alleging that it had violated the
business judgment rule and that such a large payout was a waste of corporate assets. The trial court found
for Disney and the shareholders appealed.
Issue: Did the Disney directors have the right to pay $130 million to an employee who had worked at the
company unsuccessfully and for only 14 months?
Holding: Yes, the Disney Board of Directors had the right to pay Michael Ovitz $130 million. The
compensation committee of the Board was informed of the material facts relating to the payout. While
they did not use “best practices,” the committee reasonably believed that the analysis of the terms of the
contract was within Crystal’s professional competence, and the committee relied on the information and
opinions of Crystal. Crystal was selected with reasonable care in light of his previous engagements with
the company.
The purpose of the business judgment rule is to protect directors who rely in good faith upon
information presented to them from various sources, including any other person as to matters the member
reasonably believes are within such person’s expert competence. For these reasons, we uphold the
Chancellor’s determination that the compensation committee members did not breach their fiduciary duty
of care.
The shareholder’s claim of waste is unsupported by the evidence. To recover for waste, the plaintiffs
must prove that the exchange was so one-sided that no businessperson of ordinary, sound judgment could
conclude that the corporation has received adequate consideration. The shareholders claim that the
4 2006 Del. LEXIS 307, Supreme Court of Delaware, 2006.
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contract was wasteful because it incentivized Ovitz to perform poorly in order to obtain payment. The
approval of the contract had a rational business purpose: to induce Ovitz to leave CAA, at what would be
otherwise considerable cost to him, in order to join Disney. The Chancellor found that the evidence does
not support any notion that the contract irrationally incentivized Ovitz to get himself fired.
Question: What was Michael Ovitz’s career path at Disney?
Question: Why?
Answer: Ovitz was considered by some to be the “Most Powerful Man in Hollywood.” When it hired
Question: When they approved his severance package, Disney’s board did not know how much his
severance package would cost. How could this be considered an informed decision under the business
judgment rule?
Answer: Under the business judgment rule, a court will overturn a decision only if the board of
Question: Wasn’t the payment ridiculously excessive?
Answer: A decision constitutes waste only if it was so one-sided that no reasonable person would
General Question: What do you think?
Executive Compensation
Question: How much of corporate earnings should go to the top five earners in a company (given that
there are millions of shareholders)?
General Questions: In 2006, Exxon had a profit of $36 billion, which was the largest any American
company had ever earned. Every time the price of oil increased by $1, Exxon’s earnings increased by
1.5%. Why were oil prices up? Because of the war in Iraq and increased demand from China.
Bonuses for the top five executives at Exxon increased by $14.3 million. Had the executives earned
such large increases?
Current Focus
Why has executive compensation increased so dramatically? In the 1950s, executives earned 40 times as
much as the average worker. Now they earn 458 times as much.
Question: What can companies do about executive compensation?
Answer: Some commentators suggest the following:
General Questions:
What ethical obligations do directors have in setting officers' pay?
Should there be some limit to the ratio between executive pay and the income of the average worker?
Should executive pay relate to the company's performance? To what measure of performance?
Should companies base compensation on a comparison of their performance with that of their
competitors?
If students completed the Executive Compensation Research, have them report what they found. Chart the
raw data on the board–what is the range of salaries for CEOs? Then see if the students are able to discern
any correlation among income, performance, and size.
Fundamental Corporate Changes
A corporation must seek shareholder approval before undergoing a merger, a sale of major assets,
dissolution of the corporation, or an amendment to the charter.
Right to Dissent
The Model Act and many state laws require private companies to buy back the stock of any shareholders
who object to fundamental corporate changes, such as a merger or a sale of most of the company’s assets.
Right to Protection from Other Shareholders
Anyone who owns enough stock to control a corporation has a fiduciary duty to minority shareholders.

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