Business Law II Exam 6

Sale of all or substantially all of the assets of the business

-(unrelated to the regular course of business) -Drastically changes shareholders' investment -usually applies only if 25% (or less) of business activity/income/revenue remains

When and what created the SEC?

-1934 Act created the SEC -Securities Act of 1933, Securities Exchange Act of 1934

Changes Requiring Shareholder Action

-Amendment of articles of incorporation -Merger -Consolidation -Share exchange -Sale of all or substantially all of the assets of the business -Dissolution

Tombstone Ad

-During the waiting period (more of an announcement than an offer) must state "not an offer" -Contains less information than the prospectus

Special meetings of shareholders can be scheduled as needed

-Example: merger, dissolution -Notice must list purpose of the meeting -Shareholders that represent at least 10% of voting shares can call a special meeting

Dissolution

-First step in the termination of the corporation's business

2 Principal Regulatory Components of the 1933 Act

-Registration provisions : •issuer may not offer to sell or sell securities unless -registered with the SEC or exempt from registration -Liability provisions

Judicial Dissolution

-Shareholders, secretary of state, or creditors of a corporation may ask a court to order involuntary

3 types of underwriting

-Stand-by underwriting •Sell subscriptions—only sell securities when enough sold •Usually used to sell common shares to existing shareholders based on shareholder rights agreements -Best efforts underwriting •Promise to "do their best" to sell securities •Usually—issuer not well known-underwriter not willing to take the risk -Firm commitment underwriting •"Underwriting Group" and "Selling Group" •Buy securities at a discount •Guarantee sell •Most common and most profitable •Also most risk •The "classic" underwriting agreement

Shareholder Control Devices

-Voting Trusts -Shareholding Voting agreements -Proxies

Voluntary Dissolution

-corporation must file articles of dissolution with secretary of state -Effective when articles filed

Shareholder rights in a publicly-owned corporation are limited to

-electing and removing directors, -approving vital matters, and -ensuring that management actions are consistent with state corporation statutes, the articles of incorporation, and the bylaws

Share Exchange

-one corporation becomes owner of all outstanding shares of second corporation •(compulsory exchange of shares) -Second corporation remains •becomes a wholly owned subsidiary of first corporation -Only selling shareholders must approve exchange

Merger

-one corporation dissolves -second corporation takes •business, •assets, and •liabilities of both corporations

Administrative Dissolution

-requires that the secretary of state give written notice to the corporation of grounds for dissolution -If, within 60 days, the corporation has not corrected the default, secretary dissolves corporation with certificate of dissolution

Consolidation

-two corporations join to create a new corporation •but both original corporations cease to exist

Involuntary Dissolution

-without consent of corporation by administrative action of the secretary of state or judicial action

Violations related to Section 5 of the Securities Act of 1933 and the related waiting periods

1. Prefiling period -No one may not offer to sell or sell the securities to be registered -Marks start of the quiet period, which continues for full duration -Must avoid publicity 2. Waiting period -Waiting period is time between filing date and effective date of registration statement -Securities may be offered in accordance with certain limits, but may not be sold -Preliminary prospectus used that omits price -Issuers typically send CEOs and other top officers on a "road show" to talk to securities analysts and institutional investors -Tombstone ad (more of an announcement than an offer) must state "not an offer" -Contains less information than the prospectus 3. Posteffective period -After effective date and once buyer has a final prospectus, Sec. 5 permits the security to be offered and sold -Internet may be used during the posteffective period

Securities exempt from registration

1. SECURITIES EXEMPTION •Exempt securities never need to be registered 1. Government-issued securities 2. Short-term note or draft (< 9 months to maturity) 3. Security issued by a nonprofit religious, charitable, educational, benevolent, or fraternal organization 4. Securities issued by a bank or savings and loan 5. Securities issued by common carriers regulated by the Interstate Commerce Commission 6. An insurance policy or an annuity contract 2. TRANSACTION EXEMPTIONS •Requirement to register depends upon the type of transaction 1. Intrastate (Rule 147) - Offering securities solely to investors in one state by an issuer resident and doing 80% of firm's business in that state 2. Private Offering (Rule 506 of Regulation D) •Rule 506, Regulation D: Private offering to unlimited accredited investor-purchasers and less than 35 unaccredited purchasers with sufficient investment knowledge -Accredited investors: Institutional investors (banks, mutual funds), wealthy investors, and high-level insiders of the issuer (executive officers, directors, partners) -General selling efforts prohibited -See Mark v. FSC Securities Corp. 3. Small Offerings: - Rule 504 -Regulation D: Nonpublic issuer may sell up to $1 million of securities in a 12-month period to any purchaser -General selling efforts permitted -Rule 505 -Regulation D: Any issuer may sell up to $5 million of securities in a 12-month period to less than 35 unaccredited investors (unlimited accredited investors) -General Selling efforts prohibited -Regulation A -Regulation A: Nonpublic issuer may sell up to $5 million of securities in one year period -No limit on number of purchasers, no purchaser sophistication requirement, and no purchaser resale restriction -Disclosure document is the offering circular, which must be filed with the SEC

Shareholding Voting Agreements

Shareholders agree how they will vote their shares

Nine Month rule in rule 147

In securities, exemptions: •Exempt securities never need to be registered -Short-term note or draft (< 9 months to maturity)

Accredited Purchasers

Institutional investors (banks, mutual funds), wealthy investors, and high-level insiders of the issuer (executive officers, directors, partners) -General selling efforts are prohibited -Private offering to unlimited accredited investor-purchasers and less than 35 unaccredited purchasers with sufficient investment knowledge

When must securities be registered?

They must be registered before you can offer to sell securities, unless exempt from registration

Derivative Action Rules

•person bringing suit must be a current shareholder -must have also held shares at time of the alleged wrong •Shareholder must first demand that board of directors bring the suit

Notice must be given to shareholders of record

as a date fixed by the Board of Directors

Violations related to Section 5 of the Securities Act of 1933 and the related waiting periods

broadly prohibits the use of any manipulative or deceptive device in contravention of any SEC rules prescribed as "necessary or appropriate in the public interest or for the protection of investors" •Rule 10b-5 specifies the elements of the prohibition and applies to all transactions in all securities, whether or not registered under 1933 or 1934 acts Rule 10b-5 Elements •Rule 10b-5 prohibits misstatements or omissions of material fact -Material information is any information where there is substantial likelihood that a reasonable investor would consider it important to a decision and disclosure of the fact would alter the decision •Defendant not liable without scienter, or intent to deceive, manipulate, or defraud -Probably includes gross recklessness •Rule 10b-5 requires private plaintiffs seeking damages to be actual purchasers or sellers of securities and to prove they relied on the misstatement of material fact •Rule 10b-5 prohibits a person with inside information (nonpublic, confidential) from using the information when trading securities with a person without the information

Shareholders

owners, but not (necessarily) the managers of a corporation

10-K

•10-K annual report includes: -audited financial statements; -current information about the conduct of business, management, and status of securities; -management's description and analysis of issuer's financial condition (MDA section); -names of directors and officers with compensation

10-Q

•10-Q quarterly report requires a summarized, unaudited operating statement, unaudited figures on capitalization, shareholders' equity

Ownership of Working Papers

•A client's personal records, such as accounting records, are the property of the client and the professional must return the records at end of job •Material created by a professional, such as working papers produced by independent auditors, belong to the professional -Client has a right of access to working papers

Share Repurchase

•A corporation may also distribute assets by repurchasing shares from its shareholders: -Right of redemption (or a call) •a right of the corporation to force sale by a shareholder at a fixed price •must be allowed by articles of incorporation -Open-market repurchase

Share Dividends and Share Splits

•A corporation may distribute additional shares of the corporation to shareholders instead of a cash or property dividend -Share dividend: each shareholder receives specified percentage of shares •Declared by the board, but revocable -Share split: shareholders receive specified number of shares in exchange for each share they currently own

Winding Up

•A dissolved corporation continues to exist for the sole purpose of -winding up - the orderly collection and disposal (liquidation) of assets and distribution of the proceeds from the sale of assets •Distribution of proceeds: -creditor claims are paid first, then preferred shareholders, then common shareholders

Solvency Test

•A dividend may not make a corporation insolvent, •thus a corporation may pay a dividend to the extent it has excess solvency

Conduct of Meetings

•A quorum of outstanding shares must be represented at the shareholder meeting •A majority of votes cast decides (most) issues put to a vote •Shareholders have right of full participation, including -the right to offer resolutions, -speak for or against proposed resolutions, and -ask questions of corporate officers

Shareholder Lawsuits

•A shareholder has the right to sue in his own name to prevent or redress a breach of the shareholder's contract •class action suits are an option if the requirements are met

Balance Sheet Test

•After a dividend has been paid, the corporation's assets must be sufficient to cover its liabilities, thus a corporation may pay a dividend to the extent it has excess assets

The Opinion Letter

•After auditing financial statements, the independent auditor issues an opinion letter about the financial statements expressing: -Whether the audit was performed in compliance with GAAS, and -Whether financial statements fairly present client's financial position and results of operations in conformity with GAAP •Usually, the opinion letter expresses an unqualified opinion (i.e., compliance with GAAS and GAAP), but the professional may issue a qualified opinion, disclaimer of opinion, or an adverse opinion

Termination

•After completing the winding up process, the corporation's existence terminates

Professional-Client Privelage

•Although professionals owe a duty of confidentiality to clients, communications between clients and nonlawyer professionals generally are not protected from judicial and administrative agency scrutiny when the professional's client is a party to legal or administrative action or the professional possesses evidence probative to an action •Many states have enacted an accountant- client privilege of confidentiality that protects communications between a client and an accountant as well as accountants' working papers -The privilege belongs to the client -Federal courts do not recognize the privilege in matters involving federal questions, including antitrust and criminal matters

Shareholder Litigation Committee

•Boards may create a shareholder litigation committee (SLC) whose purpose is to decide whether to sue if a shareholder makes a demand to file suit •SLC usually has independent legal counsel •Most courts have upheld SLC decisions if they comply with the business judgment rule

Conflicts of Interest

•Concerned that securities analysts might provide overly optimistic stock recommendations due to a conflict of interest (unwillingness to offend firms), the SEC adopted Regulation AC (Analyst Certification) -Requires analyst's research report to include certification that (a) views expressed in report accurately reflect analyst's personal views, and (b) whether any part of compensation is related to the recommendations or views in the reports

The Derivative Action

•Corporation harmed by another's actions •the right to sue belongs to the corporation -A shareholder has no right to sue even if shareholder's investment impaired -However, one or more shareholders may bring a derivative action for the benefit of the corporation if the directors failed to pursue a corporate cause of action

Straight Voting

•Generally— •Directors elected by a single class of shareholders •straight voting: each share has one vote for each director-nominee -Shareholder may vote for as many nominees as are directors to be elected and cast votes for each nominee with as many votes as shares held -Example: •15 people nominated for 5 director positions: a shareholder with 100 shares can vote for up to 5 nominees and cast up to 100 votes for each of those 5 nominees

Nonprofit Organizations

•In a nonprofit corporation, a member's rights and duties are defined by the ability of members to use the corporation's facilities (e.g., social club) or consume its output (e.g., cooperative grocery store) and by their obligations to support the enterprise periodically with their money (e.g., dues paid) or labor (e.g., duty to work) -All members equal unless bylaws state otherwise •With a few exceptions, rules for nonprofit corporation meetings, voting, and inspection are similar to rules of corporations for profit •A nonprofit corporation generally is prohibited from making any distribution of assets to members •A member may resign or be expelled at any time from a nonprofit corporation -Certain procedures may be necessary •Members of a nonprofit corporation have a limited right to bring derivative actions on behalf of the corporation

Dissenter's Rights

•In general, those who oppose an approved action have little recourse •Dissenters' rights or a right of appraisal do exist in some situations -generally, the right to receive fair value of shares -MBCA and many state statutes exclude shares traded on a recognized securities exchange

What is a security?

•Investment of money •Common enterprise •Profits solely from the efforts of others

Periodic Reporting

•Issuers that also register securities under the 1934 Act must file several periodic reports: -annual report (Form 10-K), -quarterly report (Form 10-Q), and -a monthly report (Form 8-K) when material events occur -(Comparable reports must be sent to shareholders)

The Zapata Rule

•MBCA has adopted the Zapata rule: -If majority of directors are not independent (i.e., an interest in the derivative suit), corporation has burden to prove directors made the decision to dismiss the action in good faith and dismissal serves the best interests of the corporation -If majority of directors are independent, the shareholders bringing the derivative action have burden to prove bad faith or no reasonable investigation

Dissolution of Corporations

•MBCA provides that a corporation may be dissolved by directors and shareholders -Voluntary dissolution -Involuntary dissolution -Administrative dissolution -Judicial dissolution

Liability and Organizational Form

•Organizing a professional business to achieve limited liability (e.g., LLP, LLC, or corporation) does not insulate professionals from liability for professional misconduct (malpractice) -Read that last statement again. It's really important

Third Parties and Liability

•Other persons besides a professional's clients may use a professional's work product -professional (especially accounts) are most likely sued by third parties under securities laws •If a professional prepares documents that prove to be incorrect, nonclients who relied on the documents may suffer damages •Nonclients may sue professionals for common law negligence, common law fraud, and violations of the securities laws •In the 1931 Ultramares case, Judge Cardozo required privity of contract (primary benefit) to hold a professional liable for negligence •State courts now adopt one of three tests to determine whether a nonclient may sue a professional for negligence: -Primary Benefit Test •privity of contract required -Foreseen Users and Foreseen Class of Users Test -Foreseeable Users Test

8-K

•Reg. FD (fair disclosure) states that when an issuer or person acting for the issuer discloses material nonpublic information to securities market professionals and holders of the issuer's securities, it must make public disclosure of that information -File or furnish Form 8-K or use other method designed to effect broad, nonselective disclosure to the public

Shareholder Liability

•Shareholder may be liable to the corporation if: -Shareholder receives dividends/distributions with knowledge of their illegality -Defective attempts to incorporate and piercing the corporate veil provide a basis to hold a shareholder liable for corporate debts beyond a capital contribution -Selling shares for a premium over the fair market value of minority shares is due to wrongful act or omission -Controlling shareholder breaches the fiduciary duty to control the corporation in a fair, just, and equitable manner that benefits all shareholders proportionately

Cumulative Voting

•Shareholders may accumulate votes by multiplying number of directors to elect by number of shares held -allocate votes among nominees as s/he chooses and may choose to cast all votes for only one nominee

Distributions to Shareholders

•Shareholders may receive distributions of the corporation's assets, generally in the form of cash or property dividends •property dividend, alternative to cash or stock, equipment, property, or stock in a subsidiary -Declared by the board of directors and paid on the date set by the directors -Once declared, dividends are debts of the corporation •shareholders may sue to force payment of the dividends -Preferred shares generally have a set dividend rate •stated in the articles of incorporation

Shareholder meetings

•State statutes and the Model Business Corporation Act (MBCA) require annual meeting of shareholders to be held -Primary purpose: elect directors

Document Retention

•The Arthur Andersen case highlights the rules about document retention -All professional firms have rules about document retention and destruction -Federal law requires all audit or review working papers to be retained for 7 years -No requirement to retain documents that prove professional's or client's guilt, as long as they do not destroy documents (i.e., evidence) with the intent to obstruct a criminal prosecution

Prospectus

•The sales document of an offering registered under the 1933 Act •Contains most of the information in the registration statement •Allows a potential investor have "all the information" about security

Procedure to Effect Changes

•To effect fundamental changes: -the board of directors must approve, -notice must be given to all shareholders (even if not entitled to vote), and -there must be majority approval •State law may alter these requirements

Limits on Cash or Property Dividends

•To protect creditor claims, statutes limit extent to which dividends may be paid: -Solvency Test -Balance Sheet Test

Elements of the General Duty

•Two elements: skill and care -must have the skill of the ordinarily prudent person in her profession •Focuses on education or knowledge -must act as carefully as the ordinarily prudent person in her profession

Fraud-on-the-market Theory

•Under the fraud-on-the-market theory, an investor's reliance on the availability of the securities on the market satisfies the Rule 10b-5 reliance requirement because market is defrauded as to the value of the securities -Market performs substantial part of valuation process, thus acts as unpaid agent of the investor -See Basic, Inc. v. Levinson: fraud-on-the-market theory provides a rebuttable presumption about an investor's reliance

Working Papers

•Work programs, audit plan, evidence of the testing of accounts, explanations of the handling of unusual matters, data that reconciles an accountant's report with client records, and comments about a client's internal controls

Class Voting

•corporations have classes of shareholders: preferred and common (and sub-classes) and give separate voting rights to separate classes •each class may be entitled to elect one (or more) directors to balance power in a corporation

What does the SEC have the power to do?

•investigate violations and hold hearings to determine whether laws have been violated •the SEC has legislative, executive, and judicial functions SEC Adjudicatory Process •Hearings before an administrative law judge -Employee of the SEC and finder of both fact and law •Decisions reviewed by commissioners of the SEC •Commissioner decisions may be appealed to the U.S. Court of Appeals SEC Consent Orders •Most actions resolved through consent orders (not litigation) -No admission of guilt—promises not to do it again •SEC has power to impose fines up to $500,000 and issue cease and desist orders Injunction and Ancillary Relief •SEC may courts to grant an injunction or ancillary relief -including disgorgement of profits •usually related to fraudulent sale or insider trading

Voting Trusts

•limited in duration (10 years) •shareholders transfer shares to voting trustee(s) •receive voting trust certificates •concentrates voting power in the voting trustees •goal—to achieve control of the corporation

Shareholder Rights of Inspection

•managers don't like shareholders' inspection of corporate books/records -most states specifically grant shareholders inspection rights •MBCA grants shareholders an absolute right of -inspection of the shareholder list and -the articles, bylaws, and minutes of shareholder meetings (within the past three years) -Shareholders have right to receive some information about the corporation financial statements •balance sheet, •income statement, and a statement of changes in shareholders' equity •Shareholders have a qualified right to inspect records older than three years -must make the demand in good faith and with a proper purpose

Criminal Violations

•maximum penalty for a criminal violation of the 1933 Act is a $10,000 fine and five years imprisonment •under the 1934 act, an individual may be fined up to $5M and imprisoned for up to 20 years •RICO -two offences in a ten-year period -max: fine of $250,000 and 20 years -treble damages in civil

Tort liability for fraud

•may be liable to a client for fraud if s/he misstates or omits facts in client communications and acts with scienter -Scienter: knowledge of the falsity of a statement or a reckless disregard for truth •Most courts extend a professional's liability for fraud to all foreseeable users of the professional's work product

Problems of Straight Voting

•nominees with most votes win, •a majority shareholder could elect the entire board -Minority shareholders cannot elect nominees without the cooperation of the majority shareholder -Such control also possible in close corporations

Contractual Liability

•professional contracts include an expectation to perform as the ordinarily prudent person in the profession -failure to do so may leas to liability compensatory damages and consequential damages •not liable for breach of contract if the client obstructs performance -(this can happen when a person knows he is in trouble) •may not delegate a duty to perform the contract without the client's consent

Proxies

•shareholder may appoint a proxy •allows minority shareholders to hove more power collectively •Limited duration and generally revocable •Irrevocable if coupled with an interest •Ex: party to a shareholder voting agreement •A proxy is normally valid for 11 months