Business Law Final - Chapter 34

The textbook lists six elements that are generally recognized as involving the duty of loyalty. What are they?

1. Competing with the corporation 2. Usurping (taking advantage) of a corporate opportunity 3. Having an interest that conflicts with the interest of the corporation 4. Engaging in insider trading (using information that is not public to make a profit trading in the corporation's securities). 5. Authorizing a corporate transaction that is detrimental to minority shareholders 6. Selling control over the corporation

The textbook lists three tests an director/officer must satisfy in order to claim the protection of the business judgment rule. What are they?

1. The director/officer took reasonable steps to become informed about the matter 2. The director/officer had a rational basis for the decision 3. The director/officer did not have a conflict of interest between his personal interest and that of the corporation. To illustrate the application of this test, I will walk you through one of the most famous business judgment rule cases decided by the Delaware Supreme Court.

By rule, each of the major exchanges require that a majority of the Board be made up of independent directors.

A director is an independent if the director is not an employee of the company.

Dividends

Are the means a corporation distributes a share of the company's profits with the owners.

Preemptive Rights

Assume the corporate charter authorizes the corporation to issue 10M share of common stock. However, the corporation has also issued (sold) 5M shares of common stock. To raise additional capital the board of directors decides to issue 2M more shares of common stock

Two most important committees

Audit Committee and the Executive Committee.

Loft Candy Company was located in Long Island City, New York. Grace Company, the company Guth used to complete the manufacturing of the Pepsi syrup before selling it to Loft and others was located in Baltimore, Maryland. Why was this case decided by the Delaware Supreme Court?

Because Loft, Inc. was incorporated in the State of Delaware and the case involved issues Delaware law. This allowed the case to be brought in Delaware

How could Guth have avoided personal liability for breach of the duty of loyalty?

By making full disclosure of details of the opportunity to Loft's board Informing Loft's Board that if Loft did not want to undertake the opportunity Guth intended to do so himself. Note also, if he intended to use Loft employees, facilities and credit he would have to seek the approval of these activities from Loft's board and would have to be prepared to pay the FMV of the facilities and personnel.

The Board of Directors will establish a record date for voting at the annual meeting

Company management, working with the transfer agent, will prepare a list of shareholders as of the record date and the company will solicit their proxy to authorize a company official to vote their shares in accordance with the instructions given to the agent by the shareholder.

Of the two major categories of duties of officers and directors, which duty did Smith violate by attempting to bind Alliance as a co-signer on his personal loan?

Duty of Care: requires an director or an officer to act in good faith (honestly) and to exercise the care that an ordinarily prudent person would exercise in similar circumstances. A beach of the duty of care that results in harm to either the corporation or its shareholders can lead to liability in negligence. As a part of the duty of care, officers and directors are expected to exercise two other duties: The duty to make informed and reasonable decisions. Directors and officers are expected to be informed on corporate matters and to conduct reasonable investigations of the relevant situation before making a decision. Duty to exercise reasonable supervision when they delegate work to corporate officers and employees. Remember the food warehouse case that was the basis for the responsible corporate officer doctrine Smith did not act in good faith, because he knew at the time he signed the loan documents that the Board of Directors had not authorized the corporation to act as a co-signer on his personal loan.

Assume that a shareholder holds 200K shares of common stock, or 4% of the number of shares outstanding

If the corporate charter authorized preemptive rights, the existing shareholder would have the right to purchase 4% of the new stock offering (80,000 shares) so that their ownership position would not be diluted. The shareholder does not have to purchase 80,000 shares. The shareholder may purchase fewer, or more. However, if more, the shareholder would have to go into the market to purchase anything over 80,000 shares.

Committees of the Board of Directors

In larger firms the Board will, and sometimes must, divide up its responsibility among the members of the Board by forming committees.

Class Discussion Problem # 2

Joseph Smith, Alex Jones and Fred Wright formed a corporation called Alliance Corp. for the purpose of selling computer services. Smith owns 51% of the stock in the company. Jones and Wright each own 24% of the stock of the company and the remaining 1% is owned by the lawyer who helped the others form the corporation. The Board of Directors is made up of 5 directors. The directors include Smith, Jones and Wright plus two other directors who are loyal to Smith. Smith also serves as the President of Alliance, Jones is the Secretary of Alliance and Wright is the Treasurer of Alliance. The other two directors are not employees of the company. Smith wants to obtain a personal loan for $250K but his bank will not give it to him without a co-signer. He makes Alliance the co-signer on the loan by signing the application as President of Alliance Corp. He defaults on the personal loan and the bank sues Alliance as the co-signer on the loan documents.

Charles Guth was Loft Candy Company's President. What facts supported Loft's breach of loyalty claim?

Loft manufactured and marketed candies, syrups and beverages. One of the beverages they sold was through a license with the Coca Cola Company. Guth was dissatisfied with the prices the company had to pay for the Coca Cola syrup. Through another company, owned by Guth's family, entered into a contract to obtain the trademark and the formula for Pepsi-Cola. Guth used Loft's captial, credit, facilities and employees to further the Pepsi enterprise. Pepsi turned around and sold the Pepsi syrup to Loft and Loft stopped selling Coca Cola in its stores. When store sales went into the tank, Loft figured out what had happened and sued Guth seeking an accounting and Guth's Pepsi stock.

There was a rational basis for their decision

Ovitz was very successful in his own right. He had connections in the industry that could be used to benefit Disney. The market was enthusiastic - Disney shares went up 4.4% in one day.

The director or officer took reasonable steps to become informed on the matter.

The Delaware Supreme Court held: The Board knew who Ovitz was, his reputation in the industry, the success of CAA, and the doors Ovitz could open on the talent side of the business to assist Disney The Board knew that he was not going to come cheap The Board brought in a compensation expert who was fully aware of the terms of the employment agreement - particularly the NFT - and had given the Board models of the financial impact of the NFT at various stock prices The Ovitz deal was structured after the contracts that the Board had given Eisner and other Disney top executives.

In Guth v. Loft, Inc., Classic Case 34.1 on page 790 of the textbook, what duty of a director/officer was involved in this case?

The duty of loyalty.

Section 36-4a of the textbook discusses the need to align the interests of officers and directors with the stockholders. The textbook says many companies have used stock options to do so. What is a stock option?

The officers or directors and key employees are offered a contract which gives them the right to purchase shares of the companies common stock. The purchase price, or the strike price, of the stock is the price of the stock at the close of trading on the day the option is granted. The grantee has a certain period of time in which to purchase the shares, provided the grantee remains in the employ of the firm. Usually, the right to purchase the shares vests over a given period of time. For example, if the option is for 10,000 shares, the grantee will be able to exercise the option in segments of 2,000 shares spaced out of five years. The concept is that as the stock price increases, presumably due to the efforts of the grantee and other grantees, the grantee can exercise the option and then sell the shares at the higher price and pocket the difference between the strike price and the FMV of the stock on the day of the sale. But you don't have to sell the shares right away. The textbook argues that there have been problems with the way in which stock options are managed. The directors and officers cook the books to artificially inflate the stock price to retain the value of the options to the grantee. This is what the Enron scandal was about If the stock price goes south, the strike price will be adjusted. This must be approved by the Board of Directors and they are walking a tightrope between the interests of the shareholders at large and retaining executive talent.

Why was this conduct a violation of Guth's duty of loyalty to Loft?

The opportunity to acquire the Pepsi trademark and formula must first be presented by Guth to Loft. The legal test for when this must occur has two parts. 1. Is the opportunity reasonably related to the corporation's line of business. 2. Was the corporation financially able to undertake the opportunity. Guth did all of this in secret for his own personal advancement and at the expense of Loft

Shareholder Rights and Duties

The shareholders are the owners of the corporation. As a result, they have the right to vote to approve certain fundamental changes in the corporation's business and to elect the directors at the annual meeting of shareholders.

There was no conflict of interest between the director's or officer's personal interest

There was absolutely no evidence in the record to even suggest any conflict of interest on the part of Eisner or the Board. The Delaware Supreme Court basically told the Disney shareholders they had two choices Sell Throw the bums out That is exactly what happened at the next annual meeting, Mr. Eisner and the holdovers from the Board were not re-elected.

Are Smith, Jones and Wright inside or outside (sometimes referred to as independent) directors? Why are they one or the other?

They are inside directors because they are employees of the company.

Do you think Alliance Corporation has the authority to borrow money? Where would you look to find out?

This is not in the textbook: There are two important governing documents of a corporation. The first is The Articles of Incorporation (in some states known as the Corporate Charter or the Certificate of Incorporation). This is the document that is filed with the Secretary of State at the time of the formation of the corporation. It includes such things as the statement of the purpose of the business. This will be stated as "any lawful purposed permitted by law" so as to avoid ultra vires issues. The capitalization of the corporation. This is the types and authorized number of debt and equity securities the Corporation is authorized to issue. The name of the corporation and the length of its existence; usually perpetual. The name of the incorporator and the name and address of the registered agent. Major changes must be approved by a shareholder vote. The By-Laws of the Corporation: will include the authorized officers of the corporation and a brief description of their duties and responsibilities. The procedures and notice requirements for the annual meeting of shareholders, special shareholders meetings, authorized powers of the officers of the corporation. The By-Laws will state whether or not the corporation is authorized to borrow money. Changes may be made by a majority vote of the Board

Section 36-4c discusses The Sarbanes-Oxley Act and its provisions regarding corporate governance. Is Alliance Corporation covered by Sarbanes-Oxley?

This question cannot be answered because the facts of the problem do not disclose if Alliance's shares are publicly traded or if it is a close corporation. If Alliance is a publicly traded company then Sarbanes Oxley would apply.

What must happen first before the corporation would be authorized to act as a co-signer on Smith's personal loan?

This would require approval by the Board of Directors The approval is given through resolutions adopted by the Board The approved resolutions would be included in the minutes of the meeting of the Board where the matter was considered and approved or disapproved.

What is the business judgment rule?

Under the business judgment rule, directors and officers will not be liable to the corporation or its shareholders for honest mistakes of judgment or bad business decisions. The idea behind the rule is to keep courts out of the business of second guessing business decisions made by officers and directors.

If the bank wanted to know if Smith was authorized to act as a co-signer on his loan, what should the bank have done?

What the bank should have done here is asked for a certified copy of the resolutions of the Board approving the action of co-signing on this personal loan for the President. A corporate officer will never have the autonomous authority to bind the corporation to a contract of this type If you, as a business person, are dealing with a corporation and you want to be certain that the corporation is authorized to enter into a proposed transaction, demand a certified copy of the resolutions of the Board of Directors approving the transaction and authorizing an officer or officers of the corporation to sign the necessary documents on behalf of the corporation.

As a general rule

a common stockholder has no right to receive a dividend. The textbook mentions a possible legal action by common stock holders to compel a dividend, but this is a very difficult case to make.

Cumulative Voting

a technique used by some firms to help protect minority shareholder interests. Instead of one vote per share, the shareholder gets one vote per share multiplied by the number of directors standing for election. If a person owned 1,000 shares and there were 7 director candidates, the shareholder would have 7,000 votes. The shareholder could cast all 7,000 votes for one candidate.

Sarbanes Oxley and the rules of the three major exchanges

also require the audit committee and the compensation committee of the board to satisfy certain requirements. At Superior, we established a check list for each committee to ensure that each of these requirement were satisfied each year.

The Audit Committee must produce

an annual report that is included in a publicly traded company's filings with the SEC reviewing all of these issues and how the committee and the company satisfied these requirements.

Looking back at the problem with Alliance Corporation and Smith, Jones and Wright

if Alliance was a publicly traded company and listed on one of the three major exchanges, Alliance would have to add two more independent directors to the Board in order to meet this requirement.

common item that distinguishes a share of common stock from a share of preferred stock

is that the preferred stock may carry a guaranteed dividend.

The Audit Committee is also responsible for

reviewing the company's internal financial controls to ensure that there are systems and procedures in place to discover and remedy any financial irregularities before they reach a crises stage.

The company will prepare a proxy statement

that contains a wealth of information about the company, its business, the identity and background of the officers and directors. This document, in conjunction with the Annual Report filed with the SEC will be made available to all shareholders of record to give them the information necessary to make decisions on issues to be voted upon at the annual meeting.

The rules of the exchanges also provide

that the Chairman of the Audit Committee must have a financial background and be able to read and to interpret properly basic accounting documents such as a balance sheet, income statement and profit and loss statement.

As an additional safeguard

the CEO and the Chief Financial Officer must also file personal certifications that the company's financial statements satisfy GAAP and internal controls are sufficient to protect the interests of investors

Post Sarbanes Oxley, the two primary committees of a board

the audit and compensation committees.

The Compensation Committee has the duty

to set the compensation to be paid to the officers of the company. In the old days, the Chairman of the Board or the CEO would call the Chairman of the Compensation Committee and say this is what I want to do on salaries next year. Not any more. The Committee now must establish a methodology for determining officer compensation, salary surveys and the like and tie these back to the success of the company in meeting its financial goals. The compensation committee must also file a report that is included in the company's reports filed with the SEC.

The Audit Committee has two major responsibilities

to work with the company's internal and external auditors and to ensure that the company's financial statements are truthful and accurate and maintained in accordance with GAAP.

When I was with Superior,

we would go through an elaborate process each year to establish the independence of each of our outside directors and the financial acumen of the chairman of the audit committee and each independent director. The full board would then make an affirmative finding on each person prior to nominating that person for as a director to be voted on by the shareholders at the annual meeting.

In a large publicly traded corporation

you can't get all of the shareholders in one place at one time. Plus, a large publicly traded corporation does not know the identity of the shareholders on a current specific date.

In this regard

you must appreciate the interplay between Sarbanes Oxley and the rules of the three major stock exchanges that form the public market for publicly traded securities.