Business associations Chapter 3 Internal governance corporate governance

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty (litigation solutions) 1. Private paternalism 2. FD analysis: Duty & So. R 3. FD analysis: Application b. Customizing the firm c. Exit solutions 2

© Amitai Aviram. All rights reserved. Private paternalism Chapter 3: The big picture • Corporate law = acting (jointly) through others • Three main problems: – The shielding problem (B’s liability to T for A’s actions) • Corporate compliance (external governance) addresses this problem – The agent problem (A’s liability to B for A’s actions) – The principal problem (B’s liability to other Bs for B’s controlling actions) • Corporate governance (internal governance) addresses the agency & principal problems 3

© Amitai Aviram. All rights reserved. Private paternalism 4 Chapter 3: The big picture • The agent problem (vertical/managerial agency problem) (management vs. SHs) – When someone works for another, they do not work as efficiently as if they worked for themselves, because they do not gain the full value of their work, so they might: • Shirk (put in less effort or care than if they worked for themselves) • Steal (act in ways that benefit them at the expense of the beneficiary) – Example • B owns Acme corp. ; A is Acme’s CEO (Chief Executive Officer) • A flies on business trip; buys 1 st class ticket • This adds to Acme’s expenses compared to flying coach, reducing B’s wealth • A claims this is in B’s interest, since comfortable flying conditions allow A to be well-rested, therefore negotiating better deals for Acme (increasing profits more than the extra cost of flying 1 st class) • But maybe A just wants to be comfortable & would function just as well flying coach

© Amitai Aviram. All rights reserved. Private paternalism 5 Chapter 3: The big picture • The principal problem (horizontal/majoritarian agency problem) (controlling SH vs. minority SHs) – When there are several Bs, we may have: • Beneficiary apathy (non-controlling Bs may shirk, relying on other Bs to spend time and effort keeping A accountable) • Beneficiary rivalry (controlling B may cause A to act in ways that are good for controlling B, but bad for other Bs) – Example • Carol owns 60% of Acme corp. ; Maya owns 40%; Acme rents office from Carol • Acme used to make an annual profit of $100 K, that was distributed as dividends to the SHs ($60 K to Carol, $40 K to Maya) • When rent contract is renegotiated, Carol raises rent by $90 K. Now profits are only $10 K, so Carol gets $6 K & Maya $4 K (the $100 K now divided $96 K/$4 K) • This is unfair to Maya if the rent raise was unjustified, but maybe the fair cost of rent really did increase by $90 K (in which case not giving it is unfair to Carol)

© Amitai Aviram. All rights reserved. Private paternalism 6 Solutions to minimizing the agency problem Bonding: Align A’s welfare with B’s welfare Morality/identity Joint ownership/performance-based compensation Voice: Give B unilateral powers that affect A’s behavior Appointment Authority / Approval Protest Exit: Give B unilateral power to end association with A & take her share of the value the association created Termination (dissolution) Dissociation Alienation Litigation: Let independent party (judge) enforce appropriate behavior by A Fiduciary duty Limitations: • Not every job is conducive to appeal to morality/identity • Joint ownership less effective than 100% ownership & works poorly when there are many As • Performance-based compensation requires ability to identify relevant benchmarks, observe performance & punish sufficiently to deter

© Amitai Aviram. All rights reserved. Private paternalism Solutions to minimizing the agency problem Bonding: Align A’s welfare with B’s welfare Morality/identity Joint ownership/performance-based compensation Voice: Give B unilateral powers that affect A’s behavior Appointment Authority / Approval Protest Exit: Give B unilateral power to end association with A & take her share of the value the association created Termination (dissolution) Dissociation Alienation Litigation: Let independent party (judge) enforce appropriate behavior by A Fiduciary duty Limitations: • SH rivalry: Voice can make the horizontal (majoritarian) agency problem worse by facilitating the majority’s tyranny of the minority (or, if minority has veto power, the reverse) • SH apathy: Voice is not effective when beneficiaries cannot effectively govern collectively, yet this is precisely when the vertical agency problem is at its worst • When Bs are rationally apathetic, either no voice, or voice taken over by activists (who advance their own interests, which tend to be short-term) 7

© Amitai Aviram. All rights reserved. Private paternalism Solutions to minimizing the agency problem Bonding: Align A’s welfare with B’s welfare Morality/identity Joint ownership/performance-based compensation Voice: Give B unilateral powers that affect A’s behavior Appointment Authority / Approval Protest Exit: Give B unilateral power to end association with A & take her share of the value the association created Termination (dissolution) Dissociation Alienation Litigation: Let independent party (judge) enforce appropriate behavior by A Fiduciary duty Limitations: • • • If exit requires the firm (or the other Bs) to buy the exiting B’s interest, this can create financial difficulties and be exploited by an opportunistic B • Alienation solves this at price of being stuck with B’s you don’t like Success is highly dependent on figuring out the “correct” value of B’s share • If shares are not actively traded, this is difficult • Even if shares are traded, firm/controller may be able to manipulate market • Traded shares usually don’t include value of controlling the firm Very effective exit may cause excessive managerial focus on the short-term 8

© Amitai Aviram. All rights reserved. Private paternalism Solutions to minimizing the agency problem Bonding: Align A’s welfare with B’s welfare Morality/identity Joint ownership/performance-based compensation Voice: Give B unilateral powers that affect A’s behavior Appointment Authority / Approval Protest Exit: Give B unilateral power to end association with A & take her share of the value the association created Termination (dissolution) Dissociation Alienation Litigation: Let independent party (judge) Fiduciary duty enforce appropriate behavior by A Limitations: • More uncertainty of outcomes (B can select good As, but can’t control quality of the judge; A can’t consult with judge to avoid violating the law) • Expensive to litigate, so when Bs are rationally apathetic, either no litigation, or litigation taken over by lawyers, who advance their own incentives (attorney fees) 9

© Amitai Aviram. All rights reserved. Private paternalism 10 Challenging an actor’s behavior • B gets two distinct challenges vs. A’s behavior (acts & omissions) – Authority: A did not have the right to do the particular act on B’s behalf – Fiduciary duty: A’s behavior had an improper purpose (wasn’t in B’s interest) • Conduct authority analysis as we’ve learned in Section 1 c 4 [R 3 A § 3. 01] 1. Manifestations by B that are perceived by A (this includes agreements between A&B, bylaws, charter & law) 2. These manifestation cause A to reasonably believe that A is authorized to act in a certain way on behalf of B – R 3 A § 2. 02(1): A has authority for acts that are “necessary or incidental” to achieving the principal’s objectives • We will learn how to conduct FD analysis in sections 3 a 2/3 a 3 – In the remainder of the class we will discuss the idea behind FD – private paternalism

© Amitai Aviram. All rights reserved. Private paternalism 11 The norm-generating rule • Litigation involves an independent party (judge) enforcing appropriate behavior by A • How do we decide what’s the appropriate behavior (the normgenerating rule)? – Private ordering: appropriate behavior is what the parties contractually agreed it would be (courts enforce the contract) – Public paternalism: judges, regulators or legislators set the norms they believe are best for B (or for society) – Private paternalism: A tasked with deciding what’s good for B, but is required to act in the interest of B (when legally enforceable, court can punish A if A acted for a purpose other than the benefit of B)

© Amitai Aviram. All rights reserved. Private paternalism 12 Norm-generating rule: private ordering • Under private ordering, government enforces voluntary agreements the stakeholders reached • Strengths – Least effort to enforce (agreements reflect balance of power between stakeholders) – Usually easy to morally justify (these are the terms the parties agreed to) – Stakeholders likely know best what terms are most suitable for them • Weaknesses – When stakeholder can’t exclude others from their contribution (e. g. , providing security, clean environment, educated population), others have no need to bargain with that stakeholder – Societies discourage some voluntary agreements; e. g. , when: • Bargaining power varies widely; • Society is more sympathetic to one party than the other; • Society wants to avoid commodification of sacred values, such as life/liberty – When it is difficult to anticipate future contingencies or to describe in objective terms all desirable/undesirable behavior: this is a particular problem for equityholders (SHs), who can’t specify their right to the firm’s profits

© Amitai Aviram. All rights reserved. Private paternalism 13 Norm-generating rule: public paternalism • Public paternalism allocates to the government the task of setting the norms it believes are best for B (or for society) – The political process determines what government’s preferences are, so stakeholders & the firm use the political process to protect their interests • Strengths – Protects stakeholders w/weak bargaining power but significant political power • E. g. , the community (which can’t exclude the firm from its contributions & wants to enforce on the firm certain social values) • Weaknesses – Polity that elects government’s officers is not identical to the group of stakeholders in a firm – so outcome of political process represents balance of political power (votes & lobbying power), which might be so unfavorable to some stakeholders that they would not participate – One size fits all: government can’t create special terms for each firm, so the balance that is struck is a compromise that isn’t optimal for some firms

© Amitai Aviram. All rights reserved. Private paternalism 14 Norm-generating rule: private paternalism • Private paternalism requires one who acts on B’s behalf to pursue B’s interests – When legally enforceable, A has a fiduciary duty to B, so a judge can punish A if she acted against B’s interest – If Bs’ interests are diverse, A can do whatever she wants, find an interest of some stakeholders that fits with that action & claim that’s the interest she is pursuing – So, private paternalism works better the more narrowly defined the interests A must pursue (ideally, Bs should have a homogenous, narrowly-defined shared interest) • Strength – Good for equityholders (SHs), who are poorly protected by private ordering & public paternalism • Weakness – For legal enforcement to be effective, A must pursue a homogenous, narrowly defined interest. Requires prioritizing one group of stakeholders over all others. • Benefit corporations sacrifice this effectiveness to allow more inclusiveness of non-SH stakeholders

© Amitai Aviram. All rights reserved. Private paternalism 15 Three modes of private paternalism • Board-primacy faction – The agency problem in SH voting & SH litigation is severe • SH rights get hijacked by plaintiff lawyers & short-term SH activists, so voice solutions should be constrained & accountability maintained mostly through an efficient fiduciary duty & market oversight – Firm’s interests = SH interests • SHs are least able to rely on private ordering & public paternalism, so the firm’s interests should be limited to SH (long-term) interests; other stakeholders can protect themselves through regulation or contract • Limiting the firm’s interests to SH interests makes FD & market oversight more efficient – Board autonomy is important • Boards are necessary because SH apathy and SH rivalry make SHs unable to govern

© Amitai Aviram. All rights reserved. Private paternalism 16 Three modes of private paternalism • SH-primacy faction – The agency problem in corporations is severe • Boards are necessary for day-to-day management, but require significant oversight to reduce the agency problem • Boards are less accountable to SHs than plaintiff lawyers & SH activists, so boards should be mostly constrained by voice solutions (making it easier for SHs to oversee directors) – Firm’s interests = SH interests • Agree with board-primacy faction (but less hostile to short-term SH interests) – Board autonomy is undesirable • Boards use their autonomy to enrich themselves and their supporters at SHs’ expense

© Amitai Aviram. All rights reserved. Private paternalism 17 Three modes of private paternalism • Stakeholder-primacy faction [less agency solutions, more stakeholder inclusiveness] – The agency problem is not as harmful to society as the prioritizing of SHs over other stakeholders of the firm • Focus on SH interests causes firms to externalize costs on other stakeholders, who can’t sufficiently protect themselves through regulation & contract • Voice & litigation solutions should be weakened or expanded to non-SH constituencies, since SHs tend to excessively focus on the short-term and on profits – Firm’s interests = Mix of all stakeholders’ interests – Board autonomy is important • Boards exist to mediate the interests of all stakeholders. They must be allowed to use their discretion, even at the cost of a slightly greater agency problem

© Amitai Aviram. All rights reserved. Private paternalism 18 SH wealth maximization norm • The shareholder wealth maximization norm states that the purpose of corporate acts should be to maximize SH’s financial interests (i. e. , value of residual claim on the firm • The norm & its limits: ALI’s Principles of Corporate Governance § 2. 01 (reflects most U. S. jurisdictions) – “A corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain. ” – “Even if corporate profit and shareholder gain are not thereby enhanced-” • Corp must act within the boundaries of the law • Corp “may take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business” • Corp may give to charity “reasonable amount of resources” • Benefit corporations explicitly reject the SH wealth maximization norm

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty 1. Private paternalism 2. FD analysis: Duty & Standard of Review 3. FD analysis: Application b. Customizing the firm c. Exit solutions 19

© Amitai Aviram. All rights reserved. Classification 20 What is a fiduciary duty? • FD is a duty that requires an actor to act in the interest of the beneficiary, beyond what is required of A by contract • FD analysis framework 1. 2. 3. – Duty: is A required to act in B’s interest? Standard of review (“So. R”): who decides if A’s act was in B’s interest? Application (of So. R to potential flaws in A’s behavior) Ratification/prior consent (if behavior by/attributable to B waived FD breach) • Regarding prior consent, consider exculpation: Under DGCL § 102(b)(7), a firm can have a clause in its charter that eliminates or limits directors’ personal liability for monetary damages for breach of FD, except: – Self-dealing & bad faith (acts/omissions not in good faith, involving intentional misconduct or knowing violation of the law, and acts/omissions where director derived improper personal benefit) Unlawful dividend payment/stock repurchase • – So, if a firm has an exculpation clause, a challenge based on unintentional negligence of a director, that requests a remedy of damages (as opposed to an injunction) will fail

© Amitai Aviram. All rights reserved. Classification Duty • Controlled actors (agents) – Agents owe a FD to the principal (so, duty test is whether A is B’s agent) – Officers: ambiguity as to whether officer FD follows rules for agents or directors; for this course, treat officers as agents • Autonomous actors – Directors: each director owes a FD to the firm (and to its SHs) – Incorporators: an incorporator owes a FD to the firm she is forming • SHs – SHs do not owe a FD to the firm or to other SHs – Exception: SH may owe FD in exercising control of the corporation • This exception is discussed in M&A; for BA, treat SHs as never owing a FD 21

22 © Amitai Aviram. All rights reserved. Classification So. R • So. R: Who decides if A’s act was in B’s interest? – Beneficiary? – Actor? – Judge? B’s discretion (Agency So. R) Between A & judicial (Enhanced scrutiny) A’s discretion (BJR) Judicial discretion (Entire fairness)

© Amitai Aviram. All rights reserved. Classification 23 So. R • Agency So. R: emphasis on beneficiary’s discretion – Applies to all agent behavior (acts/inactions) – Court must find a FD breach if A is negligent or self-deals, unless B approved A’s behavior (limits both judicial discretion & deference to A) – Drawbacks of relying on B’s discretion • Doesn’t protect against horizontal agency problem (SH rivalry: C oppressing MSHs) • Doesn’t work when Bs cannot effectively govern collectively (SH apathy) • BJR So. R: emphasis on actor’s discretion – BJR is the default So. R for behavior (acts/inactions) of autonomous actors – FD breach only if A fails to use discretion (no decision/arbitrary decision) or behaves in bad faith (i. e. , A is knowingly unfair to B) – Drawback of relying on A’s discretion: A can often hide shirking/stealing • Entire fairness So. R: emphasis on judicial discretion – Applies when autonomous actor is self-dealing (also applies when controller is self-dealing, but this isn’t part of course material) – Breach if court thinks action was unfair to B – Drawbacks of relying on judicial discretion • Uncertainty for A & B on how judge would rule (B can choose A, but can’t choose the judge; A can consult with B, but can’t consult in advance with the judge) • FD decisions are heavily fact dependent, so precedents are less useful than other areas of law • Enhanced scrutiny So. R: compromise between A & judicial discretion – Applies for certain board actions in which there is an increased risk that board has Co. I with SHs

24 © Amitai Aviram. All rights reserved. Classification So. R selection flowchart Non-fiduciary actors don’t owe FD; end of analysis Non-fiduciary actor What type of actor is A? Controlled actor Agency So. R applies Autonomous actor Was A self-dealing? Yes Entire fairness applies Yes Enhanced scrutiny applies No Did A deploy power against B or act to facilitate a change of control in the firm? No BJR applies

© Amitai Aviram. All rights reserved. Classification 25 So. R: when does entire fairness apply? • Entire fairness So. R applies if A was self-dealing – I. e. , A is conflicted with respect to the challenged behavior or received an unauthorized benefit from the fiduciary position (latter is typically an inaction anyway) • A (an actor or member of a collective actor) is conflicted if: – A has a personal interest in A’s behavior that conflicts with B’s interest & the conflict occurs in connection with the fiduciary relationship (direct conflict) – Someone with a Co. I controls or dominates A (domination conflict) • Test for control/domination (Beam v. Stewart): is the non-interested director would be more willing to risk his or her reputation than risk the relationship with the conflicted director? – Another member of the collective actor who is conflicted fails to disclose their interest to A despite a duty to do so (the duty exists if the interest is material; i. e. , a reasonable A would regard the undisclosed interest as significant to deciding on the act) (constructive conflict) • A collective actor (e. g. , board committee) has Co. I if 50% or more of its members have Co. I – Example: board composed of 4 directors votes 4 -0 to hire Ann • If 1 director has Co. I & 3 don’t, decision benefits from BJR • If 2 directors have Co. I & 2 don’t, BJR is rebutted

© Amitai Aviram. All rights reserved. Classification 26 So. R: when does enhanced scrutiny apply? Enhanced scrutiny applies when: • A deploys corporate power against SHs to achieve greater good for firm – • • • – Board interferes with SH voting rights (Blasius) Board implements actions that make it impossible or economically unfeasible for SHs to sell their shares to someone (Unocal) Special litigation committee moves to dismiss a SH derivative claim (Obeid) A embarks on a transaction that will result in a change of control (Revlon)

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty 1. Private paternalism 2. FD analysis: Duty & Standard of Review 3. FD analysis: Application • • • Flaws Agency So. R BJR Entire fairness Enhanced scrutiny b. Customizing the firm c. Exit solutions 27

28 © Amitai Aviram. All rights reserved. Application Flaws in an actor’s behavior Types of legal flaws Negligence Self-dealing Bad faith Co. I Unauthorized benefit Illegality Corporate waste Disregard of duty • Negligence (breach of A’s duty of care (“Do. C”)) – Action/inaction in which A doesn’t employ sufficient effort/care • Self-dealing (breach of A’s duty of loyalty (“Do. L”)) – Conflict of (self-)interest & duty (“Co. I”) – Unauthorized benefit from fiduciary position • Bad faith (breach of A’s Do. L) – A’s behavior is allegedly against B’s interest, but no evidence of self-dealing • Bad faith category doesn’t exist in agency So. R (FD breached only by selfdealing or negligence) • Failure to disclose (duty of disclosure) – Poorly theorized duty. Cases say breaching A’s duty of disclosure violates FD, but cases don’t follow Do. C or Do. L analysis.

© Amitai Aviram. All rights reserved. Application 29 Flaws: bad faith • Illegality – Actor knowingly violates the law (including fraud) • Corporate waste: – A’s acts are allegedly against B’s interest, but no evidence of self-dealing – Corporate waste is occasionally referred to as “irrational” acts • Conscious disregard of duty – A knowingly fails to respond to a known FD or exhibits a conscious disregard of a known FD

© Amitai Aviram. All rights reserved. Application 30 Fiduciary duty of disclosure • A has a duty to disclose to other actors (e. g. , board committee, SHs) all material info reasonably required for them to act on behalf of the firm. Failing to do so breaches FD. – E. g. : since SHs elect the directors, board would act in bad faith if it failed to provide SHs all material info it has relevant to deciding whether to elect the proposed candidates – MBCA duty of disclosure (MBCA 8. 30(c); use this for Delaware law as well): Person who owes a FD (A) has a duty to disclose info to B, when A knows that the info is material to the discharge of decision-making or oversight functions of B or B’s other actors who are connected with A’s fiduciary relationship, unless disclosure violates a superior duty imposed on A (by law, confidentiality agreement, ethics rule, etc. ) • Outcome – When failure to disclose amounts to negligence or illegality, it breaches FD in same way as A’s act that suffers from the same legal flaws – When failure to disclose does not amount to negligence or illegality, it does not breach FD, but A cannot benefit for their failure to disclose, through rules on constructive conflict & informed approval.

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty 1. Private paternalism 2. FD analysis: Duty & Standard of Review 3. FD analysis: Application • • • Flaws Agency So. R BJR Entire fairness Enhanced scrutiny b. Customizing the firm c. Exit solutions 31

© Amitai Aviram. All rights reserved. Agency So. R 32 Negligence • R 3 A § 8. 08: Test for A’s negligent behavior (act or inaction) – Did A act with care, competence & diligence normally exercised by agents in similar circumstances? – Special skills/knowledge A has/claims to have are considered in analysis • In Agency So. R, both the process and the substance of the behavior is evaluated for negligence – Process: did A possess sufficient information & skills to act? – Substance: would a reasonable actor behave in this way? • Goes beyond the process of reaching the decision how to behave, to the competence of executing that decision • Can apply to inactions as well as actions

© Amitai Aviram. All rights reserved. Agency So. R 33 Self-dealing: Conflict of interest • Rash [CA 10, 2007] – Rash hired to manage the Tulsa, OK division of JVIC’s oil refinery & power plant maintenance business – Rash owned TIPS (a scaffolding business); JVIC had its own scaffolding business – Rash often selected TIPS as subcontractor for JVIC-Tulsa’s contracts (paying over $1 M between 2001 -04) – Does Rash have a Co. I? • JVIC’s interest in a matter • Rash’s personal interest that conflicts with JVIC’s interest • Conflict occurred in a matter connected with the fiduciary relationship

© Amitai Aviram. All rights reserved. Agency So. R 34 Self-dealing: fairness (is not a defense) • Self-dealing is not always bad – Hypo: Ann is the CEO of Orange & Blue Taxi Corp, a taxi company. One of O&B’s cabs breaks down. Ann’s brother Tom is a car mechanic. Is there an advantage to the firm in having Tom fix the cab (rather than go to another mechanic)? • Fairness – Fairness is not a defense to self-dealing in agency law. Even if the Rash court found that TIPS was the best & cheapest firm to do scaffolding jobs for JVICTulsa, Rash would have breached his FD – The rule is different for autonomous actors. When directors self-deal, but the deal is fair to the firm, they do not breach their FD. – Why does the agency So. R not allow a fairness defense? • Agency So. R emphasizes beneficiary discretion: if B did not approve the deal, it is held to be bad for B, even if it looks good to the judge • This rule supports B’s power to control A: to avoid liability in conflicted situations, an agent must ask B for approval (can’t rely on deal being fair) • In contrast, with autonomous actors, Bs are seen as unable to effectively control A, so relying on B’s discretion & control is less effective

© Amitai Aviram. All rights reserved. Agency So. R 35 Self-dealing: Unauthorized benefit (from fid. position) • Hypo: Angie worked at Patty’s restaurant. Patty told Angie she would be paid an hourly wage. Nothing was mentioned about tips. • After serving a large & demanding group, she gave the bill to Tom, who paid for the group. • Tom then handed Angie a $50 bill and said “This is for you, not your boss. We were a fussy group and you had the patience of a saint. ” • Does Angie breach her FD if she doesn’t give the $50 to Patty? • • • Did A receive a benefit? Was the benefit unauthorized? Was the benefit derived in connection with A’s fiduciary position/actions on behalf of B?

© Amitai Aviram. All rights reserved. Agency So. R 36 Approval • Breach of FD (as well as exceeding authority) can be cured by the beneficiary’s approval (ratification/prior consent) – When relevant, approval analysis should be done as a separate step from the FD analysis, following the rules we learned in section 1 c • In Rash, JVIC’s president Joe Vardell told Rash that he had no problem with Rash forming a business which might contract with JVIC, but court did not view this as valid approval – Vardell’s statement was a response to Rash asking for permission to use his own “tool rental company”, not a scaffolding business – This creates ambiguity, at least, whether Vardell’s consent applied to the scaffolding business – Also issue with scope of approval: approval is limited to a specific transaction or specific type of transactions; Vardell could not absolve Rash from all breaches of FD. His statement seems to approve self-dealing in on type of transactions: with Rash’s tool rental company

© Amitai Aviram. All rights reserved. Agency So. R 37 Summary Negligence: FD breached if reasonable actor would have exercised more care/effort under the same circumstances (R 3 A § 8. 08) Self-dealing: FD breached if either: • • • A has Co. I (R 3 A §§ 8. 01, 8. 03 -8. 04); – – – • B had an interest in a matter A had a personal interest that conflicted with B’s interest The conflict occurred in connection with the fiduciary relationship A received an unauthorized benefit from the fiduciary position (R 3 A § 8. 02, 8. 04 -8. 05) – – – A received a benefit The benefit was unauthorized The benefit was derived in connection with A’s fiduciary position or actions on behalf of B

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty 1. Private paternalism 2. FD analysis: Duty & Standard of Review 3. FD analysis: Application • • • Flaws Agency BJR Entire fairness Enhanced scrutiny b. Customizing the firm c. Exit solutions 38

© Amitai Aviram. All rights reserved. BJR 39 Applying the BJR So. R • BJR is a rebuttable presumption that A’s behavior was in B’s interest; when BJR doesn’t apply, it is said that “BJR was rebutted” – Rebutting the presumption doesn’t always mean FD was breached • Analyzing a challenged action: 1. Legitimate purpose (no bad faith): This is where the presumption of the BJR applies. Court assumes a legitimate purpose unless plaintiff proves bad faith: corporate waste or illegality. If either exists, BJR is rebutted & FD is breached. 2. Reasonable investigation (no negligence): FD breached if challenged behavior amounted to gross negligence (BJR is rebutted because grossly negligent behavior can’t be considered a business judgement). 3. Independence/good faith (no self-dealing): If plaintiff shows that A was selfdealing, BJR is rebutted and behavior is analyzed under entire fairness So. R.

© Amitai Aviram. All rights reserved. BJR 40 Applying the BJR So. R • Analyzing a challenged inaction: – BJR does not apply to inactions (no business judgment to defer to), but we need to check if the inaction breached FD 1. No bad faith: FD is breached only if inaction amounted to conscious disregard of duty (which is very hard to show, like corporate waste). 2. No negligence: FD breached if challenged inaction amounted to gross negligence 3. No self-dealing: If plaintiff shows that A was self-dealing, behavior is analyzed under entire fairness So. R. • Note that self-dealing requires that A knows about their personal interest (this is true for both actions and inactions), so an inaction amounts to self-dealing only if A was aware that failing to act on B’s behalf would benefit A.

© Amitai Aviram. All rights reserved. BJR 41 Reasonable investigation (negligence) General standard: gross negligence • Mc. Padden v. Sidhu (Del. Ch. 2008): “gross negligence is conduct that constitutes – reckless indifference or actions that are without the bounds of reason” This requires some subjective “red flag” warning to A – Specific test for reasonable investigation before a decision • Identify necessary information & skills, taking into account time constraints & importance of the challenged decision to B Did actor acquire necessary information & skills? – – • • Information & skills that A (the directors) have Information & skills provided to A by advisor, if: – Advisor possesses expertise to evaluate the information/apply the skills – Advisor is independent (no self-dealing in providing the advice) – No abdication of decision (A can’t delegate the decision to the advisor, only acquire from advisor information/skills that inform the decision

© Amitai Aviram. All rights reserved. BJR 42 Exceptions to legitimate purpose (bad faith) Illegality: actor knowingly violates the law (including fraud) Corporate waste: transaction is so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration • • – Underlying concern: A knowingly pursues a purpose other than SH welfare or A’s self-interest • Under Stone v. Ritter test, conscious disregard of duty shown only if: • Directors utterly failed to implement any reporting or information system or controls; or • Having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention – Evidence of non-compliance doesn’t prove lack of a system or insufficient monitoring

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty 1. Private paternalism 2. FD analysis: Duty & Standard of Review 3. FD analysis: Application • • • Flaws Agency BJR Entire fairness Enhanced scrutiny b. Customizing the firm c. Exit solutions 43

© Amitai Aviram. All rights reserved. Entire fairness 44 The fairness test • General test: was the challenged behavior in B’s interest (in a corporation: wealth-maximizing for the SHs)? – Behavior that amounts to bad faith (illegality, corporate waste, conscious disregard of duty) is automatically unfair • Detailed test (typically used to evaluate transactions): Were the terms similar to those likely achieved in a non-conflicted (arm’s length) transaction? [Weinberger (Del. 1983)] • Fair process (“fair dealing”, examines process for determining price/other terms) • Fair price (valuation/comparison) – In re Nine Systems Corp. (Del. Ch. 2014): if process is grossly unfair, decision is unfair even if the price is fair (possible remedy: shifting attorney’s fees & costs) • Detailed fairness test for usurpation of business opportunities (Guth v. Loft [Del. Ch. 1939]: no single factor is dispositive; court balances all factors) • Was B financially able to take the opportunity? • Was the opportunity is in B’s line of business? • Did B have an interest or expectancy in the opportunity? • Would A create a conflict between his self-interest & that of B by embracing the opportunity?

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty 1. Private paternalism 2. FD analysis: Duty & Standard of Review 3. FD analysis: Application • • • Flaws Agency BJR Entire fairness Enhanced scrutiny b. Customizing the firm c. Exit solutions 45

© Amitai Aviram. All rights reserved. Enhanced scrutiny 46 Why enhanced scrutiny? – Some actions often pose significant benefit to SHs, yet are tainted by a mild degree of Co. I. Without enhanced scrutiny, we would be forced to either treat these actions as self-dealing (applying entire fairness, which may deter these actions) or as not self-dealing (applying BJR, which would immunize the action from most challenges) – Enhanced scrutiny allows the court to look into the substance of the decision (unlike the purely procedural evaluation of the BJR), without taking discretion entirely away from A – Rather than asking “how would I have acted? ”, the judge asks whether A’s actions are reasonable in relation to the alleged (legitimate) purpose of the action

© Amitai Aviram. All rights reserved. Enhanced scrutiny Applying enhanced scrutiny 1. Quasi-BJR: did the board find, in good faith & after a reasonable investigation, a legitimate purpose that warranted the board’s act? • • • Legitimate purpose: No bad faith (i. e. , no corporate waste or illegality) Reasonable investigation: No negligence Good faith: No self-dealing 2. Was the act a reasonable response proportionate to the purpose? • • Usually act is seen as unreasonable if it is: – Coercive (forces B to vote in favor of A’s desired act); or – Preclusive (prevents B from ever successfully exercising their right) But an act might be unreasonable even if it is not coercive or preclusive 47

© Amitai Aviram. All rights reserved. Enhanced scrutiny 48 Applying enhanced scrutiny: example • Meeting of Target’s SHs called to approve sale of Target to Acquirer – Rumors are that the board was originally in favor of the deal, but now want to thwart it because they discovered that they would be replaced after the merger • An hour before the meeting the board receives a non-binding offer from Spoiler Corp. to buy Target for a price that is 5% higher – The board decides to postpone the SH meeting by one month to make time for Spoiler to make a binding offer and have SHs consider it as an alternative • A Target SH sues, asking to enjoin the board and force it to hold the SH meeting immediately. • Which So. R applies? – If court determines board motivation was to keep their jobs, this is self-dealing, so entire fairness applies – If court determines board motivation was to consider a potentially better offer for SHs then this is not self-dealing. However, board’s use of power to postpone the meeting still frustrated SHs’ right to vote at the meeting, so enhanced scrutiny applies.

© Amitai Aviram. All rights reserved. Enhanced scrutiny 49 Applying enhanced scrutiny: example • Application of enhanced scrutiny to the example 1. Quasi-BJR: did the board find, in good faith & after a reasonable investigation, that firm faced a threat that warranted the board’s act? • • • 2. Legitimate purpose: allowing a better offer to materialize & allowing SHs time to consider it (so no corporate waste or illegality) Reasonable investigation: court will consider whether the board had adequate information, expertise & time to make a decision on the postponement Good faith: court investigates evidence of self-dealing; none likely here (otherwise, court would have applied entire fairness) Was the act a reasonable response proportionate to the threat posed? • Act is not coercive (SHs are not forced to vote against Acquirer’s deal) • Act is not preclusive (postponement merely delays deal by a month; if a month was enough to certainly kill the deal, it may be preclusive) • Is it unreasonable anyway? Is one month too long (considering whether less time would reasonably suffice)

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty (litigation solutions) b. Customizing the firm 1. Mandatory vs. default rules 2. Customizing via constitutional documents 3. Customizing via SH agreements c. Exit solutions 50

© Amitai Aviram. All rights reserved. Customizing the firm 51 Customizing in public & private firms Rules governing a firm can be derived from the law or from contracts created by the stakeholders Public firms derive more rules from laws and fewer from contracts compared to private firms • • More mandatory laws (that contracts cannot modify) Opting out of defaults is done by manipulating the firm’s institutions (e. g. , rights attached to shares, or to firm offices) rather than manipulating individual SHs’ rights – – • • • Example: X wants double the voting rights of other SHs Private firm (e. g. , partnership): partnership agreement provides that X has double voting rights Public firm: charter creates Class B shares with double voting rights as Class A shares; X receives Class B shares

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 52 Limits on bylaws • Boilermakers Local 154 Retirement Fund v. Chevron Corp. [Del. Ch. 2013] – Chevron & Fed. Ex boards amend bylaws to add a “forum selection bylaw”, which requires that derivative suits, fiduciary duty suits, DGCL suits and internal affairs suits involving the company will be adjudicated in Delaware courts. – The bylaw addresses venue (which court) not applicable law. What law would apply to fiduciary duty suits, internal affairs suits, etc. & why? • Plaintiff SHs sue to invalidate the bylaws, claiming: – Bylaw does not have valid subject matter – Bylaw is not binding on SHs because board, not SHs, amended the bylaw – Bylaw should be invalidated because there are many circumstances in which it can be abused

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 53 Limits on bylaws • Valid subject matter – DGCL 109(a): bylaws may address any subject “not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees. ” 1. Bylaws are subordinate to the law & charter • So, anything that the law says should be in the charter (e. g. , number of authorized shares, rights of shares) is not valid bylaw subject matter 2. Valid subject matter includes • Business/affairs of firm • Rights/powers of firm, SHs, directors, officers & employees 3. Bylaws dictate process, not substantive decisions • Court: “[B]ylaws typically do not contain substantive mandates, but direct how the corporation, the board, and its stockholders may take certain actions. ”

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 54 Limits on bylaws • Effect of board-adopted bylaws – By law, SHs have the right to amend bylaws; board may amend bylaws only if the firm’s charter allows it – The charters of Chevron and Fed. Ex allowed the board to amend bylaws – Court: Delaware law does not follow the “vested rights doctrine”, which prohibits a board from modifying bylaws in a way that diminishes SH rights without SH consent – Any SH who bought shares in the company knew of the authority the board had to amend bylaws, had consented to being governed by the bylaws as may be amended by the board – SHs can always repeal a board-amended bylaw they don’t like • Potential for abuse – In an earlier case (CA, Inc. v. AFSCME Emps. Pension Plan [Del. 2008]), the court said a bylaw is not valid because there are many potential situations in which it would mandate actions that would violate directors’ FD – Chevron court clarifies that CA was a unique case & doesn’t represent Del. law – Bylaw is not invalidated because it can be abused; if a particular act abuses the bylaw, that act can be challenged

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 55 Stock specifications • Delaware – DGCL § 102(a)(4) allows corporations not to issue any stock (charter needs to state this & either specify conditions of membership or that these conditions are in the bylaws) – DGCL § 151(a): “Every corporation may issue 1 or more classes of stock or 1 or more series of stock within any class thereof, any and all of which classes… may have such voting powers, full or limited, or no voting powers, and such [economic rights]… as shall be stated… in the certificate of incorporation… or in [a board resolution] pursuant to authority expressly vested in it by its [charter]. ” – DGCL § 151(b) allows the issuance of redeemable shares as long as after redemption there are still shares with full voting powers – DGCL § 151(e) allows the issuance of convertible shares • MBCA – MBCA § 6. 01(b) – “Minimum requirements”: • At least one class of shares with unlimited voting rights • At least one class of shares with a residual claim (i. e. , the right to receive the net assets of the corporation upon dissolution) – doesn’t have to be the class with unlimited voting rights – MBCA § 6. 01(c) – Authorizes non-voting stock, convertible stock, and other characteristics of stock

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 56 Stock specifications • Authorized shares: Maximum # of shares corporation can have – Board has authority to issue shares, up to the authorized number (DGCL § 161) – What purpose do authorized shares serve? (Note: number of authorized shares must be specified in charter; changes to charter require both board & SH vote) • Outstanding shares: # of shares corp issued (& not repurchased) • Authorized but unissued shares: Shares that are authorized but have not been issued by the firm (or were issued & repurchased) – Example: Acme’s charter says it has 1, 000 authorized shares. Acme’s board issues 200 shares to investors. Acme now has 1, 000 authorized shares, 200 outstanding shares, 800 authorized but unissued shares • Treasury shares (DGCL): shares that have been issued in the past, but later repurchased by the issuing corporation – Example: Acme Corp. now repurchases 50 of its 200 outstanding shares. After purchase, it has 1, 000 authorized shares, 150 outstanding shares, 50 treasury shares, 800 authorized but unissued shares – MBCA classifies treasury shares as authorized but unissued shares (MBCA § 6. 31(a)) • I. e. , Acme has 1, 000 authorized shares, 150 outstanding shares, 850 authorized but unissued shares

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 57 Policy on customizing control rights • Hypo 1: Acme Corp. has only one class of stock. SHs are entitled to dividends (if board authorizes dividend distribution) & to Acme’s net assets upon dissolution, but not entitled to vote – Is this permitted by MBCA § 6. 01? – Are there any risks to this capital structure? • Hypo 2: Acme has instead two classes of stock – Class A shares are the same as in the above hypo (entitled to dividends & net assets upon dissolution, but not entitled to vote) – Class B shareholders have the same rights as Class A, except that each Class B share also has one vote – Is this permitted by MBCA § 6. 01? – Are there any risks to this capital structure?

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 58 Policy on customizing control rights • Can the market protect itself? – Abe is offered Acme non-voting shares; economic value of 1 Acme share is $10 – Abe thinks Acme’s directors are a bunch of thieves • Abe estimates that they will “steal” $10 M ($1/share) • Abe agrees to buy a share for $9 ($10 -$1 stolen) – If SH can assess the decrease in share value caused by the inability to keep board accountable, then there’s no harm from non-voting shares • SH pay a price proportionate to their (limited) rights • Companies who want to raise capital more cheaply can give voting rights to SH & receive a higher price per share – Can SH assess the harm from an unaccountable board? • Does FD suffice? – Suppose that there is no way to assess the discount for lacking the ability to keep the board accountable. Nonetheless, a board action that is not in SHs’ interest violates directors’ FD. – Isn’t it enough to give SHs right to sue the board for breach of FD?

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 59 Policy on customizing control rights • If we can’t trust the market to protect itself & we can’t trust FD to protect nonvoting SHs, why not prohibit nonvoting shares? – Can still bypass with “supervoting” shares • E. g. , 1 class A share has 1 vote; 1 class B share has 1 M votes – So why not require each share to have equal voting power (“ 1 share, 1 vote”)? • Equal voting power: SEC’s attempt – In 1988, the SEC adopted Rule 19 c-4, prohibiting any stock exchange or mutual securities association from listing any stock of a corporation that takes any action to the effect of nullifying, restricting or disparately reducing the per share voting rights of existing common SH. – The Business Roundtable v. SEC (D. C. Cir. , 1990): Court vacates the rule on the ground that it exceeds SEC’s authority • SEC instead informally pressures stock exchanges to adopt similar requirements in their listing rules • But does an equal voting power rule solve the problem?

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 60 Policy on customizing control rights • Hypo based on Stroh v. Blackhawk Holding Corp. [Ill. 1971]: Chris forms Blackhawk Corp. , with two classes of shares: – Class A – “Normal shares” • Chris buys 50, 000 shares for $2/share (firm receives $100 K) – Class B – Voting rights, but no econ rights (no rights to dividends or assets in dissolution) • Chris buys 500 K such shares for 0. 1¢/share (firm receives $500) • Blackhawk sells to public 500 K Class A shares at $4/share (firm receives $2 M) Buyer Shares Acquired Chris 50 K Class A Chris Cost $100 K (~4. 8%) Votes Economic Rights 50 K (~4. 8%) 50 K (~9%) 500 K Class B $500 (~0%) 500 K (~47. 6%) 0 (0%) Public 500 K Class A $2 M (~95. 2%) 500 K (~47. 6%) 500 K (~91%) Total $2, 100, 500 1, 050, 000 550, 000 • Do Blackhawk’s shares offer equal voting power? Yes (was required by the Illinois constitution at the time) • Does this prevent a split between control & economic rights? No

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 61 Addressing SH right misappropriation • Problem of “watered stocks”: Acme worth $100, has 10 shares outstanding – – – How much is each share of Acme worth? Acme’s board issues 10 new shares to Jill for $2/share ($20 total) What is Acme worth now? How many shares does Acme have now? How much is one Acme share worth now? Value of Jill’s shares? Value of other SHs shares? • Legal solutions to the misappropriation 1. • • 2. • • Limit the number of shares that the board is allowed to issue without authorization from the existing shareholders Authorized shares: maximum number of shares that the firm can have Charter must specify the number of shares the corporation is authorized to issue (their number can only be changed by changing the charter) Both MBCA [§ 1. 40(2)] & DGCL [§ 161] use this concept Set a minimum price for the shares Par value is the minimum price for which a share can be issued (doesn’t affect the price share is sold by the SH to a new SH) E. g. , Acme has 1 M common shares, with a par value of $1. If Acme issues a new share to Sarah, it must receive consideration of no less than $1. Sarah, however, is free to sell the share at any price (or give it as a gift). DGCL uses this concept [DGCL § 153(a)]; MBCA does not

© Amitai Aviram. All rights reserved. Customizing via constitutional docs 62 Addressing creditor right misappropriation • Problem of siphoning assets to SHs: Acme has 10 shares outstanding, $100 in assets, no debt – Acme issues $50 of one-year bonds, bearing 10% interest • Acme’s net assets are now $150; it will need to pay $55 in 1 year • A year later, Acme lost $70; it has $80 in assets ($150 -70) • How much are the bondholders entitled to? – Before bonds mature, Acme declares $8/share dividend • SHs receive 100% of Acme’s assets ($80); bondholders receive nothing – Instead of dividend, Acme repurchases 8 of its shares at $10 each • 80% of SHs receive 100% of Acme’s assets; bondholders & 20% of SHs receive nothing • Legal solutions to the misappropriation 1. Contractual approach: bond agreement can create limits on 2. 3. dividends/repurchases or state that if certain financial ratios indicate firm approaches insolvency, firm must pay debt immediately DGCL approach: specify a minimum amount of assets that dividends cannot compromise (“legal capital”) MBCA approach: prohibit a dividend that causes insolvency

© Amitai Aviram. All rights reserved. Customizing via SH agreements 63 Why is agreement enforcement a major issue? • SHs in a close corporation sign a SH agreement obligating them to vote in favor of a specified slate of directors – Directors favor expanding into the widget market • Some SHs renege on the agreement; vote for directors who refuse to expand into widgets – As a result, Acme does not expand into widgets • Other SHs sue for breach of the agreement – What are the damages? How easy is it to prove them? – How can you make the agreement easier to enforce?

© Amitai Aviram. All rights reserved. Customizing via SH agreements 64 1. Voting trust • • Title of shares transferred to a trust Agreement forming the trust gives trustee power to vote the shares Disadvantages? Statutory restrictions – Publicity: some states require the voting trust to be made public (e. g. , DGCL § 218), or to submit to the firm information on participating SHs (e. g. , MBCA § 7. 30), which makes this info accessible to MSHs through SH inspection rights – Duration: some states limit the duration of voting trusts (MBCA used to have a 10 -year limit, but no longer does)

© Amitai Aviram. All rights reserved. Customizing via SH agreements 65 2. Contractual enforcement a) b) – – Specific performance DGCL § 218(c) allows voting agreements, implicitly allows a remedy of specific performance MBCA § 7. 31(b) states that voting agreements are specifically enforceable Court may refuse to enforce due to oppression / violation of other SHs’ rights Irrevocable Proxies usually revocable; can be made irrevocable if attached to an interest [MBCA § 7. 22(d)] Being a party to a voting agreement is considered an interest [MBCA § 7. 22(d)(5)] So, the proxy tends to be an enforcement mechanism that is ancillary to a voting agreement – – c) Is the SH agreement valid? – If it constrains discretion that isn’t subject to FDs (e. g. , appointing directors) – • • Voting agreements generally permissible [DGCL § 218(c); MBCA § 7. 31] If it constrains discretion that is subject to FDs (e. g. , appointing officers) Does it impermissibly constrain the board’s discretion? [Mc. Quade/Clark]

© Amitai Aviram. All rights reserved. Customizing via SH agreements 66 Mc. Quade v. Stoneham [NY 1934] • Stoneham owned a majority of the stock of the NY Giants • Mc. Graw (the Giants’ manager) & Mc. Quade (a city magistrate) bought a small amount of stock from Stoneham • The three signed a SH agreement – Agreed to do their best to elect each other as directors & appoint each other officers at specified salaries • Mc. Quade lost Stoneham’s favor & was fired – Mc. Quade sues for specific performance • Court: – Board must exercise independent business judgment on behalf of all SHs – If directors agree in advance to constrain board’s judgment, SH will not receive the benefits of their independence – Therefore, agreement is void as against public policy • Protection in the SH agreement didn’t save Mc. Quade – How can he protect himself from being fired?

© Amitai Aviram. All rights reserved. Customizing via SH agreements Mc. Quade v. Stoneham • Mc. Quade seems to offer a bright line rule Valid Constrain SH judgment • But the rule is not so bright Void Constrain director/officer judgment 67

© Amitai Aviram. All rights reserved. Customizing via SH agreements 68 Clark v. Dodge [NY 1936] • Clark knows a valuable secret formula. Dodge contributes money. They form two drug companies. • Clark and Dodge sign an agreement: Clark agrees to disclose his secret formula Dodge agrees to invest the required money Clark receives 25% of profits (salary & dividends) Dodge would vote, both as SH & director, to assure that Clark would be a director & General Manager as long as his performance was faithful, efficient and competent – Why does Clark need the agreement? Why does Dodge? – – • Clark discloses secret formula. Dodge eventually fires Clark. – Clark sues. Dodge claims SH agreement is void. – Apply the reasoning in Mc. Quade to this case

© Amitai Aviram. All rights reserved. Customizing via SH agreements 69 Clark v. Dodge • Clark court: MSHs aren’t harmed by a commitment to keep someone as an officer “as long as he is faithful, efficient and competent” – I. e. , SH agreements are valid if SH merely agree to do as directors what they could do validly anyway • This contradicts the holding in Mc. Quade – Also, SHs may be harmed by an obligation not to fire without cause (e. g. , downsizing; better/cheaper candidate) • Clark court: Mc. Quade was designed to protect MSHs who were not parties to the agreement – In Clark, all SHs are parties to the SH agreement • Clark creates an exception to Mc. Quade when all SHs are parties to the SH agreement • How can Dodge avoid the SH agreement (reach Mc. Quade outcome)?

© Amitai Aviram. All rights reserved. Customizing via SH agreements “Homemade Mc. Quade” The

© Amitai Aviram. All rights reserved. Customizing via SH agreements “Homemade Mc. Quade” • Preempting the “Homemade Mc. Quade” – The company can prevent a “Homemade Mc. Quade” by creating constructive knowledge of the agreement – including the agreement in the charter or printing a reference to the agreement on all stock certificates • Another obstacle for Homemade Mc. Quades – Galler v. Galler – In Galler, the court held that a SH agreement is valid even if not all SHs are parties to it, if: • The corporation is closely-held • The terms are reasonable (i. e. , MSH should not object) • The MSH does not object 71

© Amitai Aviram. All rights reserved. Customizing via SH agreements 72 Caselaw summary • Mc. Quade: SH can commit to how they vote as SH, but cannot constrain their judgment (or others on their behalf) as directors • Clark: SHs can constrain their judgment as directors, if all SH are parties to the SH agreement • Galler: SHs can constrain their judgment as directors even when some SHs aren’t parties to SH agreement, if terms of agreement are reasonable and fair to those SHs (& those SHs don’t complain)

© Amitai Aviram. All rights reserved. Customizing the firm Review • Controller Cass is creating a firm, and wants to own 60% of the control rights & 20% of the economic rights • Methods 1 -2 are suitable for private firms – Customizing via arrangements between SHs – Assume only other SH is minority SH Mary • Methods 3 -5 are suitable for public firms – Customizing via constitutional documents (share specifications) – Assume other SHs constantly change (“the public”) 73

© Amitai Aviram. All rights reserved. Customizing the firm 74 Review: Method 1 (voting trust) • 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80 • Mary forms a trust with Cass as the trustee, and transfers to the trust legal title to 40 shares – Mary is the beneficial owner of the fruits of this trust (e. g. , dividends), but Cass (as trustee) gets to vote them at his discretion Dividends: 80% (40+40) Mary – 40 Trust – 40 Cass – 20 Control: 60% (20+40)

© Amitai Aviram. All rights reserved. Customizing the firm 75 Review: Method 2 (voting agreement) • 1 class of shares, 100 shares outstanding: Cass buys 20; Mary buys 80 • Cass & Mary sign a voting agreement (AKA vote pooling agreement) in which Mary promises to vote 40 of her shares as Cass instructs – Some voting agreements have a designated arbitrator would decide how to vote if parties disagree – To ensure that the agreement is specifically enforceable, Mary may give Cass an irrevocable proxy to vote a 40 of Mary’s shares • Why does Cass need an irrevocable proxy? • MBCA § 7. 22: Proxies are ordinarily revocable at the will of the SH, but a SH can give an irrevocable proxy. Usually, the proxy must be coupled with an interest. Acceptable interests include: – Proxy holder is a pledgee – Proxy holder has purchased/agreed to purchase the shares – Proxy holder is a creditor of the corporation who required the irrevocable proxy in order to extend it credit – Proxy holder is an employee of the corporation who required the irrevocable proxy in his employment contract – Proxy holder is a party to a voting agreement • Proxy irrevocable only as long as proxy holder has an interest in firm

© Amitai Aviram. All rights reserved. Customizing the firm 76 Review: Method 3 (dual-class; 1 share, 1 vote) • As in Stroh – Class A shares have one vote per share, full economic rights – Class B shares have one vote per share, no economic rights • Assuming firm plans to issue 2 M A-shares to raise money – – C buys, for a symbolic price (0. 1¢) 2 M B-shares C also buys 20% of A-shares (400 K shares) Public buys remaining 80% of A-shares (1. 6 M shares) Result: C has 60% of control rights (2. 4 M out of 4 M votes) & 20% of economic rights (400 K out of 2 M A shares)

© Amitai Aviram. All rights reserved. Customizing the firm 77 Review: Method 4 (dual-class; voting/non-voting) • If non-voting common shares are permissible: – Class A shares are non-voting, full economic rights – Class B are voting, no economic rights • C buys 20% of A-shares – Remaining A-shares sold to the public – Result: C has 20% of the economic rights • C buys 60% of B-shares – Remaining B-shares sold to other investors who want to buy control rights and who are acceptable to the controller (typically, such investor would also buy A-shares to get economic rights, and will insist on sharing control rights via SH agreement with C) – Result: C has 60% of control rights

© Amitai Aviram. All rights reserved. Customizing the firm Review: Method 5 (class-specific rights) • Design share classes as follows: – Class A shareholders (as a group) appoint 2 of the 5 directors & receive 80% of the economic rights – Class B shareholders appoint 3 directors & receive 20% of the economic rights • Controller buys only Class B shares & issues to the public only Class A shares – Results: Controller has 60% of control rights (appoints 3 of the 5 directors), and receives 20% of the economic rights • Example: “Golden shares” 78

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty (litigation solutions) b. Customizing the firm c. Exit solutions 1. Alienability 2. Dissociation 3. Termination (dissolution) 79

© Amitai Aviram. All rights reserved. Exit solutions 80 Types of exit solutions • Exit solutions allow B unilaterally to leave the firm & receive her share of the firm’s value – Alienability: allow B unilaterally (without requiring consent of firm/other Bs) to sell interest in the firm to third parties Allows for the firm’s longevity & maintains firm’s goodwill, but no guarantee business ownership remains in acceptable hands • Dissociation: allow B to unilaterally sell interest in the firm back to the firm/other Bs (at the interest’s fair price) – • – • • • – Allows for the firm’s longevity, maintains firm’s goodwill & keeps business ownership in acceptable hands, but requires that: (1) parties agree on the fair price; (2) firm/remaining Bs are able to pay; (3) firm is viable to the remaining Bs without the dissociating B Termination (dissolution): allow a SH to unilaterally cause the firm to terminate, liquidate its assets & divide the proceeds but allows restrictions on alienability, but sacrifices firm’s longevity & may lose firm’s goodwill (value of the “live” business - value of the “dead” business) Public firms favor alienability over dissolution/dissociation Private firms favor dissolution/dissociation over alienability Why? (Compare to marriage)

© Amitai Aviram. All rights reserved. Alienability 81 Rules on alienability in corporate law • • – – – Transferable shares By default, SH can sell shares without restriction Restrictions on alienating SH rights separately from shares (e. g. , selling right to vote without selling shares) Perpetual existence By default, a corporation exists indefinitely Restrictive dissolution Individual SH has no right/power to dissolve Dissolution if majority of both board & SHs vote in favor, or (in rare cases) by judicial or administrative order Capital lock-in (SH can’t withdraw equity capital, giving corporation financial stability, but at expense of lost accountability) • When corp issues new shares, SH pays corp (say, $10) for shares • When SH wants to cash out, she can’t force corp to buy back her shares; instead, SH can sell shares to T (corp keeps the $10) – Exception 1: if shares were specifically made redeemable – Exception 2: corp may choose to repurchase the shares

© Amitai Aviram. All rights reserved. Alienability 82 Rules on alienability in partnership law • April, a partner in a three-partner law firm, wants to cash out • Can she (unilaterally) sell a 1/3 share of the partnership assets (e. g. , 1/3 of the furniture) to Brian? – UPA § 501 • Can she (unilaterally) sell her control rights in the partnership to Brian? Her economic rights? – UPA § 401(i), 502, 503(a)(3)

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty b. Customizing the firm c. Exit solutions 1. Alienability 2. Dissociation • • • Dissociation Buyout agreements Relationship between dissociation & buyout agreements 3. Termination (dissolution) 83

© Amitai Aviram. All rights reserved. Dissociation in corporations & partnerships • Dissociation allows B to unilaterally sell interest in the firm back to the firm/other Bs (at the interest’s fair price) • By default, corporations have “capital lock-in” (no dissociation) – But a corporation can issue shares that are redeemable at the SH’s option – Also, SHs can create a buyout agreement in which they agree on situations in which one party may force other parties to buy her shares • In UPA partnerships, each partner has a power to dissociate (this is mandatory, not just default rule) – UPA § 602(a): “A partner has the power to dissociate at any time, rightfully or wrongfully, by express will…” – Departing partner generally remains liable on pre-dissociation partnership obligations unless released by creditors [UPA § 703] – If the partnership agreement prohibits or limits dissociation (e. g. , requires partner to remain a partner for X years, or give X days advance notice), a dissociation contrary to the agreement is called “wrongful dissociation” – it creates a dissociation, but former partner is liable for breach of contract 84

© Amitai Aviram. All rights reserved. Dissociation 85 Implied terms may limit dissociation • Ann & Becky are partners in building & operating a cafeteria • Ann supervises construction & operates the cafeteria (“service partner”); Becky puts up the money – Partnership agreement states Becky is to be repaid $30 K in 1 st year of operation & $60 K/yr. thereafter, until her investment is fully repaid • Original estimate of building costs: $300 K – When building costs reach $600 K, Becky refuses to put up more money; sues for dissociation • Can Becky dissociate? – Can Ann make an argument that Becky wrongfully dissociated?

© Amitai Aviram. All rights reserved. Dissociation Statutory dissociation under UPA • By act of a dissociating partner [UPA § 601(1)] – By right: if the partnership is at will – Wrongful dissociation [UPA § 602(b)] • By terms of partnership agreement [UPA § 601(2)-(3)] • By unanimous vote of all other partners [UPA § 601(4)] – Limited to specified circumstances • By court order [UPA § 601(5)] • By operation of law [UPA § 601(6)-(10)] – E. g. , due to death, bankruptcy, unlawfulness 86

© Amitai Aviram. All rights reserved. Buyout agreements 87 Some key considerations 1. – – Who buys the equity interest? • • • Third parties No buyout agreement; just avoid share transfer restrictions Limited value if market is very thin (few buyers/sellers) Undesirable business partners Difficult when firm must have share transfer restrictions (e. g. , Del. statutory close corp. ) Remaining SHs Raises problems with liquidity of SHs Can be used opportunistically to extract benefits – Or else SH will cash out, forcing the other SHs into insolvency The firm Raises problems with firm’s liquidity (can be used opportunistically) Life insurance One of the most commonly implemented exit arrangements in close corporations is triggered upon a SH’s death. Why? Life insurance both helps with financing the buyout, and avoids arguments over valuation (since it’s clear the deceased SH’s estate would sell the shares, it would push for high valuation)

© Amitai Aviram. All rights reserved. Buyout agreements 88 Some key considerations 2. Triggering event: what has to happen to allow a SH (or the firm) to force a buy-out? – Check relevant statutes for mandatory/default right to dissociate, and make sure to cover all situations that allow dissolution/dissociation under the applicable statute 3. Price for which equity interest is bought-out – Parties may determine value periodically by agreement • Parties often neglect to do so • As interests diverge, parties may disagree – Parties may hire an appraiser • May be difficult to agree ex-post on the identity of appraiser • Appraiser may over time develop a closer connection to one party

© Amitai Aviram. All rights reserved. Buyout agreements 89 Some key considerations (price) • Parties may set a formula – Often a multiplier of annual cash flow or earnings – Example • Acme is a close corporation that owns a shopping mall; annual profit: $500 K • A similarly-situated company is publicly held, with 2 M shares outstanding, trading at $5 a share (market cap: $10 M) & an annual profit of $1 M (so price/earnings ratio: 10) – If Acme has the same P/E ratio, it should be worth $5 M ($500 K x 10) – Acme’s buyout agreement can either specify the multiplier, or require checking the multiplier at time of buy-out • Parties may use book value – Book value is the price of the assets when purchased, reduced over the years for wear & tear (depreciation) – Depreciation may not reflect real value (e. g. , antique that appreciated in value; car that lost much value in 1 st year)

© Amitai Aviram. All rights reserved. Buyout agreements 90 Some key considerations (price) • Strategic process – E. g. , “You cut, I choose”: One party names a price, the other decides whether it will buy from the other, or sell to the other, at that price – Works well if both parties have sufficient cash & info – Example: Banks A & B jointly own Acme, a home financing joint venture • Bank A (much larger than Bank B) owns 75% of the shares; Bank B owns 25% – As a result of antitrust enforcement, banks required to break up the joint venture; charter had a buyout clause that implements “you cut, I choose” • Bank A decides on a price per share (any price it wants) • Bank B then chooses whether to sell its interest to Bank A at that price, or buy Bank A’s shares at that price – Assume that both banks have no financial constraints • Would Bank A decide on price that’s higher or lower than Acme’s perceived value? – Now assume Bank A expects Bank B to have liquidity problems • Bank B has less money & has to pay for 3 times the # of shares • Does A expect that B will buy or sell? • Would A decide on price that’s higher or lower than the perceived value of Acme?

91 © Amitai Aviram. All rights reserved. Relationship between dissociation & buyout Haley v. Talcott [Del. 2004] Employment Agreement Matt Haley Redfin Seafood Grill Personal Guarantee Bank Owns 100% Personal Guarantee Loan/ Mortgage 50% Matt & Greg Real Estate, LLC Greg Talcott

© Amitai Aviram. All rights reserved. 92 Relationship between dissociation & buyout Haley v. Talcott • Talcott owns Delaware Seafood (aka Redfin Seafood Grill), a restaurant operated by Haley • Haley’s employment contract gives him a “bonus” of 50% of the restaurant’s profits, after the loan from Talcott was repaid – Why pay Talcott’s loan first? • Is this a partnership? – What do the parties do to avoid framing this as a partnership? • How is Haley vulnerable to misappropriation? – Firing Haley • What does Haley do to protect himself? – Siphoning the profits out of the company • How can Talcott siphon money out of the Redfin Grill? • What does Haley do to protect himself?

© Amitai Aviram. All rights reserved. 93 Relationship between dissociation & buyout Haley v. Talcott • Haley exercises the option; owns 50% of Matt & Greg Real Estate, LLC – LLC purchases the property, financing it through a mortgage from County Bank • Both Haley & Talcott sign personal guarantees for the mortgage – Redfin Grill leases the property from the LLC for $6, 000/month – enough to pay the mortgage but probably below market rent • Relationship deteriorates – Haley expects to receive equity interest in the Redfin Grill – Talcott refuses, and eventually sends Haley a letter purporting to accept Haley’s resignation & forbidding Haley from entering the premises of the Redfin Grill – What right does Talcott have if Haley resigns?

© Amitai Aviram. All rights reserved. 94 Relationship between dissociation & buyout Haley v. Talcott • LLC Agreement has an exit mechanism – If a member elects to “quit” the LLC, the other member may elect to purchase the departing member’s interest for fair market value. – If other member does not elect to purchase, LLC is dissolved • Why does Haley want to dissolve rather than exercise the contractual exit mechanism? – How does Haley respond to Talcott’s letter? • What’s Delaware law’s general attitude regarding judicial dissolution when a contractual exit mechanism exists? – How does it rule in this case?

© Amitai Aviram. All rights reserved. Internal governance Overview of Chapter 3 a. Fiduciary duty b. Customizing the firm c. Exit solutions 1. Alienability 2. Dissociation 3. Termination (dissolution) • • Termination in agency Forced dissolution Statutory dissolution Process of dissolution 95

© Amitai Aviram. All rights reserved. Termination in agency Terminating agent’s actual authority [R 3 A § 3. 06] • Agreement between P & A • Law (“the occurrence of circumstances specified by statute”) • Changed circumstances (“the occurrence of circumstances on the basis of which [A] should reasonably conclude that [P] no longer would assent to [A’s] taking action on [P’s] behalf. ”) • A’s or P’s death/cessation of existence/suspension of powers • P’s loss of capacity • P’s and A’s power to terminate 96

© Amitai Aviram. All rights reserved. Termination in agency 97 Death [R 3 A § 3. 07] • A’s death/cessation of existence/suspension of powers → Terminates actual authority • P’s death/cessation of existence/suspension of powers → Terminates actual authority: – Immediately (except as provided by law) – if P is not an individual – Only when A has notice of P’s death – if P is an individual – Termination effective vs. T if T has notice of P’s death (even if A doesn’t know)

© Amitai Aviram. All rights reserved. Termination in agency 98 P’s loss of capacity [R 3 A § 3. 08] • P’s loss of capacity terminates actual authority: – Immediately – if P is not an individual – Only when A has notice of P’s permanent/adjudicated loss of capacity – if P is an individual – Termination effective vs. T if T has notice of P’s permanent/adjudicated loss of capacity (even if A doesn’t know) • P can agree in writing that actual authority will become effective upon P’s loss of capacity, or not be revoked by loss of capacity – Why allow this exception with loss of capacity?

© Amitai Aviram. All rights reserved. Termination in agency 99 Power to terminate [R 3 A § 3. 10] • Regardless of any agreement between P&A, actual authority is terminated if: – A renounces authority by manifestation to P; or – P revokes authority by manifestation to A • Authority is terminated when the other party has notice • If an agreement between P&A does not allow termination of the agency (or specifies a term beyond the time the agency was terminated), the agency is still terminated, but the terminating party might be liable for breach of contract

© Amitai Aviram. All rights reserved. Termination in agency 100 Terminating agent’s apparent authority [R 3 A § 3. 11] • Termination of actual authority does not end any apparent authority held by the agent – Why is there a separate rule for terminating apparent authority? • Apparent authority ends when it is no longer reasonable for T to believe that the agent continues to act with actual authority • Hypo 1: Supermarket tells one of its cashiers that she’s fired – Is actual authority terminated? – How can it terminate the cashier’s apparent authority? • Hypo 2: Now, supermarket fires a manager responsible for purchases of produce – If the manager now orders another shipment of produce on the supermarket’s behalf, must the supermarket pay? – How can it terminate the manager’s apparent authority?

© Amitai Aviram. All rights reserved. Termination in firms 101 Types of dissolution • Voluntary dissolution: firm acts to dissolve itself – Corporation: board & SH vote (DGCL § 275; MBCA § 14. 02) – Partnership: by unanimous vote of partners • Forced dissolution: dissolution by unilateral action of any SH – Corporation: individual SH has no right/power to dissolve – Partnership: yes, by default (under the 1914 UPA, dissolution was mandatory) • Statutory dissolution: court/gov’t forces firm to dissolve – Administrative (DGCL § 284; MBCA § 14. 20) – Judicial: Individual SH/partner can petition court to dissolve in some cases (MBCA § 14. 30; UPA 801(5), (6))

© Amitai Aviram. All rights reserved. Termination in firms 102 Delaware corporations • Voluntary: Board vote + SH vote + Filing [DGCL § 275] • Forced: no unilateral right for SH to dissolve • Statutory – Administrative: Delaware AG may sue to revoke a corporate charter “for abuse, misuse or nonuse of its corporate powers, privileges or franchises” [DGCL § 284] – Judicial: No right of dissolution for “oppression” • Nixon v. Blackwell (Del. 1993): Court-imposed buy-outs are inappropriate because contractual protection is available to MSHs • What’s the disadvantage of this approach? – I. e. , if parties can contract for dissolution, why should a court dissolve the corporation in situations not covered by an agreement?

© Amitai Aviram. All rights reserved. Termination in firms 103 Tradeoff between liberal & restrictive dissolution • Forced dissolution can be made easier or harder Liberal – Forced dissolution allowed (default under UPA; was mandatory under 1914 UPA) – Judicial dissolution if MSHs’ interests are frustrated (Stuparich) – Judicial dissolution if MSHs are oppressed (MBCA § 14. 30(2)(ii)) – Judicial dissolution only due to fraud/abuse (DGCL § 284) – Only voluntary dissolution allowed (majority vote) Restrictive • Liberal dissolution sacrifices longevity and gives MSHs some leverage • On the other hand, it prevents/mitigates oppression

© Amitai Aviram. All rights reserved. Forced dissolution 104 UPA • By voluntary dissociation of a partner, if the partnership is a partnership at will [UPA § 801(1)] • By dissociation of a partner through operation of law, if within 90 days at least half of the remaining partners want to dissolve the partnership [UPA § 801(2)(i)] • By the unanimous vote of all the partners [UPA § 801(2)(ii)] • By the terms of the partnership agreement [UPA § 801(2)(iii)-(3)] • By operation of law due to unlawfulness, but there are 90 days to cure the illegality [UPA § 801(4)] • By court order [UPA § 801(5)-(6)] – Partner’s suit: Economic purpose frustrated; not reasonably practicable to carry on the partnership business – Transferee’s suit: if equitable and possible under the terms of the partnership agreement

© Amitai Aviram. All rights reserved. Statutory dissolution MBCA • MBCA § 14. 30(2) – Dissolution may be ordered when: – Corporation is deadlocked • Board is deadlocked; • SH are unable to break deadlock; and • Irreparable injury or paralysis of the corporation will result from the deadlock. – Shareholders are deadlocked • SH are evenly divided • SH fail to elect successor directors in (at least) two consecutive annual meetings – Board or controller acts illegally, oppressively or fraudulently – Corporate assets are being misapplied or wasted 105

© Amitai Aviram. All rights reserved. Statutory dissolution 106 Meiselman v. Meiselman [NC 1983] • North Carolina allows dissolution when it is “reasonably necessary for the protection of the rights and interests of the complaining [SH]” • Meiselman: To dissolve a close corporation, sufficient to show that MSHs’ reasonable expectations are frustrated – MSH doesn’t need to demonstrate oppressive/fraudulent conduct by controller • To be ‘reasonable’, expectations must - – be reasonable under the circumstances – be/reasonably should be known to controller – be central to MSH’s decision to join the venture • Meiselman: In a close corporation it is a reasonable expectation to participate in the management of the business or be employed by it – But this is limited to expectations embodied in understandings, express or implied, among the participants

© Amitai Aviram. All rights reserved. Statutory dissolution 107 Stuparich [Cal. App. 2000] • Siblings Malcolm Jr. , Candi & Ann owned equal amounts of HFM’s non-voting shares, but Malcolm owned majority of the voting shares – HFM had a profitable mobile home park & an unprofitable furniture business – Malcolm, his wife & son worked in HFM (no claim of excessive salaries); Candi & Ann didn’t – Candi & Ann wanted to separate the two parts of the business; Malcolm didn’t • After their mother’s shares are distributed, C&A expect to gain control of the corporation, and call for a SH meeting to vote – They discover that their father (Malcolm Sr. ) “clandestinely” sold his shares to Malcolm Jr. for a low price (Malcolm Jr. now has 51. 56% of voting shares) – C&A ask Malcolm to buy them out; Malcolm refuses • At a family event at the home of the Malcolm Sr. , Malcolm & Candi had an altercation that resulted in physical injuries to Candi – Fight may have been over the sisters’ unsuccessful attempt to impose an involuntary conservatorship on their father

© Amitai Aviram. All rights reserved. Statutory dissolution 108 Stuparich v. Harbor Furniture Mfg. • The sisters sue for dissolution – CA statute states that in close corporations (<35 SH) dissolution may be granted if it is “reasonably necessary for the protection of the rights or interests of the complaining [SH]” (similar to NC statute in Meiselman) • What are the sisters’ frustrated expectations? – Working for the company • Under Meiselman, is fact that sisters didn’t work at HFM grounds for dissolution? – Disagreement about HFM’s strategy • What principle can Jr. cite to justify his decision not to sell the furniture business? • Would the sisters’ argument be stronger if they wanted to keep the furniture business & Malcolm Jr. wanted to sell it? – Expectation to control the company • Does court recognize a reasonable expectation of the sisters to control the firm? – Acrimony & violence between SHs • Does court allow dissolution of the corporation due to the violent incident between Malcolm Jr. & Cindi?

© Amitai Aviram. All rights reserved. Process of dissolution 109 Hypo • Archie, Beatrice and Chris are partners in a grocery store – On January 1, they vote unanimously to dissolve the partnership – On January 2, Archie sells bread that is in the grocery store to customers & Beatrice orders more bread from a bakery • Chris claims that these transactions do not bind the partnership, because it has dissolved and so it no longer exists as a legal entity • Is he right? – Note UPA § 802(a), 804 • What effect does dissolution have? Why?

© Amitai Aviram. All rights reserved. Process of dissolution 110 Terminology • Winding-up – Liquidating the partnership’s assets/business – Settling the partnership’s debts/obligations – Dividing between the partners the remaining assets/money • Termination: The partnership ceases to exist • Dissolution: The process that begins with winding-up & ends in the termination of the partnership

© Amitai Aviram. All rights reserved. Process of dissolution Division of profits & losses • UPA provides default rules on division of profits/loss • Division of profits – Default rule: Profits divided equally between partners [UPA § 401(b)] – What if one partner contributed 90% of capital? Equal distribution – What if one partner contributed 90% of work? Equal distribution • Division of losses – Default rule: Losses divided the same way as profits. [UPA § 401(b)] • Partnership agreement can change this default – E. g. , there need not be symmetry between division of profits and losses 111

© Amitai Aviram. All rights reserved. Process of dissolution 112 Capital account • Capital account: A running balance reflecting each partner’s ownership equity (see UPA § 401(a)) • Begins with the initial contribution – Not limited to money (also labor, assets & anything else partners agree on) • Share of the profits is added • Share of losses & “draws” (distributions) is subtracted • Example – April contributed $5, 000 to ABC law firm in return for a 1/3 interest in the partnership – Firm ended 1 st year with a $3, 000 loss (so April’s share of the loss was $1, 000) – In 2 nd year firm made a $9, 000 profit (April’s share of that was $3, 000) – At end of 2 nd year, the partners made a draw of $4, 500 (April received $1, 500) – April’s capital account at end of 2 nd year is: 5, 000 - 1, 000 + 3, 000 – 1, 500 = $5, 500

© Amitai Aviram. All rights reserved. Process of dissolution 113 Dissolution as an incentive • Most firms are worth more “alive” (as an operating business) than “dead” (assets sold separately) – For that reason, even in dissolution the business is often sold in one piece – Even if sold in one piece, some of firm’s value will be lost because • Dissolution forces to sell now, which weakens the seller’s bargaining position • Outsiders aren’t sure if firm has “skeletons in its closet”, so they discount the price to account for risk of negative surprises – What is the likely outcome if a court orders dissolution due to frustrated expectations/oppression? • Judicial dissolution serves as an alternative to buy-out agreements, but also as an incentive to form buyout agreements – Analogy: parent threatens to take away a toy if siblings can’t agree how to share it