Obligations Arising Out Of Transactions In Shares

• Author: James D. Cox/Thomas Lee Hazen
• Profession: Professor of Law at Duke University/Professor of Law at the University of North Carolina, Chapel Hill
• Pages: 248-292

12.11 Rule 10b-5 and the Duty to Disclose

12.12 Rule 10b-5 and Control of

Corporate Mismanagement

PART A. STATE LAW

§ 1. T S  C C

A purchaser of a controlling interest in a corporation often pays a pre-

mium above the prevailing market price for the stock.1 Courts gener-

ally hold that any premium paid to acquire controlling stock is merely a

reflection of the greater value of that stock due to its control potential,

and as such it is a natural con sequence of stock ownership and can not be

considered a corporate asset.2 More generally, every stockholder, includ-

ing the controlling stockholder, is at liberty to dispose of her shares at

any price as long as there is no cause to believe or suspect t he sale will

proximately harm the corporation or its stockholders, or will necessa r-

ily interfere or mislead the other stockholders in exercising t heir same

right to sell.3

§ . F D  S

 C C

Numerous courts have held that a seller of control may become liable

in certain ci rcumstances for the harm to the corporat ion caused by the

purchaser. Clearly, however, the liability is far f rom absolute.4 In a lead-

ing case5 after the transfer of a controlling interest, the purchasers pro-

ceeded to loot the corporation. The court held the control sellers liable

and reasoned that, at a minimum, the transferor of a controlling block

of share s owes a duty to the cor poration to prot ect it when “the c ircum-

stances surrounding the proposed tra nsfer are such as to awaken suspi-

cion and put a prudent man on his guard—unless a reasonably adequate

investigation discloses such fact s as would convince a reasonable person

that no fraud is intended or likely to result.”6 When the circumstances

do awaken suspicion in the reasonably prudent person, t he seller of con-

trol has a duty to make such inquiry as a reasonably prudent person

would make.7 Liability does not attach, however, merely for the exercise

248 | C  C G: C  L

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of poor business judgment.

8 A minority view requires proof that the

controlling stockholder had actual knowledge, not inquir y notice.9

The cases illustrate the highly factual nature of a court’s determi-

nation in sale of control litigation. This orientation is embraced by the

American Law Institute, whose provision makes t he controlling stock-

holders’ fiduciary obligation depend in part on t he transfer not occu r-

ring when “it is apparent from the circu mstances that t he purchaser is

likely” to violate the purchaser’s fiduciary obligations so as to acqu ire a

substantial f inancial benefit for himself.10

Looting and mismanagement by the purchaser of control are clas-

sic types of misbehavior that form the backdrop for inquiring whether

the seller’s suspicions were sufficiently piqued for there to have been a

breach in disposing of control. Many cases do not involve looting or mis-

management by the new controlling stock holder but rather the diver-

sion of a potential premium from t he noncontrolling stock holders by the

former controlling stock holder. This occurs when the purchaser offers

to acquire at a substantial premium an asset of t he company11 or all the

shares of the company,12 and the controlling stockholder diverts most

or all of the premium to hi mself by converting t he offer for the asset

or all the shares to a transaction in which t he controlling stockholder

sells only his shares to t he third party at a substantia l premium. In these

situations, the courts embrace the idea that the f iduciary obligation of

controlling stock holders is not to divert or appropriate for themselves an

offer or opportunity that a third-party purchaser is prepared to extend

that would benefit all the stock holders proportionally. The language of

the American Law I nstitute’s provisions is broad enough to proscribe the

controlling stock holder’s appropriation of the corporation’s opportun ity

to sell its asset at a premium,13 but these provisions appear to proscribe

the conversion of an offer for all the stock holders’ shares only if the

controll ing stockholder se cretly acquire s shares from t he noncontrolling

shareholders as part of his disposition of a control block to a th ird party.14

No case has held, however, that the controlling stockholder breaches

its duty by failing actively to i nitiate transactions that are likely to yield

a premium for the noncontrolling stockholders’ shares.15 The control-

ling stockholder’s fiduciary dut y with respect to dispositions of control

is breached by commission, not omission.16

When there has been a breach of duty in the transfer of control,

the more frequently invoked remedy is to require t he vendor of control

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to disgorge the control premium.17 It is also possible to recover for any

assets or profits lost because of the misbehavior of the new controll ing

stockholder.18 The purchaser of control is liable for his seller’s breach on

a theory of civil conspiracy.19

§ 1. R  D  C

  S  C

In general, a director or other off icer, even though elected for a fixed

term, may resign at any ti me with definite notice.20 Unless a f uture date

or acceptance by the corporation is specified, resignation takes effec t at

once, and no acceptance is necessary.21 There are occasions, however,

when directors and officers are not free to quit with impun ity. Today it

continues to be true t hat directors can not accept payment in any form

or guise for their resignations and delivery of control or for the substi-

tution of others in their place, and they are accountable for any monies

so received.22

If directors ag ree to sell their shares, resign from t heir offices, pro-

cure other shareholders to sell their sha res, and hand over control to

irresponsible persons, they may be l iable under various theories. For

example, the directors m ay be liable to fellow shareholders for the profit

or excess price that they received over other shareholders whom they

persuaded to sell their shares, or to the corporation for secret profits

that were obtained by their off icial acts and for damages caused by the

wrongful acts of their tra nsferees and successors.

§ . T S   C O

The seller of a block of shares may lawfully arrange for sitting d irectors

to resign seriatim and for t he nominees of her purchaser to be appointed

to the board vacancies created by the resig nations, provided the block so

transferred represents working control. To be sure, it is always possible

for one who purchases control between the annual election of direc-

tors to simply wait until the next a nnual meeting or to seek a special

meeting at which the new controlling stockholder’s nominees can be

elected. This rarely occurs, because the new holder of control wishes

her influence to be felt immediately. There are sound policy reasons

supporting this desire.23 Even with a sale of less than a majority of the

250 | C C  G: C  L

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