Shareholders, Derivative Suits, Fundamental Changes, and Federal Securities (10b-5, 16(b))

Shareholder Voting, Proxies, and Cumulative Voting

Shareholders do not manage the corporation, but they exercise ultimate control by electing and removing directors and by approving fundamental changes. Shareholders act at annual and special meetings, with proper notice to holders of record as of a set record date, and a quorum (a majority of voting shares, unless the articles set a different threshold) is required. A shareholder may vote in person or by proxy — a written (or electronically transmitted) authorization to another to vote her shares.

Proxies are revocable at the shareholder's will unless they are coupled with an interest and expressly stated to be irrevocable (for example, a proxy given to a creditor or to a buyer of the shares). Shareholders may also act by written consent in lieu of a meeting where permitted, and may enter voting agreements and voting trusts to pool their voting power.

The most distinctive voting mechanism is cumulative voting, which protects minority shareholders in director elections. Under straight voting, each share casts one vote per director seat, so a 51% holder elects the entire board. Under cumulative voting, each shareholder multiplies her shares by the number of director seats up for election and may cast all those votes for a single candidate (or spread them), enabling a minority bloc to elect at least one director.

California is notable because Corporations Code §708 makes cumulative voting available — and in many cases mandatory — for the election of directors, unless a publicly traded ("listed") corporation opts out in its articles; this is a meaningful departure from the permissive, opt-in approach of many other states and a frequent California-distinction testing point. The formula for the number of shares needed to elect a desired number of directors is X = (S × N)/(D + 1) + 1, where S is total shares voting, N is the number of directors the shareholder wants to elect, and D is the total number of directors being elected.

Shareholders also have inspection rights to examine corporate books and records for a proper purpose related to their interest as shareholders.

Direct versus Derivative Suits; Demand and Demand Futility

Shareholder litigation comes in two forms. A direct suit enforces the shareholder's own rights — to vote, to receive a declared dividend, to inspect records, or for breach of a shareholder agreement; recovery goes to the shareholder. A derivative suit, by contrast, enforces a claim that belongs to the corporation — typically against directors or officers for breaching fiduciary duties — where the corporation has failed to pursue it.

The shareholder sues on behalf of the corporation, and any recovery goes to the corporation, not the individual plaintiff (though the plaintiff may recover litigation costs and attorney's fees from the corporate recovery). Distinguishing the two matters because derivative suits carry special standing and procedural requirements.

To bring a derivative suit, the plaintiff must (1) have been a shareholder at the time of the alleged wrong (the contemporaneous-ownership rule) and remain a shareholder throughout the litigation; (2) fairly and adequately represent the corporation's interests; and (3) satisfy the demand requirement — the plaintiff must first make a written demand on the board to take suitable action, and must wait (often 90 days) before filing, unless demand is excused as futile. Demand futility is the heavily tested hinge.

Under the traditional approach, demand is excused when a majority of the board is interested in the challenged transaction or not independent, or when the directors' conduct was not a valid exercise of business judgment (the Aronson v. Lewis standard asks whether reasonable doubt exists that the directors were disinterested/independent or that the transaction was a valid business-judgment decision). Some jurisdictions (and the Model Act) require universal demand in all cases.

If the board (or a special litigation committee of independent directors) reviews a demand and decides in good faith, after reasonable investigation, that the suit is not in the corporation's interest, a court may dismiss it — courts apply the business judgment rule to the committee's decision, with varying degrees of scrutiny. The corporation is named as a nominal defendant because it is the real party in interest.

Fundamental Corporate Changes and Appraisal Rights

Certain transactions so alter the nature of a shareholder's investment that they require approval beyond the ordinary board vote — these fundamental corporate changes include (1) mergers and consolidations, (2) the sale, lease, or exchange of all or substantially all of the corporation's assets outside the ordinary course of business, (3) dissolution, and (4) amendments to the articles of incorporation.

The general procedure is the same: the board adopts a resolution approving the change, then submits it to the shareholders, who must approve it — typically by a majority of the outstanding shares entitled to vote (some states and older rules require a higher supermajority; California generally requires a majority of the outstanding shares for mergers and major changes). A short-form merger of a 90%-or-more-owned subsidiary into its parent is an exception that may be accomplished by the parent's board without a shareholder vote of the subsidiary.

Because fundamental changes can force a shareholder into an investment she did not choose, the law gives dissenting shareholders an exit: appraisal rights (also called dissenters' rights). A shareholder who objects to a qualifying transaction may demand that the corporation buy her shares at their fair value as determined (by agreement or, failing that, by judicial appraisal), excluding any appreciation or depreciation caused by the transaction itself.

To perfect appraisal rights, the dissenter must ordinarily follow strict procedures: deliver written notice of intent to demand payment before the vote, not vote in favor of the transaction, and make a timely written demand for payment afterward. Appraisal is generally the exclusive remedy for a shareholder dissatisfied with the price in a fundamental transaction, absent fraud or illegality. California provides dissenters' rights for mergers, reorganizations, and certain sales, with its own qualifying thresholds (for example, limitations where shares are publicly traded and widely held, the market-out exception).

Appraisal rights typically do not attach to every change — they cluster around mergers, asset sales, and conversions, and the precise triggers vary by statute, so the bar tests whether a given transaction qualifies.

Federal Securities: Rule 10b-5 and Section 16(b)

Federal law overlays state corporate law. Rule 10b-5, promulgated under §10(b) of the Securities Exchange Act of 1934, makes it unlawful to employ any device to defraud, make a material misstatement or omission, or engage in any fraudulent practice in connection with the purchase or sale of any security.

The implied private cause of action has these elements: (1) a material misrepresentation or omission (or a deceptive device); (2) scienter — intent to deceive or, at minimum, recklessness (negligence is not enough); (3) in connection with the purchase or sale of a security (the plaintiff must be an actual purchaser or seller — the Blue Chip Stamps standing rule); (4) reliance (presumed under the fraud-on-the-market theory for publicly traded securities, or shown directly); (5) economic loss; and (6) loss causation.

Rule 10b-5 also reaches insider trading: under the classical theory, a corporate insider who trades on material nonpublic information breaches a duty to the corporation's shareholders (the disclose-or-abstain rule); under the misappropriation theory (United States v. O'Hagan), an outsider who trades on confidential information in breach of a duty to the source of the information violates 10b-5. Tippers are liable when they disclose for a personal benefit, and tippees are liable if they knew or should have known the tipper breached a duty for personal benefit.

Section 16(b) of the 1934 Act is a blunt, mechanical strict-liability rule designed to deter insider trading without proof of any actual misuse of information. It requires that directors, officers, and shareholders owning more than 10% of a class of a registered (reporting) company's equity securities disgorge to the corporation any profit realized from any purchase and sale, or sale and purchase, of the company's equity securities within a period of less than six months — so-called short-swing profits.

Liability is automatic: it does not require any showing of intent, possession of inside information, or actual fraud — only the status (insider) and the timing (matching transactions within six months). The recoverable profit is computed by matching the lowest purchase price against the highest sale price within any six-month window to maximize the disgorgement, regardless of the order or the shares' identity. For a 10% holder, the person must own more than 10% at the time of both the purchase and the sale; for directors and officers, status at either end usually suffices.

Recovery runs to the corporation (a shareholder may sue derivatively to compel it). The two regimes complement each other: 10b-5 is a fault-based fraud remedy with broad reach, while 16(b) is a no-fault profit-stripping rule confined to insiders of reporting companies.