Business Associations Class Notes 5/11/04


Here come two white books containing some Ohio corporate statutes.  They include §§ 1701, 1702, 1704, 1705, 1775, and 1782.  These materials have been furnished by this big financial printer.  These materials are required for the course.  We may and must bring them to the exam.  “Make these statutes your friend during the course!”


Business (or for-profit) corporations


In Ohio, these are governed primarily by § 1701.  Let’s start with some crucial terminology and classification.  Who are the members of the “corporate family”?  What do they do?  How are they governed?  How are they taxed?  We will do a lot of tax issue-spotting in this course because taxation has huge effects in this area of law.


The corporate family tree


Investors are people who invest money in the corporation.  “Money to a corporation is like blood to humans: without it, you die.”  Creditors (e.g. owners of company bonds) take first upon dissolution.  Dissolution has a different context in a corporate situation than in a partnership situation: it means termination of legal existence.  Creditors take first, and if there’s anything left, then the equity investors take what’s left.


Where does the term “equity” in “equity investor” come from?  It comes from the law of mortgage.  Debtors would secure a loan by giving creditors a deed that is absolute on its face.  Needless to say, some creditors applied very unfair procedures, and in response, the debtors went to the courts of equity (England having two different sets of courts), and the law courts basically laughed in their faces.  But the equity courts, which had their roots in the Church, created the equity of redemption.  If the debtor has paid off all of the loan and the interest, the equity court will enter an order of specific performance on the person of the creditor forcing him to return the deed to the debtor.  That is, you have an equity of redemption.  In modern mortgage practice, 60% of that procedure is still in place.  A foreclosure of a mortgage is always a proceeding in equity.  Not only do you draw upon equity precedent, but if it is purely in equity, there is no jury trial, and that’s really important.


All investors other than creditors are thus called equity investors.  A prime example of this classification are owners of common stock.  Another example is owners of preferred stock.  That is an equity investment too, but upon dissolution, a preferred stock owner takes after creditors but before common stock.  There are a number of different “flavors” of equity investors.  We will study a little bit about options on equity in this course, primarily options on common stock.  Options are used primarily in the context of executive stock options, which we’ll study closely.  But, the term has a broader application.  A warrant is a long-term option that is transferable.  For a few companies in this country, there are perpetual warrants out there that are occasionally traded on the stock exchange.  Executive stock options are nearly always non-transferable, with one exception.  If you die, your beneficiaries get the option and usually will have the opportunity to exercise the option if they want to.


Voting stockholders elect the directors.  Are there non-voting classes of stock?  Yes, in most states, including both Ohio and Delaware.  There can be entire classes of stock that do not vote.  For example, say a family company is going public in Ohio.  The family that owns the company might restructure the company so that the family takes “Class A” common stock, which has voting rights, while the public is sold “Class B” common stock, which is just like “Class A” stock except that it does not allow voting rights.  The family would try to establish a dynasty.  Consider that both the Washington Post and the New York Times are set up this way: the founding families have voting stock while the public has non-voting stock.


But will this go over well in trying to sell the “Class B” stock to the public?  It’s problematic.  Academic studies show that if you run things this way, there is going to be an 8-10% discount from what you could get if you sold the public voting stock, thus potentially passing voting control to the public.  Why the discount, though?  One theoretical way for a shareholder in a public company to make out very well is for there to be a takeover at a bigger company at a substantial premium, like 25-35% over market price.  If the founding family owns all of the voting stock, is there going to ever be a hostile takeover?  No, never.  There will also be fewer supplicants for a friendly takeover.


Furthermore, a number of the voting securities broker-dealers will refuse to handle the sale of non-voting stock.  You can always find someone who will, though, but you might have to pay them more.  The reason some broker-dealers won’t take on an IPO of non-voting stock is that “you sell the sizzle, not the steak”.  If the broker-dealer can’t sell all the stock in the new company, then they have to “eat” it.  They just have to hold on to the stock they can’t sell in the IPO until they can find enough buyers.  The financial markets go as much by “sizzle” as by rationality, according to Shipman.


The directors have several jobs.  The most important one is the hiring and firing of officers.  Officers are very high-level management employees with a formal legal title: “executive vice president” or whatever.  The other roles of the directors are to pass major transactions, to monitor the officers, and to set long-range plans and policies.  The directors are advised by lawyers, CPAs, management consultants, and investment bankers.  They are not expected to be super-experts in all those areas, or even be super-experts in what the company does.  Warren Buffett is a director of Coca-Cola, but he doesn’t know anything about how to run a bottling operation.  However, he does know how to pick out people who do know how to run bottling operations.  Those officers are agents.




Agency is a legal relationship that is crucial to any common law legal system because most of the work in the world is done by agents working for their principal.  Is the law of agency limited to business transactions?  No way!  It covers both personal activities and business activities.  It’s another “AC/DC”.  In order to have an agency relationship, do you need to have a contract or consideration or both?  No way!!!  Very often, there is a contract and consideration.  Take, for example, Joe Smith running a hamburger joint as a sole proprietor.  He hires Mr. Jones under a signed, written two year contract as general manager of “Hamburger Joint Unlimited”.  It’s a valid contract.  There’s consideration on both sides.  That’s an example of where there would be a contract and consideration.


But very often in the personal area, and even in other areas, there is no contract or consideration.  Let’s say it’s Thanksgiving and a student comes home from college to be with her family.  It’s the day before, and her father is cooking the turkey, and he is missing a certain ingredient.  He says: “Hey daughter!  Drive to the 7-11 and get Item X!”  Then he gives her $20.  She gets in the car, and on the way to 7-11 she’s negligent and she kills a neurosurgeon making $2 million a year.  The neurosurgeon was not negligent at all.  Can we say that she was negligently entrusted?  No!  She’s usually a good driver!  The father has not only a $300,000 auto policy, but also a $2,000,000 umbrella policy.  In many states, the family errand doctrine is such that the father can be reached.  The daughter is presumably insolvent.  Under agency principles, many states will say that the daughter is an agent for the father on family business.  But that doesn’t require consideration or a contract!  Does agency require a business setting?  No!  It often is a business setting, but that’s not required.  The widow of the neurosurgeon can reach the father and his two insurance policies under the family errand doctrine.  It’s not a sure shot, but in many states it would work.


Why do we learn agency?  Most of the work of the world is done by agents working for principals.  Agency is a conductor of liability.  Plaintiffs’ lawyers are always looking for financially solvent parties who are reachable.


What, then, is an agency?  Agency is an agreement by one person (an agent) to act for a principal at the principal’s direction and control.



We have established the definition of agency that we’ll work with: now let’s look at the three subdivisions of agency:  (1) the servant-agent, (2) the non-servant agent, and (3) the non-agent.


The servant-agent


The servant-agent means precisely the same thing as “common law employee”.  If the principal has legal power to control the agent’s time allocation as well as how and when the agent works, then the person is a servant-agent.  So where does this come up?  It comes up in tax and other statutes that refer to the word “employee”.  Both of the Supreme Court cases we read for today get into this issue.  Also, respondeat superior depends on this distinction.


In the corporate scheme of things, how do board members fit?  If a person is a director and only a director, then that person is not any type of agent.  How come?  An agent is one who agrees to act for the principal and at the principal’s control and direction.  This definition doesn’t fit a director qua director, because they are the ones who determine the principal’s policies!  This has practical ramifications: there is no wage withholding from the pay of directors.  They get a check from the company and they have to pay by declaration of estimated tax.  Furthermore, in almost all states, a person who is a director and only a director is not covered by Worker’s Compensation or Equal Employment statutes.  It’s the same way with a partner in a general partnership.  The partners, acting together, determine the partnership policy.  Thus, a partner of a partnership is not an employee of the partnership and has no wage withholding.


There are two statutory “curlicues” for this.  In Ohio, and a number of other states, partners in general partnerships can elect to participate in Worker’s Comp.  Few people choose to do this, but Shipman thinks that’s a mistake: this is a great tax deal!  In California and several other states, by statute, directors are included in Workers’ Comp.  But that’s very rare.  A third “curlicue” or oddity: in Maryland and a couple of other states, in a closely held corporation, even if a person is both an officer and a director, there can be an opting out of Workers’ Comp (but that’s almost always a stupid thing to do).


Is the top officer of a corporation a servant-agent?  Yes.  If you carefully go through the definition, you’ll find that the principal is the board of directors in this case.  They have the legal power to allocate the time of the president.  The president of a corporation is a servant-agent.  The president’s salary is withheld, and the president is covered by Workers’ Comp and Equal Employment statutes.


The non-servant agent


An example of this would be a law firm that you hire to handle a legal problem.  You go talk to a partner of a law firm, work out a fee, and they work on your problem (draft your will or whatever).  The partner offers to drive out and talk to you at your house.  The partner of the law firm, while on the way to your house to see you, negligently runs over and kills a baby.  Nobody else is negligent.  Does respondeat superior apply?  No.  The doctrine of respondeat superior applies only where the agent is a servant-agent.  With the law firm downtown, I don’t have the legal power to tell them how and when to do the work for me.  I can control the result, but I can’t control the process.  Respondeat superior is built upon the premise that where there is a servant-agent over whom the principal has the legal power over their physical activities, the principal is liable whether or not he is negligent in hiring and training that agent.  On the other hand, respondeat superior doesn’t apply to a non-servant agent.  Does that mean that the plaintiff’s mother is out of legal theories?  No.  If I was negligent in hiring the firm, that is, I negligently entrusted them to drive to my home, then I am liable.  But how can that be proved?  Maybe the partners of the firm had run over 10 babies in the last year, and I became aware of this.  Then my hiring of the law firm to come to my home may be negligent.


Why doesn’t Shipman use the term independent contractor?  “It’s because it’s the work of the devil.”  The Restatement uses it to include people who are not agents and those who are not servant-agents.  Courts use it to mean something different.  So use Shipman’s topology and you won’t get screwed up!


The president of GM is a common law employee, or servant-agent, or GM.  But the outside law firm of GM is not a servant-agent of GM.  So we have defined agency.  It can be personal or business-related.  It can be contractual or not.  It need not be in writing, usually.


In California and Ohio, by statute, if you ask your agent to sign a real estate brokerage contract on your behalf, the broker, in order to hold you, will have to show a signed power of attorney from you to your agent.  That is not true in many other states.  Under the Uniform Commercial Code, if goods are involved, you will find many requirements for a signed writing.  But in most cases, you don’t need it.  You need to satisfy the general statute of frauds, and also it’s just prudent to have a signed writing.


Consequences of agency


Agency is very broad.  What are some of the consequences of agency?  One of the most crucial consequences is that any agency relationship creates heavy fiduciary duties running both ways.  For example, in Russ v. TRW, an Ohio Supreme Court case post-1980, a huge Cleveland-based defense contractor was doing very profitable work for the Defense Department.  Russ was a young accountant assigned to calculate the cost figure in “cost plus”.  He came up with figure “x”, and went to his boss, who said “this figure is too small”.  He was told to change the figure to “5x”.  The Defense Department finally figured out the scam.  There are lots of fraud statutes on the books.  An investigation uncovers the young accountant, who is taken into the FBI Headquarters and “scared shitless”.  They play psychological hardball with him.  They tell him about Leavenworth in Atlanta.  Then they say there’s a way out “because they’re nice”.  If he cooperates and wears a wire, then they’ll go to the U.S. Attorney and tell him to give Russ immunity.  That would be great if Russ were James Bond.  Instead, Russ had a nervous breakdown and he went to see a psychiatrist.  The company fired him, saying it was his fault.


Russ sued under a section of the Restatement of Agency saying the following: “If the principal knows that what the principal is ordering the agent to do is criminal, the principal must tell the agent up front that what the agent is being told to do is a crime.”  The Ohio Supreme Court held that this fiduciary duty was violated.  They granted punitive damages (and in Ohio, when you get punitive damages, you also get attorney’s fees).  The big test on punitive damages in Ohio is Zoppo, from 1995.  In order to get punitive damages, you must show “spite”, “actual express malice”, “terrible insult”, or “conscious disregard of the rights of others”.  In Ohio, mere recklessness will not get you punitive damages.  One of the defenses offered was the Workers’ Comp immunity, which usually shields the employer from suit when they are hurt on the job.  The injury here was psychological.  That’s the fiduciary duty running from the principal to the agent.


A major fiduciary duty running from the agent to the principal is a duty to promptly and accurately account and disclose.  Here’s a hypo: you’re hired as a debt collector, and you’re dealing with very poor people.  You collect in cash.  At the end of each day, you must write out a report on what you’ve collected and turn it over.  That’s a fiduciary duty.  In the corporate area, directors, officers, all employees, promoters, and controlling persons owe a heavy fiduciary duty to the corporation, and in some cases they also owe the duty to the minority shareholders.  The law of fiduciary duty is a big part of this course.


The agent’s lien


A lien is a charge upon, or interest in, property.  Speaking poetically, it is a rough form of co-ownership.  How do we know that?  We read the Graham memo on attorney’s liens.  Your attorney is your non-servant agent.  You can’t tell him how to do his job.  You can control the result, but not the exact process.  A general rule is that an agent not paid what the principal promises to pay him may (emphasis on may) have a lien on property of the principal in his possession.  Graham discusses how in the personal injury context, if you go to a lawyer and retain him for a one-third contingent fee, and he drafts an engagement letter with strong attorney’s lien language in it, and the attorney for the defendant knows of that lien, and the defendant settles with your client without your knowledge, cuts the check solely to your client, the defendant is going to have to pay twice as to your one-third.  Why?  If you had the lien through the right language in the contract and the defendant knew about it, you, as a lawyer have a “hard-core” property interest in that cause of action.  It can be settled without liability to the defendant only with two signatures: yours and the defendant’s.  If an insurance company has a subrogation right to the settlement, there may need to be three signatures on the settlement agreement.  Liens are important!!!


So we have this guy collecting money, in cash, from poor people.  He doesn’t use force and he doesn’t lie, but he is persistent.  Let’s say the deal he has with his principal is that the agent gets to keep 20% of what he collects.  He’ll come by at the end of the day with the money and the statement of account, and the principal will write the agent a check for the 20%.  Let’s say everything goes well for six months.  One day, you collect $1,000.  You give the principal the report and say that he’ll get the cash when you get the check for your 20% ($200).  The principal says: “No.  You’re being paid too much.  Give me the money!”  The agent can count out $800 in cash, give it to him, keep the $200 and walk out.  That would be a perfectly valid agent’s lien because the deal is 20%.


Liens of agents are crucial, and attorney’s liens are one of the most important.  Graham’s memo also develops the concept of subrogation.  An insurance company would have a lien on the settlement of the personal injury claim by way of subrogation.


Here’s another hypo: there’s both a first and second mortgage on property.  The mortgagor missed a mortgage payment and the first mortgage forecloses.  Under the law in most states, the second mortgage will lose its in rem rights against the property with the foreclosure of the first mortgage.  It won’t lose the in personam rights on the note.  Therefore, when a first mortgage is foreclosed, very often the second mortgagee, to protect themselves, will buy in at the foreclosure sale (will be the high bidder).  Braunstein can tell us why this is so, but Shipman doesn’t know.  When the second mortgagee buys the first mortgagee’s interest, most courts hold that, by subrogation, the second mortgagee gets all of the rights of the first mortgagee, and that can be crucial.




Notice to a sufficiently important agent of a principal is notice to the principal itself at common law.  In the U.S. Supreme Court, post-1990, Chief Justice Rehnquist wrote an opinion regarding an EEOC proceeding where the plaintiff lost at the administrative agency level.  The statute says that a losing claimant may appeal within 30 days of notice to him.  The lawyer tried the case, went on a European vacation, and didn’t leave the memo with his secretary of what to do if things happen during your absence.  That’s malpractice per se.  The lawyer was in Europe, and, let’s say, on July 1st, the case was decided and the administrative law judge sent him a copy of the opinion.  The secretary got it in his absence.  The lawyer is in Europe for a long time, and then on July 15th, the administrative law judge sends a copy to the plaintiff.  On August 3rd, the lawyer returns from Europe and promptly files a notice of appeal.  If you measured the 30 days from when the plaintiff got notice, then this appeal is timely.  But if you measure from July 1st, then the appeal is not timely.  Rehnquist found that the secretary was the agent of the lawyer, the secretary got it on July 1st, notice to the secretary is notice to the lawyer under the law of agency, and the client is kicked out of court.  However, the client has a good malpractice cause of action against the lawyer.


There’s an exception in Article I of the Uniform Commercial Code that tries to reverse the common law rule.  If you want to get fast notice, and you’re dealing with an organization, give notice not only to the local guy but also to the president in New York and the general counsel of the company in New York.  Explain why you’re doing it.  But this is perfectly okay, and you better do this if you want to “start the clock running”.  Keep in mind that provision of the Uniform Commercial Code.


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