Business Associations Class Notes 5/12/04

Corporate and partnership law draw heavily on agency law and the law of insurance. The Perl case involves insurance in the context of a law firm. We do quite a bit in this course with law firms.

Respondeat superior

Respondeat superior – “Let the master answer.” What is this doctrine? If you have (1) a servant-agent, (2) acting within the scope of employment, (3) who commits a tort, the actor is liable, but, in addition, the master (the principal) is liable even if the master is without fault. That’s an agency doctrine. The related tort doctrine says that if the principal was negligent in hiring, training, or failing to fire the agent, then you can sue the principal in tort. Respondeat superior is much more worrisome.

In any organization of any size, there will be the agents doing the work at the bottom, and in the middle and toward the top there will be several layers of managing agents like foremen, plant superintendents, and finally the president up at the top. Does respondeat superior apply to those managing agents so as to make them, in addition to the principal (the corporation) liable without fault? The answer is no, but under Rest.2d Agency, followed by Ohio, here’s the deal as to the managing agent: he can, without liability, reasonably delegate, but his initial delegation must be reasonable and there must be reasonable supervision thereafter. If he fails either one of these tests, he can be liable to the third party.

Example: You have a supervisor of bus drivers for a bus company. One of the bus drivers is negligent one day and kills a baby. We know that the bus driver is going to be liable in negligence, and we know the corporation is going to be liable by respondeat superior even if the corporation wasn’t negligent in hiring, training, or failing to fire the driver. The parents of the baby will bring a wrongful death action. Can they also recover against the supervisor of bus drivers? Apply the formula from Rest.2d Agency. If the supervisor of the bus drivers was negligent in delegating to the bus driver initially or negligent in supervision (for example, if all the bus drivers colleagues suspected he was a dangerous driver but the supervisor never found that out), then the third party can also sue the supervising agent.

What about going up the ladder from the supervisor? Compare this to the Iraq prison scandal: how far up will it go? A supervisor of bus drivers would be expected to have a heavy hands-on role in supervision and hiring. But it would be harder to reach the president of a company that has 1,000 bus drivers. Maybe the president knew that this particular driver was a danger behind the wheel and said: “Hell, what’s a little baby here or there.” That’s a plaintiff’s lawyer’s dream!

Note the Holy Trinity of agency law: (1) P – the principal, (2) A – the agent, and (3) TP – for the third party. It’s like a troika! They’re tied together.

Note also that the supervisor of bus drivers in this hypothetical can be liable to the corporation, that is, the supervisory agency can be liable to the corporation, at least in theory. The bus driver who runs over the baby is liable, and the bus company is liable under respondeat superior.

Let’s go over these rules carefully. With a few exceptions, noted tomorrow, the principal found liable under respondeat superior has a good cause of action in indemnification (that’s one way to look at it) or in subrogation (another way) against the bus driver. Let’s stop and think about this: the subrogation theory is probably the more obvious one. In paying off the parents of the deceased baby, under duress (that is, a legal judgment) the principal becomes subrogated to the baby’s rights against the bus driver. But there’s a big, important exception: if the principal has an insurance policy covering both him and the agent, then the principal cannot go against the agent because the insurance company is covering both of them and if the insurance company went against the agent, the insurance company would have to pay off what they won against the agent and there is a big legal principle involved: where this is a pure circuity of action, the courts will not entertain the matter.

What’s a pure circuity of action? If A sues B in court and A wins, B has, as a matter of law, a mirror-image cause of action against A in the same amount. But the courts won’t entertain it! Also, under the Federal Tort Claims Act, the Supreme Court has held that the United States is liable for the negligence of one of its agents. The common law principle allowing the principal to go against the agent does not exist. Douglas says that the statute didn’t give them this right! But this decision could have gone just the other way. In Ohio, this is handled more by statute. By negligence, it will be the same situation. If all you’re alleging is negligence, you generally have to go against the state of Ohio alone, and you can’t join the state employer. However, if you’re alleging something worse than negligence, you can sue both the state of Ohio and the individual.

But caution: you may have to bring one action in the Court of Claims, and bring simultaneously the second one in the Court of Common Pleas. Likewise, the Ohio Supreme Court has held, generally speaking, that only the Ohio Court of Claims can determine whether an employee was in the scope of employment. In addition, with both the Ohio and Federal Courts of Claims, they have no equity jurisdiction and no restitution jurisdiction. Only the Federal District Court or the state court of Common Pleas can sit in equity. Does that mean that often when you sue the government you have to file two parallel suits? Yes, it does!

Corporate securities

Corporate securities determine, among other things, who controls (that is, who elects directors), which in turn controls who gets the good jobs (since the directors choose the officers), and also what cash flow will go to the shareholders. That’s all the securities we’ll handle right now.

The most junior equity (usually common stock) captures the upside. Take Google for example. The people who have big numbers of shares in Google will make out like gangbusters! One venture capital firm invested $12 million way back when, and after the IPO, some say that their holdings will be worth $1.2 billion. That’s a 100000% return! It is invariably the common stock that elects directors. Sometimes you’ll see voting preferred stock, but not all that often. So let us call common stock the most junior.

If a company sells its assets and is liquidated and it’s paying off its security holders, who takes first? Creditors. Second? Preferred stockholders. Third? Common stockholders. Those most junior stockholders will get nothing unless the creditors and common stockholders are satisfied in whole. On the other hand, the holder of a fully secured mortgage note (the most senior debt) is the most protected when the downside comes. If, for example, a bank lends $20 million and takes first mortgages on a plant and inventory worth $25 million and then bankruptcy is declared, the bank will come out okay because they are the most protected. The unsecured creditors, that is, the creditors with no lien, often take nothing or close to nothing in bankruptcy. Why? The secured creditors may have placed first mortgages on almost everything. What does this have to do with us?

Say you’re a supplier of industrial parts to midsize manufacturers. The manufacturer wants 200,000 industrial parts on credit. We check the financial statements of the company and see the first mortgages held by the bank. We’re a little worried: the sale on 90 days credit to this company is worlds apart from Exxon, which is the most solvent company in the world. (Why? Oil prices change a lot, so they are very, very conservative.) The sales manager and the president of our parts supplier will discuss the danger. We could choose not to sell. We could choose to sell, but mark up the price 35%. What else can we do? If the president of that company is Mr. Jones and he owns 60% of it, he must be deeply committed to the company. It’s his life! If he is well-off personally, then you can go to Mr. Jones and, in advance, get a signed, written guarantee of payment from him. That’s valid under the statute of frauds because it’s in writing and it’s signed by the person to be charged. There’s also consideration.

Guaranty and suretyship

That gets us into the law of guaranty and suretyship. Now, how do we research this stuff? There aren’t law school courses on this anymore. Post-World War II, there is a 1949 hornbook by West entitled “Surety and Guaranty” by Simpson, one of the “grand old men of contracts”. It’s very dated, but it’s very good and it’s a good place to start. Post-1980, there is a Restatement in this area. What’s the difference between guaranty and suretyship? If it’s a guarantee arrangement, the person making the guaranty is secondarily liable. He is making a guaranty of someone else who is primarily liable. If the creditor doesn’t mess it up and the primary creditor doesn’t pay (here, the manufacturing company), we, the supplier of industrial parts, can go against Mr. Jones and get our money. But that’s not the end of the story. By the doctrine of subrogation, once Jones pays the debt off, he can collect from his corporation because he is subrogated to our rights. Maybe the company will turn the corner and in a few years will be able to pay.

Here are some fine points: if we have already sold 600,000 units to this company on 90 day credit terms, for the second 400,000 we’re going to force Mr. Jones to waive his subrogation rights. Why? If the company goes bankrupt, we don’t want him coming in and competing with us. The general principle here is that a hard-nosed, sophisticated creditor will try to get the president to give up his subrogation rights. How can the holder of the guaranty screw up his rights? If they extend the due date of the company without the consent of Mr. Jones, they have waived their right to go against Mr. Jones. This is heavy stuff!!! It’s counterintuitive! But it’s true.

Another fine point: if Jones is wealthy, how do they button this down 100%? They have him endorse and blank General Motors stock certificates and give them to us as security for his liability. That’s allowed under the UCC. Then we get Merrill Lynch to guaranty his signature. That’s because the stock certificates will not move through the system without a broker-dealer involved to prevent forgery.

What are surety bonds? By statute in Ohio, if you’re doing construction work for a public agency, the contractor has to go to AETNA or some other approved insurance company and get a surety bond written in favor of the state. This is not cheap! The premium can run from 3-8% depending on the financial standing of the contractor. By statute, the state of Ohio cannot waive that. If you are getting a million dollar house built, you will want to have the contractor get a surety bond in your favor. Why? On surety, the writer of the bond has primary responsibility. But people sometimes pass up getting the surety out of ignorance and because it’s hard to get insurance companies to write these bonds. Keep in mind that if the surety writer has to pay off, it is subrogated to the landowner’s right against the contractor. But if the contractor is a financial turnip, then it’s worthless.

Is there more? Does it get more complex? Yes, it does! Say Mr. Jones still owns 60%, and we’re still the supplier of parts. Mr. Jones is a good executive, but he doesn’t have much money. “God loves the poor or he wouldn’t have made so many of them.” – to paraphrase Lincoln. But business is business! You don’t succeed in business without being financially hard-nosed. The only promise that capitalism makes to you is that you have the right to file for bankruptcy. “It’s the worst form of economy except for all others tried!” to paraphrase Churchill. But let’s say that Mrs. Jones is wealthy! Is it permissible to tell Mr. Jones that we’re interested in his wife’s guaranty instead of his own? Sure! We can make that proposition. The person who represents Mrs. Jones should tell her that she’ll have to pay. Her right to sue the company will be subrogated.

At closings, never bring in spouses, friends, and relatives. Creditors pass out guaranty forms for everybody to sign. Sometimes you don’t want to sign stuff! Also, keep spouses and relatives off the board of directors and officerships unless they’re absolutely needed. Under Ohio law, Mrs. Jones is not going to be personally liable if her husband goes bankrupty unless she guaranteed, she made him her agent, entered into a partnership with him, or estoppel (she told creditors not to worry; if he doesn’t pay, she’ll pay). Don’t let your clients say this stuff! Each person should stand on their own two feet.

In Cockerham, the husband had a lot of land before he got married. He married, acquired more land, and under Texas law what he acquired was community property. The wife went to town and started a dress shop as sole proprietor and also found another love interest. The dress shop is going to hell financially. Under Texas law, Mr. Cockerham’s community land would have been liable to Mrs. Cockerham’s dress store debts. But most of his land was acquired before the wedding and he would be able to keep it. So the creditors get to Mr. Cockerham. He should have said: “She’s an independent entity. She’s not my agent. She’s not my partner.” But of course, this macho guy said: “Don’t worry if her debts aren’t paid off by her! If they aren’t paid off by her, I’ll pay them off!” Under principles of estoppel, the court held that his separate farms, that is, the land that he owned when he got married, as well as his community property land was available to the wife’s creditors. Mrs. Cockerham is charged for wasting community property by supporting her lover. In 1971, the husband got custody of the kids! His big mistake financially was “popping off”. He should have given the “NOW” speech: “I’m not half of anything. She’s not my agent, and she’s not my partner.” Then he should have turned around and walked off.

We continue to discuss the business corporation and choosing which business associations you want. The tax environment is crucial. Though this is not a tax course, you have to know enough to ask the right questions.

Tax consequences of different forms of corporations

From 1913-1960, the almost invariable rule where you had a corporation was double taxation. That means: (1) the corporation itself is subject to tax, and (2) when the income is paid over (the dividend), they are again subject to tax, and (3) when the corporation dissolves and distributes its assets to shareholders, there is a tax at the corporate level on the difference between the fair market value of assets and what the company paid for them and there is a further tax at the shareholder level on the difference between what the shareholder paid for the stock and the value that he received.

An old Republican joke: a lady in Los Angeles needed her lawn mowed. The PWA sent out four people. She says, “I know this is California and we do things differently in this state, but why four people to mow the lawn?” The foreman said: “One to come, one to go, one to sleep, and one to mow.” The corporation is subject to the four way grab by the government! Shipman says: “Horrible.”

Mutual funds

The first exception came in 1942 for mutual funds. What’s a mutual fund? It invests in securities of companies. It sells its own stock to shareholders and your investment is very liquid in the fund. If you need to redeem the shares, you can redeem them for cash in just a few days. Note that they are always issuing new stock. Mutual funds have grown! There are over 8,000 registered mutual funds in this country. The advisory fees paid to the advisors of these funds is $50 billion in the aggregate. This is big business! Mutual funds are one of the most important of the institutional investors. They’ve done awfully well in terms of tax treatment. They must be reasonably diversified. In economics, we find that economics recognizes that the ordinary prudent investor wants reasonable diversification: they don’t want all their eggs in one basket.

REITs

In the late 1950’s and early 1960’s, a similar deal was put in for Real Estate Investment Trusts, or REITs. It’s an odd statute. It says that if you’re a trust taxable as a corporation and you make the election, it is similar to mutual funds. If you pay out a certain percent of your income each year (something like 95%), then as to what is paid out, you aren’t taxed on it; only the recipient shareholders are taxed on it. REITs haven’t had as great a run as mutual funds. Shipman speculates that the promoters have benefited themselves more than shareholders.

Subchapters C and S

At the same time, a huge amendment to the Internal Revenue Code, Subchapter C came into being. This is the general subchapter governing corporation. All the rules in this section are double and triple taxation! If you meet the requirements and make the election properly, you are governed mainly by Subchapter S. But where Subchapter S doesn’t deal with an issue, you go back to Subchapter C. Sub S is a bit different than the mutual fund situation. How many companies can elect? It must be a United States corporation. It can have no more than a certain number of shareholders (75 as of the last edition of the book). No shareholder can be a partnership, corporation, or ordinary trust. There are limits on the extent to which non-resident aliens can own stock in the Sub S company.

Making and keeping this election is complicated! It requires a lawyer because what you have to have is a shareholders’ agreement under O.R.C. § 1701.591 to restrict the transfers of shares and require election of consent by everybody who gets the shares. The board of directors files the consent with the Internal Revenue Service, but they have to have consents from all shareholders. It’s a two-level proposition. If you’re only dealing with one or two shareholders, it’s pretty simple, but if you’re dealing with 45, it’s going to get complicated.

If the election is made, the situation is about 70% like that of a general partnership. Tax lawyers describe this as “flow-through taxation”. What does that mean? It means that the corporation files a return, but it’s an information return as to income taxes. As to taxes other than income taxes, it’s fully subject, just like GM: excise taxes, sales taxes, real estate taxes, corporate franchise taxes and so on. But they file a return, and then at the end of the year they inform each shareholder of his or her share of the net income or net loss for the year and the shareholders include it in their income just like in a partnership (in a way). If the company keeps all the income, it’s still taxable to the shareholders currently. That’s one of the reasons why you must have a § 1701.591 agreement. You want to require, say, half of earnings to be paid out because the shareholders have to pay state, city, and federal income taxes.

Suppose the company makes $1 million in year one, has one shareholder, and pays nothing out. The company pays no tax, but the shareholder is subject to tax on $1 million, absent a 591 agreement. If the shareholder is Bill Gates, it’s no biggie since Gates is worth $50 billion. But for most people, it’s a big deal! Suppose that in year two, that money is paid out. That’s called PTI – previously taxed income. If the company broke even in year two but gave a $1 million check to the guy, he wouldn’t pay any tax on that, because it would be previously taxed income. Most states now allow did. Ohio did not until about 20 years ago.

LLCs and Subchapter K

Let us compare Sub S to the new kid on the block from Sub K-land: the LLC! First of all, you can have an LLC if you “check the box”. You can have an LLC with Sub K treatment even if a corporation, a trust, a partnership or a non-resident alien is a member of the LLC! Furthermore, the numbers can exceed the 75 specified shareholders in Sub S. Is there an upper limit? Yes…it comes in a “back-handed” way. Under current tax law, no new Sub K entity can have securities traded on a public market. We will discover that two sections of the Securities Exchange Act of 1934, §§ 15(d) and 12(g)(1), will cause (1) an entity that makes a registered public offering under the Act of 1933(?) or (2) any entity with 500 or more holders to file public periodic reports with the SEC. With those reports, under Rule 15c2-11 of the 1934 Act, a public market can be made by any broker-dealer in the country on that stock. In addition, under §§ 12(a) and (b) of the 1934 Act, if you voluntarily list any security on a national securities exchange there is per se a public market in that security. Therefore, as a practical matter, you have to work with a securities lawyer and avoid these four sections of the Act. It’s a back-handed limitation. Grandfathered in are a few old limited partnerships from the 1980s that are listed on a couple of exchanges: these are master limited partnerships. They were cut off a few years ago, but there are a few hanging around.

So we’ll get back to LLCs later. They are complicated but useful. LLCs have another use: they are widely used for mineral interests held by entrepreneurs, for real estate held by a real estate investor, and for intellectual property. Why are they so widely used? Two reasons:

(1) Wealthy people, when they die, will often leave property in trust to a bank to manage for their family. They can also do this during their lifetime. The big banks and trust companies want investment property given to them to manage in trust to be in corporate form or LLC form in order to minimize their potential liability. If you go to the bank and offer to transfer to them, in trust, a general partnership interest, they will kick you out the door! The opinion of Ohio lawyers is that the bank could be liable for the debts of that general partnership that they’re acting in trust for. If, on the other hand, you’re a wealthy person and you want to put an LLC in trust for them to hold and manage real estate, they are fairly well-shielded from liability (though not completely). If the LLC goes bankrupt, they’re unlikely to get stuck.

(2) In those three areas, with those three assets, very often you’ll have two or more entrepreneurs come together, each contributing some assets. At first, “it’s a torrid business love affair!” The entrepreneurs think they’re going to have a great, successful business! But of course, entrepreneurs usually have big egos. After a few years, each one often wants to pull their own contribution out and go on their own merry way. If you have a corporation, even a Sub S corporation, there will be a tax on “phantom income” at the corporation level, measured by the difference between the cost of the assets and the current fair market value. In other words, you get hosed! If you’re in a Sub K situation, however, and you talk with a tax lawyer early and plan it right, then very often the split will be tax free to the LLC and tax free to the member taking back what he contributed. He’ll simply take over the LLC’s basis and move forward.

But caution: don’t ever put publicly traded securities in a Sub K entity. There’s a tax trap there! There are three better ways to do this:

(1) With publicly traded securities, put it in a revocable trust. If you do it right, contributions to the trust and the unraveling of it will be tax free.

(2) The other option is a managing agency account with a big bank. As the name implies, there’s no trust, there’s no entity, although the stock will be in the name of the bank, it is a simple managing agency account and there is no consequence in setting it up, and you have the right to revoke it at any time and they will register the stock in your name and return it to you.

(3) Finally, the third way to go is a street name account at a big brokerage house. They call it this because they’ll hold the stock in the name of their own “nominees” (some of their senior executives). That makes trading a lot easier. If you need it back at any time, they’ll deliver the securities to you. This is a little more dangerous than an managing agency account with a huge bank, but it’s possible that a senior brokerage executive could take your money and run! They sued the brokerage house, and under respondeat superior, the brokerage house did repay them.

Shipman will start calling on people tomorrow!

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