Business Associations Class Notes 5/13/04

Read the cases carefully! Shipman will start calling on people next week. Read the footnotes of Zahn carefully for the terms of the preferred stock. “It’s a fascinating case at about five different levels.” We’ll be looking at some cases that were in earlier editions of the casebook that Hamilton pulled out of the latest edition.

Professional corporations

We’re still in category four, talking about the business corporation. Let’s fill out that bit of the outline, and then we’ll turn to today’s material, which is self-explanatory but crucial.

Hishon v. King & Spalding

King and Spalding was one of the truly prestigious firms in Atlanta. It’s the oldest firm in the city. The senior partners are well-connected. In the 1960’s and 70’s, we had federal equal employment statutes passed. The federal statute is Title VII of the Civil Rights Act of 1964. Title VI deals with discrimination in educational institutions, thus, OSU is subject to both of those Titles. Most states, a little later, all passed their own equal employment statutes. Ohio has a strong state statute. In many respects, it’s stronger than the federal statutes, thus local plaintiff practitioners use the local statutes whenever they can.

What was the issue? A single female associate was passed over for partnership. She sued, alleging that it was because of her gender. If that proved true, usually that creates a right of action under Title VII. King & Spalding hired the foremost civil rights litigator in the South. The argument was made by that lawyer that: (1) partners are not employees (which is generally true). There’s no withholding of their earnings. They usually are not covered by workers' compensation. (2) A partnership is an “intimate choice” of business associates and thus it would be improper to apply this civil rights law.

The Court came out very predictably: the first proposition is correct, but the second proposition is not. If you hire associates, holding out some possibility of partnership, it is discrimination against employees (associates of a general partnership law firm are employees) to discriminate. A 12(b)(6) motion was reversed. Even if the plaintiff thought she could win, would she really want to keep working there? The case was settled for a pretty big money award. Note that the equal employment statutes provide that if you prevail in your suit, you can get reasonable attorney’s fees.

How does such a settlement work? You need the lawyer to sign off on it. The lawyer is entitled under common law and federal law to the fees. The lawyer and client must agree on a settlement. They should agree on how the check should be drawn. It will usually be sent to the lawyer. The lawyer may say: “Why don’t you endorse it, I’ll endorse it, and then we’ll deposit it in the lawyer’s trust fund. Then we’ll figure out the division between us.” It gets more complicated when other parties have subrogation rights and liens.

Up to quite recently, professionals in all states were prohibited from incorporating. The state legislatures and courts thought that they should stick with the general partnership or else their personal liability would extend to their personal assets as well as the firm’s assets. Around 1960, law firms saw that their colleagues in the general counsel’s offices of corporations were getting good tax breaks on fringe benefits: for example, pension plans and health insurance. The law firms wanted relief and went in two directions: (1) they went to Congress, and Congress passed the Jenkins-Keogh Act, also known as Pension Plans for the Self-Employed. Jenkins-Keogh is not as liberal as pension plans for corporation employees. So this is only partial relief. (2) They went to state legislatures, and most state legislatures, if not all, authorized professional corporations, a special professional corporation statute. In Ohio, it was passed in about 1960 and it is in Title XVII. Shipman thinks it’s around O.R.C. § 1775. It’s an odd statute that you apply in conjunction with § 1701.

So what happened here in Ohio? For doctors and dentists, many of them immediately hopped on the professional corporation bandwagon. Many are still there today. CPAs could not do to due to the code of ethics of the AICPA (American Institute of Certified Public Accountants) prohibited incorporation. This business form was available to lawyers too. But there was a big “hiccup” along the way! The Ohio Supreme Court ruled that (1) the legislature could not legislate concerning the governance of lawyers in this way, (2) only a Supreme Court rule could allow it, and (3) they would allow it, but only if there was a charter provision, saying that each shareholder of a professional corporation of a legal nature had the same liability as a general partner of a general partnership.

Clackamas v. Wells

So this Supreme Court case is from 2003 from Oregon. This statute, even as to doctors, has a clause in it that the shareholders have the same liability as general partners of a general partnership. So what has happened in Ohio in the interim? In around 1995, the Ohio Supreme Court issued new rules, saying that lawyers can go into an LLC, a § 1701 corporation, the old professional corporation, and that the old provision about shareholders having the same liability as general partners of a partnership was abolished. Different states are at different stages on this right now, and it works differently for each profession. You must look at each profession. The Ohio legislation makes it clear that the governing boards for each profession still have regulatory oversight, and it works out differently for each profession.

In the 2003 Supreme Court case, what was the issue? There was an EEOC action by a non-shareholder employee against the corporation under Title VII of the federal civil rights statute. Title VII does not apply to a firm having fewer than 15 “employees”. But just what does “employee” mean?

Compare this to Ohio: under the Ohio equal employment statute, the number is four, and a part-time employee is explicitly counted as one. Also, the Ohio Supreme Court has held that in a veterinary firm with only three employees, the alleged mistreated non-shareholder employee, though she couldn’t sue under the federal statute, she would have about the same rights under Ohio common law. Often people’s rights are greater under state law than federal. We’re not in the Warren Court anymore! People’s rights are much more often greater under state law than federal law! Today, many federal judges are averse to 20^th century liberalism ideals, moreso than state court judges.

What’s the problem with the 15? There were four shareholder officers and directors. For state workers' compensation purposes, they were treated as employees, and that would also be the case in Ohio. For unemployment compensation purposes, both federal and state, they were treated as common law employees. If you excluded these four or five people, there weren’t 15 employees, and the company moved at summary judgment for exclusion from the statute. That issue, in the Second Circuit, had been resolved against the shareholder/employees. They held that if you choose the corporate form, the fact that you’re a shareholder, and even a majority shareholder and a director doesn’t affect the fact that if you work full-time for the company, then you are an employee. Out west, one of the courts held just the opposite: it’s a small, intimate, professional corporation. The shareholders who are also officers and who work full-time for the company are not employees. In Ohio, this case would go against the doctors.

The approach taken by Stevens in the majority opinion is somewhat in the middle. He says that he will remand the case so that the Court of Appeals can apply his opinion. But just what is Stevens’s opinion? He says that he might agree with the corporation as to shareholders who work for the company and who have such large stock holdings that they cannot be fired. It’s a cannot be fired test! If a single doctor incorporated, and he was the sole director, the president, and the sole medical employee, then no one could fire him. The Second Circuit, or Ohio, in that situation would say that this guy is still an employee. Now change the facts: three doctors own a third and each one is on the board of directors. Note: any two of them could fire the third. So, applying the Stevens test, they can all be fired!

Other crucial aspects of this opinion: Stevens goes over the status of the Restatement Second of Agency under federal law. When agency issues com up in the context of federal statutes, the Court has made it clear that they will go to Restatement Second of Agency and apply it. Why? You get national uniformity. Stevens discusses the 12-14 items you look at to determine if a person is a servant-agent, and he says that will apply. The truly important thing is usually the person’s time allocation, place allocation, and minute-by-minute conduct subject to legal power by a third person, then there is a servant-agent relationship.

In the Graham memo, we saw in the Cargill case an expansion of this doctrine for liability purposes. If X has the same de facto power over Y, then Y is a servant-agent even if X isn’t the direct supervisor of Y. Agency is a conduit for liability.

Workers' compensation

There has also been a recent Ohio Supreme Court case on control, either de facto or legal. We had a client power company that wanted a building built. They entered a construction contract with a general contractor. Those contracts will generally give the general contractor to subcontract certain functions. The general will usually subcontract out electricity, plumbing, and (he thinks) air conditioning. Let’s look at this from the point of view of both the Ohio Supreme Court and the Utah Supreme Court in Pinter.

In the Ohio case, we had a general contractor and a subcontractor. Usually, if someone like the electric company hires a general contractor and doesn’t go too far in the general supervision of that contractor, then if there is negligence by the general contractor or by a subcontractor, then the client electric company won’t be liable. The one exception will be negligence in selecting the contractor: you commit negligent selection when you pick a contractor that’s always getting people killed. All construction contracts call for progress payments: pay as you go. At the end, you’ll have about 15% outstanding, which will be paid three or four months later after a very detailed final inspection of the building as competed.

Here, the building company directed how the electric wiring on the construction site was to be handled. They weren’t an electric company, but they thought they knew everything! “Electrocuted doesn’t necessarily mean killed.” So a guy was electrocuted and seriously injured. He had a workers' compensation claim through his boss, the subcontractor. But money was scarce in that household. So the guy sued the client electric company. The Ohio Supreme Court said: if you’re the client on a construction project and you take excessive control, you have turned the people under you into your servant-agents. Both in contract and in tort, you’ll be liable. Too much is too much, and too little will get you in trouble too.

Pinter Construction Company v. Frisby

In the Pinter case, as discussed in the Montgomery memo, there is a related problem: the statutory employer doctrine for workers' compensation purposes. The case involved a construction contract. This involved the subcontract between a subcontractor and a general contractor. The general is going to subcontract out three or four things nearly always. The subcontract with the subcontractor did not mention workers' compensation. The subcontractor had no workers' compensation because they didn’t pay the premium! For a roofer, it costs about 25 cents on every dollar you pay a roofer. That’s dangerous work! But it’s 49 cents per $100 for a secretary. A worker was injured on the subcontractor’s job. The subcontractor has no workers' compensation, which is illegal, but it happens a lot. The Utah Supreme Court, not known for its 20^th century liberal leanings, applied standard American law. They held that the general contractor, at minimum, should have required, in the contract, that the subcontractor to get workers' compensation and pay the premiums. When the general didn’t do so, the general became the de facto employer of the guy who was injured, and thus the guy would get workers' compensation through the general contractor.

Why is the state interested in having workers' compensation applied? Why? (1) A lot of jobs are dangerous! (2) About half of Ohio’s state budget goes to Medicare and Medicaid, and to the extent the state can push this off onto workers' compensation based on premiums paid by employers, the state thinks that’s great! Federally, if you’re paid by workers' compensation, you can’t get Medicare. Why? Over half the medical payments in this country come from Medicaid and Medicare. It’s a huge burden on both state and federal government! For example, so long as Shipman has OSU health coverage, Medicare is secondary.

How do you keep from getting hosed? If you’re a homeowner and you hire a roofer, you ask for proof of workers' compensation coverage and proof of liability insurance.

Both workers' compensation and respondeat superior involve scope of employment determinations. Each must be in the scope of employment. As to agency, read the Nutshell carefully. Over the last hundred years, scope of employment has expanded to protect workers: there can be scope of employment even if there is a violation of the work rules of the employer. For example, a truck driver stopped for eight beers in the middle of the afternoon, and then ran over a baby. There was a clear work rule against this, either express or implied. So it would seem that this act would not be within the scope of employment! It was held that the act was within the scope of employment and the employer was liable because they could have checked his references and found out that he had been fired from his previous job for drunk driving.

There are two statutory exceptions to workers' compensation: (1) If you’re under chemical influence on the job, you can’t recover. (2) If you intentionally injure yourself, you can’t recover. One of the questions we’ll cover later is the issue of a truck driver who decides to commit suicide by driving his truck into a bigger truck on the highway. This is an analogy to “suicide by cop”. Clearly, there is no workers' compensation because he left a suicide note that was given to the cops. But what about respondeat superior? Does it go that far? Shipman doubts it very much. In the review session, we’ll say that no one can go to the widow and say that it’s alright and that he’ll be covered because it would ratify coverage after the fact. You must keep everyone’s mouth shut in order to avoid respondeat superior!

Study this material hard, we are responsible for it. We’ll come back to it throughout the course.

Malpractice insurance

Many legal malpractice policies will try to exclude real estate and business associations. Malpractice policies will always start with the insuring clause. Insuring clauses are construed broadly to protect insureds who usually don’t have the bargaining power of the insurer. But if the coverage is contrary to public policy because to allow insurance would pose a moral hazard, then even if the insurance department has approved it, it can be knocked out on public policy grounds. That’s what happened to Perl. It seems rough, but it’s not as bad as it seems. Most of this rule is very pro-insured.

The next clause will be an exclusion clause. It will usually include fraud, crime, dishonest conduct and intentional conduct. In addition, today, to get coverage for ERISA or environmental statutes, you’ll have to buy a special policy. ERISA is a federal statute: the Employee’s Retirement Income Security Act. It’s introduced briefly in the Nutshell on individual employee rights.

What’s the game that the insurance companies play? Just after the insured the formal, written, signed claim with the company (which is a prerequisite, along with immediate notification of the insurance company when something happens). Right after the claim is filed, the insurance companies have on their computer reservation of rights letters. The insured has informed the insurer and has filed your claim. Then you get a reservation of rights letter. They tell you that they have your claim and they say that they will defend you. The main reason people get liability insurance is to defend against B.S. lawsuits. The other thing that you want from insurance is coverage. Some cases really do have merit!

At this point, you should go hire a good plaintiff’s lawyer who will send to the insurance company the Zoppo letter. Zoppo is an Ohio Supreme Court case from the 1990’s on bad faith by the insurance company. If there’s bad faith by the insurance company, they are liable, and if it’s serious enough, as in Zoppo, punitive damages will flow. Remember, in Ohio, this is one of three or four states where you get attorney’s fees along with your punitive damages. When a doctor is sued, if he’s satisfied with the lawyer that the insurance company provides for him, Shipman says he should still hire a good lawyer to look over the shoulder of the insurance company’s lawyer, “just to let them know that they’re not dealing with a rube.” The Zoppo letter will remind the insurance company of its fiduciary duties. An insurance contract is one of utmost good faith (uberrima fides).

Usually, nothing will come of the reservation of rights letter. So why do they send it? By statute and common law, if they don’t send the letter and then defend you, they are estopped from affirming the exclusions or lack of coverage later. About one time in ten after the reservation of rights letter, the insurance company will file a declaratory judgment action separate from the one in which you’re being sued. In most cases, the judge in the first suit will get this judgment over to a colleague on the Common Pleas Court. Why is this done? In the old days, if the insurance investigator could wriggle out of the insured any admission that led to an exclusion, then it’s tough crap for the insured! A Texas Supreme Court case from around 1960, and an Arizona case from the 1970’s changed the world. They said that the lawyer employed by the insurance company to represent the insured owned high fiduciary duties to the insured. And if it’s through confidential attorney-client conversation that the attorney learns of the exclusion, the attorney must resign, or keep going but not say anything to the insurance company. In a really testy case, the insurance company will hire two lawyers: one to represent the insured, and one to represent the interests of the insurance company.

So we had a declaratory judgment action in Perl. In the 1950’s, it was hornbook law that if there was no coverage, then there was automatically no duty to defend. Since then, it has evolved more toward the rule in the first Perl case, referred to in the second one, which is that the mere presence of allegations that would take things out of the policy will not cause the duty to defend to go away, even if, at the end of the day, there is no coverage.

In Ohio, we have a broad declaratory judgment statute. These actions are broad. The insured will go to a lawyer, who will handle it. Under Ohio case law, if the insured wins the declaratory judgment action, the court may (emphasis on may) award reasonable attorney’s fees for the declaratory judgment action. It’s broader than insurance, but it applies to insurance.

Perl v. St. Paul Fire & Marine

Any attorney has the duty of care, the duty of loyalty, and the duty to communicate up-front all material facts. Here, the second and third were violated because the insurance adjuster used to work for the Perl firm, and the attorney didn’t run that fact by his client. He should have explained it and gotten her consent. Clear up the conflicts of interest up front, because they can kill you! It’s a contingent fee contract with a high contingent fee for settlement, 40%. The client wasn’t complaining about that. The client wasn’t complaining about the negotiations with the insurance company. She got $50,000 and $30,000 after the contingent fee was paid. But of course, to use modern terminology, “she felt used and abused”, and that generates lawsuits. Are people entirely rational about what they sue about? No. Attorneys must keep their clients totally informed day-by-day. Someone who is kept up-to-date is not likely to feel used and abused. That’s common sense.

So the client sues. What are the causes of action? (1) negligence, (2) fiduciary duty, (3) fraud, and (4) a per se rule in Minnesota and three or four other states: any agent who misbehaves significantly toward the principal during the employment must refund the whole amount paid, even if the work was good and there were no actual damages. The latter is called a prophylactic rule. It’s designed to prevent harm and strike the “Fear of God” into agents so that they’ll do right by their principals.

About 25 years ago, this way applied by a bankruptcy court in San Diego. One of the best bankruptcy firms in the world was working on one of the biggest bankruptcies in the world. They worked on this for four years, and made no interim fee requests. At the end, they filed their fee request for $7 million. The firm had a conflict of interest in the matter that they had cleared properly with the president of the company. What did the court do? They said they would get no fee! The conflict was so severe that it should have been cleared with the whole board of directors!!! Don’t deal with the sub-agents, deal with the principals! On any proceeding where you’re going to get a fee at the end, file interim fee requests as early and often as possible. Why? Bring the objectors out of the woodwork early! It would be bad enough to waste $1 million, but it’s a lot less than $7 million. File your requests early and completely.

The Supreme Court of Minnesota and the lower court agreed that there was no cause of action alleged in common law negligence or common law fraud because for any tort, you must plead and prove an actual legal injury, that is, damages. Consider the general fiduciary duty claim: you must plead and prove some actual legal injury. If you’re seeking an injunction up-front, probable damages are enough. Next, we came to the fraud exclusion. The court held that there are two types of fraud: (1) actual legal fraud with scienter, and (2) constructive or equitable fraud between the fiduciary and the beneficiary of the relationship. Thus, they held that the second type of fraud, which is basically unfairness, does not trigger the fraud exclusion. So the fraud doesn’t apply. Does the coverage clause cover the refund of fees? They said yes. They follow the maxim that insurance policies are construed, when reasonable to do so, to benefit the insured. The coverages are interpreted broadly, and the executions are construed narrowly.

What about the public policy arguments? As the firm itself, its ability to refund is based entirely on respondeat superior. The firm did not tell Perl to do what he did, and they didn’t ratify what he did. But, coverage of Perl, the actor, is against public policy. When an insurance company covers both principal and agent, principal cannot recover from the agent when the principal has to pay off to a third party. But, the court says, the result here is $20,000 to the plaintiff, to be paid by the insurance company on behalf of the firm. How do we equalize with Perl? The answer is that when the insurance company pays off on behalf of the law firm to the plaintiff, they’re subrogated to her rights. Also, they are subrogated to the rights of the firm against Mr. Perl. Therefore, the insurance company will cut a check to the plaintiff and then, on remand, the trial court is going to enter a judgment against Mr. Perl personally for $20,000.

Was all this litigation worth it to the plaintiff? Not objectively. Two trips to the Minnesota Supreme Court could take years and tens of thousands of dollars. Money is always among the top three reasons that people sue, but it is seldom #1, according to Shipman. The client was pissed off! She wanted the court to find that Perl was a bad S.O.B. The moral of the story is to keep your clients happy. Watch how a doctor practices: they are very cagey about that. They are always asking how you feel about things, asking you to telephone between visits, and telling you that you can call at home.

Start your outlining and your glossary this weekend! Don’t let a weekend go by without bringing your glossary and outline up-to-date!

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