Business Associations Class Notes 5/17/04

Pretty heavy stuff today!

Corporate statutes

To summarize a lot of last week, state corporation statutes are enabling statutes. They are designed to encourage investment, following Locke’s idea of intelligently adding labor to capital. The third part of the triangle is entrepreneurs and managers. Other heavily regulatory state statutes like antitrust, securities, environmental, and equal employment remain applicable. The state decided early on that corporations should be subject to the heavy regulatory statutes. But you won’t find those in the state statutes.

Nearly all corporate statutes in the United States are at the state level. There are a few exceptions, and let’s see what they are. If you wanted to form a bank, you would have to decide whether to go to Washington and deal with the Comptroller of the Currency or the Comptroller of the United States, or you could go to downtown Columbus and get an Ohio charter. Shipman thinks that in Ohio and New York, you’re better off with a state charter because their state statutes are more modern. The federal National Banking Act dates back to the Civil War, and it’s awful to deal with, unless you’re forced to deal with all the time.

Getting an Ohio charter doesn’t get you out of the federal regulatory scheme. An Ohio bank will not be chartered unless the bank first goes to Washington to the FDIC (Federal Deposit Insurance Corporation). In most states, this Ohio practice is followed. In Maryland and a few other states, there are some banks and savings and loans allowed to operate without federal insurance. By the way, the FDIC insures both banks and savings and loans.

If you form a holding company for your Ohio bank (which you’ll always do, for reasons to be cited later), you make a trip to another federal agency, the Federal Reserve Bank. The Federal Reserve Bank administers the Federal Bank Holding Act. They regulate the holding company, although they may do much more. The next decision to make with your Ohio bank is whether you want to have your bank join the Federal Reserve System. It’s required for all national banks, but it’s optional for state banks. The bigger state banks will join, but there are some good mid-sized and small state banks that do not join because they don’t think the benefits exceed the costs.

Why a holding company? Holding companies and non-bank subsidiaries can do things that the banks can’t do, and vice versa. That’s one reason to form a holding company. The second reason is that banks, especially national banks, can’t use stock options to reward executives, and options have become a big deal in the last 30 years. However, holding companies of banks can give out stock options. With S & Ls, a similar but more complicated decision is made. On the federal level, the only type of S & L that you can form is a mutual savings and loan. What’s a mutual S & L, mutual bank, or mutual insurance company? They have no shareholders. For an insurance company, the policyholders own the company. For S & Ls and banks, the depositors own the company. So why have mutual companies? Some of the biggest insurance companies and S & Ls are still mutual companies. The third-biggest S & L in the country is in Chicago and does well. Historically, the reason to have mutual companies was tax-related. Mutual companies used to be taxed much less heavily than stock organizations, but that has changed over the last 50 or 60 years.

If you form an S & L under state law, it will be a stock S & L, and it will have to issue stock. Nearly all states except for Maryland and one other will not allow a stock S & L to be formed without insurance from FDIC. There is also a Federal Savings and Loan Holding Company Act administered by the Office of Thrift Supervision (“straight out of ‘It’s a Wonderful Life!’”). S & Ls have about the same powers as banks and are taxed in roughly the same way. It didn’t use to be so! S & Ls, especially mutuals, didn’t use to be taxed at all! There are mutual banks, too. They have no stockholders, but rather, the depositors own them. Also, some of the biggest insurance companies in the country are still mutuals. The big insurance company in town is a mixture. The parent company is a mutual but owns a big chunk of a public stock subsidiary. Holding companies are used in insurance for the same reason they’re used in banking. Insurance holding companies are regulated mostly by the states rather than the federal government.

Through antitrust, tax statutes, employment statutes, environmental statutes and many others, Congress heavily regulates. But the regulation of corporations is left to the states.

Here is some terminology. To form a corporation, you must fill out what are called “Articles of Incorporation”, signed by one or more incorporator. You take that to the Secretary of State’s office, pay a filing fee, and the process is started. In Delaware, that same document is known as a “Certificate of Incorporation”. The generic name for both is “charter”.

In about half the states, including some big ones like Illinois and Texas, some version of the Revised Model Business Corporation Act is in effect. The casebook will give us some useful information on the MBCA. Hamilton was the reporter for the Revised MBCA. In Ohio or Delaware, the Revised MBCA doesn’t govern. So we’ll study these three sets of statutes. We study Delaware statutes because about half of the biggest corporations in the country are incorporated in Delaware. About 60% of the case law in the country comes out of Delaware. Delaware “speaks with a loud voice”. We’ll also concentrate on the Ohio statute, found at O.R.C. § 1701. It’s a very good statute, according to Shipman. He thinks if you’re going to run a corporation in Ohio, you would be nuts to incorporate in Delaware. Finally, we’ll look at the Revised MBCA. The first MBCA was put out in 1946. The revised version came out in the 1990’s. The annotated versions of the original and revised versions are a goldmine for research. The general Shipman rule is that unless there is a very good reason otherwise, incorporate locally. The corporate charter is a public document.

Why is Delaware so popular for incorporation? Part of it, Shipman says, is just tradition. The Delaware laws used to be pretty good. But other states’ laws have gotten better, and there have been some screwy Delaware Supreme Court decisions. But sometimes a Delaware PIC will have good tax benefits. For example, The Limited has a Delaware holding company that holds its intellectual property in a PIC.

In Ohio only, the rules of a corporation are called the “regulations”. Everywhere else, including Delaware, the rules are called the corporate “bylaws”. These are not a matter of public record, unless you’re a public company, in which case the bylaws will be on file with the SEC in Washington. Bylaws can be subpoenaed in litigation, though.

The general American rule is that the internal affairs of a corporation are governed by the law of the state of incorporation. But what are “internal affairs”? That means the relationship between shareholders, creditors, the corporation itself, the officers, directors, and the promoters. If it doesn’t involve these groups, then an affair is a non-internal affair, and it will be governed according to common sense. If you’re incorporated in Ohio but you set up a store in Kentucky and hire workers in Kentucky, the Kentucky workers' compensation statute will apply. Furthermore, if you make money in Kentucky, Kentucky will tax you on what you make. If one of your Kentucky drivers “runs over a baby in Lexington”, then Kentucky law will govern too. But if there’s a dispute between shareholders and the corporation over the election of directors, then Ohio law will nearly always governed. You can find this in Restatement Second of Conflicts of Laws, which actually indicates that there are a few exceptions to this. In practice, we can say that the courts are not quite as consistent as the Restatement indicates.

Zahn v. Transamerica

There’s common stock, so labeled, with Class B, which was labeled as common but de facto preferred. Then there was stock labeled as preferred. The company, Axton-Fisher, was a mid-size, barely public company. Its main business was tobacco. The company caught the attention of Transamerica. Before 1956, when Transamerica was forced to spin-off Bank of America, Transamerica owned both insurance companies and the Bank of America in California. In World War II, tobacco and liquor were hard to get domestically because they mostly went to the soldiers overseas. Axton-Fisher’s accounting statements carried the inventory at “lower of cost or market”. That meant that the value was understated on the financial statements. We looked at an example of consolidated summary financial statements earlier in the course. Transamerica wanted to gain control of the tobacco company and liquidate: an in-kind liquidation. They would take the tobacco and simply sell it and make out like gangbusters.

The court read the charter: the label preferred stock (Class A) could be called by the corporation at a certain rate. The Class B shares were a lot more complicated. Is the declaration and payment of dividends mandatory? In this case, the answer was no. How do we know this? The dividends were “when, as, and if declared”, and this was non-mandatory language. Can you have mandatory preferred stock as to dividends, though? Generally, you can’t because the board of the directors and only the board determines whether dividends are paid (with certain exceptions to be developed later). One exception is that when you have a closely-held corporation where all the shareholders have signed a § 1701.591 agreement and the creditors aren’t hurt by the agreement, then that agreement can provide for mandatory dividends.

Is the dividend cumulative? That is, if, in a given year, the directors don’t declare dividends on preferred stock, do the directors ultimately have to pay it? The footnotes of this case say that the drafter made sure it was cumulative by saying: “if they don’t declare in a year, they shall accumulate” and “if any dividends have been passed, the common stockholders can’t get a penny until any accumulated dividends are paid”. Is a preferred stock participating? Today, you seldom see participating preferred stock. But this Class B stock is participating. Once the board pays the annual dividend on the Class B, the rest of what’s left is split between the Class B and the common stock. Class B gets two bites at the apple! How do you make a preferred non-participating? You use the phrase “and no more” after the words “dividend of $X, when, as, and if declared by the board of directors”.

1. Is the stock callable? To make a stock callable, it requires special language. The language is here: the stock can be called at par plus accrued unpaid dividends. A call provision is always for the benefit of the most junior security, that is, common stock, because it puts a cap on what the more senior security can take.

2. Is the stock convertible? This takes special language too. Class B in this case could go into the common stock, but only 1:1, and they give up their accrued, undeclared dividends.

3. Does the preferred stock have a put? What’s a put? It’s an option whereby the holder of the option can force someone else to buy at a stipulated price or under a stipulated formula (like fair market value, for example).

Here, it was callable and convertible. Securities are primarily a matter of contract law.

The Court of Appeals held that because all of the directors of Axton-Fisher were officers or directors of Transamerica, there was an overarching conflict of interest, and the board of Axton-Fisher could not call the preferred stock. The district judge says to the Court of Appeals that they got it all wrong. The district judge says that the overriding rule of law is that even if there is a complete conflict of interest, if the fiduciary shows overall fairness as to disclosure up front and on the merits, and creditors are not injured, then there is always a complete defense in the corporate world against conflict of interest transactions (but in the trust world, this isn’t necessarily true).

Then the district judge says that the call provision is for the benefit of the common stock, and the conversion provision is for the benefit of the holders. Then, this judge looks at Rule 10b-5 and says that to compute damages, let’s assume the board of Axton-Fisher did it right, in which case they would have called the Class B. However, if under Rule 10b-5 they should have informed the Class B holders of what was going on. The Class B, having been informed of that, all would have converted. Therefore, the judge says to the B holders that they should get 1:1, not 2:1. Shipman says that this is right! The terms of securities, including debt securities, are everything.

Here are the three big holdings of Transamerica:

1. Controlling shareholders have very high fiduciary duty to both the corporation and to minority shareholders. Anybody who litigates knows that if you’re representing a plaintiff and you can prove a high fiduciary duty on the part of the defendants, you’re a long way toward home. That’s a very pro-plaintiff holding!

2. This holding is more by the district court than the Court of Appeals. The district judge reminded the Court of Appeals (“ever so delicately”) that even if there is a total conflict of interest in the corporate arena, and even if it is severe, if the fiduciary can show overall reasonableness as to disclosure up front and overall reasonableness on the merits, and no harm to creditors, then the transaction will stand. In this particular case, there was no injury to creditors because all the creditors were paid off. There was a failure in disclosure here that led to the 1:1 instead of 2:1 splitting of tobacco inventory.

3. Disclosure was also violated in this case under SEC § 10(b) and rule 10b-5.

If you have about the same disclosure duty under state law that you would have under 10b-5, and the disclosure duty under state law is on a fiduciary basis, then you plead the matter today under state law rather than under Rule 10b-5. How come? (1) 10b-5 always requires scienter. Under state law, if there is a heavy fiduciary duty, mere negligence, without any scienter at all, may well suffice. It’s easier to prove negligence than fraud in either federal or state court. (2) In the 1990’s, there were three federal statutes that cut way back on 10b-5 class actions. More on these statutes later in the course. These statutes are “plaintiff killing fields”. If you can avoid them, do so. They apply to class actions for fraud. Therefore, if you go under state law theories that don’t require fraud to be proved, then you avoid them. (3) In the last 25 years, about half of the federal judges have become more anti-plaintiff in the corporate area to some degree. At the state level, it’s a more even playing field. Even with class action suits, often you stick with the simpler state law theories rather than going to Washington or to the federal courthouse. This is very pragmatic but true. This case is very important! Master this case!

Frick v. Howard

Here we have a promoter of a motel. The economic word for “promoter” is entrepreneur. Promoter has a bit of a “bad touch” to it, so use the word “entrepreneur”. Entrepreneurs bring together labor, capital, and management. They’re sort of like “matchmakers”!

In this case, the guy is a lawyer, but he thinks that the town needs a motel. So he buys land for about $200,000, probably financed by a first mortgage with a local S & L. He probably disclosed that he would transfer the land to a corporation that would run the hotel. Today, he would have to negotiate with the S & L because usually it would put a “due upon sale” clause in the first mortgage note, and unless they consent to the transaction, they could accelerate the note and cause it to come due.

This is not a consumer transaction. There are no federal consumer statutes involved. Everyone is a business, not a consumer. The lawyer ups the value, in his own mind, to $310,000. The lawyer takes back roughly a $110,000 second mortgage note, plus a second mortgage. In a mortgage, there are always two instruments. There is a note, which is the in personam promise to pay of the maker, and there is the second mortage, which is a real property interest that you record at the courthouse giving you the right to foreclose if the principal and interest payments aren’t made. The two instruments are “tied together like Mary and her little lamb”.

Notes

A note is a two-party debt instrument. There is the maker of the note, who signs at the bottom, and the payee. A note is to be distinguished from a bill of exchange which is a three-party debt instrument. With that instrument, there is a maker, a drawee, and a payee. The drawee is the bank, the payee is the person who you write in, and the maker is the signer. A note is two-party. There are all kinds of bills of exchange, but we won’t get into them and we’ll stick with notes.

This is a rank real estate promotion, meaning that it is a very heavily leveraged real estate corporation. This is the opposite end of the world from the highly secure Exxon! A big danger for highly leveraged companies is that they will go insolvent. How do the courts deal with insolvent corporations? They do it in two ways:

1. The insolvent person can file a voluntary state court receivership or it can be involuntary by creditors forcing the insolvent into the state court receivership.

2. The insolvent person, at the front end, has the option of going under the Federal Bankruptcy Code of 1978, found at 11 U.S.C., and they can file a voluntary petition of bankruptcy. Also, initially the creditors could have filed an involuntary petition in bankruptcy, and a third possibility is that once a state court receivership is filed, the creditors can force it to the U.S. Bankruptcy Court. What’s the U.S. Bankruptcy Court? It’s a unit of the U.S. District Court. It has its own clerk and its own judges. It is reviewed by the U.S. District Court, and a district court judge can take charge of a proceeding at the beginning if they’d like. Here, everyone was satisfied with a state court receivership.

The creditor sign and file, on time, formal claims asking for a “piece of the pie”. It’s the same way in the U.S. district court. To research this stuff, start out with the Debtor-Creditor Nutshell, Shipman suggests.

So we’re in the state court receivership. The $110,000 note, which was originally payable to the promoter (the lawyer), who was the 100% shareholder, had been assigned by him to the plaintiff. The plaintiff had filed a secured claim in the state court receivership. He says: “I have a good $110,000 face amount claim, plus interest, as a secured creditor in this proceeding!” The court, acting sua sponte, started this proceeding to determine whether this guy had a valid claim.

So what does the court hold? First, a note, if it is worded as “pay to X or pay to the order of X” will usually be a negotiable instrument under Uniform Commercial Code Article III. But this note lacked this language. It simply said: “pay to X”. The lawyer assigned it to his buddy for lots of cash. The court holds that:

1. The note is not a negotiable instrument under Article III of the Uniform Commercial Code. If it were, the holder of that note could be a holder in due course and have greater rights than his transferor had. It’s kind of like the Recording Acts in Property. But since the words of negotiability were missing, it was a simple, straightforward assignment and the lawyer’s buddy stepped into the shoes of the lawyer. That is, every infirmity that the lawyer suffered under, the buddy will also suffer under.

2. Just what kind of infirmities was the lawyer under? The lawyer was a promoter, and he owed very high fiduciary duties to the corporation and to the other shareholder.

When he sells property to the corporation, in order for that to stand up, he must do one of two things: (1) he must prove overall fairness of disclosure and the substantive price and that creditors aren’t injured. Did the assignee of the promoter prove that as to the promoter? No. (2) The promoter can only put people on the board of directors who are independent, outside directors who are not beholden to him. If they approve, it will be tested under the Business Judgment Rule, a rule of deference. That is, if they approve it, it will stand unless the other party shows fraud, arbitrary action, ultra vires (beyond the powers), illegality, waste (meaning recklessness) and then the biggies: gross negligence in procedure, or gross negligence on the merits. The last two are usually the easiest to prove. Did the lawyer’s assignee meet the Business Judgment Rule? No, because there wasn’t an independent Board of Directors. (3) If all shareholders and all present and future creditors consent after full and fair disclosure up front, that would be another “out”. Did the buddy qualify for any of these three “outs”? No! So the infirmities of the lawyer carry over to him!

When you endorse an instrument to transfer, you have secondary liability unless you write after that endorsement “without recourse”. The lawyer didn’t want that secondary liability! There are also certain warranties under Article III whether it would be applicable or not. The lawyer probably wrote “W/R and without warranties”. What the lawyer did here was very dangerous. The lawyer probably had a duty to tell the purchaser that this was a non-negotiable note, subject to all the promoter’s claims. Careful lawyers, when drafting a non-negotiable note, will include the caption: “Non-negotiable note”. Why? There’s a case in the last thirty years that says that a lawyer who wasn’t thinking about it but created a non-negotiable note was liable to a remote purchaser who didn’t know it was a non-negotiable note. Are non-negotiable notes something you should use at times? Sure they are! If you’re a manufacturer buying 300,000 parts from someone, then if you give your non-negotiable note and the parts are defective, then if they guy sues you on the note, you can set-off. It would be the same as if the guy sold the note to a bank. But if you make the note negotiable, then the note can be sold to a third party, like a bank. When the bank sues you on the note, you can’t set-off the defective parts. Shipman says that this is all a matter of bargaining power.

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