Business Associations Class Notes 5/18/04

We did Frick v. Howard. It dealt with the fiduciary duty aspect of the promoter’s liability doctrine. Since the promoter took a non-negotiable note and assigned it to the plaintiff, the plaintiff took over all of the disabilities of the assignor and because he couldn’t meet any one of the three validating tests, he stood in the shoes of the promoter and his claim for secured status was denied.

There are also tax aspects to the formation of a corporation or the issuance of new securities. Though this is not primarily a tax course, you must know how to spot tax issues.

The Old Dominion cases

What’s the situation? The promoters formed the corporation and each of the promoters got stock in the corporation for $5. Soon after that, the corporation issues stock to the public and charges the public $15 per share. It was not alleged that there was any fraud in either sale of stock. Furthermore, there is no injury to creditors alleged. Why? It’s because the company is receiving money for stock and upon liquidation, stockholders take last after creditors and no fraud is alleged.

Here are four flavors of action. They’re related, but different. First, consider legal actions on behalf of the corporation. The easiest one is the case of Frick v. Howard, where a company goes insolvent and there is either a voluntary or involuntary state court receivership or a trustee in bankruptcy (“T/B”) who is appointed in a bankruptcy action in the United States Bankruptcy Court under 11 U.S.C. State court receiverships are quite complicated, and federal actions are even more so! These are called universal successors to all of the assets and causes of action of the corporation. The state court receiver or trustee in bankruptcy can do two things: (1) They can assert any causes of action on behalf of the corporation that the corporation has. The benefit of these causes of action ultimately goes to the creditors. “It’s a salvage operation, and it’s vicious, baby!” (2) The United States bankruptcy judge or state court receiver has jurisdiction to pass on claims. They must be filed correctly and in a timely manner. And the court for any good equitable or legal reason can disallow claims or “push them down in the pecking order”. In Frick, the court says that if the claim was refilled as an unsecured creditor’s claim, there might be a chance. But the unsecured creditors sit at the bottom of the pecking order.

Next up, we have shareholder derivative actions, governed by Rule 23.1 of the Federal Rules of Civil Procedure. A shareholder files a complaint, served it on the corporation and the actual defendants, alleging that the defendants have overreached the corporation in some way. The shareholder goes on to allege that the corporation should sue, but it hasn’t because the defendants dominate the corporation and “they ain’t going to sue themselves”. Therefore, the shareholder wants to sue on behalf of the corporation. If the court approves this (after a whole bunch of motions before the answer), then the suit is tried. If the plaintiff gets a judgment, the attorney for the plaintiff moves for attorney’s fees and there is notice and opportunity for hearing on the attorney’s fees. Then the attorney for the plaintiff takes off the top. These actions are driven by plaintiffs’ lawyers! What’s left after that (and “sometimes it’s a lot, baby”) goes to the corporation and the judgment is res judicata as to all shareholders (not just the suing plaintiffs), the corporation, and all defendants. It’s a “true true class action” because no plaintiff can opt out. What the judge says is res judicata as to everybody. This is powerful stuff!!! If the defendants win, it’s also res judicata as to everybody (they walk away scot-free). There are two other possibilities: (1) settlement, or (2) dismissal. Under Rule 23.1, these are possible only after the court orders a hearing and determines that it’s to everyone’s benefit to approve the settlement or dismissal. Any settlement will contain extensive provisions for the attorneys.

There’s a big case in New York dealing with this issue right now. There’s a several billion dollar settlement, and the attorneys are asking for hundreds of millions of dollars in fees! But some of the members of the class are looking at the proposed settlement and are objecting to the proposed attorney’s fees! Yikes, they say! They are going to hire more attorneys to be professional objectors to the fees! They want to reduce the fees from $600 million to $200 million.

Shipman observes that defendants sometimes love class actions because the defendant’s dream is to settle early, offer a good amount to the class action lawyer, go before a judge, have a hearing, and have the judge approve the settlement, giving you res judicata for everybody and forever. In class actions in most places, however, when there is a notice of a class action proceeding, class members can ask to opt out. In Matsushita, you had a friendly tender offer for a movie studio by a Japanese company. It was a good cash tender offer at a good price. The family that owned the controlling stake in the company didn’t like the fact that it was in cash because they would have to pay taxes on it. They went to the offeror and asked to have them pay with stock instead of cash. They agreed. But the problem was that two SEC rules were violated (14d-10 and 10b-13)! After the deal closed, a class action in the federal district court in Los Angeles started up under federal law. But then there was also a parallel action out of Delaware state court under Delaware law! The Delaware courts couldn’t hear the SEC issues! The parties settled in Delaware. The defendants took the settlement from Delaware to Los Angeles and claimed res judicata. “Let my defendants go!” It went to the U.S. Supreme Court, which held that as long as the hearing on settlement meets the Fourteenth and Fifth Amendments, then a settlement in a state court can cover both the state action and related federal action. But it wasn’t all over yet. The case went back to Los Angeles and a panel of the Ninth Circuit found that Justice Thomas, writing for a 9-0 Court, “didn’t really mean what he said”. “Is that chutzpah or is that chutzpah?” There was a rehearing en banc before all the Circuit judges. The full court overturned the panel! The upshot of the case is that some defendants love class actions because they love early settlements. Note, however, that those people who opted out of the federal and state actions could proceed on their own. Let’s look at two prominent class action lawyers: O’Quinn (from Houston) and Chesley (from Cincinnati). They have opposite approaches. Grisham’s King of Torts goes over all this.

What if the plaintiff wins but doesn’t get money damages? Can attorney’s fees be recovered? You’ll find that if the plaintiff’s lawyer shows a definite benefit to the client or the corporation then they can get reasonable attorney’s fees. Later in the course we’ll cover the doctrine of ultra vires. If you bring an equity action before the act has taken place (which any one shareholder can bring), and if an injunction is awarded after the plaintiff wins, then most costs will award attorney’s fees even if no money has been awarded.

There can be direct action by shareholders against the corporation or its fiduciaries. If there is an ultra vires action, the action can be asserted derivatively or directly. The lawyer will always choose direct because Rule 23.1 is a “plaintiff’s killing field”. Similarly, like an action to force declaration of a dividend, can be asserted by either a class action of shareholders against a corporation or a single shareholder. The plaintiff’s lawyer will make his decision based on what’s likely to get better attorney’s fees. That’s just how it is!

In the Massachusetts Old Dominion case, which dealt with a few of the promoters, it was said that the public selling price determined the value of the shares, and the promoters must pay the company the difference between $5 and $15 times the number of shares purchased. In the federal Old Dominion case, written by Holmes, it was said that one of the exceptions to conflict of interest regulations applied here because (1) there was no injury to creditors, (2) no fraud or information deficiency was alleged, and (3) there was consent of all shareholders. That creates a defense to conflict of interest? How did the Massachusetts Old Dominion case distinguish Holmes’s opinion? They said that at the time of the promotion a public offering was contemplated and that the low price of the promoters was not put in the perspective, and so there was no unanimous consent of all shareholders.

Rule 10b-5 says that when a promoter buys stock, for the next five years, whenever the corporation issues stock to other people, publicly or privately, you must disclose that (this is the “five year” rule). Thus, today, the promoters in Old Dominion would have put a paragraph in the offering circular that disclosed the stock holdings of the promoters. They would have disclosed that the promoters paid $5 per share even though they were asking $15 per share from the public. You must do this or risk violating federal and state securities laws! If the promoters had followed the SEC disclosure laws, then there will be unanimous shareholder approval, no harm to creditors (because it’s beneath the creditors), no informational deficiency, and no fraud. Put it all together, and you get one of the exceptions to liability under conflict of interest regulation.

Well, if people are aware of SEC disclosure rules, and other those rules these cases are irrelevant, why are these cases important? It’s all about compensating the promoter and compensating sweat equity. Today, the offering circular to the public would fully disclose the $5 price. Generally, for tax purposes, if the promoters organize for $5 and then you go to the public at $15, within two years of when you do it, the IRS will say to the promoters: “You have $10 per share of ordinary income! Pay up!” If it’s over two years, the tax cases say that it is clear that the promotion was “old and cold”.

Next up will be sweat equity.

Sweat equity and capital

So what is the lesson of Old Dominion? We want to find the true value of stock as applicable to the marriage, business-wise, of sweat-equity and capitalists. (“Not an odd couple. They get along well and they can make a lot of money.”) Let’s start a new business! We need $1 million. There’s a capitalist who has that much cash, but he needs someone to run the company on a day-to-day business. Let’s say the capitalist will work 40 hours per week. He’s a retired doctor who is no longer practicing medicine. He needs someone to put in the 80-hour weeks who has detailed operating knowledge of the business (which the capitalist doesn’t have). Let’s use Subchapter S because the projections show that there are going to be big losses for three years, and then there will hopefully be a turnaround! The capitalist finds sweat equity and makes a handshake agreement that the corporation’s two directors will enter into a three-year signed, written contract for sweat equity with enough money for him to live on. There will be a similar contract for the capitalist for less money (because he’ll be working less). Part of the sweat equity deal is that the guy gets half the upside, that is, half the common stock.

Here’s how not to do the deal right. The Internal Revenue Code sections needed here are §§ 1032, 351, 61 (gross income includes income from all sources and including non-cash assets as well as cash; shares of stock of a corporation are clearly qualifying non-cash property), and 83 (if you receive non-cash property and its transferability is restricted, you value it at its value if it had no restriction on it). In this transaction, the transfer of shares must be restricted for two years under federal and state securities laws. The restrictions will be on the face of the certificates. It will be fully valid if the restrictions are on the face in full caps: that’s considered a reasonable restraint on alienation. Complying with the securities laws is reasonable.

What happens if a lawyer has sweat equity? There’s a $1 par stock. He buys 1000 shares at $1 each. There is a restriction on the face of the certificate. The sweat equity dude buys 1000 shares at $1000 per share. The Old Dominion rule says that you take the highest price paid and project that value backwards to everyone. So our sweat equity has $999,000 income. Each share is worth $1000. He paid $1 for it. So we multiply $999 times the number of shares, 1000. If the sweat equity person is rich, then it’s no problem. They can cut a check. But, for the average person this is a total disaster. Even for Bill Gates, we wouldn’t be thrilled. It will be service income to sweat equity. Then you look at another Internal Revenue Code section: § 162. It’s not quite as bad for sweat equity as it looks. He gets a deduction! Bill Gates can use a big deduction! Since he’s working for the company full-time, he has this great deduction. But the Internal Revenue Service will contend that the sweat equity is promotional services for organizing the company, and thus is non-deductible under §§ 263-66.

Sub S rules out any different classes of stock except one category of common stock. But it has some good rules! The debt/equity distinction will give us headaches. But what’s the beauty of Sub S? The regulations have a straight debt exception. To be straight debt, it must call for definite payment of principal and interest at definite times. In that case, regardless of the debt/equity ratio, for Sub S purposes, they will leave you alone. The regulations even say that you can use, in certain cases, contractually subordinated debt. But you can’t use an income bond. What’s that? It’s interest payable only if earned. That’s not allowed!

Let’s say the capitalist buys 1000 shares of common stock at $1 per share in cash. Then the capitalist has half the upside. The business requires $1 million to get off the ground. There’s a $999,000 straight debt note. But what’s wrong? The straight debt note will have to carry an interest rate of 10-16% per year to be believable because it’s such a risky note! Does that violate the usury laws of any state? Nope. Definitely not in Ohio. There are some statutory limits in Florida and New York. There is also a Federal Act that bans “extortionary” interest rates. Plus, this isn’t a consumer transaction. To find out, double check the Nutshell.

The Dunn & Bradstreet reporting service is the service for small business. To get listed there, you must submit accounting statements, including a balance sheet which will reveal just what is going on. The note to an affiliate (that is, someone who is controlling the company or under common control of some other company) will be listed. You want suppliers to sell to you on credit. You want 30, 60 or 90 day credit! It’s the same way with a lessor. But will this fly? At that extreme a level, it will not. You’ll have big problems. So how do you deal with it? When you go to get a bank loan, they will require contractual subordination of the capitalist’s $999,000 to the bank. This will be explained more later. It really means assignment. Will that kill you under straight debt? Probably not, but the lessor will be hesitant. Suppose the lessor says: “subordinate that baby to all creditors!” The tax lawyer would say that at that point, you’ve violated straight debt. If the company gets sued by creditors, they’ll go after the capitalist! So they want everything to be joint and several. What about big suppliers? They’ll do the same thing. They’ll say that you must have a signed, written joint and several guarantee individually from both the sweat equity guy and the capitalist guy.

What about cash flow problems? If the capitalist wants to avoid an individual guarantee, he’ll have to switch his note to $990,000 of preferred stock and give up the Sub S election. There are “inbetween” ways to do this too. You could split between the note and the stock. The sweat equity-capitalist problem is easier solved in an LLC than in the corporate form.

What about Internal Revenue Code § 1244? Shipman mentioned §§ 461-466, which were added by Reagan in the 1980’s to discourage tax shelters. They say: “Even if you’re Sub S, which has a flow-through, if you don’t work full-time for the company, you can’t use flow-through losses as they arrive. You can stack them up and use them when you sell the stock.” Full-time is 40 hours per week. If you’re a full-time lawyer or banker and only work on your Sub S a few hours a week, you won’t get your flow-through like in the old days.

Here is an anomaly: what’s the tax effect of debt when it goes bad? There is an odd set of rules that we’ll look at tomorrow. One of the ironies is that often, for a closely-held company, investing in common or preferred stock is better than taking a note. Here’s a hypo: Daughter runs a non-Sub S company. It’s breaking even and it’s been around for 7-8 years. She needs to expand now. She turns to Father and wants him to buy 100,000 shares of stock. What considerations go into it? First off, look at it from a practical standpoint. Father is a retired physics professor with a good pension. He’s well-to-do but not wealthy. Suppose that Daughter is his only child and he’s not married now. Say he can rake up over $100,000. One of the problems will be that Daughter and her co-investors will be more interested in their salaries than dividends. That’s understandable! Could Father make out well? Sure! The company could do well. It could get bought out by a big public company. Does Father want to be a director or an officer? No way! He doesn’t want to be liable! What about the downside? On this hypo, if he invests and the company goes under, he’ll get an ordinary business loss under § 1244, whereas if he lent the money to the company and they went under, then § 463-66 would only give him a capital loss. § 1244 is a sometimes useful oddity. It gives a limit for a single person. Lastly, you would tell him that his potential for liability is quite low if he doesn’t try to run things, and isn’t an employee, officer, or director. This is called “disregard of the corporate fiction”. As long as he’s not active, he’s probably safe. But should he do it? He should consider his health. If he might get sick, he better hold onto his money.

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