Business Associations Class Notes 5/19/04

Let’s look at the leading research sources in the area are:

· Prentice-Hall has a loose-leaf Corporation Law Reporter. It stays up to date within a few weeks.

· In securities, there are several CCH reporters that this library has, including the Federal Securities Law Reporter and the CCH Blue Sky Law Reporter (state securities law).

· There’s also the CCH NASD (National Association of Securities Dealers, Inc.) Manual. NASD is a very powerful Delaware not-for-profit corporation. It exists under § 15A of the Securities and Exchange Act of 1934. Its job is to regulate over-the-counter (not on an exchange) securities transactions under SEC supervision. A lot of securities trading in this country is over-the-counter. It’s 100% over-the-counter is securities of the federal government as well as state and local governments. Some of the biggest countries in the country have also elected not to go into an exchange (like Microsoft).

· Similarly, there is a CCH NYSE Manual and a CCH Amex Manual. These are the two biggest exchanges in the country.

The New York Stock Exchange – the “old way”

The New York Stock Exchange is closely supervised by the SEC. The NYSE is a New York not-for-profit corporation, which has member firms. They include Merrill Lynch, Morgan Stanley, Goldman Sachs, and many others. The NYSE is a big operation. In a good year, it will net $30 million in fees from member firms and traders. This exchange represents sort of the old guard. There is not only an exchange “floor” but also “posts”. Each “post” has 30-40 stocks and there you will find specialists: member firms of the NYSE whose job is to be ready to buy and sell even if they must do so on their own account. Also, each big member firm has at least one floor broker on the floor. These brokers, if they can’t find a broker who wants to be on the other side of the transaction, goes to a specialist. Another actor is the floor governor, there to settle disputes.

The old way of doing things is continuous. It’s “two-way”. It is done by open outcry. The American Stock Exchange does things about the same way. If a company wants its stock traded on NYSE or AMEX, they have to pay a big initial fee and also an annual fee. Note that the old way is pretty non-electronic and low tech. It’s called a “continuous two-way auction market by open outcry”. The NYSE is very prestigious, the AMEX is also, somewhat.

There are about 14,000 publicly traded companies in the country. They range in value from the biggest to companies with only a few thousand shareholders and only a few tens of million dollars in assets. But, there are several million business associations in the United States. That includes limited liability companies, limited liability partnerships, general partnerships, and so on. The advantage of the publicly traded company is liquidity in the marketplace for the publicly-traded company.

Executive stock options

When we left off yesterday, we were talking about rewarding sweat equities upon the formation of a company. That leads to the concept of options for managers. Executive stock options used to be rare. Executives were paid by salaries, bonuses, and benefits. In the 1970’s, executive pay went way up. How come? Company executives basically thought they should be treated like stars. So executive stock option plans became very popular. They are governed by §§ 83, 61, and 162 of the Internal Revenue Code.

§ 83 tells you the results of a non-transferable stock option plan. When you advise a client about options, ask for a plan! The plan can only be adopted by the board of directors. No one else is allowed to do it! And if you’re a public company, you must follow SEC rules, including the proxy rules at § 14 and under § 16 (about which more later). § 162 of the Internal Revenue Code contains a major subsection on executive stock options for public companies.

The first thing to look for under the plan is the vesting period. It’s sort of “use them or lose them” provision. The point of options is to tie employees to the company in some sense: a kind of consideration. There are exceptions, though: options can vest even if someone is no longer an employee if the person dies or is seriously injured and can no longer work.

Take the example of a ten year option on 100,000 shares of $1 par stock at the current market price when the option was given: $10. The $10 is the “exercise price”. Another name is the “strike price”. Let’s say the person stayed at the company for ten years, and now the stock is at $70. The person worked hard and got lucky!

Let’s say the employee wants to exercise the option. The company is public. The employee must come up with $1 million to exercise the option! Since it’s a public company, the Sarbanes-Oxley Act, a federal statute from three years ago, says that public companies can’t lend money to insiders. If the employee is independently wealthy, he can come up with the million. But for the average person, this will be a problem. But the bigger problem comes from the tax standpoint. Other than § 83, the grant of a non-transferable stock option to an executive usually creates no income at that time. But if the employee wants to exercise the option, he’s going to get taxable income, in this case to the tune of $6,000,000! That is, 100,000 times $70 minus $10. But the good news is that subject to certain limits in § 162 (which gives a deduction for only reasonable salaries), the company gets a deduction in the same amount and in the same time that the individual realizes that income! This can make it so that a company doesn’t have to pay any income taxes!

Since it’s a public company, the employee can use Rule 144 under the Securities Act to sell within the volume limits of that Rule. If it’s a big company, this Rule will pose pretty much no problem. But if it’s a small company with just a few hundred shareholders, it will be a big issue! The way out is to go to a big securities firm and coordinate with the inside and outside legal counsel of the company and with the CEO. Remember the Bernie Ebbers story! He fired one of his top executives for not telling him when he was going to exercise his options!

The brokerage house will lend the employee some money to exercise the option, sell enough of the stock to pay back the loan plus taxes (state, city, federal, Medicare, Medicaid and all that), and give him the rest. He will have to get the company to sign off on this because the option plan will have a provision about tax withholding. The company must withhold taxes on the gross income (federal, state, city, and the employee’s Medicare tax). The company, the brokerage house, and the employee will enter into a contract. The brokerage house will get its fee, then remit the withholding that the company must then send to the tax authorities. The fee will be very high! But must we weep for the employee? No! He still has a lot of stock!

What if this is a private company? There’s no public market for the stock! What happens? Once in a while, the company will have enough money to buy the employee’s option out for what it’s worth, after withholding taxes. The employee pays taxes and the company gets the deductions. So options work well for public companies, but for private companies that will stay private they are a bad idea. If the employee is rich enough to exercise the option, they will, but that’s rare.

But there’s yet another case! Private companies often want to go public. Say a private company goes public after six years and they sell several billion dollars’ worth of stock in an IPO. After the IPO, the underwriter will restrict the sale of the stock for nine months. The employee will have to clear the sale with the boss, too.

With options and convertibles, you need to be concerned about dilution of the common stock. If there are $5 billion in outstanding convertible debentures and you can convert 10 shares for each 100 debentures, and your stock is selling for $60, the stock will get really diluted when the debenture holders convert!

Lastly, in terms of accounting, companies may, if they wish, may value the option upon its issue and treat it as an expense when issued for accounting purposes. This is done by lots of the country’s big companies! These are companies that use options “some, but not that much”. With high tech companies, the options are spread around much more liberally. Microsoft spreads its options to janitors, for example. In the future, all companies may be required to value their options when they are granted and take an expense deduction on their income statement. The FASB (faz-bee, or the Financial Accounting Standards Board) is a not-for-profit organization that sets GAAPs (generally accepted accounting principles). FASB must be consistent with what the SEC says. But the SEC generally defers to the FASB when setting GAAPs. Occasionally, the SEC will step in, and “once in a blue moon” Congress will step in and alter the rules.

Consider a company that bunched up a lot of options in a high executive. The executive goes to the board of directors and asks for permission to transfer his options to the working stiffs to make them happier so the company can make money. Shipman thinks this is a smart move.

Work with a tax lawyer up front!

Herbert G. Hatt

This gets into family law! A woman who owned a company married a younger man and let him buy planes and stuff. Then their marriage went downhill. They signed a prenuptial agreement. Let’s cover the law of prenuptial agreements and in particular the law in Ohio after 1980.

1. All states require a writing.

2. Ohio and many other states require that the parties have separate and independent lawyer.

3. There must be mutual full disclosure.

4. The contract must be fair when made.

5. This was added by the Gross v. Gross decision in the Ohio Supreme Court. For subsistence alimony (which is only awarded when a marriage goes on a long time), it must be fair when performed.

So family law enters into business associations in a big way! In this case and Wilderman, we see that if you’re a Sub C corporation, the Internal Revenue Service is always bugging you on the issue of reasonableness of salaries. In Wilderman, the Internal Revenue Service found that what the husband was getting was unreasonable. Thus, they disallowed many of the deductions. For a public company, the same rule applies in theory. In practice, however, it doesn’t so apply because public companies hire compensation consultants who have access to the earnings of corporate executives. Also, the federal income tax statutes regulate, and if you meet those technical requirements, you’re capitalized. Most public companies have a majority of their directors as outside, independent directors. The Internal Revenue Service, as a practical matter, usually doesn’t challenge the independence of directors of public companies. For private companies, there is constant friction of § 162(a), and that’s a big reason they go with Sub S or a limited liability company. If you’re an LLC or Sub S, the issue of excessive compensation doesn’t arise because there is a flow-through.

Wilderman v. Wilderman

This is a two shareholder corporation. The husband worked for the father when the father ran the company. When the husband married the wife, the father turned in his stock certificate and two stock certificates were issued to the husband and wife. There were two directors: he and she. The marriage and business went well for some time. The husband was a good worker and a fine businessman. The salary scale was set at the company by the fact that the husband was doing most of the work. He made himself the President and CEO, and made his wife the “inside person”, doing the books and records. As long as the marriage goes well, it’s not a big deal, but the marriage goes sour. It’s a deadlock! The board of directors had two members, and they disagreed! Could there be an election of a new board of directors by the shareholders? No, because the stock was split 50-50! It’s a classic deadlock situation!

What facts were on the husband’s side? There’s a corporate rule that officers are elected for a term: one year and “for so much longer as is needed until a replacement or successor is elected”. Therefore, they both remained directors and he remained the CEO. What’s the other big piece of paper in any business transaction? It’s the bank signature card! Shipman thinks that the bank signature cards said that either person could write checks on behalf of the corporation. Shipman thinks that the wife wrote her own check to herself at the old, low scale, and then the husband declared as CEO that he was worth a lot more than when the board of directors had last passed on it! He started paying himself a lot more! Under Delaware law, the wife could go and get a custodian appointed and she could also bring a shareholder derivative action.

In Ohio, there is no statutory provision for a custodian. We do have, however, case law that is favorable to the wife if this were an Ohio corporation: Crosby v. Beam, which is “a case of almost constitutional dimensions”. It holds that if there is a true close corporation then (1) the fiduciary duties between the parties are intense, (2) the courts will give relief promptly and (3) the suit can be broadly either as a derivative action, or bypassing Rule 23.1, which is good for plaintiffs.

So here are the holdings of the present case: (1) Only the board of directors can set the salary for officers and top executive employees. (2) If there is a deadlock, the president (with check signing authority) can continue to pay himself under the last pay scale approved by the board, including any bonuses.

Dodge v. Ford Motor Co.

This case holds that (1) with regard to a close corporation, any shareholder can sue the corporation and the directors directly to force a declaration of dividends. This doesn’t have to be a derivative action. (2) The action of the directors in not declaring dividends is under the deference rule of business judgment. If the defendants can show business judgment, the plaintiff must show one of these things: (1) arbitrariness, (2) ultra vires, (3) illegality, (4) waste, (5) bad faith, (6) gross negligence in procedure or (7) gross negligence on the merits. The last two are the biggies!

Here, the Dodge brothers, who were minority shareholders in this closely-held company run by Ford, were able to show gross negligence on the merits. How? The company was making lots of money, and more every year. The company was rolling in dough!

So what did the court say? Correctly, according to Shipman, the court ruled that there existed a cause of action and if you can show gross negligence then you can get the court to force the company to grant dividends. But the court is reluctant to draft these sorts of orders.

But on the other hand, they make fun of Henry Ford for lowering the price of his cars as demand was growing. Ford didn’t have a lot of formal education, and the high falutin’ lawyers made fun of him. The answer is a simple economic principle: a healthy company wants to push the price down if possible because it helps create a barrier to the entry of competitors! If you have a good product and you sell it cheaper and cheaper, then it will be harder and harder to raise capital to go head-to-head with you.

In Ohio, there is also In re Estate of Byrum, an estate tax case. It came after 1970. It was written by Justice Powell. This case involved both the federal estate tax and Ohio law in regard to dividends. What’s the federal estate tax? There are two important federal taxes: the federal tax on gifts, tied to a related tax on estates. The estate tax can run up to 55%, and the gift tax can run high too. There are exceptions, though: transfers between spouses are exempted from both taxes. (About nine states have these taxes, too, and many states have inheritance taxes, which are similar to estate taxes. Florida, on the other hand, has neither. They want to encourage old, wealthy people to move there! But they tax all kinds of weird stuff other than income and wealth!) This is a big deal for tax planning for the wealthy. Note that the exemptions are up to about $1.3 million. Most people don’t have to worry. Recently, the exemption was only $600,000. Technically, the estate tax is begin phased out. The gift tax will stay, “or else the income tax will be gutted”.

So what’s the situation in Byrum? This guy owned a lot of the stock of a close corporation. He gave away some to children, but kept 60% for himself so he could run the company. According to the Internal Revenue Code, if you transfer property with retained major powers over that property, then at your death, the property is in your estate even though you transferred it to your kids. The government argued that since the old man was going to set the dividend policy on the companies he maintained a major power over the transferred minority shares. Justice Powell went through Ohio law and found statements that there was a heavy fiduciary duty of majority shareholders in all matters, including dividends. Thus, because the fiduciary duty was so strong, the old man had not retained a major power over the stock that was transferred to the kids. Crosby v. Beam would agree with Justice Powell. This is very relevant stuff!

What about a public company? Can you get a court order for a dividend there? In theory yes, but in practice, “forget it, baby!” But the situation with a public company isn’t as bad if there are no dividends. For example, Microsoft pays no dividends, but their shares are highly liquid. But with a close corporation, your shares are not very alienable and not very liquid!

Slappey Drive Indus. Park v. United States

This deals with the deductibility of interest. It’s governed by §§ 162 and 163 of the Internal Revenue Code. § 163 sets forth a threefold test:

(1) There are a lot of technical rules in § 163 that must be mastered. First: you can’t make a public issue of debt securities payable to the bearer. There must be a name on it! Outside the English-speaking world, that’s done to screw the tax authorities! But here, you can’t screw around with the tax authorities. If you issue debt to the public, you can’t make it payable to the bearer. There must be a name on there so the Internal Revenue Service can trace just who got the interest. But this doesn’t apply to private issuances of debt.

(2) Most public issuances of debt have to be registered. It’s sort of like the previous rule: there must be a bond registry maintained by the company.

(3) The debt must be classic debt in form. There must be definitely amounts of principal and interest required to be paid at specified times, even if there is no income!

(4) The debt must not be de facto equity. With closely held, Sub C corporations, as in Slappey Drive, the shareholders who were also creditors did not force the company to pay interest and principal on time. The court held that this is sloppy, and the company shouldn’t be allowed the interest deduction.

In practice, if a public company meets the first two qualifications, the court won’t go to the de facto equity test. How else can you deal with this? You can avoid it completely by electing Sub S. A Sub S corporation is a flow-through. As long as the debt is straight debt in form (“the Pat Robertson rule”), no sweat. The other way to avoid the problem is with an LLC, governed by Sub K, and thus it’s flow-through and you don’t get into the de facto equity or unreasonable salary problems (with an exception to be mentioned tomorrow). But one of the big selling points of a Sub S or LLC is that you avoid the unreasonable salaries and de facto equity tests. If you’re Sub C these days, you can still have problems with those areas! Watch out for the Internal Revenue Service agents!

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