Business Associations Class Notes 5/20/04

Here is some background information.

Not-for-profit corporations

Yesterday, we talked about the NYSE, organized as a New York not-for-profit corporation. All not-for-profit corporations have members who elect directors or trustees. They don’t have shareholders, but they do have creditors. There are two big subdivisions of not-for-profit corporations:

1. Charitable, religious, educational and corporations for the prevention of cruelty to animals – The most favored not-for-profits are those that meet Internal Revenue Code § 501(c)(3). To gain this status, you must file papers with the IRS in advance to convince them that you’re charitable. One requirement is that no insider can have an undue right to the income or assets of the foundation. In practice, that means that the promoter can be a trustee, director, or president and can collect a reasonable salary and benefits, including a reasonable salary plan. Some people who run charitable corporations get good money! If you are a charitable organization, you’re governed by ordinary state corporation law and also the law of charitable trusts. If you’re a § 1702 charitable corporation, you’ll be governed by both § 1702 and § 1701 (to the extent that it’s not inconsistent), and also by the law of charitable trusts. If you’re going to start a charitable organization, though, do it under § 1702. If you get into a dispute over trust law, you’ll have to go to a treatise.

Under § 503(c)(3), you’re exempt from federal income taxation. You’re also exempt from most federal excise taxes. You can also get an exemption from real property taxes! But that’s not the end of the financial feast! Under IRC § 170, within certain percentage limits, donors making donations to you get a federal income tax deduction.

2. Non-charitable not-for-profits – § 503(c)(6) describes business leagues, which provide some tax breaks, but not nearly as many as if you are a § 501(c)(3).

The NYSE approved a termination amount of $150 million! Many people are annoyed because the NYSE has net income of only $25-30 million in a good year. The Attorney General of New York is threatening to sue, which he can do if he can show that the directors were reckless is setting this amount. If he succeeds, that money can be recaptured. So Grasso and Spitzer are hissing at each other almost every day!

Family law

Very often, in dealing with business associations, family law comes up in a big way, especially in the areas of property and divorce. In a common law jurisdiction, like Ohio and 40 other states, they will start by breaking up the property held in each person’s name, and then they will determine whether it is separate property or marital property. Separate property is property that either person brought into the marriage or received by gift, devise, or intestate succession. Other property that is held in a spouse’s name, especially personal earnings, is marital property. Upon divorce in Ohio and other states, marital property will tend to get split 50-50. The divorce action in Ohio consists of two subparts: dissolution and divorce. Judges prefer dissolution.

Upon death, in most common law states, the surviving spouse can get a forced share of the other spouse’s property. It will range from 1/3 to ½. Study each state’s statutes carefully. In Ohio, if there is no prenupital agreement, then the forced share applies to both separate and marital property. If a rich lady marries a poor man, and she dies but excludes him from her will, the poor guy can retain a lawyer and get 1/3 of everything she had. That’s why prenuptial agreements are often used! In many states, these agreements not only have to be signed, but also acknowledged and recorded.

Suppose the rich lady marries the poor guy and there’s no prenuptial agreement and that contrary to actuarial predictions, the poor young guy dies well before the rich old lady. Is there any claim by the heirs of the poor young guy? No, because in the common law system, we say that the potential interest of the other spouse that would rise to fruition if he outlives her is an inchoate expectancy. Thus, if that spouse dies earlier, nothing of the wife’s property passes under his will.

Consider the “Cat in the Hatt” situation. Suppose there had been no prenuptial agreement. What rights in management of the company would Hatt have had? If we’re in a common law jurisdiction without a prenuptial agreement, and the property was titled in her name then he would have no management rights. But what if she took dividends from her funeral home business to start a new funeral home company, taking title in her own name? That would be marital property in most jurisdictions. But, since it’s titled in her name and it doesn’t involve land, she would have the sole management power over that new business.

How about some really tough hypos? Let’s say they they’re in a state with a heavy homestead statute. She takes her money and buys a homestead in her own name. She then wants to contribute this homestead to a third corporation where she will own all of the stock. How many signatures are needed on the deed of the property in her name to the corporation? In most states, having homestead statutes, community property or common law, there will need to be two signatures.

Suppose the lady takes money and buys a farm that is not a homestead, and after a few years she wants to form a fourth corporation, contributing the land. In Ohio, where the homestead statute exists but is rather limited, how many signatures are needed? In about six states, including Ohio, dower and curtesy statutes kick in, and we need two signatures. Know these hypos! If you screw them up, it’s sure to be malpractice!

If the lady owns stock in a company in a common law state and the stock is in her own name, and she’s the only shareholder, how many signatures do you need on the Sub S consent form? You only need one, because if she’s in a common law jurisdiction and the corporation is titled in her name, whether it’s separate or marital, she has the sole management power and you only need one signature because dower and curtsey are not involved, and stock in a corporation is not a homestead (with one exception)!

Husband and wife may own things jointly as tenants in common or tenants with right of survivorship or tenants by the entireties in some states. Don’t forget the “Dos Signatures” rule! Today, more and more married couples hold everything in joint names like this.

Community property

Nine states are community property states. They vary greatly between each other. There has been a rash of new statutes and court decisions in the last thirty years. In a community property state, they divide between separate property and “community” or “marital” property. Let’s say Hatt and the lady had their funeral home in Texas instead of Indiana and there’s no prenuptial agreement. In Texas and all other community property states, all personal earnings are always per se community property regardless of how the title is taken. Also, in Texas, Louisiana, and Idaho, earnings from separate property are community property. In the rest of the community property states, if you don’t co-mingle and you have several different bank and brokerage accounts, then separate property stays separate.

Let’s say there is income from the funeral home, plus dividends from lots of GM stock. The lady leaves her money to charity. Here, the less rich spouse dies before the more wealthy one. In Texas, the poor guy could get half of the community property. In a community property system, it’s not a mere inchoate expectancy, it’s a vested right.

What does this have to do with business associations? When you get to management of community property assets, “that is a goddamn mess”. There are a couple of easy hypos. In many community property states you can hold community property in joint tenancy. If there are two names on the property, you’ll need two signatures to transfer. If there is a homestead in a community property state, note that you’ll almost always need two signatures to transfer it.

Do community property states have dower and curtesy? Yes and no. Mainly no, though. But in California and Texas, if a common law couple moves into those states from another state, then by statute their common law property is still governed by the law of their original state and you could still need two signatures.

Here’s the big question: Sub S requires not only the board of directors making the election but also the consent of all shareholders. The regulations used to say, and still say, that in a community property state, regardless of how property is titled, it will take the signature of both spouses in order for the election to be valid. The management theory in the community property states “is all fouled up”! In these states, if a company is started up in a husband’s name, the attorney must assure that the wife writes down that she doesn’t object to the transfer. They will add a paragraph that says: “My husband is not my partner or my agent and I’m not liable for his debts.” Always watch out for tax elections in community property states!

If you sue a husband on a community property debt, you must join the wife to get at her share of the community property. Also, for an Arizona partnership to agree to an arbitration clause, even though the agreement is in the husband’s name, you must get a signoff from the wife. So community property law is pretty wild!

In a few states, if the husband has been married before and gets divorced, picks up a new wife, and the new wife is a big moneymaker, then in a number of states, the alimony payments and child-support payments due to the former wife and kids of the first marriage can be taken out of the wife’s personal property even if she doesn’t co-mingle. This wouldn’t happen in a common law state though. In a lot of those states, the part of the community that the wife manages (that is, her personal earnings) can be liable to the contracts and the torts of the husband! It’s wild!

If someone is practicing law as a sole proprietor and you’re going to enter into a five-year computer lease with him, you will want a signed statement from the proprietor’s wife that says her part of the community property stands behind the husband’s debt before you ink the transaction. How does she protect herself? She goes to an attorney, who tells the husband to form an LLC or one-man corporation.

Equitable subordination – Pepper v. Litton

Here we have a closely held corporation. The owner had not taken his salary out. A creditor sues. Then all of the sudden, the owner puts a lien on the assets of his company. The outside creditors went into state court and challenged this on the ground of common law fraud with scienter. The Virginia courts said that these were valid claims that he should have paid off as he earned them, but they were valid nonetheless. The creditor filed an involuntary petition in bankruptcy. The major shareholder timely filed a secured claim and showed the Virginia court action to back it up.

Justice Douglas holds that bankruptcy courts are always courts of equity. Furthermore, a claim can be equitably subordinated if there are strong equitable grounds for doing so. The outside creditor in this case did show such strong equitable grounds. Even though there was purportedly a preclusion issue from the Virginia court decision, Douglas held that the bankruptcy courts recognize claim and issue preclusion, but because bankruptcy proceedings are unique and policy-oriented, then the bankruptcy courts can deviate from normal preclusion jurisprudence if there’s a really good reason. This was a case where it was okay to deviate! Therefore, they pushed the secured claim of the insider below all creditors, including unsecured creditors who were outsiders. This is equitable subordination: you push a claim down one or more levels on the pecking order. Any court of equity has the power to do this! A state court receiver has the same power.

Contractual subordination

The result is a bit different than the result in Pepper. Say you have a mid-sized public company that needs to raise more money. They have already borrowed a lot of money from a big insurance company and the loan agreement requires the insurance company’s consent to any new debt. The public company goes to the insurance company, and the insurance company says that they may issue new debts to outsiders, but only if it is contractually subordinated to the insurance company.

The mid-sized public company will issue debentures (unsecured debt) to the public, with the following clause: “This debt is contractually subordinated to the debt of Insurance Company. In any insolvency or bankruptcy proceeding, we authorize Insurance Company to file a claim on their own behalf for their own debt and to file, as our agent, a claim for this subordinated debt. If the total of those claims yields Insurance Company less than the face amount of the debt to Insurance Company plus interest, then Insurance Company keeps everything. If the total of the two claims filed by Insurance Company yields more than the principal and interest of Insurance Company’s debt, then the excess will be returned to us. These paragraphs create an agency and we hereby declare that the agency is irrevocable as an agency coupled with an interest.”

Contractual subordination is, in effect, an assignment coupled with an agency coupled with an interest declared to be irrevocable. Why that wording? The typical agency power is revocable even if the revocation would cause the party revoking to be liable in damages (which is counter-intuitive but correct). The big exception is an agency coupled with an interest. Do you make an agency coupled with an interest merely by stating that it’s coupled with an interest? No. The Restatement Second of Agency says that the agent’s interest in performing services for a principal doesn’t make it an agency coupled with an interest. But, if the agent advances substantial money or property, and the parties state that, then the agency is irrevocable. In our example above, the drafter “gilds the lily” to show intent.

Here are two examples: Joe Jones enters a two-year contract with Mr. Smith who is a sole proprietor of a café. The agreement provides that Jones is to act as general manager of the café for two years. Can the parties validly add to that contract the provision that it is an agency coupled with an interest and thus irrevocable? No, because the agent’s mere interest in providing services according to a contract ain’t enough. So let’s say after a year Smith called in Jones and says: “Your agency powers are over and you’re fired.” And the agency really is over! Jones can sue if his firing violated an employment discrimination statute.

On the other hand, change the facts. Let’s say the business is teetering on the edge of bankruptcy and the agent agrees to advance a $100,000 loan to the principal, agreeing further that in light of the agent’s advancing the money, the agency is declared to be coupled with an interest and thus irrevocable. With this changed hypo, the result would be different. The agency power could not be terminated because the agent could give no cause. If the agent is dipping into the till, then the agency can be terminated.

Subordinated debt is widespread. If the subordination goes only to payment of principal, it won’t screw up the tax deduction of a corporate payor. But if interest payments are also subordinated, you’re dead. If the subordination goes to all creditors and not just institutional lenders, then I think you’re dead too.

If you’re advising a controlling shareholder or a relative of a controlling shareholder, you must tell them that in an insolvency proceeding you’ll probably get equitably subordinated. In Ohio, O.R.C. §§ 1336.56-59 constitute the fraudulent preference statute. We also have a form of the UFTA (Uniform Fraudulent Transfer Act). Insiders and relatives and affiliates of insiders will usually get pushed down. Sarbanes-Oxley says that as to a public company, if there is “misconduct” by an officer or director of a public company concerning the company, bonus and incentive plan payments during the period of the misconduct can be recaptured by the company. The law also says that if you get a judgment against you for securities fraud, state homestead statutes will not exempt your homestead. They’re aiming at Florida and Texas, where you may have a lot of acres plus a home of any value. In Texas, you have an urban homestead that no one can touch. Sarbanes-Oxley says that if you have securities fraud with a public company, the Florida, Texas, and other homestead statutes go away and you lose your homestead.

Insiders have other problems. The first two cases talk about the corporate veil. The corporate veil can be disregarded for fraud and some other reasons. In DeWitt, Flemming made the Cockerham mistake! He did the “macho” thing and promised to stand by his corporation. He said, “If the corporation doesn’t pay you, I will.”

In Debaun, it is held that majority shareholders owe duties to the corporation. The bank sold their majority stake to a madman! The judge allows the derivative action because he wanted the money to be put into the company so that the creditor would get paid. The attorney for the minority shareholders could get a reasonable attorney’s fee. The controlling shareholders owe heavy duties. For starters, remember Pepper. Even if they lend money to the company, if it goes bankrupt, they’re probably going to get pushed down the pile.

Back to Class Notes