Business Associations Class Notes 5/24/04


Here’s some rich and complex stuff.  Listen hard!  We’ll go over it slowly.


Bearer instruments


In English speaking countries, there is no such thing as bearer stock certificates.  Well, what are those?  They would be like U.S. currency, which can be used by the bearer for all debts, public and private, and there is no record at the Treasury of who has dollar bills at any one time.  It’s the same for all sizes of bills!  In civil law countries (basically the rest of the world aside from the English-speaking countries), it’s not so.  Both stock certificates and bonds are typically issued in bearer form.  If you have a bearer bond from a big company in Germany, for example, that pays interest twice a year, how do you get the interest?  Shipman has been told that you make sure you don’t lose the bearer bond!  You take it to a designated bank twice a year, and they’ll stamp the back of your bond and give you cash.  They’ll also photocopy the bond.  This is very conducive to tax evasion!


What about voting with bearer stock?  It’s a similar process.  You take the certificate to a certain bank before the shareholder meeting, you get a ballot, and you cast a vote.  They make a checkmark on the back of the certificate saying that the vote for the current meeting has already been cast.  In English speaking countries, this isn’t allowed.


The state statutes all require that stock certificates be in registered form, in other words, the exact opposite of bearer form.  The company maintains books known as stock transfer books.  Sometimes this is delegated to an independent bank known as the transfer agent.  The board of directors will set a record date for all shareholders’ meetings.  The holders of record as of the record date vote.


What about dividend payments on stock?  There are three big dates.  There’s a declaration date when the board declares them.  Under United States law, if it’s a cash dividend, the declaration creates a debt and the company can’t back out unless the resolution itself states otherwise (and that’s very rare).  Let’s say that the board meets on April 1 and declares a semi-annual dividend.  April 1 is the declaration date.  The second date is the actual payment date.  Let’s say they choose July 1.  They will also select a date between the declaration and payment date when the dividend will be payable to holders of record, for example, May 15th.  The choice of the dates and the spacing is governed by NASD, NYSE, AMEX, and SEC rules.  Under Rule 10b, it’s a fraud not to comply with the rules of the NASD and the exchanges if you are a public company.  Once you notify the NASD and exchanges of the dividend, they will set a date by which the stock will become ex dividend, that is, a date by which a person purchasing it doesn’t get a dividend.  How are dividends paid in the United States?  They will be mailed out on the record date.


The governing law concerning the transfer of stock certificates and registered debt is found in three places: Uniform Commercial Code Articles 1, 8, and 9; ORC § 1701.04-.37 (sprinkled throughout), and the rules of NASD, NYSE, and AMEX.  Most of the time, the former two sources will agree completely.  Once in a while, though, there may be some slack between the two.  It usually doesn’t cause a problem, but it does every once in a while.


Article 8 classifies stock in corporations as investment securities.  Nearly all courts will say that close corporation stock, even though it’s not publicly traded, is of a type that is publicly traded, and thus they will apply Articles 8, 9 and 1 in full.  A very small number of cases will deviate from this approach.  What’s important about investment securities?  The big deal is that it’s just like the Record Acts!  A bona fide purchaser is someone who gives consideration, acts in good faith, and who is not on notice of an adverse claim.


Let’s say bank B lends Mr. Smith $100,000 on Mr. Smith’s GE stock certificates.  Smith takes the certificates to bank B and endorses them in blank, meaning, he doesn’t say who he’s endorsing to.  The bank will put on a signature guarantee, in case they have to foreclose on the pledge and sell the stock.  The NYSE rules require a guarantee of signature from an NYSE member firm or a bank.  The loan officer is negligent and puts the certificates in his briefcase.  On the way home, he loses the briefcase!  A thief finds the briefcase and the stock certificate endorsed in blank.  The thief takes the certificates to his stock broker and the stock broker has no reason to doubt his word that he bought the certificates from Smith.  The broker sells the certificates through NYSE.  The purchaser has 100% title to those certificates.  How does bank B change its operations after this event?  They will have Smith sign a separate piece of paper: a stock power or assignment.  They will keep the two documents separate at all times.


State statutes protect the company in paying dividends.  They may rely upon their books of record unless they have actual knowledge to the contrary.  But there are two exceptions to this rule: (1) upon final dissolution, to get your money from the company, you must present your actual certificate, which they will stamp “cancelled”, and keep it.  (2) If it’s a series of payments in partial liquidation, you’ll have to present your certificate several times.  This is certainly cumbersome, but the Internal Revenue Service loves it because they can trace who gets what in dividends and interest.  Some companies have gone to a wholly electronic dividend payment system, but these are the small minority.  Most use the old paper method.


Public offerings of debt over one year in duration have to be in registered form to get the Internal Revenue Code § 163 interest deduction.  The Internal Revenue Service pushed for this!  But there are two exceptions: (1) if it’s a non-public issue of debt, for example, the debt of a close corporation, then you don’t need to comply.  (2) If it’s less than one year, even if it’s public, you don’t need to comply.


Salgo v. Matthews


This case involved an insolvent insurance company in Texas.  The Federal Bankruptcy Code does not apply to insolvent insurance companies.  The insurance departments have the power to go into state court and get receiverships and that’s the way insolvent insurance companies are handled.  What happened here?  It was a proxy fight!  A big block of stock was held by an insolvent insurance corporation.  On the books of the company where the proxy fight was taking place, of record, all that was indicated was that the insolvent insurance company was the holder of record.  But that wasn’t the whole story!  The Texas trial court, which is the court that appointed the receiver, had this issue come before it and it issued an order as to how the shares in the company where the proxy fight was taking place would be voting.  The issue was whether the Texas court’s order was valid, and whether it had to be recognized by the company having the proxy fight.  Yes!  You could go “a little bit behind the record”.


State statutes literally require the appointment of an important officer called the Inspector of Elections for each shareholders’ meeting.  This person is important because if there is a close or disputed item, the inspector will conduct an administrative hearing, take evidence from lawyers for both sides, and then will issue his certificate.  He’ll basically say, “Jones won” or “Smith won” and give his reasoning.  In most states, that report is accepted in the courts prima facie.  There is a presumption that they are correct.  If it’s a close corporation and you don’t anticipate any dispute, they’ll usually pick one of the corporate officers and name him Inspector of Elections.  If there is likely to be a dispute, they’ll hire one of the Big Four accounting firms.  If you have issues that you want to work out up front (before the meeting) in court, in many states the only way to do so is through declaratory judgment.  If you went for a mandatory injunction, they may say that you’re invading the responsibility of the Inspector of Elections.  But if you ask for declaratory judgment, there may not be a problem.


Ling and Co. v. Trinity Sav. and Loan Ass’n.


On the back of the stock certificate in small print was a notice that transfer of a big block of stock probably would require prior approval of the NYSE.  The person pledging the stock didn’t make his loan payment and the S & L wanted to foreclose and sell the stock.  But what’s the problem?  The rules of the NYSE did somewhat prohibit the transfer, and those rules were not unreasonable restraints on alienation on a common law basis.  The court holds that a straightforward interpretation of Article 8 of the Uniform Commercial Code says that generally speaking, restrictions on transfer must be conspicuously put on the face of the certificate (e.g. full caps or a different color with big type).  Neither one was done here!  The Uniform Commercial Code goes on to say that if it’s a bona fide mortgagee or purchaser for value without notice of this, that person will take free of the restriction.  The court held that since the notice hadn’t been placed conspicuously on the face of the certificate, the trial court should determine whether the S & L had actual knowledge of the restriction at the time that they made the loan.


The second issue was whether the restriction was valid under the Texas Corporation Code.  Shipman claims that they strained a bit, but they found that the restriction was not unreasonable under common law, and thus it would meet the Texas standard.  The Ohio standard is that unreasonable restraints on alienation are not valid, but the case law shows that some strict restraints will be allowed, especially given a good reason.


Security title


In these two cases, the stock certificates have been genuine.  But forgery exists, and it’s a problem!  About a dozen years ago in Japan, a very rich lady went to #6 bank and presented what she claimed was a negotiate certificate of deposit from #1 bank.  It had the lady’s name on it and it was for several billion dollars U.S.  She wanted to pledge the instrument in return for a loan of a few billion dollars.  #1 bank was very solvent.  #6 made the loan, she went through the money really fast, and they had gotten her to endorse the certificate of deposit in blank.  #6 wanted to cash the certificate at #1.  #1 said that it was a forgery!  The government of Japan met and bailed out #6.  How could this be avoided?  If you’re worried about forgeries and you have a negotiable instrument, the bank will want to go to security title.  #6 bank would have told the lady to endorse it in blank.  Then they would say that as soon as they transfer the certificate to their own name they would write her a loan check for $2 billion.  Had #6 followed this procedure, #1 would have noted the forgery and would have told #6 that she was trying to con them.


But debtors will fight security title!  That’s how mortgages came up in England!  If you wanted a loan from a rich dude, then you had to give the dude title to your land.  If the dude failed to give back your deed when you paid the dude back, you would go to the court of equity and force the dude to return the deed.  Note that the parol evidence rule today still recognizes the problem in that one of the exceptions to the rule is that if something appears to be an absolute conveyance is actually a mortgage, then parol evidence can be introduced to show it’s so.



DeadlocksIn re Radom & Neidorff, Inc.


This case talks about dissolution, which has two “flavors”: (1) voluntary and (2) involuntary.  Voluntary dissolution is governed by § 1701.86-.91, where the shareholders vote to dissolve the corporation.  That vote will give the directors authority to sell the assets and .86-.91 will direct the directors (at their own peril!) to pay or make adequate provision for all creditors.  Then the directors will distribute the cash left over to the shareholders.  Once in a great while, it will be an in-kind­ dissolution of the corporation.  If there’s only one shareholder, and they only own Greenacre, then the corporation can distribute Greenacre to the sole shareholder.  That’s rare, because under the Internal Revenue Code §§ 331-338, if it’s a Sub C company, there will be a double tax: one at the corporate level and one at the shareholder level.  That’s why companies often use an LLC.  The tax problems can be overcome if the sale is set up solely for the stock of another company: the whole thing can be tax-free!


Involuntary dissolution comes in two “sub-flavors” at common law: a court can enter an order of dissolution when it finds (1) fraud, (2) oppression (in a close corporation), or (3) deadlock (by statute).  You’ll find these statutes in Ohio at § 1701.86-.91.  They read very much like the New York statute in the present case.  So we’re looking at a particular way of involuntarily dissolving a corporation.  Here’s an important legal point: all dissolution orders by courts are on the equity side of the docket (as opposed to the law side).


What are the facts of the case?  We had a New York statute that on its face was broad in the categories of deadlock and oppression.  There were two directors: the sister and the brother who actually ran things.  Was the sister an employee of the company?  She was not.  Her husband had been a 50% shareholder with her brother and when her husband died, he left his stock to her.  Her husband had been an employee, but she isn’t.  The company is solvent.  It’s making plenty of money because the brother is a good businessman.  This is sort of the opposite of the Hatt case.  The brother and sister don’t get along!  There’s a deadlock!  The board can’t do anything because a majority can never be mustered!  There’s also a deadlock at the shareholders’ level.  If there is a deadlock at the shareholders’ level, the directors stay in place until their replacements are elected and take office.  This is different from the political arena!  If the board deadlocks, the president keeps their ongoing powers!  Recall Wilderman!


At one time, the directors had agreed on the management of the company and the brother was making money for the company.  Shipman thinks that the bank signature card for the company required the signatures of both the brother and the sister.  Usually, only one or the other’s signature is needed.  This is different than the case of Wilderman.  The brother and sister are suing each other!  The sister won’t sign his salary checks!  But he had a very simple remedy: he could have sued under Rule 65 for a temporary injunction.  In Ohio, you would add Crosby v. Bing to that.  He made a buyout offer to her, but it was ridiculously low, even laughable.  His lawyer then moves under the New York statute for an order of dissolution.  Both levels held that the statute says courts “may” enter an order of dissolution, not “must”.  Why would they entertain the notion?


The person seeking equity must do equity.  If the person seeking equity has unclean hands and the other person doesn’t, then you don’t get your relief.  If both people have unclean hands, then you consider their “comparative rectitude”.  Equity orders are heavy stuff!


Deadlocks are fairly common in closely-held corporations.  It’s not uncommon to see these kinds of disputes arise, and they’re pretty difficult.  What’s the lawyer’s duty in this kind of case?  The ABA says that if there is dissention within the “corporate family”, you take orders from the majority bloc of the board of directors.  But here, we go a level beyond that.  The board of directors is split and fighting.  The ABA says that you can’t represent any member of the board and that you should tell them to each get their own lawyer.


Shareholder votingGearing v. Kelly


Here we have two families that come together to start a corporation.  Let’s say that each has 100 shares out of 200 shares outstanding total.  The company they form has no cumulative voting, it has straight voting.  Straight voting means that if you own 100 shares and there are four directors all elected annually (that is, the board is not classified – divided into two or three classes where some are elected each year and others are elected in alternate years), and they haven’t opted to have cumulative voting in the charter, then for each of the four spots, you can cast 100 votes.  To put it another way, you cannot accumulate more than 100 votes and spread them as you wish.


In Delaware, the rule is that if the charter is silent, then it’s straight voting, but if the charter has a cumulative voting clause then cumulative voting will be allowed.  Cumulative voting is not consistent with regular political voting in the United States.  In England and the United States, proportional representation is frowned upon.  Instead, it’s “first around the post”, and the person who gets the plurality wins.  There were three presidential candidates in Ohio in 1992.  Clinton got way less than 50%.  The first around the post was Clinton, and thus he got all of Ohio’s electoral votes.  Nebraska and Maine are the only states with a proportional system.  In many parliamentary systems proportional representation is encouraged, and some of them even use cumulative voting.


The essence of cumulative voting is that you take the number of directors to be elected, multiply it by the number of shares you own, take the product and you can distribute it as you wish.  In good times, the company gave each of the two families two directors.  They went into the annual meeting and agreed to cast a joint ballot of the two shareholders, giving each side two directors.  But one of the directors from one side resigns due to disputes that have arisen.  The New York statute at that time said that the board of directors, in the case of a death or resignation, could elect a successor unless the articles of incorporation stated otherwise.  But there was no special quorum dispensation and no special dispensation on number of votes needed (Ohio has a different statutory scheme and the Gearing problem can arise more easily here than in New York).  Let’s say Jones director #2 resigns.  Smith #1, the chairman of the board, can call a special meeting of the directors.  All statutes and all bylaws and all charters will give him that power.  He gives proper notice of the time, place, and purpose of the meeting, namely, to elect a successor to Jones #2.  If you have a four person board of directors, the ordinary quorum requirement will be three, a majority.  If one director resigns or dies, the ordinary quorum requirement remains the same: a majority of the full board of directors.  So Jones #1 boycotts the meeting at which Smith #1 and Smith #2 elect Smith #3 to the board of directors.  Jones #1 brings an election review proceeding.  In Ohio, you would go to the county prosecutor to get them to bring a quo warranto action.  The judge will appoint the other side’s lawyer to present their side.


What’s quo warranto?  It’s half civil and half criminal!  It translates to: “By what right do you hold an alleged office?”  Jones #1 says that if she showed up, the Smiths would have screwed her over by appointing Smith #3.  She claims that the only way she could keep the balance from shifting was to boycott the vote.  It’s an appealing argument, but what does the court hold?  They say that Jones #1 was bad because she purposely didn’t show!  Thus, they don’t give her any relief.  How do you avoid the Gearing problem with two different classes of stock (class “J” and class “S”)?  How do you handle death, resignation, or disability under the Ohio statutes?  Stick with situations where there is an even number of directors.


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