Business Associations Class Notes 5/25/04

A word about statutes: the first thing you do is read them carefully. Use the plain meaning of the text first; that’s where you start. Most of the time that’s also where you end. But, later in the course, we will spend time with fiduciary duties, which are largely a product of court decisions. Legislatures, by and large, leave the issue up to the courts. Fiduciary duties can take strange twists and turns.

Statutes usually have a long list of definitions at the front, and R.C. Chapter 1701 is no exception. In the old days, these definitions were alphabetical, but about 25 years ago, they gave up, and thus they are no longer alphabetical. We need to read these definitions carefully, noting that they’re in no particular order.

Also, note that the statutes in our little books are about 15 months out of date. Make sure you check the law reporter for something that is totally up to date.

Requirements for a valid vote

It was held in Gearing that the woman, by purposefully being absent from the meeting, sort of “dirtied her hands” in a way that equity is not available to her. This case ties in to the issue of what makes for a valid vote by directors or by shareholders. There are four requirements:

Valid call

There must be a valid call by a person having the authority to call. In Gearing, for example, the guy on the other side appears to have the power to call. By way of explanation, the statutes distinguish between annual meetings versus other meetings scheduled by the charter or regulations (special meetings). In general, the people in charge of a company will give notice of general or annual meetings. The O.R.C. requires that for shareholders’ meetings. As to directors’ meetings, however, the O.R.C. appears to say that the notice for directors of either special or general meetings need not state the purpose. That is contrary to the common law, and if you’re the chairman of the board, you ignore this in practice and give decent notice anyway with the purpose.

Valid notice as to time, place, and purpose

The notice must be valid as to time, place, and purpose. The rules are slightly different for shareholders as opposed to directors. At common law, if it is a regular meeting, in theory, notice need not be given. But in practice, you should not rely on that rule, especially if you’re a public company. If you’re a public company, you must follow SEC rules.

How much lead time do you have to give? Check your charter, bylaws, and state statutes and find out how much notice is required and how you compute it. Be careful! R.C. 1701.02 says there is a “mailbox rule”, more or less. But…Shipman says this is probably unconstitutional under Tulsa Collection, a U.S. Supreme Court opinion written by Justice O’Connor. This is part of the line of cases defining procedural due process for state action. It’s a long line of cases that starts with Mullane from the 1940s. That case involved the settlement of common trust funds. Banks got the New York legislature to pass a statute that individual notice didn’t have to be given to settlees, but rather than publication in a newspaper in Manhattan would be enough. Justice Jackson wrote the seminal procedural due process opinion of all time, and said that this procedure isn’t valid under the Fourteenth Amendment! For known beneficiaries, he said, notice must be given by ordinary mail.

In Tulsa Collection, a will was admitted to probate in Oklahoma. The Oklahoma statute provided that notice must be given within 60 days after publication in an Oklahoma newspaper of the death of the decedent and those who didn’t meet the deadline were forever barred! The facts were that the decedent had a big debt to the hospital for his last illness. The executor was very aware of this and gave no actual notice to the hospital. The hospital failed to meet the deadline! Thus, the executor says: you’re out of luck! Justice O’Connor held that in a “garden-variety” case, there is no state action for purposes of the Fourteenth Amendment. But, she says, where there is a sharp, Draconian period, it won’t govern as to creditors that the executor knew or should have known about. As to those people, individual notice by ordinary mail and a decently long statute of limitations is required. Therefore, the hospital wasn’t cut off from filing their personal claim in the probate proceeding.

Another big case just before Tulsa Collection was a mortgage foreclosure in Indiana, where a first mortgage was foreclosed. Everyone knew that there was a second mortgage and the address of the holder of that second mortgage was known to everyone. Justice Marshall said that individual notice by ordinary mail was required by the Fourteenth Amendment. If you put those cases together, R.C. 1701.02 appears to violate the Fourteenth Amendment. Besides, now we have fax machines and the internet, and thus it makes no sense! In a close corporation, you would generally know how to reach the directors and shareholders by fax or e-mail. If you need to give five days advance notice, just fax it! So you wouldn’t follow R.C. 1701.02 even if it were constitutional.

Isn’t this a little tedious? No, you need to be tedious to get the job done! To get everything right, you better double check the requirements. It’s not simple!

Quorum requirement

Check if the quorum requirement is met! Look at the statute, regulations, and the charter, and if there is a special agreement under R.C. 1701.591, you must look at that too. Those agreements are kind of rare, though. If you have four directors and one resigns, then the quorum remains at three (a majority of the full membership). But a quorum need not mean a majority. Maybe it means that everyone must be there!

There are two big exceptions: (1) Ohio’s statute says: if there is a vacancy in the board of directors due to death, resignation, total disability, etc., then “unless the articles are to the contrary, the remaining directors can fill the vacancy even if the remaining directors are less than a quorum”. This makes the Gearing problem worse in Ohio than it was in New York! (2) What quorum of shareholders is needed to elect directors? It’s tricky! In Delaware, by statute, one-third or more of the outstanding shares must be represented in person or by proxy. Proxy means that you get permission from another shareholder to vote on their behalf at a certain meeting on a certain date. That piece of paper is called the proxy. The person who holds it is called the proxy agent. For a big public company, they will solicit your proxy, as required by federal law. You sign the proxy card and they will send you a stamped return envelope, you put it in the envelope and return it. Almost all proxies are revocable, because it’s an agency that’s seldom coupled with an interest. The interest of the proxy agent in voting, standing by itself, is not enough to make it an agency coupled with an interest.

What are the exceptions again? Let’s say Smith is the President and CEO of Smith, Inc., which is a corporation. Smith owns 100% of the stock. The company runs a mid-sized grocery store. The problem is that the corporation is having financial difficulties. Mr. Smith talks to Mr. Jones and asks Jones to sign a two-year contract with the corporation as general manager (not an officer). Part of the deal is that Mr. Jones will lend the company $200,000. Mr. Jones’s lawyer says Jones will do this only if Smith gives Jones an irrevocable proxy to vote his stock during the two year period. Smith agrees and writes out a document as an irrevocable proxy. The last paragraph says: “This is a proxy coupled with an interest, and it is irrevocable for the two year period.” According to the Restatement Second, that will be a valid, irrevocable proxy for the two years because it’s coupled with an interest.

New York and Delaware, by statute, go even further, saying that if Jones doesn’t lend any money but simply agrees to be general manager for two years under a two-year signed contract, that if a proxy is given and it is stated to be irrevocable, then it will (by golly!) be irrevocable because the statute says so! Ohio doesn’t have a comparable provision. In Ohio, you would go under the common law or R.C. 1701.591.

In Ohio, when it comes to election of directors, the statute itself imposes no quorum requirement whatsoever. Thus, in theory, if a company had 1 million outstanding shares and Mr. Jones, owner of one share, was the only guy who showed up to a duly called meeting to elect directors, then unless the charter or regulations provide otherwise, Mr. Jones is a valid quorum! This seems like a shock, but this is true of presidential elections too! If only 10% of the people voted, the election would be just as valid as if 40% of people voted!

Valid vote

In all states, once there is a valid quorum at the shareholders meeting, the vote requirement is simple. You need a plurality. It’s the English/U.S. “first around the post” political scheme. It’s non-proportional representation!

Shareholders can vote by proxy, but directors cannot. They vote only if they show up at a meeting. But there are two exceptions. Delaware and Ohio statutes say that if you have a valid telephonic hookup on which all directors can speak to each other, then the vote taken telephonically will be binding. The statutes also provide a handy tool: action can be taken without a meeting if you have all directors or shareholders sign a document whereby they assent to a certain action! The signatures need not be on the same document if you send out counterparts to everybody and they sign and return them by fax or mail. You can collect up the piece of paper and collectively it will be enough. You can even have a joint meeting of shareholders and directors!

In Delaware, there’s a statute that sets out the consent procedure. If Smith owns 51% of Smith, Inc., which can be a public or private company, then Smith, without a meeting, can file a consent which will be just as valid as if a meeting took place. Shipman considers this barbaric! But there are two cautions: if it’s a public company, then under § 14(c) of the Securities and Exchange Act of 1934, you have to send of notice to all shareholders. Once the action is taken, the statutes generally require that minority shareholders be advised. We only have this procedure in Ohio in a couple of specialized sections. One of them is waiver of preemptive rights under R.C. 1701.15.

Suppose the articles provide for four directors, three of whom are present. The fourth has died. The remaining directors haven’t elected a replacement yet, and the articles of incorporation preclude that procedure. The three directors show up. That’s a quorum, unless the articles require more. Let’s say valid notice has been given. If the vote on a resolution is 3-0, then unless the articles or regulations provide otherwise, that’s a valid board action! What if the board votes 2-1? It’s tricky! If the regulations or the charter require a majority of the four, then 2-1 doesn’t cut it. In many states, that will be valid action, and that’s why in Gearing the lady didn’t show up. What if there’s one vote for and two abstentions? There’s a quorum. Do we match the one against the one voting, or do we match it against the three who aren’t voting? Generally, this will not constitute board action. There is some material in the Revised Model Act that goes the other way.

Cullen v. Milligan is an Ohio case involving R.C. 1701.95, which says that for purposes of liability on dividends, a directors who is present and does not vote no will be deemed to have voted yes. The only way to avoid liability under R.C. 1701.95 is to vote. The question in the case was whether the statute applies to issues other than dividends, and the answer was no, it doesn’t. In Delaware and most United States jurisdictions, directors are far more “under the gun” than in Ohio. The common law rule, codified by statutes in most states, says that in order to avoid liability as a director on an issue, if you’re present you must (1) affirmatively vote no and then (2) turn to the corporate secretary and say “Please enter in the corporate minutes my formal dissent from the board action!” If you’re absent from a meeting, you must get the minutes as fast as possible, and if you disagree with what the board did, you must register your dissent by registered mail to the corporate secretary.

What’s the big deal? The majority rule is very counterintuitive to laymen and a lot of lawyers. If you’re a director of a Delaware corporation and they’re doing something foolish, you need to vote no and also make sure it’s reflected in the minutes that you dissent. The Ohio rule isn’t so demanding, because if you turn to the secretary and say “I vote no”, then you don’t have to take the second step of formally entering a dissent to the board of directors. The majority rule is not only counterintuitive, but it also builds up bad relations on the board. It’s annoying enough to vote no! But when you turn to the secretary and dictate your dissent, it really ticks people off! But there is a time not only to vote no, but to make sure you enter your dissent into the minutes. The way corporate cultures operate, once directors get the agenda for a meeting and they decide they’ll vote no, they tell the other directors in advance. This is often enough to kill the action.

As to shareholder votes, in Delaware, the general rule is that, unless the articles provide otherwise, when shareholders act on matters other than election of directors, for the shareholder vote to be valid, over 50% of all outstanding shares must be voted affirmatively. In Ohio, the rule is stricter: if the articles and regulations are silent, then for a lot of actions (like merger) the requirement goes up to two-thirds. If you are a public company, you will hire a proxy-soliciting firm such as D.H. King Co. If the meeting has been validly called and valid notice has been given then if a majority of those present vote yes, then you’re okay. You see how abstentions can screw things up.

If you have an even number of directors, cumulative voting will generally prevent a deadlock in the election of directors. If there are an odd number of directors, it usually will not help. For more information, look at Aranov & Einhorn’s Proxy Contests. It’s old, but good.

Here is the math. First, you can’t form a company in Ohio with straight voting. Your initial formation must be with cumulative voting. However, if you go to R.C. 1701.61-.72, you’ll find that after formation, if you get the requisite shareholder vote, you can amend the articles to go to straight voting. The required vote will usually be (1) two-thirds plus (2) if the vote against is enough to elect one director, then the amendment doesn’t pass.

Say you have four directors. All of them are elected annually. The majority of the directors want to go to straight voting. They call a meeting under R.C. 1701.72. Frank is a minority shareholder who owns 21 shares. He can elect one director. So if he votes no, we can’t switch to straight voting. But that’s not the end of the story. The majority can form a mirror image Delaware corporation, and if your articles are silent on cumulative voting, then there is no cumulative voting. Delaware is like most states! Then they can merge the Ohio and Delaware companies, which will require two-thirds of the outstanding vote. But what’s the problem? On the merger of the Ohio company into the Delaware company, Frank will be entitled to appraisal rights and the fair market value of his 21 shares in cash. If he held only 20 shares, the charter amendment could go through and there would be no appraisal rights.

Here are a few more procedural points on the Ohio system: it will be straight voting unless one or more shareholders states before the meeting that it will be cumulative voting and the secretary gives notice to everyone that it’s going to be cumulative voting. Why? If someone thinks it’s straight voting and shows up and it’s really cumulative voting, that person will get screwed. Cumulative voting works only if everyone knows the rules in advance. That’s fairly common in all states.

Let’s prove the deal with odd and even numbers of directors. Let’s say we have an Ohio corporation whose charter says nothing about cumulative voting, meaning that there is cumulative voting, because the statute says so. There are 200 shares outstanding. Smith owns 100 and Jones owns 100. There are four directors, and they are all elected annually, that is, it’s not a classified board of directors.

How will the two sides likely vote? From game theory, we assume that each side uses minimax theory, meaning that each side is highly rational and will vote to minimize harm to themselves while maximizing the upside. This is a rational model, which isn’t to say that it always reflects the real world. So how will the two sides likely vote? Take the number of shares times the number of directors to be elected. Thus, each side has 400 votes. The statute says that you can accumulate and spread among one or more of the four as you wish to maximize your situation. The ballot will likely come back with 200 votes for each of Jones-1, Jones-2, Smith-1, and Smith-2. Let’s assume all the requirements for a valid vote have been met and that there has been notice given that cumulative voting will be happening. The Inspector of Elections issues a certificate of the result. There were only four candidates, and therefore a new board will take over! If any of these people are different from the old directors, the old people will be pushed out!

Here is a different case: say there are only 3 directors, all elected annually. One or both sides demands cumulative voting and the secretary gives notice. There is proper call of meeting, proper notice of time, place and purpose, the charter is silent concerning cumulative voting, meaning that in Ohio, voting will be cumulative. (In Delaware, if the charter is silent, we’ll have straight voting.) Jones-1, Jones-2, Smith-1, and Smith-2 will all get 150 votes! But then there’s a deadlock! No one is elected! There are no three directors with a plurality over the fourth! The result is that the Inspector of Elections will enter an order than no directors were elected at the meeting and that the old board of directors carries over. Don’t forget that in the corporate world, when it comes to directors and officers, you’re elected to serve for a term plus so much longer, if needed, until your successors are duly elected and qualified. (What does qualified mean? When someone gets elected to be a director or officer, have them send a letter of acceptance.) Cumulative voting prevents deadlock in the election of directors only when there is an even number of directors.

How do we get around this? In the Jones/Smith hypothetical, there are three Joneses and three Smiths who want to be active in the company. Each is contributing a lot of cash. Let’s say we’re counsel for the Jones family and a different firm is counsel for the Smith family, while a third firm altogether is counsel for the new company, to be formed.

How do we advise Ms. Jones, who will be the CEO, and who will have two sons active in the business as directors? How do we avoid the Gearing problem? We can set the board at six, and since that’s an even number, we’ll get three from each family. But that doesn’t deal with Gearing! What happens if the two sons get killed in an accident? The other side can call a director’s meeting and replace the two sons with directors favorable to their side, and you’d be stuck that way until at least the next annual meeting.

One way to get around this is with a R.C. 1701.591 shareholder agreement. But these aren’t used much. The legal fees are pretty high! Also, you have the same problem that you have with prenuptial agreements. A third of the time, you can’t negotiate the agreement! And if you can’t negotiate the agreement, maybe you shouldn’t get married! Also, if you get too much down on paper, you won’t get a deal. Also, sometimes when you get lawyers involved, they’ll want to kill a deal over a very small provision.

So what if we have two classes of stock, let’s say Class J and Class S? Under Ohio law, you can have two classes and you can have the charter provide that the two classes are exactly the same except that each class will annually elect three directors, voting separately. You can provide further that no board of directors’ action will be valid unless at least one member of each class of directors votes yes. Then, to go against Gearing and the Ohio statute, you can provide that if there is a vacancy in the J directors, then just the Class J shareholders will be called to a meeting in order to vote for a replacement. You can provide that the board of directors will have zero power to vote for a replacement.

You can also have Class J voting, Class J non-voting, Class S voting and Class S non-voting. If the big kahunas of each family want to give gifts of shares without screwing up voting powers, then the kahunas can give non-voting stock. You can have classes of stock that are almost entirely non-voting in many states. However, in other states, all shares must have a vote. Sometimes the statutes and constitutions don’t mean what they say! Maybe the founders have shares with 100 votes per share, but the publicly issued stock will have 1 vote per share. Often, that will satisfy state statutes and the state constitution. In Ohio, in a given class, each share in a class must have the same voting rights according to R.C. 1701.44. In Delaware, the rule is different. In Providence & Worcester, a clause said that if you own 300 shares or less, you have 1 vote per share, but if you own more than 300 shares, than you only have 1/10^th of a vote per share. This was in the original charter of the old railroad, and it served as an anti-takeover provision. Later, as applied to Cincinnati Millicron, there was a shareholder vote to have the same thing, and Delaware courts allowed them to add this clause. In Ohio, however, a P & W provision is not allowed. You would have to have different classes of shares in order to have different voting rights.

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