Business Associations Class Notes 5/26/04

The Ohio case in the 1880’s against Rockefeller and his trusts were the source of the term “antitrust”. There are several federal antitrust statutes (such as the Sherman Antitrust Act), and in Ohio we have the Valentine Act. Tomorrow, we’ll cover ultra vires and read the Litwin case. In that case, we’ll find that what the officers and directors did was contrary to the bank’s charter. The plaintiffs’ shareholder derivative action had two counts: (1) negligence and (2) ultra vires. The plaintiffs claimed that since what the officers and directors did was ultra vires, they had liability without fault (i.e. strict liability). The court said that the plaintiffs had it wrong. They said that in the corporation area if what an officer or director does is ultra vires, it’s not strict liability, but rather evidence of negligence.

Why did the plaintiff make the argument that he did? In the trust area, if you’re a trustee or an executor or administrator of an estate, and you do something ultra vires, the trust rule generally is that of absolute liability without fault. That rule is related to a rule on conflicts of interest. Unless a trust instrument provides otherwise, a trustee who sells stock to the trust which later goes down in value has absolute liability. Fault need not be shown. In the corporate world, if (1) a conflict of interest is fully and fairly disclosed up front, (2) there’s no injury to creditors and (3) what the director or officer did was reasonable then there is a defense. It can be hard to show those three things.

Why is there a difference between the corporate arena and the law of trust? The law of trust and executors and administrators is designed to deal with the conservation of capital, and the law of business associations deals with the same thing. However, the law of business associations is more entrepreneurial in that it also takes into consideration reasonable risk taking and growth of capital. We’ll see this again in Wills, Trusts, and Estates. The ultra vires stuff is important. What is the lawyer’s role? What are their possible liabilities?

In a major corporate transaction, the third party dealing with the corporation will usually ask his counsel and the lawyer for the corporation whether the contract has been duly and validly adopted by the corporation and is binding on the corporation in accordance with the terms of the contract. This includes, if needed, the approval of the board of directors, and, if needed, the approval of shareholders, but most transactions, even if fairly large, don’t require board and/or shareholder approval. The officers of the company can do a lot by themselves. We will see more on the authority of officers. The lawyer will have to draw up a memo saying whether shareholder approval is needed, whether it has been obtained, if the shareholders are entitled to appraisal rights, whether you need the approval of the board of directors, whether there has been a validly called meeting, whether papers have been circulated, whether you have the right vote, and finally whether the officers have the authority to do what they’re purported to do.

The attorney for the corporation may want to strike the word “duly” and leave “validly”. The two terms are not synonyms! If they were synonymous, they wouldn’t both be used. “Validly” means that “the holy water may not have been sprinkled on right, but it’s still a valid transaction.” When you add “duly”, it means that it’s been performed “in a way that would please a grand hall monitor, superintendent of an authoritarian school; square corners have been turned and everything has been done right.” You have to get the right papers at closing! You can have big headaches in court in the future, even if you win!

In the last 15 years, the Silverado accords have become a big deal. Some lawyers had a retreat and talked about how opinions ought to be worded. If you’re asked to give an opinion subject to the Silverado accords, don’t sign it right away! Double check the definitions! They’re “wacky!” Careful lawyers will add reservations related to environmental laws, RICO, equity orders, and doctrines of good faith and commercial reasonableness. They will also add a section dealing with fraudulent conveyance statutes. “They are murder!” Sometimes you can’t get around this stuff, though. To limit costs, sometimes the other side will accept an opinion of the corporate counsel if, to the best of their knowledge (not having audited or anything like that), “X, Y, and Z are true”. Then there will be a paragraph that describes when the firm is on notice of certain facts. The point is that this is tough stuff. In opinions, you’ll always have to consider ultra vires.

Some big limiting factors on corporate power are loan agreements, mortgages, notes, and other instruments that you’ve signed with creditors. The other side will ask for an opinion saying that these old agreements don’t run against the new one. So ultra vires is a big deal! Pay attention to it! It’s very important in practice!

Organizing the company

The naming of corporations and LLCs is getting sticky! It’s mostly a matter of state law, but not entirely. There are two or three things you can do. In most states, you can pay $10 or $15 to reserve a name for 30-60 days. Shipman says this is wise! It makes sure that no one else has a name similar to what you’re reserving. What if you’re a Pennsylvania company and you want to come in Ohio such that in Pennsylvania, your name doesn’t conflict, but in Ohio it does? Let’s say your name in Pennsylvania is “XYZ Inc.” We look at Ohio’s assumed name statute. You get an overstamp. You basically say: “We are actually XYZ, Inc., a Pennsylvania corporation. But in Ohio, we’re doing business as Smith, Inc.” If you think you’ll do business in several states, reserve the name quickly because names are important. In Ohio, if a general partnership owns land, then unless the names of all the partners are in the firm name, the partnership must file an assumed name certificate, which is enforced when you go to sell land: if you haven’t done it, you can’t sell!

Trademarks, service marks, and trade dress overlap with local statutes somewhat. There is also the Lanham Act that allows many of these suits to be brought in federal court. These statutes are distant relatives of the patent and copyright statutes. They’re sort of types of intellectual property statutes.

In all states, when you authorize the issuance of stock, you must describe it as either common or preferred stock and you must give the par value for the stock. In Ohio, by a recent amendment, you can name the initial directors in the articles of incorporation. It used to be the case that there was an incorporators meeting, and essentially things got complicated. So the new, simpler method is better. Also, in Ohio, you’ll have to have a shareholders’ meeting early on because only the shareholders can adopt the permanent regulations.

Regulations and bylaws

What we call regulations in Ohio are called bylaws everywhere else, including Delaware. In Ohio, the shareholders must adopt the permanent regulations with a couple of minor exceptions found in the statute. That’s populist. At the other extreme, Indiana requires the directors to propose and the shareholders to vote upon any proposal to amend the bylaws. That means shareholders acting by themselves cannot amend the bylaws! Well, what’s in the middle? Delaware, which is very complicated. Either the directors or shareholders may, at a meeting properly called with proper notice, adopt or amend bylaw provisions. However, the board of directors can’t tinker with what the shareholders have done.

In Ohio and two other states, the shareholders, acting alone, can also amend the articles of incorporation! That’s virtually unheard outside of Ohio and a couple of other states. That’s very populist. Shipman thinks it’s right. We’re also one of the few states where shareholders, acting alone, can vote to dissolve the corporation. We’re only one or two or three states where that’s true.

There’s a lot of work in advance that goes into forming a corporation. There are tax factors, licensing, zoning, permits, bank account forms, insurance, and all kinds of other things. “The biggie not covered yet in the casebook is compliance with Ohio and federal securities laws.” We’ll get to that soon.

Lastly, all states have provisions concerning foreign corporation (meaning out-of-state) qualifying to do business in that state, e.g. R.C. Chapter 1703. Why do we have these? (1) They’re a big aid to the tax authorities to know who to tax. (2) One of the requirements of these statutes is to designate a registered agent for service of process. Let’s say a Delaware corporation has its main offices in New York City. If it’s subject to Chapter 1703, they must file a consent to service of process. They will often name a corporation service company, such as CT Corp. They must also have a registered office in Ohio. CT Corp. can provide that for them too.

Why do people resist this so much? The consent to service of process statutes don’t stop with torts in Ohio, but govern torts worldwide! If you’re a Delaware corporation with your main office in New York and you’re qualified to do business in Ohio but also do business in the Philippines, you can be sued in Ohio! But how do these statutes fare under the Dormant Commerce Clause? The U.S. Supreme Court has held that if there is some kind of business operation, like an office or store or property or mine in the state of Ohio, then that breaks the chain of interstate commerce enough for Ohio to regulate the business. If the corporation simply mails things into Ohio, then even though Ohio courts would have jurisdiction over that company in a products liability case, the Dormant Commerce Clause precludes Chapter 1703 from applying.

Bendix was a case regarding Chapter 1703 and also a separate tolling statute in Ohio. That statute says if a defendant in an action has been out of the state, then in computing whether the statute of limitations has run, you “carve out” the period of absence and don’t count that. For example, a plaintiff’s medical malpractice usually has a 12 month statute of limitations. If the guy comes in to see you 12 months and two weeks after the event, but the doctor was out of the state for three weeks during that period, then the statute of limitations hasn’t tolled! You’re still timely! Wherever you’re taking advantage of a tolling statute, the plaintiff must plead a good prima facie case for tolling or else they’ll get booted out on summary judgment!

So Bendix was an Illinois corporation that delivered equipment to an Ohio vendee and installed it in the vendee’s plant. Chapter 1703 exempts that from having to qualify to do business in Ohio. Four years and two months later, a fraud suit against Bendix was started in Ohio courts. (Remember that delivering and installing machinery constitutes minimum contacts if there’s a long-arm statute!) Also remember that the plaintiff’s complaint must clearly plead why he is within the statute of limitations. The vendee said that based on the absence statute, the company could have qualified to do business in Ohio, but they didn’t qualify to do business in Ohio, and thus they’re absent from Ohio! But Justice Kennedy held that the statute was discriminatory against interstate commerce, and the tolling statute was knocked down. With the tolling statute knocked down, the general Ohio four-year fraud statute of limitations booted the vendee out of court! The question is: why the heck did they wait that long? There’s malpractice somewhere. So unless you can find a compelling state interest to justify the restriction on interstate commerce, the statute goes down as unconstitutional!

Pre-incorporation contracts – Stanley J. How & Assoc., Inc. v. Boss

What’s involved here? Check out the signature lines! Ed Boss signs for a Minnesota corporation that hasn’t been formed yet! The corporation is to be the obligor. But the corporation isn’t formed and there’s a suit by the architect against the promoter. This case represents the majority view in American law. It’s even more the majority view under English law. How come? It’s an axiom of agency law that if there is a non-existent principal and the agent knows it, and the agent signs on behalf of the non-existent principal, then the agent is absolutely liable. Does this seem harsh? Courts want someone liable on the contract. They don’t want legal “airballs” out there. Is there American authority to the contrary? Yes, in the Quaker Hill case in the notes, the vendor twisted the promoter’s arm, and the promoter signed the way that Boss did. They found that the usual rule was not fair under those facts. But that’s a minority rule.

What happens if the corporation is formed? If the corporation is formed and you have a highly formal document, namely, a 3-way novation agreement, then it will clearly be valid. A novation is a recognized “animal” of contract law. But things usually aren’t that simple!

The McArthur case talks about ratification and adoption, which are agency terms both in tort and in contract. In torts, we learn that even if there is no authorization up front and even if respondeat superior doesn’t apply, if the principal ratifies the tort afterwards, then you may sue the actual tortfeasor and the principal. For example, if you’re a bus company superintendent and a driver comes in saying: “I socked this dude on the bus to teach him a lesson because he was annoying me”, and then the superintendent says: “I woulda hit him three times”, then that is implied ratification, and the company will be liable. Ratification can be implied.

How does this come up in the context of pre-incorporation contracts? In McArthur, we’re in Minnesota in the 1880’s. First off, the promoter and employee orally agree on a 14 month employee contract. On April 2, the corporation is formed and the board of directors meets. They have knowledge of the oral contract of employment made by the promoter in January. They approve! Then, on July 2, the employee is dismissed without cause. The employee sues for damages against the corporation. It’s not an action for specific performance! It’s a legal action.

What’s wrong here? In the old days, and the new days in some states, partial performance doesn’t take a contract outside of the statute of frauds. At the time, there was no strong partial performance doctrine! The employee says that this was ratified by the board of directors, and therefore the corporation is bound. The corporation gives two defenses: (1) under British law and many American states, if the principal was not in existence when the agent made the contract, then there can be no ratification because the ratification relates back to the original event, and there was no corporation in existence on that date! Besides, if you relate it back to that date, you’re in violation of the statute of frauds! So this seems like a good argument. But what the court held was that there is a separate of related doctrine of adoption, and that the board could not ratify on April 2, but it could “hop over one compartment” and adopt, which doesn’t relate back to January 2. When we put the day at April 2, there are 11 months to go, and there is no statute of frauds problem. The doctrine of restitution would apply to any corporation that is formed.

What about the lawyer who does the work of bringing a corporation into existence? Does the lawyer have a right to get paid when the corporation is born? The cases are split. Let’s say Peter Promoter walks into your office with his wife, Paula. They want to promote a company and it will take a lot of complicated and detailed work. Can a lawyer represent both of them? You have dual clients. Under Canons 5, 4, and 9 of the Ohio Code of Professional Responsibility, you must warn them (1) of the potential conflicts between them, (2) that there is no strict attorney-client privilege and that what one tells you can be discovered by the other, and (3) that there would be advantages to each one having their separate attorney. If, knowing this, they still want you to represent them, that’s fine, with a major caveat: on every major matter, you would have to stop and explain how the major matter is favorable and unfavorable to each client. It’s a same thing when a married couple comes in and wants you to craft both their wills. This can get hairy!

Here’s a widely used hypo from CLE symposia: H & W come in and want you to draft both of their wills. The ordinary will is fully revocable until the person dies and/or goes crazy (AKA “lose mental capacity”). You draft the wills, and married couples will usually leave to each other. Three months later, W calls, saying that she wants a new will drafted leaving everything to her lover. So the first question is whether you can do that. Of course you can’t! What else do you have to do? At a bare minimum, you must phone the husband and tell him, at minimum, that you can no longer represent him vis-à-vis the will, that you’re no longer representing the wife, and that he should immediately go to a new lawyer to make a new will revoking the old one. You also have to tell the wife that you can no longer represent her at all. Representing joint clients can get sticky! Some say you have to tell H about the lover. Shipman supposes they’ll get the message when you tell them to go get a new lawyer and a new will. What if the husband says, “Why are you telling me this?” You want to make sure that nobody gets killed. Later, we’ll talk about quasi-clients in the corporate area: they’re not quite joint clients, but you incur the same duties. There are also third-party non-clients who are in privity of contract with you, for example: if you represent a corporation selling Greenacre to a third-party, and that party wants your opinion that the contract is cool, and you address the opinion to that party, that is a third-party non-client who is in privity with you. You can be liable in negligence on the opinion to him!

Here’s a hypo we were supposed to think about: Mrs. Smith wants to buy some land for a corporation that hasn’t been formed yet. She doesn’t want the land for herself, but only for the corporation. Can she assure that the land is available if she forms the corporation? She’s not sure if she can get loan from her husband and parents. We’ll represent Smith and the corporation but not anybody else because the conflicts are too strong. From Stanley J. How, we find that a contract between the corporation to be formed and the owner would leave her holding the bag if the corporation isn’t formed. The thing to do is to pay the guy to have an option running a few weeks. The option states that it may be assigned to a corporation to be formed. If the formation of the corporation goes ahead, she assigns the option to the corporation for the cost of the option. If the corporation doesn’t get formed, she’s only out a few hundred dollars for the cost of the option.

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