Business Associations Class Notes 6/1/04

We’ll pierce the corporate veil tomorrow! We should re-read Assignments 12 and 13.

More on premature commencement

We’re on premature commencement, de facto, de jure, and all that stuff. Last time, we had worked our way through Assignment 10(d) and cases under the old Model Business Corporation Act. Under that Draconian and straightforward position, are you going to hold mere inactive investors to the same liability standard that you hold active investors? The courts said no, because the very purpose of corporate statutes is to encourage investment especially by inactive investors and you don’t want to be Draconian. Note that in Ohio and Delaware statutes such R.C. 1701.922 (only a dozen years old, and which mirrors the Delaware statute) are extremely protective, and after giving a lot of protection in the statute, it states that it does not limit or displace common law doctrines such as de facto, estoppel and so on.

Frontier Refining Company v. Kunkel’s, Inc.

This case arises in a state that had the old Model Act formula: “digital, either one or zero; either you’re perfectly formed, or you’re out of it, baby”. We had odd facts. They’ll blow your mind! Just what are the facts here? A promoter wanted to start a gas station. Kunkel needed additional money and he went to two prospective investors: Fairfield and Beach. He asked them to invest in the gas station. This case shows why investors should get a letter from the corporate lawyer stating that the corporation is validly and duly created under state law. The two guys wrote checks to the promoter, who promised to form a corporation, but never did. The promoter goes to the owner of the service station and enters into contracts under the name: “Kunkel d/b/a Kunkel’s, Inc.” However, he never went to the Secretary of State and he never filed a charter!

The business went belly up! The seller of the gas station wasn’t paid! So the seller sues the promoter and the two investors. The testimony at trial was disputed. There are six different theories the lawyer and client will usually put forward: (1) general partnership, (2) agency, (3) joint enterprise, (4) statute, (5) third party beneficiary, and (6) guaranty.

The joint enterprise theory, like agency, covers both profit-making activities and all other activities (i.e. not just business activities). There is some case law in Ohio suggesting that joint enterprise is alive and well! Here’s a hypo showing how this theory might be used: two guys, Jones and Smith, go hunting in Jones’s car. They have a hunting license. They’re hunting during the deer season and they agree that if they kill a deer, they’ll take it back, dress it, put it in cold storage, and then sell the meat. Is that a partnership? If it’s an isolated incident mixing business and pleasure, it will almost never be a partnership. Partnership is co-ownership of a business for a profit. But on the other hand, the courts have applied partnership to lottery tickets! One guy gives $5 to another guy at a bar to buy a $10 ticket. The other guy buys it and wins big. The court has found that they are partners!

The joint enterprise theory is never applied to the ordinary carpool to work. Imagine Jones is driving his car, is negligent, and runs over a baby who is not negligent. Jones is judgment-proof, but Smith is wealthy. The plaintiff’s lawyer is looking for someone who will bleed green. The plaintiff sues Jones and Smith jointly and severally. In many states, the plaintiff will win, but in other states the theory has been pushed backwards.

If there is co-ownership of a business for profit, it fits the general partnership statute, and you can reach all the partners individually. Another category is the third-party beneficiary. It may be that contractual dealings between the capitalist and sweat equity have created a third-party beneficiary. If they have, a third-party beneficiary can sue in contract. The next-to-last theory you look at is guaranty. If Smith, Inc. goes under, but Mr. Smith, the 100% owner, has guaranteed the debts of the company, then you can sue Mr. Smith. In some states, the statute of frauds may be waived.

In the present case, if you read the Wyoming statute on defective formation carefully, it seems to say that people who act like a corporation even though they’re not approved to be one will be jointly and severally liable for the corporation’s debts and liabilities. Here, the two outside investors are a bit difficult to put in the category of mere inactive investors. It’s not as though someone is going to his uncle and is getting a $5,000 loan. It’s not 100% clear, but Shipman’s reading is that they disregard the statute and go to the theory of estoppel because when the entrepreneur failed to make his monthly payments on what he had borrowed, Frontier sued him in his individual capacity. They sued Kunkel d/b/a Kunkel, Inc. and got judgment against him in his individual capacity. The paperwork that he signed with Frontier was all signed that way, and the court’s holding is based on estoppel. They simply hold that because the fellow was dealt with as an individual, the Model Act provision that might have made the investors jointly and severally liable was inapplicable. Shipman thinks it’s a close case and the investors took a big risk. They should have gotten a lawyer! (Of course.)

More on ultra vires

Ultra vires and “no authority of agent” are two different defenses. Let us see why. Ultra vires means that the corporation itself, acting through all of its organs (officers, directors, and shareholders) simply does not have the power. On the other hand, when you say that the agent did not have actual or apparent authority, it’s entirely separate. The corporation is saying that the action is something that the directors and/or shareholders should have approved. This is quite separate, though related to ultra vires at times.

Suppose a particular corporate action is illegal. Shipman believes that it is a separate defense from the other two, though it is very closely related. If you’re trying to enjoin an action as a shareholder, and the directors have violated a statute, you will usually add illegality as a count of your suit. The question will be: does the statute, as interpreted by the court, give standing to a shareholder to raise the illegality issue? It depends! This question usually comes up under the rubric of “implied private right of action”. We use torts lingo. Note that illegality includes criminality but is broader than criminality. If certain conduct violates a criminal statute, the conduct will be both criminal and illegal. But if it only violates a civil statute, the conduct will not be criminal but will still be illegal.

Note that sometimes this is part of contracts lingo, though under a different name. If a contract is void as against public policy, either party may get a judicial determination stopping the prospective performance of that contract. This is similar but different from the “implied private right of action”. In Ohio, under the securities statute, R.C. Chapter 1707, there are three or four express private rights of action, R.C. 1707.38-.45. But in those sections, it explicitly says that the courts will not imply private rights of action beyond what we the legislature have expressly stated. However, despite that language, the Ohio Supreme Court has held that if you have a contract to be performed in the future and that contract is in material violation of R.C. Chapter 1707, either party can come into court and get a declaratory judgment saying that the contract shall not be performed.

The hypothetical from Thursday

X, Inc., a closely-held Ohio corporation formed in 1921 to do manufacturing, states the purpose in its charter to manufacture industrial goods. It has never amended its charter to broaden that purpose. Two items come before the board of directors. I’m the outside legal counsel for X, Inc., and the board of directors and officers want my opinion on both items. First, one of the officers thinks that investing $500,000 in the capital stock of a big NYSE natural gas company would be a good investment. The directors ask me whether this would be ultra vires. In R.C. 1701.13, a lot of powers are given to the corporation and they don’t need to be copied into the charter to be valid. Generally speaking, according to the statute, ultra vires cannot be raised as a defense by the corporation itself, but that the provision does not limit quo warranto actions by the state. The provision also doesn’t limit officers’ and directors’ liability. Finally, non-complicit minority shareholders of the company can bring injunctive actions to prevent ultra vires contracts from being performed so long as the judgment setting aside the contract is not grossly unfair to the other party to the contract.

But that’s not all! Lawyers are always looking to protect themselves. “It’s a jungle out there!” Lawyers have malpractice liability to worry about. We may be asked to render an opinion that a contract has been duly and validly adopted and is enforceable in a court by its terms. We may have to render an opinion to our company and also to a third party.

Assuming that the company is solvent and has the money to invest and assuming that the board and officers have done their research in investing in the NYSE, one of the express statements of R.C. 1701.13 is that for companies like X, investing as a pure investor without control in a company doing something different from what your company does is not subject to an ultra vires objection.

Let’s assume that the company is financially solvent. One of the officers wants X to purchase 100% of the capital stock of Z, Inc., a closely held Ohio corporation producing natural gas in Northeast Ohio, where X has its plants. If X had been formed in 1980 and the lawyer had put in “any lawful business” as the purpose, there would be no problem. We would simply make sure they had done their due diligence on Z, and that they have the money to do it. But this is a 1921-formed corporation with a specific purpose: to manufacture industrial goods. R.C. 1701.13 says: if you’re buying control of another company and that company is not within your purposes, then it can be ultra vires! Why do we say “can” instead of “will”? It probably would be ultra vires, but there’s the possibility that it won’t be, if Z’s natural gas wells are very close to X’s plants and X would plan to use the natural gas produced by Z to run their manufacturing plants. Then it would be the same situation as Jacksonville (see Hamilton, notes, p. 277).

But let’s say X is getting their natural gas from a utility and they’re happy with it. We would tell X to look at R.C. 1701.69-.72 and propose an amendment to the articles of incorporation to allow the corporation to run for “any lawful purpose”. That will probably give rise to appraisal rights to shareholders voting against the amendments. There will probably be no problem if X is closely held.

One more point on ultra vires: if all shareholders, voting and non-voting, approve after full and fair disclosure in advance and if creditors are not hurt by the ultra vires action, then the ultra vires cause of action disappears insofar as shareholders are concerned. There are two people who can come after you: the state can come after you in a quo warranto action. Also, if what you’re proposing may violate agreements with creditors and the creditors don’t assent, then the creditors can shut down the transaction. As important as the articles are, the credit instruments of any corporation (from Exxon down to Mom ‘n’ Pop, Inc.) are just as important, if not more. In real life, you’ll find yourself negotiating with creditors for waivers, you’ll read these credit instruments to find out what is proscribed and what is allowed, and some of the credit instruments get very long and detailed.

More on attorneys’ opinions and disregard of the corporate fiction

One thing you have to often right an opinion about is whether stock has been duly and validly issued and non-assessable. Another opinion that must sometimes be given is on whether the corporation is duly organized and existing as a corporation under Ohio law. Clients will press lawyers for a third opinion: that they, as shareholders, will not be personally liable for the debts, liabilities and obligations of the corporation. Attorneys will not touch that opinion “with a 50-foot pole”! There are six or seven theories out there for disregard of the corporate fiction. You can discuss with a client the things they can do to minimize the problem, but the legal opinion is that you simply cannot and should not give that opinion.

However, it is an uphill battle for people asserting disregard of the corporate fiction because legislatures have purposefully set up corporate statutes and other statutes to encourage investment by inactive investors. The very first thing that an inactive investor wants is assurance that you can only lose what you put into a stock and no more. For example, consider the case of Abbott v. Post from 1940. This case involved the pre-1933 National Bank Act dealing with insolvency of national banks. Before 1933, national banks had to issue $100 par common stock. That means the shareholders had to pay at least $100 per share of stock to the company when it was issued. The act also provided that if the bank went insolvent, each shareholder could be assessed up to par.

What was done in 1933 to encourage investment in banks? They prospectively did away with the assessment of stock. Also, both the Hoover and Roosevelt administrations set up the Reconstruction Finance Corporation, whose job was to pull banks out of bankruptcy. It was run for many years by Jesse Jones, a very wealthy businessman from Houston. The banks all went to Jones wanting loans from the RFC. He checked their balance sheet and told them that they couldn’t afford to make the interest payments. Instead, he caused the RFC to buy preferred stock of the banks, and as the banks recovered, the RFC redeemed the stock and over the years managed to break even.

This case involves a big investor in a national bank who went to a lawyer before he invested. The lawyer told him about the double liability provision. So this investor formed a personal holding corporation, put money into the corporation, and then the corporation bought the stock in the national bank. The investor was the only shareholder of the corporation. During the Depression, that national bank went belly up! The U.S. Supreme Court held that there was a strong pubic policy involved and the sole shareholder of the personal holding company could and would be reached. This had no application post-1933 because to sell stock of national banks, Congress prospectively did away with the rule.

What’s the importance in Ohio? During the Great Depression, Article XIII § 3 of the Ohio Constitution was adopted, which generally forbids assessability of stock. That’s where you start Ohio research about disregard of the corporate fiction.

Bartle v. Home Owners Coop.

The parent is a non-profit corporation composed of World War II veterans seeking inexpensive housing. The not-for-profit cooperative formed a 100% owned stock subsidiary which constructed houses and sold them without profit to the veterans who were members of the parent cooperative. There is no fraud or “sham” alleged (those are two of the seven possibilities for piercing the corporate veil). A “sham” is more of a legal conclusion than an aid to analysis, while fraud has some legal substance to it. But neither one was alleged. What was alleged was undercapitalization of the stock subsidiary. The contract creditors of the subsidiary, which went insolvent, wanted to reach the assets of the not-for-profit parent on the ground that the subsidiary was undercapitalized. They also alleged and pretty much proved that the subsidiary could never make a profit because the deal, from day one, was to make inexpensive houses sold without a markup to impecunious veterans who are members of the parent corporation.

When you have undercapitalization and no profit alleged in a contracts case New York law says that if there’s no fraud or sham, then it means that the financial statements of the company were reasonably accurate and therefore anyone doing the business of the subsidiary could have gotten signed, written guarantees from the parent which would have been fully enforceable. However, they didn’t do so. To look ahead to the next case, the court also finds that there is no estoppel. That’s the majority argument, and that’s still the rule in New York. But in different jurisdictions it’s different.

Consider the dissent in Bartle. The dissent makes arguments similar to two tax problems that this setup would have. From a tax standpoint, the commissioner of internal revenue could attack it in two ways: first, they could use § 482, where you have two or more persons or entities under common control or where one controls the other. The commissioner may reallocate items of income, expense, and deductions so as to fairly reflect income. The Internal Revenue Service could have come in here and said that the houses were worth $8,000 but were being sold for $6,000. It could have allocated $2,000 as dividends to the member of the cooperative parent saying that the difference is an implied dividend. The dissent argues that this same line of reasoning should apply on the disregard of the corporate fiction theory. The majority hears the argument but doesn’t find it persuasive. There are real tax problems here!

DeWitt Truck Brokers v. W. Ray Flemming Fruit Co.

This is a contract case. It’s easier to pierce the corporate veil in torts cases than in contracts cases because a contract creditor could always, in theory, insist upon a guarantee by the controlling person or persons. In this case, too, there is no fraud or sham alleged. It’s clearly another undercapitalized corporation. It’s also pretty much like Bartle in that this corporation could never profit. In both cases, the corporation is always operating on the edge, and when a bad development came along, they went “over the abyss” into “financial hell”, or in other words, they went insolvent. Remember that if you can prove fraud or a sham, you can definitely pierce the veil. Here, there was no express written guarantee by the controlling shareholder, but there’s the “next best thing”: an oral guarantee! Here we have soft estoppel. There is not necessarily detrimental reliance. What happened here was that one of the unpaid creditors went up to the trucker and said: “Hey! You’re way behind on your payments!” The trucker said: “If the company doesn’t pay, I will.” This is the Cockerham case again! Somebody’s trying to be too (financially) macho! But that’s soft estoppel, not estoppel per § 186 of Restatement First of Contracts.

In DeWitt, the defendant brings up the statute of frauds. The statute of frauds says that a promise to answer for the debts of another must be in a signed writing. The defendant says that this is just crap! It’s not in writing and it’s not signed. But, in the last 100 years, the statute of frauds has softened a good bit, though not totally. For example, if you write out a check with a notation of what property it’s for and what the purchase price is and you hand it to the other guy, even if he doesn’t cash it, it’s held to be a signed memorandum. It describes the land and the price, so it’s found to satisfy the statute of frauds. Also, there is the doctrine of part performance, which can get you out from under the statute of frauds. When a major or 100% shareholder of a corporation makes a statement such as: “I will stand by my corporation!” The court says that he’s not answering for the debts of another, but rather he’s answering for his own debts. Post-1980, we have an Ohio Court of Appeals case stating exactly that.

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