Business Associations Class Notes 6/14/04


The instructions for the exam


It will be three hours long and it will where the registrar says it is.  There are two key points.  We’ll be an associate at a law firm.  It will have an office in Ohio and also a community property state Z that’s not Texas, Louisiana, or Arizona or California.  It also has an office in common law state X, not Ohio.  We work for a senior partner at the firm who is a trial lawyer.  He’s admitted in all three jurisdictions.  People come to him for all kinds of reasons.  We have to produce a preliminary memo to him.  As the case progresses, this will be fleshed out.  But the partner usually has a conference with the client and he wants to know roughly what is involved.  We’re told it’s okay to be concise, but don’t be brief.  Raise the issues and state the arguments, pro and con.  Look for ambiguities in the facts.  Look for courses of action as well as causes of action.  What should people do?  Allocate your time brutally.  Make sure you don’t leave any questions blank!  Most of Shipman’s questions will be set in Ohio and will involve Ohio law.


December 1996 Exam Question One


Unless otherwise stated, we can assume that all conflicts of interest have been cleared.  We can also assume that all clients are paying by the hour.  Here we have BCD, Inc. formed in 1985 by Mr. Smith, who purchased 1,000,000 shares for $.01 each at par.  His sister, as an accommodation, purchased 50,000 shares at the same price.  The sister is a physician and has a lot of money.  None of the other directors has much wealth.  Generally Accepted Accounting Principles are applied.  In auditing the statements of a company, the auditors proceed under GAAS: Generally Accepted Auditing Standards.


Sarbanes-Oxley caused an accounting oversight board to be created.  Its relationship to the FASB has yet to be determined.  Its relationship to accounting standards is going to be quite heavy.  The money for FASB and the Accounting Oversight Board comes from fees charged to public companies.  The AOB is subject to oversight by the SEC.


CPAs are licensed by individual states.  There’s a standard nationwide exam, so it’s pretty easy to get admitted in different states as long as you pay the fees.  The CPA owes its first duty to public investors and creditors.  Then they owe a duty to the company.  The independent CPA firm is paid to “tattle” on the person that pays it!  It’s like being required to pay your spouse’s lover.


There is some chance that the insurance company will say that the coverage doesn’t fly, and the insurance company will probably win.  So there’s probably no coverage!  She wants to know what her exposure is.  There will be big legal fees.


First we’ll want to see whether she had no knowledge or reason to know of the cooked books.  There are no criminal worries if this is true.  There could be a trustee in bankruptcy action, but there probably isn’t recklessness on the part of our client.  Her medical license should be dealt with by a lawyer in the firm who deals with the medical board.  We must show that she had no knowledge.  So hopefully her medical license will not be affected.  What about taxes?  If she received money for being a director, then her legal fees and what she has to pay in settlement will be tax deductible.  She has a good income as a physician.  So talk to a tax lawyer.  This may all be deductible as she pays it.  She might ask whether she should transfer assets to her husband.  No, because that would be a fraudulent conveyance and it would also look bad in the litigation.  Hopefully, she has a family trust for the benefit of her husband and children with spendthrift clauses.


In practice, you’ll find that the independent investment advisor and the estate and tax lawyers are always trying to get people to set up trusts with spendthrift clauses.  But it’s hard to get people to do that.  There’s a substantial gift tax payable and they don’t want to part with control of the money.


If we can show that she is “pure as the driven snow”, then we’re in good shape because it’s hard to prove scienter against someone who is trying to do the right thing.  This is for the purposes of Rule 10b-5.  In addition, the 1995 Federal Act puts a number of procedural inhibitions upon plaintiffs who want to file.  You can get around them with a good case, like the Citigroup case, where the plaintiff’s lawyer knew just how to get around it.  § 12(a)(2) is a strict privity section, and she wasn’t in strict privity with any of the victims.  But we must double check that she hasn’t pulled a “Martha” in the last couple of weeks.  She says the first news she had was yesterday, but we must make sure she wasn’t selling any stock before that.


What about § 11?  The first big deal is that this statute is negligence-based.  If a plaintiff’s lawyer has a shot at good money under § 11, they’ll go under § 11.  But .38 to .43 of the Ohio statute is very close.  It’s also negligence-based.  § 11 does not apply if there is no registered public offering.  In that sense, it’s different from R.C. § 1701.38 to .41 which apply to public and non-public, registered and non-registered transactions.  There is a semblance of a privity requirement.  You must prove that the shares you bought came out of the registered public offering.  You don’t have to be the first purchaser.  You could be the second, third, fourth or fifth.  That requirement doesn’t help us in the question because all the shares in the public market came out of the registered public offering.  You should always check the statute of limitations; in many cases people wait too long to sue.  In this case, we can expect that the suits will be filed within the next few days or weeks, so there will be no statute of limitations defense.


If the defendant can prove no legal cause or causation-in-fact or partial no causation-in-fact, then that is a defense.  There are two Franklin County cases in the 1990’s on this.  Early in the 1990’s the Federal Reserve Board kept interest rates fairly low, which encourages homebuilding.  Interest rates have been fairly low for the last four years and we’ve had a homebuilding boom.  Two separate local homebuilding companies went public during that period.  Unfortunately, about nine months after they went public, the Fed greatly increased interest rates.  Homebuilding temporarily went to hell.  There were § 11 suits against the companies.  The defendants made out either a partial or total § 11(e) defense.


There were bogus accounts receivable and the nature of those accounts was not disclosed in the prospectus, obviously.  The company has virtually no defense under § 11 except the statute of limitations and § 11(e).  No plaintiff will collect much of anything from the companies.


Let’s divide the prospectus into the narratives and the certified financials.  As to the narratives, where the directors are not relying on experts, the director must prove for a defense: (1) she made a reasonable investigation, and (2) after such reasonable investigation she reasonably believed the prospectus narrative material to be true.  As to the expert material, the test is different.  There is no requirement of reasonable investigation as to the certified financials.  The test is simple: did the director reasonably believe the certified financials to be true?  In the real world, a lot of material crosses over between the two categories.  It’s not absolutely clear whether she made a reasonable investigation.


What about another possible defense for our client?  Legislation from the 1990’s provides under § 11 that there is no joint and several liability; it is several only.  That means that if we can slot her into that, and the jury finds that of the 100% of fault involved she contributed only 3%, then we would simply multiply the liability by the percent and that would be her liability.  It would still be a lot of money, but note that if she doesn’t qualify for this, it’s joint and several liability.


The Securities Act of 1933 was based in part upon the English Companies Act and in part on state “Blue Sky” law in the United States.  In the English Companies Act, a director can rely in good faith on officers and others.  That is the law in Ohio at § 1701.59.  It’s also the law in Delaware at § 141-144.  It’s a good faith reliance rule.  As long as you’re not reckless or worse and your heart is pure, you can rely upon what officers tell you.  This looks like an accounting matter, though.  The auditors should have gone out and “kicked the tires” on some of these post office addresses.  That is, they should have traced it to the actual office or factory.  Lawyers who are working on a registration statement and who are careful always do that.  The leading case in the area is Escott, and it says that you do have to kick the tires.  As to important written documents, you must get the actual material and read it.


Probably the plaintiffs’ lawyers are looking for big money from the accounting firm.  They will want to settle with our client early.  You like to settle out with peripheral defendants early for modest amounts because it’s very expensive to finance a class action.  Under R.C. 1701.38, Shipman thinks her liability is about the same.  What about the liability of the accounting firm?  That’s under § 11 and also under the Rest.2d of Torts § 552, which is negligence-based and would provide a similar result to the federal result.  The seminal case in Ohio is Heddon View from the 1970’s.  There are later cases including two in the 1990’s that were decided the same day.  The cases hold that comparative negligence will apply if the client was negligence and caused a tort that damaged himself, you “chop off” that 30-40%.  Those cases are especially important because Shipman thinks that they apply to lawyers.  When a lawyer is sued by a client, you’ll want to throw in the defense of comparative negligence.  Is the Restatement § 552 applicable to lawyers?  Not in Ohio.  The authority for that comes from Dublin Securities, reported in the Bankruptcy Reporter in the 1990’s.


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