Business Associations Class Notes 6/16/04

Covenant to register

Especially in big Rule 506 transactions, there will be a covenant to register. For example, venture capitalists come in and advance money under Rule 506 for stock. They usually won’t do it unless they think the company will have a chance of going public down the road. They will require a covenant to register the stock that they purchased under certain conditions. Usually, there is not one, but two or three rounds of venture capital financing before a company can go public. The contract to register is a valid contract. Note this practical limitation: if you’re a venture capital outfit and you’re investing in a company and the contract to register is conditioned on the company “turning the corner” and starting to make money, you still have to find an investment banker interested in such transactions.

In addition, if it is agreed that the company will go public, the underwriters will not let the venture capitalists sell over one-half. This is a matter of merchandising. If the venture capitalists want to sell more than that, it looks like a bailout and the offering won’t take. The underwriter will require signatures for a lock-up period, usually nine months, from the venture capital types and the twenty top employees holding the most options. One of the prospectus items will be the Rule 144 overhang. The underwriter wants nine months during which the insiders will not cash in. At the end of nine months, when Rule 144 will be fully effective as to people who have held the stock for a year or more and as to non-executives who want to sell, the market price of the stock will go down an average of 8%. It’s a risky business to take a company public, but it can also make you a lot of money! Underwriting fees can approach 6%. There are also attorneys’ fees and auditors’ fees that will run the total cost up to 9%.

None of Regulation D itself deals with affiliates. Also, if a company is public, Rule 144 has a volume limit. Say you have a situation where Smith owns 80% of X, Inc., a closely held company. GM or some other big company comes along and wants to buy X, either for cash or stock (which would be tax-free). Can Smith, an affiliate, sell to GM? Smith can’t use Rule 144 because, among other things, Rule 144 never applies to a company that is never public. He can’t use § 4(2) because that is limited to the actual issuer. Smith can use § 4(1) plus § 2(11): when you put them together, the controlling person can, in this situation, sell to GM so long as it is a non-distribution. The first sentence of § 2(11) talks about distribution. If something is a non-distribution, then when you put § 2(11) together with § 4(1), you have an exemption. This will be a non-distribution if Smith meets the test of Ralston Purina: (1) there is full and fair disclosure up front, (2) the purchaser can fend for himself, (3) the stock is legended and there is an investment letter, and (4) GM is given access to Smith and all top executives. So, there does exist a § 4(1) exemption under this situation. It’s a bit trickier than using Rule 506, but if you’re careful it can be done.

Close corporations

Today, we’re mainly talking about corporate norms and the power of shareholders.

Corporate norms – McQuade v. Stoneham

Stoneham owned the majority stock of the New York Giants, and McGraw was his manager in the 1920’s. McGraw was also a minority shareholder in the Giants corporation. These two basically ran the team and the business. There were about 7-8 other minority shareholders. McQuade, a state court judge, somehow got to know McGraw and Stoneham. McGraw and Stoneham asked McQuade to buy some stock in the corporation to the tune of around $100,000. They invited him to be an officer of the company. Stoneham didn’t call a corporate lawyer! McQuade negotiated with McGraw and Stoneham and entered into a contract with him in their personal capacities. First off, there was a shareholder voting agreement for a short term whereby the two sellers agreed to vote their stock to elect Stoneham as a director. The agreement was in writing and was short-term. It was signed. There was no bad intent, and all courts upheld this first, limited shareholders’ voting agreement. Shareholder voting agreements that are limited, reasonable, in writing and signed can be valid even if they don’t meet the standards of R.C. 1701.591 because the courts encourage such agreements. In the second agreement, Stoneham and McGraw, as directors, agreed that they would keep McQuade as an officer of the corporation for a reasonable length of years.

The stock changed hands. McQuade paid the money and took over as treasurer. He performed well. One day, Stoneham called him in and said: “You’re fired!” McQuade sues. The first count is that he wants an injunction for reinstatement. The second count is that if he can’t get reinstatement, he wants monetary damages. The trial court did not grant reinstatement. The trial court thought that the agreement was valid, but in those days you couldn’t get affirmative injunctive relief to keep a job because the feeling was that you always had a damage remedy that was adequate at law. That’s a correct statement of the law as of 1921.

But the exceptions have grown. The first exception is found in civil service statutes: if you have a civil service protection with government and you are wrongfully removed without cause, you can go into court and get an affirmative injunctive order for reinstatement. The second exception comes in the 1930’s with federal labor legislation: if you were fired in violation of the union contract or federal labor laws, you, or the union on your behalf, could go into court and get affirmative injunctive relief for a wrongful discharge. The third exception was tenure in educational institutions, which has grown over the last ninety years. If you have tenure and are dismissed, you can go to court and get reinstated. The fourth exception is found in state and federal equal employment statutes from the 1960’s and 1970’s. You can sue for reinstatement. Most plaintiffs will opt for money damages, though, because you don’t want to go back to a job where they don’t want you. The fifth exception is that if you’re wrongfully dismissed from state employment in violation of state union laws, you and your union can get you reinstated. But people will often choose damages instead.

Lastly, there are two “new kids on the block”. Arbitrators can grant remedies that courts cannot unless the arbitration agreement states to the contrary. In Staklinski, from the Court of Appeals of New York, a close corporation formed an agreement with a top executive for employment for a term. The agreement was in writing and signed. After a year or two, the company thought the employee had a disability such that he couldn’t perform and that therefore their performance in paying money to him was excused. He disagreed about being disabled and he wanted his job back. The case goes to arbitration, where the arbitrator finds that (1) he is not disabled though he does have some health problems, and (2) an affirmative order is entered that he must be reinstated. This goes all the way to the Court of Appeals of New York, a majority of which held that arbitrators can issue orders that courts cannot unless the arbitration agreement states to the contrary. If you don’t want an arbitration agreement to go that far, the magic language is: “The arbitrator shall strictly stick to the law.” The cases have gone even further than this case.

In the Gigax case from the Court of Appeals in Dayton, arising from Crosby v. Bing, we learn that there is an intense fiduciary duty in close corporations that can be enforced different ways. Four people formed a company, contributing equal amounts of money and each one being a director. For a long time, everyone got along fine. There were no employment contracts for a term. There were no R.C. 1701.591 agreements. But one day, three of the directors ganged up on Gigax and gave him the pink slip. The case had two holdings: (1) applying Crosby v. Bing to the facts of this case, there were no grounds for discharge for cause, and (2) though Gigax wasn’t too smart, he was doing a reasonably good job, and when you have a close corporation with no financial stringency and no grounds for discharge for cause, the three can’t call in the fourth one and dismiss him. The court entered an order of reinstatement for Gigax. Then one of the judges said that there was another branch to the case. The line of cases stemming from Mers v. Dispatch dealt with improper discharge. Later there was a case with a bunch of physicians who formed a corporation. There were no employment contracts. There was an agreement up front that if a majority of the board of directors wanted to terminate one of the doctors as an employee they could do it. The Court of Appeals in Dayton held that this was not contrary to the holding of Gigax.

Two opinions from Minnesota in the 1970’s in Pedro v. Pedro dealt with a company that had been run by Pedros for generations without an employment contract or .591-type agreement. One day, one of the Pedros was fired without cause. The Minnesota Supreme Court held that because the company had a tradition of jobs for all qualified Pedros, he could collect.

Keep in mind that the trial court held that both parts of the agreement in the present case were valid, but they couldn’t grant reinstatement. This is correct for 1921, though these exceptions have been created since then. McQuade had done a good job, and he was not fired for cause. The part of the agreement that purported to bind the two people qua directors was not okay, and was contrary to public policy. It was contrary to corporate norms, and hence unenforceable. Note that McQuade got screwed! He paid out all this money for minority stock. They kicked him out and took his money! The court also alluded to the fact that McQuade was a public official and he violated New York law by negotiating for a private position while on the pubic payroll. The rest of the cases follow from this one.

How far could McQuade have gone with an enforceable contract under New York law? With whom would he have had to negotiate? The voting agreement is okay, but we’re talking about a position with the company. He would have to negotiate with the other board members, who hire and fire officers and other top executives. The New York statute provided that the board would elect officers once a year. McQuade could have gone to the full board and gotten a position for a certain number of years as a high executive employee with board approval. Such a contract will go on to say: “Employee agrees to serve as an officer and/or a director, if elected, without any further compensation.” In other words, his compensation package would be spelled out for this particular job. That’s as far as he could have gone in New York in 1921. But what about in Ohio in 2004? What else could he have done, and how, under R.C. 1701.591? Could he have gotten a five-year contract as treasurer under .591? What do you have to do to get such an agreement? You need the concurrence of both the directors and all the shareholders (including non-voting shareholders). You have to meet the technical requirements of the statute.

Say McQuade had entered into a five year contract, the board approved it, and it’s in writing. Could he then be dismissed with cause? The answer is that of course he can. But could he be dismissed without cause? If McQuade had an agency coupled with an interest and the contract stated that it was irrevocable, this makes for a tenth exception. McQuade bought stock, though he didn’t buy it from the corporation. If he had bought the stock from the corporation, it would have been an agency coupled with an interest and if there was an irrevocability clause, it would have been irrevocable. After World War II, statutes in both New York and Delaware have modified the common law rule as to proxies. Very often in a close corporation there will be a shareholders’ voting agreement and a proxy given. Is that a proxy coupled with an interest under agency law? At common law, it’s not clear, but by statute in both New York and Delaware the answer is yes. Furthermore, in New York, if it’s in connection with a valid employment contract, it is coupled with an interest. Keep in mind that the common law rule is strict, but consider one of the examples given by R.2d Agency: a company is having financial problems. Smith buys stock from them and at the same time takes an executive position. He cannot be dismissed without cause because this is an agency coupled with an interest and is thus irrevocable. But if the contract waives that protection, the waiver is valid most of the time.

Clark v. Dodge

Here we have sweat equity with a secret process meeting a capitalist with a lot of money. A corporation is formed and the capitalist is to contribute a lot of money and get 75% of the stock. Sweat equity is to turn over the secret process and get the remaining 25% of the stock. There is a close corporation agreement between the two of them. It is limited and carefully drafted. It is limited to the lifetime of the two individuals and it says that sweat equity will be retained as a corporate officer as long as his work is adequate. The salary specified is reasonable. The company is formed, and after a while, the capitalist uses his 75% stock interest to take over the board and cause the board to fire sweat equity. Sweat equity sues for specific performance. The trial court says that based on McQuade v. Stoneham, the contract violates corporate norms. The Court of Appeals of New York disagrees, saying that because 100% of the shareholders had signed, the infringement of the corporate norms were minor, the creditors weren’t hurt, and the employment arrangement for sweat equity was only so long as he did a good job. They remand to the trial court, where it was found that sweat equity had not turned over the secret process. Sweat equity is booted out of court for having unclean hands!

Galler v. Galler

We have two brothers with about 46% stock holdings each and 8% to a minority shareholder who was a high executive employee. The brothers did some tax planning together and entered into an agreement as to what would happen after the first brother died. There were provisions as to voting of the stock and there were also provisions on payments to the widow of the deceased brother. Those payments were limited, creditors weren’t hurt because of the limits, and in addition, the payments could only be made if they were income tax deductible. So the first brother dies and the widow of the second brother sues for specific enforcement. There are three different sets of litigation. There is no close corporation statute in Illinois at the time of the litigation. This is solely a common law matter. When all is said and done, the result is: (1) the agreement was for a reasonable length, that is, the agreement was going to terminate on the death of the widow of the first brother to die, (2) the purpose was reasonable, (3) the agreement was in a signed writing, (4) nothing in the agreement hurt creditors because it was so limited, and (5) the court was impressed with the fact that the widow’s pension was not large and that it would cease if the amounts proved not to be tax-deductible.

What’s the difference between this case and Clark v. Dodge? The difference is that we had one non-signing shareholder: the 8% minority holder. The court wants to hold for the widow, and they hold that the minority shareholder didn’t object and that he wasn’t really hurt. Therefore, the agreement was upheld. The litigation was long and vicious.

Zion v. Kurtz

We had a Delaware close corporation doing business in New York. We have two 50% shareholders who had a shareholders’ agreement between them that was signed, written, with a proper purpose, not unreasonable in length, and without harm to creditors. But under Delaware law, a close corporation agreement is valid only if, among other others, the charter of the company is amended to put in the charter that it is a close corporation. Ohio has a number of technical requirements, but it doesn’t have this one. The majority opinion was that this was a mere technical deviation that did not hurt the company or the other shareholder, and thus that the court would enforce it. The dissent says that a rule is a rule and a requirement is a requirement, and that the parties should have dotted their t’s and crossed their i’s, so the agreement shouldn’t be enforced.

Matter of Auer v. Dressel

Here we get wild! We have a small, public New York corporation. Under New York law, the board of directors is to elect the president annually. Note that the way to avoid conflict with those requirements is to have a contract for five or ten years to be a high executive employee and to serve as an officer or director, if elected, at no additional compensation. Here, there was no contract. The president was elected and was very popular with a group of minority shareholders. But he got on the outs with the board of directors. Under New York statute as well as Ohio statute, the president could be removed with or without cause. (This is found in Ohio at R.C. 1701.61-.66: the statute says that it’s not going to affect any contract that he had.) The minority shareholders call a meeting. All state statutes provide that if a certain percentage of shareholders get together and sign a call and file it with the secretary, the board must call a meeting. Ohio has this statute at R.C. 1701.37-.59. It’s a very populist statute! Be warned: if it’s a public company, gathering the signatures together will constitute the solicitation of a proxy under 1701.14. If you only do ten or fewer, there is an exemption, but otherwise you must file a statement with the SEC. The controlling case is Studebacker, from the Second Circuit in the 1950’s. The second problem is that the board is going to resist this. How do you react? Under FRCP Rule 65, you file for a TRO. If you prove that you’ve filed the correct signatures, the court will issue a mandatory injunction forcing the board to call the meeting.

What were the purposes of the meeting in the call? It was to remove the directors for cause. Under New York law, there was no common law right as of that time to remove directors without cause unless the charter so provided. Most states in the last fifty years have turned this around. But it was held that there is a common law right to remove directors for cause. Was removing the president for cause something that created the right to remove the directors for cause? The New York court says this should be reviewed after the meeting. In Delaware, the courts will consider this question up front. You can’t use proxies to remove directors for cause. Proxies are used for all kinds of purposes by shareholders!

The dissident shareholders wanted to put before all the shareholders assembled at the meeting a resolution that seems to read like an order for the board to reinstate the deposed, loved president. The court is shifty and subtle! They admit that in New York, the board has the authority to elect and remove officers. Therefore, under McQude, a shareholder resolution ordering the board to reinstate the guy would be void. If it were an order, the court would strike it down. However, they construe the language of the resolution as being precatory: a request of the shareholders assembled to reinstate the president. The court says that precatory resolutions to the board as to corporate business are fair game even if it would be unfair if that resolution were mandatory. Why is this important? Under SEC Rule 14(a)(8), shareholders are allowed to put in, at company expense, certain shareholder resolutions. Management hates these!

In many instances, the shareholders cannot put in mandatory resolutions, but in many of those instances where they can, they can change the language to: “We respectfully request the board to do such and so” and be able to put it in. Be cautioned that (1) in Ohio, because shareholders have the power to amend the regulations and articles, there are times shareholders can put in mandatory resolutions at meetings. (2) The statute on call of meetings has been amended recently to increase the percentage required. If it’s a public company, you’ll have to file an SEC proxy statement to get a certain percentage. (3) In Ohio, R.C. 1701.58, dealing with removal of directors without cause, has been extensively amended in the last five years to say that if the board is classified (think of the U.S. Senate: 1/3 elected every two years), you can’t remove without cause. This was put in by anti-takeover forces. Most takeover bids in Ohio deal with getting control of the board of directors of the target. Ohio is one of the few states where the shareholders can amend the articles to increase the number of directors and to fill the vacancies. A contested takeover bid for a public company in Ohio will typically involve the call of a meeting to increase the board from 9 to 35 (management has the advantage of cumulative voting in most Ohio companies and will elect some of the 26 additional directors). The amendment to R.C. 1701.58 a few years ago is largely meaningless in the context of a hostile tender offer in Ohio. The Ohio amendment was patterned after Delaware, where the amendment actually means something because shareholders, acting alone, cannot amend the articles or regulations. Hostile takeovers are hot stuff! We’ve just scratched the surface!

Back to Class Notes