Business Associations Class Notes 6/2/04

Next time we’ll go over extraordinary transactions: amendment of articles, sale of all assets, dissolution, statutory merger, and control share acquisitions. All the directors and shareholders typically must approve of such transactions, and dissenting shareholders typically get appraisal rights so they can cash in their shares. This goes beyond so-called “reorganizations”, which come in two flavors: (1) recapitalization, and (2) amalgamations, or putting two or more companies together in one of several ways. In Wall Street firms, you never get a department labeled “amalgamations”; it’s always called “mergers and acquisitions”. Dissolution of the company is a big event!

More on disregard of the corporate fiction

Where are we in the roadmap of the course? Yesterday and last week, we talked about defective incorporation: de facto corporations and corporations by estoppel. We established that if a corporation was either a corporation de jure (meaning in perfect compliance) or de facto, nobody can complain about the errors. In this section, disregard of the corporate fiction, we go a step beyond that. All of these corporations are either corporations de jure or de facto. In other words, the plaintiff is not relying on some defect in formation, but instead is going to this question: assuming there is enough compliance to be de facto or de jure, can third parties nonetheless look through the corporate veil and hold the active shareholders, officers, and directors liable? There are seven different ways to do this. Public policy is what comes up in Abbott. Fraud will always appear, though it’s difficult to show. Soft estoppel was found in DeWitt, which was similar to the Cockerham case. Undercapitalization was raised in the first two cases which were contract cases. New York has a tougher rule, saying that if you’re a contract creditor, it is very difficult to pierce the veil because you could have chosen not to deal with the company in contract. In the absence of fraud or a “mere sham”, only the company will be on the hook.

Baatz v. Arrow Bar

This takes place in a Fargo bar. Bar owners got a statute passed saying that in South Dakota, there will be no dram shop liability. Most states have dram shop liability, meaning that if you serve excessive liquor to X, and X goes out and negligently kills Z, then Z’s survivors can bring suit against the bar. Based on this legislative victory for the bar owners, the Arrow Bar decided to drop its liability insurance. So their bartender serves too many drinks to X and X runs out and negligently kills Z, and Z’s survivors bring a wrongful death action. They sue the bartender. They try to sue the owners too. If they had been tending the bar themselves, then they could have been sued as primary actors.

The primary actor doctrine says that even though the principal may be liable under respondeat superior, you can also sue the actor. There are three exceptions of recent vintage, however: (1) Under the Federal Tort Claims Act, if a United States government employee is merely negligent, your only suit is against the federal government itself, and the federal government cannot recover from the actor because the FTCA didn’t include statutory provisions to that effect. (2) In Ohio and many other state tort claims acts, if a state or local employee is merely negligent, you can only sue the employer and you can’t join the employee, except if the employee has acted recklessly or worse, in which case you can sue both the employer and employee. (3) Under federal equal employment law, if an executive sexually harasses someone, you can’t sue that executive; you can only sue the private employer. This doesn’t seem to make sense! But this doctrine has been rejected through the Ohio equal employment statute. This means that many plaintiffs’ attorneys send to sue using the Ohio statute rather than the federal statute.

So we can sue the corporation under respondeat superior. But the problem is that the corporation has a lot of debt to the bank and not much in the way of net assets once you consider its debts. The bank has a lot of perfected first mortgages on the borrower’s property, because the bank stays in business by taking mortgages on everything. Why would the bank loan to the company when it didn’t have much capital? The shareholders were forced by the bank to sign written guarantees before the bank lent to the corporation. That’s a fact of life! Until a corporation becomes fairly prosperous with a lot of assets of its own, banks won’t make loans to it unless they get a guarantee from the shareholders.

Undercapitalization as a way to pierce the veil

This is fairly pro-plaintiff in theory. The black letter rule is that undercapitalization is a key factor, but as to common torts, if the corporation has been covered with reasonable amounts of insurance, that will be considered adequate capitalization. There was no insurance policy here! They relied on the state statute! What’s wrong with that? The South Dakota Supreme Court declared the statute unconstitutional! The plaintiff argued that even though the company had some money, the fact that the shareholders had guaranteed the bank loan was enough to show undercapitalization.

In many states, if you have some kind of immunity and you nonetheless get insurance, then that will be deemed a waiver of immunity with one exception: if the insurance policy itself has a clause saying “the writing of the insurance by the insurance company and the getting of the insurance by the insured are not considered to be a waiver of any immunity or privilege”. If you work for an insurance company, you want to put that clause in all your policies because it will generally be honored. This is also becoming an issue for not-for-profit organizations. The cost of directors’ and officers’ insurance has gone way up! The premiums have probably doubled in the last five years! Non-profits have convinced their directors (or trustees) that there is nothing wrong with that. It’s true that it’s less of a problem than with a non-profit, but it’s still a problem.

Radaszewski v. Telecom Corp.

A parent owns 100% of a subsidiary in the “gear-crunching” business. The subsidiary went to an insurance company and got a good policy. The subsidiary had a very negligent driver. The other driver was not negligent. The injured people can sue the trucking companies. But people who finance big trucking companies take out mortgages on the “big rigs”. So the injured party wants to pierce the corporate veil up to the wealthy parent corporation. There is no fraud, no soft estoppel, no mere sham, so we get to the question: if a parent owns 100% of a subsidiary is there a per se agency or partnership? But there is no per se! The very purpose of corporate law is to allow a parent to set up a 100% subsidiary. If they operate it right, the mere fact that you own it 100% doesn’t mean that the subsidiary is your agent or partner. If you don’t rule this way, you undercut the very basis of corporate law!

The plaintiffs tried to argue undercapitalization, but the rejoinder was that the subsidiary had an insurance policy. But the answer to the rejoinder was that the insurance company went bankrupt! The court holds that there was no evidence that the subsidiary knew the insurance company was on shaky ground. They made reasonable efforts to get reasonable insurance, and having proved that they’re safe.

In Seminole Hot Springs, a lawyer created a corporation to start a swimming pool. A kid drowned due to the negligence of the pool’s employees. The plaintiff sued to pierce the corporate veil and named the company and its major shareholders as defendants. The California Supreme Court held the piercing of the corporate veil quite proper against the shareholders.

Next, the plaintiff wanted to nail the lawyer for the company because he had acted as an accommodation director and officer because California law at the time required three directors. The client begged him to do it, and he consented. “The road to hell is paved with good intentions!” When the lawyer acts as an accommodation director or officer, he can be reached. The lawyer’s malpractice policy will usually exclude the lawyer acting as an officer, director, guardian or administrator. Plus, all insurance policies require a separate ERISA and environmental insurance policy. However, this court remanded for a new trial against the lawyer because he was not named as a part in the original suit. The California Supreme Court held that since he was not a party in the original suit, the findings against him were not res judicata or collateral estoppel. If you’re a plaintiff suing to pierce the corporate veil, you must name as additional parties to your suit everyone who you want to “reach out and touch” financially.

The U.S. Supreme Court took the same view. There was a suit against the corporation (only) and there was judgment in favor of the plaintiff. The plaintiff wanted the judgment executed against the shareholders on the grounds of piercing of the corporate veil. The Court held that there was no way! If you want your judgment to apply to piercing parties as well as the company itself, you must name those parties in the original suit and serve them. This is one of the first things that the plaintiff must think about.

Good plaintiffs’ medical malpractice lawyers, when suing a doctor, never name the nurses, secretaries or aides as defendants. The big reason that they’re not named is that their testimony won’t be helpful to you if you’re suing them.

In a community property state, if H is the major shareholder and the stock is in his name, but it’s community property, to bind the whole community, you must name W as well as H because the community property under her name is not bound to the suit unless you name her! W may have more money than H if she saved her earnings! The contract rule on joint liability is that you must sue all jointly liable persons. However, with joint and several liability, you can pick and sue wealthy people first. If you win and think you can pick up more money against the others, then you can go and do it! In contract, however, that’s not so! So in a community property state, if you’re piercing against one spouse, to bind the whole community you’ll have to name the other spouse and bind him or her.

An issue in all community property states is whether the contract or tort was for the community or separate property. Check out the Nutshell to start your research. Keep in mind that in a common law state, you will not be able to reach the marital property of the other spouse if that spouse was not on the corporate board and stayed out of the spouse’s business.

Fletcher v. Atex, Inc.

Maybe courts will toss these terms around as conclusions: “mere agency”, “mere instrumentality” and “no separate personality”.

When you have a parent and subsidiary, you will have lots of overlap of the officers and directors. You will also have, in a well-run corporation, good coordination of management and cash flow. Those management tools virtually give a license for disregard of the corporate entity, according to the plaintiff, but the court says no.

United States v. Bestfoods

This gets us into federal-state relations and especially environment statutes. The Sixth Circuit construed the Superfund statute, which deals with hazardous sites where people have dumped chemicals into the ground over the years. The federal government surveys these sites and presumably will clean them up eventually. They designate them, and once they clean them up, they send the bill to “the owner” or “the operator” according to the statute. If you buy land, you work with an environmental attorney in advance. They will have aerial surveys. You will also look at local newspapers. If you’re a good faith purchaser for consideration and didn’t know, and a reasonable person would not have known of the problem, you can’t get stuck with the bill.

The Sixth Circuit said that disregard in the environmental area would be narrow, would require great proof and that state law disregard could be “disregarding”. Souter, writing for the Court, says that the federal government and state agencies can rely either on the statute or on general disregard law under state law. He gets into some more technical points. Does the plaintiff make out his case merely by showing that most of the officers and directors of the subsidiary are also officers and directors of the parent? Not necessarily. It’s not dispositive.

In Fleet Factors out of the Eleventh Circuit, it was a Superfund case and the company couldn’t pay. Fleet Factors, however, was wealthy so the government went after them on the basis of a loan agreement between them and the little company. The government claims that the loan agreement was so broad as to make Fleet Factors either an owner or an operator for the purposes of the statute. There was a big cry in Corporate America, and the EPA issued a regulation purported to overturn the case! But that’s not all! The D.C. Circuit held the regulation invalid! If you work in environmental law, this case casts a long shadow. So work with an environmental lawyer early!

If you’re a parent, do your due diligence! There’s also a Fifth Circuit case in which a company bought most of the stock of a subsidiary and left most of its directors there, but then added one of their own directors and a couple officers. The Fifth Circuit held that the fact that they left most of the old board there was heavy evidence against disregard of the corporate entity.

Stark v. Flemming

A senior citizen is about ready to retire, but she has no Social Security. She goes to a lawyer, and in order to qualify for Social Security, she put real estate into a business association and took down a salary. The federal government sued and wanted the court to declare that because she did this simply to qualify for Social Security, it was per se bad. But the Circuit said no! If she performed the services, and the wages were reasonable, then it’s okay!

Roccograndi v. Unemployment Comp. Bd. of Review

Here is another social insurance case. Here it’s unemployment insurance. A family owned the stock of a corporation. If you worked a certain number of hours per week, then you got unemployment compensation if you were laid off. The family arranged it such that different people worked the minimum hours to get the unemployment compensation. The public policy exception was invoked to pierce the veil!

Cargill, Inc. v. Hedge

In Minnesota, if one of Mr. and Mrs. Farmer owns a farm, they have a homestead exemption. Here, they incorporated. Can the creditors of the corporation levy on the farm without regard to the homestead exemption? This is a reverse piercing opinion. The farmers argue that they were true farmers and thus their homestead exemption should not be set aside. The court bought it, but many courts don’t.

Pepper v. Litton

Equitable subordination is a “halfway house” to piercing of the corporate veil. If the veil is pierced in bankruptcy, you don’t have to get to equitable subordination. The district judge was outraged! He didn’t hold that they would disregard the corporate entity. The Virginia court said that there was no common law fraud involved here: the money was actually owed to the common law shareholder. If you want to be treated like a corporation, you must act like a corporation.

Sale of assets, statutory merger, and control share acquisition

R.C. 1701.73-.76 says that if you’re going to have a sale of substantially all assets, the directors must propose and the shareholders must approve. With a public company, the proxy statement will also be subject to the Securities Exchange Act of 1934. R.C. 1701.86-.91 say that if the shareholders vote to dissolve the company, that gives the directors the power to sell the assets. What’s the difference? R.C. 1701.73-.76 deals with the situation where the company will sell all its present assets, take the money, and start a new business. If you’re going to do this, you must give the dissenting shareholders a cash appraisal. If, on the other hand, the board of directors is empowered to sell the assets in dissolution pursuant to R.C. 1701.86-.91, there is no appraisal right. What does this mean for a lawyer? It means that if you’re going to dissolve, adopt only the resolution under R.C. 1701.86-.91 and do not, on top of that, adopt a sale of assets resolution, because if you do the latter under R.C. 1701.73-.76, the dissenting shareholders will get appraisal rights. Under 1701.95, if the directors don’t do that, they are individually personally liable jointly and severally. That tends to get your attention! Therefore, if it’s a manufacturing company and there is a R.C. 1701.86-.91 resolution and they sell their assets to GM, they will realize that there may be products liability in the future. What do they do? They go to an insurance broker and buy tail coverage from a solvent insurer. It’s the same kind of coverage a doctor or lawyer buys when they retire. It costs a premium on top of what normal yearly coverage starts. You don’t want to move to Florida and then have your home taken from you. And it lasts forever!

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