Business Associations Class Notes 6/21/04


All agents are fiduciaries to their principals.  No fiduciary, including an agent or a director, may, by contract with a third party limit his fiduciary duties to the beneficiary of that fiduciary relationship.  The case that sets out this rule is ConAgra v. Cargill from the Nebraska Supreme Court from the 1980’s.  The Delaware Supreme Court agrees with this case.  X, Inc. was approached by Z, Inc., which said to the board of X, Inc. that they wanted to buy all or substantially all of their assets.  They proposed to assume all of their disclosed, noncontingent, and uncontested liabilities.  In many states, that might be considered a de facto merger, but Delaware does not recognize de facto mergers.  We also don’t have to worry about that because it was a cash offer.  The federal securities laws and state Blue Sky laws are inapplicable, at least as far as the Securities Act of 1933 goes, because it’s an all-cash offer in U.S. dollars.  Could the officers themselves approve such a thing?  The statutes in all states on this transaction specify a two-step transaction.  The directors of the selling corporation must approve and call a special shareholders’ meeting and a specified majority or supermajority of all the shareholders must approve.


The directors of X, Inc. met with the people from Z, Inc. and said: “Let’s go!”  They approved the contract offered by Z, Inc.  But notice that the contract is in limbo and not effective until the shareholders of X, Inc. approve it at a meeting.  The contract included language saying that the directors of X, Inc. agreed to put the matter before the shareholders of X, Inc. and “support [the offer], if consistent with the fiduciary duties of the directors of X, Inc.”  Now, a second suitor, B, Inc., comes along and talks to the directors of X, Inc., saying that it will offer what it thinks is a better deal by a cash tender offer to all shareholders of X, Inc.  B says: “How’s about it?”  The directors did so, and of course, it screwed up the shareholders’ meeting called to approve the Z, Inc. offer.  Z, Inc. brings an action against both B, Inc. and all directors of X that in effect says: “I’ve been unjustly used as a ‘stalking horse’!  I’ve been used to make the main horse run faster!   The directors backed out of their word!  Give us money and/or an injunction!”  The case should have gone off on contract principles.  The language phoned in to the X directors to put in the contract was standard and it says: “if the fiduciary duties of the X, Inc. directors cause them to change their mind, they can do so legally.”


Why?  Here’s a big deal: the Nebraska Supreme Court chose not to go by contract but rather by an agency principal.  They said that if the X, Inc. directors collectively held all or nearly all of the stock of X, Inc., the principal would not buy because substantially all stock would have consented to an alternate arrangement.  (Note that creditors have nothing to fear.)  The Delaware courts have picked this up in the case of Paramount from 1994, where Delaware expressly approved ConAgra v. Cargill.  So what’s a lock-up?  It’s unclear in Delaware exactly what you can do for a lock-up.  Probably you can have a clause saying that if the deal doesn’t go through, Z, Inc. will be reimbursed for its legal, accounting, investment banking and similar expenses.  That is called a “modest breakup fee” clause.  In states other than Delaware, such a clause is valid.  Some people have tried to go further and include “massive breakup fees”.  In one recent case, there was a merger involving $50-60 billion where the breakup fee was to the tune of $4-5 billion.  It was paid, and there was no suit over it.


The Z, Inc.-type businesses of the world can negotiate an option to purchase X, Inc.’s stock at the current market price.  The Delaware court said that this can be done within limits, but you can’t allow the person to make a killing.  If the stock is at 30, you can grant Z an option for 20% of the stock, except if the stock of X goes over, for example, 40, then you can’t allow them that particular benefit.  In 2003 in the Omnicare case, there was a decision that boggles the mind!  It was from the Delaware Supreme Court.  You had a situation where about three shareholders of X, Inc. owned, collectively, 60%.  The vote in Delaware to approve a transaction is only a simple majority of all outstanding shares.  In Ohio, this often goes up to 2/3rds.  Z, Inc. contracted with the three directors who held 60% and got a promise from them in their individual capacity that they would vote to approve the deal.  B, Inc. entered and made a much better offer.  Z brought an action against the directors in their individual and corporate capacities.  The Delaware Supreme Court held that even though these three people were contracting in their individual capacity concerning their stock, it still was an impermissible lock-up under Delaware law.  It was a 3-2 decision.  The opinion said that if the directors, in their individual capacity, had put the language in similar to what the Houston lawyer put in as in ConAgra v. Cargill, that is, that they would vote as shareholders to support consistent with their fiduciary duties as directors, then it probably would have been okay.  There is a Minnesota case that followed the Delaware case that was not as picky on lock-ups.  We have no idea what the situation would be here in Ohio.


Here’s another big agency and fiduciary principle: no fiduciary may unreasonably delegate.  Within a law firm, for example, a senior partner conducts an interview and assures the potential client that they will be treated right.  They will be introduced to the associates and told up front that the associates will do most of the work under his supervision.  If he is a noted trial lawyer but he isn’t going to try the case, you put that into writing early on.  If your firm takes a case and you want the assistance of an outside law firm, you must first clear that with the client in writing.


A Seventh Circuit case from Indiana involves an Indiana insurance company.  The company had entered into a 15-year contract with C, whereby C was going to run everything.  The company went insolvent.  When an insurance company goes insolvent, the state insurance commissioner goes to a state court and they take over the company’s assets.  Creditors file claims.  A claim was filed by C for compensation for the future under the contract.  This did not involve past, paid compensation.  The past compensation was reasonable.  There was no fraud.  C had been doing his job.  The Seventh Circuit held that this was a highly unreasonable delegation by the board of directors of its functions, and therefore the future portion of the contract was unenforceable and C would take nothing.  Today, if you’re going to have a contract like this, the lawyer will (1) research carefully and keep the contract reasonable in length, (2) reword it to say: “I, C, will give advice to the board of directors, which advice they may or may not take in their own discretion”.


Cognovit clauses


These start out in 1960.  They are also known as “confession of judgment” clauses.  What are they?  In around 15 states, these clauses were routine both in consumer and commercial transactions.  In California, New York and most American states, they were quickly ruled against public policy.  Near the end of a contract, it would say: “I, the maker, do hereby appoint any licensed attorney in Ohio to confess judgment in full on this note at any time on my behalf.  This authority is irrevocable and we declare it is an agency coupled with an interest.”  In the old days, trial lawyers would simply go down to the courthouse and find people who they litigated against with a stack of notes and have the other guy sign them.  The other guy would do the same for you.  This is an odious practice, according to Shipman.


In the 1970’s, the U.S. Supreme Court took up two cases in the 1970’s under the Fourteenth Amendment related to cognovit clauses.  In the Ohio case that reached the Supreme Court, the cognovit clause was in a commercial contract between two businessmen each separately represented by independent lawyers.  Evidence was also presented to the Court that the Ohio practice was that one the cognovit judgment had been entered, if the maker had a good defense, then he could usually move for a new trial and move to set aside the cognovit judgment.  Once you get that judgment, you can get a writ of execution and levy on whatever that guy has.  The Supreme Court ruled in two cases that, at least in a commercial transaction between sophisticated people, the practice does not violate the Fourteenth Amendment.  After the two cases came an FTC rule outlawing cognovit clauses in consumer paper.  An Ohio statute did two things: (1) it outlawed the clauses as to consumer paper, similar to the FTC rule, and (2) it set out a full-caps legend that must be typed verbatim into the note.


These clauses are widely used in commercial transactions in Ohio.  Why is this agency law?  It’s an agency coupled with an interest; note the drafting.  What if Mr. Smith goes crazy after signing the commercial cognovit note?  Under standard agency rules, insanity automatically terminates any power of attorney or any agency.  However, the courts have held that if you have a cognovit note stated to be irrevocable and coupled with an interest then that rule will not apply.  If Mr. Smith gives a cognivit note in a commercial transaction to Huntington Bank and then goes insane, Huntington Bank can still use it against him.  But what if Mr. Smith dies?  The standard agency rule is that the death of a principal terminates agency even if neither agent nor third party knows of the death.  There is an old U.S. Supreme Court case written by Chief Justice Marshall so holding.  Most states follow that, even as to cognovit notes.  Cognovit notes have two big problems: (1) the death problem, and (2) the lawyer for the creditor can’t sign it; you must find someone who is not a lawyer for the debtor or the creditor.  It’s very difficult to get people to sign it because it’s too much of a grey area.


In Ohio and the states where cognovit notes are used, people put too much trust in them as a good security device.  In other words, if you’re a small supplier asked to supply 100,000 units to a small manufacturer, unsecured, you can use the cognovit note, but you should keep in mind that institutional creditors such as banks and insurance companies are ahead of you with recorded first mortgages.  The cognovit clause will help you collect a little bit, but not a lot.  On the other hand, if you’re a debtor with a lot of power, don’t agree with the cognovit clause!  The judgment can get on the record in two hours, but it can take two years to get out of it!  The problem is that it is very difficult for debtors or lessees to avoid the cognovit clauses in Ohio.  All creditors’ and lessors’ lawyers have them on their forms.


One more bit about agency: the problems that have talked about death and insanity revoking powers of attorney have caused problems for a long time.  In World War II, nearly every state enacted a “Servicemen’s Statute”, providing that if you were a serviceman, you executed a power of attorney before you went to fight overseas, you told your spouse to sell Greenacre, your spouse negotiated with Mr. X to sell Greenacre, and a contract was signed, then if neither the spouse nor Mr. X knew that the serviceman had been killed before the contract was signed, the contract would still be binding.  At common law, before these statutes, that was not the result; the contract would not have been binding.  On big deals, then and now, the third party dealing with the serviceman will insist that the serviceperson transfer to a revocable trust with a bank as trustee, since even today you can avoid a lot of these problems.


Thirty years ago, a “new kid” arrived on the block.  By statute in all states, durable power of attorney say that if someone in a signed, dated power of attorney writing states that “if I lose my legal capacity to act for myself, then Ms. X is my agent for all of the following matters”.  The power of attorney can be springing.  So long as the person is in their right mind, Ms. X has no power.  On the other hand, the power of attorney can be by a fully competent person.  They can have their lawyer draft a durable power of attorney for Ms. X while he’s fully in his right mind.  So long as the principal retains his sanity, the power of attorney can be revoked by him.  If he loses his sanity, and thus he himself cannot revoke, how can it be revoked?  It can be revoked through a proceeding for the guardianship of the person and the property in the probate court brought by the relatives of the principal.  Suppose the daughters don’t like Ms. X and think that she’s not taking care of him well and squandering his money.  They can go into the probate court and ask that, for example, the eldest daughter be appointed guardian of the person and of the property.  That appointment will cut off Ms. X’s powers.  Note that the durable power of attorney will not give Ms. X the power to commit the subject to a nuthouse.  She would have to go through very formal procedures at the probate court.  The court would have to appoint an attorney for the man to determine if he’s a nut.


The newer kids on the block are the living will (by statute in the last twenty years) and the health care power of attorney.  You can go to a lawyer and have drafted a health care power of attorney appointing certain people to have your health care power of attorney if you are unable to work with the doctors in the hospital.  But note that so far as the property is concerned, the “old kid on the block”, the revocable trust is often the best available choice.  The old man can revoke that trust at any time while he’s competent and get control of the property back.  Also, the bank can never be appointed the guardian of the person; it can only be the guardian of the property.  The proceedings in the probate court are public, and most families hate to deal with it.  Finally, as an attorney involved in such matters, keep in mind that you should tell the person under a power of attorney to account annually to the children and spouse and get them to approve.  Note also that the Code of Professional Responsibility gets tricky if a lawyer acts in these capacities.



Gottfried v. Gottfried


When minority shareholders sue the company to force a dividend, the business judgment rule will apply.  You’ll have to show gross negligence, bad faith, or fraud.  In this case, the minority didn’t get along with the majority, but the court pointed out that the directors had redeemed a lot of preferred stock and that actually a good bit of money had come out of the company and that the business judgment shield was not shredded.  Tax-wise, these transactions are covered by Internal Revenue Code §§ 301-302 and 306.  Within the past two years, many types of dividends of a Sub C company are taxed with only half of the amount being included in gross income.  It is a partial relief of the double tax and it is crucial.  Where stock is redeemed, the transaction may be a capital gains transaction or it may be a dividend transaction.


Fiduciary duties of stock redemptions – Donahue v. Rodd Electrotype Co.


The Massachusetts line of cases as to close corporations is followed in Ohio by a state court of appeals case from the 1980’s called Estate of Schroer v. Stamco Supply, Inc.  In Donahue, an old man is the president and CEO and has the controlling stock interest in a corporation.  He shows no signs of retiring.  In business school parlance, there is no succession plan.  He just keeps on going because he has a good salary.  The company has never paid dividends.  The biggest minority shareholders are his sons.  A smaller minority shareholder is the husband of the plaintiff, who worked for the company and died before judgment.  The sons are anxious for a succession plan.  They want to get the person out and they come up with what, to them, is an extremely logical plan: the corporation should repurchase the shares.  In Ohio, this is governed by R.C. 1701.11-.37.  The Ohio statute is more restrictive on repurchases than many states.  There are instances where you need a shareholder’s vote in order to do it, but there are other instances where you do not need it.  Here, there was no fraud, no allegation of an unreasonable price and no allegation that the company lacked the surplus or was rendered insolvent.  It’s a pretty clean case!


The minority employee, and later his widow, argued that either the transaction with the old man ought to be rescinded, or the same offer should be made to the widow.  It’s an equal protection argument under the guise of fiduciary duties.  On these facts, the Massachusetts court analyzes the position of a minority shareholder in a close corporation.  It can be pretty grim money wise.  The controlling shareholders are likely to get the good jobs and pay themselves decent salaries, meaning they have no need for dividends.  The minority shareholders get no dividends, and if they attempt to sell their stock, they will find that it’s hard to sell.  When you have stock in a big publicly traded corporation, you can buy and sell a small amount of stock.  If the majority shareholders can show a legitimate business purpose for what they did, we will let them do it without giving the minority shareholders a remedy.  In a famous footnote, another exception is provided.  If the articles of incorporation or bylaws (regulations) do not provide to the contrary or if 100% of the shareholders consent and there is no danger to creditors, then we will go along with it.  What does it all mean?


Here is a paradigm hypothetical.  Father is asked to invest in the stock of a company where his daughter is the majority shareholder.  Suppose that’s his only child, he’s not married, and he can afford it, but he wants his money back in five years.  How will his attorney set it up?  He’ll buy the stock with a redemption agreement whereby the company agrees to redeem the stock at fair market value in five years.  Fair market value will be defined as fair market value without minority discount.  That is, they will value all the shares and spread the value among them.  But that’s not enough!  Father’s lawyer will have to include a requirement that the company first amend its regulations and have all shareholders ratify the redemption agreement in advance therein.  If he fails to do this, Father may get caught by the Massachusetts cases.  Father could theoretically lend his daughter’s company money, but in the real world that probably wouldn’t work because the banks and suppliers would balk unless Father subordinated the debt to all institutional creditors.


In one case, a minority shareholder had veto power over dividends.  He was wealthy and wanted zero dividends.  The younger people needed dividends to get living expenses!  This ended up in a suit, and the court held that a minority shareholder with veto power will be considered a de facto controlling shareholder and will thus be subject to the same liabilities.  Likewise, in Ohio, if you run the citatory on Crosby v. Beam you’ll find an Ohio Court of Appeals case that is exactly the same: minority shareholders with veto power through a shareholders’ agreement can be held to the same standard.


Stock dividends


R.C. 1701.95 refers us back to .04-.06 and .11-.37.  There are two tests for a stock dividend in Ohio.  There is the total surplus test.  After a dividend, the total surplus must be zero or positive.  There are two flavors of surplus: earned surplus is a running balance of net profits minus dividends minus losses and minus certain portions of stock redemptions.  The balance of earned surplus can be positive, negative, or zero.  The other flavor of surplus is capital surplus.  There are four ways to create a capital surplus (four subaccounts).  Each subaccount will be either zero or positive; never negative.  The four subaccounts are (1) consideration in excess of par, (2) donated surplus, (3) reduction surplus, which comes about by reducing the par value of outstanding stock, and (4) contrary to generally accepted accounting principles, Ohio allows revaluation surplus.  If you have land that cost you $1 million and it’s now worth $10 million, you can put on the left-hand side of the balance sheet: “Revaluation of land: $9 million”, and then on the right-hand bottom of the balance sheet, you add in “revaluation surplus” in the amount of $9 million.  Legal scholars think that Delaware and New York allow the same, but Shipman has never been totally sure.  In some states, the surplus test is limited to earned surplus.  In both Delaware and Ohio, you put the two together to see if you meet the test.  Most companies keep the GAAP flavors.


The second test which must also be met in Ohio is the insolvency test, which is a cash flow test.  It is the equity insolvency test, which is: do you have enough liquid assets to pay your liabilities as they come due in the course of business?  The other insolvency test is the bankruptcy insolvency test: do assets exceed liabilities?  In the Bankruptcy Code, each test is used in various places.  But you must meet both tests, or else directors are personally liable for issuing dividends.  Read R.C. 1701.95 carefully and you will find that if the directors rely in good faith upon outside CPAs, company officers, and lawyers, then they’ll be in good shape.  But what’s wrong with relying on lawyers?  Most lawyers won’t help you much because they don’t want to get involved!  However, if you have good officers who have prepared good written reports, then that helps.  If you can get an outside firm to check the numbers, that’s also good.  A lawyer will tell you that the defense exists and how to get it.  If you follow a good lawyer’s advice on procedure and do things by the numbers, then you’ll be ahead in court.


There is a crucial Fifth Circuit bankruptcy case from the 1930’s called Arnold v. Phillips.  It holds that in bankruptcy, where debt obligations are issued in a stock redemption or dividend, the test is applied twice: initially, and also when payment is due.  Shipman believes that this case is still good law.  In addition, Ohio and other states the fraudulent conveyance statutes are applicable.  As a remedy against the recipient shareholders, they are better than the corporate statute.  The Ohio Fraudulent Preference Statute, R.C. 1336.56-.59, and the Ohio Fraudulent Transfer Act both are especially hard on preferences to insiders (what the Securities Act of 1933 would call “affiliates”).  In the Enron bankruptcy, for example, two days before the bankruptcy filing the company bought about $100 million in certified checks from the bank and paid a lot of insiders.  There is a suit to set aside this purchase as fraudulent or wrongful purchases under the Bankruptcy Act.  Shipman thinks that the trustee in bankruptcy will win.


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