Associations Class Notes 6/21/04
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.
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.”
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.
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.
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.
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”.
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.
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.
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.
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.
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.
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.
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.
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
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?
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.
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.
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.
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.
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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