Business Associations Class Notes 6/24/04


I think we’re wrapping up corporations today!


A few final remarks on 10b-5: when a close corporation comes under Crosby v. Beam, you need not rely on federal law.  He believes that fraud is not required because the fiduciary duties are so intense.  The absence of fraud is important because in the last 25 years, the federal courts have required extremely heightened pleading for fraud.  Also, the 1995 Act reinforces the requirement as to fraud class actions concerning securities.  If you can plead something lesser than fraud, do it, because it’s much easier to make out a case.  In addition, if the defendant has insurance, remember that negligence and gross negligence will be covered by the policy, while hardcore fraud will not be covered.


More on duty of care


We’re leading up to a defense both to duty of care and duty of loyalty actions: the defense of special litigation committees, composed of truly independent outside directors studying the matter and concluding that it ought to be stopped.  We also look at the defense on the merits of the shareholder decision not to sue.  That will work under either duty of care or duty of loyalty.  It requires that you can get disinterested shareholders holding a majority of the stock to vote with you after full and fair disclosure up-front.  You also must show that creditors are not harmed.  This is the non-unanimous shareholder ratification rule.  There is also a unanimous shareholder ratification rule.


Let’s say three siblings each hold 10% of the stock of a Sub C company.  The father owns the remaining 70%.  The three siblings are the directors and officers and they set their own pay.  In the absence of a defense, if the father starts an action under Crosby v. Beam or under Rule 23.1, the sibling’s only defense to the reasonableness of their compensation is overall reasonableness.  That is always possible.  If the defendants can show overall reasonableness, both in disclosure and on the merits, and creditors aren’t harmed, then they have a defense.  Note that this is a defense on the merits.  A little company like this would not have outside directors who could set up a litigation committee.  What would we advice the siblings?  We would advise them to hold a joint shareholders’ and directors’ meeting and get all four people to vote “yes” for salaries.  As long as there is full and fair disclosure up-front and no creditors are harmed, this is an absolute defense.


Here is another defense lawyer’s trick.  Defense lawyers have tried to bifurcate or trifurcate the trial.  If you can convince the judge to do that up-front, then in the preceding example the defense can be asserted early.  If the defendants win, they are home free because it’s a total defense.  This has recently been used in the 1990’s Supreme Court Exxon case.  The case came out of Hawaii.  Exxon had a huge tanker serviced under a contract with a dry-dock company.  That company was negligent in servicing the Exxon ship, and as a result, the ship developed serious problems upon leaving the dock.  The captain forgot to map where he was!  Because the captain didn’t know where he was, the ship ran aground and caused a huge amount of damage.


Exxon sued the dry-dock company in negligence and in contract.  The attorney for the dry-dock company convinced the judge to bifurcate, saying: “There is an overriding legal principle that if ordinary negligence by the defendant is followed by gross negligence on the part of the plaintiff, then there is no legal cause, and thus the dry-dock company has a 100% defense.”  The judge granted the motion and found that what the Exxon captain did was gross negligence, and under respondeat superior, Exxon is bound by the captain’s actions.  He agreed with the defendant’s legal principle in negligence and he also said the same reasoning applied to the warranty count on the express written contract.  Even if there is a warranty, the judge said, if the plaintiff reacts with gross negligence then the company has a 100% defense.


The U.S. Supreme Court held that the trial court judge was totally correct on the merits.  What the defense lawyers did here is get to the “nub” of the matter quickly.  Within each “half” of the case, they can use 12(b)(6) and summary judgment.  The court did not have to hear testimony about damages.  They simply looked at one part of it.


In the example above, what is done by the three siblings will not bind the Internal Revenue Service because it’s a Sub C company.  If the Internal Revenue Service comes calling, you will have to persuade them.  However, the brothers are very much protected.  One of the requirements is that creditors are not hurt.  What if the brothers are paid out much more than they’re worth?


Marciano v. Nakash


In Delaware, as well as in some other states, courts have held that the ultimate handling of conflicts of interest is up to the court.  If a party meets those statutes, the court just pushes the burden of proof back to the plaintiff.  A case to that effect was Comolli v. Comolli from the California Court of Appeals.  In this case, we have the flip side.  This is a close corporation with two 50% shareholders (different families).  There are no independent, outside directors on the board.  One family runs the company.  The company runs into financial troubles.  The family running the company, without consulting the other family, lends the company money.  The company goes insolvent and a state court receivership is started in Delaware.  The other family objects because the family running the company could in no way approve the transaction under Del. § 144 since they held only 50% of the stock and there were no independent outside directors on the board.  The family out of power thus said that the claim for the note is per se bad.


The Delaware Supreme Court, very consistent to their earlier case, says that the defense of overall reasonableness both in disclosure and on the merits with no harm to creditors is always available to a defendant in a duty of loyalty action.  Here, the chancellor examined the loan carefully and found that the loan was reasonable overall.  There was no fraud or bad faith.  The court-made exception for overall reasonableness that preceded the statute is not touched by the statute.


Heller v. Boylan


This case references the famous case of Rogers v. Hill from the U.S. Supreme Court of the 1920’s.  George Washington Hill was the president of American Tobacco Company in New York City.  He was a “man about town”.  In 1909, American Tobacco, a New Jersey company, had gone to the shareholders and gotten them to approve, in the bylaws, a cash bonus plan based on tables, that is, “if net profit is over x, then set aside z%” and so on.  American Tobacco proved extremely profitable over the years and the cash bonuses went through the roof.  A minority shareholder brought a shareholders’ derivative action.  There was no committee of independent, outside directors to pass on it, so it went to full trial.  The case went in the federal court on diversity jurisdiction, and was decided, pre-Erie, under federal common law (Swift v. Tyson).  The U.S. Supreme Court held, similar to the Delaware courts, that even with full and fair disclosure up-front, approval of a disinterested majority of shareholders, and no injury to creditors, then if it amounts to waste, it’s no good.  Hill objected that the “money machine” can’t be turned off because the cash bonus plan was in the bylaws.  The Court said that it was part of the duty of the directors to recommend an amendment to the shareholders that is contrary to the directors’ interests.  In Delaware, the doctrine of waste is now well entrenched.


In the Delaware Supreme Court in the past three years, there was a case involving Walt Disney.  Michael Eisner hired an assistant weirder than him.  They didn’t get along well, and he decided to terminate the assistant.  They came up with a termination package and it was put before the board for approval.  Most of the board consisted of independent, outside directors.  Before trial, the Delaware Supreme Court determined whether the pleadings were good enough.  They said that waste is alleged.  The case was sent back.  There was also a case involving The Limited recently in the same court.  The Limited is a big NYSE company, and there are a lot of social friends of Les Wexner on the board.  He entered into a conflict of interest transaction with The Limited, and the independent directors blessed the transaction.  The chancellor examined the exact relationship of each of the alleged outside directors and found, contrary to first appearance, they had very significant business dealings with Wexner.  The case was remanded for trial, and The Limited later settled the case.


Sinclair Oil Corp. v. Levien


Sinclair USA is a big oil company.  It owned about 93% of Sinclair Venezuela.  The latter was, itself, a public company with several hundred shareholders.  The directors and officers of Sinclair Venezuela were all directors, officers, or employees of Sinclair USA.  Sinclair USA needed money.  The directors of Sinclair Venezuela declared very good dividends over a number of years so that the parent corporation could replenish its bank account.  Here we have a “man bites dog” lawsuit!  It’s not a suit to force declaration of dividends, but rather a suit by the minority shareholders that the payment of these dividends hurt Sinclair Venezuela because they had business opportunities that they could have taken advantage of if not for the dividend policy.  The threshold question was whether the case should be judged under conflict of interest analysis.  If you do, Sinclair USA must prove overall reasonableness.  On the other hand, is the case to be judged under the business judgment rule where the plaintiff, in order to stay in court, would have to show fraud, ultra vires, illegality, arbitrary action, or gross negligence to “shred the shield”.


The court pointed out that the dividends did not violate any bank loan agreement or the Delaware restrictions on dividends (that is, you must have surplus and the dividend can’t leave you cash flow insolvent).  The court said that even though it may look like a conflict of interest transaction, if the parent received nothing out of it except a ratable return on each share of its stock, equal to the ratable return each minority shareholder received on their stock, then it’s not governed by conflict of interest principles, and you must look at the business judgment rule!  On the merits, they held that there is no reason to shred the business judgment shield.  There were a few contracts that the parent had entered into with the subsidiary that the parent wasn’t performing.  The court held that there was a conflict of interest there.


Weinberger v. UOP, Inc.


Both of these companies are NYSE public companies.  The parent owned 51% of the stock of the subsidiary from an earlier friendly cash tender offer.  The parent has extra money to invest and it’s looking for something to invest in.  The financial and operating folks figure that if they can get the other 49% of the subsidiary at the same price per share they paid for the first 51% then it would be a great investment.  At the time of the friendly tender offer, the board of directors of the subsidiary contained a majority of independent outside directors.  But at the time of the controversy, only three out of the seven board members were independent.  The parent wanted a cash-out merger, meaning that the subsidiary would be merger into the parent for cash and the parent would pay cash only.  This invoked the proxy rules at the subsidiary level since the subsidiary was an NYSE company.  The Securities Act of 1933 was not applicable to the transaction because cash is not a security either for federal, Ohio or Delaware law.


Was Rule 13e-3 applicable to the situation?  This is the “going private” rule.  It applies only to SEC-reporting companies.  It was not in effect at the time, but let us describe the effect it would have had.  The thrust of the rule is that if you have a public company with public shareholders having equity securities and through one or more transactions with an affiliate those public shareholders who did have equity securities end up with no equity securities then the rule applies.  Note that if the rule had been in effect at the time, it would have applied.  The rule says that, in addition to all other disclosure, the board of directors, in the proxy statement, must expressly state whether, in their opinion, the transaction is fair to minority shareholders.  The board of directors must give detailed reasons for their conclusion.  The Rule goes on to say that the directors cannot delegate this task to an investment banker, though they will hire an investment banker to help them.  This is a high burden because the Rule goes on to state that projections, forward-looking information, appraisals, and “soft” data must be consulted.  You must go way beyond GAAP!


The parent’s financial department had worked up tables indicating that the stock of the subsidiary would be worth about $22 or $23.  They wanted to pay $19 which is what they paid before.  The parent went through the books and records of the subsidiary without the consent of the board of directors of the subsidiary.  They did their due diligence without the consent of the board.  The information of the subsidiary belongs to the subsidiary, not the parent!  They also did not set up an independent negotiating committee.  They had three outside directors.  The court says that they should have appointed an independent negotiating committee who would acquire independent counsel, investment bankers and CPAs and that if they had done all that, the business judgment rule would have saved the parent.  There was no approval by a disinterested majority of shareholders, because a majority of shareholders were interested!


Self-dealing is a serious conflict of interest.  You can revert to the more hospitable business judgment rule if you set up an independent negotiating committee at the subsidiary, but in this case the parent did not.  There is no other defense available.  Therefore, the parent has the burden of pleading and proving overall reasonableness.  Overall reasonableness includes reasonableness on the merits as well as reasonableness of disclosure.  The parent’s records showed that they believed the stock was worth $22-23.  That was never disclosed to anyone at the subsidiary.  The defense was not made out, and thus the case was remanded to determine damages.  If you proceed under duty of loyalty, causation-in-fact can often go by the wayside.  You also do not need to show fraud or bad faith if the plaintiff shows a serious conflict of interest.  In that case, it is up to the defendant to make out one of the four or five applicable defenses.  If the defendant fails to make those out, the defendant is going to be a big loser.



What’s the fallout?  Rule 13e-3 would be applicable today.  The federal disclosure requirements don’t add a lot to the Delaware requirements.  There are two Sixth Circuit cases, Nationwide v. Howing from the 1970’s that discuss Ohio fiduciary duty law and Rule 13e-3.  The casebook tells us that we’re in the area of “squeeze-outs”, or cash-out mergers.  The casebook gives us a number of cases.  In a number of jurisdictions, there are some very strict anti-squeeze-out cases.  But Shipman suggests that where there is full and fair disclosure up-front (no fraud), there are instances where a squeeze-out is fair.


Consider a Washington Supreme Court case from the 1950’s, Matteson v. Zielbarth.  A small startup corporation was about 63% owned by one person who worked there full-time.  The other guy owned slightly more than one-third, enough to block a merger.  Business was rough, and the company was about to go under.  The fellow running the company did some shopping around and found Z, Inc., which thinks they have a pretty good business.  If the minority shareholder will agree to certain terms, Z, Inc. will swoop in and take over the business, continuing to employ the fellow running the company.


It is stipulated that the fellow running the company was honest and that the salary he was receiving was reasonable.  The salary being offered by Z is also stipulated to be reasonable.  The minority shareholder decided to be difficult.  The shareholder decided that he wanted a portion of the money the main guy gets or else he would use his power to block the deal.  The guy running the company, with the consent of Z, Inc., set up a new company, N, Inc., and merged the old company into the new company with him getting stock and with the minority shareholder being cashed out.  There was no fraud; everything was done on the up and up.  There was a strong business purpose.  Shipman believes that the deal was reasonable.  The court says that where the person being frozen out has an appraisal remedy, if he waits until after the merger to sue, then he has no damage remedy (as long as there is no fraud).


There are three Ohio cases we should know about in this area: first, there’s the case of McConnell dealing with the Bluejackets from the Court of Appeals, after 1995.  McConnell and the Wolff family got together to get an NHL team for Columbus.  They didn’t have an arena yet.  They went to the mayor and City Council.  McConnell, the Wolffs, and Lamar Hunt formed an LLC and got a ballot initiative for a half-percent sales tax to build an arena.  The ballot initiative was killed partly by Bob Fitrakis raising up a storm on talk radio.


They still wanted a team!  They went to the NHL and Nationwide Insurance.  The head of Nationwide indicated that they would consider building the arena and leasing it to the team, which is what ultimately occurred.  Hunt wasn’t thrilled with this change, and decided to block the transaction.  McConnell and Wolff formed a new limited partnership and went ahead.  Hunt sued on corporate opportunity and freeze-out.  In the LLC agreement, a very important clause said that any one of the members could compete with the LLC.  That is often included in real estate LLCs because real estate folks often have side ventures.  The Court of Appeals in Franklin County held that because of the clause in the LLC agreement, the transaction was reasonable.  This is one of the leading cases in Ohio on Business Associations law.  The opinion talks about Crosby v. Beam and other important Ohio cases.


When is the appraisal remedy a shareholder’s sole remedy?  The Ohio Supreme Court decided two cases on this issue on the same day in the early 1990’s.  The cases mean different things to different people.  One was Stepak v. Schey and the other was State v. Maraschari.  Here is Shipman’s interpretation: when one minority shareholder sues in advance to block a deal, the fact that he would have an appraisal remedy at the end does not toss him out of court.  If you sue to enjoin, you may have to post a big bond.  When you sue afterwards and there is no fraud or major disclosure discrepancy, the cases suggest that in the absence of ultra vires, you can’t get damages, rather, you must elect the appraisal remedy.


Corporate opportunity


This grew tremendously in the 20th century.  In 1910, you had to prove an expectancy in the corporation in order to prove corporate opportunity.  That changed in the 1930’s with one of the most famous cases ever decided: Guth v. Loft, out of the Delaware Supreme Court, which involved Pepsi.  The decision was very pro-plaintiff.


Another case was Irving Trust Company v. Duetsch, which was from the Second Circuit in the 1920’s.  There was a struggling company.  The DeForrest patents come on the market.  The controlling person doesn’t have enough money to buy them from the holder.  But the controlling person thinks that he can rake up the cash in a couple of months.  He wants to tie up the patents, so he has the company sign a contract to buy the patents with the closing several months in the future.  If he couldn’t raise the money, he figured it would be the company on the line and not him.  But his goal was to raise the money.  He worked hard and succeeded.  He caused the company to assign the contract to him.  He closed on the contract and made a lot of money.


The company went bankrupt, and the trustee in bankruptcy is the universal successor to everything the company had, including causes of action against affiliates.  So the trustee in bankruptcy sues.  It’s a close case because the law says that a wealthy director, officer, or controlling person does not have lend money to the company when it wants to take an opportunity.  In this case, the court held that as a prophylactic principal that where the company has obligated itself by signing a contract, the controlling person cannot use the defense that the company didn’t have the money.  If the controlling person takes over the contract and it’s good, then the company or the trustee in bankruptcy will sue in constructive trust, damages, and accounting.


The case of Miller out of the Minnesota Supreme Court from the 1960’s does a good job summarizing the law of corporate opportunity from the first half of the 20th century.  The early cases aren’t fully consistent.  The court’s reaction is to say that when it comes right down to it, the test is really just whether what the officer or controlling person did was reasonable.  In the 1970’s, the ALI stepped into the fray.  They come up with a Restatement which says that if the controlling person or officer or directors does not disclosure what he is going to do at the outset to the other directors, officers and shareholders, then he has per se violated his fiduciary duty and the corporation can sue him.


Northeast Harbor Golf Club, Inc. v. Harris


This case follows the Restatement.  Delaware, within the past 25 years, has expressly rejected the ALI Restatement and they stick with Guth v. Loft.  They probably would not be unhappy with Miller.


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