Business Associations Class Notes 6/28/04


More on conflicts of interest


Let us finish up the material on conflicts of interest, then we’ll look at partnerships, which we’ll look at today, tomorrow, and the day after.  We’ll do limited partnerships and LLCs on Thursday.


Perlman v. Feldmann


This is a highly egalitarian decision that came as a big shock to the corporate community.  There were earlier cases dealing with the sale of a control bloc to a looter.  The big case was Gerdes v. Reynolds from the Supreme Court of New York in the 1930’s.  What were the facts back in that case?  There was a liquid pool of money in the corporation.  The corporation was managed, under contract, by an investment company.  The investment advisor had two classes of stock: (1) the voting stock, and (2) non-voting stock.  A purchaser appeared for the voting stock, offering much more than liquidation value for the stock.  The officers, directors, and controlling person making the sale did some checking of the proposed purchaser, but not enough—they were negligent.  The stock was sold.  The purchaser took out the old board and put in his guys, as you would expect.  The new guys looted the investment company!  The trustee in bankruptcy brought suit in state court against the controlling shareholder and the officers and directors of the seller.  It was held that the trustee in bankruptcy could get a double recovery.  He could recover jointly and severally the control premium that the purchase paid for the voting stock.  Next, in ordinary negligence, the trustee in bankruptcy could recover from the same group.  All jurisdictions follow the looting cases.  Within the past twenty years, a Delaware decision has expressly approved them.


Perlman itself is a diversity case in the Second Circuit under Indiana law.  The facts took place during the Korean War.  At time, especially during war, wage and price controls are imposed by the federal government, and the Korean War was one of those times.  When those controls are imposed, you get startling results concerning the exemptions.  In both World War II and the Korean War, employee fringe benefits such as pension and profit sharing plans as well as Blue Cross/Blue Shield were exempt from wage and price controls.  Furthermore, government contractors making those payment were allowed to recoup them as cost from the federal government.  The federal government treated those costs as legitimate.  Out of these wars sprouted employer-paid Blue Cross/Blue Shield and pension/profit-sharing plans because during both periods companies needed every able-bodied worker they could find and they could not raise the wage level to attract more workers.  They couldn’t raise wages, but they could pay fringe benefits.


The same thing was true with Perlman in the Korean War.  There were huge federal contracts left for big companies like GM.  All of these contracts involved using a lot of steel.  There was not enough steel to go around.  The end users could not raise the price that they paid for steel, but the price of stocks and bonds of corporations was not subject to the wage and price controls.  Therefore, if you were an end user like GM and you were having trouble getting steel, you would get together with another end user and try to buy mid-sized steel companies by buying the controlling bloc of stock.  The end users who bought stock from the controlling family did not loot or financially abuse the company.  They paid a fair price by the steel.  We know it was fair because it was set by central planners (ha ha).  The case was brought originally as a shareholders’ derivative action, which would indicate that the plaintiff thought the recovery ought to go into the corporate treasury.


In the course of the Second Circuit opinion, we see a strange “mid-course correction”: the opinion starts out by saying that “control is a corporate asset” and that the controlling person has misused or misappropriated it for himself.  Then, towards the end of the opinion, the court oozes into the remedy: they decide to share the control premium with the minority shareholders, indicating that this right can be asserted either derivatively, as a duty owed to the corporation (under FRCP Rule 23.1) or directly, as a class action (Rule 23) on the basis of duties owed to the minority shareholders themselves.  The court could have cited a case that we started the course with, Speed v. Transamerica, for that exact proposition (and Shipman says they should have).  The California cases expressly say that the cause of action is AC/DC: it can be asserted either or both ways.


Since this case, the New York courts have said that if there is no looting and no fraud by the corporate shareholders, then the controlling bloc of stock is his and it’s prerogative to get as much money as he can.  The New York rule is discussed in Wellman v. Dickinson out of the Southern District of New York.  It is found in F.Supp. from the 1960’s.  New York law is followed and discussed.  Speed v. Transamerica is the first case that says controlling shareholders owe special duties both to the company and to the minority shareholders.  As the century goes back, we’ll get more egalitarian in most states.


In California, we have one of the leading cases in the United States: Brown v. Halbert.  It’s a published opinion by the California Court of Appeals from the 1960’s.  What were the facts?  Mr. X owned about 80% of a prosperous stock savings and loan in the 1970’s before the air went out of S & L stocks.  Mr. Purchaser approached Mr. X and said: “Merge your company into mine in a statutory merger, and I will pay you and the minority shareholders a certain number of dollars per share.”  A statutory merger or sale of all assets tends to spread the control premium out over all shareholders on a per share basis.  Mr. X said: “No way!  Can you make me another offer?”  Mr. Purchaser says: “I think I see what you’re driving at.  I’ll buy your 80% at more bucks per share and then we’ll work together to get the minority shareholders to sell out at a lower price.”  They did so and didn’t inform the minority shareholders what had happened.  Mr. X helped Mr. Purchaser get the minority shares at a much smaller price per share.  The California Court of Appeals holds that the control premium must be spread out evenly for two reasons: (1) Mr. Purchaser had originally wanted to tango in an egalitarian way that would have paid everyone the same per share.  (2) This was botched by Mr. X, who additionally committed fraud in helping get Mr. Purchaser the rest of the stock at a cheaper price.  This case cites Perlman v. Feldmann with great approval.


The next big California case was from the California Supreme Court: Ahmanson.  Mr. Ahmanson lived in San Diego.  Sometime during the 1930’s, he started a stock savings and loan.  He was a financial genius and the S & L did very well.  He owned about 80% of the S & L.  It was not publicly traded, and he wanted a public market so that he and his controlling shareholder buddies transferred their stock to Newco.  That can be done tax-free under Internal Revenue Code § 351.  Newco then owned about 80% of the stock S & L and Newco made an IPO that made Mr. Ahmanson financially liquid as well as rich.  Before this, he was rich, but his money was tied up in the company.  Meanwhile, Ahmanson tried to pick up the minority stock with very lowball offers.  The minority shareholders generally had enough sense to reject him.  They still owned stock only in the S & L but not Newco.  However, the worth of the S & L was now in the public domain!


A suit was brought and it reached the California Supreme Court.  They discuss Perlman and Brown v. Halbert.  The cause of action could be asserted either directly, derivatively, or both.  Was it a breach of the fiduciary duty to form the holding company and not let the minority shareholders in on equal, per share terms?  It was held that this was probably so, but the case was tried below under an erroneous legal standard.  The case shall be sent back to the trial court, which will be told that the controlling shareholder will win if he can show both of two things: (1) there was a valid, bona fide business purpose for excluding the minority shareholders, and (2) the purpose could not have been served by less drastic means.  Of course, he couldn’t prove that.  He died, and his estate settled the suit.  Here is where it gets interesting.  For tax purposes, the Internal Revenue Service often recognizes two important concepts: (1) minority discount, and (2) control premium.  Compute the value of 100% of the stock.  Multiply the result by the percent holdings of the minority shareholder.  Apply to that figure a discount from 15-40% recognizing the minority status.


In Delaware appraisal law, they have said no to a minority discount on a closely-held minority stock interest.  In Ohio, the situation is unclear.  There are opinions indicating that where it is a closely-held concern, if you elect appraisal rights, they may apply that.  If you buy 8% of a company that is closely-held, then the regulations will be amended to say that the stock will be redeemed when the buyer dies and to establish a fair market value “without regard to minority discount”.  Why do we put this in the regulations?  There are Massachusetts cases that indicate that this may not happen unless you put this language in the regulations.


The Internal Revenue Service was in dispute with the Ahmanson estate.  He had the controlling bloc of Newco.  Let’s say that Newco stock was selling at $45 per share.  What does that mean?  It is the value of an atomized 100 share bloc having no real factor in control.  That’s why most tender offers are at well above the NYSE price.  They say to Ahmanson’s estate that a control premium will be added because he has such a big bloc.  According to the newspapers, the statute of limitations for a refund claim had not run, and they used this doctrine to get around the control premium!  There’s an interconnection here between tax and finance (and “everything else”).  Nobody knows what the current situation in Ohio is.  Somebody buying will not pay a control premium, with certain exceptions.  They fear that they may have to pay twice because of these doctrines.


Honigman v. Green Giant


Why is the Green Giant jolly?  Green Giant is a very old company, and the founding family took Class A stock that on a share-for-share basis was just the same as Class B, except that Class A carried 1,000 votes per share as opposed to just one vote per share.  Some call this kind of stock “founders’ stock”.  If the company were liquidated, the Class A stock held by the family would only get about 2-3%.  However, they control.  The family talked with investment bankers and proposed this deal: call a shareholders’ meeting to amend the articles, under which on a ten year basis we can exchange our Class A shares for Class B shares and get our equity participation increased from 3% to 9%.  In other words, they would be paid to be egalitarian.  This proposition was put to the shareholders.  The proxy statement had full and fair disclosure.  There was overwhelming approval by the Class B holders.  Mrs. Honigman was a shareholder in Detroit who didn’t like this.  She went to Milwaukee to bring suit in federal court in a diversity case.  She argued that Perlman v. Feldmann gave her an inalienable right to stop this transaction.


The court held “pish tosh”, there is no fraud, no damage to creditors, no waste, no illegality, full and fair disclosure up-front, and an overwhelming majority voting for it.  Therefore, under the Delaware standard, with shareholder blessing, Mrs. Honigman hasn’t a leg to stand on.  She argued that control was a corporate asset and it ought not be subjected to this kind of waiver.  The court laughed at her argument.  It is one of the most important cases ever decided in the Perlman v. Feldmann chain.


In Ohio, we have one provision that you should pay close attention to: R.C. 1701.59(D) combined with .59(F).  .59(D) generally says: as to duty of care owed by directors to the company, you can’t hold them liable in money damages unless the plaintiff proves recklessness or intentionality.  We have noted before that .59(D) doesn’t apply to purely prospective injunction relief.  It also doesn’t apply to hardcore conflict of interest transactions.  But many companies today will have a majority of independent, outside directors.  On the other hand, R.C. 1701.59(F) says that .59(D) does not apply to a controlling person acting as a controlling person—the Tomash analysis.  If a company is not a public company and the independent outside directors approve the transfer of a controlling bloc of stock to somebody, then the shield of .59(D) does not apply to that transaction.  That’s a very important section!  If it’s a public company, then that provision of .59(F) doesn’t apply.


There are two other places where Perlman v. Feldmann doesn’t apply.  You have an amalgamation.  The acquiring company enters into contracts with many of the controlling persons of the acquired company.  Does this violate conflict of interest law?  Does it violate Perlman v. Feldmann?  The answer is pretty well developed in Delaware law: if the employment contracts are reasonable and are fully and fairly disclosed up-front, there is no problem with the transaction.  Why is this the correct resolution, according to Shipman?  In an amalgamation, one of the first things that the purchasing company wants to button down with either employment contracts or covenants not to compete is that the goodwill will transfer: the controlling persons won’t turn around and compete with you.  The employment contracts or covenants not to compete are crucial.  If you don’t get them, it can be legal malpractice.


Next, if you look through Delaware law of the last thirty years, you’ll find that if there is a good reason for treating the controlling person a little differently from others, it will be upheld if you can show there is a sound reason for doing it and that it is reasonable and fully disclosed up-front.  Let’s say Smith owns 19% of X, Inc., which is an NYSE company.  GM wants to amalgamate X, Inc. into itself in a statutory merger using its own common stock as the consideration.  GM wants to button the deal down as early as possible, and they talk to Smith and the directors of X, Inc., saying: “Under R.C. Chapter 1704 and under the poison pill, if the board of directors agrees to this, we can buy Smith’s stock right now and we’ll buy it for our common stock using Rule 506.  We agree that within seven months we will cause X, Inc. to be merged into GM for GM common stock at the same rate that Smith got the stock.  If you research Delaware law, you will find that’s okay.  There is no doubt that it’s okay under Ohio law.  Both sides of the transaction will be tax-free under Internal Revenue Code § 368(A)(1)(a).  Generally, acquiring corporation outside of New York, they don’t want to chance it and they will comply with Perlman, Ahmanson, and Brown v. Halbert.  Note how egalitarian these cases are.





We will primarily be studying the Uniform Partnership Act of 1914.  The book has many references to the Revised Uniform Partnership Act of the last 15 years.  The Revised Act has notes that are very good research tools; so does the original.  In Ohio, our Act is close to the old one with one maddening change: the numbers in the O.R.C. are one off!  Partnerships and LLCs are deep jello.  Your client can get screwed very, very fast.  We will make analogies to corporations, which Shipman proposes are much more logical.


Just what is a partnership?  Read §§ 1-8 and you get the picture.  Partnership is created when there is co-ownership of a business for profit.  If you’re in the not-for-profit realm, look at R.C. Chapter 1702 and go to a not-for-profit corporation!  Never use unincorporated business forms for a not-for-profit association!  On the other hand, the definition of business in the cases is broad.  Ohio cases in the last thirty years have applied the statute to lottery tickets, for example.  Jack says to Jill: “I’m going to buy some lottery tickets with this number.”  Jill says: “Buy one for me too.”  He buys two $5 tickets, and they win!  Jill, in most states, can assert partnership law and get half of what those two tickets are worth.  In addition, in a Mississippi case after World War II, a brother wanted to engage in a business operation.  His sister sent him some money that looked like a loan.  The operation took off like gangbusters, and it was held that the brother and sister were 50-50 partners and the brother had to split with the sister.  If there had been a big tort liability, the sister would have argued that opposite: that she was a mere creditor.


Partnerships come in two flavors: today and tomorrow we will discuss advertent partnerships.  On Wednesday, we’ll talk about inadvertent partnerships.  It is malpractice for a lawyer to recommend a plain vanilla UPA general partnership today!  Use the LLC or a corporation!  But aren’t a lot of law firms set up as LLPs?  Those are general partnerships with some limitation of tort liability but no limitation of tort liability.  That’s just wrong and bad!  They should be LLCs instead.  But don’t worry unless you’re going to become a partner.  There is no such thing as an inadvertent LLC or corporation.


Richert v. Handly


How does the statute of frauds apply to partnerships?  A famous Houston lawyer got out of the issue on the basis of the statute of frauds.  If it involves real estate, here in Ohio we have strong partial performance doctrines that may well override a lot of the authority other places.


Assumed name statutes


If you are doing business under an assumed name, you are supposed to file an assumed name certificate.  As to a partnership, the statute is especially demanding in that if you are a partnership and the firm name contains less than all of the names of all of the partners, the county recorder is not to accept real estate documents unless there is an assumed name certificate filed.  If the firm name is Smith & Jones and there is only Smith and only Jones, you’re okay.  But if you’re in Baker & Hostetler, there are a lot more partners than just Baker or Hostetler.


Partnership property


Partnership property can still be partnership property even if it’s in the name of one of the partners.  You don’t want to run a partnership that way; you want to put partnership property in the partnership name.  Before the Uniform Partnership Act of 1914, partnership property had to be held in a cotenancy by partnership.  The Uniform Partnership Act of 1914 says you can clearly hold partnership property in the partnership name.  Common name statutes in Ohio and most states say that if you’re suing a partnership simply to bind the partnership assets, the statute will come to your aid if it’s not a very big deal.  Likewise, a partnership can use the Ohio common name statute to sue with just one signature: that of the managing partner.  That’s true in most American states, though it’s not so in three or four states.  Do partnerships ever issue stock certificates or anything similar?  No, it’s the partnership agreement that governs.  There are no stock certificates.


We have a Paul Bunyan at the bar, and a capitalist comes up.  He just bought a timber-cutting agreement.  He says: “Let’s chop some wood!”  Bunyan asks: “How much timber is there?”  Bunyan looks, comes back and says: “You’re 30% too high.”  But they agree anyhow, explicitly agreeing on a 50-50 profit split.  They also explicitly agree that sweat equity (Bunyan) was to use his tractor and other equipment.  He was to be paid “above the line”, that is, before computation of net loss, and he was to be reimbursed for the use of his tractor.  Nothing was said about interest about capital, meaning that there shall be no interest on capital.  Nothing was said about the partner’s salary.


Was this agreement void because it was not in writing?  No, because it was fully performed already.  A general partnership was created.  The timber was cut and sold.  Each party had a capital account.  The capital account goes up by the assets you contribute and by your share of the net profits.  It goes down by your share of the net losses.  This was a partnership for one transaction: the timber under the timber lease.  The tax return was prepared by a CPA, who gave copies to both parties.  The partnership agreement may be subject to amendment by conduct, including how the tax return is prepared.  Either partner can sign, but the others are entitled to a copy of the return and a statement of their distributive share of all items.  The CPA computed the return and found that overall there had been a loss and that the loss is allocable 50-50 between the partners.  Clearly, the profits were to be divided equally.  The CPA, in effect, said that there was a negative balance in the capital account of Sweat Equity.  The purpose of the partnership was completed.  There was a dissolution.  With a general partnership, very often you have to use the traditional method of accounting to settle up.  There is a major Ohio Supreme Court case from the 1980’s and a major Arizona case from the 1970’s to the contrary.  Accounting is always in equity.  The partnership and all partners are parties.  Most often, the cost of the accounting is borne by the partnership itself.


What was the problem?  Bunyan thought that the deal that had been cut was “profits: 50-50 and losses: 100-0”.  Could that deal have explicitly been made as between the parties up-front?  Sure, under § 18, which merely gives you default rules.  If the parties had expressly so agreed up-front and there had been a tort liability, would that bind the injured third party?  Would it have bound contract creditors?  No.  Just read § 18 and you’ll see that it will not bind those third parties.  But if all creditors have been paid and there are no tort liabilities, then this is merely between the parties.  The Supreme Court holds that § 18 is clear: you agreed on the profit ratio while your handshake agreement was silent on the loss ratio.  In that situation, the loss ratio is the same as the profit ratio.  Bunyan isn’t happy!  But he does get a tax deduction.  In California, the courts will usually reach a different result.  In some other states, they might reach a different result if they can find no partnership.  If there’s a loss, and there is sweat equity, in some states they will say that no partnership was formed.  But this is the minority rule.


Many law firms have a “draw” against profits.  They set up a formula by which the partners can periodically draw out about half of what the firm estimates will be the profits for the year.  Note that if the draw against profits is greater than what the profits turn out to be, the partner will get a note from the senior partner asking for his check within ten days.  If the draw is less, as it usually is, within about two weeks after the end of the year, the partner will get the difference from the firm.  Cautious law firms never borrow money to pay partners’ draws.  With one big law firm in New York, there is no payment during the year.  They wait until January, and then write a check.  During the year, the partners must write checks for estimated tax, and they’ll have no idea how much to pay and no money to pay it with.  Skadden Arps only distributes 83% in any year, though you pay tax on 100%.  That’s because they want to build up their internal finances.  When you retire, you have several million dollars in the capital account that you have already paid taxes on.  Don’t borrow money for partners’ draws!


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