Business Associations Class Notes 6/3/04
Extraordinary transactions
In 1830, the rule was (and it is today) that as to any association (business or not-for-profit) there could be no dissolution, charter amendment, merger, or sale of all assets unless you met one of three conditions:
1. All shareholders agree,
2. The charter itself authorizes such action upon a lesser vote, or
3. A statute authorizes such action on a lesser vote.
In the corporate world, starting after the Civil War, legislatures modernized the statutes in all four areas. They provided a scheme (similar to what we see in R.C. 1701.69-91) that upon the appropriate stated shareholder vote there could be a dissolution, charter amendment, amalgamation (statutory merger), or a sale of all assets. These changes were sweeping, and it set the base for the growth of the modern big corporation. If you look at nearly any corporation’s history, you’ll find many mergers, etc. involved. It’s a quite Darwinian process: corporation adapt to changing conditions (“the one part of Darwinism that is least controversial”). In order to make these changes palatable to shareholders, the legislatures provided that many of these votes, if passed, would constitute such a change in the original business deal that it would be only fair to give dissenting shareholders, voting “no”, a cash appraisal remedy. Legislatures have made the business corporation and the not-for-profit corporation very flexible and adaptable by having the foresight to allow these actions. But with partnerships and LLCs, much of this flexibility is missing.
In most states, all of these extraordinary transactions require both the board of directors to vote “yes”, and the shareholders to vote “yes”. Ohio is a little different. On dissolution and charter amendments, the shareholders acting alone are authorized to do it. That’s not true for merger or sale of all assets. Shipman proposes that this is because Ohio is a quite populist state: Ohio and Massachusetts are the only states east of Illinois with constitutional initiatives. For example, term limits arrived in Ohio by way of a constitutional initiative. Also, in Ohio, only shareholders can adopt most regulations, and the shareholders may amend the regulations acting alone, which is very rare among state statutes (but correct, in Shipman’s opinion).
Dissolution
Last time, we talked about dissolution and talked about how complicated it is. The directors must pay or make adequate provision for payment of all liabilities before distributing assets to shareholders. R.C. 1701.95 gives this teeth! If the directors fail to do this, they will be individually jointly and severally liable! (“How do you like them apples?”)
Now we’re talking about the purchaser of a corporation for cash, but I’m not sure what’s happening. One company buys another. To what extent does the purchasing company assume the contract and tort liabilities of the target corporation? The purchase will be taxable to the selling corporation itself. Then when it dissolves and turns over the cash in excess of liabilities, what the shareholders receive will again be subject to tax. It’s a double tax! But if the selling corporation is Sub S, then the double tax will shrink to a single tax because there will be no tax at the corporate level. But it’s still a big item! On transactions like this, make sure to get the corporate and environmental people in early.
The United States has had a corporate income tax since 1913. Almost from the beginning, there have been certain provisions related to tax-free transactions: Internal Revenue Code § 351 (dealing with formation of a corporation) and § 368. The tax burden on this cash transaction would be monumental (in some cases). § 368 provides two or three ways to do this tax-free, both to the selling corporation and to its shareholders. One of the requirements is that the sole consideration be stock (in some cases, voting stock) of the acquiring corporation. In the transaction described above, under § 368 (a)(1)(C), if the sole consideration is voting stock of the acquiring corporation, this can be done tax-free!
Statutory merger
This is an alternative to one company buying another. What’s a statutory merger? Consider the traditional Christian conception of marriage: “the two become one”. There is a formal merger agreement approved by the board of directors of both companies, the shareholders of the acquired corporation, and, in most cases, the shareholders of the acquiring corporation. The agreement says that the two corporations will become one. That’s the “poetry”, but let’s consider the “prose”. The statute says that all debts, obligations, and liabilities of the acquired corporation, “by operation of law” become debts, obligations, and liabilities of the acquiring corporation. This applies to liabilities, whether known or unknown, whether contingent or not contingent, and whether contested or not contested. A big Ohio Supreme Court case of the 1990s applied this language quite literally to a stock redemption agreement of the acquired corporation. The question was: after the merger, could this be enforced against the acquiring corporation? Yes!
The de facto merger doctrine – Ferris v. Glen Alden
Statutory mergers are inherently dangerous on the liability side! It’s very Draconian. Careful lawyers had developed the habit by the 1950’s, especially in tax-free transactions, of going on the asset purchase. Ferris v. Glen Alden, decided by the Pennsylvania Supreme Court in the 1950’s, involved an amalgamation of two big NYSE companies. The consideration was voting stock of the acquiring corporation. The Pennsylvania statute authorized the sale of all assets and statutory merger in a separate statute. They chose to go with the sale of all assets. A shareholders’ suit was brought before the meeting on ultra vires grounds: this was a de facto merger in that the whole business of the acquired corporation was being taken over, stock was being issued, and there was a contractual assumption of all known, uncontested liabilities. The paperwork that had to be submitted to shareholders differed in the two transactions. In addition, if it were a mere sale of assets, there would be no shareholder appraisal right.
The Pennsylvania Supreme Court agreed with the plaintiff shareholders and said this really was a de facto merger! They told the two companies to go back to the drawing board to comply with the notice requirement and give appraisal rights.
Subsequent cases in other jurisdictions expanded the de facto merger doctrine to liabilities, saying: when you buy the whole business for your own stock and contractually assume the known, uncontested liabilities, it is also a de facto merger for liability purposes. That is to say, you take over all of the liabilities of the acquired corporation, even those that were unknown, undisclosed, contingent, and/or contested! “Hey, baby! You’re getting what might be a Trojan Horse!”
Delaware has flatly rejected Farris v. Glen Alden. Two or three Ohio Supreme Court cases in the last twenty years have said, in essence, that in the absence of fraud or a mere change in form of a single corporation, Ferris v. Glen Alden will not be followed in Ohio. But that’s not the end of the story.
Ray v. Alad
This case is out of California’s appellate court. A manufacturing corporation sold all of its assets to a bigger corporation for cash and went out of business. The acquiring company continued the product line. After the amalgamation, a machine manufactured by the selling corporation exploded and there was product liability. The plaintiff could, of course, go after the old company that sold, and under the Uniform Fraudulent Conveyance Act could go after the shareholders. But that’s messy. The contractual assumption of liabilities was narrow and clearly did not include this. There is no third-party beneficiary. What about the de facto merger doctrine? The courts in this situation said: Ferris v. Glen Alden involved the acquiring company issuing stock, which in the old days was a requirement of statutory merger. Where cash or notes are used, it doesn’t apply. Also, this is a liability that came into being after the amalgamation.
The California court, then much more pro-plaintiff than it is now, said: “Not to worry. On this narrow set of facts, we will create by a tort doctrine the product continuation doctrine.” When the acquiring corporation continues the name and product line after amalgamation, injury from a machine built before by the selling corporation will, as a matter of tort law, attach to the acquiring corporation. This case is not followed in Ohio, and probably not in Delaware either. In other states, it runs the spectrum. In Michigan, this doctrine has been embraced, while in other states, they have either modified the doctrine or have declined to follow it. From a planning standpoint, if you’re a cash purchaser of a product line, the only way to protect yourself is to force the selling corporation, at its expense, to buy tail insurance covering both the selling and purchasing corporations. That’s the only way, in a number of states, that you can protect yourself.
Control share acquisition
This method of merger is dealt with in R.C. 1701.831 along with the definitions in R.C. 1701.01. You can, either with a public or private company, simply buy the controlling bloc, up to 100%, of the stock of the acquired corporation! This can be done tax-free if you use your own voting stock to buy it, Internal Revenue Code § 368(a)(1)(B). Why might you do that? The acquired corporation may have franchises, contracts, and mortgage notes that would cause real problems if you tried to buy the assets. The mortgage might be due and payable if you sell the assets! There may be employment contracts with the acquired company that are very valuable, yet it may be unclear if the employees would be obligated to come aboard. But if you buy the company, those people still need to come to work for that company. This mode differs from the other two in an important way: the board of directors has no legal veto power! With a statutory merger or a sale of all assets, the board of directors does have a theoretical and sometimes actual veto power. With this technique, you can make an end run around the board of directors! Then you can boot those guys off the board of directors or expand the board and take control!
There are two flavors of control share acquisition:
1. Tender offer – it’s an offer by an acquirer to a portion or all of the shareholders of a company to sell stock to you, with the exception that if the offer is not public (Ralston Purina: arf arf arf!), it’s not considered a tender offer. That’s important because many federal and state statutes use the term “tender offer”!
2. Non-tender offers – Something either is or isn’t a tender offer: there is no “undistributed middle”. Many statutes use the phrase “control share acquisition”, which includes tender offers but is broader than tender offers. R.C. Chapter 1701 and 1704 both apply to control share acquisitions whether or not they are tender offers. R.C. Chapter 1707 is limited in application to tender offers.
Subscriptions versus options
A true option gives the holder the right, but not the duty, to buy something. So if you buy the option but then discover it’s a bad deal, you can walk away without paying anything except what you paid for the option. If it’s a subscription, you must look at the common law and statutes. Generally speaking, in most states, these are the rules:
1. A subscription must be in writing in order to be enforceable. (This is also true of an option under Article VIII of the Uniform Commercial Code.)
2. In nearly all states, the company need not give consideration to the subscriber in order for it to be a valid contract. Many statutes expressly so provide, and when there is no statute on it and there are two or more subscribers subscribing on the strength of each other’s subscription, then you know from Cordozo that the consideration is supplied by the mutuality of the two or more subscribers. The statute will usually say that the board may call the subscription at any time consistent with the agreement. The statute will usually further provide that the board of directors may release one or more subscribers. But there are two exceptions:
a. It’s not at all clear that they can do that without liability to the corporation in bankruptcy.
b. Under the law of contracts, if you release one subscriber, you may well release all unless the others consent to the release because, in a number of states, if there is joint liability in contract and you release one of the obligees, the others are automatically released unless they have consented.
3. Subscriptions to stocks or bonds are themselves securities for the purposes of the federal securities laws. You must find an exemption. But here in Ohio under R.C. 1707.02 and .03, there is an exception for certain subscriptions, but that will do you no good because you will still have to find a federal exemption.
4. If there is a federal bankruptcy filing, nobody knows what happens! A literal reading of the Federal Bankruptcy Code would indicate that the trustee in bankruptcy cannot call the subscription. Shipman isn’t sure if that’s absolutely accurate.
Can the board of directors call the subscriptions even if the company is nearly insolvent? It varies a lot by state. The bottom line here is that the subscriber is usually legally obligated to purchase. That’s the difference between the two!
Par value
Historically, if you go back 130 years, par value tended to represent the value of the stock. If people thought the common shares were worth $100 per share, then par value would be $100. That is no longer true except with respect to preferred stock. If you’re selling preferred stock for $100, it will almost invariably be put at $100 par. Also, in a lot of foreign countries, the old understanding is still in place. In modern usage, you can use no par stock, but you should never use it. Also, don’t ever use high par stock except for preferred stock. You should use $0.01 par stock for common stock, even if you’re selling for $40 per share. Sometimes they’ll even make it $0.0001! They do that because of franchise taxes, stock issuance taxes and transfer taxes. What does this have to do with par value? In Ohio and many other states, if you use no par stock, the franchise tax is computed on the fair market value of your assets. But if you use par value, it’s computed on the par value of your stock and therefore if you’ve used $0.01 par or $0.0001 par, the franchise tax will be a lot lower. Neither Ohio or Delaware have stock issuance or transfer taxes. Under those statutes, you’ll end up getting screwed if you use no par or high par value.
So why do we still have par value? In Revised Model Business Corporation Act states, you can choose to do without it! In fact, very few people take advantage of this. They use $0.01 par except for preferred stock because loan agreements, note agreements, and trust indentures, some going back 70-80 years are tied to par value. “It’s just too much history there!” Also, occasionally, par value is very useful in that a high par value restricts the board of directors on dividends because, in a nutshell, under the Ohio dividend statutes, R.C. 1701.27-.37, the board of directors can declare dividends only out of surplus. Surplus, generally speaking, is the excess of consideration for stock over par value (that’s capital surplus) and accumulated earnings (that’s earned surplus). If the par is high, the board of directors, acting alone, is restricted on dividends.
Consider this hypothetical: a corporation is organized by Promoter, who takes 600 shares, with his friends taking 400 shares. Each share has a par value of $1,000 per share and each investor pays $1,000 per share in cash. The company thinks it’s going to need $1,000,000. After they set up the company, they see that they need only $500,000. The board of directors consists of Promoter and two subordinates at the company. Can the company return the extra $500,000 as dividends by themselves? No, they can’t, because there’s no surplus! There is no earned surplus because the company has just been set up, and there’s no capital surplus because $1,000 par has been issued.
How could they pay a dividend? They’ll have to go to the shareholders under R.C. 1701.69-.72 for a charter amendment (let’s assume the amendment is to reduce the par value from $1,000 per share to $1 per share). If they do that, under R.C. 1701.27-.37 and .69-.72, there will be created $999,000 in capital surplus and the dividend can then be paid. Promoter and his friends on the board will have to call a shareholders’ meeting and get 67 votes to go with Promoter’s 600 votes to amend the charter. On these facts, he could probably do it. But if Paul and his buddies declared the dividends without doing this, under R.C. 1701.95, they are personally liable to the corporation jointly and severally for $500,000!
Hanewald v. Bryan’s Inc.
If an investor buys $100 par stock for $1 per share and buys 1,000 shares, the corporation can come back to that investor and recover $99,000. There is no way out of it! The statute expressly says that the corporation can do that! The incorporation includes a trustee in bankruptcy or a state court receiver, and if things go belly up, they’ll write another check for $99,000. This is why investors want an opinion from their attorney and the attorney for the company that the stock is fully paid and non-assessable. This case says that if you have such a statute, the creditors themselves can directly go after the hapless investor who thinks he’s got a bargain.
The Ohio statute provides that if the directors, in good faith, value assets, then the remedy may be cut off. If our investor has Blackacre, which has no liens attached and he says it’s worth $100,000 and the directors, in good faith, value it at $100,000, then he will not be liable. But caution: if he knows it’s not worth $100,000, there may be fraud. In modern times on a transaction that big, the board would often get an independent appraisal that would show the watered stock. The board will get statements certified by CPAs who will insist upon an independent appraisal. The securities laws can easily be violated by watered stock, inflated assets and the like. Remember that these are questions the attorney for the company must go over before he issues an opinion that the stock is duly and validly issued and is non-assessable.
Suppose your stock has $5 par value to it, but it’s now trading for $1 and you have to have $500,000 in order to survive. Can you sell 500,000 shares to an investor for $1 and avoid these rules? An old U.S. Supreme Court case indicates that the answer is maybe yes. Suppose you have an option to buy stock. You will always include in it an anti-dilution provision. In other words, if there is a 100% stock dividend, you’ll up the amount of shares you can purchase by doubling and halve the number of shares you purchase by one-half. Suppose you have an option to buy $5 par preferred stock for $5 and there is a 100% stock dividend. That means you can purchase double the amount of shares for $2.50 per share. But the stock still has a $5 par value, and you’re screwed! As a part of the anti-dilution clause, there is a provision that says that you won’t take action that will push the fair market value below par value.