Business Associations Class Notes 6/7/04


The Ohio rule regarding the disregard of the corporate fiction


If you go back 25 years, the Ohio Supreme Court cases had all held that you need fraud or sham to disregard the corporate fiction.  Since then, a Sixth Circuit case and an Ohio Supreme Court case that expanded the grounds somewhat for disregarding the corporate fiction.  After that, you see a bunch of Ohio Court of Appeals opinions.  These opinions differ, some saying that Ohio law is now pretty much like the law of any other jurisdiction, others saying that the two big cases did not open things up that broadly.  A third group of cases have given an extensive definition to fraud and have included constructive and equitable fraud along with “hardcore” legal fraud.  So in Ohio you’ll have to read a bunch of cases and carefully qualify the extent of the opinions you give to clients because no one is completely sure where Ohio law is right now.


Preemptive rights in Ohio


Courts used to say that there were preemptive rights in Ohio unless the charter provided otherwise.  A few years ago, the statute was amended as to newly formed corporations.  Now we have an “opt-in” situation rather than an “opt-out” situation.  You don’t have statutory preemptive rights unless the charter so provides.  Delaware has always been an opt-in state in modern times.


Generally, if new stock in a corporation is issued, it must be offered to all shareholders on a proportional basis.  But there are common law exceptions.  The big case in Ohio on preemptive rights is Barsan v. Pioneer.  It follows the Massachusetts authority.  This case made a point about waiver.  Shareholder by shareholder, there can be a waiver.  If all shareholders waive, then there is no problem.  The waiver can be formal (in writing), or it can be informal (by conduct).  That’s one common law exception.  Next up comes non-cash property.  When stock is issued for non-cash property, meaning a corporation wants to issue common stock to a non-shareholder in exchange for some property owned by that non-shareholder.  Shipman doesn’t know how this exception is consistent with the rationale for preemptive rights!  When a company makes a non-only purchase of another company, that’s non-cash property and will also fit within the common law exceptions.  Preemptive rights are a sticky issue!


Generally, when public companies go public in an opt-out state, they will often amend their articles to deny preemptive rights.  That can be done under Ohio law, and no appraisal right is involved.  Considering the problems posed by preemptive rights, few Ohio lawyers organizing a new company in the old days opted out in the original charter.  Shipman finds this interesting.  He thinks this will change with the “opt-in” situation.  If you have preemptive rights you can have problems!


In Ohio, preemptive rights are dealt with in R.C. 1701.14-.20.  In older Ohio companies, there generally won’t be an opt-out, and the change won’t apply to a company established before the change.  The common law exceptions are actually built into R.C. 1701.14 along with some other exceptions.  This section says that if you’re subject to preemptive rights, you can, without a shareholder’s meeting and without a charter amendment, “bless” the transaction if you get shareholders owning two-thirds or more of the stock to say that preemptive rights will not apply to that transaction.  Note that if you do that, you must immediately notify all shareholders of what you’ve done.  Also, this provision exists “on top of” the common law waiver provision.  Preemptive rights can exist by contract among the shareholders.  There are a number of cases where, when you deal you a close corporation, you find that there is a shareholders’ voting agreement (per R.C. 1701.591) that has contractual preemptive rights provisions in it.  There are situations where the shareholders want the proportionate ownership kept.


This affects lawyers in a big way!  Lawyers are often called upon to issue the opinion that stock is “duly and validly authorized and issued, fully paid and non-assessable”.  Does this opinion include “no violation of anybody’s preemptive rights”?  There’s disagreement on this point!  Careful lawyers for purchasers request a second paragraph that says: “Issuance of the stock does not contravene anybody’s preemptive rights under the charter, the statute, or any contract or agreement”.


Here’s an example: in the first merger, all the shareholders voted yes, but the lawyer forgot to amend the articles to take out preemptive rights.  Down the road, under new management, they didn’t realize that preemptive rights were still there.  They sued the lawyer in the first transaction, and Shipman argues that the lawyer’s opinion was correct.


Hyman v. Velsicol Corp.


This is an old case with a lot of lessons for us.  There was an Illinois corporation, two capitalists, and one sweat equity.  It was a start up, and everyone put in an equal amount of cash.  With start-ups, you’ll need more money down the road!  You’ll seldom make it on the first infusion of money.  The company needed more money.  The two capitalists owned two-thirds of the stock and were two of the three directors.  The board of directors authorized the corporation to sell a huge number of new shares for a huge amount of money.  The company was under preemptive rights.  Each shareholder was notified of his right to subscribe to a third of the offering at the stipulated price.  The two capitalists, who planned the issue, had the money for their one-third.  But sweat equity didn’t have the money!


So sweat equity sues under the theory of fiduciary duties.  The two capitalists were technically complying with preemptive rights.  If sweat equity could have afforded it he could have exercised his right to buy one-third of the new shares.  Preemptive rights doesn’t displace fiduciary duties!  In a close corporation, the officers, directors, and controlling shareholders owe strong fiduciary duties to each other.  In Ohio, Crosby v. Bing codifies that doctrine.  So sweat equity asks for an injunction stopping the issue because he has no money and after the issue he’ll only own a few percent of the enterprise.  We’re told that the injunction was denied, but we don’t get all the facts.  Sweat equity came into court with unclean hands!  Those who seek equity must do equity!  Sweat equity had gone to work for a competitor and the Illinois court held that under the unclean hands doctrine there was no relief on the fiduciary duty theory.  The capitalists “kissed the books” correctly on the preemptive rights doctrine!


What other lessons can we draw from this case?  If you represent a sweat equity type and the startup is in corporate form, sweat equity will want a clause saying: “If new money is needed for capitalist, they will advance it for preferred stock that is not participating or voting, or else they will advance it as debt.”  In a high-tech startup, sweat equity wants to be a major owner when the enterprise goes public.  This will entail heavy bargaining, but keep in mind what sweat equity’s point is.  If the startup is in a limited liability company, the problem is going to be there, but it will be much less acute.  The contractual provisions protecting sweat equity while dealing with the capitalists can be dealt with a lot more easily as an LLC with the Internal Revenue Code.  LLCs are very good for startup ventures in that Sub K is simply more flexible than Sub C or Sub S.



Common law rule regard indemnification without a contract


An agent can get indemnification from the principal if four conditions are met:


1.     The agent is not negligent.

2.     There is no crime.

3.     The agent acts within the scope of his employment.

4.     The agent violates no implied or express work rule.


The Uniform Partnership Act of 1914 codifies this rule at § 18.  The leading case on the rule is a Pennsylvania trial court case from the 1800s called D’Arcy, in which a Pennsylvania principal sent his agent down to Haiti, and through no fault of the agent, he got thrown in jail and he had to litigate.  The agent finally got out of jail and back to Pennsylvania, where he sued the principal for indemnification for the litigation expenses.  It was held that he made out the case and would be entitled to indemnification even though he had no contract for indemnification with the principal.


That’s the rule as of 1930.  Then, in McCollum, a New York trial court case from about 1940 shocked the corporate world!  McCollum was an executive of a company that’s now part of ExxonMobil.  In the 1930’s, a number of the oil companies engaged in fixing the price of oil.  There were large downward pressures on oil and many of the company did “naughty things” in violation of the Sherman Antitrust Act.  The government brought a lot of cases and got a lot of convictions.  But when they brought the criminal case against McCollum, he paid the expenses out of his own pocket and got an acquittal.  Then he asked his employer for indemnification, but the employer refused and he sued based on the common law principle of agency law.  This case added a fifth requirement to those on the board: McCollum didn’t show any benefit to the employer, and therefore he couldn’t get indemnified!  Some states refused to follow McCollum.  They followed the “classic statement”.


After World War II, statutes came about like R.C. 1701.13(E).  In Delaware, it’s § 144.  In Ohio, if you’re sued in your corporate capacity either by or on behalf of the corporation or by a third party and you prevail on the merits or otherwise (such as based on statute of limitations), then you are absolutely entitled to indemnification from the company.  This doesn’t mean you don’t have to have insurance.  Insurance and indemnification don’t completely overlap.  Your rights under indemnification are no better than the solvency of the corporation.  But if you have an insurance policy that covers you, then the insolvency of the company you work for doesn’t affect your insurance coverage, assuming, of course, that your insurance company is solvent.  Therefore, your R.C. 1701.13(E)(3) right against a corporation might not be worth much.


R.C. 1701.13(E)(5)(b) says that if you’re sued in your corporate capacity, the board of directors may advance your attorney’s fees.  R.C. 1701.13(E)(1) talks about suits by or on behalf of the company, while R.C. 1701.13(E)(2) talks about third party suits including shareholder actions, creditor actions, actions under the securities laws, and actions under criminal provisions.  Both statutes say that other certain circumstances, the board of directors may indemnify you.  (E)(1) and (E)(2) do not have any “must” language in them.  But here’s the new kid on the block from the 1980’s: R.C. 1701.13(E)(5)(a), which also deals with attorney’s fees.  This is a “must” provision.  If you’re sued in your corporate capacity and you make a demand on the company, the company must pay your reasonable attorney’s fees monthly subject to one big condition: you must sign a written undertaking to reasonably cooperate, and if you are found to have been reckless in discharging your duties, you will have to reimburse the corporation for such attorney’s fees advanced.


In the 1980’s, we also got R.C. 1701.59(D) and 1701.59(F).  (D) provides that in an action by or on behalf of the corporation against you, if you were acting in your corporate capacity, no money damages will be awarded unless you are found to have been reckless.  (D) applies only to directors, and the same is true of .13(E)(5)(a), except Shipman thinks that the latter applies to a director acting as an officer and it may turn out that .59(D) also does.  R.C. 1701.59(F) makes it clear that (D) does not apply to a suit against a director in his capacity as a controlling shareholder.  We’ll get back to the duties of controlling shareholders later.  The infamous Delaware case of Smith v. Van Gorkum brought about these statutes.  The Delaware statute differs somewhat from the Ohio provisions.  For the Delaware provisions to apply, the shareholders must vote it in, but in Ohio it’s just the opposite: they apply unless the shareholders vote it out.


Merritt-Chapman & Scott Corp. v. Wolfson


Wolfson was a “corporate bad boy” of the 1960’s and 1970’s.  He was the director of a public company and the federal government claimed that he violated the securities laws, so they brought a criminal action against him in two or three trials.  He won on some of the counts, but the government won on some other counts.  Other charges were dropped as the case went along.  The question is how the Delaware version of (E)(3) worked.  The decision is very pro-director.  The court held that:


1.     You can prevail in different ways: either by acquittal or by a second trial where the government drops a charge.

2.     It is not all-or-nothing, that is, Wolfson should allocate his legal expenses among the various counts and as to the allocated expenses, to those counts where he prevailed, he is entitled to indemnification.


The Justice Department, in its sentencing guidelines, wants corporations not to indemnify, and the pressure is on corporations to cut loose accused executives and stomp on them.


Director and officer’s liability insurance is important.  If you’re advising a client, don’t go on a board without it.  Look at the coverage and exclusion clauses of the insurance policy.  Coverage clauses are usually construed broadly to protect the insured, and exclusion clauses are generally construed narrowly against the insurer.  What are some of the big provisions?  In the exclusion clauses, you’ll find exclusions for dishonesty, fraud, criminal conduct, and intentionality.  Just what is intentionality?  In Delaware § 102, we’re told that these new clauses can apply only to actions under the fiduciary duty of care and not under the fiduciary duty of loyalty.  Ohio R.C. 1701.59(D) and .13(E)(5)(a) don’t make that distinction.  The courts have held that if the action is a duty of loyalty action against a director or officer, and all that’s shown at trial is inadvertent breach of the duty of loyalty, Delaware § 102 will apply.  Shipman thinks that the same rule applies here.


What’s another big exclusion?  One is Rule 10(b)(5) under the Securities Exchange Act of 1934.  ERISA is also an exclusion.  The biggest headache is a clause that says: “If the director or officer received some corporate benefit that other shareholders did not receive in proportion to their stock holding, then the policy will not apply.


This gets us into the way policies have been drafted for the last 35 years.  In the old days, the policies were written as occurrence policies.  If you bought a policy for the calendar year 2004 but you didn’t get sued until 2010 under a discovery rule, that occurrence policy would cover you.  But the problem with this type of policy from the insurance companies’ standpoint is that it has a long tail; the insurance companies can’t figure out how much they’re on the hook for.  So about thirty years ago, the insurance companies switched to claims made policies.  Today, your D & O policy will cover you for claims made in 2004 with two additions, one going backward and one going forward: (1) if you notify the insurer in 2004 of something that may give rise to a claim and the claim is made later, then the 2004 policy will cover you.  (2) If you’re buying a policy from the company for the first time in 2004, things that you fully disclose in detail to them that happened earlier can, for an additional premium, be covered.


When a professional retires, they purchase tail coverage.  Tail coverage will cover things that come up in the future.  The premium will usually be one and one half to three times your usual annual premium.  The application for tail coverage or for looking backwards is going to have a very complete disclosure provision in it.  The insured and the insurance company must deal with each other in utmost good faith.


McCullough v. Fidelity & Deposit Co.


This case dealt with a bank that had generally informed its insurance company that there had been a bank examination.  If the insurance company had read the full examiner’s report, they would have seen that a bunch of claims were about to break loose.  The court held that in order for the “forward looking” out to apply, you must be specific and detailed in your reporting to the insurance company.  Shipman says that McCullough should have hired a lawyer.


Here’s one more situation where you can get your attorneys’ fees.  The outside legal counsel for a corporation is asked to review a proposed merger in detail.  He does so using reasonable care and he gives a written opinion to the directors and officers that, in his opinion, neither federal nor state antitrust statutes are violated by the transaction.  Three years later, the Justice Department sues the corporation and the officers and directors claiming that it does violate the antitrust laws.  The outside lawyer in that situation will recommend to the board that he enter an appearance for both the corporation and the directors and officers because he advised all of them that in his opinion he thought it was legal.  He would say that because he advised everyone that way, there is no conflict of interest.  What he is trying to fight is the government strategy, which is to divide and conquer.  It is perfectly proper for the outside counsel to make an appearance for everyone and handle the litigation since they were proceeding on his authority.  The board of directors will go along with this and allow it.  It’s not literally covered by .13, but it is a form of indemnification of attorneys’ fees that happens every day.


Connected with that and relevant to today’s discussion is the defense of good faith reliance on legal counsel.  Here are the leading authorities on this: Maness v. Myers from the U.S. Supreme Court, which deals with the lawyer’s side.  The client was selling “girlie” magazines.  But were they hardcore pornography or not?  In a civil proceeding, the government asked for the production of the magazine, and the lawyer advised him against it.  There was a court hearing, and the judge asked the client why he didn’t submit, and he said that his lawyer gave him a legal opinion that he didn’t have to.  The judge issued a contempt order for the lawyer, and the U.S. Supreme Court held that insofar as the lawyer is concerned, if you give advice to a client in good faith that precludes recklessness, then a court has no jurisdiction to enter a contempt order against you under the Sixth Amendment.


Here are a couple of journal articles.  One article in the Vanderbilt Law Review by Hawes said that when there is reasonable reliance on counsel by a client, it proves good faith and reasonable care by the client.  But there are causes of action where you can lose even if you’re not negligent and you’re in good faith.  But the role of the lawyer in this area in giving opinions is crucial.  Under Delaware § 102, if there is an inadvertent breach of the duty of loyalty, you can get protection.  If people have relied on reasonable advice of counsel, then they’re okay too.  But sometimes clients hold back key facts from their lawyer.  Also, the lawyer’s opinion will often tell them that something is legal if you do these four things, but then in the real world, clients will thumb their nose at one of the things and only do three things.  The things may be very onerous!  But the role of lawyers is crucial.  So is the role of CPAs.  If you have a truly independent CPA and you disclose everything to her and she comes back with what looks like a reasonable statement, and you have fully disclosed and her credentials and reputation are good, then they’ll have trouble getting at you.  This will be an issue in the Enron case.


Back to Class Notes