Business Associations Class Notes 6/8/04


Rule 504 or 506 can be used in preference to statutory four-two.


Preemptive rights – Katzowitz v. Sidler


This case was decided on fiduciary duty.




We covered the agency common law doctrines whereby under agency law the agent is sometimes entitled to indemnification from the principal without getting any deeper.  In theory, this is a doctrine separate from exoneration and R.C. 1701.59(D) is a pure exoneration statute.  R.C. 1701.13(E)(5)(a) is an indemnification statute.  But there are times when a statute is both an exoneration and an indemnification statute.  If, for example, a trust agreement provides that in any suit against the trustee by or on behalf of the trust or its beneficiaries, the trustee will be held harmless by the assets of the trust then the agreement is both indemnification and exoneration.  But that wouldn’t be legal under trust law.  The most that a provision in a trust agreement can exonerate the trustee for in suits by beneficiaries is gross negligence.  Trust law is more demanding than corporate law and more demanding than general indemnification law.


It is still fairly standard in a tort case if there are two defendants and one is negligent while another has committed an intentional tort like fraud, it is fairly widespread that the judgment that the court will enter in that case is joint and several liability on the part of both defendants to the plaintiff, but the defendant that is negligent is entitled to indemnification from the defendant who committed the intentional tort.  What about comparative negligence?  Case after case has held that comparative negligence statutes by themselves do not preclude this result.  A Louisiana court has held that you cannot apply comparative negligence to intentionality.  But New York cases in the past fifteen years have held that if even if due care had been used, the intentional actor was smart enough that he would have committed the tort anyway.  Out west and in the south, you’ll find a number of states that have eliminated joint and several liability by statute.  They call for percentage allocation rather than joint and several liability.  Shipman has his doubts whether these statutes would apply when one person is intentional and one is negligent.  He thinks that the intentional actor will be 100% liable.  But indemnification comes up a lot in torts.


Moral hazard and indemnification by express contract


A contract of indemnity is subject to the rule that to the extent it purports to cover recklessness or intentionality it is invalid because if, for example, Al Capone could have gotten indemnity for the St. Valentine’s Day Massacre, there would have been twenty massacres!  In most states, insurance can cover recklessness but it can’t cover intentionality.  In Ohio within the past twenty years, we have had two opinions in the cases of Worth v. Aetna and Worth v. Huntington Bank.  What was involved was an indemnity contract whereby the contract provision called for one party to bear the other party’s attorney’s fees.  This is the place to start your research in Ohio because they review the cases of the last 40 years.  In some areas, in Ohio, you can’t even indemnify for negligence.  Generally, though, provision for attorney’s fees is not valid.  The court held a special situation that involved a contract for attorney’s fees.


Here’s an Agent Orange case: soldiers couldn’t sue the government, so they tried to sue government contractors.  Scalia established a government contractor defense.  If a contractor warns the government that the specifications will produce a defective contract, then the government contractor has a complete defense.  The company that was one of the manufacturers of Agent Orange sued because they had settled with veterans who had been badly injured.  The Court of Claims decision was appealed to the U.S. Supreme Court.  Rehnquist denied relief on two grounds: (1) the government contractor defense had not be properly used by the manufacturer, and (2) the Courts of Claims, AKA the United States Claims Court, has no equity jurisdiction and no jurisdiction in restitution.


In the Globus case, involving the first company in the country trying to apply computers to legal research, there had been a public offering of the company’s stock, and the underwriter (broker-dealer firm) buying it from the company and reselling it had extracted an indemnification agreement from the issuer.  That agreement was carefully drafted and it excluded reckless and intentional action by the underwriter.  You can bet that the underwriter wanted an opinion from the lawyer for the company that the contract was valid, and the lawyer for the company knew that on common law grounds, it would not be valid if it covered reckless or intentional misconduct.  The underwriter got sued and had to pay a judgment because the offering circular to the public was misleading.  The underwriter then sued the issuer on the indemnification contract under state law.  But it excluded reckless or intentional conduct.  It was proven at trial that the underwriter knew of the deficiency in the offering circular!  So the opinion should have been really short.  Instead, the court held in Globus I that they would make it a federal question!  The federal securities laws themselves, on top of state law, limit indemnification for securities misdeeds.  They remanded to the district court for a remedy, the case came back up, and they held in Globus II that under federal law, no indemnification, but they would allow 50-50 contribution.  Most lawyers in their opinions will now put in a paragraph disclaiming any opinion on indemnification where federal securities laws are involved.


When you make a public offering, you must put in the prospectus an agreement with the SEC that the company will not pay off unless a court first determines otherwise by declaratory judgment.  When prosecutors go after a company they try to force them not to indemnify their corporate executives.  That is, they would try to force an Ohio company not to pay out under R.C. 1701.13(E)(5)(a).


In a Minnesota Supreme Court case, Tomash, a director of a closed-end investment company heavily regulated under the Investment Company Act of 1940 was engaged in front-running.  He had inside information on what the company was going to buy, and so he went and bought that same stuff before the company did, and he also sold before the company did.  That violates § 17 of the Investment Company Act of 1940, and it’s a serious conflict of interest.  You can only engage in this activity if the commission blesses it in advance.  The SEC sued him for an injunction, and they got it.  But the equities aren’t all on one side.  Before he did this, he went to the inside lawyer for the company and disclosed what he wanted to do.  The lawyer said that it was okay!  The director then applied, under Minnesota law, to the company for indemnification.  The state had a statute like R.C. 1701.13(E).  The board of directors refused under .13(E)(1) and (2).  He goes into court to force the board to pay it.  The opinion is mostly a reading of the statute, which says that the board may indemnify in (E)(1) and (2).  Only (E)(3) has a mustHowever, at the end of the opinion, they say: “By the way…the indemnification statute says that they will indemnify you qua director, and when the guy engaged in front-running, he changed personality and became a non-corporate individual!  In that incarnation, you’re not entitled to indemnification!”


There is a New Mexico case that follows on New Mexico’s version of (E)(3), where a big public utility started a suit against a director, who counterclaimed and moved under FRCP Rule 65 for a TRO saying that they can’t continue their part of the suit unless they agree to pay his attorneys’ fees.  The court held that (E)(3) means exactly what it says.  It was clear there that the director was acting in his corporate capacity.  The courts go all different ways in this area.


In Toledo, a big public company asked a guy to join their board.  Unbeknownst to the company, Mr. X was the 100% shareholder of a closely held manufacturing company.  Under the SEC proxy rules, he should have disclosed that to the company because it should go into the proxy statement.  The public company entered into a lot of business with the closely held company.  Then they found out and when to the United States Attorney’s office, asking them to lock up Mr. X.  Mr. X paid the attorneys’ fees out of his own pocket and got an acquittal.  Then he asked for $1.5 million in attorneys’ fees under (E)(3).  The company asserted Tomash, but the matter went to arbitration.  The arbitrator didn’t buy the Tomash argument and entered a judgment of $1.5 million in Mr. X’s favor.  Remember that Tomash is there, but it will sometimes be overlooked because it is quite subtle.  It’s a “first cousin” of the insurance policies exclusion for the director getting a benefit that the other shareholders don’t get in proportion to their stock holdings.


If you’re representing an executive, your remedy is a counterclaim for attorneys’ fees, and you move under Rule 65 for a preliminary and permanent injunction forcing the company to pay your attorneys’ fees as the case progresses.  Merely putting that in your answer is not enough.  You must file a motion for an immediate hearing!  Go to the clerk or judge and ask for an early hearing on the issue.


Here’s a hypothetical from prior exams: a woman is a director of a company and she is charged with sexual harassment.  She is the president (the #2 officer) and the #1 officer, the CEO, calls the outside counsel and asks the counsel to investigate.  Can the regular outside counsel do this?  Yes, assuming you have not advised the president on this issue.  You must give the president a “Miranda” warning that you’re only representing the company and not the woman.  But what if you represent the woman?  You must file the written demand for attorneys’ fees.  But will you get it?  There are two issues and they’re close: (1) is the internal corporate investigation a “proceeding”?  Shipman thinks so.  (2) Does the CEO have the power, without going to the board, to order the outside law firm to do this?  Sure, no problem.  (3) Does this fit within (E)(5)(a)?  Shipman thinks so, but there are equal employment overtones and if you’re the outside law firm conducting the investigation, you have a duty to conduct a fair proceeding.



The first version of R.C. Chapter 1707 was passed in 1913.  The first state statute was in Kansas in 1912.  The Kansas Secretary of State that the farmers were being sold “so many pieces of the blue sky”.  This is why we call state securities statutes “Blue Sky” statutes.  There is a CCH “Blue Sky” Reporter.  The state statutes provide for registration of securities at R.C. 1701.09, which in effect says that unless exempt, every person must first register every security before you offer it for sale in that state.  The exemptions in the Ohio Act are found in R.C. 1707.02 and .03.  In the Securities Act of 1933 you’ll find the same stuff in § 3, 4, and 5.  Just before World War I, the Supreme Court upheld the constitutionality of the state “Blue Sky” statutes.  So R.C. Chapter 1707 has a “don’t breathe” clause, and then exemptions like .02(E).


A security listed on any major stock exchange or listed on the national market system of NASDAQ is exempt from registration by everybody.  But there is no comparable thing in the federal statutes.  If GM makes a public offering, they will have to register just like a startup company.   But that’s not the end of the story.  A big public company like GM can use a shorter registration form and, in fact, their offering will go through faster than an IPO because the SEC is very aware of GM and its reputation for high solvency.  Broker-dealers must register under R.C. 1707.14.  Court cases have held that if you have more than an incidentally small number of transactions, you’re in the business.


In R.C. 1707.13, there is a substantive fairness provision.  If the commissioner can find that the securities are to be sold on grossly unfair terms, he can stop it.  There is no similar provision federally.  But if you try to register federally and it’s a real screwjob, then the SEC will delay you forever.  In R.C. 1707.29, .44 and .45 are criminal provisions.  .44 reads like a regular high-scienter criminal statute.  But .29 says that if you claim that you don’t have scienter because you didn’t have knowledge but if a reasonable investigation would have produced such knowledge, then you are presumed to have known what you would have learned from a reasonable investigation.  In other words, ordinary negligence is the mens rea!  R.C. 1707.38-.45 deals with civil liability.


The first federal statute was the Securities Act of 1933.  This deals with public offerings by companies and their affiliates.  That usually includes directors, high officers, and anyone who is a controlling person.  The Securities Exchange Act of 1934 deals more with broker-dealers, stock exchanges, the trading markets and the NASD.  Just what is the NASD?  It’s a Delaware-chartered not-for-profit company subject to heavy SEC oversight which governs the “over-the-counter” (that is, not on a stock exchange) markets.  The NASD runs quotation systems.  There is a national market system which is automated.  There are also other automated systems, the most prominent being the bulletin board.  The smaller public companies in Central Ohio are found on the bulletin board.  They also have the “sheets”, that used to be mimeographed, but now they’re more electronic.  Excluding mutual funds, there are only 14,000 public companies.  There are 8,000 mutual funds.  That’s out of several million business associations in the country.  How did the NYSE come about?  They started out under a tree, then they got a building.


The first question with regard to any federal securities act is whether it is a security.


Smith v. Gross


Here was an entrepreneur selling earthworms.  Earlier cases had held that if you buy cattle from an entrepreneur and he keeps and feeds them for you, then that is an investment contract.  But if you take care of your own cattle they are not securities.  Smith brought a suit under § 12(a)(1) under the Securities Act of 1933 for rescission.  That statute says that if you should have registered but didn’t, the investor can rescind and get his money back.  Of course, the investor will only rescind when the stock goes down!  So we have a suit against the vendor of the earthworms.  There was clearly a public offering here and Regulation D was not complied with.  There was no registration statement.  But, of course, if there is no security, then there is no recovery under the Securities Act of 1933.  They said that the cattle cases aren’t applicable.  The court held that the only market for earthworms was the entrepreneur buying them back when they grew up, but that’s still an investment contract and therefore there could be a rescission.


Securities and Exchange Comm’n v. Ralston Purina Co.


If an issuer makes a private offering, it will be exempt.  This is called statutory 4(2).  It can apply to any kind of company.  There is no dollar limit on statutory 4(2).  You also don’t need to file notice with the SEC in order to perfect the exemption.  In Ohio, the statute is .03(Q), and you do have to file to perfect the exemption.  If you meet either statutory 4(2) or .03(Q), you can pay the fee and do it.  There is a tricky statute in Ohio that is .03(O), which doesn’t require filing.  So you define what the offering is, which involves “come to rest” and “integration”.  In this case, neither party was arguing with the other over these two issues.  This case involved no charge of fraud or unfairness.


The company was a very prosperous NYSE company in St. Louis that generally had stock of increasing value from 1941 on.  They could have filed a short form with the SEC, but they didn’t.  The S-8 is limited to public companies and its employee stock options.  That wasn’t used.  What remedy does the SEC seek?  They only want an injunction forcing the company to file.  This is not a criminal proceeding.  What was the company doing?  They picked out employees who they thought were up and coming, and they offered stock in the company to them.  The people who were picked out ranged from the deck foreman to the President and CEO with a lot inbetween.  It was a broad group of people.  In the 1930’s, the SEC general counsel had issued his opinion that once you define what the offering is, if the number is 25 or fewer, there will nearly always be an exemption from registration.  If the number is 26 or greater, it will not be a private offering.  The Supreme Court looked at the legislative history and found a congressional statement saying that generally speaking, if you make a public offering to employees it’s like a public offering to anyone.


The Court could have gone either of two ways: (1) it could have accepted the SEC rule of thumb, saying that the company was way over the 25 number, and thus there was no private officer.  (2) It could have said that the SEC could have its own rule of thumb, but that’s not binding on the courts.  The latter is what they actually said.  The test for determining whether it’s public or not is the “needs to be served” test.  If the people need the protections of a registration statement (which will contain a prospectus) then whether it is to few or many offerees, it’s a public officer.  Justice Clark tried to get more specific, saying that if the offering were limited to people who could “fend for themselves” and all of those people have access (emphasis on access) to information that a registration statement would provide, then it is non-public regardless of the numbers involved.  In other words, in this particular case, had the offering been limited to the ten top officers in St. Louis, it would have been fine because those ten people can “fend for themselves” and they had access to the information that a statement could provide.


The Wall Street law firms interpreted the case as saying that we can go further if Chrysler wants to sell its 5 year notes to the 150 biggest banks in the country, they put together a private placement memorandum containing the essential financial, accounting, and narrative statements and they hold a meeting giving top representatives from those banks access to management to ask questions, then even though there are 150 offerees then it’s private.  That’s the only good news from this case.


Justice Clark’s last point was that the burden of pleading and proving an exemption is totally upon the proponent of the exemption.  That’s also true in R.C. 1701.38-.45.  Later Fifth Circuit cases made it clear that the proponent of the exemption had to come into court with the list of the exact names of every offeree and further proof that nobody else was approached and show that each of those met the “needs to served” test.  Those Fifth Circuit cases were awful.


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