Table of Contents
Not-for-profit corporations will not have shareholders, they will have members. The people who run the not-for-profit will be called directors or trustees. Below them will be officers. Beneath them will be non-officer executives. And below that, you have “the people who actually do the work”. There will be creditors in a not-for-profit corporation.
At the end of §§ 1701 and 1702, they both state the following: “§ 1701 applies to corporations formed under other chapters (e.g. § 1702), except to the extent that § 1702 is inconsistent with § 1701, in which event you go to § 1702.” Is it always to determine when there is inconsistency? No. Go to § 1702, and you’ll find the mirror image of that. It says: “In construing this chapter, construe it with § 1701, except if § 1701 is inconsistent, in which case use this statute.” The specific trumps the general every time.
The NYSE is organized as a
Investors are people who invest money in the corporation. “Money to a corporation is like blood to humans: without it, you die.” Creditors (e.g. owners of company bonds) take first upon dissolution. Dissolution has a different context in a corporate situation than in a partnership situation: it means termination of legal existence. Creditors take first, and if there’s anything left, then the equity investors take what’s left.
All investors other than creditors are called equity investors, for example, owners of common or preferred stock. Upon dissolution, a preferred stock owner takes after creditors but before common stock. We will study a little bit about options on equity in this course, primarily options on common stock. Options are used primarily in the context of executive stock options, which we’ll study closely. But, the term has a broader application. A warrant is a long-term option that is transferable. For a few companies in this country, there are perpetual warrants out there that are occasionally traded on the stock exchange. Executive stock options are nearly always non-transferable, with one exception. If you die, your beneficiaries get the option and usually will have the opportunity to exercise the option if they want to.
stockholders elect the directors. There
are also non-voting classes of stock in most states, including both
Corporate securities determine, among other things, who controls (that is, who elects directors), which in turn controls who gets the good jobs (since the directors choose the officers), and also what cash flow will go to the shareholders. The most junior equity (usually common stock) captures the upside. It is invariably the common stock that elects directors. Sometimes you’ll see voting preferred stock, but not all that often, so we’ll call common stock the most junior.
If a company sells its assets and is liquidated and it’s paying off its security holders, creditors take first, preferred stockholders take second, and common stockholders take third. Those most junior stockholders will get nothing unless the creditors and common stockholders are satisfied in whole. On the other hand, the holder of a fully secured mortgage note (the most senior debt) is the most protected when the downside comes. The unsecured creditors, that is, the creditors with no lien, often take nothing or close to nothing in bankruptcy because the secured creditors may have placed first mortgages on almost everything.
The first version of R.C. Chapter 1707 was passed in 1913. The first state statute was in
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
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.
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
The company was a very prosperous NYSE company in
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
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. 1707.38-.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 be served” test. Those Fifth Circuit cases were awful.
established, among other things, that with all exemptions the burden of
pleading and proof in every detailed respect falls upon the claimant of the
exemption. R.C. 1707.38-.45 establishes
the same thing in
State law is often more demanding than federal law. For example, R.C. 1707.29 and .44-.45, in a criminal case, make a defendant far more vulnerable than in a federal criminal prosecution. The major case on the subject is State v. Warner out of the Ohio Supreme Court from the 1980’s. The court held that R.C. 1707.29 means what it says: the mens rea element in a criminal prosecution under R.C. 1707.29 is simply ordinary negligence. Federally, the mens rea element is willfulness, which has been construed as a very high burden on the federal government.
How much does federal law preempt state law? The short answer is some but not much. In the 1990’s, there were three big federal
statutes. First, in 1996, there was
NSMIA, or the National Securities Markets Improvements Act. This Act has several preemptive
provisions. As to investment advisors,
the federal government takes over primary regulation of the big ones and the
states take over primary regulation of the little ones. As a result, in the 1990’s,
In 1998, an act was passed that says with respect to certain fraud and other suits they will become subject to the 1995 federal act (which was very pro-defendant). If they are in state court, they are to be removed to federal court where the defendant advantages of the 1995 Act apply. There is a big exception, though. In an action for breach of fiduciary duty under the law of the state of incorporation, the 1998 Act doesn’t apply, and if the plaintiff’s lawyer is careful in drafting, you can avoid the 1995 Act. In CTS from the U.S. Supreme Court in the 1980’s, the Court said that regulation of tender offers by the states must be reasonable and limited and if they are not reasonable and limited then they will be preempted.
So there is some federal preemption but not a heck of a
lot. Common law remedies are not
displaced by federal or state securities laws and are the best more often than
you think! Under the federal securities
laws, a securities broker must avoid recommending unsuitable securities to
purchasers. There is a remedy under Rule
10(b)(5). Under 10(b)(5), it is only if
the customer proves that the recommendation was made with scienter. That’s
hardcore. In a big
The plaintiff argued that Olde & Co. is a member of the
NYSE and that one of the rules of the NYSE says that every member must “know
thy customer”. The primary purpose of
the rule is to protect the member firm.
If a customer doesn’t buy up after he buys, the member firm is
responsible to the party on the other side of the transaction. The court held that under
Cases like this will usually go to arbitration. Usually, broker-dealers will force customers to sign arbitration clauses up front, and usually the broker-dealer insists on arbitration. We don’t know why they didn’t do so here! In arbitration, suitability claims under 10(b)(5) require scienter, at least in theory. But in practice, arbitrators will often give recovery for mere negligence on the part of the broker-dealer firm regarding suitability. On the other hand, studies of all massive arbitration system, like the securities system, indicate that arbitrators tend not to give lavish or large awards. They cut down on the amount. They’re more liberal in giving the plaintiff something, but the dollar amounts are smaller.
Some examples of exemptions
Around 93% of all transactions are exempt. Let’s go over some of the important
ones. § 4(1) says that if you’re not an
issuer or an underwriter or an affiliate of the company, stock which you
purchase through the organized trading markets will be exempt. For example, I’m contacted by Johnson in
If you are an affiliate as defined in Rule 405, you must construe § 4(1) with § 2(11), which gets tricky. 2(11) defines “underwriter” in terms of a person taking with a view to distribution. In United States v. Wolfson out of the Second Circuit, the court held that in a criminal case the last sentence of § 2(11) applies not only to the first sentence of § 2(11) but also to § 4(1), meaning that an affiliate owning stock can sell only in one of only three ways: (1) The company files a registration statement for him. This happens only once in 10,000 times because it’s very expensive. (2) As to public companies, Rule 144 provides a limited, specified exemption that is widely used. (3) He can make a non-distribution. Look at 2(11)’s first sentence, and you’ll find the word “distribution”. The SEC concedes that if an affiliate makes a non-distribution, 4(1) applies to him.
An affiliate can sell under Rule 144 on the stock exchange (but there’s a lot of paperwork). He will get market price for his stock on the exchange. He can legally make a non-distribution in theory? The SEC says that the term “distribution” in § 2(11) equals “non-public offering” in § 4(2) as defined by Ralston Purina. He could sell the stock to a big mutual fund with a legend saying that the taker is buying for investment and not distribution. The taker cannot sell for one year. If there is full and fair disclosure to the mutual fund up-front, that would be perfectly legal. However, he won’t do that because he’ll have to sell at a 15-40% discount. So he’ll go to the internal general counsel to get the paperwork going to sell and he’ll sell under Rule 144 at the full market price. So to construe § 4(1) you must construe it with § 2(11), United States v. Wolfson, and Rule 144.
This accounts for the fact that in the
Another person that cannot use § 4(1) is someone who has purchased stock in an exemption and sells before it has come to rest. That is why under Regulation D securities sold under that exemption must be legended. In the public trading markets, delivery to your broker of a legended security is per se bad delivery! Therefore, if you buy in a 506 offering and get legended securities, then even if the company is a public company you’ll be unable to sell the securities until you get the company to issue you a “squeaky-clean” certificate.
Can a person be both an affiliate and also not meet the “come to rest” period? Yes. What’s the “come to rest” period? At common law, it is two years. Under United States v. Sherwood out of the Southern District of New York in the 1950’s, under Rule 144 for a public company the period is cut to one year. Public companies are treated better under the securities laws in about eight ways.
The SEC introduction to Regulation D talks about “come to
rest” and integration. Rule 504 is the
“mom and pop” exemption. This exemption
cannot be used by a public company or investment company. There is a dollar limit of $1,000,000. Under all of Regulation D, there can be no general advertising. The same is true under § 4(2). If you’re an
Is Rule 504 a 4(2) rule? That is, is it adopted under 4(2)? No, it’s adopted under § 3(b) of the Securities Act of 1933 which gives the commission power to adopt exemptions for (1) private offerings and (2) limited public offerings below a certain number of dollars (currently $5-$7.5 million). Rule 504 is broader in the sense that it can cover limited public offerings just as R.C. 1707.03(O) can.
What about 3(a)(11)?
Generally don’t use the 85% rules in Rule 147. 85% of the assets must be in
So Rule 504 is the “mom ‘n’ pop” exception. In
Federally, Rules 701-703T of the Securities Act of 1933 provide a similar exemption for non-public companies up to a certain dollar limit. The rules under 701-703T say that you need not integrate what you sell under these rules with Regulation D. Regulation D makes the same statement. Integration makes your hair go gray in this area! Why is it restricted to non-public companies? For non-public companies, the SEC has a short form, the S-8, for employee stock purchase plans and options. It’s an easy form to use. Later on we’ll see that employee stock options and purchase plans are a lot more valuable for public companies than for private companies. Beginning 25 years ago, executives could make tens of millions of dollars through these plans. In the 1990’s, this expanded to up to $1 billion. Jack Welch has a net worth of around half a billion dollars. So corporate executives can pull a lot of money!
This rule was first adopted in the 1970’s and revised several times since then. It’s kind of at the other end of the scale from Rule 504.
1. This Rule falls under Securities Act of 1933 § 4(2), which has no dollar limit. Thus, this Rule has no dollar limit either. Rule 504 is under § 3(b) which has a dollar limit, and 504 has an even smaller dollar limit imposed upon it.
2. Rule 506 also applies to all types of issuers, including corporations, partnerships, LLCs, LLPs, not-for-profit organizations, and general partnerships issuing debt: it is broad.
3. Like Rule 504, Rule 506 also applies to all types of securities.
4. Like Rule 504, you must always file the proper reports with the commission on time. The report is the Form D, and you’ll find it set out in the CCH Federal Securities Reporter. Many, if not most exemptions have a precondition of a proper notice filing either with the SEC or the states or both.
5. A precondition to Regulation D, Rule 504 and Rule 506 is no general advertising. That’s also a precondition to § 4(2) and R.C. 1707.03(O).
6. Like Rule 504, there is an integration test. As a rule of thumb, lawyers will tend to look one year back and one year forward, though Shipman is not sure that it really goes that far. If different securities are issued for very different purposes, there will be no integration.
7. Both as to Rule 504 and Rule 506, the securities must be legended upon delivery. The sales agreement and private placement memorandum must prominently, in advance warn investors of this. This deals with the “come to rest” test.
8. For Rule 504 there is no advance disclosure precondition. You still have to comply with the civil liability section. From Rule 504 to 506, there is a drastic change. Regulation D has an elaborate twist: if every purchaser is an accredited investor as defined in the rule, there is no advance disclosure requirement. In big offerings, everyone will be accredited investors. But there are caveats:
a. One or more of the people are going to request a lot of stuff and the rule itself tells you: what you provide to one, provide to all.
b. To protect yourself under the civil liability provision, you will always put together a decent private placement memorandum. Note that a prospectus is only with a registered public offering. The memorandum will be numbered and you will get receipts from everyone and make them sign a form that they won’t circulate or distribute them to anyone except their own lawyers, investment bankers and accountants for advice. We do this because of the no general advertising provision. Careful lawyers also get, in advance, signed and dated investment letters under Rule 504 because someone will try to purchase for 40 friends and they are going to screw up a Rule 506 because they won’t be accredited investors.
9. Even if all of your investors are accredited and they’re all sharp, there must be a due diligence meeting where the lawyer, management, and CPA make themselves available for questions before people are going to buy.
10. What part of the “fend for themselves” test goes into Rule 506? Shipman says this is subtle: if all purchasers are accredited investors, the test does not apply because if you read the rule carefully, there is a built-in, implied statement that accredited investors are conclusively presumed as a matter of law to be able to fend for themselves. Is it true? Maybe, maybe not. If all purchasers are accredited investors, the issuer does not have to appoint a purchaser representative. But if one or more purchasers is not an accredited investor, then this is the rule: if one of these purchasers is not a financial sophisticate, the issuer must hire, out of its own pocket, an independent investment banker aside from the one it uses to advise as to the suitability of the investment.
11. Rule 504 has no limit on the number of purchasers because it is a 3(b) rule, that is, it covers limited public offerings as well as private offerings. But Rule 506 is a 4(2) rule, and the SEC does have a limit on number of purchasers. This is after integration and “come to rest” are applied. The number of purchasers in an offering, so defined, may not exceed 35. If you sell 1,000 shares to Mr. Jones and 1,000 shares to his wife, Ms. Smith, that counts as two purchasers. It’s not tenancy in common or joint tenancy with right of survivorship. The rule tells us that we use the old view of marriage! The two are one even if the stock is separately titled and separately paid for by each spouse! The counting rule is quite liberal. But that’s not all! What else does the commission have to help? Each accredited investor counts as zero investors! In other words, you could have 80 accredited investors plus 20 other people.
This counting rule ties in to 3(c)(1) of the Investment Company Act of 1940, which was the fifth federal securities statute passed. If you’re an investment company, there is an extra strong burdensome level of registration. The commission was aiming at mutual funds. However, the definition of investment company is much broader. Lawyers are concerned about inadvertently becoming an investment company. But if you’re a bona fide commercial bank, a bona fide insurance company, a pension or profit-sharing trust for employees, or a bona fide charitable trust, then you’re exempt. There is also an exemption for a company that invests in real estate mortgage notes. In Ohio, you may have to file as a bond investment company. The big exemption from this Act is 3(c)(1). This section says that if a company has fewer than 100 holders and it’s not presently making a public offering, then it’s exempt. Therefore, if you set up a partnership that has mainly financial instruments in it, and there are only 80 partners then if you’re not presently making a public offering, you’ll be exempt. This directly ties in with Rule 506 because a 506 offering is not a public offering even if there are 70 accredited investors buying.
If you have purchasers who are not accredited investors, you work through Rules 501-503 and find that, for a big offering, you will have to put together a private placement memorandum that contains just about what a prospectus would contain for a public offering.
What about the
What if the private offering crosses state lines? You must make the filings in all states on time. If it’s an ongoing offering, you’ll have to make several different filings during the year. If it’s really important that a form be filed on time, send someone there in person.
As of 1994 and 1995, the high-tech companies in
What’s the difference between guaranty and suretyship? If it’s a guaranty arrangement, the person making the guaranty is secondarily liable. He is making a guaranty of someone else who is
primarily liable. What are surety bonds? By statute in
Cockerham v. Cockerham
– The husband had a lot of land before he got married. He married, acquired more land, and under
From 1913-1960, the almost invariable rule where you had a corporation was double taxation, meaning: (1) the corporation itself is subject to tax, and (2) when the income is paid over (the dividend), they are again subject to tax, and (3) when the corporation dissolves and distributes its assets to shareholders, there is a tax at the corporate level on the difference between the fair market value of assets and what the company paid for them and there is a further tax at the shareholder level on the difference between what the shareholder paid for the stock and the value that he received.
The first exception came in 1942 for mutual funds. In the late 1950’s and early 1960’s, a similar deal was put in for Real Estate Investment Trusts, or REITs. It’s an odd statute. It says that if you’re a trust taxable as a corporation and you make the election, it is similar to mutual funds. If you pay out a certain percent of your income each year (something like 95%), then as to what is paid out, you aren’t taxed on it; only the recipient shareholders are taxed on it. REITs haven’t had as great a run as mutual funds. Shipman speculates that the promoters have benefited themselves more than shareholders.
At the same time, a huge amendment to the Internal Revenue
Code, Subchapter C came into being. This
is the general subchapter governing corporations. All the rules in this section are double and
triple taxation! If you meet the
requirements and make the election properly, you are governed mainly by
Subchapter S. But where Subchapter S
doesn’t deal with an issue, you go back to Subchapter C. Sub S is a bit different than the mutual fund
situation. How many companies can
elect? It must be a
Making and keeping this election is complicated! It requires a lawyer because what you have to have is a shareholders’ agreement under O.R.C. § 1701.591 to restrict the transfers of shares and require election of consent by everybody who gets the shares. The board of directors files the consent with the Internal Revenue Service, but they have to have consents from all shareholders. It’s a two-level proposition. If you’re only dealing with one or two shareholders, it’s pretty simple, but if you’re dealing with 45, it’s going to get complicated.
If the election is made, the situation is about 70% like that of a general partnership. Tax lawyers describe this as “flow-through taxation”. That means that the corporation files a return, but it’s an information return as to income taxes. As to taxes other than income taxes, it’s fully subject, just like GM: excise taxes, sales taxes, real estate taxes, corporate franchise taxes and so on. But they file a return, and then at the end of the year they inform each shareholder of his or her share of the net income or net loss for the year and the shareholders include it in their income just like in a partnership (in a way). If the company keeps all the income, it’s still taxable to the shareholders currently. That’s one of the reasons why you must have a § 1701.591 agreement. You want to require, say, half of earnings to be paid out because the shareholders have to pay state, city, and federal income taxes.
Suppose the company makes $1 million in year one, has one
shareholder, and pays nothing out. The
company pays no tax, but the shareholder is subject to tax on $1 million,
absent a R.C. 1701.591 agreement. If the
shareholder is Bill Gates, it’s no biggie since Gates is worth $50
billion. But for most people, it’s a big
deal! Suppose that in year two, that
money is paid out. That’s called previously taxed income. If the company broke even in year two but
gave a $1 million check to the guy, he
wouldn’t pay any tax on that, because it would be previously taxed
income. Most states now allow this, but
Let us compare Sub S to the new kid on the block from Sub K-land: the LLC! First of all, you can have an LLC if you “check the box”. You can have an LLC with Sub K treatment even if a corporation, a trust, a partnership or a non-resident alien is a member of the LLC! Furthermore, the numbers can exceed the 75 specified shareholders in Sub S. There is an upper limit, and it comes in a “back-handed” way. Under current tax law, no new Sub K entity can have securities traded on a public market. We will discover that two sections of the Securities Exchange Act of 1934, §§ 15(d) and 12(g)(1), will cause (1) an entity that makes a registered public offering under the Act of 1933(?) or (2) any entity with 500 or more holders to file public periodic reports with the SEC. With those reports, under Rule 15c2-11 of the 1934 Act, a public market can be made by any broker-dealer in the country on that stock. In addition, under §§ 12(a) and (b) of the 1934 Act, if you voluntarily list any security on a national securities exchange there is per se a public market in that security. Therefore, as a practical matter, you have to work with a securities lawyer and avoid these four sections of the Act. It’s a back-handed limitation. Grandfathered in are a few old limited partnerships from the 1980s that are listed on a couple of exchanges: these are master limited partnerships. They were cut off a few years ago, but there are a few hanging around.
LLCs have another use: they are widely used for mineral interests held by entrepreneurs, for real estate held by a real estate investor, and for intellectual property. They are widely used for two reasons: (1) Wealthy people will often leave property in trust to a bank to manage for their family. The big banks and trust companies want investment property given to them to manage in trust to be in corporate form or LLC form in order to minimize their potential liability. If the LLC goes bankrupt, they’re unlikely to get stuck. (2) Very often you’ll have two or more entrepreneurs come together, each contributing some assets. After a few years, each one often wants to pull their own contribution out and go their own way. If you have a corporation, even a Sub S corporation, there will be a tax on “phantom income” at the corporation level, measured by the difference between the cost of the assets and the current fair market value. If you’re in a Sub K situation, however, very often the split will be tax free to the LLC and tax free to the member taking back what he contributed. He’ll simply take over the LLC’s basis and move forward.
But caution: don’t
ever put publicly traded securities in a Sub K entity. There’s a tax trap there! There are three better ways to do this: (1)
With publicly traded securities, put it in a revocable trust. If you do it right, contributions to the
trust and the unraveling of it will be tax free. (2) Another option is a managing agency
account with a big bank. As the name implies,
there’s no trust, there’s no entity, although the stock will be in the name of the bank, it is a simple
managing agency account and there is no consequence in setting it up, and you
have the right to revoke it at any time and they will register the stock in
your name and return it to you. (3)
Finally, the third way to go is a street name account at a big brokerage
house. They call it this because they’ll
hold the stock in the name of their own “nominees” (some of their senior
executives). That makes trading a lot
easier. If you need it back at any time,
they’ll deliver the securities to you.
Hishon v. King & Spalding – A single female associate was passed over for partnership, so she sued, alleging that it was because of her gender. If that proved true, usually that creates a right of action under Title VII. The argument was made by the defendants that: (1) partners are not employees (which is generally true). There’s no withholding of their earnings. They usually are not covered by workers' compensation. (2) A partnership is an “intimate choice” of business associates and thus it would be improper to apply this civil rights law.
The Court ruled that the first proposition is correct, but the second proposition is not. If you hire associates, holding out some possibility of partnership, it is discrimination against employees (associates of a general partnership law firm are employees) to discriminate. A 12(b)(6) motion was reversed. Even if the plaintiff thought she could win, would she really want to keep working there? The case was settled for a pretty big money award. Note that the equal employment statutes (and other civil rights statutes) provide that if you prevail in your suit, you can get reasonable attorney’s fees.
Up to quite recently, professionals in all states were
prohibited from incorporating. The state
legislatures and courts thought that they should stick with the general
partnership or else their personal liability would extend to their personal assets
as well as the firm’s assets. Around
1960, law firms saw that their colleagues in the general counsel’s offices of
corporations were getting good tax breaks on fringe benefits: for example, pension plans and health
insurance. The law firms wanted relief and went in two directions: (1)
they went to Congress, and Congress passed the Jenkins-Keogh Act, also known as
Pension Plans for the Self-Employed.
Jenkins-Keogh is not as liberal as pension plans for corporation employees. So this is only partial relief. (2) They went to state legislatures, and most
state legislatures, if not all, authorized professional
corporations, a special professional corporation statute. In
This statute, even as to doctors, has a clause in it that
the shareholders have the same liability as general partners of a general
partnership. So what has happened in
Clackamas v. Wells –
This Supreme Court case is from 2003 from
Compare this to
What’s the problem with the 15? There were four shareholder officers and
directors. For state workers'
compensation purposes, they were treated as employees, and that would also be
the case in
Stevens, for the majority, says that he will remand the case
so that the Court of Appeals can apply his opinion. He says that he might agree with the
corporation as to shareholders who
work for the company and who have such large
stock holdings that they cannot be fired.
It’s a cannot be fired test! If a single doctor incorporated, and he was
the sole director, the president, and the sole medical employee, then no one
could fire him. The Second Circuit, or
Stevens goes over the status of the Restatement Second of Agency under federal law. When agency issues com up in the context of federal statutes, the Court has made it clear that they will go to Restatement Second of Agency and apply it. Why? You get national uniformity. Stevens discusses the 12-14 items you look at to determine if a person is a servant-agent, and he says that will apply. The truly important thing is usually the person’s time allocation, place allocation, and minute-by-minute conduct subject to legal power by a third person, then there is a servant-agent relationship.
In the Graham memo, we saw in the Cargill case an expansion of this doctrine for liability purposes. If X has the same de facto power over Y, then Y is a servant-agent even if X isn’t the direct supervisor of Y. Agency is a conduit for liability. In a recent Ohio Supreme Court case on control (de facto or legal), we had a client power company that wanted a building built. There was a general contractor and a subcontractor. Usually, if someone like the electric company hires a general contractor and doesn’t go too far in the general supervision of that contractor, then if there is negligence by the general contractor or by a subcontractor, then the client electric company won’t be liable. The one exception will be negligence in selecting the contractor: you commit negligent selection when you pick a contractor that’s always getting people killed. All construction contracts call for progress payments: pay as you go. At the end, you’ll have about 15% outstanding, which will be paid three or four months later after a very detailed final inspection of the building as competed.
Here, the building company directed how the electric wiring on the construction site was to be handled. They weren’t an electric company, but they thought they knew everything! “Electrocuted doesn’t necessarily mean killed.” So a guy was electrocuted and seriously injured. He had a workers' compensation claim through his boss, the subcontractor. But money was scarce in that household. So the guy sued the client electric company. The Ohio Supreme Court said: if you’re the client on a construction project and you take excessive control, you have turned the people under you into your servant-agents. Both in contract and in tort, you’ll be liable. Too much is too much, and too little will get you in trouble too.
Pinter Construction Company v. Frisby – This case concerns the statutory employer doctrine for workers' compensation purposes. It involved a construction contract, which in turn involved a subcontract. The subcontract did not mention workers' compensation. The subcontractor had no workers' compensation because they didn’t pay the premium! A worker was injured on the subcontractor’s job. The subcontractor has no workers' compensation, which is illegal, but it happens a lot. The Utah Supreme Court held that the general contractor, at minimum, should have required, in the contract, that the subcontractor to get workers' compensation and pay the premiums. When the general didn’t do so, the general became the de facto employer of the guy who was injured, and thus the guy would get workers' compensation through the general contractor. Both workers' compensation and respondeat superior involve scope of employment determinations. Over the last hundred years, scope of employment has expanded to protect workers: there can be scope of employment even if there is a violation of the work rules of the employer.
There are two statutory exceptions to workers' compensation: (1) If you’re under chemical influence on the job, you can’t recover. (2) If you intentionally injure yourself, you can’t recover. One of the questions we’ll cover later is the issue of a truck driver who decides to commit suicide by driving his truck into a bigger truck on the highway. This is an analogy to “suicide by cop”. Clearly, there is no workers' compensation because he left a suicide note that was given to the cops. But what about respondeat superior? Does it go that far? Shipman doubts it very much. In the review session, we’ll say that no one can go to the widow and say that it’s alright and that he’ll be covered because it would ratify coverage after the fact. You must keep everyone’s mouth shut in order to avoid respondeat superior!
What’s the game that the insurance companies play? Just after the insured the formal, written, signed claim with the company (which is a prerequisite, along with immediate notification of the insurance company when something happens). Right after the claim is filed, the insurance companies have on their computer reservation of rights letters. The insured has informed the insurer and has filed your claim. Then you get a reservation of rights letter. They tell you that they have your claim and they say that they will defend you. The main reason people get liability insurance is to defend against B.S. lawsuits. The other thing that you want from insurance is coverage. Some cases really do have merit!
At this point, you should go hire a good plaintiff’s lawyer
who will send to the insurance company the Zoppo
letter. Zoppo is an Ohio Supreme Court case from the 1990’s on bad faith by the insurance company. If there’s bad faith by the insurance
company, they are liable, and if it’s serious
enough, as in Zoppo, punitive
damages will flow. Remember, in
Usually, nothing will come of the reservation of rights
letter. So why do they send it? By statute and common law, if they don’t send
the letter and then defend you, they are estopped
from affirming the exclusions or lack of coverage later. About one time in ten after the reservation
of rights letter, the insurance company will file a declaratory judgment action separate from the one in which you’re
being sued. In most cases, the judge in
the first suit will get this judgment over to a colleague on the
So we had a declaratory judgment action in Perl. In the 1950’s, it was hornbook law that if there was no coverage, then there was automatically no duty to defend. Since then, it has evolved more toward the rule in the first Perl case, referred to in the second one, which is that the mere presence of allegations that would take things out of the policy will not cause the duty to defend to go away, even if, at the end of the day, there is no coverage.
So the client sues. What are the causes of action? (1) negligence, (2) fiduciary duty, (3) fraud, and (4) a per se rule in Minnesota and three or four other states: any agent who misbehaves significantly toward the principal during the employment must refund the whole amount paid, even if the work was good and there were no actual damages. The latter is called a prophylactic rule. It’s designed to prevent harm and strike fear into agents so that they’ll do right by their principals.
The Supreme Court of Minnesota and the lower court agreed that there was no cause of action alleged in common law negligence or common law fraud because for any tort, you must plead and prove an actual legal injury, that is, damages. Consider the general fiduciary duty claim: you must plead and prove some actual legal injury. If you’re seeking an injunction up-front, probable damages are enough. Next, we came to the fraud exclusion. The court held that there are two types of fraud: (1) actual legal fraud with scienter, and (2) constructive or equitable fraud between the fiduciary and the beneficiary of the relationship. Thus, they held that the second type of fraud, which is basically unfairness, does not trigger the fraud exclusion. So the fraud doesn’t apply. Does the coverage clause cover the refund of fees? They said yes. They follow the maxim that insurance policies are construed, when reasonable to do so, to benefit the insured. The coverages are interpreted broadly, and the executions are construed narrowly.
What about the public policy arguments? As to the firm itself, its ability to refund is based entirely on respondeat superior. The firm did not tell Perl to do what he did, and they didn’t ratify what he did. But, coverage of Perl, the actor, is against public policy. When an insurance company covers both principal and agent, principal cannot recover from the agent when the principal has to pay off to a third party. But, the court says, the result here is $20,000 to the plaintiff, to be paid by the insurance company on behalf of the firm. How do we equalize with Perl? The answer is that when the insurance company pays off on behalf of the law firm to the plaintiff, they’re subrogated to her rights. Also, they are subrogated to the rights of the firm against Mr. Perl. Therefore, the insurance company will cut a check to the plaintiff and then, on remand, the trial court is going to enter a judgment against Mr. Perl personally for $20,000.
Was all this litigation worth it to the plaintiff? Not objectively. Two trips to the Minnesota Supreme Court could take years and tens of thousands of dollars. Money is always among the top three reasons that people sue, but it is seldom #1, according to Shipman. The client was pissed off! She wanted the court to find that Perl was a bad S.O.B. The moral of the story is to keep your clients happy. Watch how a doctor practices: they are very cagey about that. They are always asking how you feel about things, asking you to telephone between visits, and telling you that you can call at home.
State corporation statutes are enabling statutes, designed to encourage
investment. The third part of the
triangle is entrepreneurs and managers.
Other heavily regulatory state statutes like antitrust, securities,
environmental, and equal employment remain applicable. The state decided early on that corporations
should be subject to the heavy regulatory statutes. But you won’t find those in the state statutes. Nearly all corporate statutes in the
To form a corporation, you must fill out what are called
“Articles of Incorporation”, signed by one or more incorporator. You take that
to the Secretary of State’s office, pay a filing fee, and the process is
The general American rule is that the internal affairs of a corporation are governed by the law of the
state of incorporation. “Internal
affairs” denotes the relationship between shareholders, creditors, the
corporation itself, the officers, directors, and the promoters. If you’re incorporated in
Zahn v. Transamerica – Here are the three big holdings of Transamerica: (1) Controlling shareholders have very high fiduciary duty to both the corporation and to minority shareholders. Anybody who litigates knows that if you’re representing a plaintiff and you can prove a high fiduciary duty on the part of the defendants, you’re a long way toward home. (2) This holding is more by the district court than the Court of Appeals. The district judge reminded the Court of Appeals (“ever so delicately”) that even if there is a total conflict of interest in the corporate arena, and even if it is severe, if the fiduciary can show overall reasonableness as to disclosure up front and overall reasonableness on the merits, and no harm to creditors, then the transaction will stand. In this particular case, there was no injury to creditors because all the creditors were paid off. There was a failure in disclosure here that led to the 1:1 instead of 2:1 splitting of tobacco inventory. (3) Disclosure was also violated in this case under SEC § 10(b) and rule 10b-5.
The court read the charter: the label preferred stock (Class A) could be called by the corporation at a certain rate. The Class B shares were a lot more complicated. Is the declaration and payment of dividends mandatory? In this case, the answer was no. How do we know this? The dividends were “when, as, and if declared”, and this was non-mandatory language. Can you have mandatory preferred stock as to dividends, though? Generally, you can’t because the board of the directors and only the board determines whether dividends are paid (with certain exceptions to be developed later). One exception is that when you have a closely-held corporation where all the shareholders have signed a § 1701.591 agreement and the creditors aren’t hurt by the agreement, then that agreement can provide for mandatory dividends.
Is the dividend cumulative? That is, if, in a given year, the directors don’t declare dividends on preferred stock, do the directors ultimately have to pay it? The footnotes of this case say that the drafter made sure it was cumulative by saying: “if they don’t declare in a year, they shall accumulate” and “if any dividends have been passed, the common stockholders can’t get a penny until any accumulated dividends are paid”. Is a preferred stock participating? Today, you seldom see participating preferred stock. But this Class B stock is participating. Once the board pays the annual dividend on the Class B, the rest of what’s left is split between the Class B and the common stock. Class B gets two bites at the apple! How do you make a preferred non-participating? You use the phrase “and no more” after the words “dividend of $X, when, as, and if declared by the board of directors”.
Is the stock callable? To make a stock callable, it requires special language. The language is here: the stock can be called at par plus accrued unpaid dividends. A call provision is always for the benefit of the most junior security, that is, common stock, because it puts a cap on what the more senior security can take. Is the stock convertible? This takes special language too. Class B in this case could go into the common stock, but only 1:1, and they give up their accrued, undeclared dividends. Does the preferred stock have a put? A put is an option whereby the holder of the option can force someone else to buy at a stipulated price or under a stipulated formula (like fair market value, for example).
The Court of Appeals held that because all of the directors of Axton-Fisher were officers or directors of Transamerica, there was an overarching conflict of interest, and the board of Axton-Fisher could not call the preferred stock. The district judge says to the Court of Appeals that they got it all wrong. The district judge says that the overriding rule of law is that even if there is a complete conflict of interest, if the fiduciary shows overall fairness as to disclosure up front and on the merits, and creditors are not injured, then there is always a complete defense in the corporate world against conflict of interest transactions (but in the trust world, this isn’t necessarily true).
Then the district judge says that the call provision is for the benefit of the common stock, and the conversion provision is for the benefit of the holders. Then, this judge looks at Rule 10b-5 and says that to compute damages, let’s assume the board of Axton-Fisher did it right, in which case they would have called the Class B. However, if under Rule 10b-5 they should have informed the Class B holders of what was going on. The Class B, having been informed of that, all would have converted. Therefore, the judge says to the B holders that they should get 1:1, not 2:1. Shipman says that this is right! The terms of securities, including debt securities, are everything.
If you have about the same disclosure duty under state law
that you would have under 10b-5, and the disclosure duty under state law is on
a fiduciary basis, then you plead the matter today under state law rather than
under Rule 10b-5. How come? (1) 10b-5 always requires scienter. Under state law, if there is a heavy
fiduciary duty, mere negligence, without any scienter at all, may well
suffice. It’s easier to prove negligence
than fraud in either federal or state court.
(2) In the 1990’s, there were three federal statutes that cut way back
on 10b-5 class actions. More on these
statutes later in the course. These statutes
are “plaintiff killing fields”. If you
can avoid them, do so. They apply to
class actions for fraud. Therefore, if
you go under state law theories that don’t require fraud to be proved, then you
avoid them. (3) In the last 25 years,
about half of the federal judges have become more anti-plaintiff in the
corporate area to some degree. At the
state level, it’s a more even playing field.
Even with class action suits, often you stick with the simpler state law
theories rather than going to
Frick v. Howard – This case deals with the fiduciary duty aspect of the promoter’s liability doctrine. Since the promoter took a non-negotiable note and assigned it to the plaintiff, the plaintiff took over all of the disabilities of the assignor and because he couldn’t meet any one of the three validating tests, he stood in the shoes of the promoter and his claim for secured status was denied.
In this case, the promoter is a lawyer who thinks that the town needs a motel. He buys land for about $200,000. He probably disclosed that he would transfer the land to a corporation that would run the hotel. Today, he would have to negotiate with the S & L because usually it would put a “due upon sale” clause in the first mortgage note, and unless they consent to the transaction, they could accelerate the note and cause it to come due. This is not a consumer transaction. There are no federal consumer statutes involved. Everyone is a business, not a consumer. The lawyer ups the value, in his own mind, to $310,000. The lawyer takes back roughly a $110,000 second mortgage note, plus a second mortgage. In a mortgage, there are always two instruments. There is a note, which is the in personam promise to pay of the maker, and there is the second mortage, which is a real property interest that you record at the courthouse giving you the right to foreclose if the principal and interest payments aren’t made. The two instruments are “tied together like Mary and her little lamb”.
A note is a two-party debt instrument. There is the maker of the note, who signs at the bottom, and the payee. A note is to be distinguished from a bill of exchange which is a three-party debt instrument. With that instrument, there is a maker, a drawee, and a payee. The drawee is the bank, the payee is the person who you write in, and the maker is the signer. A note is two-party. There are all kinds of bills of exchange, but we won’t get into them and we’ll stick with notes.
This is a rank real estate promotion, meaning that it is a very heavily leveraged real estate corporation. This is the opposite end of the world from the highly secure Exxon! A big danger for highly leveraged companies is that they will go insolvent. How do the courts deal with insolvent corporations? They do it in two ways: (1) The insolvent person can file a voluntary state court receivership or it can be involuntary by creditors forcing the insolvent into the state court receivership. (2) The insolvent person, at the front end, has the option of going under the Federal Bankruptcy Code of 1978, found at 11 U.S.C., and they can file a voluntary petition of bankruptcy. Also, initially the creditors could have filed an involuntary petition in bankruptcy, and a third possibility is that once a state court receivership is filed, the creditors can force it to the U.S. Bankruptcy Court, a unit of the U.S. District Court with its own clerk and its own judges. It is reviewed by the U.S. District Court, and a district court judge can take charge of a proceeding at the beginning if they’d like.
The creditor sign and file, on time, formal claims asking
for a “piece of the pie”. It’s the same
way in the
The $110,000 note, which was originally payable to the promoter (the lawyer), who was the 100% shareholder, had been assigned by him to the plaintiff. The plaintiff had filed a secured claim in the state court receivership. He says: “I have a good $110,000 face amount claim, plus interest, as a secured creditor in this proceeding!” The court, acting sua sponte, started this proceeding to determine whether this guy had a valid claim.
So what does the court hold? First, a note, if it is worded as “pay to X or pay to the order of X” will usually be a negotiable instrument under Uniform Commercial Code Article III. But this note lacked this language. It simply said: “pay to X”. The lawyer assigned it to his buddy for lots of cash. The court holds that: (1) The note is not a negotiable instrument under Article III of the Uniform Commercial Code. If it were, the holder of that note could be a holder in due course and have greater rights than his transferor had. It’s kind of like the Recording Acts in Property. But since the words of negotiability were missing, it was a simple, straightforward assignment and the lawyer’s buddy stepped into the shoes of the lawyer. That is, every infirmity that the lawyer suffered under, the buddy will also suffer under. (2) Just what kind of infirmities was the lawyer under? The lawyer was a promoter, and he owed very high fiduciary duties to the corporation and to the other shareholder.
When he sells property to the corporation, in order for that to stand up, he must do one of two things: (1) he must prove overall fairness of disclosure and the substantive price and that creditors aren’t injured. Did the assignee of the promoter prove that as to the promoter? No. (2) The promoter can only put people on the board of directors who are independent, outside directors who are not beholden to him. If they approve, it will be tested under the Business Judgment Rule, a rule of deference. That is, if they approve it, it will stand unless the other party shows fraud, arbitrary action, ultra vires (beyond the powers), illegality, waste (meaning recklessness) and then the biggies: gross negligence in procedure, or gross negligence on the merits. The last two are usually the easiest to prove. Did the lawyer’s assignee meet the Business Judgment Rule? No, because there wasn’t an independent Board of Directors. (3) If all shareholders and all present and future creditors consent after full and fair disclosure up front, that would be another “out”. Did the buddy qualify for any of these three “outs”? No! So the infirmities of the lawyer carry over to him!
When you endorse an instrument to transfer, you have secondary liability unless you write after that endorsement “without recourse”. The lawyer didn’t want that secondary liability! There are also certain warranties under Article III whether it would be applicable or not. The lawyer probably wrote “W/R and without warranties”. What the lawyer did here was very dangerous. The lawyer probably had a duty to tell the purchaser that this was a non-negotiable note, subject to all the promoter’s claims. Careful lawyers, when drafting a non-negotiable note, will include the caption: “Non-negotiable note”. Why? There’s a case in the last thirty years that says that a lawyer who wasn’t thinking about it but created a non-negotiable note was liable to a remote purchaser who didn’t know it was a non-negotiable note. Are non-negotiable notes something you should use at times? Sure they are! If you’re a manufacturer buying 300,000 parts from someone, then if you give your non-negotiable note and the parts are defective, then if they guy sues you on the note, you can set-off. It would be the same as if the guy sold the note to a bank. But if you make the note negotiable, then the note can be sold to a third party, like a bank. When the bank sues you on the note, you can’t set-off the defective parts. Shipman says that this is all a matter of bargaining power.
There are also tax aspects to the formation of a corporation or the issuance of new securities. Though this is not primarily a tax course, you must know how to spot tax issues.
The Old Dominion cases – What’s the situation? The promoters formed the corporation and each of the promoters got stock in the corporation for $5. Soon after that, the corporation issues stock to the public and charges the public $15 per share. It was not alleged that there was any fraud in either sale of stock. Furthermore, there is no injury to creditors alleged. Why? It’s because the company is receiving money for stock and upon liquidation, stockholders take last after creditors and no fraud is alleged.
Here are four flavors of action. They’re related, but different. First, consider legal actions on behalf of the corporation. The easiest one is the case of Frick v. Howard, where a company goes
insolvent and there is either a voluntary or involuntary state court
receivership or a trustee in
bankruptcy (“T/B”) who is appointed in a bankruptcy action in the United States
Bankruptcy Court under 11 U.S.C. State
court receiverships are quite complicated, and federal actions are even more
so! These are called universal successors to all of the
assets and causes of action of the corporation.
The state court receiver or trustee in bankruptcy can do two things: (1)
they can assert any causes of action on behalf of the corporation that the corporation
has. The benefit of these causes of
action ultimately goes to the creditors.
Next up, we have shareholder derivative actions, governed by Rule 23.1 of the Federal Rules of Civil Procedure. A shareholder files a complaint, served it on the corporation and the actual defendants, alleging that the defendants have overreached the corporation in some way. The shareholder goes on to allege that the corporation should sue, but it hasn’t because the defendants dominate the corporation and they won’t sue themselves. Therefore, the shareholder wants to sue on behalf of the corporation. If the court approves this (after a whole bunch of motions before the answer), then the suit is tried. If the plaintiff gets a judgment, the attorney for the plaintiff moves for attorney’s fees and there is notice and opportunity for hearing on the attorney’s fees. Then the attorney for the plaintiff takes off the top. These actions are driven by plaintiffs’ lawyers! What’s left after that goes to the corporation and the judgment is res judicata as to all shareholders (not just the suing plaintiffs), the corporation, and all defendants. It’s a “true true class action” because no plaintiff can opt out. What the judge says is res judicata as to everybody. This is powerful stuff!!! If the defendants win, it’s also res judicata as to everybody (they walk away scot-free). There are two other possibilities: (1) settlement, or (2) dismissal. Under Rule 23.1, these are possible only after the court orders a hearing and determines that it’s to everyone’s benefit to approve the settlement or dismissal. Any settlement will contain extensive provisions for the attorneys.
In Matsushita, you
had a friendly tender offer for a movie studio by a Japanese company. It was a good cash tender offer at a good
price. The family that owned the
controlling stake in the company didn’t like the fact that it was in cash
because they would have to pay taxes on it.
They went to the offeror and asked to have them pay with stock instead of cash. They agreed.
But the problem was that two SEC rules were violated (14d-10 and
10b-13)! After the deal closed, a class
action in the federal district court in
There can be direct action by shareholders against the corporation or its fiduciaries. If there is an ultra vires action, the action can be asserted derivatively or directly. The lawyer will always choose direct because Rule 23.1 is a “plaintiff’s killing field”. Similarly, like an action to force declaration of a dividend, can be asserted by either a class action of shareholders against a corporation or a single shareholder. The plaintiff’s lawyer will make his decision based on what’s likely to get better attorney’s fees. That’s just how it is!
In the Massachusetts Old
Dominion case, which dealt with a few of the promoters, it was said that the
public selling price determined the value of the shares, and the promoters must
pay the company the difference between $5 and $15 times the number of shares
purchased. In the federal Old Dominion case, written by Holmes, it
was said that one of the exceptions to conflict of interest regulations applied
here because (1) there was no injury to creditors, (2) no fraud or information
deficiency was alleged, and (3) there was consent of all shareholders. That creates a defense to conflict of
interest? How did the
Rule 10b-5 says that when a promoter buys stock, for the next five years, whenever the corporation issues stock to other people, publicly or privately, you must disclose that (this is the “five year” rule). Thus, today, the promoters in Old Dominion would have put a paragraph in the offering circular that disclosed the stock holdings of the promoters. They would have disclosed that the promoters paid $5 per share even though they were asking $15 per share from the public. You must do this or risk violating federal and state securities laws! If the promoters had followed the SEC disclosure laws, then there will be unanimous shareholder approval, no harm to creditors (because it’s beneath the creditors), no informational deficiency, and no fraud. Put it all together, and you get one of the exceptions to liability under conflict of interest regulation.
Well, if people are aware of SEC disclosure rules, and other those rules these cases are irrelevant, why are these cases important? It’s all about compensating the promoter and compensating sweat equity. Today, the offering circular to the public would fully disclose the $5 price. Generally, for tax purposes, if the promoters organize for $5 and then you go to the public at $15, within two years of when you do it, the IRS will say to the promoters: “You have $10 per share of ordinary income! Pay up!” If it’s over two years, the tax cases say that it is clear that the promotion was “old and cold”.
So what is the lesson of Old Dominion? We want to find the true value of stock as applicable to the marriage, business-wise, of sweat-equity and capitalists. Let’s start a new business! We need $1 million. There’s a capitalist who has that much cash, but he needs someone to run the company on a day-to-day business. Let’s say the capitalist will work 40 hours per week. He’s a retired doctor who is no longer practicing medicine. He needs someone to put in the 80-hour weeks who has detailed operating knowledge of the business (which the capitalist doesn’t have). Let’s use Subchapter S because the projections show that there are going to be big losses for three years, and then there will hopefully be a turnaround! The capitalist finds sweat equity and makes a handshake agreement that the corporation’s two directors will enter into a three-year signed, written contract for sweat equity with enough money for him to live on. There will be a similar contract for the capitalist for less money (because he’ll be working less). Part of the sweat equity deal is that the guy gets half the upside, that is, half the common stock.
Here’s how not to do the deal right. The Internal Revenue Code sections needed here are §§ 1032, 351, 61 (gross income includes income from all sources and including non-cash assets as well as cash; shares of stock of a corporation are clearly qualifying non-cash property), and 83 (if you receive non-cash property and its transferability is restricted, you value it at its value if it had no restriction on it). In this transaction, the transfer of shares must be restricted for two years under federal and state securities laws. The restrictions will be on the face of the certificates. It will be fully valid if the restrictions are on the face in full caps: that’s considered a reasonable restraint on alienation. Complying with the securities laws is reasonable.
What happens if a lawyer has sweat equity? There’s a $1 par stock. He buys 1000 shares at $1 each. There is a restriction on the face of the certificate. The sweat equity dude buys 1000 shares at $1000 per share. The Old Dominion rule says that you take the highest price paid and project that value backwards to everyone. So our sweat equity has $999,000 income. Each share is worth $1000. He paid $1 for it. So we multiply $999 times the number of shares, 1000. If the sweat equity person is rich, then it’s no problem. They can cut a check. But, for the average person this is a total disaster. Even for Bill Gates, we wouldn’t be thrilled. It will be service income to sweat equity. Then you look at another Internal Revenue Code section: § 162. It’s not quite as bad for sweat equity as it looks. He gets a deduction! Bill Gates can use a big deduction! Since he’s working for the company full-time, he has this great deduction. But the Internal Revenue Service will contend that the sweat equity is promotional services for organizing the company, and thus is non-deductible under §§ 263-66.
Sub S rules out any different classes of stock except one category of common stock. But it has some good rules! The debt/equity distinction will give us headaches. But what’s the beauty of Sub S? The regulations have a straight debt exception. To be straight debt, it must call for definite payment of principal and interest at definite times. In that case, regardless of the debt/equity ratio, for Sub S purposes, they will leave you alone. The regulations even say that you can use, in certain cases, contractually subordinated debt. But you can’t use an income bond. What’s that? It’s interest payable only if earned. That’s not allowed!
Let’s say the capitalist buys 1000 shares of common stock at
$1 per share in cash. Then the
capitalist has half the upside. The
business requires $1 million to get off the ground. There’s a $999,000 straight debt note. But what’s wrong? The straight debt note will have to carry an
interest rate of 10-16% per year to be believable because it’s such a risky
note! However, that does not violate the
usury laws of any state, though there are some statutory limits in
The Dunn & Bradstreet reporting service is the service for small business. To get listed there, you must submit accounting statements, including a balance sheet which will reveal just what is going on. The note to an affiliate (that is, someone who is controlling the company or under common control of some other company) will be listed. You want suppliers to sell to you on credit. You want 30, 60 or 90 day credit! It’s the same way with a lessor. But will this fly? At that extreme a level, it will not. You’ll have big problems. So how do you deal with it? When you go to get a bank loan, they will require contractual subordination of the capitalist’s $999,000 to the bank. This will be explained more later. It really means assignment. Will that kill you under straight debt? Probably not, but the lessor will be hesitant. Suppose the lessor says: “subordinate that baby to all creditors!” The tax lawyer would say that at that point, you’ve violated straight debt. If the company gets sued by creditors, they’ll go after the capitalist! So they want everything to be joint and several. What about big suppliers? They’ll do the same thing. They’ll say that you must have a signed, written joint and several guarantee individually from both the sweat equity guy and the capitalist guy.
What about cash flow problems? If the capitalist wants to avoid an individual guarantee, he’ll have to switch his note to $990,000 of preferred stock and give up the Sub S election. There are “inbetween” ways to do this too. You could split between the note and the stock. The sweat equity-capitalist problem is easier solved in an LLC than in the corporate form.
What about Internal Revenue Code § 1244? Shipman mentioned §§ 461-466, which were added by Reagan in the 1980’s to discourage tax shelters. They say: “Even if you’re Sub S, which has a flow-through, if you don’t work full-time for the company, you can’t use flow-through losses as they arrive. You can stack them up and use them when you sell the stock.” Full-time is 40 hours per week. If you’re a full-time lawyer or banker and only work on your Sub S a few hours a week, you won’t get your flow-through like in the old days.
Here is an anomaly: what’s the tax effect of debt when it goes bad? There is an odd set of rules that we’ll look at tomorrow. One of the ironies is that often, for a closely-held company, investing in common or preferred stock is better than taking a note. Here’s a hypo: Daughter runs a non-Sub S company. It’s breaking even and it’s been around for 7-8 years. She needs to expand now. She turns to Father and wants him to buy 100,000 shares of stock. What considerations go into it? First off, look at it from a practical standpoint. Father is a retired physics professor with a good pension. He’s well-to-do but not wealthy. Suppose that Daughter is his only child and he’s not married now. Say he can rake up over $100,000. One of the problems will be that Daughter and her co-investors will be more interested in their salaries than dividends. That’s understandable! Could Father make out well? Sure! The company could do well. It could get bought out by a big public company. Does Father want to be a director or an officer? No way! He doesn’t want to be liable! What about the downside? On this hypo, if he invests and the company goes under, he’ll get an ordinary business loss under § 1244, whereas if he lent the money to the company and they went under, then § 463-66 would only give him a capital loss. § 1244 is a sometimes useful oddity. It gives a limit for a single person. Lastly, you would tell him that his potential for liability is quite low if he doesn’t try to run things, and isn’t an employee, officer, or director. This is called “disregard of the corporate fiction”. As long as he’s not active, he’s probably safe. But should he do it? He should consider his health. If he might get sick, he better hold onto his money.
In the 1970’s, executive stock option plans became very popular. They are governed by §§ 83, 61, and 162 of the Internal Revenue Code. § 83 tells you the results of a non-transferable stock option plan. When you advise a client about options, ask for a plan! The plan can only be adopted by the board of directors. No one else is allowed to do it! And if you’re a public company, you must follow SEC rules, including the proxy rules at § 14 and under § 16 (about which more later). § 162 of the Internal Revenue Code contains a major subsection on executive stock options for public companies. The first thing to look for under the plan is the vesting period: the “use them or lose them” provision. The point of options is to tie employees to the company in some sense: a kind of consideration. There are exceptions, though: options can vest even if someone is no longer an employee if the person dies or is seriously injured and can no longer work.
The Sarbanes-Oxley Act, a federal statute from three years ago, says that public companies can’t lend money to insiders. If the employee is independently wealthy, he can exercise his $1 million option. But for the average person, this will be a problem. But the bigger problem comes from the tax standpoint. Other than § 83, the grant of a non-transferable stock option to an executive usually creates no income at that time. But if the employee wants to exercise the option, he’s going to get taxable income, in this case to the tune of $6,000,000! That is, 100,000 times $70 minus $10. But the good news is that subject to certain limits in § 162 (which gives a deduction for only reasonable salaries), the company gets a deduction in the same amount and in the same time that the individual realizes that income! This can make it so that a company doesn’t have to pay any income taxes!
Since it’s a public company, the employee can use Rule 144 under the Securities Act to sell within the volume limits of that Rule. If it’s a big company, this Rule will pose pretty much no problem. But if it’s a small company with just a few hundred shareholders, it will be a big issue! The way out is to go to a big securities firm and coordinate with the inside and outside legal counsel of the company and with the CEO. Remember the Bernie Ebbers story! He fired one of his top executives for not telling him when he was going to exercise his options!
The brokerage house will lend the employee some money to exercise the option, sell enough of the stock to pay back the loan plus taxes (state, city, federal, Medicare, Medicaid and all that), and give him the rest. He will have to get the company to sign off on this because the option plan will have a provision about tax withholding. The company must withhold taxes on the gross income (federal, state, city, and the employee’s Medicare tax). The company, the brokerage house, and the employee will enter into a contract. The brokerage house will get its fee, then remit the withholding that the company must then send to the tax authorities. The fee will be very high!
What if this is a private company and there’s no public market for the stock? Once in a while, the company will have enough money to buy the employee’s option out for what it’s worth, after withholding taxes. The employee pays taxes and the company gets the deductions. So options work well for public companies, but for private companies that will stay private they are a bad idea. If the employee is rich enough to exercise the option, they will, but that’s rare. But there’s yet another case! Private companies often want to go public. Say a private company goes public after six years and they sell several billion dollars’ worth of stock in an IPO. After the IPO, the underwriter will restrict the sale of the stock for nine months. The employee will have to clear the sale with the boss, too.
With options and convertibles, you need to be concerned about dilution of the common stock. If there are $5 billion in outstanding convertible debentures and you can convert 10 shares for each 100 debentures, and your stock is selling for $60, the stock will get really diluted when the debenture holders convert!
Lastly, in terms of accounting, companies may, if they wish, may value the option upon its issue and treat it as an expense when issued for accounting purposes. This is done by lots of the country’s big companies! In the future, all companies may be required to value their options when they are granted and take an expense deduction on their income statement. The FASB (faz-bee, or the Financial Accounting Standards Board) is a not-for-profit organization that sets GAAPs (generally accepted accounting principles). FASB must be consistent with what the SEC says. But the SEC generally defers to the FASB when setting GAAPs. Occasionally, the SEC will step in, and “once in a blue moon” Congress will step in and alter the rules.
Herbert G. Hatt –
A woman who owned a company married a younger man and let him buy planes and
stuff. Then their marriage went
downhill. What starts off fairly
harmonious, given a death or resignation or two, becomes awful. This is a frequent exam question. In this case, the parties signed a prenuptial
agreement. Let’s cover the law of
prenuptial agreements and in particular the law in
In this case and Wilderman, we see that if you’re a Sub C corporation, the Internal Revenue Service is always bugging you on the issue of reasonableness of salaries. In Wilderman, the Internal Revenue Service found that what the husband was getting was unreasonable. Thus, they disallowed many of the deductions. For a public company, the same rule applies in theory. In practice, however, it doesn’t so apply because public companies hire compensation consultants who have access to the earnings of corporate executives. Also, the federal income tax statutes regulate, and if you meet those technical requirements, you’re capitalized. Most public companies have a majority of their directors as outside, independent directors. The Internal Revenue Service, as a practical matter, usually doesn’t challenge the independence of directors of public companies. For private companies, there is constant friction of § 162(a), and that’s a big reason they go with Sub S or a limited liability company. If you’re an LLC or Sub S, the issue of excessive compensation doesn’t arise because there is a flow-through.
Wilderman v. Wilderman – This is a two shareholder corporation. The husband worked for the father when the father ran the company. When the husband married the wife, the father turned in his stock certificate and two stock certificates were issued to the husband and wife. There were two directors: he and she. The marriage and business went well for some time. The husband was a good worker and a fine businessman. The salary scale was set at the company by the fact that the husband was doing most of the work. He made himself the President and CEO, and made his wife the “inside person”, doing the books and records. As long as the marriage goes well, it’s not a big deal, but the marriage goes sour. It’s a deadlock! The board of directors had two members, and they disagreed! Could there be an election of a new board of directors by the shareholders? No, because the stock was split 50-50! It’s a classic deadlock situation!
What facts were on the husband’s side? There’s a corporate rule that officers are
elected for a term: one year and “for so much longer as is needed until a
replacement or successor is elected”.
Therefore, they both remained directors and he remained the CEO. What’s the other big piece of paper in any
business transaction? It’s the bank
signature card! Shipman thinks that the
bank signature cards said that either person could write checks on behalf of
the corporation. Shipman thinks that the
wife wrote her own check to herself at the old, low scale, and then the husband
declared as CEO that he was worth a lot more than when the board of directors
had last passed on it! He started
paying himself a lot more! Under
So here are the holdings of the present case: (1) Only the board of directors can set the salary for officers and top executive employees. (2) If there is a deadlock, the president (with check signing authority) can continue to pay himself under the last pay scale approved by the board, including any bonuses.
Dodge v. Ford Motor Co. – This case holds that (1) with regard to a close corporation, any shareholder can sue the corporation and the directors directly to force a declaration of dividends. This doesn’t have to be a derivative action. The court ruled that there existed a cause of action and if you can show gross negligence then you can get the court to force the company to grant dividends. But the court is reluctant to draft these sorts of orders. (2) The action of the directors in not declaring dividends is under the deference rule of business judgment. If the defendants can show business judgment, the plaintiff must show one of these things: (1) arbitrariness, (2) ultra vires, (3) illegality, (4) waste, (5) bad faith, (6) gross negligence in procedure or (7) gross negligence on the merits. The last two are the biggies!
So what’s the situation in Byrum? This guy owned a lot
of the stock of a close corporation. He
gave away some to children, but kept 60% for himself so he could run the
company. According to the Internal
Revenue Code, if you transfer property with retained
major powers over that property, then at your death, the property is in
your estate even though you transferred it to your kids. The government argued that since the old man
was going to set the dividend policy on the companies he maintained a major
power over the transferred minority shares.
Justice Powell went through
What about a public company? Can you get a court order for a dividend there? In theory yes, but in practice, “forget it, baby!” But the situation with a public company isn’t as bad if there are no dividends. For example, Microsoft pays no dividends, but their shares are highly liquid. But with a close corporation, your shares are not very alienable and not very liquid!
In practice, if a public company meets the first two qualifications, the court won’t go to the de facto equity test. How else can you deal with this? You can avoid it completely by electing Sub S. A Sub S corporation is a flow-through. As long as the debt is straight debt in form, no sweat. The other way to avoid the problem is with an LLC, governed by Sub K, and thus it’s flow-through and you don’t get into the de facto equity or unreasonable salary problems (with an exception to be mentioned tomorrow). But one of the big selling points of a Sub S or LLC is that you avoid the unreasonable salaries and de facto equity tests. If you’re Sub C these days, you can still have problems with those areas! Watch out for the Internal Revenue Service agents!
Pepper v. Litton –
Here we have a closely held corporation.
The owner had not taken his salary out.
A creditor sues. Then all of the
sudden, the owner puts a lien on the assets of his company. The outside creditors went into state court
and challenged this on the ground of common law fraud with scienter. The
Justice Douglas holds that bankruptcy courts are always courts of equity. Furthermore, a claim can be equitably subordinated if there are
strong equitable grounds for doing so. The
outside creditor in this case did
show such strong equitable grounds. Even
though there was purportedly a preclusion issue from the
The result is a bit different than the result in Pepper. Say you have a mid-sized public company that needs to raise more money. They have already borrowed a lot of money from a big insurance company and the loan agreement requires the insurance company’s consent to any new debt. The public company goes to the insurance company, and the insurance company says that they may issue new debts to outsiders, but only if it is contractually subordinated to the insurance company.
The mid-sized public company will issue debentures (unsecured debt) to the public, with the following clause: “This debt is contractually subordinated to the debt of Insurance Company. In any insolvency or bankruptcy proceeding, we authorize Insurance Company to file a claim on their own behalf for their own debt and to file, as our agent, a claim for this subordinated debt. If the total of those claims yields Insurance Company less than the face amount of the debt to Insurance Company plus interest, then Insurance Company keeps everything. If the total of the two claims filed by Insurance Company yields more than the principal and interest of Insurance Company’s debt, then the excess will be returned to us. These paragraphs create an agency and we hereby declare that the agency is irrevocable as an agency coupled with an interest.”
Contractual subordination is, in effect, an assignment coupled with an agency coupled with an interest declared to be irrevocable. Why that wording? The typical agency power is revocable even if the revocation would cause the party revoking to be liable in damages (which is counter-intuitive but correct). The big exception is an agency coupled with an interest. You can’t make an agency coupled with an interest merely by stating that it’s coupled with an interest. The Restatement Second of Agency says that the agent’s interest in performing services for a principal doesn’t make it an agency coupled with an interest. But, if the agent advances substantial money or property, and the parties state that, then the agency is irrevocable. In our example above, the drafter “gilds the lily” to show intent.
Subordinated debt is widespread. If the subordination goes only to payment of principal, it won’t screw up the tax deduction of a corporate payor. But if interest payments are also subordinated, you’re dead. If the subordination goes to all creditors and not just institutional lenders, then I think you’re dead too.
If you’re advising a controlling shareholder or a relative
of a controlling shareholder, you must tell them that in an insolvency
proceeding you’ll probably get equitably subordinated. In
Insiders have other problems. The first two cases talk about the corporate veil. The corporate veil can be disregarded for fraud and some other reasons. In DeWitt, Flemming made the Cockerham mistake! He did the “macho” thing and promised to stand by his corporation. He said, “If the corporation doesn’t pay you, I will.”
In Debaun, it is held that majority shareholders owe duties to the corporation. The bank sold their majority stake to a madman! The judge allows the derivative action because he wanted the money to be put into the company so that the creditor would get paid. The attorney for the minority shareholders could get a reasonable attorney’s fee. The controlling shareholders owe heavy duties. For starters, remember Pepper. Even if they lend money to the company, if it goes bankrupt, they’re probably going to get pushed down the pile.
In English speaking countries, there is no such thing as bearer stock certificates. Such certificates can be used by the bearer
for all debts, public and private, and there is no record of who has them at
any one time. You can find these
instruments in civil law countries. Both
stock certificates and bonds are typically issued in bearer form. If you have a bearer bond from a big company
The state statutes all require that stock certificates be in registered form, in other words, the exact opposite of bearer form. The company maintains books known as stock transfer books. Sometimes this is delegated to an independent bank known as the transfer agent. The board of directors will set a record date for all shareholders’ meetings. The holders of record as of the record date vote.
What about dividend payments on stock? There are three big dates. There’s a declaration date when the board
declares them. Under
The governing law concerning the transfer of stock certificates and registered debt is found in three places: Uniform Commercial Code Articles 1, 8, and 9; ORC § 1707.04-.37 (sprinkled throughout), and the rules of NASD, NYSE, and AMEX. Most of the time, the former two sources will agree completely. Once in a while, though, there may be some slack between the two. It usually doesn’t cause a problem, but it does every once in a while.
Article 8 classifies stock in corporations as investment securities. Nearly all courts will say that close corporation stock, even though it’s not publicly traded, is of a type that is publicly traded, and thus they will apply Articles 8, 9 and 1 in full. A very small number of cases will deviate from this approach. What’s important about investment securities? The big deal is that it’s just like the Record Acts! A bona fide purchaser is someone who gives consideration, acts in good faith, and who is not on notice of an adverse claim.
Let’s say bank B lends Mr. Smith $100,000 on Mr. Smith’s GE stock certificates. Smith takes the certificates to bank B and endorses them in blank, meaning, he doesn’t say who he’s endorsing to. The bank will put on a signature guarantee, in case they have to foreclose on the pledge and sell the stock. The NYSE rules require a guarantee of signature from an NYSE member firm or a bank. The loan officer is negligent and puts the certificates in his briefcase. On the way home, he loses the briefcase! A thief finds the briefcase and the stock certificate endorsed in blank. The thief takes the certificates to his stock broker and the stock broker has no reason to doubt his word that he bought the certificates from Smith. The broker sells the certificates through NYSE. The purchaser has 100% title to those certificates. How does bank B change its operations after this event? They will have Smith sign a separate piece of paper: a stock power or assignment. They will keep the two documents separate at all times.
State statutes protect the company in paying dividends. They may rely upon their books of record unless they have actual knowledge to the contrary. But there are two exceptions to this rule: (1) upon final dissolution, to get your money from the company, you must present your actual certificate, which they will stamp “cancelled”, and keep it. (2) If it’s a series of payments in partial liquidation, you’ll have to present your certificate several times. This is certainly cumbersome, but the Internal Revenue Service loves it because they can trace who gets what in dividends and interest. Some companies have gone to a wholly electronic dividend payment system, but these are the small minority. Most use the old paper method.
Public offerings of debt over one year in duration have to be in registered form to get the Internal Revenue Code § 163 interest deduction. The Internal Revenue Service pushed for this! But there are two exceptions: (1) if it’s a non-public issue of debt, for example, the debt of a close corporation, then you don’t need to comply. (2) If it’s less than one year, even if it’s public, you don’t need to comply.
Salgo v. Matthews –
This case involved an insolvent insurance company in
State statutes literally require the appointment of an important officer called the Inspector of Elections for each shareholders’ meeting. This person is important because if there is a close or disputed item, the inspector will conduct an administrative hearing, take evidence from lawyers for both sides, and then will issue his certificate. He’ll basically say, “Jones won” or “Smith won” and give his reasoning. In most states, that report is accepted in the courts prima facie. There is a presumption that they are correct. If it’s a close corporation and you don’t anticipate any dispute, they’ll usually pick one of the corporate officers and name him Inspector of Elections. If there is likely to be a dispute, they’ll hire one of the Big Four accounting firms. If you have issues that you want to work out up front (before the meeting) in court, in many states the only way to do so is through declaratory judgment. If you went for a mandatory injunction, they may say that you’re invading the responsibility of the Inspector of Elections. But if you ask for declaratory judgment, there may not be a problem.
Ling and Co. v. Trinity Sav. and Loan Ass’n. – On the back of the stock certificate in small print was a notice that transfer of a big block of stock probably would require prior approval of the NYSE. The person pledging the stock didn’t make his loan payment and the S & L wanted to foreclose and sell the stock. But what’s the problem? The rules of the NYSE did somewhat prohibit the transfer, and those rules were not unreasonable restraints on alienation on a common law basis. The court holds that a straightforward interpretation of Article 8 of the Uniform Commercial Code says that generally speaking, restrictions on transfer must be conspicuously put on the face of the certificate (e.g. full caps or a different color with big type). Neither one was done here! The Uniform Commercial Code goes on to say that if it’s a bona fide mortgagee or purchaser for value without notice of this, that person will take free of the restriction. The court held that since the notice hadn’t been placed conspicuously on the face of the certificate, the trial court should determine whether the S & L had actual knowledge of the restriction at the time that they made the loan.
The second issue was whether the restriction was valid under
the Texas Corporation Code. Shipman
claims that they strained a bit, but they found that the restriction was not
unreasonable under common law, and thus it would meet the
In these two cases, the stock certificates have been genuine.
But forgery exists, and it’s a problem!
About a dozen years ago in
But debtors will fight security title! That’s how mortgages came up in
In re Radom & Neidorff, Inc. – This case talks about dissolution, which has two “flavors”: (1) voluntary and (2) involuntary. Voluntary dissolution is governed by § 1701.86-.91, where the shareholders vote to dissolve the corporation. That vote will give the directors authority to sell the assets and .86-.91 will direct the directors (at their own peril!) to pay or make adequate provision for all creditors. Then the directors will distribute the cash left over to the shareholders. Once in a great while, it will be an in-kind dissolution of the corporation. If there’s only one shareholder, and they only own Greenacre, then the corporation can distribute Greenacre to the sole shareholder. That’s rare, because under the Internal Revenue Code §§ 331-338, if it’s a Sub C company, there will be a double tax: one at the corporate level and one at the shareholder level. That’s why companies often use an LLC. The tax problems can be overcome if the sale is set up solely for the stock of another company: the whole thing can be tax-free!
Involuntary dissolution comes in two “sub-flavors” at common
law: a court can enter an order of dissolution when it finds (1) fraud, (2)
oppression (in a close corporation), or (3) deadlock (by statute). You’ll find these statutes in
What are the facts of the case? We had a
At one time, the directors had agreed on the management of
the company and the brother was making money for the company. Shipman thinks that the bank signature card
for the company required the signatures of both the brother and the sister. Usually, only one or the other’s signature is needed.
This is different than the case of Wilderman. The brother and sister are suing each
other! The sister won’t sign his salary
checks! But he had a very simple remedy:
he could have sued under Rule 65 for a temporary injunction. In
The person seeking equity must do equity. If the person seeking equity has unclean hands and the other person doesn’t, then you don’t get your relief. If both people have unclean hands, then you consider their “comparative rectitude”. Equity orders are heavy stuff!
Deadlocks are fairly common in closely-held corporations. It’s not uncommon to see these kinds of
disputes arise, and they’re pretty difficult.
What’s the lawyer’s duty in this kind of case? The
Gearing v. Kelly – Here we have two families that come together to start a corporation. Let’s say that each has 100 shares out of 200 shares outstanding total. The company they form has no cumulative voting, it has straight voting. Straight voting means that if you own 100 shares and there are four directors all elected annually (that is, the board is not classified – divided into two or three classes where some are elected each year and others are elected in alternate years), and they haven’t opted to have cumulative voting in the charter, then for each of the four spots, you can cast 100 votes. To put it another way, you cannot accumulate more than 100 votes and spread them as you wish.
The essence of cumulative voting is that you take the number
of directors to be elected, multiply it by the number of shares you own, take
the product and you can distribute it
as you wish. In good times, the company
gave each of the two families two directors.
They went into the annual meeting and agreed to cast a joint ballot of
the two shareholders, giving each side two directors. But one of the directors from one side
resigns due to disputes that have arisen.
Let’s say Jones director #2 resigns. Smith #1, the chairman of the board, can call
a special meeting of the directors. All
statutes and all bylaws and all charters will give him that power. He gives proper notice of the time, place,
and purpose of the meeting, namely, to elect a successor to Jones #2. If you have a four person board of directors,
the ordinary quorum requirement will be three, a majority. If one director resigns or dies, the ordinary
quorum requirement remains the same:
a majority of the full board of
directors. So Jones #1 boycotts the
meeting at which Smith #1 and Smith #2 elect Smith #3 to the board of
directors. Jones #1 brings an election
review proceeding. In
What’s quo warranto?
It’s half civil and half criminal!
It translates to: “By what right
do you hold an alleged office?” Jones #1
says that if she showed up, the Smiths would have screwed her over by
appointing Smith #3. She claims that the
only way she could keep the balance from shifting was to boycott the vote. It’s an appealing argument, but what does the
court hold? They say that Jones #1 was
bad because she purposely didn’t show!
Thus, they don’t give her any relief.
How do you avoid the Gearing
problem with two different classes of stock (class “J” and class “S”)? How do you handle death, resignation, or
disability under the
A word about statutes: the first thing you do is read them carefully. Use the plain meaning of the text first; that’s where you start. Most of the time that’s also where you end. But, later in the course, we will spend time with fiduciary duties, which are largely a product of court decisions. Legislatures, by and large, leave the issue up to the courts. Fiduciary duties can take strange twists and turns.
Statutes usually have a long list of definitions at the front, and R.C. Chapter 1701 is no exception. In the old days, these definitions were alphabetical, but about 25 years ago, they gave up, and thus they are no longer alphabetical. We need to read these definitions carefully, noting that they’re in no particular order.
Also, note that the statutes in our little books are about 15 months out of date. Make sure you check the law reporter for something that is totally up to date.
It was held in Gearing that the woman, by purposefully being absent from the meeting, sort of “dirtied her hands” in a way that equity is not available to her. This case ties in to the issue of what makes for a valid vote by directors or by shareholders. There are four requirements:
There must be a valid call by a person having the authority to call. In Gearing, for example, the guy on the other side appears to have the power to call. By way of explanation, the statutes distinguish between annual meetings versus other meetings scheduled by the charter or regulations (special meetings). In general, the people in charge of a company will give notice of general or annual meetings. The O.R.C. requires that for shareholders’ meetings. As to directors’ meetings, however, the O.R.C. appears to say that the notice for directors of either special or general meetings need not state the purpose. That is contrary to the common law, and if you’re the chairman of the board, you ignore this in practice and give decent notice anyway with the purpose.
The notice must be
valid as to time, place, and purpose.
The rules are slightly different for shareholders as opposed to
directors. At common law, if it is a
regular meeting, in theory, notice need not be given. But in practice, you should not rely on that
rule, especially if you’re a public company.
If you’re a public company, you must follow SEC rules.
How much lead time do you have to give? Check your charter, bylaws, and state statutes and find out how much notice is required and how you compute it. Be careful! R.C. 1701.02 says there is a “mailbox rule”, more or less. But…Shipman says this is probably unconstitutional under Tulsa Collection, a U.S. Supreme Court opinion written by Justice O’Connor. This is part of the line of cases defining procedural due process for state action. It’s a long line of cases that starts with Mullane from the 1940s. That case involved the settlement of common trust funds. Banks got the
In Tulsa Collection, a will was admitted to probate in
Another big case just before Tulsa Collection was a mortgage foreclosure in
Isn’t this a little tedious? No, you need to be tedious to get the job done! To get everything right, you better double check the requirements. It’s not simple!
Check if the quorum requirement is met! Look at the statute, regulations, and the charter, and if there is a special agreement under R.C. 1701.591, you must look at that too. Those agreements are kind of rare, though. If you have four directors and one resigns, then the quorum remains at three (a majority of the full membership). But a quorum need not mean a majority. Maybe it means that everyone must be there!
There are two big exceptions: (1) Ohio’s statute says: if
there is a vacancy in the board of directors due to death, resignation, total
disability, etc., then “unless the articles are to the contrary, the remaining
directors can fill the vacancy even if
the remaining directors are less than a quorum”. This makes the Gearing problem worse in
Consider the situation under the Model Business Corporation Act. If you have a four person board and one person dies, then three is a quorum. If you have the three living directors show up and you have a 2-1 vote, you have good action. One yes and two abstentions under the common law is not good action. But Cullen v. Milligan held that if you’re present and abstain from a vote on dividends, it counts as a yes.
What are the exceptions again? Let’s say Smith is the President and CEO of Smith, Inc., which is a corporation. Smith owns 100% of the stock. The company runs a mid-sized grocery store. The problem is that the corporation is having financial difficulties. Mr. Smith talks to Mr. Jones and asks Jones to sign a two-year contract with the corporation as general manager (not an officer). Part of the deal is that Mr. Jones will lend the company $200,000. Mr. Jones’s lawyer says Jones will do this only if Smith gives Jones an irrevocable proxy to vote his stock during the two year period. Smith agrees and writes out a document as an irrevocable proxy. The last paragraph says: “This is a proxy coupled with an interest, and it is irrevocable for the two year period.” According to the Restatement Second, that will be a valid, irrevocable proxy for the two years because it’s coupled with an interest.
New York and Delaware, by statute, go even further, saying
that if Jones doesn’t lend any money but simply agrees to be general manager
for two years under a two-year signed contract, that if a proxy is given and it
is stated to be irrevocable, then it will (by golly!) be irrevocable because
the statute says so!
In all states, once there is a valid quorum at the shareholders meeting, the vote requirement is simple. You need a plurality. It’s the English/U.S. “first around the post” political scheme. It’s non-proportional representation!
Shareholders can vote by proxy, but directors cannot. They vote only if they show up at a
meeting. But there are two
Suppose the articles provide for four directors, three of whom are present. The fourth has died. The remaining directors haven’t elected a replacement yet, and the articles of incorporation preclude that procedure. The three directors show up. That’s a quorum, unless the articles require more. Let’s say valid notice has been given. If the vote on a resolution is 3-0, then unless the articles or regulations provide otherwise, that’s a valid board action! What if the board votes 2-1? It’s tricky! If the regulations or the charter require a majority of the four, then 2-1 doesn’t cut it. In many states, that will be valid action, and that’s why in Gearing the lady didn’t show up. What if there’s one vote for and two abstentions? There’s a quorum. Do we match the one against the one voting, or do we match it against the three who aren’t voting? Generally, this will not constitute board action. There is some material in the Revised Model Act that goes the other way.
Cullen v. Milligan
What’s the big deal?
The majority rule is very
counterintuitive to laymen and a lot of lawyers. If you’re a director of a
As to shareholder votes, in Delaware, the general rule is
that, unless the articles provide otherwise, when shareholders act on matters other than election of directors, for
the shareholder vote to be valid, over 50% of all outstanding shares must be voted affirmatively. In
If you have an even number of directors, cumulative voting will generally prevent a deadlock in the election of directors. If there are an odd number of directors, it usually will not help. For more information, look at Aranov & Einhorn’s Proxy Contests. It’s old, but good.
Here is the math.
First, you can’t form a company in
Say you have four directors.
All of them are elected annually.
The majority of the directors want to go to straight voting. They call a meeting under R.C. 1701.72. Frank is a minority shareholder who owns 21
shares. He can elect one director. So if he votes no, we can’t switch to
straight voting. But that’s not the end
of the story. The majority can form a mirror image
Here are a few more procedural points on the Ohio system: it will be straight voting unless one or more shareholders states before the meeting that it will be cumulative voting and the secretary gives notice to everyone that it’s going to be cumulative voting. Why? If someone thinks it’s straight voting and shows up and it’s really cumulative voting, that person will get screwed. Cumulative voting works only if everyone knows the rules in advance. That’s fairly common in all states.
Let’s prove the deal with odd and even numbers of
directors. Let’s say we have an
How will the two sides likely vote? From game theory, we assume that each side uses minimax theory, meaning that each side is highly rational and will vote to minimize harm to themselves while maximizing the upside. This is a rational model, which isn’t to say that it always reflects the real world. So how will the two sides likely vote? Take the number of shares times the number of directors to be elected. Thus, each side has 400 votes. The statute says that you can accumulate and spread among one or more of the four as you wish to maximize your situation. The ballot will likely come back with 200 votes for each of Jones-1, Jones-2, Smith-1, and Smith-2. Let’s assume all the requirements for a valid vote have been met and that there has been notice given that cumulative voting will be happening. The Inspector of Elections issues a certificate of the result. There were only four candidates, and therefore a new board will take over! If any of these people are different from the old directors, the old people will be pushed out!
Here is a different case: say there are only 3 directors,
all elected annually. One or both sides
demands cumulative voting and the secretary gives notice. There is proper call of meeting, proper
notice of time, place and purpose, the charter is silent concerning cumulative
voting, meaning that in
How do we get around this? In the Jones/Smith hypothetical, there are three Joneses and three Smiths who want to be active in the company. Each is contributing a lot of cash. Let’s say we’re counsel for the Jones family and a different firm is counsel for the Smith family, while a third firm altogether is counsel for the new company, to be formed.
How do we advise Ms. Jones, who will be the CEO, and who will have two sons active in the business as directors? How do we avoid the Gearing problem? We can set the board at six, and since that’s an even number, we’ll get three from each family. But that doesn’t deal with Gearing! What happens if the two sons get killed in an accident? The other side can call a director’s meeting and replace the two sons with directors favorable to their side, and you’d be stuck that way until at least the next annual meeting.
One way to get around this is with a R.C. 1701.591 shareholder agreement. But these aren’t used much. The legal fees are pretty high! Also, you have the same problem that you have with prenuptial agreements. A third of the time, you can’t negotiate the agreement! And if you can’t negotiate the agreement, maybe you shouldn’t get married! Also, if you get too much down on paper, you won’t get a deal. Also, sometimes when you get lawyers involved, they’ll want to kill a deal over a very small provision.
So what if we have two classes of stock, let’s say Class J
and Class S? Under
You can also have Class J voting, Class J non-voting, Class
S voting and Class S non-voting. If the
big kahunas of each family want to give gifts of shares without screwing up
voting powers, then the kahunas can give non-voting stock. You can have classes of stock that are almost entirely non-voting in many
states. However, in other states, all
shares must have a vote. Sometimes the
statutes and constitutions don’t mean what they say! Maybe the founders have shares with 100 votes
per share, but the publicly issued stock will have 1 vote per share. Often, that will satisfy state statutes and
the state constitution. In
Why did the plaintiff make the argument that he did? In the trust area, if you’re a trustee or an executor or administrator of an estate, and you do something ultra vires, the trust rule generally is that of absolute liability without fault. That rule is related to a rule on conflicts of interest. Unless a trust instrument provides otherwise, a trustee who sells stock to the trust which later goes down in value has absolute liability. Fault need not be shown. In the corporate world, if (1) a conflict of interest is fully and fairly disclosed up front, (2) there’s no injury to creditors and (3) what the director or officer did was reasonable then there is a defense. It can be hard to show those three things.
Why is there a difference between the corporate arena and the law of trust? The law of trust and executors and administrators is designed to deal with the conservation of capital, and the law of business associations deals with the same thing. However, the law of business associations is more entrepreneurial in that it also takes into consideration reasonable risk taking and growth of capital. We’ll see this again in Wills, Trusts, and Estates. The ultra vires stuff is important. What is the lawyer’s role? What are their possible liabilities?
In a major corporate transaction, the third party dealing with the corporation will usually ask his counsel and the lawyer for the corporation whether the contract has been duly and validly adopted by the corporation and is binding on the corporation in accordance with the terms of the contract. This includes, if needed, the approval of the board of directors, and, if needed, the approval of shareholders, but most transactions, even if fairly large, don’t require board and/or shareholder approval. The officers of the company can do a lot by themselves. We will see more on the authority of officers. The lawyer will have to draw up a memo saying whether shareholder approval is needed, whether it has been obtained, if the shareholders are entitled to appraisal rights, whether you need the approval of the board of directors, whether there has been a validly called meeting, whether papers have been circulated, whether you have the right vote, and finally whether the officers have the authority to do what they’re purported to do.
The attorney for the corporation may want to strike the word “duly” and leave “validly”. The two terms are not synonyms! If they were synonymous, they wouldn’t both be used. “Validly” means that “the holy water may not have been sprinkled on right, but it’s still a valid transaction.” When you add “duly”, it means that it’s been performed “in a way that would please a grand hall monitor, superintendent of an authoritarian school; square corners have been turned and everything has been done right.” You have to get the right papers at closing! You can have big headaches in court in the future, even if you win!
In the last 15 years, the Silverado accords have become a big deal. Some lawyers had a retreat and talked about how opinions ought to be worded. If you’re asked to give an opinion subject to the Silverado accords, don’t sign it right away! Double check the definitions! They’re “wacky!” Careful lawyers will add reservations related to environmental laws, RICO, equity orders, and doctrines of good faith and commercial reasonableness. They will also add a section dealing with fraudulent conveyance statutes. “They are murder!” Sometimes you can’t get around this stuff, though. To limit costs, sometimes the other side will accept an opinion of the corporate counsel if, to the best of their knowledge (not having audited or anything like that), “X, Y, and Z are true”. Then there will be a paragraph that describes when the firm is on notice of certain facts. The point is that this is tough stuff. In opinions, you’ll always have to consider ultra vires.
Some big limiting factors on corporate power are loan agreements, mortgages, notes, and other instruments that you’ve signed with creditors. The other side will ask for an opinion saying that these old agreements don’t run against the new one. So ultra vires is a big deal! Pay attention to it! It’s very important in practice!
The naming of corporations and LLCs is mostly, but not entirely, a matter of state law. There are two or three things you can do. In most states, you can pay $10 or $15 to reserve a name for 30-60 days. Trademarks, service marks, and trade dress overlap with local statutes somewhat. There is also the Lanham Act that allows many of these suits to be brought in federal court. These statutes are distant relatives of the patent and copyright statutes. They’re sort of types of intellectual property statutes.
In all states, when you authorize the issuance of stock, you
must describe it as either common or preferred stock and you must give the par value for the stock. In
What we in
Lastly, all states have provisions concerning foreign corporation (meaning
out-of-state) qualifying to do business in that state, e.g. R.C. Chapter
1703. Why do we have these? (1) They’re a big aid to the tax authorities
to know who to tax. (2) One of the
requirements of these statutes is to designate a registered agent for service
of process. Let’s say a
Why do people resist this so much? The consent to service of process statutes
don’t stop with torts in
Bendix was a case
regarding Chapter 1703 and also a separate tolling
What happens if the corporation is formed? If the corporation is formed and you have a highly formal document, namely, a 3-way novation agreement, then it will clearly be valid. A novation is a recognized “animal” of contract law. But things usually aren’t that simple!
The McArthur case talks about ratification and adoption, which are agency terms both in tort and in contract. In torts, we learn that even if there is no authorization up front and even if respondeat superior doesn’t apply, if the principal ratifies the tort afterwards, then you may sue the actual tortfeasor and the principal. For example, if you’re a bus company superintendent and a driver comes in saying: “I socked this dude on the bus to teach him a lesson because he was annoying me”, and then the superintendent says: “I woulda hit him three times”, then that is implied ratification, and the company will be liable. Ratification can be implied.
How does this come up in the context of pre-incorporation
contracts? In McArthur, we’re in
What’s wrong here? In the old days, and the new days in some states, partial performance doesn’t take a contract outside of the statute of frauds. At the time, there was no strong partial performance doctrine! The employee says that this was ratified by the board of directors, and therefore the corporation is bound. The corporation gives two defenses: (1) under British law and many American states, if the principal was not in existence when the agent made the contract, then there can be no ratification because the ratification relates back to the original event, and there was no corporation in existence on that date! Besides, if you relate it back to that date, you’re in violation of the statute of frauds! So this seems like a good argument. But what the court held was that there is a separate of related doctrine of adoption, and that the board could not ratify on April 2, but it could “hop over one compartment” and adopt, which doesn’t relate back to January 2. When we put the day at April 2, there are 11 months to go, and there is no statute of frauds problem. The doctrine of restitution would apply to any corporation that is formed.
What about the lawyer who does the work of bringing a corporation into existence? Does the lawyer have a right to get paid when the corporation is born? The cases are split. Let’s say Peter Promoter walks into your office with his wife, Paula. They want to promote a company and it will take a lot of complicated and detailed work. Can a lawyer represent both of them? You have dual clients. Under Canons 5, 4, and 9 of the Ohio Code of Professional Responsibility, you must warn them (1) of the potential conflicts between them, (2) that there is no strict attorney-client privilege and that what one tells you can be discovered by the other, and (3) that there would be advantages to each one having their separate attorney. If, knowing this, they still want you to represent them, that’s fine, with a major caveat: on every major matter, you would have to stop and explain how the major matter is favorable and unfavorable to each client. It’s a same thing when a married couple comes in and wants you to craft both their wills. This can get hairy!
Here’s a widely used hypo from CLE symposia: H & W come in and want you to draft both of their wills. The ordinary will is fully revocable until the person dies and/or goes crazy (AKA “lose mental capacity”). You draft the wills, and married couples will usually leave to each other. Three months later, W calls, saying that she wants a new will drafted leaving everything to her lover. So the first question is whether you can do that. Of course you can’t! What else do you have to do? At a bare minimum, you must phone the husband and tell him, at minimum, that you can no longer represent him vis-à-vis the will, that you’re no longer representing the wife, and that he should immediately go to a new lawyer to make a new will revoking the old one. You also have to tell the wife that you can no longer represent her at all. Representing joint clients can get sticky! Some say you have to tell H about the lover. Shipman supposes they’ll get the message when you tell them to go get a new lawyer and a new will. What if the husband says, “Why are you telling me this?” You want to make sure that nobody gets killed. Later, we’ll talk about quasi-clients in the corporate area: they’re not quite joint clients, but you incur the same duties. There are also third-party non-clients who are in privity of contract with you, for example: if you represent a corporation selling Greenacre to a third-party, and that party wants your opinion that the contract is cool, and you address the opinion to that party, that is a third-party non-client who is in privity with you. You can be liable in negligence on the opinion to him!
Here’s a hypo we were supposed to think about: Mrs. Smith
wants to buy some land for a corporation that hasn’t been formed yet. She doesn’t want the land for herself, but
only for the corporation. Can she assure
that the land is available if she forms the corporation? She’s not sure if she can get loan from her
husband and parents. We’ll represent
Smith and the corporation but not anybody else because the conflicts are too
If a corporation was either a corporation de jure (meaning
in perfect compliance) or de facto, nobody can complain about the errors. Last time, we had worked our way through
Assignment 10(d) and cases under the old Model Business Corporation Act. Under that Draconian and straightforward
position, are you going to hold mere
inactive investors to the same liability standard that you hold active
investors? The courts said no, because
the very purpose of corporate statutes is to encourage investment especially by
inactive investors and you don’t want to be Draconian. Note that in
Company v. Kunkel’s, Inc. – This case arises in a state that had the old
Model Act formula, meaning your corporation is either formed or not with no
gray area. A promoter wanted to start a
gas station. Kunkel needed additional
money and he went to two prospective investors:
The business went belly up! The seller of the gas station wasn’t paid! So the seller sues the promoter and the two investors. The testimony at trial was disputed. There are six different theories the lawyer and client will usually put forward: (1) general partnership, (2) agency, (3) joint enterprise, (4) statute, (5) third party beneficiary, and (6) guaranty.
The joint enterprise theory, like agency, covers both
profit-making activities and all other activities
(i.e. not just business activities).
There is some case law in
If there is co-ownership of a business for profit, it fits the general partnership statute, and you can reach all the partners individually. Another category is the third-party beneficiary. It may be that contractual dealings between the capitalist and sweat equity have created a third-party beneficiary. If they have, a third-party beneficiary can sue in contract. The next-to-last theory you look at is guaranty. If Smith, Inc. goes under, but Mr. Smith, the 100% owner, has guaranteed the debts of the company, then you can sue Mr. Smith. In some states, the statute of frauds may be waived.
In the present case, if you read the
Let us tie up the loose ends of incorporating. What’s the rule about the number of
Is there a minimum number of shareholders? Up to 1950, there were court decisions that
followed the European practice that since the state statutes required a minimum
of three directors, you had to have a minimum of three shareholders. Statutes in the 1960’s reversed this, and in
But: (1) In many
countries, there must be a minimum of three shareholders. In those countries, if there is an American
parent that is the only shareholder, then you get two locals to buy one share
each, and they will known as accommodation shareholders. The parent will have the option to buy back
these shares. Watch foreign statutes
carefully! (2) Even in
Always end the name of the company with “(comma) Inc.” or
“(comma) Incorporated”. That is
recognized throughout the
The goal is to file the charter, filled out correctly. It’s called the articles of incorporation in
Par value: under our statute, you can use par or
no-par. But never use no-par! Also,
never use high par except for preferred stock!
How come? Many states, like
If you go back 150 years, people usually set par value at the initial offering, at what they thought the stock was actually worth. That has ceased to be true in this country, though in some foreign countries it’s still somewhat true. Today, in this country, par value is partially artificial, though important. It’s important because the corporation must receive at least par value for the issuance of stock or the purchaser will be subject to assessment by statute and at common law for the difference. A sophisticated purchaser of stock will always ask for the opinion of the legal counsel to the corporation that the stock is duly and validly issued. Only the board of directors can issue stock. The lawyer will also have to check that the charter authorizes enough shares so that there are unissued shares available to cover the issue. If that is so, then it is not assessable, it is fully paid. If you use low par stock, like $0.01 or $0.0001, then you probably won’t have a problem, and thus that’s what most attorneys will advise. One reason you do that is to minimize the exposure of directors and lawyers under creditors’ rights proceedings. High par can be used to restrict the power of the board of directors, acting alone, without a charter amendment, to pay dividends and/or buy stock back from selected shareholders.
What is assessability all about? It goes to the heart of a corporation. The usefulness of a corporation is that you
can get inactive investors to buy stock and they have some assurance that if
the company goes bankrupt, their assets in their own possession are not going
to be liable for the deficit at the corporate level. Early in corporate history, up until 100
years ago, most corporate statutes made shareholders subject to assessment if
the corporation went bankrupt. As late
as 1960, if you filed in
There is a federal estate and gift tax. Some states have a gift tax too. If Mother is setting up a company and putting $1 million in with 1000 authorized shares at $1 par per share, and she immediately give 40% of the shares to her children as tenants in common, go see the tax lawyer because there is a gift there for federal and state purposes.
The state has records that you’ll be interested in from time
to time: The Secretary of State can give
you, for a fee, not only a certified copy of the articles of incorporation, you
can also get a certified copy of the docket sheet for the corporation running
back to formation. Plus, you can get
certified copies of everything that’s there.
The Secretary of State, also for a fee, will give you a certificate of
good standing. What does this indicate? All state statutes provide that if you don’t
make the required filings annually with the Secretary of State and/or your
state tax returns, then they can cancel
your corporation. The certificate of
good standing says that a particular corporation is in good standing with the
state. If you’re going to make a big
deal, you always send someone to the Secretary of State’s office to get
that. Also, you will have to get an attorney’s
opinion that the corporation is duly and validly organized and existing as a
In many states, you can get a certificate of tax good standing from the tax authorities. What’s the significance of that? It’s limited, but useful, according to Shipman. They will certify that there are no assessed taxes unpaid. How does assessment take place? Case law tells us that assessment occurs in the office of the tax official when that official makes the assessment by writing or typing in the office! It’s basically a claim by the tax commissioner that you owe money. Then the assessment is sent to you. This certificate will not deal with non-assessed tax claims. That is to say, all tax authorities will have informal or formal audits ongoing, or they will be planning them before the expiration of the statute of limitations. This certificate of tax good standing does not estop them as to that. However, it’s still a worthwhile document to obtain. It’s a part of due diligence. In many states, a failure to file your tax return or pay your taxes on time can mean the loss of your corporate charter.
First off, there is the de jure corporation. It has either been perfectly formed, or close enough that not even the state in a quo warranto action can challenge.
People v. Ford –
This is an Illinois Supreme Court case from around 1921. The people were represented by the
What’s this merely directory business? Many state constitutions that didn’t give
their own constitutions a lot of effect, when the state Supreme Court was faced
with a strong directive in the constitution, they would say that the statement
is merely directory, meaning it’s a
directive by the people to the legislature.
But there was no recourse if the legislature didn’t do what the
constitution said! If you’re in a state
with constitutional initiatives such as
So up at the top is de jure. As of 1940, below de jure, the average state would say even if you aren’t de jure, if you’re a de facto corporation or a corporation by estoppel, then private parties cannot argue that you’re not a valid corporation even though the state may come in a say that you’re not de jure and “cut your head off”. So in a case involving contract creditors contracting with a corporation that hadn’t gotten its certificate filed, if there’s no fraud by anybody, the contract is made in the corporate name, there was no individual guarantee from the shareholder then you have a corporation by estoppel, if not a de facto corporation. It takes a bit more to be a de facto corporation rather than by estoppel. If you’re de facto, it operates against tort and contract creditors, but if you’re by estoppel, it only applies to contract creditors who made a deal with you in the corporate name.
You know a document has been filed when you have a time-stamped copy with the official seal on it that says it’s been filed. You don’t know before that whether the document has been filed. Always print and file a day or two early. Things can get screwed up! Leave yourself time to recover!
In 1946, the old MBCA, which Shipman said was a
“hare-brained” statute, said that you’re either a corporation or not, and
there’s no de facto or by estoppel defense.
That’s the situation in Robertson
v. Levy. How far was the old MBCA
pushed? In Sherwood and Timberline,
the courts had to follow what the statute said as to the people active in the
formation and running of the company.
There’s no out! They were liable
just as general partners would be! Both
cases, however, used a lot of common sense.
As to purely inactive investors, in good faith, the joint and several liability
would not apply. That is generally true
Let’s suppose the defectively organized company itself is
suing and the articles haven’t been filed.
This means beyond the
powers. Here in
In § 1701.13, we’re given a helpful enumeration of powers. Why did they do that? In the 1920’s, when you had to enumerate your purpose, the charters would enumerate five or six purposes and then would enumerate about 20 powers and then they would say: “the purposes are powers and the powers are purposes!” They were trying to get back at the legislatures for not allowing the phrase “for any lawful purposes!” The federal and state governments decided early on that in limiting the powers of corporations they would rely more on antitrust, tax, labor, and environmental laws than they would on provisions in the charter. That’s very different from the practice as of 1800! Ultra vires remains important!
What was the law as of 1940, and how did it get up to that point? If a contract was fully performed on both sides, there is limited ultra vires relief; almost none. The exception was corporate directors or officers engaging in ultra vires acts, which creates a mild presumption of negligence. In theory, the state can come in and by action of quo warranto cut your head off for an ultra vires action.
Litwin v. Allen –
What if the bank were a state bank under
If a contract is executory on both sides, then any
shareholder of the company can sue the company and the other party and get an
injunction to stop it. R.C. 1701.13, at
the end, adopts that rule with this caveat: if the contract is partially performed on one side or the
other or if an injunction would be inequitable, then there is no relief. R.C. 1701.13 provides relief in this
area. The casebook talks about a
Say there’s an
Ultra vires and “no authority of agent” are two different defenses. Let us see why. Ultra vires means that the corporation itself, acting through all of its organs (officers, directors, and shareholders) simply does not have the power. On the other hand, when you say that the agent did not have actual or apparent authority, it’s entirely separate. The corporation is saying that the action is something that the directors and/or shareholders should have approved. This is quite separate, though related to ultra vires at times.
Suppose a particular corporate action is illegal. Shipman believes that it is a separate defense from the other two, though it is very closely related. If you’re trying to enjoin an action as a shareholder, and the directors have violated a statute, you will usually add illegality as a count of your suit. The question will be: does the statute, as interpreted by the court, give standing to a shareholder to raise the illegality issue? It depends! This question usually comes up under the rubric of “implied private right of action”. We use torts lingo. Note that illegality includes criminality but is broader than criminality. If certain conduct violates a criminal statute, the conduct will be both criminal and illegal. But if it only violates a civil statute, the conduct will not be criminal but will still be illegal.
Note that sometimes this is part of contracts lingo, though
under a different name. If a contract is
void as against public policy, either party may get a judicial determination
stopping the prospective performance of that contract. This is similar but different from the
“implied private right of action”. In
The hypothetical from Thursday
X, Inc., a closely-held
But that’s not all! Lawyers are always looking to protect themselves. “It’s a jungle out there!” Lawyers have malpractice liability to worry about. We may be asked to render an opinion that a contract has been duly and validly adopted and is enforceable in a court by its terms. We may have to render an opinion to our company and also to a third party.
Assuming that the company is solvent and has the money to invest and assuming that the board and officers have done their research in investing in the NYSE, one of the express statements of R.C. 1701.13 is that for companies like X, investing as a pure investor without control in a company doing something different from what your company does is not subject to an ultra vires objection.
Let’s assume that the company is financially solvent. One of the officers wants X to purchase 100%
of the capital stock of Z, Inc., a closely held
But let’s say X is getting their natural gas from a utility and they’re happy with it. We would tell X to look at R.C. 1701.69-.72 and propose an amendment to the articles of incorporation to allow the corporation to run for “any lawful purpose”. That will probably give rise to appraisal rights to shareholders voting against the amendments. There will probably be no problem if X is closely held.
One more point on ultra vires: if all shareholders, voting and non-voting, approve after full and fair disclosure in advance and if creditors are not hurt by the ultra vires action, then the ultra vires cause of action disappears insofar as shareholders are concerned. There are two people who can come after you: the state can come after you in a quo warranto action. Also, if what you’re proposing may violate agreements with creditors and the creditors don’t assent, then the creditors can shut down the transaction. As important as the articles are, the credit instruments of any corporation (from Exxon down to Mom ‘n’ Pop, Inc.) are just as important, if not more. In real life, you’ll find yourself negotiating with creditors for waivers, you’ll read these credit instruments to find out what is proscribed and what is allowed, and some of the credit instruments get very long and detailed.
One thing you have to often write an opinion about is
whether stock has been duly and validly issued and non-assessable. Another opinion that must sometimes be given
is on whether the corporation is duly organized and existing as a corporation
However, it is an uphill battle for people asserting disregard of the corporate fiction because legislatures have purposefully set up corporate statutes and other statutes to encourage investment by inactive investors. The very first thing that an inactive investor wants is assurance that you can only lose what you put into a stock and no more. For example, consider the case of Abbott v. Post from 1940. This case involved the pre-1933 National Bank Act dealing with insolvency of national banks. Before 1933, national banks had to issue $100 par common stock. That means the shareholders had to pay at least $100 per share of stock to the company when it was issued. The act also provided that if the bank went insolvent, each shareholder could be assessed up to par.
What was done in 1933 to encourage investment in banks? They prospectively did away with the
assessment of stock. Also, both the
This case involves a big investor in a national bank who went to a lawyer before he invested. The lawyer told him about the double liability provision. So this investor formed a personal holding corporation, put money into the corporation, and then the corporation bought the stock in the national bank. The investor was the only shareholder of the corporation. During the Depression, that national bank went belly up! The U.S. Supreme Court held that there was a strong pubic policy involved and the sole shareholder of the personal holding company could and would be reached. This had no application post-1933 because to sell stock of national banks, Congress prospectively did away with the rule.
What’s the importance in
Bartle v. Home Owners Coop. – The parent is a non-profit corporation composed of World War II veterans seeking inexpensive housing. The not-for-profit cooperative formed a 100% owned stock subsidiary which constructed houses and sold them without profit to the veterans who were members of the parent cooperative. There is no fraud or “sham” alleged (those are two of the seven possibilities for piercing the corporate veil). A “sham” is more of a legal conclusion than an aid to analysis, while fraud has some legal substance to it. But neither one was alleged. What was alleged was undercapitalization of the stock subsidiary. The contract creditors of the subsidiary, which went insolvent, wanted to reach the assets of the not-for-profit parent on the ground that the subsidiary was undercapitalized. They also alleged and pretty much proved that the subsidiary could never make a profit because the deal, from day one, was to make inexpensive houses sold without a markup to impecunious veterans who are members of the parent corporation.
When you have undercapitalization and no profit alleged in a
Consider the dissent in Bartle. The dissent makes arguments similar to two tax problems that this setup would have. From a tax standpoint, the commissioner of internal revenue could attack it in two ways: first, they could use § 482, where you have two or more persons or entities under common control or where one controls the other. The commissioner may reallocate items of income, expense, and deductions so as to fairly reflect income. The Internal Revenue Service could have come in here and said that the houses were worth $8,000 but were being sold for $6,000. It could have allocated $2,000 as dividends to the member of the cooperative parent saying that the difference is an implied dividend. The dissent argues that this same line of reasoning should apply on the disregard of the corporate fiction theory. The majority hears the argument but doesn’t find it persuasive. There are real tax problems here!
Dewitt Truck Brokers v. W. Ray Flemming Fruit Co. – Flemming’s company worked as a middleman between farmers and purchasers of fruit. Flemming paid the plaintiff trucking company to transport fruit. Flemming assured the trucking company that he would guarantee to pay them back even if his corporation didn’t. Flemming didn’t pay them in time, and the trucking company sued Flemming personally. Flemming tried to argue that he wasn’t personally liable, but instead only the corporation was liable. The trucking company, on the other hand, argued that they should be able to “pierce the corporate veil” so they could make Flemming personally liable. The district court found for the plaintiffs and Flemming appealed. Did the district court correctly find that it was appropriate to “pierce the corporate veil” and make Flemming liable for the debts of his corporation? When a person owns basically all the stock in a corporation, plus some other factors are present such as a lack of corporate formalities, undercapitalization and non-payment of dividends, or if the corporation is more or less a façade for an individual, the corporation may be disregarded for the purposes of liability and the dominant stockholder may be held liable. Flemming owned most of the stock. He never had a shareholder meeting, and he was the only real director. No one except Flemming ever got paid by the corporation. Flemming kept withdrawing whatever money the corporation had for his personal use. The corporation basically had no capital of its own. Given all this, plus Flemming’s personal assurance to the plaintiff creditor, the appellate court has no problem upholding the district court’s findings of fact. Flemming is held personally liable for the debt.
This is a contract case. It’s easier to pierce the corporate veil in torts cases than in contracts cases because a contract creditor could always, in theory, insist upon a guarantee by the controlling person or persons. In this case, too, there is no fraud or sham alleged. It’s clearly another undercapitalized corporation. It’s also pretty much like Bartle in that this corporation could never profit. In both cases, the corporation is always operating on the edge, and when a bad development came along, they went “over the abyss” into “financial hell”, or in other words, they went insolvent. Remember that if you can prove fraud or a sham, you can definitely pierce the veil. Here, there was no express written guarantee by the controlling shareholder, but there’s the “next best thing”: an oral guarantee! Here we have soft estoppel. There is not necessarily detrimental reliance. What happened here was that one of the unpaid creditors went up to the trucker and said: “Hey! You’re way behind on your payments!” The trucker said: “If the company doesn’t pay, I will.” This is the Cockerham case again! Somebody’s trying to be too (financially) macho! But that’s soft estoppel, not estoppel per § 186 of Restatement First of Contracts.
In DeWitt, the defendant brings up the statute of frauds. The statute of frauds says that a promise to answer for the debts of another must be in a signed writing. The defendant says that this is just crap! It’s not in writing and it’s not signed. But, in the last 100 years, the statute of frauds has softened a good bit, though not totally. For example, if you write out a check with a notation of what property it’s for and what the purchase price is and you hand it to the other guy, even if he doesn’t cash it, it’s held to be a signed memorandum. It describes the land and the price, so it’s found to satisfy the statute of frauds. Also, there is the doctrine of part performance, which can get you out from under the statute of frauds. When a major or 100% shareholder of a corporation makes a statement such as: “I will stand by my corporation!” The court says that he’s not answering for the debts of another, but rather he’s answering for his own debts. Post-1980, we have an Ohio Court of Appeals case stating exactly that.
Next time we’ll go over extraordinary transactions: amendment of articles, sale of all assets, dissolution, statutory merger, and control share acquisitions. All the directors and shareholders typically must approve of such transactions, and dissenting shareholders typically get appraisal rights so they can cash in their shares. This goes beyond so-called “reorganizations”, which come in two flavors: (1) recapitalization, and (2) amalgamations, or putting two or more companies together in one of several ways. In Wall Street firms, you never get a department labeled “amalgamations”; it’s always called “mergers and acquisitions”. Dissolution of the company is a big event!
All of these corporations are either corporations de jure or
de facto. In other words, the plaintiff
is not relying on some defect in formation, but instead is going to this
question: assuming there is enough compliance to be de facto or de jure, can
third parties nonetheless look through the corporate veil and hold the active
shareholders, officers, and directors liable?
There are seven different ways to do this. Public
policy is what comes up in Abbott. Fraud will always appear, though it’s
difficult to show. Soft estoppel was found in DeWitt, which was
similar to the Cockerham case. Undercapitalization
was raised in the first two cases which were contract cases.
Baatz v. Arrow Bar –
This takes place in a
The primary actor doctrine says that even though the principal may be liable under respondeat
superior, you can also sue the actor.
There are three exceptions of recent vintage, however: (1) Under the
Federal Tort Claims Act, if a United States government employee is merely
negligent, your only suit is against the federal government itself, and the
federal government cannot recover from the actor because the FTCA didn’t
include statutory provisions to that effect.
So we can sue the corporation under respondeat superior. But the problem is that the corporation has a lot of debt to the bank and not much in the way of net assets once you consider its debts. The bank has a lot of perfected first mortgages on the borrower’s property, because the bank stays in business by taking mortgages on everything. Why would the bank loan to the company when it didn’t have much capital? The shareholders were forced by the bank to sign written guarantees before the bank lent to the corporation. That’s a fact of life! Until a corporation becomes fairly prosperous with a lot of assets of its own, banks won’t make loans to it unless they get a guarantee from the shareholders.
Undercapitalization as a way to pierce the veil
This is fairly pro-plaintiff in theory. The black letter rule is that undercapitalization is a key factor, but as to common torts, if the corporation has been covered with reasonable amounts of insurance, that will be considered adequate capitalization. There was no insurance policy here! They relied on the state statute! What’s wrong with that? The South Dakota Supreme Court declared the statute unconstitutional! The plaintiff argued that even though the company had some money, the fact that the shareholders had guaranteed the bank loan was enough to show undercapitalization.
In many states, if you have some kind of immunity and you nonetheless get insurance, then that will be deemed a waiver of immunity with one exception: if the insurance policy itself has a clause saying “the writing of the insurance by the insurance company and the getting of the insurance by the insured are not considered to be a waiver of any immunity or privilege”. If you work for an insurance company, you want to put that clause in all your policies because it will generally be honored. This is also becoming an issue for not-for-profit organizations. The cost of directors’ and officers’ insurance has gone way up! The premiums have probably doubled in the last five years! Non-profits have convinced their directors (or trustees) that there is nothing wrong with that. It’s true that it’s less of a problem than with a non-profit, but it’s still a problem.
Radaszewski v. Telecom Corp. – A parent owns 100% of a subsidiary in the “gear-crunching” business. The subsidiary went to an insurance company and got a good policy. The subsidiary had a very negligent driver. The other driver was not negligent. The injured people can sue the trucking companies. But people who finance big trucking companies take out mortgages on the “big rigs”. So the injured party wants to pierce the corporate veil up to the wealthy parent corporation. There is no fraud, no soft estoppel, no mere sham, so we get to the question: if a parent owns 100% of a subsidiary is there a per se agency or partnership? But there is no per se! The very purpose of corporate law is to allow a parent to set up a 100% subsidiary. If they operate it right, the mere fact that you own it 100% doesn’t mean that the subsidiary is your agent or partner. If you don’t rule this way, you undercut the very basis of corporate law!
The plaintiffs tried to argue undercapitalization, but the rejoinder was that the subsidiary had an insurance policy. But the answer to the rejoinder was that the insurance company went bankrupt! The court holds that there was no evidence that the subsidiary knew the insurance company was on shaky ground. They made reasonable efforts to get reasonable insurance, and having proved that they’re safe.
In Seminole Hot Springs, a lawyer created a corporation to start a swimming pool. A kid drowned due to the negligence of the pool’s employees. The plaintiff sued to pierce the corporate veil and named the company and its major shareholders as defendants. The California Supreme Court held the piercing of the corporate veil quite proper against the shareholders.
Next, the plaintiff wanted to nail the lawyer for the
company because he had acted as an accommodation
director and officer because
The U.S. Supreme Court took the same view. There was a suit against the corporation (only) and there was judgment in favor of the plaintiff. The plaintiff wanted the judgment executed against the shareholders on the grounds of piercing of the corporate veil. The Court held that there was no way! If you want your judgment to apply to piercing parties as well as the company itself, you must name those parties in the original suit and serve them. This is one of the first things that the plaintiff must think about.
Good plaintiffs’ medical malpractice lawyers, when suing a doctor, never name the nurses, secretaries or aides as defendants. The big reason that they’re not named is that their testimony won’t be helpful to you if you’re suing them.
In a community property state, if H is the major shareholder and the stock is in his name, but it’s community property, to bind the whole community, you must name W as well as H because the community property under her name is not bound to the suit unless you name her! W may have more money than H if she saved her earnings! The contract rule on joint liability is that you must sue all jointly liable persons. However, with joint and several liability, you can pick and sue wealthy people first. If you win and think you can pick up more money against the others, then you can go and do it! In contract, however, that’s not so! So in a community property state, if you’re piercing against one spouse, to bind the whole community you’ll have to name the other spouse and bind him or her.
An issue in all community property states is whether the contract or tort was for the community or separate property. Check out the Nutshell to start your research. Keep in mind that in a common law state, you will not be able to reach the marital property of the other spouse if that spouse was not on the corporate board and stayed out of the spouse’s business.
Fletcher v. Atex, Inc. – Maybe courts will toss these terms around as conclusions: “mere agency”, “mere instrumentality” and “no separate personality”. When you have a parent and subsidiary, you will have lots of overlap of the officers and directors. You will also have, in a well-run corporation, good coordination of management and cash flow. Those management tools virtually give a license for disregard of the corporate entity, according to the plaintiff, but the court says no.
The Sixth Circuit said that disregard in the environmental area would be narrow, would require great proof and that state law disregard could be “disregarding”. Souter, writing for the Court, says that the federal government and state agencies can rely either on the statute or on general disregard law under state law. He gets into some more technical points. Does the plaintiff make out his case merely by showing that most of the officers and directors of the subsidiary are also officers and directors of the parent? Not necessarily. It’s not dispositive.
In Fleet Factors out of the Eleventh Circuit, it was a Superfund case and the company couldn’t pay. Fleet Factors, however, was wealthy so the government went after them on the basis of a loan agreement between them and the little company. The government claims that the loan agreement was so broad as to make Fleet Factors either an owner or an operator for the purposes of the statute. There was a big cry in Corporate America, and the EPA issued a regulation purported to overturn the case! But that’s not all! The D.C. Circuit held the regulation invalid! If you work in environmental law, this case casts a long shadow. So work with an environmental lawyer early!
If you’re a parent, do your due diligence! There’s also a Fifth Circuit case in which a company bought most of the stock of a subsidiary and left most of its directors there, but then added one of their own directors and a couple officers. The Fifth Circuit held that the fact that they left most of the old board there was heavy evidence against disregard of the corporate entity.
Stark v. Flemming – A senior citizen is about ready to retire, but she has no Social Security. She goes to a lawyer, and in order to qualify for Social Security, she put real estate into a business association and took down a salary. The federal government sued and wanted the court to declare that because she did this simply to qualify for Social Security, it was per se bad. But the Circuit said no! If she performed the services, and the wages were reasonable, then it’s okay!
Roccograndi v. Unemployment Comp. Bd. of Review – Three shareholders in a family corporation appealed a ruling saying that they couldn’t basically lay themselves off from their own company to collect unemployment checks because they were really self-employed and had the power to work or not work. Can the corporate entity be ignored for the purposes of determining whether the claimants are statutory employees or if they are self-employed? The corporate entity may be ignored in determining whether the claimants are just self-employed people whose business wasn’t going so good at the time. It seems pretty tricky to vote on who will get laid off each time there isn’t enough work to go around. This court sees right through it. The administrative rulings against the claimants are affirmed.
Here is another social insurance case. Here it’s unemployment insurance. A family owned the stock of a corporation. If you worked a certain number of hours per week, then you got unemployment compensation if you were laid off. The family arranged it such that different people worked the minimum hours to get the unemployment compensation. The public policy exception was invoked to pierce the veil!
Cargill, Inc. v. Hedge
Pepper v. Litton – Litton was the sole shareholder of Dixie Splint Coal Company. Pepper sued the company for royalties he was due on a lease. Before this case came up, Litton made the company confess a judgment, pay him claims for back salary, and then declare bankruptcy. The district court disallowed Litton’s claim, but the Court of Appeals reversed, saying that the previous judgment was res judicata. Did the bankruptcy court have the power to disallow Litton’s judgment against the company of which he was the sole shareholder? Bankruptcy courts sit in equity and can set aside deals that don’t have the hallmarks of an “arms-length bargain”. Basically, the Court says that you can’t hide behind a one-man corporation to avoid being liable to creditors.
Equitable subordination is a “halfway house” to piercing of
the corporate veil. If the veil is
pierced in bankruptcy, you don’t have to get to equitable subordination. The district judge was outraged! He didn’t hold that they would disregard the
corporate entity. The
Sale of assets, statutory merger, and control share acquisition
R.C. 1701.73-.76 says that if you’re going to have a sale of
substantially all assets, the directors must propose and the shareholders must
approve. With a public company, the
proxy statement will also be subject to the Securities Exchange Act of 1934. R.C. 1701.86-.91 say that if the shareholders
vote to dissolve the company, that gives the directors the power to sell the
assets. What’s the difference? R.C. 1701.73-.76 deals with the situation
where the company will sell all its present assets, take the money, and start a
new business. If you’re going to do
this, you must give the dissenting shareholders a cash appraisal. If, on the other hand, the board of directors
is empowered to sell the assets in dissolution pursuant to R.C. 1701.86-.91, there is no appraisal right. What does this mean for a lawyer? It means that if you’re going to dissolve,
adopt only the resolution under R.C. 1701.86-.91 and do not, on top of that, adopt a sale of assets resolution, because
if you do the latter under R.C. 1701.73-.76, the dissenting shareholders will
get appraisal rights. Under 1701.95, if
the directors don’t do that, they are individually personally liable jointly
and severally. That tends to get your
attention! Therefore, if it’s a
manufacturing company and there is a R.C. 1701.86-.91 resolution and they sell
their assets to GM, they will realize that there may be products liability in
the future. What do they do? They go to an insurance broker and buy tail
coverage from a solvent insurer. It’s
the same kind of coverage a doctor or lawyer buys when they retire. It costs a premium on top of what normal
yearly coverage starts. You don’t want
to move to
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:
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”.
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.
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!
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
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!”
Ray v. Alad – This
case is out of
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:
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:
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!
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
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. 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
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.
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.
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
Preemptive rights in
Courts used to say that there were preemptive rights in
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
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
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
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
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.
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
That’s the rule as of 1930.
Then, in McCollum, a
After World War II, statutes came about like R.C.
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
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
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
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
Rule 504 or 506 can be used in preference to § 4(2).
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
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.
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
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
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.
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.
But I didn’t have a chance to get the hypothetical down.
How do we approach a problem? Rule
things out. First consider the ultra
vires/1701.13 problem. The corporate
charter must have an “all lawful business” clause. If there is an ultra vires problem, you go to
1701.69-.72. There must be a charter
amendment and it will likely create appraisal rights. What about 1701.14 preemptive rights? Under .14 and the common law, if you’re
issuing stock for non-cash property, there is an exception. What about fiduciary duties under
1701.59? Due diligence must be done
concerning a transaction. You must get
financial statements. Rule 10b-5 applies
to a securities offering. The U.S.
Supreme Court, in Gustafson in the
1980’s, held that 12(a)(2) doesn’t
apply to unregistered private offerings.
§ 14(e) deals with tender offers for any security, public or private,
but it must be a tender offer. The big
worries of the guy are going to be §§ 1707.38-.45 and .29. The criminal mens rea test in
The instructions for the exam
It will be three hours long and it will where the registrar
says it is. There are two key
points. We’ll be an associate at a law
firm. It will have an office in
December 1996 Exam Question One
Unless otherwise stated, we can assume that all conflicts of interest have been cleared. We can also assume that all clients are paying by the hour. Here we have BCD, Inc. formed in 1985 by Mr. Smith, who purchased 1,000,000 shares for $.01 each at par. His sister, as an accommodation, purchased 50,000 shares at the same price. The sister is a physician and has a lot of money. None of the other directors has much wealth. Generally Accepted Accounting Principles are applied. In auditing the statements of a company, the auditors proceed under GAAS: Generally Accepted Auditing Standards.
Sarbanes-Oxley caused an accounting oversight board to be created. Its relationship to the FASB has yet to be determined. Its relationship to accounting standards is going to be quite heavy. The money for FASB and the Accounting Oversight Board comes from fees charged to public companies. The AOB is subject to oversight by the SEC.
CPAs are licensed by individual states. There’s a standard nationwide exam, so it’s pretty easy to get admitted in different states as long as you pay the fees. The CPA owes its first duty to public investors and creditors. Then they owe a duty to the company. The independent CPA firm is paid to “tattle” on the person that pays it! It’s like being required to pay your spouse’s lover.
There is some chance that the insurance company will say that the coverage doesn’t fly, and the insurance company will probably win. So there’s probably no coverage! She wants to know what her exposure is. There will be big legal fees.
First we’ll want to see whether she had no knowledge or reason to know of the cooked books. There are no criminal worries if this is true. There could be a trustee in bankruptcy action, but there probably isn’t recklessness on the part of our client. Her medical license should be dealt with by a lawyer in the firm who deals with the medical board. We must show that she had no knowledge. So hopefully her medical license will not be affected. What about taxes? If she received money for being a director, then her legal fees and what she has to pay in settlement will be tax deductible. She has a good income as a physician. So talk to a tax lawyer. This may all be deductible as she pays it. She might ask whether she should transfer assets to her husband. No, because that would be a fraudulent conveyance and it would also look bad in the litigation. Hopefully, she has a family trust for the benefit of her husband and children with spendthrift clauses.
In practice, you’ll find that the independent investment advisor and the estate and tax lawyers are always trying to get people to set up trusts with spendthrift clauses. But it’s hard to get people to do that. There’s a substantial gift tax payable and they don’t want to part with control of the money.
If we can show that she is “pure as the driven snow”, then we’re in good shape because it’s hard to prove scienter against someone who is trying to do the right thing. This is for the purposes of Rule 10b-5. In addition, the 1995 Federal Act puts a number of procedural inhibitions upon plaintiffs who want to file. You can get around them with a good case, like the Citigroup case, where the plaintiff’s lawyer knew just how to get around it. § 12(a)(2) is a strict privity section, and she wasn’t in strict privity with any of the victims. But we must double check that she hasn’t pulled a “Martha” in the last couple of weeks. She says the first news she had was yesterday, but we must make sure she wasn’t selling any stock before that.
What about § 11? The
first big deal is that this statute is negligence-based. If a plaintiff’s lawyer has a shot at good money
under § 11, they’ll go under § 11. But
.38 to .43 of the
If the defendant can prove no legal cause or
causation-in-fact or partial no
causation-in-fact, then that is a defense.
There are two
There were bogus accounts receivable and the nature of those accounts was not disclosed in the prospectus, obviously. The company has virtually no defense under § 11 except the statute of limitations and § 11(e). No plaintiff will collect much of anything from the companies.
Let’s divide the prospectus into the narratives and the certified financials. As to the narratives, where the directors are not relying on experts, the director must prove for a defense: (1) she made a reasonable investigation, and (2) after such reasonable investigation she reasonably believed the prospectus narrative material to be true. As to the expert material, the test is different. There is no requirement of reasonable investigation as to the certified financials. The test is simple: did the director reasonably believe the certified financials to be true? In the real world, a lot of material crosses over between the two categories. It’s not absolutely clear whether she made a reasonable investigation.
What about another possible defense for our client? Legislation from the 1990’s provides under § 11 that there is no joint and several liability; it is several only. That means that if we can slot her into that, and the jury finds that of the 100% of fault involved she contributed only 3%, then we would simply multiply the liability by the percent and that would be her liability. It would still be a lot of money, but note that if she doesn’t qualify for this, it’s joint and several liability.
The Securities Act of 1933 was based in part upon the
English Companies Act and in part on state “Blue Sky” law in the
Probably the plaintiffs’ lawyers are looking for big money
from the accounting firm. They will want
to settle with our client early. You
like to settle out with peripheral defendants early for modest amounts because
it’s very expensive to finance a class action.
Under R.C. 1701.38, Shipman thinks her liability is about the same. What about the liability of the accounting
firm? That’s under § 11 and also under
the Rest.2d of Torts § 552, which is negligence-based and would provide a
similar result to the federal result.
The seminal case in
Two or three loose ends from yesterday:
Would our client from yesterday have any indemnification
rights or rights over the independent CPA firm, the investment banking firm or
Law firms seldom say that they’re undertaking a 100% investigation or an audit. There are exceptions to that: if there is a sexual harassment claim in a corporation and four of the seven directors authorized the investigation of the fifth director, then the law firm will be extremely careful and investigate the facts fully. Generally speaking, however, they expressly state in their opinion that they are relying on facts supplied by officers and in the normal course of events, if there is nothing strange about what the officers tell them, they can do so. Both CPA firms and law firms will sometimes require officers’ certificates. They will have the officer read, sign and date it. If you’re an officer, be careful!
In Sarbanes-Oxley § 404, as to public companies, there has to be a system of firm internal controls established. This has led to an elaborate system of subaffirmations that top management requires from division managers, addressed to them. This creates additional expense, to the tune of $4 million a year for a $1 billion company.
For lawyers, in giving opinions they will negotiate in the initial agreement that in certain matters they may reasonably rely upon officers’ certificates. That’s a good way to cut down on legal cost. In a public offering, the outside law firm’s duties run in two different directions: (1) to the officer and directors, and (2) to the quasi-client. If the lawyer knows or reasonably should know that what is being done violates the law, then the quasi-client (buyer of the security) can sue the lawyer.
In Tomash, which had to do with indemnification, the director there had asked the lawyer for the company whether what he was doing was legal, and the lawyer said: “Go ahead, it’s legal.” The lawyer was wrong, and an SEC injunction was issued against him. His best cause of action was against the corporate lawyer who gave the advice, and then under respondeat superior against the corporation.
What about the legal opinion to the underwriters? It’s a long opinion on many matters. The outside law firm would be liable to the underwriter. One opinion, for example, is that the corporation has picked the correct SEC form to file on. In the case of a mistake, there is clear liability. Lawyers never opine that there has been full compliance with the federal securities laws because these laws include anti-fraud provisions and there’s no way that the lawyer can be clear that he’s getting the full story from all the officers. However, the underwriters do require an independent opinion concerning the truthfulness of the prospectus. “Based on what we know (without a full audit or full investigation), nothing has come to our attention that causes us not to believe that the prospectus is truthful in all material respects.” The next sentence will say: “The preceding sentence does not relate to the financial statements.” In the real world, there is a lot of overlap between the narrative and financial statement portions of the prospectus, and one of the big issues is whether there was an overlap in the case we talked about.
What about the law firm’s liability to the client? Their opinion is limited and there is
probably no possibly of liability. But
lawyers can be held liable. One of the big law firms in
One more thing about deals, registered and unregistered: as to the unaudited interim statements (CPAs only audit annual statements), you can get a “comfort letter” from the CPA firm. The purchaser will require such a “comfort letter” concerning the unaudited statements. It reads much like the attorney’s negative opinion: “We have not conducted an audit or a complete investigation. This is supplied to you alone; nobody else may rely on it. The opinion may not be assigned or transferred and it applies only to this deal.” Lawyers in practice refer to this as dealing with the “sister-in-law problem”. Say you’re asked for a big opinion for a client. Suppose the guy gets the opinion and the sister-in-law has a similar problem, and the guy copies the letter for her, but it doesn’t fit her situation. If you don’t have that clause, it’s possible that the sister-in-law can sue you.
They will also state: “We have conducted certain limited inquiries concerning the unaudited statement. To the best of our knowledge, in our opinion [to prevent a warranty or contract], based on what we know, the interim statements contain no material untrue matter and they are consistent with the bases on which the audited statements were prepared.”
Comfort letters are useful for three reasons: (1) The letters come with a prestigious letterhead. (2) The accountants take this seriously, even though they don’t audit. (3) You probably trigger R.2d Torts § 552 because the auditing firm is on notice of special foreseeability.
There are instances in which it would be wise to get audited statements for the six month period if you’re really suspicious. But it will take a while a cost a lot of money. It costs almost as much to certify a six month period as it does to certify a twelve month period.
In general, the Securities Act of 1933 deals with offerings by issuers and affiliates of issuers that are public nature. If an offering is private, 4(1), 4(2) and Rule 506 will usually exempt them. The Securities Exchange Act of 1934 deals primarily with the day-to-day trading markets, both the stock exchanges (NYSE, AMEX) and the over-the-counter markets (NASDAQ).
If you’re a big public company, there is nothing that will exempt you from registration, but you’ll get shorter forms under the Securities Act of 1933. Be aware of these two forms: under the ’33 Act, you use S-1 if you can’t find a simpler form. We have talked about the S-8, which is a simpler form for employee stock options and employee stock purchase plans. The S-8 can only be used by public reporting companies.
In the Securities Exchange Act of 1934, at § 12 we find talk
of registration of securities, too. The
big form you use, either with a stock exchange or with NASD is Form 10 under
the ’34 Act. In addition, you will have
to file a listing application and signed listing agreement with the stock
exchange or NASD. If you’re a new
company, going public, you usually will list on an exchange or on NASDAQ at the
same time that you have your ’33 Act statement approved. But you don’t have to say the same thing
three different times. Once your S-1 is
effective, you just fill out the first couple of pages of the Form 10 and
listing application and then attach your ’33 Act statement to it. Then you incorporate by reference. This information is publicly available in
At § 10(b) of the Securities Exchange Act of 1934, fraud is
prohibited in connection with the purchase or sale of any security by any
person. It covers everything! It’s not often useful to plaintiffs due to
the restrictions of the ’95 Act and the fact that you always have to plead
scienter with great particularity.
However, the last two U.S. Supreme Court cases on the subject have
turned out to be very pro-plaintiff.
American investors bought warrants in a
§ 14(e) of the Securities Exchange Act of 1934 relates to any tender offer by any person for any security. If you make a tender offer to a little company and you use the mails or means of interstate commerce, you’re covered. But § 14(e) does not specifically require the use of the mails or interstate commerce. If you’re using it affirmatively, it’s usually present, so plead it and prove it. The Supreme Court has held that where the statute doesn’t require an interstate commerce connection but the plaintiff proves it, you’re okay.
Compare §§ 12(a)-(b) and 12(g). §§ 12(a)-(b) are voluntary because no one is required to list their securities on a stock exchange. § 12 (g) is mainly mandatory in that if you have over 500 shareholders and over a certain amount of money in assets, you must file. § 12 (g) also permits voluntary filing. Why would anyone want to do that, though? The answer comes from the Williams Act. The big deal is §§ 13(a)-(b): public periodic reporting with the SEC is required. Once you go public and list on the NYSE, you’ll be filing reports thereafter. Under §§ 14(a)-(c), you have proxies. Under § 16, you have insider trading reports. § 16(b) has to do with recapture of short-swing profits. § 16(c) deals with an officer, director, or 10% shareholder and says that a short sale is a crime. A short sale is a sale of stock you don’t own. You sell short when you think the stock is going down. In the 1920’s, the CEO of a company sold his stock short and made a mint! This was deemed “un-American”! Also, you can’t sell “against the box”, meaning borrowing it from your own stock certificates in your safe deposit box. You have to actually transfer the certificate when you sell the stock!
The Williams Act, §§ 13(d)-(e) and 14(d)-(e), deals with control share acquisitions and tender offers. §§ 14(d) and 13(d) are restricted to § 12 companies. But there’s an oddity: § 14(e) and the regulations thereunder apply to tender offers for any security, whether registered or not. For a private company, go to the regulations for § 14(e) and Rule 10b-13. For a public company, go to § 14(d) and regulations plus § 14(e) and regulations plus Rule 10b-13. Most regulation of tender offers today is under state law but the federal law is important, too.
There are two other ways you can become subject to § 13. If you’re a public utility holding company or an investment company, those statutes incorporate the Securities Exchange Act of 1934 provisions. Under § 15(d) and regulations of the Securities Exchange Act of 1934, if you file an effective Securities Act of 1933 statement, you become subject to § 13. Now go to 15c-(2)(11), which says that the SEC has power by regulations to govern quotations for securities on a stock exchange or the over-the-counter market. Rule 15c-(2)(11) is mind-boggling, but it has a simple purpose: before this Rule, if you were a securities broker-dealer and you wanted to enter into the NASD quotation system, you could do it for quotations for a company not subject to § 13 of the Securities Exchange Act of 1934. The Rule reverses this: no broker-dealer will enter quotations for a company not subject to § 13 of the Securities Exchange Act of 1934 into a quotation system. There is one exception, which is if a broker-dealer, on his own, gathers material substantially similar to what would be in the SEC file for a § 13 company, in which case the broker-dealer can enter quotations. This would be easy for an insurance company because, for 100 years, state law has required insurance companies to maintain mountains of public periodic information at the state capitol. It’s difficult aside from insurance companies to do this.
Hypothetical on § 12(g)
There is no conflict of interest. We never represented the person before
today. She should clear it with her
boss. She’s the COO, and she must work
for a CEO and the board of directors.
Recall the Bernie Ebbers problem.
Bernie found out that a guy was selling stock without his
permission. He took him out to eat, and
when they got back, his office had been cleared out. Consider Rule 10b-5 and R.C. 1707.44: if you
sell securities of an insolvent person and the other side doesn’t know of the
insolvency, that’s a crime under
Would a § 13(d) report have to be filed? She owns far less than 5% of the shares outstanding. Why do we raise this issue? The rules under § 13(d) deal with beneficial ownership. Probably no problem there. A § 16(a) report would be due under Sarbanes-Oxley. It must be done electronically within two or three days. This won’t be a problem because most bigger companies have people either in the corporate secretary’s office or general counsel’s office who are equipped to make these filings for her, and with advance consultation with those people she could get them to file the report on her behalf. If she happened to be out of town on the day that it’s due, she could give those people a signed, written power of attorney to file the reports. If you’re over 5%, there will be both a § 13(d) report and a separate § 16(a) report. What’s the theory behind the two sections? Under § 16(a), the market pays tremendous attention to what the insiders are doing. Under § 13(d), it’s an early warning system of a possible takeover bid. If you’re over 5%, whether or not you’re an officer, director, or 10% holder, you’ll have to report. We don’t think there’s a problem under § 16(a). Corporate insiders hate this, but the system works pretty well according to Shipman.
§ 16(b) says that if the client or people within her beneficial ownership range purchase and sell within a six-month period or sell and purchase within a six month period, then any shareholder can bring a suit and recapture the difference. Even if she is pure as the driven snow, it’s no defense. What’s “sale and purchase”? Let’s say that looking back six months over her beneficial ownership range (that is, your family, trusts and other close people). We look backwards first and see if she or anyone in her beneficial ownership range has made a purchase in the past six months. If it was more than six months, we look forward. It makes sense that if she buys stock for $10 and sells for $70, it’s clear she’ll be hit with $60 per share recapture. But if she sells for $70 and then purchases for $40, $30 per share will be recaptured. We have to warn her about the future!
Next up, we go over Rule 144, which never applies to a company that is never public. This Rule is very favorable to public companies and their insiders and those buying in exempt transactions from insiders. Our client is under Rule 144 even if all the stock she bought was option stock or stock she bought through a broker on the securities market because she is an affiliate as defined in Rule 405. We make a checklist for the company: are they current in their § 13 filing? If not, we can’t use the Rule. Next, we compute her beneficial ownership (including ownership by her husband and kids and live-in mother/mother-in-law, family trust, partnership and charitable organizations that she runs). We look at those people’s transactions and see if this proposed transaction, coupled with others, will pass the volume limit test. We explain that it must be a brokers’ transaction. Next, if she has acquired any security in an exempt transaction from the issuer, there will be a holding period of one year that will attach. In addition, any securities of that nature that she has will have a legend on them, and she’ll have to go to the transfer agent and get securities without a legend because legended delivery is per se bad delivery. It must be squeaky clean!
She will have to timely file a Form 144. If she was over 5%, she would have to do
three different filings! In practice,
half of the transactions have to be unwound, but people screw it up. You’ll be dealing with a local office of the
brokerage house. When the Form 144 hits after the transaction, the
The company may have filed a stop transfer order with the transfer agent because she’s a #2 officer. How do we deal with this in advance? The transfer agent will usually accept the written opinion of internal counsel that it’s okay. Get that file in advance with the transfer agent. That will eliminate the stop transfer order. The internal counsel will usually request the opinion of the personal lawyer for the officer or director and we can give it. Lastly, the brokerage house that she has got her to fill out a questionnaire, with one question being: “Are you the officer or director of a public company?” Many brokerage houses also require the opinion of the internal counsel for the company and again, on that opinion, the internal counsel will usually require our opinion as a condition precedent. It is a bit complicated, and there is a lot of paperwork.
She should pick a specific certificate with a high tax basis. She should use specific identification. For § 16(b) purposes, you cannot specifically identify. A court will pick the stock with the lowest basis. Probably all of her stock has a basis lower than $70 per share. A lot of it is probably option stock for which she may have paid $20 or $30 per share. You will have to go over the tax effects with a tax attorney.
Make sure to get reasonable diversification of investments! If all our client’s wealth is in her house and this stock, she would be well advised to sell some of the stock and diversify her portfolio a bit. At Enron, there were mid-level executives in just this situation, holding millions of dollars in Enron stock on January 1 of the year. By the end of the year, the stock was worth $0.10 per share rather than $70 or $80. The company looks very good and she seems to have been there a long time. On the other hand, if all she has is the house and this, she has lumped all her eggs in one basket. But on the other, other hand, if you take out a second mortgage you can deduct the interest for federal income tax purposes.
Especially in big Rule 506 transactions, there will be a covenant to register. For example, venture capitalists come in and advance money under Rule 506 for stock. They usually won’t do it unless they think the company will have a chance of going public down the road. They will require a covenant to register the stock that they purchased under certain conditions. Usually, there is not one, but two or three rounds of venture capital financing before a company can go public. The contract to register is a valid contract. Note this practical limitation: if you’re a venture capital outfit and you’re investing in a company and the contract to register is conditioned on the company “turning the corner” and starting to make money, you still have to find an investment banker interested in such transactions.
In addition, if it is agreed that the company will go public, the underwriters will not let the venture capitalists sell over one-half. This is a matter of merchandising. If the venture capitalists want to sell more than that, it looks like a bailout and the offering won’t take. The underwriter will require signatures for a lock-up period, usually nine months, from the venture capital types and the twenty top employees holding the most options. One of the prospectus items will be the Rule 144 overhang. The underwriter wants nine months during which the insiders will not cash in. At the end of nine months, when Rule 144 will be fully effective as to people who have held the stock for a year or more and as to non-executives who want to sell, the market price of the stock will go down an average of 8%. It’s a risky business to take a company public, but it can also make you a lot of money! Underwriting fees can approach 6%. There are also attorneys’ fees and auditors’ fees that will run the total cost up to 9%.
None of Regulation D itself deals with affiliates. Also, if a company is public, Rule 144 has a volume limit. Say you have a situation where Smith owns 80% of X, Inc., a closely held company. GM or some other big company comes along and wants to buy X, either for cash or stock (which would be tax-free). Can Smith, an affiliate, sell to GM? Smith can’t use Rule 144 because, among other things, Rule 144 never applies to a company that is never public. He can’t use § 4(2) because that is limited to the actual issuer. Smith can use § 4(1) plus § 2(11): when you put them together, the controlling person can, in this situation, sell to GM so long as it is a non-distribution. The first sentence of § 2(11) talks about distribution. If something is a non-distribution, then when you put § 2(11) together with § 4(1), you have an exemption. This will be a non-distribution if Smith meets the test of Ralston Purina: (1) there is full and fair disclosure up front, (2) the purchaser can fend for himself, (3) the stock is legended and there is an investment letter, and (4) GM is given access to Smith and all top executives. So, there does exist a § 4(1) exemption under this situation. It’s a bit trickier than using Rule 506, but if you’re careful it can be done.
Today, we’re mainly talking about corporate norms and the power of shareholders.
The stock changed hands.
McQuade paid the money and took over as treasurer. He performed well. One day,
But the exceptions have grown. The first exception is found in civil service statutes: if you have a civil service protection with government and you are wrongfully removed without cause, you can go into court and get an affirmative injunctive order for reinstatement. The second exception comes in the 1930’s with federal labor legislation: if you were fired in violation of the union contract or federal labor laws, you, or the union on your behalf, could go into court and get affirmative injunctive relief for a wrongful discharge. The third exception was tenure in educational institutions, which has grown over the last ninety years. If you have tenure and are dismissed, you can go to court and get reinstated. The fourth exception is found in state and federal equal employment statutes from the 1960’s and 1970’s. You can sue for reinstatement. Most plaintiffs will opt for money damages, though, because you don’t want to go back to a job where they don’t want you. The fifth exception is that if you’re wrongfully dismissed from state employment in violation of state union laws, you and your union can get you reinstated. But people will often choose damages instead.
Lastly, there are two “new kids on the block”. Arbitrators can grant remedies that courts
cannot unless the arbitration agreement states to the contrary. In Staklinski,
from the Court of Appeals of
In the Gigax case
from the Court of Appeals in
Two opinions from Minnesota in the 1970’s in Pedro v. Pedro dealt with a company that had been run by Pedros for generations without an employment contract or .591-type agreement. One day, one of the Pedros was fired without cause. The Minnesota Supreme Court held that because the company had a tradition of jobs for all qualified Pedros, he could collect.
Keep in mind that the trial court held that both parts of
the agreement in the present case were valid, but they couldn’t grant
reinstatement. This is correct for 1921,
though these exceptions have been created since then. McQuade had done a good job, and he was not
fired for cause. The part of the
agreement that purported to bind the two people qua directors was not okay, and was contrary to public policy. It was contrary to corporate norms, and hence
unenforceable. Note that McQuade got
screwed! He paid out all this money for
minority stock. They kicked him out and
took his money! The court also alluded
to the fact that McQuade was a public official and he violated
How far could McQuade have gone with an enforceable contract
Say McQuade had
entered into a five year contract, the board approved it, and it’s in
writing. Could he then be dismissed with cause? The answer is that of course he can. But could
he be dismissed without cause? If McQuade had an agency coupled with an
interest and the contract stated that it was irrevocable, this makes for a
tenth exception. McQuade bought stock,
though he didn’t buy it from the corporation.
If he had bought the stock from
the corporation, it would have been an agency coupled with an interest and if
there was an irrevocability clause, it would have been irrevocable. After World War II, statutes in both
Galler v. Galler –
We have two brothers with about 46% stock holdings each and 8% to a minority
shareholder who was a high executive employee.
The brothers did some tax planning together and entered into an
agreement as to what would happen after the first brother died. There were provisions as to voting of the
stock and there were also provisions on payments to the widow of the deceased
brother. Those payments were limited,
creditors weren’t hurt because of the limits, and in addition, the payments
could only be made if they were income tax deductible. So the first brother dies and the widow of
the second brother sues for specific enforcement. There are three different sets of litigation. There is no close corporation statute in
What’s the difference between this case and Clark v. Dodge? The difference is that we had one non-signing shareholder: the 8% minority holder. The court wants to hold for the widow, and they hold that the minority shareholder didn’t object and that he wasn’t really hurt. Therefore, the agreement was upheld. The litigation was long and vicious.
Matter of Auer v.
Dressel – Here we get wild! We have a small, public
What were the purposes of the meeting in the call? It was to remove the directors for
The dissident shareholders wanted to put before all the
shareholders assembled at the meeting a resolution that seems to read like an order for the board to reinstate the deposed,
loved president. The court is shifty and
subtle! They admit that in
In many instances, the shareholders cannot put in mandatory
resolutions, but in many of those instances where they can, they can change the
language to: “We respectfully request the board to do such and so” and be able
to put it in. Be cautioned that (1) in
These start out in 1960.
They are also known as “confession of judgment” clauses. What are they? In around 15 states, these clauses were
routine both in consumer and commercial transactions. In
In the 1970’s, the U.S. Supreme Court took up two cases in
the 1970’s under the Fourteenth Amendment related to cognovit clauses. In the
These clauses are widely used in commercial transactions in
One more bit about agency: the problems that have talked about death and insanity revoking powers of attorney have caused problems for a long time. In World War II, nearly every state enacted a “Servicemen’s Statute”, providing that if you were a serviceman, you executed a power of attorney before you went to fight overseas, you told your spouse to sell Greenacre, your spouse negotiated with Mr. X to sell Greenacre, and a contract was signed, then if neither the spouse nor Mr. X knew that the serviceman had been killed before the contract was signed, the contract would still be binding. At common law, before these statutes, that was not the result; the contract would not have been binding. On big deals, then and now, the third party dealing with the serviceman will insist that the serviceperson transfer to a revocable trust with a bank as trustee, since even today you can avoid a lot of these problems.
Thirty years ago, a “new kid” arrived on the block. By statute in all states, durable power of attorney say that if someone in a signed, dated power of attorney writing states that “if I lose my legal capacity to act for myself, then Ms. X is my agent for all of the following matters”. The power of attorney can be springing. So long as the person is in their right mind, Ms. X has no power. On the other hand, the power of attorney can be by a fully competent person. They can have their lawyer draft a durable power of attorney for Ms. X while he’s fully in his right mind. So long as the principal retains his sanity, the power of attorney can be revoked by him. If he loses his sanity, and thus he himself cannot revoke, how can it be revoked? It can be revoked through a proceeding for the guardianship of the person and the property in the probate court brought by the relatives of the principal. Suppose the daughters don’t like Ms. X and think that she’s not taking care of him well and squandering his money. They can go into the probate court and ask that, for example, the eldest daughter be appointed guardian of the person and of the property. That appointment will cut off Ms. X’s powers. Note that the durable power of attorney will not give Ms. X the power to commit the subject to a nuthouse. She would have to go through very formal procedures at the probate court. The court would have to appoint an attorney for the man to determine if he’s a nut.
The newer kids on the block are the living will (by statute in the last twenty years) and the health care power of attorney. You can go to a lawyer and have drafted a health care power of attorney appointing certain people to have your health care power of attorney if you are unable to work with the doctors in the hospital. But note that so far as the property is concerned, the “old kid on the block”, the revocable trust is often the best available choice. The old man can revoke that trust at any time while he’s competent and get control of the property back. Also, the bank can never be appointed the guardian of the person; it can only be the guardian of the property. The proceedings in the probate court are public, and most families hate to deal with it. Finally, as an attorney involved in such matters, keep in mind that you should tell the person under a power of attorney to account annually to the children and spouse and get them to approve. Note also that the Code of Professional Responsibility gets tricky if a lawyer acts in these capacities.
Gottfried v. Gottfried – When minority shareholders sue the company to force a dividend, the business judgment rule will apply. You’ll have to show gross negligence, bad faith, or fraud. In this case, the minority didn’t get along with the majority, but the court pointed out that the directors had redeemed a lot of preferred stock and that actually a good bit of money had come out of the company and that the business judgment shield was not shredded. Tax-wise, these transactions are covered by Internal Revenue Code §§ 301-302 and 306. Within the past two years, many types of dividends of a Sub C company are taxed with only half of the amount being included in gross income. It is a partial relief of the double tax and it is crucial. Where stock is redeemed, the transaction may be a capital gains transaction or it may be a dividend transaction.
Donahue v. Rodd
Electrotype Co. – The
The minority employee, and later his widow, argued that
either the transaction with the old man ought to be rescinded, or the same
offer should be made to the widow. It’s
an equal protection argument under the guise of fiduciary duties. On these facts, the
Here is a paradigm
hypothetical. Father is asked to
invest in the stock of a company where his daughter is the majority
shareholder. Suppose that’s his only
child, he’s not married, and he can afford it, but he wants his money back in five
years. How will his attorney set it
up? He’ll buy the stock with a redemption agreement whereby the company
agrees to redeem the stock at fair market value in five years. Fair market value will be defined as fair
market value without minority discount. That is, they will value all the shares and
spread the value among them. But that’s
not enough! Father’s lawyer will have to
include a requirement that the company first amend its regulations and have all
shareholders ratify the redemption agreement in advance therein. If he fails to do this, Father may get caught
In one case, a minority shareholder had veto power over
dividends. He was wealthy and wanted zero dividends. The younger people needed dividends to get
living expenses! This ended up in a suit,
and the court held that a minority shareholder with veto power will be
considered a de facto controlling shareholder and will thus be subject to the
same liabilities. Likewise, in
R.C. 1701.95 refers us back to .04-.06 and .11-.37. There are two
tests for a stock dividend in
The second test which must also be met in
There is a crucial Fifth Circuit bankruptcy case from the
1930’s called Arnold v. Phillips. It holds that in bankruptcy, where debt
obligations are issued in a stock redemption or dividend, the test is applied twice: initially, and also when payment
is due. Shipman believes that this case
is still good law. In addition,
Agent for an undisclosed principal or a partially undisclosed principal
Exchange Comm’n v. Texas Gulf Sulfur Co. – You’re a big
Let us analyze this in the agency context: they were agents for an undisclosed principal. Is this per se against public policy or fraudulent? No, it’s definitely not. There are many big investors, buying under 5% of outstanding shares, who want to keep their transactions confidential for various legitimate reasons. If you happen to get hints from the press that all is not well, you can sell without any restriction under 10b-5 and you don’t have to deal with Rule 144 paperwork. On the other hand, they may use the press carefully to find out that there is positive news and they want to load up on more stock. In a big Second Circuit case, a person was an agent for the world’s biggest user of a certain commodity. But if there is a fiduciary duty between the agent and the third party or the principal and the third party, then you must come clean up front. Also, if the third party puts the direct question to the agent: “Are you buying only for your own account and not for resale?” and the agent lies, there is an action in fraud.
There are two “curlicues” on the doctrine. The plaintiff’s lawyer will always look for this early if the apparent defendant is judgment-proof. On the other hand, if the defendant is GM or Exxon, you’ll always get paid if you win. What happens if the principal gives the agent the money up front to buy the commodity with, and the agent squanders it away? That may be the commission of a fraud upon the principal because the money was given in trust. If the principal pays up front and the agent doesn’t pay, there are two rules. The majority rule is that you can’t reach the principal under the doctrine of agent for an undisclosed principal. The more modern rule in Restatement Second of Agency is to the contrary: whether or not the principal has already paid the agent, the third party can get relief from the principal even though the principal has to pay twice. You hire people who you can trust completely and who are financially solvent to do this kind of thing.
In Texas Gulf Sulfur, the farmers were all paid. They hired responsible people who issued their own checks that were valid. The farmers sued for rescission. Texas Gulf Sulfur settled the fraud suits. The Canadian provinces later amended their statutes to require disclosure up front of the drilling information, that is, it would be considered material to the transaction.
What is a partially disclosed principal? This is where the agent says: “I’m buying for someone else and I can’t tell you who it is, but I’ll give you my own check and my check is good.” The rules are fairly close to those for the completely undisclosed principal.
In fraud and related theories, we are assuming no fiduciary relationship at all. You have big problems! Starting in 1910, American fraud law began to expand. Prior to 1910, the law of fraud was very narrow when it relied upon total non-disclosure. It was helpful if there was an overt material representation or half-truth. But if there was total non-disclosure and no fiduciary or other special relationship between the parties, most American courts would not have allowed a fraud claim. Samford Brass, consistent with Restatement Second of Torts, deals with the special fact doctrine, where the total non-disclosure is about not only a material fact, but a highly material fact which we will call a special fact. Note that a highly material fact puts the case in the arena of Sherwood v. Walker, the barren cow case.
This case involves securities. We have an AMEX company that needs to raise
equity capital. They undertake a Rule
506 offering with, among others, Mr. P who is generally sophisticated and
moderately knowledgeable about securities.
The company sells him options to buy stock. In those days, that meant the option would
have to be held for two years before you could get an unlegended security, and
then the security would have to be held for two years. The security was unlegended. The private placement memo did not mention
the Rule 144 restrictions on disposition.
The stock does very well for a time, during which Mr. P goes to the
company and asks to exercise the option.
He would have made a lot of money.
But the president of the company says that exercising the option would
violate Rule 144. By the time the
holding period was satisfied, the stock had plummeted. A diversity suit was brought in federal court
On the contract count, the court held that the plaintiff
didn’t have a cause of action. On the
fraud side, they reversed summary judgment for the defendant and remanded for
trial. They said that
A case with a similar result under contract doctrine comes
from the 1970’s in
We have two subdivisions of the Texas Gulf Sulfur case: we’ll pay more attention to the insider
trading portion but we’ll also deal with the issue of the press release. The top brass of the company told everyone to
keep quiet. Was the management of the
company in violation of § 13 by imposing a blackout period? The court says no: it was within their
business judgment. The SEC agreed. But some people didn’t keep the
blackout! They told other people to go
out and buy lots of stock! This is a
civil proceeding for injunctive relief and disgorgement. The courts have held that the SEC has
inherent power to go into the federal courts and get disgorgement. Note, however, that Sarbanes-Oxley goes
beyond disgorgement. The court holds
that the rule is that mere possession of material inside information is enough
to put everyone under the “Just Say No” rule.
The company insiders said that they weren’t allowed to disclose because
the president of the company would fire them.
The court says that they should abstain.
The thrust of the ruling is equal
protection. It’s a typical
What about the press release? The majority opinion screws up worse. They say the company will be civilly liable to people selling on the basis of the press release without any discussion of scienter. Judge Friendly’s concurring opinion corrects the majority opinion. We now have the 1995 Act which adds on more. Note the potential liability associated with false press releases and the like. The DJIA has gone up from 880 to 10,300 since 1981. Some days the volume on the NYSE is 2-3 billion shares. The over-the-counter market has also grown. The 1995 Act tries to deal with this. It enacts a “statutory caution defense”: if your press release has enough cautionary language, you won’t be held liable. The case law has also developed this independently of the statute.
Apple Computer had a successful IPO in the 1970’s. They were going to come out with Lisa. Steve Jobs put out a bunch of glowing press releases and a lot of people believed him. The Wall Street Journal and New York Times covered the new computer and they wrote many stories saying it was all crap. The stock shot up and then took a nosedive. The first issue was whether press releases could trigger 10b-5. Could people reading the press releases rely on 10b-5 to get relief if the stock took a nosedive? The court said that if you promote your products vigorously enough, you can get sued under 10b-5. The president wanted indemnity from the company and vice versa. The jury came in saying that the company had zero liability, but the president had liability of $100 million. The judge set aside the verdict and ordered a new trial. The Ninth Circuit opinion added an important defense: the total mix of information. They told the judge that on retrial he must let in as evidence all of the WSJ and NYT articles because it could be the case that the articles were circulated so broadly that there could have been no reliance on the Apple press releases. Rumor has it that the company settled to the tune of $21 million.
In 2003, the California Supreme Court, reviewing a Rule 12(b)(6)
motion (which, in
Texas Gulf Sulfur deals with organized trading market transactions. The people are not dealing one-on-one with each other. Someone buys GM stock and it later goes down. GM had suspected that things were going bad but kept quiet for two weeks while investigating it and a negative press release comes out after you buy. Under Sherwood v. Walker, can you go to the SEC and have them find out who was on the other side of your transaction and force the other person to rescind? No, because this is impractical. Sherwood must be restricted to one-on-one situations. The Texas Gulf Sulfur is extremely egalitarian and equal protection-based. The next two cases add several limits. All of Rule 10b-5 is fraud-based and requires scienter. It is generally agreed that Rule 14e-3, adopted under § 14(e), requires no fraud. Textual analysis of § 14(e) suggests that the first sentence, which is self-executing, deals with fraud. The second sentence, which came a few years later and which is not self-executing (that is, requires rulemaking) is clearly not fraud-based.
Justice Powell said that neither Mr. Chiarella nor the employer owed a fiduciary duty to the shareholders of the target company. Both Mr. Chiarella and his employer did, however, owe a fiduciary duty to the offeror. For the first time before the U.S. Supreme Court, the government says there is another theory that they want to pull out. They want to claim that this was misappropriation of the principal’s confidential information, which, in itself, should be considered fraud. But the theory wasn’t raised in the indictment, which means that it couldn’t be raised later! But the misappropriation theory is alive and well, at least in the Second Circuit.
Take, for example, the case of United States v. Carpenter out of the Supreme Court. Carpenter landed a job at the Wall Street Journal. He wrote a column called “Heard on the Street” that had a great effect on the market. Some traders would get up extra early to get the WSJ and read that particular column and trade based on what it said. Carpenter told his lovers of this, and they made out like bandits. If he was going to say something good about a company, he would tell his lovers in advance. At the various brokerage houses where his lovers traded, the compliance officers and computers picked up on the pattern. They went to the SEC and the United States Attorney. There was a joint investigation, and eventually Carpenter confessed. There was a criminal prosecution under Rule 10b-5 and the Federal Mail/Television/Radio Fraud Act. The jury convicted him on both counts. The Second Circuit affirmed. The case went to the U.S. Supreme Court, where the mail fraud count was affirmed 8-0. He clearly had violated the mail fraud statute by robbing his employer of confidential information. The Rule 10b-5 count was affirmed 4-4. There hasn’t been a subsequent opinion on the theory of misappropriation, so the Second Circuit continues to apply it. The theory is rather uneven in other circuits.
That’s not the end of the story. SEC v. Dirks was an appeal of an SEC disciplinary action against a broker-dealer. In this opinion, the Chiarella test was made more explicit. The opinion said that mere possession of inside information is not enough for Rule 10b-5. To that extent, both of these Supreme Court cases limit the ruling in Texas Gulf Sulfur. The tipper must have violated his duty of loyalty to the company, and there must be a benefit to the tipper. Rule 10b-5 is a fraud section. Many things can be a benefit: (1) business benefits, (2) reciprocity benefits, or (3) social/romantic/sexual benefits.
The president of an NYSE company goes to a bar and bring his assistant along, gets drunk, talks too loud, and Mr. X overhears in the next booth. Mr. X has no fiduciary relationship with the company or anyone else. Can Mr. X, insofar as 10b-5 is concerned, trade on this information? Yes! On the other hand, if the president of the company talks about a tender offer that the company is going to make in two weeks at a big premium, we go to Rule 14e-3 which says that in the limited context of a tender offer reinstates the broad mere possession test of Texas Gulf Sulfur. Note that the second sentence of Rule 14e-3 is not a fraud section. It is also quite broad in that it applies to any tender offer of any security of any company, public or private. These provisions are most certainly enforced! Computers can catch them or ex-lovers can tip off investigators.
Chiarella itself established that 10b-5 is a fraud rule. That was amplified by SEC v. Dirks. The latter case held that the tipper must have violated his duty of loyalty to the company and must have received a benefit, broadly defined, from doing so. A breach of the duty of care of the tipper to the company is not enough.
In a prior exam, the CEO of an NYSE company went with an assistant to a local café, ordered too much to drink, and talked way too loud to his assistant. In the booth next to him was Mr. X, who owed no fiduciary duty to the company or the two individuals. He overheard, and he went out and loaded up on the company’s stock. 10b-5 does not apply to this situation because Chiarella and Dirks, insofar as 10b-5 is concerned, overrule the mere possession test of Texas Gulf Sulfur. This is due to the literal language of 10b-5 because it’s a fraud statute. Justice Powell explained that journalists and others perform valuable functions in society and in the securities markets. If a journalist gets a company official to say more than he should, with the company official violating only his duty of care to the company and getting no benefit, and the journalist spreads the word, then society is all the better for it, so the journalist shouldn’t be punished.
Consider 14e-3 in this situation. The president and his executive assistant were discussing a bigger NYSE company that was going to pick up the subject NYSE company in a statutory merger at a big premium. This was confidential. Nobody knew it except the two companies and their agents. Both § 14(e) and 14e-3 are limited to tender offers. So the question is whether a statutory merger or sale of all assets is ever a tender offer. The answer is no, because they are both non-coercive in that the shareholders and board of directors must vote on it. A tender offer is more hostile and doesn’t require shareholder or board approval. So 14e-3 does not apply either. However, what Mr. X did in soliciting shareholders was probably a tender offer and there was no compliance.
If 14e-3 had been adopted when Chiarella was decided, then Mr. Chiarella would have run afoul of
14e-3 because the undisclosed information related to a tender offer and under
14e-3 the mere possession test of Texas
Gulf Sulfur, in that limited circumstance, is reinstated. That is to say
that the plaintiff need not prove fraud, breach of fiduciary duty of loyalty,
or benefit by the tipper. Is 14e-3 a
valid Rule? Two big cases say yes, and
Shipman says they’re right. The first is
United States v. Chestman, a criminal
case from the 1980’s from the Second Circuit.
In this case, a wife of a top executive in
There followed a criminal prosecution under 14e-3 and 10b-5 of the stock broker. The husband was granted immunity to testify against the broker. There was a jury conviction on both counts. The case came up before the Second Circuit. As to 10b-5, the court applies the Dirks-Chiarella test. They hold that the government didn’t prove that the daughter and the daughter’s husband were fiduciaries to each other, and since the daughter didn’t get the husband to promise to keep it confidential before she told him, the 10b-5 “chain” was broken, and thus the broker’s conviction on the 10b-5 count had to be overturned. But as to the 14e-3 count, they held that the Rule is valid. They ruled that no fiduciary duty need be found. The conviction was upheld and the sentence was not reduced.
There are courts that would hold that there is always a fiduciary duty between husband and wife under a status concept so long as they are living together and they’re not contemplating divorce. What the Court of Appeals held was that they wouldn’t buy the status argument. They admitted that fiduciary duty and confidential handling of information can flow from one of two sources: (1) status, which is the most common, or (2) contract. For example, if the wife had said up front: “Husband, this must be kept in the strictest confidence, and I’ll only tell you if you promise to keep it secret”, then there is a contract. By contrast, if a cab driver overhears you talking on a cell phone about anything but a tender offer, the cabbie can pig out on that stock. On the other hand, if you tell the cab driver that you’re about to make a highly confidential call, ask him if he will keep it confidential, and he says yes, then there is a contractual fiduciary duty, and if the cab driver pigs out, he violates Rule 10b-5.
A U.S. Supreme Court out of the last five years upheld
14e-3. In the process of doing so, they
also discussed 10b-5. A senior partner
Also in the last five years, Regulation FD (“fair disclosure”) under the Securities Exchange Act of 1934 relates to publicly reporting companies. That’s because it’s a rule under § 13, the reporting provision. If an officer or director spills the beans on undisclosed information, then within two days you must publicly file a report with the SEC as to “what the beans are” so that everybody can play on a level playing field. This was very controversial! The SEC chairman barely got it passed. The deciding vote came in from one of the commissioners, who joined only after the Commission put in a big exemption from the Rule: a bona fide member of the media doing bona fide media work to whom the beans are spilled does not have to comply with Regulation FD. The holdout commissioner was correct, in Shipman’s opinion. He didn’t want the rule challenged on First Amendment grounds.
Since the 1980’s, there have been a number of amendments to the Securities Exchange Act of 1934 on insider trading. None of the statutes define insider trading; Congress has left that to the courts. However, there are a number of very important provisions. One of them is that lawyers, CPA firms, investment bankers, and the company itself must avoid reckless conduct in safeguarding material, undisclosed inside information. In one of Shipman’s exam questions, a guy is a partner in a law firm. His son goes to the office and the father takes a phone call while the father is in the office. The call is from someone planning a big tender offer. The son is a party animal! He’s also quick-witted. He’s a finance major. He leaves and pigs out. How do we advice the senior partner of the law firm when the FBI appears? First, we tell him to be nice to the FBI. Next, we advise him that the partner was reckless in talking in front of his son. Don’t share confidential information with anybody. The partner is going to pay treble damages! In a civil action, the SEC can triple the ante! The partner must come up with the big money to get the SEC and FBI off of the firm’s back. You have to give it to him straight, according to Shipman. It’s his problem, not the firm’s. Also, all law firms have very careful written procedures on buying and selling securities that you must adhere to. If you work for a firm that does a lot of takeover work, the spouse should invest in mutual funds, not stocks. Pigging out is a basic human instinct!
These three duties overlap heavily. Federal Rules of Civil Procedure 23 and 23.1
have to do with kinds of class actions.
23.1 deals with a shareholder bringing a suit on behalf of the corporation.
The duty doesn’t run to the shareholder personally, but it does run to
the corporation. It’s a lot harder to
start a Rule 23.1 action off the ground than it is to get a Rule 23 action
started. Under Crosby v. Beam, as to close corporations in
This is an area of heavy legislative challenge. The 1995 Act, as to fraud actions involving
securities, put a whole new layer of restrictions on class actions or
quasi-class actions. A quasi-class
action is where twenty individual shareholders bring twenty different suits on
the same transaction. The 1998 Act
expanded this, saying that if the class action involving fraud and securities
is in the state courts under state law, then the defendants can remove them to the (more
defendant-friendly) federal courts. The
newest kid on the block, about to be born, is a bill before the Senate this
week. It’s a class action bill recently
passed by the House. It’s broader than
securities and says that as to many class actions entirely under state law,
even if only negligence is alleged, the defendants may remove to the federal
courts. This is very popular in the
House, but not popular with the federal bench.
In the Senate, it’s going to be close.
Shipman predicts it will become law eventually. At the state level, there has been a lot of
tort reform action, including in
Smith v. Van Gorkum –
This is duty of care only. The directors
were the cream of the
This case hit the corporate world like a bombshell because
this is the way boards did business before this case! Before Zahn
v. Transamerica, the first big 10b-5 case, insider trading was rife! The Delaware Supreme Court says that the
business judgment rule can be shredded by the plaintiff showing (1) fraud, (2)
ultra vires, (3) bad faith, (4) arbitrary or capricious action, or (5) waste
(recklessness by the directors). But
then they added: (6) gross negligence on the merits, and (7) procedural gross negligence. Here, the Delaware Supreme Court said that
there was procedural gross negligence by the board, which gets us into the role
of shareholder approval in a public company in
In Delaware, the rule, at least since the 1940’s has been
that if holders of a disinterested majority of shares, after full and fair
disclosure up-front, vote not to sue
or to approve or ratify, then upon such approval the business judgment rule is
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.
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
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
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
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
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
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
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
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
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.
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.
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
Perlman itself is
a diversity case in the Second Circuit under
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
Since this case, the
The next big
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.
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
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
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
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
Next, if you look through
I. Introduction to BA
e. Lawyers’ Duties and Liabilities
II. Matters to Think Through Before Incorporation
a. Tax Factors
c. Convertible Securities
f. Antenuptial Agreements
i. Community Property
k. Preferred Stock
l. Rights of Creditors
III. Actual Formation of the Corporation
a. Defective Incorporation
b. Corporation by Estoppel
c. De Facto Incorporation
d. Liability for Pre-Incorporation Contracts
e. Ultra Vires
IV. Disregard of the Corporate Entity
V. Par Value, Preemptive Rights, Fiduciary Duties
VII. Directors’ and Officers’ Insurance
VIII. Securities Regulation: Introduction to the Securities Act of 1933, Securities Exchange Act of 1934, and R.C. Chapter 1707
IX. Corporate Norms and Shareholders’ Agreements
X. Close Corporations
XIII. Dividends and Redemptions
XIV. Insider Trading
XV. Fiduciary Duties of Care, Loyalty, and of Full Fair Disclosure Up Front