Corporations Outline
Table of Contents
Business
(or for-profit) corporations
Tax consequences of different forms of
corporations
Valid notice as to time, place, and purpose
Pre-incorporation contracts and premature
commencement
Disregard
of the corporate fiction
The Ohio rule regarding the disregard of
the corporate fiction
Common law rule regarding indemnification
without a contract
Moral hazard and indemnification by express
contract
The law firm’s role in offerings
Connecting the ’33 and ’34 Acts
Agency in the contract setting
Fiduciary duties of stock redemptions
Duties of care of loyalty and of full and
fair disclosure
Not-for-profit corporations
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
Business (or for-profit) corporations
In
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.
Voting
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.
Securities and
Exchange Comm’n v. Ralston Purina Co. – If an issuer makes a private
offering, it will be exempt. This is
called statutory § 4(2). It can apply to
any kind of company. There is no dollar
limit on statutory § 4(2). You also
don’t need to file notice with the SEC in order to perfect the exemption. In
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.
Ralton Purina
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
Tax consequences of different forms of
corporations
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
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.
In
Perl v.
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
started. In
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.
(2) The
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
In
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!
In
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
in
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.
In
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.
The
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.
Valid notice as to time, place, and 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
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
exceptions.
In
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
is an
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
The
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?
Attorney opinions
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
statute in
Pre-incorporation contracts and premature
commencement
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
strong. From
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
Frontier Refining
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
directors? The
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
the
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
corporation under
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
throughout the
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.
Disregard of the corporate fiction
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
under
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
contracts case
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.
(2) In
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
– In
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