Corporations Outline


Table of Contents


Business (or for-profit) corporations. 3

The corporate family tree. 3

Securities. 4

Rule 504. 9

Rule 506. 11

Guaranty and suretyship. 13

Taxation. 14

Tax consequences of different forms of corporations. 14

Subchapters C and S.. 14

LLCs and Subchapter K.. 15

Professional corporations. 16

Workers' compensation. 18

Malpractice insurance. 19

Corporate statutes. 21

Notes. 24

Four flavors of action. 26

Sweat equity and capital 28

Executive stock options. 30

Equitable subordination. 34

Contractual subordination. 34

Bearer instruments. 36

Security title. 38

Dissolution. 39

Deadlocks. 40

Shareholder voting. 40

Requirements for a valid vote. 41

Valid call 41

Valid notice as to time, place, and purpose. 42

Quorum requirement 43

Valid vote. 44

Formation. 49

Organizing the company. 49

Regulations and bylaws. 49

Pre-incorporation contracts and premature commencement 50

Classes of corporations. 56

Ultra vires ?R.C. 1701.13. 58

Disregard of the corporate fiction. 61

Extraordinary transactions. 69

Dissolution. 69

Statutory merger. 70

The de facto merger doctrine. 70

Control share acquisition. 72

Subscriptions versus options. 72

Par value. 73

The Ohio rule regarding the disregard of the corporate fiction. 75

Preemptive rights in Ohio. 75

Common law rule regarding indemnification without a contract 77

Indemnification. 80

Moral hazard and indemnification by express contract 81

The law firm’s role in offerings. 86

Comfort letters. 87

Connecting the ?3 and ?4 Acts. 88

Covenant to register. 92

Close corporations. 93

Corporate norms. 93

Agency in the contract setting. 98

Actual authority. 98

Apparent authority. 99

Cognovit clauses. 105

Fiduciary duties of stock redemptions. 107

Stock dividends. 108

Duties of care of loyalty and of full and fair disclosure. 116

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.?span style='mso-spacerun:yes'>?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.?span style='mso-spacerun:yes'>?The specific trumps the general every time.


The NYSE is organized as a New York not-for-profit corporation.?All not-for-profit corporations have members who elect directors or trustees.?They don’t have shareholders, but they do have creditors.?There are two big subdivisions of not-for-profit corporations:?(1) Charitable, religious, educational and corporations for the prevention of cruelty to animals ?The most favored not-for-profits are those that meet Internal Revenue Code ?501(c)(3).?To gain this status, you must file papers with the IRS in advance to convince them that you’re charitable.?One requirement is that no insider can have an undue right to the income or assets of the foundation.?In practice, that means that the promoter can be a trustee, director, or president and can collect a reasonable salary and benefits, including a reasonable salary plan.?Some people who run charitable corporations get good money!?If you are a charitable organization, you’re governed by ordinary state corporation law and also the law of charitable trusts.?If you’re a ?1702 charitable corporation, you’ll be governed by both ?1702 and ?1701 (to the extent that it’s not inconsistent), and also by the law of charitable trusts.?If you’re going to start a charitable organization, though, do it under ?1702.? If you get into a dispute over trust law, you’ll have to go to a treatise.?Under ?503(c)(3), you’re exempt from federal income taxation.? You’re also exempt from most federal excise taxes.?You can also get an exemption from real property taxes!?But that’s not the end of the financial feast!?Under IRC ?170, within certain percentage limits, donors making donations to you get a federal income tax deduction.?(2) Non-charitable not-for-profits ??503(c)(6) describes business leagues, which provide some tax breaks, but not nearly as many as if you are a ?501(c)(3).


Business (or for-profit) corporations


In Ohio, these are governed primarily by ?1701.?The promoter wants a vehicle that he can (1) raise money with (to entice inactive investors to put their money in), (2) can control (the promoter wants to control the board of directors because it will determine who the officers and highly paid employees are and who gets the fringe benefits), and (3) if things go to hell he can minimize his liability (subject to qualified exceptions for disregard of the corporate fiction; but the inactive investor seldom gets reached).?Who can be tapped (that is, who will be liable) if things go wrong?? What about deadlock?


The corporate family tree


Investors are people who invest money in the corporation.? “Money to a corporation is like blood to humans: without it, you die.?span style='mso-spacerun:yes'>?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 Ohio and Delaware.?The directors have several jobs.?The most important one is the hiring and firing of officers.?Officers are very high-level management employees with a formal legal title: “executive vice president?or whatever.?The other roles of the directors are to pass major transactions, to monitor the officers, and to set long-range plans and policies.?The directors are advised by lawyers, CPAs, management consultants, and investment bankers.




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. ?/span>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 Kansas in 1912.?The Kansas Secretary of State that the farmers were being sold “so many pieces of the blue sky??This is why we call state securities statutes “Blue Sky?statutes.?There is a CCH “Blue Sky?Reporter. ?/span>The state statutes provide for registration of securities at R.C. 1707.09, which in effect says that unless exempt, every person must first register every security before you offer it for sale in that state.?The exemptions in the Ohio Act are found in R.C. 1707.02 and .03.?In the Securities Act of 1933 you’ll find the same stuff in ?3, 4, and 5.?Just before World War I, the Supreme Court upheld the constitutionality of the state “Blue Sky?statutes.?So R.C. Chapter 1707 has a “don’t breathe?clause, and then exemptions like .02(E).


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


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


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


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


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


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


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


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


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


Justice Clark’s last point was that the burden of pleading and proving an exemption is totally upon the proponent of the exemption.? That’s also true in R.C. 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 Ohio.?Both federally and in Ohio, the fact that you’re exempt from registration doesn’t exempt you from implied or express civil liabilities.? For example, R.C. 1707.38-.45 apply equally as to registered transactions as they do to exempt transactions.


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, Ohio passed an investment advisors act that covers financial planners.?NSMIA also says that if a company is listed on a major exchange or on the national market system of the NASD, no state can require registration of the issuance of securities by that company.?It reads just like R.C. 1707.02(E) in Ohio.?Before this federal Act, several states like Florida did not exempt nationally-listed corporations from registration.?Only the state of incorporation can deal with alleged securities and fiduciary duty violations.?As to mutual funds, certain things were reserved to the SEC, while the states can do certain other things.?We’ll later discuss the provision dealing with Rule 506.


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 Ohio case, a NYSE member broker-dealer recommended some investments to a customer, and they went south.?The customer said that given his precarious financial position, they should not have recommended a speculative security.?If he had sued under 10(b)(5), it would have had to go to federal court because the Securities Exchange Act of 1934 says that all actions under the Act must be in federal court (which is different from the other federal securities statutes).


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 Ohio common law this created a statutory tort for a negligent failure to observe suitability, and the plaintiff won!? Shipman says that the plaintiff’s attorneys were very smart.


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 Dayton who is a physician.?Three months ago, he bought GM stock, registered in his own name, through the NYSE.?He is not a director or officer of GM.?Neither is his wife or any other relative.?He doesn’t meet the 10% rule, which is the third way you can be an affiliate.? If you add up the GM stock all of his family owns, it’s still well under 10% of the shares outstanding.?Insofar as the Securities Act of 1933 is concerned, he has a ?4(1) exemption.?Insofar as Ohio law is concerned, R.C. 1707.02(E) exempts him.? To sell the stock, he will have to sell it through a broker, but he had to have a brokerage account in order to buy the stock in the first place.


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 United States, many major investors elect not to sit on the board of a company that they own a lot of stock in.?If they sit on the board of the company, they will be subject to the restrictions of Rule 144 and Rule 10(b)(5).?On the other hand, let’s say a rich guy in New York wants to buy 4.5% of GM.?He can go to his bank and the bank can purchase in “street name? and as long as he stays under 5%, he doesn’t even have to surface under 13(d).?He will prefer to remain anonymous because if that is his only connection to GM and his family owns no GM stock and he acquired the stock over one year ago on the NYSE, then he can sell it at any time!?If, on the other hand, he’s on the board, he has all the Rule 144 limits plus, if there is material, undisclosed and unfavorable information about the company, 10(b)(5) absolutely precludes him from selling.?In Europe, the big companies all have the big investors on their board.?But in this country, a lot of the people who are big investors prefer to stay off the board.? As long as they’re under 10% including family holdings and as long as they don’t seek out or get inside info, they can sell when they want to and they can buy when they want to.


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.


Rule 504


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 Ohio entrepreneur and you’re getting in the car and dropping in on 80 bankers that you don’t know, that would be construed as general advertising.?But if you hire an Ohio company as your general agent and they deal with these banks all the time and they send out a fax to them, then it’s okay.


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 Ohio.?85% of the revenue and profit have to be from Ohio.?Only 1 out of 50 times will you meet that.?If you’re organizing a company in Ohio with its principal place of business in Ohio but half the business will be done in Kentucky.?In that case, don’t use 3(a)(11).?Also, like 4(2), 3(a)(11) counts offerees not purchasers, and if there is a single rotten offeree, either 4(2) or 3(a)(11) is lost forever.?This is Draconian!?It’s a financial trap and snare and sinkhole!?Rules 504 and 506 concentrate, in the main, on purchasers, who you can more easily keep account of.?Under 504, there is no limit on the purchasers because it is a limited public offering rule.?In 506, there is a limit on purchasers, but that limit is pretty liberal.?But under Regulation D, there is no general advertising.?That is true in all of the rules under Regulation D.?That’s a trap!


So Rule 504 is the “mom ‘n?pop?exception.?In Ohio, you’ll use R.C. 1707.03(O).?Whenever you can use .03(O) instead of .03(Q), do so, because (O) is easier to satisfy.??1707.03(O) is limited to equity securities of a corporation or a limited liability company.?What’s an equity security??It’s a stock, warrant, or debt convertible into stock.?What is the counterpart in Ohio to pure debt??Look for the .02 regulations in a section dealing with commercial paper.?There are two sets of .02 regulations.?The first one, about 30 years old, says that despite the wording of the section, it is limited to debt sold to insiders/affiliates.?But in the 1990’s, the commissioner expanded .02, saying that if something is a pure debt security and if it would meet .03(O) if it were an equity security then it will meet that particular regulation.? Another set of Ohio regulations that are crucial are the regulations under .03(V).?There are some “nice?exemptions there, including one for certain employee stock purchase plans and employee stock options.


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!


Rule 506


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 Ohio situation??For an offering exempt either under ?4(2) or under Rule 506, you can get an exemption for the Ohio portion if you make timely filing and a $100 fee.?Each filing is only good for 60 days.?If you go for the whole year, you’ll have to make seven different filings.?In the real world, many exemptions are lost because they’re not careful in getting the filing there on time.?Make sure you have a stamped copy before the final due date that you can put in your file.?In Ohio, R.C. 1707.39 and .391 will allow you, in limited circumstances, to file late.? Texas has an even more advanced scheme. ?/span>Federally and generally under state law, if you miss the deadline you’re dead, and you get strict liability and malpractice.


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 California, Seattle, Texas and Massachusetts were using Rule 506 heavily.?They were finding that the various states were questioning their disclosure and were trying to impose substantive fairness tests.?The big problem was that the suggestions of the various states were contradictory; you couldn’t please everyone.?So there is a lot of political dispersion.?As a reaction, a part of NSMIA provides as follows: this applies only as to Rule 506 offerings, and not to ?4(2).?Rule 506 is much safer than ?4(2)!?Rule 504 is safer still!?In Ohio, always use .03(O) in preference to .03(Q) because it is a lot simpler.?NSMIA says that states can continue to require (1) notice filing, (2) a filing fee, (3) application of broker-dealer rules, (4) application of fraud law, and (5) application of criminal law.?But the states shall not, as a matter of routine, question the disclosure in a Rule 506 transaction or use their anti-fraud powers to impose substantive fairness tests.? This has worked, and though Shipman is in favor of state regulation, he thought state variation had gotten out of hand.? Another part of NSMIA dealt with broker-dealer rules.?It said that a federally registered broker-dealer can continue to be forced to register under state law.?There can be filing fees.?Criminal, fraud and injunctive provisions can be used.?But in applying selling practice and other rules, such as net capital, the states can only enforce the federal rules.?But can federal courts enforce Ohio broker-dealer rules??The Ohio Supreme Court has held that federal and state regulation must work together closely in this area.


Guaranty and suretyship


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 Ohio, if you’re doing construction work for a public agency, the contractor has to go to AETNA or some other approved insurance company and get a surety bond written in favor of the state, and this is not cheap!?On surety, the writer of the bond has primary responsibility.


Cockerham v. Cockerham ?The husband had a lot of land before he got married.?He married, acquired more land, and under Texas law what he acquired was community property.? The wife went to town and started a dress shop as sole proprietor and also found another love interest.?The dress shop is going to hell financially.? Under Texas law, Mr. Cockerham’s community land would have been liable to Mrs. Cockerham’s dress store debts.?But most of his land was acquired before the wedding and he would be able to keep it.?So the creditors get to Mr. Cockerham.?He should have said: “She’s an independent entity.?She’s not my agent.?She’s not my partner.?span style='mso-spacerun:yes'>?But of course, this macho guy said: “Don’t worry if her debts aren’t paid off by her!? If they aren’t paid off by her, I’ll pay them off!?span style='mso-spacerun:yes'>?Under principles of estoppel, the court held that his separate farms, that is, the land that he owned when he got married, as well as his community property land was available to the wife’s creditors.? Mrs. Cockerham is charged for wasting community property by supporting her lover.?In 1971, the husband got custody of the kids!?His big mistake financially was “popping off??He should have given the “NOW?speech: “I’m not half of anything.?She’s not my agent, and she’s not my partner.?span style='mso-spacerun:yes'>?Then he should have turned around and walked off.




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.


Subchapters C and S


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 United States corporation.?It can have no more than a certain number of shareholders (75 as of the last edition of the book).?No shareholder can be a partnership, corporation, or ordinary trust.?There are limits on the extent to which non-resident aliens can own stock in the Sub S company.


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 Ohio did not until about 20 years ago.


LLCs and Subchapter K


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.

Professional corporations


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 Ohio, it was passed in about 1960 and it is in Title XVII.?It’s an odd statute that you apply in conjunction with ?1701.


In Ohio, many doctors and dentists immediately hopped on the professional corporation bandwagon.?Many are still there today.?CPAs could not because the code of ethics of the AICPA (American Institute of Certified Public Accountants) prohibited incorporation.?This business form was available to lawyers too.?But there was a big “hiccup?along the way!? The Ohio Supreme Court ruled that (1) the legislature could not legislate concerning the governance of lawyers in this way, (2) only a Supreme Court rule could allow it, and (3) they would allow it, but only if there was a charter provision, saying that each shareholder of a professional corporation of a legal nature had the same liability as a general partner of a general partnership.


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 Ohio in the interim??In around 1995, the Ohio Supreme Court issued new rules, saying that lawyers can go into an LLC, a ? 1701 corporation, the old professional corporation, and that the old provision about shareholders having the same liability as general partners of a partnership was abolished.?Different states are at different stages on this right now, and it works differently for each profession.?You must look at each profession.?The Ohio legislation makes it clear that the governing boards for each profession still have regulatory oversight, and it works out differently for each profession.


Clackamas v. Wells ? This Supreme Court case is from 2003 from Oregon.?There was an EEOC action by a non-shareholder employee against the corporation under Title VII of the federal civil rights statute.?Title VII does not apply to a firm having fewer than 15 “employees??But just what does “employee?mean?


Compare this to Ohio: under the Ohio equal employment statute, the number is four, and a part-time employee is explicitly counted as one.?Also, the Ohio Supreme Court has held that in a veterinary firm with only three employees, the alleged mistreated non-shareholder employee, though she couldn’t sue under the federal statute, she would have about the same rights under Ohio common law.?Often people’s rights are greater under state law than federal.? We’re not in the Warren Court anymore!?People’s rights are much more often greater under state law than federal law!? Today, many federal judges are averse to 20th century liberalism ideals, moreso than state court judges.


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 Ohio.?For unemployment compensation purposes, both federal and state, they were treated as common law employees.?If you excluded these four or five people, there weren’t 15 employees, and the company moved at summary judgment for exclusion from the statute.?That issue, in the Second Circuit, had been resolved against the shareholder/employees.? They held that if you choose the corporate form, the fact that you’re a shareholder, and even a majority shareholder and a director doesn’t affect the fact that if you work full-time for the company, then you are an employee.?Out west, one of the courts held just the opposite: it’s a small, intimate, professional corporation.?The shareholders who are also officers and who work full-time for the company are not employees.?In Ohio, this case would go against the doctors.


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 Ohio, in that situation would say that this guy is still an employee.?Now change the facts: three doctors own a third and each one is on the board of directors.?Note: any two of them could fire the third.?So, applying the Stevens test, they can all be fired!


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.


Workers' compensation


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.?span style='mso-spacerun:yes'>?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!


Malpractice insurance


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 Ohio, this is one of three or four states where you get attorney’s fees along with your punitive damages.?When a doctor is sued, if he’s satisfied with the lawyer that the insurance company provides for him, Shipman says he should still hire a good lawyer to look over the shoulder of the insurance company’s lawyer, “just to let them know that they’re not dealing with a rube.??/span>The Zoppo letter will remind the insurance company of its fiduciary duties.?An insurance contract is one of utmost good faith (uberrima fides).


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 Common Pleas Court.? Why is this done??In the old days, if the insurance investigator could wriggle out of the insured any admission that led to an exclusion, then it’s tough crap for the insured!?A Texas Supreme Court case from around 1960, and an Arizona case from the 1970’s changed the world.?They said that the lawyer employed by the insurance company to represent the insured owned high fiduciary duties to the insured.?And if it’s through confidential attorney-client conversation that the attorney learns of the exclusion, the attorney must resign, or keep going but not say anything to the insurance company.?In a really testy case, the insurance company will hire two lawyers: one to represent the insured, and one to represent the interests of the insurance company.


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 Ohio, we have a broad declaratory judgment statute.? These actions are broad.?The insured will go to a lawyer, who will handle it.?Under Ohio case law, if the insured wins the declaratory judgment action, the court may (emphasis on may) award reasonable attorney’s fees for the declaratory judgment action.?It’s broader than insurance, but it applies to insurance.


Perl v. St. Paul Fire & Marine ?Any attorney has the duty of care, the duty of loyalty, and the duty to communicate up-front all material facts.?Here, the second and third were violated because the insurance adjuster used to work for the Perl firm, and the attorney didn’t run that fact by his client.?He should have explained it and gotten her consent.?Clear up the conflicts of interest up front, because they can kill you!? It’s a contingent fee contract with a high contingent fee for settlement, 40%.?The client wasn’t complaining about that.?The client wasn’t complaining about the negotiations with the insurance company.?She got $50,000 and $30,000 after the contingent fee was paid.?But of course, to use modern terminology, “she felt used and abused? and that generates lawsuits.


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.


Corporate statutes


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 United States are at the state level, with a few exceptions.? Through antitrust, tax statutes, employment statutes, environmental statutes and many others, Congress heavily regulates.


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 Delaware, that same document is known as a ?i style='mso-bidi-font-style:normal'>Certificate of Incorporation??The generic name for both is “charter??In about half the states, including some big ones like Illinois and Texas, some version of the Revised Model Business Corporation Act is in effect.?In Ohio or Delaware, the Revised MBCA doesn’t govern.?So we’ll study these three sets of statutes.?The first MBCA was put out in 1946.?The revised version came out in the 1990’s.?The general Shipman rule is that unless there is a very good reason otherwise, incorporate locally.?The corporate charter is a public document.?In Ohio only, the rules of a corporation are called the “regulations??Everywhere else, including Delaware, the rules are called the corporate “bylaws?? These are not a matter of public record, unless you’re a public company, in which case the bylaws will be on file with the SEC in Washington.?Bylaws can be subpoenaed in litigation, though.


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 Ohio but you set up a store in Kentucky and hire workers in Kentucky, the Kentucky workers' compensation statute will apply.?Furthermore, if you make money in Kentucky, Kentucky will tax you on what you make.?If one of your Kentucky drivers “runs over a baby in Lexington? then Kentucky law will govern too.?But if there’s a dispute between shareholders and the corporation over the election of directors, then Ohio law will nearly always govern.?You can find this in Restatement Second of Conflicts of Laws, which actually indicates that there are a few exceptions to this.?In practice, we can say that the courts are not quite as consistent as the Restatement indicates.


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 ?i style='mso-bidi-font-style: normal'>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 Washington or to the federal courthouse.?This is very pragmatic but true.?This case is very important!?Master this case!


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 U.S. district court.


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!?span style='mso-spacerun:yes'>?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.


Four flavors of action


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 United States bankruptcy judge or state court receiver has jurisdiction to pass on claims.? They must be filed correctly and in a timely manner.?And the court for any good equitable or legal reason can disallow claims or “push them down in the pecking order??In Frick, the court says that if the claim was refilled as an unsecured creditor’s claim, there might be a chance.?But the unsecured creditors sit at the bottom of the pecking order.


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 ?i style='mso-bidi-font-style:normal'>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 Los Angeles started up under federal law.?But then there was also a parallel action out of Delaware state court under Delaware law!?The Delaware courts couldn’t hear the SEC issues!?The parties settled in Delaware.?The defendants took the settlement from Delaware to Los Angeles and claimed res judicata.?“Let my defendants go!?span style='mso-spacerun:yes'>?It went to the U.S. Supreme Court, which held that as long as the hearing on settlement meets the Fourteenth and Fifth Amendments, then a settlement in a state court can cover both the state action and related federal action.?But it wasn’t all over yet.?The case went back to Los Angeles and a panel of the Ninth Circuit found that Justice Thomas, writing for a 9-0 Court, “didn’t really mean what he said??There was a rehearing en banc before all the Circuit judges and the full court overturned the panel!?The upshot of the case is that some defendants love class actions because they love early settlements.?Note, however, that those people who opted out of the federal and state actions could proceed on their own.


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 Massachusetts Old Dominion case distinguish Holmes’s opinion??They said that at the time of the promotion a public offering was contemplated and that the low price of the promoters was not put in the perspective, and so there was no unanimous consent of all shareholders.


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!?span style='mso-spacerun:yes'>? If it’s over two years, the tax cases say that it is clear that the promotion was “old and cold?


Sweat equity and capital


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 Florida and New York.?There is also a Federal Act that bans “extortionary?interest rates.?Plus, this isn’t a consumer transaction.


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!?span style='mso-spacerun:yes'>? 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.?span style='mso-spacerun:yes'>?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. ?/span>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.


Executive stock options


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. ?/span>In this case, the parties signed a prenuptial agreement.?Let’s cover the law of prenuptial agreements and in particular the law in Ohio after 1980.?All states require a writing.?Ohio and many other states require that the parties have separate and independent lawyers.?There must be mutual full disclosure.?The contract must be fair when made.?This was added by the Gross v. Gross decision in the Ohio Supreme Court.?For subsistence alimony (which is only awarded when a marriage goes on a long time), it must be fair when performed.


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 Delaware law, the wife could go and get a custodian appointed and she could also bring a shareholder derivative action.


In Ohio, there is no statutory provision for a custodian.? We do have, however, case law that is favorable to the wife if this were an Ohio corporation: Crosby v. Beam, which is “a case of almost constitutional dimensions??It holds that if there is a true close corporation then (1) the fiduciary duties between the parties are intense, (2) the courts will give relief promptly and (3) the suit can be brought either as a derivative action, or bypassing Rule 23.1, which is good for plaintiffs.


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 Ohio, there is also In re Estate of Byrum, an estate tax case.?It came after 1970.?It was written by Justice Powell.?This case involved both the federal estate tax and Ohio law in regard to dividends.?What’s the federal estate tax??There are two important federal taxes: the federal tax on gifts, tied to a related tax on estates.?The estate tax can run up to 55%, and the gift tax can run high too.?There are exceptions, though: transfers between spouses are exempted from both taxes.?(About nine states have these taxes, too, and many states have inheritance taxes, which are similar to estate taxes.?Florida, on the other hand, has neither.?They want to encourage old, wealthy people to move there!?But they tax all kinds of weird stuff other than income and wealth!)?This is a big deal for tax planning for the wealthy.? Note that the exemptions are up to about $1.3 million.?Most people don’t have to worry.?Recently, the exemption was only $600,000.?Technically, the estate tax is begin phased out.?The gift tax will stay, “or else the income tax will be gutted?


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 Ohio law and found statements that there was a heavy fiduciary duty of majority shareholders in all matters, including dividends.?Thus, because the fiduciary duty was so strong, the old man had not retained a major power over the stock that was transferred to the kids.?Crosby v. Beam would agree with Justice Powell.?This is very relevant stuff!


What about a public company?? Can you get a court order for a dividend there??In theory yes, but in practice, ?i style='mso-bidi-font-style:normal'>forget it, baby!?span style='mso-spacerun:yes'>?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!


Slappey Drive Indus. Park v. United States ?This deals with the deductibility of interest.?It’s governed by §§ 162 and 163 of the Internal Revenue Code.??163 sets forth this test: (1) There are a lot of technical rules in ?163 that must be mastered.?First: you can’t make a public issue of debt securities payable to the bearer.?There must be a name on it!?Outside the English-speaking world, that’s done to screw the tax authorities!?But here, you can’t screw around with the tax authorities.?If you issue debt to the public, you can’t make it payable to the bearer.?There must be a name on there so the Internal Revenue Service can trace just who got the interest.?But this doesn’t apply to private issuances of debt.?(2) Most public issuances of debt have to be registered.?It’s sort of like the previous rule: there must be a bond registry maintained by the company.?(3) The debt must be