VIEWS: 1,194 PAGES: 35 CATEGORY: 2nd Year Classes POSTED ON: 11/24/2009
This is part my outline for John Dobbyn's "Business Organizations" (aka Corporations) class at Villanova, from Spring 2009.
Neutral Rules: enforced when no one’s been hurt. Generally, neutral rules favor Δ. Rules of Restraint: someone’s been hurt, and the court wants to enforce the rule to punish the violator. Favors π because the burden of proof falls on Δ. Types of Businesses 1. Sole Proprietorship 2. Partnership 3. Limited Partnership 4. Corporation 5. Sub Chapter S Corporation 6. Corpnership 7. Limited Liability Company (LLC) 8. Limited Liability Partnership (LLP) 9. Professional Corporation (PC) Factors to Consider 1. Liability a. Contract Liability b. Tort Liability 2. Tax (P&L Flow-Through) 3. Management 4. Longevity 5. Ability to Pull Your Money Out 6. Ability to Raise Money (Credit) 7. Methods of Raising Addt’l Money 8. Government Regulation/Formality 1. Sole Proprietorship Definition: business owned by a single individual Liability: the owner carries all liability for the business. Thus, sole proprietorships are only viable when the owner carries COMPREHENSIVE GENERAL LIABILITY (CGL) INSURANCE. CGL Insurance does not cover liability stemming from contract debt or intentional tort. Taxes: Because the owner is one with the company, the government only taxes the profits once. Profits and losses flow directly through the company to the owner. Longevity: Sole Proprietorships die when the owner dies, becomes incompetent, or walks away. Thus… when it comes to Get-Out-Ability: it’s fairly easy, so long as you can find a buyer. Gov’t Regulation / Formality: small. If you use a fictitious name, you must file your D/B/A with the states in which your conduct business. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 1 2. Partnerships Definition: 2 or more individuals / doing business / as co-owners / for profit. Partnerships are not considered separate entities from the owners, except that: 1. Plaintiffs may name a Partnership as a defendant, and 2. Partnerships may own property. Contract Liability: Partners are jointly liable for contract damages (meaning that plaintiffs must first sue the partnership and only then may go after any/all partners for the rest). THUS: If you represent a Δ Partner, immediately join the other partners as parties to the suit. It’s the difference between an immediate judgment against each Δ and your client having to file a separate lawsuit for contribution. Tort Liability: Plaintiffs may sue the Partnership (as stated above) and may sue the Partners, who are jointly and severally liable for the damages. NOTE: The wealthiest partner thus becomes a target for all tort suits! If P1 commits a tortious act which damages π, π will sue P2 (the wealthy partner). P2 may either seek contribution from the other partners or he may seek to indemnify himself against the partnership (meaning that he would sue the partnership for its assets, to cover his individual loss) Taxes: Profits and losses flow directly through, thus avoiding double-taxation. The general rule is that P&L are split pro rata, although this may be changed. This is true for paper losses (such as depreciation) as well as actual losses. Management: Any partner may make day-to-day decisions. A majority of partners set policy decisions. To make major changes to the partnership or its business, the partners must unanimously vote. Longevity: Under the UNIFORM PARTNERSHIP ACT, reverse liability theory kills the partnership when a partner becomes insolvent or incapacitated, dies, or walks away from the business. o All assets are liquidated. All debts become due; some are accelerated (such as leases). o If any $$ is left, it’s divided amongst the partners (and the ―Dead‖ partner’s heirs/estate). o With respect to the death of a partner, cross-insurance offers some protection for those who wish to keep the partnership going. When you cross-insure, you take a life insurance policy on each partner for slightly more than their share partnership’s assets. Upon death, you use the bulk of the insurance payout to repurchase that partner’s share in the assets, and use what’s left over to form a new partnership. BUT: Once a partnership’s dead, the partners are free to walk away. Not all may wish to stay. Under the REVISED UNIFORM PARTNERSHIP ACT (adopted by a minority of states), the insolvent or dead partner is simply disassociated. The value of his share of the partnership goes into his estate. The remaining partners have to buy it back, using their own or partnership assets. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 2 Partnerships (cont’d) Get-Out-Ability: Partners are free to transfer their future profits in the corporation and their rights upon liquidation. Partners are forbidden from transferring their status as a partner, losses, ownership rights in partnership property, or the rights to use partnership property. TECHNICALLY: any partner can walk away at any time, thus dissolving the partnership. The hitch, though, is that a partnership is a contract. Breaching said contract may lead the breaching partner to assume liability for lawsuits brought against the partnership for breaching contracts, lost profits owed to the other partners, etc. Credit: Since the profits and losses of the business run through to the partners, the business’ credit is the same as the partners. Methods of Raising Additional Capital: If an individual wants to put money into a partnership, it requires unanimous approval. Formalities: As with SP, partnerships should file their D/B/A. Further, they should draft partnership agreements which state management responsibilities/divisions and distribution of profits and losses. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 3 3. Limited Partnerships Definition: a limited partnership must have at least one General Partner who assumes contract and tort liability for the partnership. There is no limit on the number of Limited Partners—those who invest but assume no liability. Limited Partners become General Partners if they participate in management. Limited Partners may, however, do 4 things: 1- Lend money to the partnership. 2- Work for the partnership. 3- Work as a contractor for the partnership. 4- Personally guarantee the partnership’s debt. Liability: General partners are subject to the same liability rules as partners in regular partnerships. Limited partners are not subject to any liability. There are merely investors. (clearly, if a limited partner personally guarantees debt, that’s different) Tax: Profits and Losses flow through a limited partnership. Typically, general partners take a greater share than limited partners. This is a practical observation, however—not a rule. Management: The same rules apply to general partners as apply to partners in regular partnerships: Any general partner may make day-to-day decisions. A majority of general partners are required to make broad policy decisions. To make decisions affecting the nature of the partnership, the general partners must vote unanimously. As investors, the limited partners have no voice in management. Longevity: The rules of reverse liability apply to General Partners, but not to Limited Partners. Get-Out-Ability The same rules apply to General Partners as apply to partners in regular partnerships. So long as all Limited Partners agree at the outset that a Limited Partner may withdraw his investment, he may. If not, he may not. Credit: The LP’s credit is the General Partner’s credit. If the General Partner is unable to supply sufficient credit, a Limited Partner may personally guarantee a loan. How Else Can You Raise Money: If an individual wants to put money into the partnership, it requires unanimous approval of the general partners. Formalities: As with SP, partnerships should file their D/B/A. Further, they should draft partnership agreements which state management responsibilities/divisions and distribution of profits and losses. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 4 4. Corporations Definition: a corporation is a legal fiction, created by statute. In most respects, it is treated as a man. Individual (or corporate) shareholders invest money in the corporation. Liability: with limited exceptions, a corporation shields its shareholders from liability. (Those exceptions are called ―Piercing the Corporate Veil‖ – page 14) There are three ways to get money out of a corporation: 1- The Corporation can issue dividends. 2- The Corporation can pay a salary/bonus. 3- The Corporation can pay interest on bonds (secured debt) or debentures (unsecured debt). Tax: a major downside of the corporation is double-tax. As the corporation earns money, it’s taxed. As the corporation issues dividends to its shareholders, the dividends are taxed again. TO AVOID THE DOUBLE-TAX PENALTY: Have interested parties lend the corporation money instead of invest as shareholders. They’ll still enjoy the liability shield, but the money will only be taxed once. Additionally, the corporation can claim the interest payments as a deduction against profits. o BUT: if the corporation’s debt to equity ratio is too far skewed from 1:1, the I.R.S. will penalize both parties. They’ll owe back taxes, penalties, and may face criminal charges. The corporation can ―Zero Out‖ its earnings and pay it as salary. o BUT: The I.R.S. will examine it and penalize the parties if the salary isn’t reasonable for the individual’s responsibility. It may be okay to say that John will get the lesser of 33% of profits or $50K; it’s not okay to say that your 3 employees will simply each earn 33% of profits. o WHY? It protects creditors and ensures that outside, non-employee shareholders might see some return on their investment. CORPORATIONS CANNOT SIT ON EXCESS SURPLUS TO AVOID THE DOUBLE-TAX. The I.R.S. will hit the Corporation with an Excess Accumulation Tax. To avoid this tax, however, the Corporation need only articulate a ―good corporate purpose‖ (note that it’s articulation, and not implementation, which is necessary). Good purposes may include: saving for big projects, creating a buffer against the credit crisis, or simply ―saving for a rainy day.‖ Corporations (cont’d) Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 5 Management: The Shareholders elect the Board of Directors. The Directors set corporate policy. The Directors appoint corporate officers. These officers carry out the Directors’ policies in dayto-day decision making. Permanence: There are only two ways to kill a corporation: 1- Insolvency 2- Voluntary Dissolution (where the majority of the Board of Directors forward a vote to the Shareholders, who in turn vote to dissolve the company) NOTE: if the corporation dissolves, all assets are liquidated to pay off the creditors (starting with secured debt and working to unsecured debt). If anything’s left – and, generally, nothing is – preferred shareholders are paid off before common shareholders. Get-Out-Ability: Generally, it’s easy: just sell your stock. That said, there has to be a market for it. If you own NYSE stock it’s not an issue, but it’s generally more difficult to find buyers for smaller, privately-held corporate stock. Credit: The Corporation develops its own line of credit by paying its bills on time. How Can You Raise More Capital? At the first shareholder meeting, have the shareholders authorize shares of stock which are not immediately issued. As the corporation needs to raise capital, it can sell stock (which, until sold, remains an inchoate corporate asset). Formality: Corporations are creatures of statute which require much formality: 1- You must draft the articles of incorporation. 2- You must file the articles of incorporation (which are not considered filed until recognized by the State). 3- You must file your certificate of incorporation in any state where you do business. 4- You must draft the corporate by-laws. 5- You must draft the stock legends and restrictions (which must be printed on the actual stock certificates). 6- Corporations must hold at least one shareholders’ meeting per year, and either counsel or the Secretary should keep minutes from those meetings. 7- Corporations must hold at least one directors’ meeting each year (if not more often), and keep minutes from those meetings – either taken by counsel or by Secretary. 8- The Directors must issue an annual report to all Shareholders. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 6 5. Sub Chapter S Corporation Definition: A special kind of corporation created for flow-through of profits and losses. NOTE: profits and losses are divided pro rata, and may not be otherwise distributed. Restrictions: Stock may only be held by actual persons (or trusts). Nonresident aliens may not hold stock. There cannot be more than 100 SH. If there are more than 100 SH, it converts the Sub Chapter S to a standard corporation. In order for profits & losses to flow through, all shareholders must sign consent! There can only be 1 class of stock (common) for dividend purposes (BUT: there can be multiple classes for voting purposes) Liabilities: same as a corporation Taxes: so long as all shareholders sign consent, profits flow through (as in a partnership) – thus, the Sub Chapter S Corporation avoids the double-tax. To ensure that a Sub Chapter S Corporation doesn’t grow to have more than 75 shareholders, the founders should put Stock Transfer Restrictions into play. The transfer restrictions might require a shareholder to sell the stock back to the corporation (or pro rata to the existing shareholders), or dictate that, upon death, the stock reverts to the corporation. If you have more than 75 people who want to form a Sub Chapter S Corporation, all isn’t lost. Have 75 buy stocks and make sure that the above-mentioned Stock Transfer Restrictions are written both into the corporate by-laws and on the stock certificates. Have the other investors loan the company money (either in form of bond or debenture). Make the bond/debenture convertible into stock in the event that a shareholder sells his stock back to the corporation. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 7 6. Corpnerships Definition: a limited partnership, where the General Partner is a corporation. Advantages: Limited partners can invest money and enjoy limited liability by forming a corporation which takes their place as the General Partner. The GP corporation takes on liability for the Corpnership, but shields its own shareholders (presumably the Corpnership’s limited partners) from liability. Disadvantages: Not all jurisdictions recognize the legitimacy of Corpnerships. In keeping with Delaney, jurisdictions which don’t recognize Corpnerships argue that such entities are, in actuality, just plain old partnerships. Thus, if you set up a Corpnership in NY, you’d better be certain that you don’t establish contacts in ―Delaney states‖ (such as KS) – because, if you do, you’re toast. The courts will treat you like a normal partnership and will hold the ―Limited Partners‖ liable as regular partners. NOTE: Even in Corpnership-friendly states, you may still be able to hold the limited partners liable (assuming that they’re also the Directors of the General Partner Corporation). You’ll have to use one of the theories of Piercing the Corporate Veil (elements discussed in greater detail, infra): Undercapitalization: to the harm of X, the SH failed to keep enough $$ in the Corporation. Alter-Ego: Although set up as a separate entity, the SH have treated it as their own piggy-bank. Instrumentality: Misrepresentation: If the Corpnership Limited Partners misrepresented who creditors are dealing with… although this is weak, because it’s essentially the argument that the Delaney states make (which NY rejects). Anderson/Abbott: [seemingly inapplicable – Anderson/Abbott theory denies shareholders the ability to use a corporation as a shield to statutorily imposed duties or obligations.] Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 8 7. Limited Liability Company (LLC) Created by the WY legislature to combat DE’s growing power base as the home of corporate law. Corporations have shareholders; LLCs have members. Unfortunately, the statute was (1) adopted by DE and (2) poorly drafted. Thus, LLCs MUST BE DRAFTED BY EXPERTS! Many issues simply haven’t been resolved, so unresolved questions of law must be clearly delineated in the LLC founder’s agreement, such as: 1- What happens if a member dies or goes bankrupt? 2- Can you pierce the LLC veil, as you can with corporations? 3- How do you spread voting rights out amongst members? 4- Etc. Liability: all members enjoy full limitations on liability. Taxes: P&L flow through, if the members unanimously approve and ―check the [I.R.S. form] box.‖ Like a Corporation: No Reverse Liability (so there’s permanence) Better than a SubChapter S Corp because: P&L do not need to be distributed pro rata No restrictions on who may be a member. 8. Limited Liability Partnership (LLP) Liability: No limited liability for contractual debt. However, partners are afforded limited tort liability so long as they have ―clean hands‖—that is, if P1 acts negligently and P2 & P3 didn’t contribute and shouldn’t have anticipated P1’s act, they can’t be held responsible. HOWEVER: You must carry liability insurance. The minimum varies. TX, $100K. DE, $1M 9. Professional Corporation (PC) Established for doctors and lawyers… they enjoy all benefits of corporation EXCEPT limited liability. RESTRICTION: must be of one profession (all doctors, all lawyers). Multiple disciplines okay. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 9 WHO HAS THE AUTHORITY TO BIND A PARTNERSHIP? There are three ―levels‖ of voting within partnerships: 1. UNANIMOUS VOTE: decisions which change the nature of the partnership A pizza shop which decides to start selling women’s jewelry, or dissolving the partnership 2. MAJORITY VOTE: policy decisions When you always order pepperoni, which kind of pepperoni should you order? 3. ANY PARTNER HAS SOLE AUTHORITY: day-to-day decisions (carrying out the policies) Placing the pepperoni order PROBLEM: ―The Parachute Hypo.‖ Courts only grant injunctions where partners have duty not to act. But here, there’s no majority to set a new policy decision (blocking P2’s purchase). Each has sole authority to place the order. P1 can tell the vendor that P2 lacks authority, but that does not kill his implied authority to order. BEST SOLUTIONS: Appoint a neutral arbitrator (3 rd vote) in the partnership agreement to tackle these problems, or Put in the partnership agreement that all purchases over $1,000 require unanimous approval. When we talk about each partner’s individual authority to bind the partnership, we break it down further: 1. EXPRESS AUTHORITY: express, written, or otherwise stated authority to act. EX: John has the express authority to hire and fire employees, and to reorder supplies. REMOVE BY: altering whatever documents bestow the express authority. 2. IMPLIED AUTHORITY: not everything can be stated, so some authority it implied. Implied authority is best defined as ―whatever is reasonably implied in day-to-day management.‖ EX: Anything within ―carrying out day-to-day decisions‖ but not covered by express authority. REMOVE BY: arguing that the partner’s actions aren’t carrying out day-to-day decisions, but instead are policy decisions (which require majority vote). 3. APPARENT AUTHORITY: a subset of Implied Authority. It exists when the partner lacks authority to act but, to an outsider, it appears that he has authority. EX: Three partners… majority vote not to re-order item X. The third partner reorders the item anyway. When the bill comes in, the partnership refuses to pay because P3 ―lacked authority.‖ Because the Partnership did not put the vendor on notice that P3 lacked authority to order, the court will find apparent authority so that vendor may hold partnership liable. Note: if it’s an item that the partnership regularly orders, the court will find apparent authority. But if it’s an item that’s ordered for the first time, onus on vendor to determine authority. SMITH v DIXON: 2 kinds of apparent authority: (1) co-extensive with implied authority, and (2) historical/precedential apparent authority (done in the past, so he still has authority to do it). VENDOR BEWARE! Partnership not required to put vendor on notice of partner’s (in)ability to act. If V asks P1 if P1 has authority and P1 says ―yes‖ (when answer is ―no‖), the partnership is not liable. HERE: Vendor should have checked the partnership agreement… HERE: Vendor may sue P1 for misrepresentation. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 10 PROMOTERS: one who contracts on behalf of a Corp. before the corporation comes into existence. CORPORATE LIABILITY STEMMING FROM PROMOTER CONTRACTS REMEMBER: Corporations are born free from liability. Corporations are not held liable for the promoter’s contracts unless/until the corporation ratifies the contract (this is true both for returnable products and for non-returnable products and services). Contracts formed between vendors and the corporation-to-be are treated as offers that the corporation either accepts (ratifies) or rejects after formation. If a corporation impliedly accepts the benefit of a contract, the court will find that it accepted the contract and hold it liable for its contractual obligations. EX: the corporation profits from Lisa’s manuscript without ratifying Lisa’s contract. PROMOTER PROFITS FROM CORPORATE CONTRACTS GENERALLY: A promoter who later assumes control of Corp. can’t profit from agency dealings. BUT: There are 5 ways that Promoters may take profits. 1- The promoter does not take control of the corporation, fully discloses his profits to the Board of Directors, and the Board approves the contract. 2- The promoter retains control of the corporation, but the other independent shareholders ratify the purchase and profit after the promoter makes full disclosure. 3- Massachusetts Promoter Fraud Rule: A promoter may profit if: i. The promoter becomes a Director and the sole Shareholder, and ii. The purchase of property will not affect the corporation’s solvency. 4- Promoters may also take a profit if they sell property to the corporation that they acquired before they began the agency relationship. EX: John inherits land before promoting Corp. X, and later sells this land to Corp. X. 5- Suppose a promoter buys land and discovers it is worth much more than the purchase price. He may sell the land and profit from the sale of the land if he never sets up the corporation. PROMOTER LIABILITY A promoter’s liability depends on the intent of the parties. o When V knows that C isn’t formed and performance to take place before formation, we presume V intended someone to be liable. Thus, Promoter has burden of proving otherwise. o Easiest defenses: K Clause ―Parties don’t intend promoter to be liable.‖ When V knows that C isn’t formed and performance to take place after formation, the burden falls on V to prove that the parties intended the promoter to be held liable. When P & V sign K, Corp. ratifies, and Corp. fails to perform – same rules apply. o If V performed before C’s formation, P bears burden of proving he shouldn’t be held liable. Best defense: novation clause (once ratified by C, C absolves P of all liability). o If V performed after C’s formation, V bears burden of proof. o o Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 11 SETTING UP A CORPORATION 1. Find out how much each shareholder invests & fill in the STOCK SUBSCRIPTION AGREEMENT. 2. Draft the ARTICLES OF INCORPORATION. 1- Who are the incorporators? i. Names & Addresses 2- Capitalization (how we get $$ into the corporation) i. Common Stock ii. Preferred Stock Note: a corporation can accept 3 things for stock: $$/property, secured debt, or services already performed We must note the # of shares authorized & # of shares immediately issued. 3- The Corporation’s Purpose (in most states, we now say the corporation exists ―For Any Lawful Purpose‖) 4- Name the Authorized Agents for Service of Process 5- Original Directors i. Names & Addresses 6- Original Officers i. Names & Addresses 7- Special Provisions (as mandated by state statutes) THE ARTICLES MUST BE FILED WITH THE STATE SECRETARY // COMMISSIONER OF CORPORATIONS! 3. STATEMENT OF CONDITION (filed annually to notify state of incorporation of any changes to the Articles of Incorporation). 4. THE BYLAWS 5. MINUTES OF THE 1ST INCORPORATORS’ MEETING 6. MINUTES OF THE 1ST DIRECTORS’ MEETING 7. Order the STOCK CERTIFICATES Be sure to fill out the stock legends & restrictions. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 12 DEFECTIVE INCORPORATION Defective incorporation is subject to two types of attack: 1. QUO WARRANTO proceedings (attack by the state) 2. Attack by private parties Why? Because if it’s not a corporation, it’s a partnership – o 2 or more people / doing business together / as co-owners / for profit – and all the partners can be held liable (joint liability for contract liability, joint & several for tort liability). Corporations can raise 3 defenses to such attacks. They’ll argue that they are a: 1. DE JURE CORPORATION: organized under state law, but done so imperfectly There are mandatory (―You must . . .‖) and directory (―You should . . .‖) requirements. If a corporation fails to satisfy a mandatory requirement (i.e., filing the Articles), it is defective. If it fails to satisfy a directory requirement, the court will hold that the corporation was a De Jure Corporation all along & will order it to remedy the issue ASAP. 2. DE FACTO CORPORATION De Facto Corporations will hold up against private attacks but not against Quo Warranto proceedings There are 3 Elements: 1. Does the State have a statute permitting incorporation? 2. Was there a good faith attempt to incorporate? 3. Was there an attempt to exercise corporate powers? (They sign contracts & enter into deals as a corporation.) 4. [the 4th unspoken element – is it fair to call it a de facto corporation?] 3. CORPORATION BY ESTOPPEL The π will never claim that the Δ was a corporation by estoppel; corporation by estoppel is a defense employed when π seeks to hold Δ personally liable. There are 3 Elements: 1. Misrepresentation (Δ says: π acted as though contracting with Corp. & holding only the Corp. liable.) 2. Justifiable Reliance (Δ says: I justifiably relied on my limitation of liability) 3. Harm (damages sought by π) Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 13 PIERCING THE CORPORATE VEIL You can pierce horizontally or vertically. The same tests apply in either case. 1. UNDERCAPITALIZATION i. Gross & Deliberate Undercapitalization Take into consideration—what kind of business is it? What’s the risk or either contract or tort liability? Would an insurance policy balance out against little liquid capital? Keep in mind that it must be both gross and deliberate. If a corporation is just slightly or accidently undercapitalized, this theory doesn’t work. ii. Participation by the SH you want to hold liable iii. Unfairness iv. Harm WALKOVSKY v. CARLTON (taxi cab case): Undercapitalization theory failed b/c the legislature had defined ―reasonable‖ insurance coverage by statute. Thus, it wasn’t gross undercapitalization. 2. ALTER-EGO THEORY i. The corporation is the alter-ego of the shareholders. Most common proof: the SHs are shuttling funds in and out of the corporation without going through the normal formalities (dividends, salaries, etc.) – they are using the corporation as a personal bank account. ii. Unfairness iii. Harm 3. INSTRUMENTALITY THEORY i. The Shareholders dominate the will of the corporation. per Dobbyn, this is always true… ii. Unfairness iii. Harm 4. MISREPRESENTATION i. There’s been some misrepresentation about who the πs are doing business with. If Δ creates a dummy corp. but represents that π does business with other… ii. Unfairness iii. Harm 5. ANDERSON v. ABBOTT i. ―Corporateness‖ used to avoid statutory liability or to circumvent well-established public policy. EX: ins. co.’s argument in Dobbyn’s hypo about family-owned Deli (son sues father) FLETCHER v. ATEX (the Kodak case): no piercing the veil because Kodak did everything correctly: 1. Not undercapitalized, because substantial capital left in each corporation. 2. Not alter-ego, because all transfers made as loans with proper documentation & ratification by BoDs. 3. Not instrumentality, because each board acted independently & made decisions for respective corp. 4. Not misrepresentation (not an issue here) 5. Not Anderson v. Abbott (not applicable here) Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 14 SUBORDINATION OF SHAREHOLDER DEBT It’s like piercing the corporate veil, only less severe. Under one of the following theories, we find that debts owed to shareholders are subordinated to debts owed to outsiders. 1. UNDERCAPITALIZATION i. Gross & Deliberate Undercapitalization A showing of ―gross‖ undercapitalization for subordination of s/h debt doesn’t have to be as severe as it might to pierce the corporate veil. ii. Perpetrated by the shareholders whose debt we wish to subordinate iii. Unfair iv. Harm 2. ALTER-EGO i. The shareholders use the corporation as their alter ego Typically, S/H use the corporation as an alter-ego by shuttling funds into and out of the corporation as though it were a private bank account. ii. Unfair iii. Harm 3. INSTRUMENTALITY i. The shareholders exercise dominion over the corporation (control the corporation) ii. Unfair iii. Harm COSTELLO v. FAZIO Partners reorganize, emerge as corporation, and go bankrupt. Partners’ (now S/H’s) debts subordinated. Why? In this case, shareholder debt was subordinated on a theory of undercapitalization. Although the shareholders still had the same amount of $$ into the corporation as they had into the partnership: o As a partnership, the partners remain individually responsible for the partnership’s debts (either jointly (contract), or jointly and severally (tort)). As a corporation, the partners enjoyed limited liability. The limitation on liability created an atmosphere where it was inappropriate to leave so little money within the corporation. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 15 PROXY VOTING If a shareholder cannot make it to a meeting, he or she may vote by paper proxy. The proxy must state the time, place, and purpose of the meeting. If it’s a special meeting, it must state the purpose with specificity. If it’s a general meeting, there’s no need to state the agenda. Who Pays For the Proxies? 1- Management (the group of shareholders that controls the board of directors) Management may use funds to: 1. Give notice of the meeting to SH 2. To induce SH to reply, in order to raise a quorum This is true regardless of what the battle is over. Management may use funds to advocate a position if – 1. It’s over policy, not personnel, and 2. The expenses are reasonable The term ―Reasonable Expenses‖ is loosely construed. Per Dobbyn, the line lies somewhere between persuasion & bribery. 2- The Insurgents 1. The fight is over policy, not personnel, 2. The expenses are reasonable, 3. And the insurgents must win to get paid. 4. Per Dobbyn: some jurisdictions require shareholder approval. Revoking Proxies To revoke your proxy, simply: 1- send in a notice of revocation. 2- send in a second proxy. 3- show up to the meeting. 4- die or become incapacitated. To avoid a proxy fight, skip to § 228 – CONSENTS Under §228, shareholders may file consents for any issue that shareholders must or may vote upon at a regular or special meeting. If enough shareholders file consent that it would have passed by shareholder vote at the meeting, it passes. You don’t need to give notice, you don’t need to go through all the cost of sending out and gathering proxies. NOTE: you can do this so long as the Articles don’t state otherwise… NOTE: this doesn’t work for removing Directors. The Due Process requirement trumps §228. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 16 REMOVING DIRECTORS In DE, Directors may be removed for cause so long as they have due process: 1- Full notice of the time & place of the meeting 2- Full notice of the charges 3- An opportunity to defend himself (often done through the proxy campaign). Assuming that you are in a jurisdiction which allows removal only for cause… [NOTE: under §141, Directors may be removed with or without cause… unless the board’s classified, in which case directors may only be removed for cause (unless otherwise stated in the Articles).] Suppose the director has received notice of the time, place, and charges, and the charges do not amount to cause… … the director may go to an Equity Court and demand an injunction. Suppose the director has heard rumors of a meeting, but hasn’t received any notice… … an injunction is appropriate because he has not received notice. Suppose the director has received the charges, but they’re not true… … no injunction. He instead can defend himself both by proxy fight and at the meeting. Suppose the evidence presented won’t be sufficient to prove cause… … no injunction. … but, after the evidence is presented, if it wasn’t sufficient to convince a reasonable man to remove the director for cause, he can get an injunction. Suppose a Class A S/H discovers that Class B Directors are stealing trade secrets. Can he remove them? NO. He cannot elect them, so he cannot remove them. But he can get an injunction to stop them from entering the building & stealing trade secrets. KINDS OF INJUNCTIONS 1. Temporary Restraining Order (TRO) We need an immediate injunction. Otherwise, irreparable harm will befall π. Further, there’s no harm to Δ because Δ is doing something he didn’t have a right to do in the first place. Only valid for 10 days. 2. Preliminary Injunction Scheduled during the TRO. Both sides put on evidence to prove that a permanent injunction is or is not necessary. 3. Permanent Injunction Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 17 CORPORATE CONFLICTS – HIERARCHY OF LAW If a conflict arises between any two of these sources, defer to the higher authority. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Constitution Federal Statutes Federal case law State Constitutions State Statutes State case law Articles of Incorporation The Bylaws Stock Legends / Restrictions Shareholders’ Resolution Directors’ Resolution SHAREHOLDER POWERS v. DIRECTOR POWERS ―Management By Gimmicks‖: Assume you have a board of 5… Voting agreement: 3 of the 5 agree to vote together. This works best when it’s not needed. The moment the 3 have a disagreement on some issue, the voting agreement is likely to fall apart. Voting trust: a lawyer sets up a trust, and the 3 S/H give their stock to the trust. The trust issues each S/H ―voting trust certificates‖ which grant the dividend and liquidation rights back to the S/H. But the trust retains all voting rights, which are exercised by the trustee. This is a game to see who controls the corporation: the Shareholders or the Directors. In all cases, you have to ask yourself: does your client have an effective power base within the organization to accomplish his goals? If so, proceed. If not, go to the court of equity. The hierarchy (above) may determine whether your client will succeed in court… §141(a) The Corporation’s business is managed by the Directors, and their powers are controlled by the Articles of Incorporation. If you have a Board of 1, that’s quorum. Otherwise, quorum is a majority (unless stated otherwise by the Articles or Bylaws). §141(b) Generally, shareholders define the business and elect the Directors. The shareholders set the boundaries… but from there, the Directors are in charge of all policy decisions. What one can do, the other can’t! Can the shareholders say: a free coke with each purchase? No. Can the directors? Yes. Can the shareholders say: we sell to wholesale now… we should adapt and sell to retail? Yes. Can the directors? No. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 18 SHAREHOLDER POWERS v. DIRECTOR POWERS (cont’d) CHARLESTOWN BOOT & SHOE: the business was folding and the S/H wanted the board to work with a man of their choosing. The S/H passed a resolution to that effect. The Board ignored the resolution and problems ensued. The S/H did not have an effective power base, because the Directors ignored the resolution. The Equity Court found: the directors were not bound by the S/H resolution. The S/H lacked the power to tell the Directors how to do their job (in this case, to follow Osgood’s advice). DOBBYN: The S/H should have ousted the Directors, and replaced them with stooges. AUER v. DRESSEL: Auer (the majority S/H) was fired as President. He wanted to do three things: to (1) get rid of 4 (of 11) crooked Directors; (2) replace those 4 with men of his own choosing; and (3) to have himself reinstated as president. Auer had a power base in the corporation because he was the majority S/H. He could not exercise this power, however, unless he acted at a S/H’s meeting. Thus, under direction provided by the Articles of Incorporation, he requested the new President of the Corporation to call a meeting. (When the president refused, Auer went to the Court—the Court ordered the meeting). Note: Auer couldn’t file a consent to remove the directors, b/c that would strip them of due process. Auer has the directors removed for cause. The Board argued that, under the Articles, only the Directors had the power to remove Directors for cause. Auer argued successfully that the original incorporators could not have given the power to remove a crooked board to the same crooked board. The power, then, existed concurrently in both parties. Auer lacked the ability to fill Directors’ positions between regular meetings because, per the Articles and By-Laws, the power to fill interim seats was vested in the Directors. Thus, Auer moved to amend the Articles and By-Laws to give this power to the S/H. S/H have the power to amend Articles and By-Laws. o Because this was a meeting of only the Class A S/H, Auer restricted the amendments so that they only affected the Class A S/H. Otherwise, it would have required the vote of all shareholders. THE S/H MAY PASS A RESOLUTION ADVISING THE BOARD OF THEIR FEELINGS ON CERTAIN ISSUES… BUT THE S/H CANNOT DICTATE TO THE BOARD WHAT IT SHOULD DO. THE S/H CANNOT APPOINT OFFICERS—THAT POWER LIES WITH THE BOARD. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 19 SHAREHOLDER POWERS v. DIRECTOR POWERS (cont’d) These rules define the limits of Directors’ Powers. 1. SCHNELL v. CHRIS-CRAFT: Directors cannot use corporate powers to benefit themselves. They can only use corporate powers for good corporate purposes. 2. BLASIUS: A Board of Directors may not unilaterally impede or dilute shareholders voting power where the S/H seek to undertake legitimate actions within the shareholders’ power The Board didn’t act unilaterally—the S/H ratified the Board’s actions. o Stroud v. Grace: S/H cannot ratify Board actions where those actions are 1. Fraudulent 2. A waste of corporate assets 3. A breach of the Director’s fiduciary duties 4. [OR—where the ratification wasn’t based on full disclosure.] This wasn’t a legitimate exercise of S/H power—the S/H don’t have these powers. If π meets his burden of proof, Δ Directors must prove that their actions were Intrinsically Fair How? By proving that their actions were for a ―Good Corporate Purpose.‖ Examples: 1. Even though the Directors’ actions interfere with legitimate S/H voting or action, it’s Intrinsically Fair because the Directors’ actions were for a good corporate purpose. o For example: the Board amends the bylaws under §109 to add two new Board positions and fills the vacancies for a good corporate purpose when: The 2 are from CA, and Corp. expansion is in the Western 11; The 2 are techies, and the Board doesn’t understand their product line; The 2 are outsiders who will ensure that the accounting is all above board. This is true even though adding these Directors to the Board may interfere 2. The S/H action would have harmed the corporation (thus violating the S/H’s fiduciary duty not to harm the corporation). o NOTE: selling stock to a shark most likely doesn’t constitute harm to the corporation, even if it’s known that the shark’s going to recapitalize the corporation. For it to be harmful, it would have to be an extreme case. 3. UNOCAL: A Board of Directors may not take defensive action unless: i. There was an actual threat to the corporation, and ii. The measures undertaken by the board were reasonable in proportion to the threat. BLASIUS trumps UNOCAL. If the Board acts to prevent a threat to the corporation and its actions impede a legitimate S/H vote, the Board must prove that it was fair to impede S/H action under BLASIUS. If it wasn’t intrinsically fair, the Board’s actions are reversible. If it was intrinsically fair, the Board’s actions are still subject to UNOCAL review. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 20 OFFICERS Officers carry out the will of the directors. Day-to-day, they carry out the Board of Director’s policies. The Question: If an officer acts, is the corporation bound? When do officers have power to bind the corp.? The 5 Sources of Authority for Any Officer: 1- Express 2- Implied 3- Apparent 4- Course of Conduct: 1- The officer acts beyond his Express and Implied Authority 2- The officer has previously done this 3- The Directors permitted this act in the past when they all knew or should have known 4- And they acquiesced by silence. 5- The 3rd Party wants the Corp. bound b/c he relied on Officer’s authority in the past. 5- One Shot Deal 1- The officer acts beyond his Express and Implied Authority 2- All the Directors knew or should have known of the action, 3- And acquiesced by silence. 4- The Corp. receives some benefit or the 3 rd party acted to his detriment. President 12345- Express Implied: the President has the power to execute all contracts in the usual course of business Apparent ―Course of Conduct‖ ―One Shot Deal‖ Vice President The VP has the same authority as the president. Some VP’s authorities are limited by title—e.g., VP of Finance. Note: if the Board limits the President’s authority to act, it simultaneously limits the VP’s authority. CEO / GM Same authority, except 2- Implied: CEOs & GMs may make minor policy decisions. EX: the nurse hypo. Treasurer 2- Implied: to give & receive receipts for funds. If you give the Treasurer a check & he gives you a receipt—you are free & clear. Secretary 2- Implied: to certify the authenticity of corporate documents Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 21 CERTIFICATION OF THE BOARD AND CLASSIFIED STOCK Board Certification: When you have a board of 9, and only 3 seats come up for election each year. Stock Classification: Rather than getting one vote for each share of stock that they own, stockholders get as many votes as = (share of stock owned) x (number of seats up for election). They can use all or none of their votes for each seat. To determine how many shares you need to fill a board position: X = (# of shares outstanding) x (# of seats open) +1 (# of seats you want to fill) + 1 If you start a corporation, be sure to include a certified board and classified stock – it’s protection against sharks. If you have 3 folks up for election each year, it will take 2-3 years for the shark to get control. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 22 FIDUCIARY DUTIES OF DIRECTORS 1. BUSINESS JUDGMENT RULE π: The Corporation (brought by the S/H as a derivative action) Δ: The offending Directors C/A: either negligence or bad faith Remedy: equitable or $$ damages A: Negligence: failing to do your homework / due diligence Elements: 1- Negligence 2- Causation o Generally: if you sue less than the entire Board, hard to prove causation. o Difficult to prove. (BONDS v. ANDREWS: Negligent, but could D solve strike?) 3- Damages Every director is responsible for knowing what’s going on with the corporation. B: If you accept a Board position with a business AFFECTING A PUBLIC INTEREST, you hold yourself out as having special knowledge: Banks Insurance companies Public utilities KAIMIN v. AMERICAN EXPRESS: where Directors do their homework, courts are slow to overturn their decisions. NOTE: §102(b)(7): If in the Articles of Incorporation… provision eliminating $$ damages for breach of the negligence prong of the Business Judgment Rule. C: Bad Faith: Directors’ actions must be 100% for the Corporate interests. Elements: 1- Bad Faith 2- Causation 3- Damages Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 23 FIDUCIARY DUTIES OF DIRECTORS (cont’d) 1. BUSINESS JUDGMENT RULE (cont’d) THE ENHANCED SCRUTINY RULE Applies to any deal which shifts control of the corporation: mergers, takeovers, etc. As Applied to Negligence Claims π: alleges negligence sufficient to survive a motion to dismiss (low standard) Δ: must prove non-negligence & reasonableness π: proves causation & damages As Applied to Bad Faith Cases π: alleges bad faith sufficient to survive a motion to dismiss (low standard) Δ: must prove intrinsic fairness to the corporation and S/H π: proves causation & damages (In either case, if Δ fails to meet his burden of proof, π is automatically entitled to equitable relief.) Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 24 FIDUCIARY DUTIES OF DIRECTORS (cont’d) 2. INTERESTED DIRECTOR RULE π: The Corporation (brought by S/H as a derivative action, or by the other directors) Δ: The other party to the contract C/A: Interested Director case. Either: - The corporation contracts with one of its directors, or - The corporation contracts with another corporation and they share at least 1 director Remedy: the only available remedy is rescission of the contract Burdens: π proves: it’s an IDR case. Flips to Δ to prove 1 of 3 things: 1. The contract was approved by a majority of independent uninterested Directors. π proves: the deal was unfair to the corporation. 2. The contract was approved by a majority of independent uninterested S/H. π proves: the deal was unfair to the corporation. 3. The deal was scrupulously fair. π proves: damages (NOTE: only remedy is rescission) What if the contract was for consumable goods or non-returnable services? The Corporation should bring a separate suit for UJER. TALBOT v. JAMES: an agent cannot take a secret profit from agency work. The principle must approve the profit. James contracted with corporation (he was a director). He did not disclose his $20,000 profit. DOBBYN: Corporation should have brought an IDR suit against James. After proving that it was an IDR case, the burden would flip to James to show that either: (1) the directors approved it (nix); (2) the S/H approved it (nix); or (3) it was scrupulously fair to the corporation. He might do this by presenting evidence as to what other contractors would charge, including their profit margins. If he failed to make his case, he would lose. Since rescission of the contract couldn’t undue construction of the building, the corporation would slap him with an UJER suit for the $20,000. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 25 FIDUCIARY DUTIES OF DIRECTORS (cont’d) 3. USURPATION OF A CORPORATE OPPORTUNITY π: Corporation Δ: the Director C/A: Usurpation of a Corporate Opportunity Remedy: a constructive trust The Coca-Cola Test: based on Interest & Expectancy THE BURDEN RESTS WITH π. 1. Did the corporation have an interest in the opportunity? 1) If the board was fully informed of the decision and passed a resolution that it was not interested, the corp. did not have an interest & the director may act on the opportunity. 2) If the board knew of the opportunity but did not pass a resolution (in either direction), the director cannot act on the opportunity. 3) If the board didn’t know about it – go to Question 2. 2. Did the corporation have expectancy in the opportunity? It comes down to a totality of the circumstances test, based on-1) Was the corporation able to financially handle the opportunity? 2) Did the opportunity relate to the Corporation’s current business? 3) If it’s related to the business—was it essential to the corporation? 4) Does the opportunity put the Director in a conflict of interest with the Corporation? 5) Did the opportunity come to the Director in his capacity as a Director? 6) Did the Director use Corporate funds to seize the opportunity? The Klinicki v. Lundgren Test 3. Is it a Corporate Opportunity? If ―No‖ to all 3, stop. If ―Yes‖ to one, continue. If the director = full time: Is this opportunity in the Corporation’s line of business? If the director = part time: Should the director reasonably have expected opp. to be of interest to the Corp? Did the person who communicated the Opp. expect Director to turn it over to Corp.? 4. Did the Director offer the Opportunity to the Corporations? No STOP. The Director loses. Yes Continue to Question #3. 5. If the Director offered the Opportunity to the Corporation, was it rejected by: A disinterested majority of the Directors? - The Business Judgment Rule applies - Directors must have full disclosure! A disinterested majority of the voting S/H? - S/H must have full disclosure! Was it absolutely fair for Δ to take the opportunity? Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 26 FIDUCIARY DUTIES OF DIRECTORS (cont’d) 3. USURPATION OF A CORPORATE OPPORTUNITY (cont’d) HYPO: Corporation X needs a patent. It contracts to buy Corporation Y & all its assets effective 4/15. On 4/10, Corporation X realizes that it lacks the resources to do it. Q: may a Corporation X director step in to buy Corporation Y personally? A: No. IRVING TRUST v. DEUTSCH Under the Coca-Cola test, it would be different if: - the Board passed a resolution passing on the opportunity. Under the Kliniki test, it would be different if: - the opportunity was rejected by a disinterested (and fully informed) majority of directors, - the opportunity was rejected by a disinterested (and fully informed) majority of S/H, or - it was absolutely fair to the corporation Here, it is not absolutely fair. Although the corporation lacks funds today, it may be able to borrow or otherwise raise capital between 4/10 and 4/15, negotiate a payment plan, or make some other arrangements. HORN: (the Brooklyn apartment case). A director was hired to help a Corporation buy apartments because of his related experience. While serving as Director, he buys two apartment buildings for himself. The court ruled that this wasn’t Usurpation of a Corporate Opportunity. Why? DIRECTORS WITH SPECIAL EXPERIENCE: 1- Had the Director previously been in this business? 2- Had the Director continually been in this business for himself? 3- Was the Director employed full time by the corporation? Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 27 FIDUCIARY DUTIES OF MINORITY SHAREHOLDERS Minority duties have only one duty: not to sell their vote / right to vote. FIDUCIARY DUTIES OF CONTROLLING SHAREHOLDERS OVERREACHING MINORITY SHAREHOLDERS π: the minority/non-controlling shareholders Δ: the controlling shareholder(s) c/a: overreaching minority S/H to the benefit of controlling and detriment of minority S/H Remedy: either equitable or financial damages Burdens of Proof π: demonstrate the controlling S/H overreached the minority S/H to controlling S/H’s benefit and the minority S/H detriment. Δ: [demonstrate that the deal was affirmatively fair – and affirmative defense] π: causation, damages ZAHN: controlling S/H forced board to call Class B stock (which enjoyed 2x liquidation preferences) so that, after the call, the controlling S/H could liquidate the assets and keep all profits for themselves. The court found that the controlling S/H overreached to their benefit and the minority’s detriment. BUT: the controlling S/H can act to the minority’s detriment if it’s in the best interests of the corp. Example: eliminating preferred stock to effectuate a merger. Example: giving common S/H greater dividends to drive up market price of corporation (this helps the corporation raise capital) OVERREACHING – INTERESTED MERGERS An interested merger occurs when the same party sits on both sides of the deal. If it’s not an interested merger, π must prove that they did not get a reasonable price for their stock. If it is an interested merger, Δ must prove that π received a fair price & it is a fair deal. To avoid problems, directors dealing with interested mergers should appoint an independent board to appraise the situation. Test for independence: 1. Did the controlling S/H control the terms of the merger? 2. Did the so-called independent directors have arm’s length negotiating power? Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 28 SALE OF CORPORATE ASSETS A controlling S/H may sell his controlling stock at a premium. Control of the corporation is not a ―corporate asset‖ such that profits must be split amongst all S/H. HOWEVER: S/H have a duty not to sell the control or ―good will‖ of the corporation to someone who will hurt the corporation. PERLMAN v. FELDMAN: Feldman sold his controlling share, which meant that the buyer controlled who the corporation would sell its product to (product was steel, during the Korean war…). This was the sale of a corporate asset, even if no harm befalls the corporation! Damages = (the $$ Feldman received for his stock) – (FMV of the stock) This difference represents the cost of the ―good will‖ Feldman sold. The result (the damages) are then apportioned amongst all S/H. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 29 DIVIDENDS REMEMBER: Dividends are issued by the Board. Like all decisions made by the board, the decision to issue dividends is subject to the Business Judgment Rule (negligence/bad faith)! TYPES OF SURPLUS: Earned Surplus: (all profits since Day 1) - (all losses & costs since Day 1) Paid in Capital Surplus: the difference between what the corporation sold its stock for and the par value. Reduction Capital Surplus: the resulting surplus after a reduction of par value (for existing stock) JURISDICTIONS Balance Sheet Surplus Jurisdiction (DE, NY): pay dividends out of any kind of surplus Earned Surplus Jurisdictions: you can only pay dividends out of Earned Surplus CA: CA eliminated par values (leaving only liabilities & surplus). You can pay dividends so long as it doesn’t leave the corporation insolvent (either where it’s bankrupt or functionally unable to pay its bills). RANDALL v. BAILEY: - You can write up and must write down the value of assets when determining surplus to issue dividends. For all other purposes, you must follow G.A.A.P. NOTE: writing up the value of assets is subject to the Business Judgment Rule (negligence/bad faith). To avoid potential issues, Directors should hire an independent board to evaluate and re-evaluate the values of assets. - It may be unreasonable to write up the value of non-liquid assets—such as the warehouse or manufacturing equipment. - You don’t have to write something all the way up. If worth $8M, you can write up to $7M. NIMBLE DIVIDENDS Allowed in DE by statute – see §170. If the corporation doesn’t have any surplus (because DE is a Balance Sheet Surplus jurisdiction), it may issue a dividend which is the lower ceiling of: - This year and/or last year’s profits - The extent to which assets exceed (liabilities + preferred capital) Paying nimble dividends benefits one class over another – the common over the preferred. It is not overreaching, however, because it is intrinsically fair. It drives up the value of corporate stock & raises capital. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 30 § 251 MERGERS and CONSOLIDATIONS Class A – Tax Free… EXCEPT: S/H who are cashed-out or demand appraisal rights must pay taxes. §251 Merger (Long-Form Merger) - A & B come together and only A survives. - The voting shareholders must get 20 days’ notice of the time, place, and purpose of the meeting. The corporation must give the S/H notice of their appraisal rights. The corporation must give the S/H a copy of the Merger Agreement or summary thereof. - A SH get voting rights and non-voting/dissenting A SH get appraisal rights. - B SH get voting rights and appraisal rights. - §251 sets forth the requirements, what needs to be done. - §259 dictates that all of B’s assets and liabilities automatically transfer to A. Liabilities include: normal debt, lawsuits, warranties, etc §251 Consolidation - A & B come together and C emerges. - The voting shareholders must get 20 days’ notice of the time, place, and purpose of the meeting. The corporation must give the S/H notice of their appraisal rights. The corp. must give the S/H a copy of the Consolidation Agreement or summary thereof. - A SH get voting rights and appraisal rights. - B SH get voting rights and appraisal rights. - §259 dictates that all of A’s & B’s assets and liabilities automatically transfer to C. Liabilities include: normal debt, lawsuits, warranties, etc For either a merger or consolidation: - Note that both are statutory creatures. Thus, if you’re going to do either, you must follow the statutes exactly. - Once the corporations have voted for the merger/consolidation, each corporation’s Secretary must certify the vote. - Finally, the Secretaries file the certified votes and the Merger/Consolidation Agreement with the State Secretary. The merger/consolidation becomes effective as soon as the State Secretary files the documents, unless the Agreement stipulates that it becomes effective at a later date. § 262 – APPRAISAL RIGHTS When S/H enjoy appraisal rights, they are free to demand an independent evaluation of the fair market value of their stock (so that the surviving corporation can buy them out). S/H must notify the corporation of their intent to demand appraisal rights before the vote, so that the surviving corporation understands the extent of the liabilities it takes on. - The quantity of shares it must buy, and at what price Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 31 STOCK-FOR-STOCK and STOCK-FOR-ASSET COMBINATIONS These are not defined by statute. Thus, no one gets appraisal rights. Stock-For-Stock Combinations (Class B – Tax Free) A approaches B’s shareholders directly and offers them stock in A Corp for their stock in B Corp. This only works if A can acquire a majority of the voting B Corp. Stock (perhaps 30-50%) A SH do not get voting rights, b/c A merely acquires assets with previously authorized stock. The B S/H do not get a formal vote, because they individually decide whether or not to exchange their stock in B Corp. for stock in A Corp. Typically, A Corp. would follow this with either a §253 or §251(f) short form merger. Advantages: - A gets no vote, and B doesn’t get a formal vote. - No appraisal rights (unless followed with a short-form merger – and even then, the potential liability stemming from the appraisals is much less b/c it’s only a minority of B S/H). - A does not have to absorb B’s liability. - Can be done even if B Corp’s Directors are hostile, because you don’t need their support. Disadvantages: - Leaves A (and A SH) open to piercing of the corporate veil. The potential exists for: Instrumentality theory Alter Ego theory Undercapitalization Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 32 STOCK-FOR-STOCK and STOCK-FOR-ASSET COMBINATIONS These are not defined by statute. Thus, no one gets appraisal rights. Stock-For-Assets Combinations (Class C – Tax Free) Corp. A approaches B and trades A Corp. stock for all of B’s assets. If B distributes the A Corp. stock as a dividend, there’s a strong argument that A should have to assume all of B’s liabilities. If B acts as a holding company for the A stock, it has assets to offset its liabilities, thus weakening the same argument. Before the combination: A & B should notify B’s suppliers & customers that A will be assuming all assets and new liabilities, and the B will keep the old liabilities. Amend contracts to reflect same. Advantages: - No minority shareholders left over to deal with later by short-form merger. No need to go through a second step—we’re already where we need to be. - No danger (as with a Stock-For-Stock Combination) of piercing the corporate veil. - No need to approach individual shareholders. Instead, the directors pass a resolution and send it to the S/H, who vote all at once. The one vote is binding upon all. Disadvantages: - It can only be done on a friendly basis because you need the B Corp Directors’ vote. - Transferring all of the assets from B to A can be costly and time consuming. - The formal B S/H vote is time-consuming and costly (proxy solicitations…) Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 33 SHORT FORM MERGERS – §253 & §251(f) § 253 – Merger of a Parent and Subsidiary Corporation Applies only when A owns > 90% of B WHEN ―A‖ IS THE SURVIVING CORPORATION How it works: - File a ―Merger Agreement‖ demonstrating that board Boards approve the merger. - Neither the A nor B S/H get a vote. - A S/H do not receive appraisal rights, because their stock ownership hasn’t changed. - The minority B S/H receive appraisal rights. WHEN ―B‖ IS THE SURVIVING CORPORATION How it works: - File the ―Merger Agreement,‖ same as above. - The minority B S/H do not get voting rights, because they still own shares in B. - The A S/H get voting rights, because you’re switching the name from ―A‖ to ―B.‖ - The A S/H do not get appraisal rights, because – although the name is different – the substance of the company remains the same. - As above, the minority B S/H receive appraisal rights. § 251(f) – Another Short Form Merger Used when A owns < 90% of B. NOTE: Under §251(f), A must be the surviving corporation. A does not get voting or appraisal rights if: (1) A’s Articles of Incorporation remain unchanged. (2) A’s S/H aren’t affected. (3) The amount of common stock A offers to the B SH does not increase the outstanding common stock of A by more than 20%. [for such purpose, we include everything that is convertible to common stock – including convertible preferred stock and convertible loans/debentures] B does not get voting rights, but still gets appraisal rights. Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 34 STOCK SPLITS Business Orgs * Prof. Dobbyn * Spring 2009 * Justin Kerner Page 35
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