PARTNERSHIPS, CORPORATIONS AND THE VARIANTS PROF. BRUCE MCCANN LECTURE 12 DIVIDENDS AND DUTY OF CARE PP. 479-528 Business Organizations 2009-2010 Lectures

PARTNERSHIPS,CORPORATIONS

AND THE VARIANTS

PROF. BRUCE MCCANN

LECTURE 12DIVIDENDS AND DUTY OF CARE

PP. 479-528

Business Organizations2009-2010 Lectures

PIERCING THE CORPORATE VEIL

Lec. 12, pp 479-528 Corporations Prof. McCann

The issue is not whether the corporate entity should be disregarded for all purposes, nor whether its very purpose was to defraud the plaintiff. Rather, the issue is whether in the particular case and for purposes of that case "justice and equity can best be accomplished and fraud and unfairness defeated by a disregard of the distinct entity of the corporate form." (Kohn v. Kohn (1950) 95 C.A.2d 708)

Sea-Land Rule


Corporate entity will be disregarded and veil of limited liability pierced if: There is a unity of interest and ownership such that the

separateness of the personalities of the entity and the individual (or other entity) no longer exists Unity of interest determined by analysis of

Lack of corporate formalities Commingling of corporate and non-corporate assets Undercapitalization Treating corporate assets as if belonged to owner(s)

Circumstances must be such that adherence to the fiction of separateness would

SANCTION A FRAUD PROMOTE INJUSTICE

Sea-Land Rule – “Promote Injustice?”


Means more than that a creditor will go unpaid.

There must be a wrong beyond creditor’s inability to collect, e.g., Unjust enrichment to person or entity who looted

corporation Scheme to move assets to one entity and liabilities to

another Must be sufficient to “merit the evocation” of the

court’s equitable powers.

Declaring Dividends


Highlights the tension between creditors and shareholders CREDITORS do not want money taken out of the

corporation until they have been paid SHAREHOLDERS like dividends because

(a) represents a return on investment that is no longer subject to market forces;

(b) declaring a dividend signals optimism about the future and often drives the share price higher.

Basic Policy Objective: Protect the Creditor


Limit so that dividends can only be paid from “surplus” after sufficient capital held in reserve to pay debts.

Solely Within Authority of Directors


Holders of common shares have no vested right to a dividend Some preferred shares carry right to a dividend and

enforcement power (such as right to name directors) if required dividend is not paid to preferred shareholders

Courts will not interfere with directors’ decision to declare or withhold dividend absent showing of fraud, bad faith or abuse of discretion by directors

BUT once a dividend is declared, shareholders may enforce in court

TYPES OF SURPLUS


Capital surplus Excess portion of price received by corporation for its stock

after subtracting the par value Plus any amount directors deem necessary (sometimes

required by creditors) Earned surplus

Earning of the company from operations after subtracting liabilities and net of capital accounts

Reduction surplus The amount directors vote to take out of Stated Capital (e.g.,

by reducing par or because augmented from capital surplus and now unwinding

Revaluation surplus The amount of previously unrealized appreciation directors

choose to recognize (and which moves into earned surplus)

Approaches Vary By Jurisdiction:


1. Can only be paid from Earned Surplus2. Can only be paid if balance sheet shows there is

money left over after liabilities and stated capital are subtracted from assets (the “Balance Sheet” test).

3. Can only be paid if there are “current profits” (regardless of whether there is any earned surplus) (the “nimble dividends” test);

4. Can only be paid of assets exceed liabilities (doesn’t consider stated capital or other equity); and

5. Can pay so long as won’t leave company “insolvent”

Delaware


Sec. 170: Can pay dividends from surplus (over stated

capital) or, if there is no surplus, can pay from current net profits and last year’s net profits.

RATIONALE: If company has not been profitable such that there is no surplus, probably cannot borrow. If law forbid the payment of dividends until there is a surplus, much more difficult to attract investors seeking a return on their investment.

Model Act


Does not distinguish between dividends and redemptions or other distributions, calls all of them “Distributions”

Requires all distributions meet two tests: 1. The “equity solvency” test – after the distribution will

the corporation still be able to pay its debts as they come due?

2. The “balance sheet” test – after the distribution, are the remaining assets greater in value than its liabilities plus the amounts the corporation would have to pay to shareholders under existing agreements if the corporation were dissolved at the time of the distribution

Stock Dividends


Issue additional shares in lieu of cash.Reasons:

Don’t want to spend the cash but want to appease shareholders

Want to increase voting rights of pro-board shareholders in case of takeover bid

Need to issue more shares to make an offering work and must issue stock dividends to keep voting rights intact

Drives down stock price somewhat (because more shares over which ratios operate, such as “earnings per share”)

Are Creditors Really Protected By These Rules?


All decisions still made by the shareholders.The “real” assets of the corporation, the ones

that could readily generate money to pay creditors, aren’t weighted any differently than assets like patents So balance sheet test is almost meaningless to

creditor

By gaming “par” values or using “nimble dividends” test, the creditors are put well behind the shareholders

How Creditors Protect Themselves


COVENANTS

“(a) Use of Proceeds. Proceeds received from the Payee pursuant to this Note will be used by the Borrower for working capital and general company purposes.

(b) Affirmative Covenants. Until the conversion or repayment (or prepayment) of this Note in accordance with the terms and conditions set forth herein, each Borrower shall perform all covenants in this Section 4(b).

Typical Terms


(c) Negative Covenants. Until the conversion, repayment (or prepayment) of this Note in accordance with the terms and conditions set forth herein, the Borrower will not, without the prior written consent of the Payee, undertake to do any of the following: (i) create, issue, sell or transfer any debt securities of the Borrower or enter into or incur other indebtedness other than indebtedness which, together with this Note, does not exceed $200,000 in principal amount (for purposes hereof, “Indebtedness” shall mean any indebtedness of the Borrower for borrowed money from banks, other financial institutions, (except indebtedness consisting of drawing down on existing lines of credit) and any Person (defined as natural persons, corporations, limited liability companies, limited partnerships, general partnerships, limited liability partnerships, joint ventures, trusts, land trusts, business trusts, or other organizations, irrespective of whether they are legal entities));

Negative Covenants Continued

Lec. 12, pp 479-528 Corps Prof. McCann

(ii) (A) redeem, repurchase or otherwise acquire for consideration any outstanding equity securities of the Borrower (or securities convertible or exercisable into or exchangeable for equity securities of such entity) or permit any Borrower to take such action; or (B) declare or pay any cash or property dividend or distribution of any kind on any class of stock or membership interest (except with respect to ordinary course inter-company transfers and accounts of the Borrower); (iii) make any material change in its ownership or organization or the manner in which its business is conducted outside of the ordinary course of its business; (iv) transfer, sell, lease, or in any other manner convey any equitable, beneficial or legal interest in any assets of the Borrower except inventory sold in the normal course of business, or allow to exist on its assets any mortgage interest, pledge or security interest , title retention device, or other encumbrance, junior or senior to Payee, other than as set forth herein.

STOCK BUY-BACKS (REDEMPTIONS)


Clearly a Distribution of Money to the Shareholder Cash goes to shareholder Stock goes to company Shareholder ends up with fewer shares but there are

now fewer shares altogether, so net effect on percentage of ownership is unaffected

What does company have? Nothing of value. The stock it has purchased cannot be shown as an asset because to do so would allow any stock it issued and kept to be an “asset.”

KLANG V SMITH FOOD & DRUG

Lec. 12, pp 479-528 Corps Prof. McCann

Because the policy behind the rule that payments must come from surplus is to prevent a board from draining capital to the detriment of creditors, and if surplus is determined by asset valuation, valuation at time of determination is appropriate and it is irrelevant whether or not the balance sheet uses current valuations. Therefore, balance sheet amounts are not determinative.

Board’s determination will be accepted absent showing of bad faith or fraud

Why Buy-Backs?


Often want to empty large cash holdings which attract take-over interest.

Repurchase tends to drive stock price up because Now are fewer shares outstanding, giving those

outstanding shares more value Evidences economic health, increasing confidence

If directors issued large dividend checks instead, shareholders would pay taxes at higher rates than if got a “return on capital” which is a capital gains item

Directors’ Duty of Care


Francis v United Jersey Bank: Director is fiduciary of the corporation and its

shareholders And in the context of the business of the

corporation, may be a fiduciary to its creditors Where there is constructive or actual trust

Director must “discharge duties in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions”

Francis v United Jersey Bank


Where director breaches duty, personally liable if negligence was a proximate cause of a loss to the creditor or shareholder or corporation

Plaintiff has burden of showing loss would have been avoided if defendant had performed her duties

Analysis includes determination of “reasonable steps” director should have taken

BUT causation will be inferred where reasonable to conclude particular result from a failure to act and that result has occurred.

Caremark


Director liability can be grounded on several theories: Liability following poor decision by board

because decision was negligent and ill advised Liability based on failure to act where due

diligence would prevent the loss

BUT, “absent cause for suspicion there is no duty…to install and operate a system of corporate espionage to ferret out wrongdoing that they have no reason to suspect exists.”

Caremark cont’d


There must be a system in place adequate to assure the board that appropriate information will come to its attention in a timely manner

Failure to insist upon and maintain such a system may render a director liable

Caremark cont’d


Plaintiffs must show:Director knew orShould have known were violations of lawTook no steps to prevent or remedyFailure proximately caused the loss

Rule


Model Act and ALI, and most statutes, allow directors to rely on others if that reliance is reasonable because the adviser “merits confidence”

Documents

PARTNERSHIPS, CORPORATIONS AND THE VARIANTS PROF. BRUCE MCCANN LECTURE 12 DIVIDENDS AND DUTY OF CARE PP. 479-528 Business Organizations 2009-2010 Lectures