CH-32-34 Limited Partnerships and Limited Liability Companies – Smith and Robersons Business Law : Book Guide

This Document Contains Chapters 32 to 34 Chapter 32 LIMITED PARTNERSHIPS & LIMITED LIABILITY COMPANIES ANSWERS TO QUESTIONS AND CASE PROBLEMS 1. 1. John Palmer and Henry Morrison formed the limited partnership of Palmer & Morrison for the management of the Huntington Hotel. The limited partnership agreement provided that Palmer would contribute $400,000 and be a general partner and that Morrison would contribute $300,000 and be a limited partner. Palmer was to manage the dining and cocktail rooms, and Morrison was to manage the rest of the hotel. Nanette, a popular French singer who knew nothing of the limited partnership affairs, appeared for four weeks in the Blue Room at the hotel and was not paid her fee of $8,000. Subsequently, the limited partnership became insolvent. Nanette sued Palmer and Morrison for $8,000. a) For how much, if anything, are Palmer and Morrison liable? b) If Palmer and Morrison had formed a limited liability limited partnership, for how much, if anything, would Palmer and Morrison be liable? c) If Palmer and Morrison had formed a limited liability company with each as members, for how much, if anything, would Palmer and Morrison be liable? d) If Palmer and Morrison had formed a limited liability partnership with each as general partners, for how much, if anything, would Palmer and Morrison be liable? Answer: Liability of Members of Limited Partnerships, LLCs, LLPs, and LLLPs. (a) As an actual general partner, Palmer has personal, unlimited liability for the full $8,000. The issue here is whether the limited partner Morrison is also liable as a general partner because of his involvement in the management of the hotel. In general, a limited partner cannot share in the management or control of the association; if he does so, he forfeits his limited liability. The 1985 Act has eliminated the broader liability of a limited partner whose participation is substantially the same as a general partner. Under the 1985 Act, a limited partner who participates in the control of the business only has liability to those persons who transact business with the limited partnership reasonably believing that the limited partner is a general partner. Based on the facts as stated in the problem, good arguments can be made for Morrison's liability. It would appear that Nanette dealt with the partnership under the reasonable belief that Morrison was a general rather than a limited partner. If so, Morrison has personal, unlimited liability for the full $8,000. The RULPA provides a "safe harbor" by enumerating certain activities in which a limited partner may engage without being deemed to have taken part in the control of the business. The 1985 amendments have expanded the safe harbor list. However, none of the enumerated activities include management of the entire business. Under the facts as stated, Morrison is supposed to manage the hotel. This would seem to go beyond the permissible activities listed in both the RULPA and in the 1985 amendments, so Morrison is likely to be held liable as a general partner. (b) As a general partner in an LLLP, Palmer’s liability is limited to the extent provided by the LLP statute. Under a partial shield statute, Palmer would not be protected and would have personal, unlimited liability for the full $8,000. Under a full shield statute, Palmer would not have personal liability; only his capital contribution would be available. If Morrison were held liable as a general partner, then his liability presumably would be the same as Palmer’s. (c) As members of an LLC, Palmer and Morrison would have limited liability for the obligation. (d) As members of an LLP, under a partial shield statute, Palmer and Morrison would not be protected and would have personal, unlimited liability for the full $8,000. Under a full shield statute, Palmer and Morrison would not have personal liability; only their capital contributions would be available. 2. 2. A limited partnership was formed consisting of Webster as the general partner and Stevens and Stewart as the limited partners. The limited partnership was organized in strict compliance with the limited partnership statute. Stevens was employed by the partnership as a purchasing agent. Stewart personally guaranteed a loan made to the partnership. Both Stevens and Stewart consulted with Webster about partnership business, voted on a change in the nature of the partnership business, and disapproved an amendment to the partnership agreement proposed by Webster. The partnership experienced serious financial difficulties, and its creditors seek to hold Webster, Stevens, and Stewart personally liable for the debts of the partnership. Who, if any, is personally liable? Answer: Liabilities in a Limited Partnership. Webster is personally liable; Stevens and Stewart are not. As a general partner Webster has unlimited, personal liability for obligations of the partnership. A limited partner has limited personal liability for obligations of the partnership unless he takes part in control. The RULPA, Section 303 specifies a number of activities in which a limited partner may engage without losing limited liability: (1) being a contractor for, an agent or employee of the limited partnership or of a general partner; (2) consulting with and advising a general partner with respect to the business of the limited partnership; (3) acting as surety for the limited partnership; (4) approving or disapproving an amendment to the partnership agreement; and (5) voting on one or more of the following matters: (a) the dissolution and winding up of the partnership; (b) the sale, exchange, lease, mortgage, pledge, or other transfer of all or substantially all of the assets of the limited partnership other than in the ordinary course of its business; (c) the occurrence of indebtedness by the limited partnership other than in the ordinary course of its business; (d) a change in the nature of the business; or (e) the removal of a general partner. Thus, under the RULPA, Stevens and Stewart would not have taken part in control and therefore would retain their limited liability. 3. 3. Fox, Dodge, and Gilbey agreed to become limited partners in Palatine Ventures, a limited partnership. In a signed writing each agreed to contribute $20,000. Fox’s contribution consisted entirely of cash; Dodge contributed $12,000 in cash and gave the partnership her promissory note for $8,000; and Gilbey’s contribution was his promise to perform two hundred hours of legal services for the partnership. a) What liability, if any, do Fox, Dodge, and Gilbey have to the partnership by way of capital contribution? b) If Palatine Ventures had been formed as a limited liability company(LLC) with Fox, Dodge, and Gilbey as members, what liability, if any, would Fox, Dodge, and Gilbey have to the LLC by way of capital contribution? Answer: Contributions in a Limited Partnership and an LLC. (a) Under the RULPA, the contribution of a partner may be cash, property, or services rendered or a promissory note or other obligation to contribute cash or property or to perform services. A partner is liable to the partnership for the difference between the contribution actually made and the amount stated in the certificate as having been made. Thus Dodge and Gilbey are liable for the remainder of the $8,000 Dodge has not yet provided and the $20,000 that Gilbey has not yet provided. If Dodge has already paid the promissory note and Gilbey has already contributed the promised 200 hours of legal services for the partnership, then they have no further liability. Under the 1985 amendments, a promise by a limited partner to contribute to the partnership is not enforceable unless it is in a signed writing. (b) As members of an LLC, their liability for contributions would be the same as in (a). 4. 4. Madison and Tilson agree to form a limited partnership with Madison as general partner and Tilson as the limited partner, each to contribute $12,500 as capital. No papers are ever filed, and after ten months the enterprise fails with liabilities exceeding assets by $30,000. Creditors of the partnership seek to hold Madison and Tilson personally liable for the $30,000. Explain whether the creditors will prevail. Answer: Defective Formation of a Limited Partnership. Madison and Tilson are jointly liable for the $30,000. Madison is liable because he was a general partner. Tilson is liable as a general partner because no limited partnership had been formed and he did not renounce his interest in the business. The RULPA clarifies an ambiguity that formerly existed in the law by requiring the equity participant to either withdraw from the business and renounce future profits or file an amendment curing the defect. 5. 5. Kraft is a limited partner of Johnson Enterprises, a limited partnership. As provided in the limited partnership agreement, Kraft decided to leave the partnership and demanded that her capital contribution of $20,000 be returned. At this time, the partnership assets were $150,000 and liabilities to all creditors totaled $140,000. The partnership returned to Kraft her capital contribution of $20,000? a) What liability, if any, does Kraft have to the creditors of Johnson Enterprises? b) If Johnson Enterprises had been formed as a limited liability company, what liability, if any, would Kraft have to the creditors of Johnson Enterprises? Answer: Liability for Distributions in Limited Partnerships and LLCs. (a) Kraft is liable to the limited partnership and/or the creditors for $10,000 for six years; for one year, Kraft is potentially liable for the other $10,000 if needed. Of the $20,000 distributied $10,000 is wrongful and $10,000 is rightful. The funds available for distribution to partners equals $10,000 ($150,000 of assets minus $140,000 of liabilities liabilities to creditors). Section 607 of the RULPA provides that a partner may not receive a distribution from a limited partnership to the extent that, after giving effect to the distribution, all liabilities of the limited partnership interests, exceed the fair value of the partnership's assets. For one year, Kraft is potentially liable for the other $10,000 if needed, as provided by §608, which states: “If a partner has received the return of any part of his contribution without violation of the partnership agreement or this Act, for a period of one year thereafter he is liable to the limited partnership for the amount of his contribution returned, but only to the extent necessary to discharge the limited partnership's liabilities to creditors who extended credit to the limited partnership during the period the contribution was held by the partnership.” (b) In an LLC the result would be similar. Under the great majority of LLC statutes, any member who receives a return of her contribution in violation of the LLC's operating agreement or the limited liability company act is liable to the limited liability company for the amount of the contribution wrongfully returned. Under a few of the statutes, even members who receive a return of their capital contribution without violating the LLC agreement or the limited liability company act remain liable to the limited liability company for a specified time to the extent necessary to pay creditors. 6. 6. Gordon is the only limited partner in Bushmill Ventures, a limited partnership whose general partners are Daniels and McKenna. Gordon contributed $10,000 for his limited partnership interest and loaned the partnership $7,500. Daniels and McKenna each contributed $5,000 by way of capital. After a year, the partnership is dissolved, at which time it owes $12,500 to its only creditor, Dickel, and has assets of $30,000. c) How should these assets be distributed? d) If Bushmill Ventures had been formed as a limited liability company with Gordon, Daniels, and McKenna as members, how should these assets be distributed? Answer: Distributions of Assets after Dissolution in Limited Partnerships and LLCs. (a) In a limited partnership, Section 804 of RULPA provides- Dickel: $12,500 as creditor Gordon: $ 7,500 as creditor Gordon: $ 5,000 for capital contributions Daniels: $ 2,500 for capital contributions McKenna: $ 2,500 for capital contributions (b) Under typical LLC statute, the same distribution would occur unless the operating agreement provides otherwise. 7. 7. Discuss when a limited partner does or does not have the following rights or powers: (a) to assign his interest in the limited partnership, (b) to receive repayment of loans made to the partnership on a pro rata basis with general creditors, (c) to manage the affairs of the limited partnership, (d) to receive his share of the profits before the general partners receive their shares of the profits, and (e) to dissolve the partnership upon his withdrawing from the partnership Answer: Rights in Limited Partnership. (a) Yes. RULPA Section 702. (b) Yes. RULPA Section 804. (c) No. If he does he forfeits his limited liability. RULPA Section 303. (d) No under RULPA Section 804 unless the partnership agreement so provides (e) No. RULPA Section 801. 8. 8. Discuss when a member of a limited liability company does or does not have the following rights or powers: (a)¬to assign her interest in the LLC, (b)¬to receive repayment of loans made to the LLC on a pro rata basis with general creditors, (c)¬to manage the affairs of the LLC, and (d) to dissolve the LLC upon her withdrawing from the LLC. Answer: Rights in LLC. a) Yes. b) Yes. c) Yes, without forfeiting limited liability. d) Depends on LLC statute. Initially, many LLC statutes required an LLC to be dissolved upon the withdrawal (dissociation) of a member. Most statutes permitted the nondissociating members by unanimous consent to continue the LLC after a member dissociates. Some allowed continuation by majority vote. Although some States still retain these provisions, a number of States and the amended ULLCA have eliminated a member’s dissociation as a mandatory cause of dissolution. 9. 9. Albert, Betty, and Carol own and operate the Roy Lumber Company, a limited liability partnership (LLP). Each contributed one-third of the capital, and they share equally in the profits and losses. Their LLP agreement provides that all purchases more than $2,500 must be authorized in advance by two partners and that only Albert is authorized to draw checks. Unknown to Albert or Carol, Betty purchases on the firm's account a $5,500 diamond bracelet and a $5,000 forklift and orders $5,000 worth of logs, all from Doug, who operates a jewelry store and is engaged in various activities connected with the lumber business. Before Betty made these purchases, Albert told Doug that Betty is not the log buyer. Albert refuses to pay Doug for Betty's purchases. Doug calls at the mill to collect and Albert again refuses to pay him. Doug calls Albert an unprintable name, and Albert then punches Doug in the nose, knocking him out. While Doug is lying unconscious on the ground, an employee of Roy Lumber Company negligently drops a log on Doug's leg, breaking three bones. The firm and the three partners are completely solvent. What are the rights of Doug against Roy Lumber Company, Albert, Betty, and Carol? Answer: Liability in an LLP. This problem has the same facts as Problem 1 in Chapter 32 but here the company is an LLP. Because the partnership is not liable in parts (a) and (c), the answers remain the same as in Chapter 32. Depending upon the LLP statute, in part (b) the partners’ liability for the partnership obligation may change from that in a general partnership. In part (d), under all LLP statutes the partners’ liability for the partnership obligation will change from that in a general partnership. (a) The Roy Lumber Company Partnership is not liable for logs; Betty is personally liable for logs. No act of a partner in contravention of a restriction on authority shall bind the partnership to persons having knowledge of the restriction. R.U.P.A. Section 301(1), U.P.A. Section 9(4). Thus, the partnership will not be bound as to the logs because Doug had knowledge of the lack of authority. Betty is liable for breach of warranty of authority. (b) The Roy Lumber Company Partnership is liable for the forklift truck. Since Doug was unaware of the $2,500 restriction upon partners' purchases and the purchase of a forklift was within the apparent authority of Betty, the partnership is bound. R.U.P.A. Section 301(1), U.P.A. Section 9(1). As partners in an LLP, under a partial shield statute, the partners would not be protected and would have personal, unlimited liability. Under a full shield statute, the partners would not have personal liability; only their capital contributions would be available. (c) Partnership is not liable for the diamond bracelet; Betty is personally liable for the bracelet. R.U.P.A. Section 301(2) provides: An act of a partner which is not apparently for carrying on in the ordinary course the partnership business or business of the kind carried on by the partnership binds the partnership only if the act was authorized by the other partners. U.P.A. Section 9(2) is similar: "An act of a partner which is not apparently for the carrying on of the business of the partnership in the usual way does not bind the partnership unless authorized by the other partners." (d) Partnership is liable for the injured leg; the employee is liable for injured leg. A partnership, as are all principals, is liable under the doctrine of respondeat superior for torts committed by employees within the scope of their employment. As partners in an LLP, under a partial shield statute or under a full shield statute, the partners would not have personal liability; only their capital contributions would be available. 10. 10. In January, Dr. Vidricksen contributed $250,000 to become a limited partner in a Chevrolet car agency business with Thom, the general partner. Articles of limited partnership were drawn up, but no effort was made to comply with the state’s statutory requirement of recording the certificate of limited partnership. In March, Vidricksen learned that, because of the failure to file, he might not have formed a limited partnership. At this time, the business developed financial difficulties and went into bankruptcy on September 11. Eight days later, Vidricksen filed a renunciation of the business’s profits. Is Dr. Vidricksen a general partner? Answer: Liability of Limited Partner/Defective Formations. Vidricksen was a general partner with Thom insofar as their relationship with third party creditors is concerned. A person who has contributed to the capital of a business erroneously believing that he has become a limited partner will not be considered a general partner if, upon ascertainment of the mistake, he promptly renounces his interest in the business's profits. Although Vidricksen had filed a renunciation, his renunciation was not prompt because it was filed six months after he first learned that something was wrong with the organizational setup. Vidricksen v. Grover, 363 F.2d 372 (9th Cir. 1966). 11. 11. Dale Fullerton was chairman of the board of Envirosearch and the sole stockholder in Westover Hills Management. James Anderson was president of AGFC. Fullerton and Anderson agreed to form a limited partnership to purchase certain property from WYORCO, a joint venture of which Fullerton was a member. The parties intended to form a limited partnership with Westover Hills Management as the sole general partner and AGFC and Envirosearch as limited partners. The certificate filed with the Wyoming secretary of state, however, listed all three companies as both general and limited partners of Westover Hills Ltd. Anderson and Fullerton later became aware of this error and filed an amended certificate of limited partnership, which correctly named Envirosearch and AGFC as limited partners only. Subsequently Westover Hills Ltd. became insolvent. What is the potential liability of Envirosearch and AGFC to creditors of the limited partnership? Answer: Limited Partnerships/Dissolution. Westover Hills Ltd. was held to be a limited partnership for purposes of bankruptcy. Under the Uniform Limited Partnership Act, if the parties intend to form a limited partnership, failure to comply with the requirements regarding the certificate of partnership results only in the nonformation of the limited partnership, not the formation of a general partnership. The parties in this case clearly intended to form a limited partnership. The Revised Uniform Limited Act of 1976 provides that an intended limited partner who subsequently discovers that the limited partnership has been defectively formed may remedy the situation either by causing an appropriate certificate of amendment to be filed or by withdrawing from the enterprise and renouncing future profits. AGFC complied with the first alternative, thereby ensuring that it did not lose its limited partner status. Therefore, Westover Hills Ltd. is a limited partnership for the purposes of bankruptcy. 12. 12. Namvar Taghipour, Danesh Rahemi, and Edgar Jerez formed a limited liability company (the LLC) to purchase and develop a parcel of real estate. The LLC's articles of organization designated Jerez as the LLC’s manager. In addition, the written operating agreement among the members of the LLC provided: “No loans may be contracted on behalf of the [LLC] … unless authorized by a resolution of the members.” On the next day, the LLC acquired the intended real estate. Two years later, Jerez, without the knowledge of the LLC's other members, entered into a loan agreement on behalf of the LLC with Mount Olympus. According to the loan agreement, Mount Olympus lent the LLC $25,000 and, as security for the loan, Jerez executed and delivered a trust deed on the LLC’s real estate property. Mount Olympus then disbursed $20,000 to Jerez and retained the $5,000 balance to cover various fees. In making the loan, Mount Olympus did not investigate Jerez’s authority to enter into the loan agreement beyond determining that Jerez was the manager of the LLC. Jerez absconded with the $20,000. The LLC never made payments on the loan, since it was unaware of the loan, and consequently defaulted. Mount Olympus then foreclosed on the LLC’s property, giving notice of the default and pending foreclosure sale to only Jerez. Explain whether the foreclosure was valid. Answer: Management Rights of LLC Members. The LLC was bound by the loan agreement and, consequently, Mount Olympus was not liable to Taghipour for Jerez's actions. Taghipour v. Jerez, 2002 UT 74, 52 P.3d 1252, Supreme Court of Utah, 2002. When two statutory provisions purport to cover the same subject, the legislature's intent must be considered in determining which provision applies. To determine that intent, rules of statutory construction provide that “when two statutory provisions conflict in their operation, the provision more specific in application governs over the more general provision.” Section 48-2b-127(2) is the more specific provision. In this case, Jerez was designated as the LLC's manager in the articles of organization. Jerez, acting in his capacity as manager, executed loan agreement documents, for example, the trust deed and trust deed note, on behalf of the LLC that are specifically covered by section 48-2b-127(2). As such, these documents are valid and binding on the LLC. Therefore, the court of appeals correctly concluded that the LLC was bound by the loan agreement and, consequently, that Mount Olympus was not liable to Taghipour for Jerez's actions. 13. 14. 13. Carolinian is a closely held, manager-managed limited liability company, organized under the laws of South Carolina. Carolinian owns and manages various hotel and rental properties in South Carolina. In February 2014, the Levys obtained a judgment against Patel, a member of the Carolinian, in the amount of $2.5 million. Thereafter, the Levys obtained a charging order in the circuit court, which constituted a lien against Patel's distributional interest in Carolinian. Subsequently, the Levys filed a petition to foreclose the charging lien, and the foreclosure sale was held in April 2016. The Levys were the successful bidders, purchasing Patel’s distributional interest for $215,000. Carolinian was represented at the foreclosure sale by its registered agent and its attorney, who unsuccessfully bid $190,000 on Carolinian’s behalf. Carolinian’s Operating Agreement provides that a member’s financial rights can be redeemed at any time up until foreclosure sale but neither Carolinian nor any of the remaining members redeemed Patel’s interest prior to the foreclosure sale, and the Levys did not thereafter seek to be admitted as members of Carolinian. 15. Following the foreclosure sale, Carolinian asserted it was entitled to purchase Patel’s distributional interest from the Levys pursuant to Article 11 of the Operating Agreement, which provides that if a member attempts to transfer all or a portion of his membership share without obtaining the other members’ consent, such member is deemed to have offered to the LLC all of his membership share. Carolinian contended that, since the Levys failed to obtain the consent required under Section 11.1 of the Operating Agreement, their distributional interest was deemed to have been offered to Carolinian, and Carolinian was entitled to purchase that interest under Section 11.2. The Levys objected to Carolinian’s attempt to force them to sell their interest, arguing they were not subject to the terms of Article 11 of the Operating Agreement. Explain who should prevail. Answer: Assignment of LLC Interest. The Levys’ should prevail. The provisions of Article 11 of the Operating Agreement did not restrict the Levys' right to foreclose their charging lien against Patel's distributional interest, and Carolinian may not invoke the provisions of Article 11 to compel the Levys to sell the distributional interest they acquired through the foreclosure sale. Levy v. Carolinian, LLC, 410 S.C. 140, 763 S.E.2d 594 (2014). The Levys admit Carolinian had the right to redeem Patel's distributional interest at any time prior to the foreclosure sale; however, the Levys contend the ability to redeem that interest was extinguished by virtue of the judicial sale. Moreover, because the Levys were not required under Section 11.1 to obtain consent from Carolinian or its members prior to the foreclosure sale, we find Carolinian may not now invoke the right to purchase under Section 11.2, as that section, by its terms, applies only where consent under Section 11.1 is required and not obtained prior to the transfer. We hold that Carolinian's ability to purchase Patel's interest is not controlled by any part of Article 11, but rather by Section 3.5 of the Operating Agreement, which provided Carolinian the opportunity to purchase Patel's interest before the foreclosure sale, not after. Carolinian may not now invoke the provisions of Article 11 to compel the Levys to sell the distributional interest they acquired through the foreclosure sale. 16. ANSWERS TO “TAKING SIDES” PROBLEMS On April 5, Handy contracted to purchase land with the intent of forming a limited liability company (LLC) with Ginsburg and McKinley for the purpose of building a residential community on the property. On April 21, they learned from Coastal, an environmental consulting firm they had hired, that the property contained federally protected wetlands. The presence of wetlands adversely affected the property’s value and development potential. Handy, Ginsburg, and McKinley abandoned construction plans and instead decided to sell the property. To advertise and promote that sale, they placed on the property a sign that stated the property had “Excellent Development Potential.” Unaware of the existence of wetlands, Pepsi acquired an option to purchase the property from Handy on August 5. At that time, Willow Creek had not yet been formed and Handy had not yet purchased the property. On August 18, Handy, Ginsburg, and McKinley formed Willow Creek Estates, LLC. During the option period, Pepsi hired a soil-engineering consultant to conduct an environmental investigation of the property. In Handy’s written answers to specific questions from the consultant about the property, Handy did not disclose that the property contained wetlands or that Coastal had already performed a written preliminary wetlands determination the month before. On September 4, Willow Creek, LLC took title to the property. Four months later Willow Creek, LLC sold the property to Pepsi for more than twice the amount of its purchase price and did not disclose the existence of wetlands on the property. After Pepsi learned that the property contained wetlands, it brought an action for fraud against Willow Creek, Handy, Ginsburg, and McKinley. (a) What are the arguments that Handy, Ginsburg, and McKinley are not individually liable to Pepsi for fraud? (b) What are the arguments that Handy, Ginsburg, and McKinley are individually liable to Pepsi for fraud? (c) Explain who should prevail. Answer: (a) Handy, Ginsburg, and McKinley, as members and/or managers of a limited liability company (LLC), are not obligated personally for any debt, obligation, or liability of the LLC solely by reason of being a member or acting as a manager of the LLC. (b) Handy, Ginsburg, and McKinley committed the fraud before the LLC had been formed and thus are individually liable. (c) Handy, Ginsburg, and McKinley are individually liable to Pepsi for fraud. This problem is based on the unpublished opinion The Pepsi-Cola Bottling Company of Salisbury, Maryland v. Handy, Court of Chancery of Delaware (2000), 2000 WL 364199. The issue presented is whether the defendants are being sued “solely by reason of being a member” of Willow Creek LLC where the claim is based upon fraudulent acts committed by the LLC members before the LLC was formed and took title to the property. “To express it in terms of the facts at bar, if a person makes material misrepresentations to induce a purchaser to purchase a parcel of land at a price far above fair market value, and thereafter forms an LLC to purchase and hold the land, can that person later claim that his status as an LLC member protects him from liability to the purchaser * * *? I think not. * * *” Because the facts alleged in the complaint establish that the LLC was not formed (and the property was not acquired by the LLC) until after the allegedly critical wrongful acts had been committed, it follows that the defendants could not have been acting “solely as members of the LLC when they committed those acts. Therefore the defendants are not protected by [the LLC statute]. Chapter 33 NATURE, FORMATION, AND POWERS ANSWERS TO QUESTIONS AND CASE PROBLEMS 17. 1. After part of the shares of a proposed corporation had been successfully subscribed, the promoter hired a carpenter to repair a building that was intended to be conveyed to the proposed corporation. The promoter subsequently secured subscriptions to the balance of the shares and completed the organization, but the corporation, finding the building to be unsuitable for its purposes, declined to use the building or to pay the carpenter. The carpenter brought suit against the corporation and the promoter for the amount that the promoter agreed would be paid to him. Who, if anyone, is liable? Answer: Promoters' Contracts. The corporation is not liable on pre-incorporation contracts unless after it has been organized and comes into existence it assumes or adopts such contracts made on its behalf, or accepts the benefits of such contracts. The promoters, however, would be liable. Thus, the carpenter may recover in this case from the promoter. 18. 2. C. A. Nimocks was a promoter engaged in organizing the Times Printing Company. On September 12, on behalf of the proposed corporation, he made a written contract with McArthur for her services as comptroller for a one-year period beginning October 1. The Times Printing Company was incorporated October 16, and on that date McArthur commenced her duties as comptroller. Neither the board of directors nor any officer took formal action on her employment, but all the shareholders, directors, and officers knew of the contract made by Nimocks. On December 1, McArthur was discharged without cause. a) Has she a cause of action against the Times Printing Company? b) Has she a cause of action against Nimocks? Answer: Promoters' Contracts. McArthur has a cause of action against Times, but not against Nimocks. Although her contract was made with the promoter prior to the existence of the corporation, the corporation upon being organized adopted the contract by acceptance of her services and thereby effectively became a party to it and bound by it. 19. 3. Todd and Elaine purchased for $300,000 a building that was used for manufacturing pianos. Then, as promoters, they formed a new corporation and resold the building to the new corporation for $500,000 worth of stock. After discovering the actual purchase price paid by the promoters, the other shareholders desire to have $200,000 of the common stock canceled. Can they succeed in this action? Answer: Promoters' Fiduciary Duty. The other shareholders are entitled to have the $200,000 of stock canceled. The promoters Todd and Elaine owe a fiduciary duty to the corporation, its subscribers and its initial shareholders. As such the promoters are not permitted to make a secret profit by violation of their fiduciary duty. 20. 4. Wayne signed a subscription agreement for one hundred shares of stock of the proposed ABC Company, at a price of $18 per share in a State that has adopted the Revised Act. Two weeks later, the company was incorporated. A certificate was duly tendered to Wayne, but he refused to accept it. He was notified of all shareholders’ meetings, but he never attended. A dividend check was sent to him, but he returned it. ABC Company brings a legal action against Wayne to recover $1,800. He defends on the ground that his subscription agreement was an unaccepted offer, that he had done nothing to ratify it, and that he was therefore not liable on it. Is he correct? Explain. Answer: Subscribers. No, Wayne is not correct. Under the Revised Act, Wayne would be liable for the stock subscription he signed. Therefore, judgment for ABC Company. Subscriptions for shares of stock are irrevocable for six months. Revised Model Business Corporation Act provides that a preincorporation stock subscription is irrevocable for a period of six months, unless otherwise provided by the terms of the subscription agreement or unless all of the subscribers agree to the revocation of the subscription. 21. 5. Julian, Cornelia, and Sheila petitioned for a corporate charter for the purpose of conducting a retail shoe business. They complied with all the statutory provisions except having their charter recorded. This was simply an oversight on their part, and they felt that they had fully complied with the law. They operated the business for three years, after which time it became insolvent. The creditors desire to hold the members personally and individually liable. May they do so? Answer: Defective Incorporation. The law on the subject of individual liability where a corporation has been defectively organized is not certain. Despite the legal formulas, the cases basically attempt to strike a fair balance between the interests of the associates attempting to comply with the law and the outside parties dealing with them. (a) Common Law Approach. The corporation is not a corporation de jure. Filing of the articles of incorporation with the Secretary of State is generally essential to corporate existence. Since the articles were never filed, de jure existence is generally foreclosed. Individual liability can be escaped if the corporation was a corporation de facto which requires (1) the existence of a general corporation statute, (2) a bona fide attempt to comply with that law in organizing a corporation under the statute, and (3) the actual exercise of corporate power by conducting business in the belief that a corporation has been formed. The problem posed here is whether there has been a sufficient attempt to comply with the statute even though the articles were never filed. Although a conscious failure to file usually prevents de facto status, some cases recognize a bona fide attempt to file or procure the filing as sufficient. On these facts it is unclear whether a bona fide attempt had been made. If not, Julian, Cornelia, and Sheila are jointly liable to the creditors of the defectively organized corporation. If “oversight” indicates that they were not conscious of the failure to file, some courts would not hold them liable. (b) Revised Model Business Corporation Act Approach. Section 2.04 provides that “All persons purporting to act as or on behalf of a corporation knowing there was no incorporation under this act, are jointly and severally liable for all liabilities created while so acting.” If Julian, Cornelia or Sheila knew there had been no filing, those of them who knew are jointly and severally liable to the creditors. 22. 6. Arthur, Barbara, Carl, and Debra decided to form a corporation for bottling and selling apple cider. Arthur, Barbara, and Carl were to operate the business, while Debra was to supply the necessary capital but was to have no voice in the management. They went to Jane, a lawyer, who agreed to organize a corporation for them under the name A-B-C Inc., and paid her funds sufficient to accomplish the incorporation. Jane promised that the corporation would definitely be formed by May 3. On April 27, Arthur telephoned Jane to inquire how the incorporation was progressing, and Jane said she had drafted the articles of incorporation and would send them to the secretary of state that very day. She assured Arthur that incorporation would occur before May 3. Relying on Jane’s assurance, Arthur, with the approval of Barbara and Carl, on May 4 entered into a written contract with Grower for his entire apple crop. The contract was executed by Arthur on behalf of “A-B-C Inc.” Grower delivered the apples as agreed. Unknown to Arthur, Barbara, Carl, Debra, or Grower, the articles of incorporation were never filed, through Jane’s negligence. The business subsequently failed. What are Grower's rights, if any, against Arthur, Barbara, Carl, and Debra as individuals? Answer: Defective Incorporation. (a)Common Law Approach. (1) A-B-C Inc. is not a corporation de jure. Filing of the articles of incorporation with the Secretary of State is generally essential to corporate existence. Since the articles were never filed, de jure existence is generally foreclosed. (2) Individual liability can be escaped if A-B-C Inc. was a corporation de facto. The problem posed is whether there has been a sufficient attempt to comply with the statute even though the articles were never filed. Although a conscious failure to file usually prevents de facto status, some cases recognize a bona fide attempt to file or procure the filing as sufficient, especially where, as here, because of the form of the contract, the outsider thought he was dealing with a corporation, and did not rely on the credit of individuals. (3) Even if the requirements of de facto status are not met, Grower may be estopped from questioning the valid incorporation of A-B-C Inc. since he dealt with the participants on a corporate basis, as shown by the form of the contract. This area of law is based on considerations of fairness, however, and the law attempts to balance social interests, including the protection of the individual and protection of outside parties. Fairness does not require giving that outside party the double security of being able to recover from both a corporation and its individual participants. On the other hand, since the individuals received the benefit of the contract (the apples), and since the form of the contract is the only evidence given of the existence of the corporation and the failure to incorporate was due to the fault of the attorney they chose, it could be argued that the individuals should be held liable.. If A-B-C Inc. was not de facto and the doctrine of corporation by estoppel does not apply, all four (Arthur, Barbara, Carl and Debra) may be held liable. On the other hand, some cases hold only the active managers of the business (i.e., Arthur, Barbara, and Carl) liable. (b) Model Business Corporation Act Approach. Section 2.04 provides that “All persons purporting to act as or on behalf of a corporation knowing there was no incorporation under this act, are jointly and severally liable for all liabilities created while so acting.” Since Arthur, Barbara, and Debra did not know of the failure to incorporate, they are NOT jointly and severally liable to the creditors. MBCA Section 146. 23. 7. The Pyro Corporation has outstanding 20,000 shares of common stock, of which 19,000 are owned by Peter B. Arson; 500 shares are owned by Elizabeth Arson, his wife; and 500 shares are owned by Joseph Q. Arson, his brother. These three individuals are the officers and directors of the corporation. The Pyro Corporation obtained a $750,000 fire insurance policy to cover a certain building it owned. Thereafter, Peter B. Arson set fire to the building, and it was totally destroyed. Can the corporation recover from the fire insurance company on the $750,000 fire insurance policy? Why? Answer: Piercing the Corporate Veil. No. Judgment in favor of the fire insurance company. The court would pierce the corporate veil and not permit Arson to do indirectly, through the instrumentality of the corporation, what he could not do directly. 24. 8. A corporation is formed for the purpose of manufacturing, buying, selling, and dealing in drugs, chemicals, and similar products. The corporation, under authority of its board of directors, contracted to purchase the land and building it occupied as a factory and store. Collins, a shareholder, sues in equity to restrain the corporation from completing the contract, claiming that as the certificate of incorporation contained no provision authorizing the corporation to purchase real estate, the contract was ultra vires. Can Collins prevent the contract from being executed? Answer: Sources of Corporate Powers. No. The corporation may execute the contract. One of the general powers conferred by statute is the authority to acquire real estate, especially real estate for use in conducting the business the corporation is organized to carry on. Section 3.02, Model Act. 25. 9. Amalgamated Corporation, organized under the laws of State S, sends several traveling salespersons into State M to solicit orders, which are accepted only at the home office of Amalgamated Corporation in State S. Riley, a resident of State M, places an order that is accepted by Amalgamated Corporation in State S. The Corporation Act of State M provides that “no foreign corporation transacting business in this state without a certificate of authority shall be permitted to maintain an action in any court of this state until such corporation shall have obtained a certificate of authority.” Riley fails to pay for the goods, and when Amalgamated Corporation sues Riley in a court of State M, Riley defends on the ground that Amalgamated Corporation does not possess a certificate of authority from State M. Result? Answer: Classification of Corporations: Foreign or Domestic. The Amalgamated Corporation may maintain the suit in the court of State M without obtaining a certificate of authority to transact business in State M. The activities of Amalgamated Corporation in sending traveling salespersons into State M who solicit orders there which do not ripen into contracts until accepted at the home office in State S, and the shipping of goods from state S into state M, do not amount to transacting business in State M. . See Section 15.01(b) of the Model Act, in particular (6). 26. 10. Dr. North, a surgeon practicing in Georgia, engaged an Arizona professional corporation consisting of twenty lawyers to represent him in a dispute with a Georgia hospital. West, a member of the law firm, flew to Atlanta and hired local counsel with Dr. North’s approval. West represented Dr. North in two hearings before the hospital and in one court proceeding, as well as negotiating a compromise between Dr. North and the hospital. The total bill for the law firm’s travel costs and professional services was $21,000, but Dr. North refused to pay $6,000 of it. The law firm brought an action against Dr. North for the balance owed. Dr. North argued that the action should be dismissed because the law firm failed to register as a foreign corporation in accordance with the Georgia Corporation Statute. Will the law firm be prevented from collecting on the contract? Explain. Answer: Classification of Corporations: Foreign or Domestic. Judgment for the law firm. In most jurisdictions, single or isolated transactions do not constitute doing business within the meaning of such registration statutes. Even if the transactions are part of the business which the corporation is organized to conduct, such isolated acts will not constitute doing business if they indicate no intent to engage in continuous business activity. The purpose of such statutes is to require registration of foreign corporations intending to conduct business within the state on a continuous basis, not as a temporary matter. Here, the law firm's activities were concentrated in Arizona, although various attorneys in the firm handled litigation outside the state of incorporation. Although West had represented clients in Georgia on two prior occasions, these had nothing to do with his representation of Dr. North. The law firm's representation of Dr. North amounted to an isolated transaction. Therefore, a certificate of authority was not required and the firm can collect from Dr. North. Reisman v. Martari, Meyer, Hendricks, & Victor, 155 Ga. App. 551, 271 8.E.S2d 685 (1980). 27. 11. An Arkansas statute provides that if any foreign corporation authorized to do business in the state should remove to the federal court any suit brought against it by an Arkansas citizen or initiate any suit in the federal court against a local citizen, without the consent of the other party, Arkansas’s secretary of state should revoke all authority of the corporation to do business in the state. The Burke Construction Company, a Missouri corporation authorized to do business in Arkansas, has brought a suit in federal court and has also removed to a federal court a state suit brought against it. Burke now seeks to enjoin the Secretary of State from revoking its authority to do business in Arkansas. Should the injunction be issued? Explain. Answer: Corporation As a Citizen/Foreign Corporation. No. Judgment for Burke on grounds that the statute violates the federal diversity statute. A corporation is regarded as a citizen of the state of its incorporation and of the state in which it has its principal office for the purpose of determining whether diversity of citizenship exists between the parties to a lawsuit, so as to provide a basis for federal court jurisdiction.. Terral v. Burke Construction Co., 257 U.S. 529, 42 S.Ct. 188, 66 L.Ed. 352 (1922). 28. 12. Little Switzerland Brewing Company was incorporated on January 28. On February 18, Ellison and Oxley were made directors of the company after they purchased some stock. Then, on September 25, Ellison and Oxley signed stock subscription agreements to purchase 5,000 shares each. Under the agreement, they both issued a note that indicated that they would pay for the stock “at their discretion.” Two years later in March, the board of directors passed a resolution canceling the stock subscription agreements of Ellison and Oxley. The creditors of Little Switzerland brought suit against Ellison and Oxley to recover the money owed under the subscription agreements. Are Ellison and Oxley liable? Why? Answer: Subscribers. Yes, they are liable. Judgment for the creditors. A subscriber to corporate stock is liable for his subscription regardless of any separate agreement between the subscriber and the corporation. Any person who permits the corporation to hold him out as a subscriber is estopped from denying the validity of the subscription as against creditors. Furthermore, the directors of the corporation did not have the authority to release Ellison and Oxley from liability on the agreements. Little Switzerland Brewing Co. v. Oxley, 156 W.Va. 800, 197 S.E.2d 301 (1973). 29. 13. Oahe Enterprises was formed by the efforts of Emmick, who acted as a promoter and contributed shares of Colonial Manors, Inc. (CM), stock in exchange for stock in Oahe. The CM stock had been valued by CM’s directors for internal stock option purposes at $19 per share. However, one month prior to Emmick’s incorporation of Oahe Enterprises, CM’s board reduced the stock value to $9.50 per share. Although Emmick knew of this reduction before the meeting to form Oahe Enterprises, he did not disclose this information to the Morrises, the other shareholders of the new corporation. Can Oahe Enterprises recover the shortfall? Answer: Promoter's Fiduciary Duty. Yes. The court held that Emmick had failed in his duty to the corporation to disclose information regarding stock he intended to transfer into Oahe for Oahe shares and is therefore liable for the shortfall to the corporation therefrom. As a promoter of Oahe, Emmick stood in a fiduciary relationship to both the corporation and its stockholders and was bound to deal with them in the utmost good faith. "The obtaining of a secret profit by a promoter through the sale of property to a corporation is uniformly held to be a fraud on the corporation and stockholders, and the promoter may be required to account for such profit." The case was remanded to the circuit court with directions to redetermine the fair market value of the CM stock exchanged by Emmick for Oahe stock. Golden v. Oahe Enterprises, Inc., 295 N.W.2d 160 (S.D. 1980). 30. 14. Healthwin-Midtown Convalescent Hospital, Inc. (Healthwin), was incorporated in California for the purpose of operating a health-care facility. For three years thereafter, it participated as a provider of services under the Federal Medicare Act and received periodic payments from the U.S. Department of Health, Education and Welfare. Undisputed audits revealed that a series of overpayments had been made to Healthwin. The United States brought an action to recover this sum from the defendants, Healthwin and Israel Zide. Zide was a member of the board of directors of Healthwin, the administrator of its health-care facility, its president, and owner of 50 percent of its stock. Only Zide could sign the corporation’s checks without prior approval of another corporate officer. Board meetings were not regularly held. In addition, Zide had a 50 percent interest in a partnership that owned both the realty in which Healthwin’s health-care facility was located and the furnishings used at that facility. Healthwin consistently had outstanding liabilities in excess of $150,000, and its initial capitalization was only $10,000. Zide exercised control over Healthwin, causing its finances to become inextricably intertwined with both his personal finances and his other business holdings. The United States contends that the corporate veil should be pierced and that Zide should be held personally liable for the Medicare overpayments made to Healthwin. Is the United States correct in its assertion? Why? Answer: Disregard of Corporateness: Closely Held. Judgment for the U.S. The corporate veil may be pierced if (1) there is such unity of interest and ownership that the personalities of the corporation and the individual no longer exist separately; and (2) if it would be inequitable to treat the acts as those of the corporation alone. It is not necessary that there is actual fraud; it is sufficient that the failure to pierce the corporation's veil would result in an injustice. Other factors the courts consider in determining whether the corporate veil should be pierced include: inadequacy of the corporation's capitalization or its insolvency; failure to observe corporate formalities; absence of regular board meetings; nonfunctioning of corporate directors; commingling of corporate and noncorporate assets; diversion of assets from the corporation to the detriment of creditors; and failure of an individual to maintain an arm's length relationship with the corporation. All these factors are present here. The corporation was initially undercapitalized and its liabilities continued to exceed its assets substantially: Healthwin consistently had outstanding liabilities in excess of $150,000, and its initial capitalization was only $10,000. Zide exercised his control over Healthwin so as to cause its finances to become inextricably intertwined with both his personal finances and his other business holdings. Zide handled Healthwin's finances so as to accommodate his own business interests. Another factor present here is that the operations of Healthwin were marked by an essential disregard of corporate formalities. For example, board meetings were not regularly held. Furthermore, to leave Healthwin's corporate veil unpierced would result in an injustice. Healthwin's insolvency would subject all its creditors, including the United States, to inequitable risks regarding the corporation's debts. Therefore, Healthwin's corporate entity should be disregarded and Zide held personally liable. U.S. v. Healthwin-Midtown Convalescent Hospital, 511 F. Supp. 416 (Calif. Cent. Dist. 1981). 31. 15. MPL Leasing Corporation is a California corporation that provides financing plans to dealers of Saxon Business Products. MPL invited Jay Johnson, a Saxon dealer in Alabama, to attend a sales seminar in Atlanta. MPL and Johnson entered into an agreement under which Johnson was to lease Saxon copiers with an option to buy. MPL shipped the equipment into Alabama and filed a financing statement with the secretary of state. When Johnson became delinquent with his payments to MPL, MPL brought an action against Johnson in an Alabama court. Johnson moved to dismiss the action, claiming that MPL was not qualified to conduct business in Alabama and was thus barred from enforcing its contract with Johnson in an Alabama court. Alabama law prevents foreign corporations not qualified to do business in Alabama from enforcing their intrastate contracts in the Alabama court system Is Johnson correct? Answer: Foreign Corporations. Judgment for MPL affirmed. Alabama law prevents foreign corporations not qualified to do business in Alabama from enforcing their contracts in the Alabama court system. This provision, however, only applies to business that is "intrastate" in nature. MPL's activities within the state of Alabama were limited to delivering the copiers to Johnson by common carrier and filing suit against Johnson when he fell behind with his payments. These minimal contacts were insufficient to constitute "intrastate" business. Therefore, MPL, though not qualified to conduct business in Alabama, may enforce its rights against Johnson in an Alabama court. Johnson v. MPL Leasing Corp. 441 So.2d 904 (Ala.S.C. 1983). 32. 16. In April, Cranson was asked to invest in a new business corporation that was about to be created. He agreed to purchase stock and to become an officer and director. After his attorney advised him that the corporation had been formed under the laws of Maryland, Cranson paid for and received a stock certificate evidencing his ownership of shares. The business of the new venture was conducted as if it were a corporation. Cranson was elected president, and he conducted all of his corporate actions, including those with IBM, as an officer of the corporation. At no time did he assume any personal obligation or pledge his individual credit to IBM. As a result of an oversight of the attorney, of which Cranson was unaware, the certificate of incorporation, which had been signed and acknowledged prior to May 1, was not filed until November 24. Between May 1 and November 8, the “corporation” purchased eight computers from IBM. The corporation made only partial payment. Can IBM hold Cranson personally liable for the balance due? Answer: Recognition of Corporateness. No, Cranson is not personally liable. The fundamental question presented by the appeal was whether an officer of a defectively incorporated association may be subjected to personal liability. Two doctrines have been used by the courts to clothe an officer of a defectively incorporated association with the corporate attribute of limited liability; the doctrine of de facto corporations and the doctrine of estoppel. In other cases involving a failure to file articles of incorporation, the courts have held that where one has recognized the corporate existence of an association, he is estopped to assert the contrary with respect to a claim arising out of such dealings. Since IBM was estopped to deny the existence of the "corporation" the court held that Cranson was not personally liable for the balance on account of the computers. . Cranson v. International Business Machines Corp. 234 Md. 477, 200 A.2d 33 (1964). 33. 17. Berger was planning to produce a fashion show in Las Vegas. In April 1965, Berger entered into a written licensing agreement with CBS Films, Inc., a wholly owned subsidiary of CBS, for presentation of the show. In 1966, Stewart Cowley decided to produce a fashion show similar to Berger’s and entered into a contract with CBS. CBS broadcast Cowley’s show, but not Berger’s; and Berger brought this action against CBS to recover damages for breach of his contract with CBS Films. Berger claimed that CBS was liable because CBS Films was not operated as a separate entity , and that the court should disregard the parent-subsidiary form. In support of this claim, Berger showed that the directors of CBS Films were employees of CBS, that CBS’s organizational chart included CBS Films, and that all lines of employee authority from CBS Films passed through CBS employees to the CBS chairman of the board. CBS, in turn, argued that Berger had failed to justify piercing the corporate veil and disregarding the corporate identity of CBS Films in order to hold CBS liable. Decision? Answer: Disregard of Corporateness: Parent-Subsidiary. Judgment for CBS. Generally, a corporation is a creature of the law, endowed with a personality separate and distinct from that of its owners. A principal reason that legal recognition is given to the separate corporate personality is to allow stockholders an opportunity to limit their personal liability. Therefore, in order to pierce the corporate veil holding the parent liable for the acts of its subsidiary, Berger must have shown (1) control and complete domination of the subsidiary by the parent; (2) use of such control to commit fraud or wrong; and (3) that the control and breach of duty is the proximate cause of the injury complained of. Here the evidence does not sustain any finding that CBS completely dominated the finances, policy, and business practices of CBS Films. Therefore, the instrumentality rule is inapplicable, and the parent, CBS, cannot be held liable for any breach of contract by its subsidiary CBS. Berger v. Columbia Broadcasting System, Inc., 453 F.2d 991 (1972). 34. 18. Frank McAnarney and Joseph Lemon entered into an agreement to promote a corporation to engage in the manufacture of farm implements. Before the corporation was organized, McAnarney and Lemon solicited subscriptions to the stock of the corporation and presented a written agreement for the subscribers to sign. The agreement provided that the subscribers would pay $100 per share for stock in the corporation in consideration of McAnarney and Lemon’s agreement to organize the corporation and advance the preincorporation expenses. Thomas Jordan signed the agreement, making application for one hundred shares of stock. After the articles of incorporation had been filed with the Secretary of State but before the charter was issued to the corporation, Jordan died. The administrator of Jordan’s estate notified McAnarney and Lemon that the estate would not honor Jordan’s subscription. After the formation of the corporation, Franklin Adams signed a subscription agreement making application for one hundred shares of stock. Before the corporation accepted the subscription, Adams informed the corporation that he was canceling it. a) Can the corporation enforce Jordan's stock subscription against Jordan's estate? b) Can the corporation enforce Adams's stock subscription? Answer: Transfer of Securities. (a) The corporation may recover from Jordan's estate. A subscription for shares of a corporation to be organized is irrevocable for a period of six months unless provided otherwise by the terms of the agreement or unless its revocation is consented to by all the subscribers. §6.20, RMBCA. Though the administrator is not personally liable, the estate is. (b) The corporation may not recover from Adams. In post-organization subscriptions or agreements to purchase the corporation's shares, the subscriber may withdraw or cancel his subscription at any time before it is accepted by the corporation. He cannot withdraw after the subscription has been accepted as the acceptance forms a contract. 35. 19. Green & Freedman Baking Company (Green & Freedman) was a corporation owned by the Elmans that produced and sold baked goods. The terms of a col¬lective bargaining agreement required Green & Freedman Baking Company to make periodic payments on behalf of its unionized drivers to the New England Teamsters and Baking Industry Health Benefits and In¬surance Fund (Health Fund). After sixty years of opera¬tion Green & Freedman experienced financial difficulties and ceased to make the agreed-upon contributions. The Elmans mixed their own finances with those of Green & Freedman's. The Elmans, through their domination of Green & Freedman, caused the corporation to make payments to themselves and their relatives at a time when the corporation was known to be failing and could be expected to default, or was already in default, on its obligations to the Health Fund. It then transferred all remaining assets to a successor entity named Boston Bakers, Inc. (Boston Bakers). Boston Bakers operated essentially the same business as Green & Freedman until its demise two years later. The Health Fund sued Green & Freedman, Boston Bakers, and the two corporations’ principals, Richard Elman and Stanley Elman, to recover the payments owed by Green & Freedman with interest, costs, and penalties. There was no evidence of financial self-dealing in the case of Boston Bakers. Both corporate defendants conceded liability for the delinquent contributions owed by Green & Freedman to the Health Fund. The suit against the Elmans was based on piercing the corporate veil with respect to Green & Freedman and Boston Bakers. The Elmans, however, denied they were personally liable for these corporate debts. Are the Elmans liable? Explain. Answer: Piercing the Corporate Veil. The Elmans are not liable for the obligations of Green & Freedman but are liable for the obligations of Boston Bakers. The legal standard for when it is proper to pierce the corporate veil is not precise because it can vary according to the case circumstances. Courts consider the respect paid by the shareholders themselves to the separate corporate identity; the fraudulent intent of the individual defendants; and the degree of injustice that would be visited on the litigants by recognizing the corporate identity. In this case, there is ample evidence of fraudulent intent to afford a reasonable jury, applying the these criteria, and exercising its broad authority over the veil-piercing issue, a legally sufficient basis to reach beyond Green & Freedman's corporate identity and hold the Elmans liable for the corporation's unpaid contributions. These facts support a reasonable inference by a jury that the Elmans, in the two years before Green & Freedman's demise, did not treat Green & Freedman as a separate entity, placed personal interests ahead of the corporation's responsibilities, and did not themselves honor the corporate form. The next question is whether a jury could hold the Elmans personally liable for Boston Bakers' successorship obligation to pay Green & Freedman's indebtedness. For this to happen there must be showing of fraud related to Boston Bakers. The Health Fund claims the bulk transfer of assets is inherently fraudulent, a claim which is undercut by the fact that the Elmans did not conceal the transfer. There is no evidence of financial self-dealing in the case of Boston Bakers such as occurred with Green & Freedman. The Elmans do not have personal liability for Boston Bakers' corporate obligation to make good Green & Freedman's delinquent payments to the Health Fund. Crane v. Green & Freedman Baking Company, Inc., 134 F.3d 17 (1998) 36. 20. Ronald Nadler was a resident of Maryland and the CEO of Glenmar Cinestate, Inc., a Maryland corporation, as well as its principal stockholder. Glenmar leased certain space in the Westridge Square Shopping Center, located in Frederick, Maryland, and in Cranberry Mall, located in Westminster, Maryland. Tiller Construction Corporation and Nadler entered into two contracts for the construction of movie theaters at these locations, one calling for Tiller to do the work for Nadler at Westridge for $637,000, and the other for Tiller to do the work for Nadler at Cranberry for $688,800. Ronald Nadler requested that Tiller send all bills to Glenmar, the lessee at both shopping malls, but agreed to be personally liable to Tiller for the payment of both contracts. All inventory was bought and paid for locally and Tiller paid sales tax in Maryland. Although there was no formal office in the state, Tiller leased a motel room for a considerable period of time, posted a sign at the job site, and maintained telephones listed in information. In addition, Tiller engaged in fairly pervasive management functions, and the value of the projects comprised a substantial part of Tiller’s revenues during the period. At the time of the suit, there was a net balance due for the Cranberry project in the amount of $229,799.46, and on the Westridge project for the sum of $264,273.85, which Nadler refused to pay, even though he had approved all work and the work had been performed in a timely, good, and workmanlike manner. Tiller Construction Corporation sued Ronald Nadler and Glenmar Cinestate, Inc., for breach of contract. Nadler filed a motion to dismiss based on Maryland’s business corporation statute which prohibits a foreign corporation that conducts intrastate business in Maryland from maintaining a suit in Maryland courts if the corporation fails to register or qualify under Maryland law. Nadler asserted that Tiller was a New York corporation that had never qualified to transact business in the state of Maryland. Tiller conceded that the corporation had not qualified to do business in Maryland but argued that Tiller was not required to qualify because its activities did not constitute, in the contemplation of the statute, doing business in the state as Tiller just had occasional business in Maryland. Discuss whether Tiller could bring suit in Maryland. Answer: Classification of Corporations/Domestic or Foreign. Under Maryland law a foreign corporation is doing business within the state when it transacts some substantial part of its ordinary business in that state, and it is forbidden from bringing suit in a Maryland court if it has not properly registered or qualified there. Where, however, the corporation does not engage in significant business activity in Maryland, a corporation is permitted to maintain an action in the courts of this state even though it has neither registered nor qualified. Whether the acts engaged in by a foreign corporation are sufficient to constitute “doing business” must be determined from the facts of each case, including (1) whether the foreign corporation pays state taxes; (2) whether it maintains property, an office, telephone listings, employees, agents, inventory, research and development facilities, advertising and bank accounts in the state; (3) whether it makes contracts in the state; and (4) whether its management functions in the state are pervasive. The trial court found that all inventory was bought and paid for locally and that Tiller had paid sales tax in Maryland. The court also found that, although there was no formal office in the state, Tiller leased a motel room for a considerable period of time, posted a sign at the job site, and maintained telephones listed in information. In addition, Tiller engaged in fairly pervasive management functions, and the value of the projects comprised a substantial part of Tiller’s revenues during the period. From this the court properly determined that Tiller was doing business in Maryland and concluded that Tiller had indeed transacted some substantial part of its ordinary business in Maryland. Tiller, therefore, cannot bring suit against Nadler in a Maryland court. Tiller Construction Corp. v. Nadler, 334 Md. 1, 637 A.2d 1183 (1994) 37. 38. 21. Harold Lang Jewelers, Inc. (Lang), a Florida corporation, through its single employee, had sold and consigned merchandise to jewelry stores in western North Carolina for almost thirty years. Lang’s employee came frequently to North Carolina for the purpose of transacting business. When the employee came to North Carolina, he always brought jewelry with him for delivery. When he visited jewelry stores in the State, he would either (a) make a direct sale on the spot without any confirmation from any other person or (b) consign the jewelry, also without any further confirmation or approval from any other person. When the employee took orders, he either shipped the ordered items to the business in North Carolina or personally delivered the merchandise. He also took returns of merchandise from customers in the State. Lang filed suit against, alleging that Johnson owed Lang $160,322.90 plus interest for jewelry sold or consigned. Johnson asserted as one of its defenses that Lang could not sue in a North Carolina court because Lang had failed to obtain a certificate of authority to transact business in the State. Explain whether the court should dismiss Lang’s action. Answer Foreign Corporations Yes, a foreign corporation must obtain a certificate of authority in every State in which it conducts intrastate business. Harold Lang Jewelers, Inc. v. Johnson, Court of Appeals of North Carolina, 2003, 156 N.C. App. 187, 576 S.E.2d 360; review denied, 357 N.C. 458, 585 S.E.2d 765. Transacting business in the State “require[s] the engaging in, carrying on or exercising, in North Carolina, some of the functions for which the corporation was created.” The activities carried on by the corporation in North Carolina must be substantial, continuous, systematic, and regular. Lang’s business in North Carolina has been regular, systematic, and extensive. Lang has been coming to North Carolina almost thirty years to sell and consign merchandise to several jewelry stores. In fact, Lang routinely came to North Carolina as frequently as twice every four weeks during some parts of the year, and each time he brought with him merchandise to deliver. Moreover, Lang’s employee finalized the sales in North Carolina. 39. ANSWERS TO “TAKING SIDES” PROBLEMS In May, Parr and Presba, while in the course of negotiations with Barker (a salesperson for Quaker Hill) to purchase plants and flowers, undertook to organize a corporation to be named the Denver Memorial Nursery, Inc. On May 14 and 16, Parr signed two orders on behalf of Denver Memorial Nursery, Inc. which, to the knowledge of Quaker Hill, was not yet formed, that fact being noted in the contract. A down payment in the amount of $1,000 was made. The corporation was not formed prior to entering into the contract because Quaker Hill insisted that the deal be concluded at once since the growing season was rapidly passing. Under the contract, the balance of the purchase price was not due until the end of the year. The plants and flowers were shipped immediately and arrived on May 26. The Denver Memorial Nursery, Inc. was never formed. Quaker Hill seeks to recover the unpaid balance of the purchase price from Parr and Presba. (a) What are the arguments that Parr and Presba are personally liable for the unpaid balance? (b) What are the arguments that Parr and Presba are not personally liable for the unpaid balance? (c) Explain who should prevail. Answer: (a) Quaker Hill would argue that promoters who enter a contract in the name of a proposed corporation are personally liable in the absence of an agreement that they should not be liable even if the corporation adopts the contract. (b) Parr and Presba would argue that they are not personally liable because Quaker Hill manifested an intent to look for payment only from Denver Memorial Nursery, Inc. (c) Parr and Presba are not liable as individuals. Quaker Hill, Inc. v. Parr, 364 P. 2d 1056, Colorado Supreme Court (1961). The general principle applicable here is that promoters are personally liable on their contracts, though made on behalf of a corporation to be formed. A well-recognized exception to this general rule, however, is that if the contract is made on behalf of the corporation and the other party agrees to look to the corporation and not to the promoters for payment, the promoters incur no personal liability. In this case, the plaintiff, acting through its agent, was well aware of the fact that the corporation was not formed and nevertheless urged that the contract be made in the name of the proposed corporation. The entire transaction contemplated the corporation as the contracting party. Personal liability does not arise under such circumstances. Chapter 34 FINANCIAL STRUCTURE ANSWERS TO QUESTIONS AND CASE PROBLEMS 40. 1. Olympic National Agencies was organized with an authorized capitalization of preferred stock and common stock. The articles of incorporation provided for a 7 percent annual dividend for the preferred stock. The articles further stated that the preferred stock would be given priority interests in the corporation’s assets up to the par value of the stock. After some years, the shareholders voted to dissolve Olympic. Olympic’s assets greatly exceeded its liabilities. The liquidating trustee petitioned the court for instructions on the respective rights of the shareholders in the assets of the corporation upon dissolution. The court ordered the trustee to distribute the corporate assets remaining after the preference of the preferred stock is satisfied to the common and preferred stockholders on a pro rata basis. Was the court correct in rendering this decision? Explain. Answer: Preferred Stock. No. The preferred stockholders should be paid only the par value of their stock before any liquidation dividends are paid to the common stockholders. Where one class of stock is afforded a stated preference as to assets on liquidation and the articles of incorporation are silent as to any further participation, the clear implication is that the rights of the preferred stock are exhausted once the preference has been satisfied. In Re Olympic National Liquidation Agencies, Inc. 442 P.2d 246 (Wash. 1968). 41. 2. The XYZ Corporation was duly organized on July 10. Its certificate of incorporation provides for total authorized capital of $1 million, consisting of 10,000 shares of common stock with a par value of $100 per share. The corporation issues for cash a total of 500 certificates, numbered 1 to 500 inclusive, representing various amounts of shares in the names of various individuals. The shares were all paid for in advance, so the certificates are all dated and mailed on the same day. The 500 certificates of stock represent a total of 10,500 shares. Certificate 499 for 300 shares was issued to Jane Smith. Certificate 500 for 250 shares was issued to William Jones. Is the validity of the stock thus issued in any way questionable? What are the rights of Smith and Jones? Answer: Issuance of Shares. The XYZ Corporation may not validly issue more than 10,000 shares of its common stock, as that number of shares is all that it is authorized by its charter to issue. Any certificate representing shares in excess of the amount authorized is void. Certificates Nos. 499 and 500 are void because they each represent an over-issue of 250 shares. Jane Smith is entitled to a new certificate for fifty shares. Both Jane Smith and William Jones are entitled with respect to the over-issue of 250 shares to recover from the issuer the price he or the last purchaser for value paid for it with interest from the date of his demand. U.C.C. Section 8-104 (1)(b). 42. 3. Doris subscribed for 200 shares of 12 percent cumulative, participating, redeemable, convertible, preferred shares of the Ritz Hotel Company with a par value of $100 per share. The subscription agreement provided that she was to receive a bonus of one share of common stock of $100 par value for each share of preferred stock. Doris fully paid her subscription agreement of $20,000 and received the 200 shares of preferred stock and the bonus stock of 200 shares of the par value common. The Ritz Hotel Company later becomes insolvent. Ronald, the receiver of the corporation, brings suit for $20,000, the par value of the common stock. What judgment? Answer: Amount of Consideration for Shares. Ronald is entitled to recover $20,000 from Doris. Par value shares may be issued for any amount, not less than par, set by the board of directors or shareholders. The par value of stock must be stated in the articles of incorporation. Doris paid nothing for the 200 shares of bonus par value common stock. As the common stock had a par value of $100 per share and may not be issued for less than par, Doris owes the full amount of the par value of it. 43. 4. Hyperion Company has an authorized capital stock of 1,000 shares with a par value of $100 per share, of which 900 shares, all fully paid, were outstanding. Having an ample surplus, Hyperion Company purchased from its shareholders 100 shares at par. Subsequently, Hyperion, needing additional working capital, issued the 200 shares in question to Alexander at $80 per share. Two years later, Hyperion Company was forced into bankruptcy. How much, if any, may the trustee in bankruptcy recover from Alexander? Answer: Treasury Stock. The trustee in bankruptcy may not recover with respect to the sale of the 100 treasury shares, but may recover $2,000 from Alexander with respect to the 100 previously unissued shares. The outstanding 900 shares of capital stock were all fully paid. When Hyperion Company purchased from its shareholders 100 shares at par ($100) it was not only solvent but had an ample surplus. The 100 shares purchased became treasury shares. Treasury shares may be disposed of by the corporation for such consideration expressed in dollars as may be fixed from time to time by the board of directors. Hyperion had the right to sell the 100 shares of treasury stock to Alexander for $80 per share. With respect to the sale of 100 previously unissued shares, the trustee in bankruptcy has a valid claim against Alexander for $20 per share, or $2,000. Shares having a par value may be issued for such consideration expressed in dollars, not less than the par value thereof, as shall be fixed from time to time by the board of directors. Alexander bought 100 shares at $80 per share, or $20 per share less than par, and therefore owed the Hyperion Company the unpaid balance of $2,000. This right of Hyperion Co. became an asset of its trustee in bankruptcy. 44. 5. For five years, Henry and James had been engaged as partners in building houses. They owned the equipment necessary to conduct the business and had an excellent reputation. In March, Joyce, who previously had been in the same kind of business, proposed that Henry, James, and Joyce form a corporation for the purpose of constructing medium-priced houses. They engaged attorney Portia, who did all the work required and caused the business to be incorporated under the name of Libra Corp. The certificate of incorporation authorized one thousand shares of $100 par value stock. At the organizational meeting of the incorporators, Henry, James, and Joyce were elected directors, and Libra Corp. issued a total of 650 shares of its stock. Henry and James each received 200 shares in consideration for transferring to Libra Corp. the equipment and goodwill of their partnership, which had a combined value of more than $40,000. Joyce received 200 shares as an inducement to work for Libra Corp. in the future, and Portia received 50 shares as compensation for the legal services she rendered in forming Libra Corp. Later that year, Libra Corp. had a number of financial setbacks and in December ceased operations. What rights, if any, does Libra Corp. have against Henry, James, Joyce, and Portia in connection with the original issuance of its shares? Answer: Liability for Shares. The answer differs depending upon the statutory provision that has been adopted in the state of incorporation. In general, consideration for the issuance of capital stock is defined in a more limited fashion than under contract law. In a number of states, future services are considered to be invalid consideration. However, the Revised Act greatly liberalized the rules regarding valid consideration. The Revised Act specifically validates contracts for future services and promissory notes as consideration for the issuance of shares. However, the Revised Act requires that the corporation annually inform shareholders of all shares issued for promissory notes or future services. Under the Revised Act, Joyce's consideration is valid and there is no liability on his part or on the part of the directors. However, in a number of states, Joyce has obtained her shares for invalid consideration and remains liable to the corporation for the purchase price of $2,000. In those states Henry and James are also liable as directors for the issuance of stock for an illegal consideration. The consideration given by Henry and James for their shares was sufficient. Good will and equipment are valid considerations. In the absence of fraud, the judgment of the Board or shareholders as to the value of the consideration received for shares is conclusive. The consideration given by Portia was sufficient, because legal services already rendered is valid consideration. Again, the judgment of the Board or shareholders as to the value of the consideration received for shares is conclusive. See Section 6.21 of the RMBCA. 45. 6. Paul Bunyan is the owner of noncumulative 8 percent preferred stock in the Broadview Corporation, which had no earnings or profits in 2015. In 2016, the corporation had large profits and a surplus from which it might properly have declared dividends. The directors refused to do so, however, instead using the surplus to purchase goods necessary for the corporation's expanding business. The corporation earned a small profit in 2017. The directors at the end of 2017 declared a 10 percent dividend on the common stock and an 8 percent dividend on the preferred stock without paying preferred dividends for 2016. a) Is Bunyan entitled to dividends for 2015? For 2016? b) IS BUNYAN ENTITLED TO A DIVIDEND OF 10 PERCENT RATHER THAN 8 PERCENT IN 2017? Answer: Dividend Preferences. (a) Under the majority rule, Bunyan is not entitled to dividends in either year. The preferred stock is noncumulative. When the directors do not see fit to declare a dividend on the preferred stock for any particular year, the holders of noncumulative preferred stock have lost all rights to a dividend for that year, as undeclared dividends do not cumulate. (b) No. As the holder of noncumulative preferred Bunyan is entitled to the preferred dividend of 8% for 2014. In the absence of a specific provision in the articles of incorporation that the preferred is also participating, Bunyan is not entitled to any dividends beyond 8%. 46. 7. Alpha Corporation has outstanding 400 shares of $100 par value common stock, which has been issued and sold at $105 per share for a total of $42,000. Alpha is incorporated in State X, which has adopted the earned surplus test for all distributions. At a time when the assets of the corporation amount to $65,000 and the liabilities to creditors total $10,000, the directors learn that Rachel, who holds 100 of the 400 shares of stock, is planning to sell her shares on the open market for $10,500. Believing that this will not be in the best interest of the corporation, the directors enter into an agreement with Rachel to buy the shares for $10,500. About six months later, when the assets of the corporation have decreased to $50,000 and its liabilities, not including its liability to Rachel, have increased to $20,000, the directors use $10,000 to pay a dividend to all of the shareholders. The corporation later becomes insolvent. (a) Does Rachel have any liability to the corporation or its creditors in connection with the corporation’s reacquisition of the 100 shares? (b) Was the payment of the $10,000 dividend proper? Answer: Dividend Preferences. (a) No. The agreement of the corporation to purchase the stock of Rachel was valid when made because at that time the corporation had $13,000 earned surplus and $2,000 capital surplus. (b) The payment of the $10,000 dividend was illegal. A dividend may be properly paid only out of earnings or earned surplus. At the time this dividend was paid, the liabilities of the corporation totaled $30,500 ($20,00 plus the $10,500 owed to Rachel), the stated capital was $30,000 (the original $40,000 reduced by the $10,000 of shares repurchased from Rachel), the capital surplus was $1,500 (the original $2,000 reduced by the $500 of shares repurchased from Rachel), and as a result the earned surplus was a negative $12,000. Therefore, the corporation had a deficit and payment of the dividend further impaired its capital. 47. 8. Almega Corporation, organized under the laws of State S, has outstanding twenty thousand shares of $100 par value nonvoting preferred stock calling for noncumulative dividends of $5 per year; ten thousand shares of voting preferred stock with $50 par value, calling for cumulative dividends of $2.50 per year; and ten thousand shares of no par common stock. State S has adopted the earned surplus test for all distributions. As of the end of 2012, the corporation had no earned surplus. In 2013, the corporation had net earnings of $170,000; in 2014, $135,000; in 2015, $60,000; in 2016, $210,000; and in 2017, $120,000. The board of directors passed over all dividends during the four years from 2013 through 2016, because the company needed working capital for expansion purposes. In 2017, however, the directors declared on the noncumulative preferred shares a dividend of $5 per share, on the cumulative preferred stock a dividend of $12.50 per share, and on the common stock a dividend of $30 per share. The board submitted its declaration to the voting shareholders, and they ratified it. Before the dividends were paid, Payne, the record holder of five hundred shares of the noncumulative preferred stock, brought an appropriate action to restrain any payment to the cumulative preferred or common shareholders until the company paid to noncumulative preferred shareholders a full dividend for the period from 2013 to 2016. Decision? What is the maximum lawful dividend that may be paid to the owner of each share of common stock? Answer: Dividend Preferences. The board had authority to exclude noncumulative shares from any past year dividend. The cumulative preferred stock is entitled to a dividend of $2.50 per share for each of the four years when the board of directors passed over all dividends plus $2.50 per share for the current year if common stock is to receive any dividend in the current year. The noncumulative preferred stock would have no right to any accrual of dividends during the four years when no dividends were declared. The noncumulative preferred stock is entitled to a dividend of $5.00 per share for the current year if common stock is to receive any dividend amounting to $100,000 out of current earnings and available surplus. This amount, added to dividends totaling $125,000 on the cumulative preferred stock to make up for dividend arrearages and current dividends, would aggregate $225,000 of dividends on both classes of preferred stock payable in the current year. As the total earnings and earned surplus for the five years amount to $695,000, exclusive of any surplus on hand from operations prior to the first year of no dividend, the remainder available for dividends on the common stock equals $470,000 which results in a maximum lawful dividend to common stock of $47 per share. A dividend of $30 per share on the common stock amounting to $300,000 would therefore be permissible, and would leave a remaining surplus of $170,000. The ratification by the voting shareholders does not have any bearing on the problem. The board is the body in complete control of dividends (barring some retention of authority in the shareholders contained in the articles of incorporation) so long as there is no abuse of discretion. 48. 9. Sayre learned that Adams, Boone, and Chase were planning to form a corporation for the purpose of manufacturing and marketing a line of novelties to wholesale outlets. Sayre had patented a self-locking gas tank cap but lacked the financial backing to market it profitably. He negotiated with Adams, Boone, and Chase, who agreed to purchase the patent rights for $5,000 in cash and 200 shares of $100 par value preferred stock in a corporation to be formed. The corporation was formed and Sayre’s stock issued to him, but the corporation has refused to make the cash payment. It has also refused to declare dividends, although the business has been very profitable because of Sayre’s patent and has a substantial earned surplus with a large cash balance on hand. It is selling the remainder of the originally authorized issue of preferred shares, ignoring Sayre’s demand to purchase a proportionate number of these shares. What are Sayre’s rights, if any? Answer: Dividends and Other Distributions. The corporation is obligated to pay Sayre $5,000. Sayre will probably be unable to compel the declaration and payment of a dividend. Sayre has no preemptive right to purchase original unissued shares of preferred stock. (a) After a corporation comes into being it may either expressly or impliedly ratify a contract made on its behalf and thus become bound. There is no evidence of express ratification of the contract by vote of the shareholders or directors, but there is ample evidence of implied ratification by acceptance of the benefits of the contract for purchase of the gas tank cap rights. The corporation takes the burdens with the benefits and is bound to pay the $5,000 to Sayre. (b) As to the refusal to declare dividends, the courts say that it is not their business to operate business corporations and to substitute their business judgment for that of the board of directors. On the other hand, the courts are equally ready to say that it is the purpose of corporations to make money and pay it out to shareholders in the form of dividends. The directors will not be permitted to abuse their discretion in the withholding of dividends. Dodge v. Ford Motor Co., in text. (c) The Act, Section 6.30 provides that unless otherwise provided in the articles of incorporation, holders of shares shall not be entitled to any preemptive right. 49. 10. Wood, the receiver of Stanton Oil Company, sued Stanton’s shareholders to recover dividends paid to them for three years, claiming that at the time these dividends were declared, Stanton was in fact insolvent. Wood did not allege that the present creditors were also creditors when the dividends were paid. Were the dividends wrongfully paid? Explain. Answer: Liability For Improper Dividends and Distribution. No, judgment for the shareholders. Shareholders are not required to repay dividends unless (1) the dividend impairs the corporation's capital stock and the shareholders have notice of this fact; or (2) the dividend was made while the corporation was insolvent and suit is brought by creditors existing when the dividend was paid. Under the second theory, the shareholders are liable to the representative of the existing creditors for the amount of the dividends thus received. Because Wood did not allege that some of the present creditors were also creditors when the dividends were paid, the court must rule for the shareholders. Wood v. City National Bank, 24 F.2d 661 (2d Cir. 1928) 50. 11. International Distributing Export Company (I.D.E.) was organized as a corporation on September 7, 2010, under the laws of New York and commenced business on No¬vember 1, 2010. I.D.E. formerly had been in existence as a sole proprietorship. On October 31, 2010, the newly organized corporation had liabilities of $64,084. Its only assets, in the sum of $33,042, were those of the former sole proprietorship. The corporation, however, set up an asset on its balance sheet in the amount of $32,000 for goodwill. As a result of this entry, I.D.E. had a surplus at the end of each of its fiscal years from 2011 until 2016. Cano, a shareholder, received $7,144 in dividends from I.D.E. during the period from 2012 to 2017. May Fried, the trustee in bankruptcy of I.D.E., recover the amount of these dividends from Cano on the basis that they had been paid when I.D.E. was insolvent or when its capital was impaired? Answer: Improper Dividends. Judgment for Cano. There was no evidence that the corporation was not paying its debts as they matured. The wrongful declaration of a dividend out of capital, in violation of the incorporation statute, is a wrong of those committing it. Innocent participants are not accomplices to its commission. In order to hold the stockholder who received the dividend liable, it is necessary to prove the stockholder's complicity in and knowledge of the wrong. Fried did not prove that Cano had knowledge that his dividends were paid out of I.D.E.'s capital, or that the dividends impaired I.D.E.'s capital. Therefore, Cano cannot be held liable. Fried v. Cano, 167 F.Supp. 625 (S.D. N.Y. 1958). 51. 12. GM Sub Corporation (“GM Sub”), a subsidiary of Grand Metropolitan Limited, acquired all outstanding shares of Liggett Group, Inc., a Delaware corporation. Rothschild International Corporation (“Rothschild”) was the owner of 650 shares of the 7 % cumulative preferred stock of Liggett Group, Inc. According to Liggett's certificate of incorporation, the holders of the 7 % preferred were to receive $100 per share “in the event of any liquidation of the assets of the Corporation.” GM Sub had offered $70 per share for the 7 % preferred, $158.63 for another class of preferred stock, and $69 for each common stock share. Liggett's board of directors approved the offer as fair and recommended acceptance by Liggett's shareholders. As a result, 39.8 % of the 7 % preferred shares was sold to GM Sub. In addition, GM Sub acquired 75.9 % of the other preferred stock and 87.4 % of the common stock. The acquisition of the overwhelming majority of these classes of stock—coupled with the fact that the 7 % preferred shareholders could not vote as a class on the merger proposal—gave GM Sub sufficient voting power to approve a follow-up merger. As a result, all remaining shareholders other than GM Sub were eliminated in return for payment of cash for their shares. These shareholders received the same consideration ($70/share) as in the tender offer. Rothschild brought suit against Liggett and Grand Metropolitan, charging each with a breach of its duty of fair dealing owed to the 7 percent preferred shareholders. Rothschild based both claims on the contention that the merger was a liquidation of Liggett insofar as the rights of the 7 percent preferred stockholders were concerned and that those preferred shareholders therefore were entitled to the liquidation preference of $100 per share, not $70 per share. Are the preferred shareholders entitled to a liquidation preference? Why? Answer: Preferred Stock. Judgment for Liggett and Grand Metropolitan. Preference rights of preferred stock can be eliminated legally through the merger process. In addition, a merger is a separate and distinct process from a liquidation or a sale of assets. Thus, the 7 % preferred was always subject to defeasance by merger as the merger provisions of Delaware law are a part of Liggett's charter. The preferential rights attaching to shares of preferred stock are contractual in nature and governed by the express provisions of a corporation's charter. The holders of the 7 % preferred were entitled to be paid $100 per share only in the event of "any liquidation of the assets of the corporation." The liquidation of the preferred shareholders' rights was not a liquidation of the corporation itself, however, since the corporation continued to operate as a legal entity. Because the merger did not activate the preferred shareholders' right to $100 per share, that right could not have been violated. Furthermore, the $70 price offered was a fair and adequate price as of the time of the tender offer and merger. Therefore, neither Liggett nor Grand Metropolitan breached a duty of fair dealing. Rothschild International Corp. v. Liggett Group, Inc., 463 A.2d 642 (Del. 1983). 52. 13. Smith’s Food & Drug Centers, Inc. (SFD) is a Delaware corporation that owns and operates a chain of supermarkets in the Southwestern United States. Jeffrey P. Smith, SFD’s chief executive officer, and his family hold common and preferred stock constituting 62.1 percent voting control of SFD. On January 29, SFD entered into a merger agreement with the Yucaipa Companies that would involve a recapitalization of SFD and the repurchase by SFD of up to 50 percent of its common stock. SFD was also to repurchase 3 million shares of preferred stock from Jeffrey Smith and his family. In an April 25 proxy statement, the SFD board released a pro forma balance sheet showing that the merger and self-tender offer would result in a deficit to surplus on SFD’s books of more than $100 million. SFD hired the investment firm of Houlihan Lokey Howard & Zukin (Houlihan) to examine the transactions, and it rendered a favorable solvency opinion based on a revaluation of corporate assets. On May 17, in reliance on the Houlihan opinion, SFD’s board of directors determined that there existed sufficient surplus to consummate the transactions. On May 23, SFD’s stockholders voted to approve the transactions, which closed on that day. The self-tender offer was oversubscribed, so SFD repurchased fully 50 percent of its shares at the offering price of $36 per share. A group of shareholders challenged the transaction alleging that the corporation’s repurchase of shares violated the statutory prohibition against the impairment of capital. They argued that (a) the negative net worth that appeared on SFD’s books following the repurchase constitutes conclusive evidence of capital impairment and (b) the SFD board was not entitled to rely on a solvency opinion based on a revaluation of corporate assets. Explain who should prevail. Answer: Dividends and Other Distributions. Decision for Smith’s Food & Drug Centers. This problem is based on Klang v. Smith’s Food & Drug Centers, Inc., Supreme Court of Delaware, 702 A.2d 150 (1997), http://scholar.google.com/scholar_case?case=7152442145222039076&q=702+A.2d+150&hl=en&as_sclt=2,34. A corporation may not repurchase its shares if, in so doing, it would cause an impairment of capital. A repurchase impairs capital if the funds used in the repurchase exceed the amount of the corporation’s “surplus,” defined by the statute to mean the excess of net assets over the par value of the corporation’s issued stock. The books of a corporation do not necessarily reflect the current values of its assets and liabilities. Among other factors, unrealized appreciation or depreciation can render book numbers inaccurate. It is unrealistic to hold that a corporation is bound by its balance sheets for purposes of determining compliance with the statute. Accordingly, a corporation may revalue properly its assets and liabilities to show a surplus and thus conform to the statute. The legislature enacted the statute to prevent boards from draining corporations of assets to the detriment of creditors and the long-term health of the corporation. Allowing corporations to revalue assets and liabilities to reflect current realities complies with the statute and serves well the policies behind this statute. The SFD board of directors appropriately revalued corporate assets to comply with the statute. In the absence of bad faith or fraud on the part of the board of directors, courts will not substitute their concepts of wisdom for that of the directors. The statute entitles boards to rely on experts such as Houlihan to determine compliance with the statutory restrictions on distributions. 53. 14. In addition to a class of common stock, Peabody Coal Company had outstanding a class of cumulative 5% preferred shares with a par value of $25.00 with the following contractual rights as stated in the corporation’s articles of incorporation: 54. Preferences on Liquidation In the event of any liquidation, dissolution or winding up of the Company (whether voluntary or involuntary), the holders of the 5% Preferred Shares then outstanding shall, to the extent of the full par value of their shares and unpaid cumulative dividends accrued thereon be entitled to priority of payment out of the Company's assets over the holders of the Common Shares then outstanding. After such payment to the holders of the 5% Preferred Shares, the remaining assets shall be distributed pro rata to the holders of the Common Shares then outstanding. 55. Redemption The Company, upon the sole authority of its Board of Directors, may at any time redeem and retire all or any part of the 5% Preferred Shares at any time outstanding by paying or setting aside for payment for each share so called for redemption the sum of $26.00 plus a sum equal to the amount of all dividends accrued or in arrears thereon at the redemption date. 56. Peabody entered into negotiations for its sale to the Kennecott Copper Company. In order to complete the transaction, Peabody submitted to its shareholders a resolution for the approval of the sale to Kennecott and the adoption of a plan of complete liquidation. The proposed dissolution plan would (1) entitle the preferred shareholders to a preferential liquidating dividend of $25 par value per share plus any unpaid cumulative dividends accrued and (2) pay the remainder of the assets on a pro rata basis to the holders of the common stock of Peabody. The resolution was approved by the common and preferred shares voting as a single class. Preferred shareholders have challenged the plan of liquidation claiming that the corporation should have redeemed the preferred stock and then liquidated the corporation, thus entitling each preferred share to a $26 redemption payment along with accrued dividends. Explain whether the preferred shareholders should succeed. Answer: Liquidation Preferences. No, the preferred shareholders should not succeed: the preferred shareholders were given their contractual rights, pursuant to the corporate charter. This problem is based on Elward v. Peabody Coal Co., 121 Ill.App.2d 298, 257 N.E.2d 500 (1970). The rule has been stated that the rights of preferred stockholders are a matter of contract fixed by the articles of incorporation and the stock certificates. Tennant v. Epstein, 356 Ill. 26, 189 NE 864 (1934); Opelka v. Quincy Memorial Bridge Co., 335 Ill. App. 402, 82 NE2d 184 (1948). Furthermore, we agree with the rule cited by defendant that one who purchases and subscribes to stock of a corporation impliedly agrees to be bound by the acts approved by a majority of the stockholders, or by the corporate agents duly chosen by the majority, if accomplished within the scope of the powers conferred by the charter. Wheeler v. Pullman Iron & Steel Co., 143 Ill. 197, 32 NE 420 (1892). As stated in Fletcher's Cyclopedia on Corporations, Vol. 16A, § 8022 (1962): The general rule is that where a statute confers power on a majority, or a certain percent, of the stockholders to dissolve, the right is absolute, so far as the motives of the majority are concerned, in the absence of actual fraud, and not subject to judicial review on behalf of minority stockholders. 57. ANSWERS TO “TAKING SIDES” PROBLEMS 58. A closely held corporation sought to repurchase 25 percent of its outstanding shares from one of its shareholders. The corporation and the shareholder agreed that the corporation would purchase all of the shareholder’s stock at a price of $500,000, payable $100,000 immediately in cash and the balance in four consecutive annual installments. The state’s incorporation statute provides: “A corporation may purchase its own shares only out of earned surplus but the corporation may make no purchase of shares when it is insolvent or when such purchase would make it insolvent.” At the time of the repurchase of the shares, the corporation had an earned surplus of $250,000. (a) What are the arguments that the repurchase of shares satisfied the incorporation statute? (b) What are the arguments that the repurchase of the shares did not satisfy the incorporation statute? (c) Which argument should prevail? Answer: (a) At the time of repurchase there is sufficient earned surplus ($250,000) to pay the $100,000 due. Each subsequent installment of the repurchase transaction should be treated as an independent purchase transaction by applying the statutory earned surplus test at the time of each subsequent payment. (b) The statutory earned surplus test should be applied only once: at the time of purchase. The transaction should be viewed as a purchase for $500,000 cash and a loan of the unpaid cash price ($400,000) back to the corporation. The corporation’s earned surplus was $250,000, which was not sufficient to cover the $500,000 purchase price. (c) Courts have taken differing views on this matter. The court in Neimark v. Mel Kramer Sales, Inc., 306 NW 2d 278, Wisconsin Court of Appeals (1981) discussed the first approach: “For example, the effect of the Fourth Circuit Court of Appeals’ holding in Mountain State Steel Foundries, Inc. v. Commissioner, 284 F.2d 737 (1960), was to treat an installment repurchase transaction as if each successive installment constituted an independent purchase transaction by applying the surplus test at the time of each payment] In re Matthews Construction Co., 120 F.Supp.818 (S.D. Cal. 1954), also involved application of the surplus cutoff test and like Mountain State, indiscriminately applied the reasoning found in Robinson v. Wangemann, 75 F.2d 756 (5th Cir. 1935), that a contract of sale was executory until each payment was made in cash, and therefore applied the surplus cutoff test to each installment payment. However, the court in Neimark v. Mel Kramer Sales, Inc. took the second approach: The application of the surplus cutoff test is required to be timed to the purchase rather than the payment of cash. Such a construction comports with the need for corporate flexibility in acquiring its own stock for legitimate purposes and the protection of creditors and holders of other securities of the corporation. * * * The Minnesota and Texas Supreme Courts, and the Ninth Circuit Court of Appeals, have taken similar views. Solution Manual for Smith and Robersons Business Law Richard A. Mann, Barry S. Roberts 9781337094757, 9780357364000, 9780538473637