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Chapter 29 Planning in CHC

Chapter 29 Planning in CHC. Overview Dilemma – incorporated partnership Nature of CHC Shareholder voting arrangements Types: cumulative voting, class voting, voting trust, Irrevocable proxy, vote-pooling agreement, transfer restrictions Lawyer as director What if agreement –

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Chapter 29 Planning in CHC

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  1. Chapter 29Planning in CHC Overview Dilemma – incorporated partnership Nature of CHC Shareholder voting arrangements Types: cumulative voting, class voting, voting trust, Irrevocable proxy, vote-pooling agreement, transfer restrictions Lawyer as director What if agreement – deviates from model? Compare shareholder and management Ks does not comply with statute?Fiduciary duties of minority shareholders Module X – Close Corporations Bar exam Corporate practice Law profession Citizen of world Chapter 29 Planning in CHC

  2. Fundamentals Introduction to firm Corporate basics Corporations and policy Corporate federalism Corporate social responsibility Corporate political action Corporate form Organizational choices Incorporation Locating corporate authority Corporate finance Numeracy for corporate lawyers Capital structure Corporate externalities Piercing corporate veil Corporate environmental liability Corporate criminal liability Corporate governance Shareholder voting Shareholder information rights Public shareholder activism Fiduciary duties Shareholder litigation Board decision making Board oversight Director conflicts Executive compensation Corporate groups Stock trading Securities markets Securities fraud class actions Insider trading Corporate deals Sale of control Antitakeover devices Deal protection Close corporations Planning Oppression • Fundamentals • Introduction to firm • Corporate basics • Corporations and policy • Corporate federalism • Corporate social responsibility • Corporate political action • Corporate form • Organizational choices • Incorporation • Locating corporate authority • Corporate finance • Numeracy for corporate lawyers • Capital structure • Corporate externalities • Piercing corporate veil • Corporate environmental liability • Corporate criminal liability • Corporate governance • Shareholder voting • Shareholder information rights • Public shareholder activism • 10. Close corporations • Planning • Oppression • 7. Fiduciary duties • Shareholder litigation • Board decision making • Board oversight • Director conflicts • Executive compensation • Corporate groups Chapter 29 Planning in CHC

  3. Corporation – Traditional Model • Shareholder role • Vote (and voice) • elect board • veto fundamental changes • amend bylaws, adopt resolutions • Sue (BJR) • Sell (liquidity) Shareholders Board of directors Corporation • Management role • Manage / supervise business • control cash flow • delegate authority • Initiate fundamental changes Chapter 29 Planning in CHC

  4. Partnership – Traditional Model • Partners’ role • Vote • Fundamental changes (all) • Approve new partners (all) • Sue (accounting) • Heightened duties • No BJR • Sell  withdraw • Management • Bind partnership (each P) • Day-to-day business (equal) • Information rights Partnership Chapter 29 Planning in CHC

  5. 4. In a CHC, a shareholder … • Can veto fundamental transactions • Must accept majority’s will (board action) • Can bind the corporation • 5. In a partnership, profits … • Flow to the partners • Must be claimed in an accounting • Are shared on majority action • In a CHC, profits … • Create a right to shareholder dividends • Must be claimed in an accounting • Are shared based on majority (board) action • In a partnership, a partner who wants out: • Must get approval of all partners • Must get approval of majority of partners • Simply withdraws and gets pro rata cash • In a CHC, a shareholder who wants out: • Must get approval of all shareholders • Must get approval of board • Is stuck • In a partnership, a partner … • Can block major decisions • Must accept majority’s will • Must get approval to bind partnership Answers: 1-c / 2-c / 3-a / 4-b / 5-a / 6-c Chapter 29 Planning in CHC

  6. The close corporation What do they want? Chapter 29 Planning in CHC

  7. Shareholder-level arrangements • Voting • Cumulative voting • Class voting • Voting trust • Irrevocable proxy • Vote-pooling agreement • Liquidity • Transfer restrictions • Buy-sell rights Close Corporation(incorporated partnership) Close Corporation Shareholders Board of Directors • Board-level arrangements • Delegation • Specify functions / positions • Decisions • Salaries • Dividends • Fundamental transactions Chapter 29 Planning in CHC

  8. Shareholder voting … Straight (plurality) voting Cumulative voting Chapter 29 Planning in CHC

  9. Straight (plurality) voting Justin (400) Kathy (400) Lorenzo (200) How many directors does each elect with straight (plurality) voting? Who are the top 4 vote-getters? 4 directors Widget Inc Chapter 29 Planning in CHC

  10. Straight (plurality) voting Justin (400) Kathy (400) Lorenzo (200) 4 directors Widget Inc Chapter 29 Planning in CHC

  11. Straight (plurality) voting Justin (400) Kathy (400) Lorenzo (200) 4 directors Widget Inc Chapter 29 Planning in CHC

  12. Alternatives to traditionalshareholder voting … Cumulative voting Class voting Voting trust Vote-pooling agreement “Tie breaker” director Chapter 29 Planning in CHC

  13. Cumulative voting Justin (400) Kathy (400) Lorenzo (200) • What is cumulative • voting? • How many directors for each shareholder? • Possible to circumvent? 4 directors Widget Inc Chapter 29 Planning in CHC

  14. MBCA § 7.28 Voting for Directors; Cumulative Voting (a) Unless otherwise provided in the articles of incorporation, directors are elected by a plurality of the votes cast by the shares entitled to vote in the election at a meeting at which a quorum is present. (b) Shareholders do not have a right to cumulate their votes for directors unless the articles of incorporation so provide. (c) A statement included in the articles of incorporation that "[all] [a designated voting group of] shareholders are entitled to cumulate their votes for directors" (or words of similar import) means that the shareholders designated are entitled to multiply the number of votes they are entitled to cast by the number of directors for whom they are entitled to vote and cast the product for a single candidate or distribute the product among two or more candidates. Chapter 29 Planning in CHC

  15. A = 30 shares * 4 directors = 120 votes B = 70 shares * 4 directors = 280 votes Assume a corporation with two shareholders, A (30 shares) and B (70 shares). They choose cumulative voting. The board has 4 directors. How many votes can A and B cast for directors? Cumulative voting A B 30 70 4 directors Chapter 29 Planning in CHC

  16. A A1 (120 votes) B B1, B2, B3 (with 280 votes, cannot give all three more than 120) Assume a corporation with two shareholders, A (30 shares) and B (70 shares). They choose cumulative voting. The board has 4 directors. How many votes can A and B cast for directors? Can A cast all her votes for her board candidate and be assured of election? Cumulative voting A B 30 70 4 directors Chapter 29 Planning in CHC

  17. A A1 (60 votes), A2 (60 votes) B B1 (70 votes), B2 (70 votes), B3 (70 votes), B4 (70 votes) Assume a corporation with two shareholders, A (30 shares) and B (70 shares). They choose cumulative voting. The board has 4 directors. How many votes can A and B cast for directors? Can A cast all her votes for her board candidate and be assured of election? Can A split her votes and be assured of electing two board candidates? Cumulative voting A B 30 70 4 directors Chapter 29 Planning in CHC

  18. Cumulative voting • Widget Inc has cumulative voting. How many shares does Lorenzo need to get X directors on board? • Assume 1000 shares outstanding. Four directors on board • Formula: • X = S * d / (D + 1) + fraction • Where • X = # shares required • S = # shares at meeting • d = # directors wanted • D = # directors to elect Chapter 29 Planning in CHC

  19. Alternatives to traditionalshareholder voting … Cumulative voting Class voting Voting trust Vote-pooling agreement “Tie breaker” director Chapter 29 Planning in CHC

  20. Class voting Justin (400) Kathy (400) Lorenzo (200) Can shareholders vote by class? How is this accomplished? Class J (1 D) Class K (1 D) Class L (2 Ds) Widget Inc Chapter 29 Planning in CHC

  21. Alternatives to traditionalshareholder voting … Cumulative voting Class voting Voting trust Vote-pooling agreement “Tie breaker” director Chapter 29 Planning in CHC

  22. Voting trust Justin (400) Kathy (400) Lorenzo (200) • What is a voting trust? • Why must file with • corporation? • Why limited to • 10 years? Transfer shares Trustee Vote according to trust agreement Board Widget Inc Chapter 29 Planning in CHC

  23. Alternatives to traditionalshareholder voting … Cumulative voting Class voting Voting trust Vote-pooling agreement “Tie breaker” director Chapter 29 Planning in CHC

  24. Vote-pooling agreement Justin (400) Kathy (400) Lorenzo (200) • What is a vote-pooling agreement? • What if a party does not vote as promised? • Does mandatory arbitration solve this? What about irrevocable proxy? Agreement Vote according to agreement Board Widget Inc Chapter 29 Planning in CHC

  25. Alternatives to traditionalshareholder voting … Cumulative voting Class voting Voting trust Vote-pooling agreement “Tie breaker” director Chapter 29 Planning in CHC

  26. “Tie breaker” director Justin (400) Kathy (400) Lorenzo (200) You(0 shs) Class J (1 D) Class K (1 D) Class L (2 Ds) Class TB (1 D) Can there be shares without economic rights? Should you be a director? Widget Inc Chapter 29 Planning in CHC

  27. Lawyer as director “A man who is his own lawyer has a fool for a client.” NYSE listing standards Louis Brandeis (1856-1941) Chapter 29 Planning in CHC

  28. 4. In a CHC, a voting trust … • Can be unlimited in time • Requires approval of all Shs • Creates beneficial owners • 5. In a CHC, a vote-pooling agreement… • Must include all Shs • Can include arbitration if Shs do not comply • Must include corporation as party • In a CHC, a tie-breaking D … • Must be approved by all Shs • Must be in shareholders’ agreement • Can be in articles – new class of stock • In a CHC, plurality voting: • Means Shs can elect Ds according to pro rata shs • Requires that each director receive a majority of votes • Allows majority Sh to elect all Ds • In a CHC, cumulative voting allows 20% Sh to choose: • 3 of 4 Ds • 2 of 4 Ds • 1 of 4 Ds • In a CHC, class voting must be set out in … • Shareholders’ agreement • Bylaws • Articles Answers: 1-c / 2-c / 3-c / 4-c / 5-b / 6-c Chapter 29 Planning in CHC

  29. Close Corporations(private contracting) What if agreement -- deviates from model? does not comply with statute? is unfair? is incomplete (no liquidity)? Chapter 29 Planning in CHC

  30. Close Corporation(incorporated partnership) • Shareholder-level arrangements • Voting • Cumulative voting • Class voting • Voting trust • Irrevocable proxy • Vote-pooling agreement • Liquidity • Transfer restrictions • Buy-sell rights Close Corporation Shareholders • Board-level arrangements • Delegation • Specify functions • Positions • Decisions • Salaries • Dividends • Veto rights Board of Directors Chapter 29 Planning in CHC

  31. Management limits (CHC) • McQuade v. Stoneham • (NY 1934) • Majority SHs • SH / mgmt limits • Triggs v. Triggs • (NY 1978) • Majority SHs • SH /mgmt limits • Zion v. Kurtz • (NY 1980) • All SHs • Minority veto 1 2 4 3 5 • Dodge v. Clark • (NY 1936) • All SHs • SH / mgmt limits • MBCA - hypo • (1984) • Majority SHs • SH /mgmt limits • Smith v. Atl Prop • (Mass App 1981) • All SHs • Minority veto / duties?

  32. McQuade v. Stoneham (NY 1934) As shareholder, each will vote his shares to elect: > 3 parties as directors > remaining 4 Stoneham nominees Stoneham 55% McGraw 5% McQuade 5% Non-party shareholders As director, each votes to electStoneham as president - $45,000 McGraw as vice president - $7,500 McQuade as treasurer - $7,500 Board NY Giants Creditors What is theoretical problem? Chapter 29 Planning in CHC

  33. NY Court of Appeals (1934):"... stockholders may not, by agreement among themselves, control the directors in the exercise of judgment vested in them ... to elect officers and fix salaries."  "Directors may not by agreement .... abrogate their independent judgment.” McQuade v. Stoneham (NY 1934) Chapter 29 Planning in CHC

  34. Clark v. Dodge (NY 1936) Agreement: (1) Clark will be director and general manager so long as "faithful, efficient, competent"  (2) Clark will receive 1/4 of corporation's net income as dividends or salary  (3) Dodge will not circumvent agreement Dodge 75% Clark 25% Board Close Corporation Creditors Chapter 29 Planning in CHC

  35. NY Court of Appeals (1936):"... as director Dodge should continue Clark as general manager, so long as he proved faithful efficient and competent -- an agreement that could harm nobody ..." "... Clark should always receive salary or dividends one-fourth of "net income" ... it is just to construe that phrase as meaning whatever was left for distribution after the directors had ... set aside whatever they deemed wise ...” Clark v. Dodge (NY 1936) Chapter 29 Planning in CHC

  36. Triggs v. Triggs (NY 1978) • Agreement: • Frederick Sr (44.5%) and son Ransford (28.0%) • Frederick Sr. to be board chair (with guaranteed salary) • Ransford to be president (also with a salary). • Ransford has right to buy Frederick Sr.'s shares on his death Father (44%) Sons (28%, 14%, 14%) Board Close Corporation Chapter 29 Planning in CHC

  37. NY Court of Appeals (1978): No argument is made that the stock purchase option, standing alone would be invalid .... The critical issue is whether, because of ... the provisions said to fetter the authority of the board, the stock purchase provision is now unenforceable..... following the signing of the agreement, the assertedly illegal provisions of the agreement were ignored  .... the agreement "did not in any way sufficiently stultify the Board of Directors in the operations of this business“ Triggs v. Triggs (NY 1978) Chapter 29 Planning in CHC

  38. Hypothetical Justin and Kathy agree to the following. • As shareholders they will elect themselves to the JKL board. • As directors, they will use their best efforts to elect Justin as CEO and Kathy as CFO – each to be paid $75,000. They also agree to have the corporation pay annual dividends of 50% of net profits. • Without Lorenzo, is their agreement valid? • Can their agreement be valid without fitting safe harbor? Consider the MBCA. Chapter 29 Planning in CHC

  39. MBCA • § 7.32 Shareholder Agreements • (a) An agreement among the shareholders ... that complies with this section is effective among the shareholder and the corporation even though it is inconsistent with one or more other provisions of the Act in that it -- • (1) eliminates the board ... or restricts the discretion ... of directors ... • (3) establishes who shall be directors or officers of the corporation; • (8) otherwise governs the exercise of the … management of the business and affairs of the corporation • (b) An agreement authorized by this section shall be -- • (1) set forth • (A) in the articles or bylaws and approved by all shareholders • (B) in a written agreement signed by all shareholders .... and made known to the corporation ... • (3) valid for 10 years, unless agreement otherwise. § 7.31 Voting Agreements (a) Two or more shareholders may provide for the manner in which they will vote their shares by signing an agreement for that purpose. A voting agreement created under this section is not subject to the provisions of section 7.30 [which imposes notice requirements and 10-year limit for voting trusts] Chapter 29 Planning in CHC

  40. Zion v. Kurtz (NY 1980) Kurtz (80%) Zion (20%) Shareholder agreement Kurtz to file articles under Delaware CHC statute Management agreement Veto right to Zion Board Corporation (CHC under Delaware statute) Chapter 29 Planning in CHC

  41. NY Court of Appeals (1980):There are no intervening rights of third persons, the agreement requires nothing that is not permitted by the [Delaware] statute, and all of the stockholders of the corporation assented to it, The certificate of incorporation may be ordered reformed, by requiring Kurtz to file the appropriate amendments … Zion v. Kurtz (NY 1980) Chapter 29 Planning in CHC

  42. Smith v. Atlantic Properties (Mass App 1981) Shareholders Shareholder agreement: 4 equal shareholders on board Management agreement: 80% vote of board for declaration of dividends (effective unanimity) Board Close Corporation (Massachusetts) Chapter 29 Planning in CHC

  43. Mass Appeals Court (1981):Whatever may have been the reason for Dr. Wolfson’s refusal to declare dividends … that he recklessly ran serious and unjustified risks of precisely the penalty taxes eventually assessed …. inconsistent with duty of “utmost good faith and loyalty” Court order:(1) directors prepare financial statements(2) directors confer on dividends(3) hearing if don’t stipulate!! Smith v. Atlantic Properties (Mass App 1981) Chapter 29 Planning in CHC

  44. “With power comes responsibility” Chapter 29 Planning in CHC

  45. Management limits (CHC) • McQuade v. Stoneham • (NY 1934) • Majority SHs • SH / mgmt limits • Triggs v. Triggs • (NY 1978) • Majority SHs • SH /mgmt limits • Zion v. Kurtz • (NY 1980) • All SHs • Minority veto 1 2 4 3 5 • Dodge v. Clark • (NY 1936) • All SHs • SH / mgmt limits • MBCA - hypo • (1984) • Majority SHs • SH /mgmt limits • Smith v. Atl Prop • (Mass App 1981) • All SHs • Minority veto / duties?

  46. 4. In a CHC, a mgmt agreement by some shareholders … • Is void under MBCA • Is valid under MBCA if in writing • Is not within MBCA safe harbor • 5. In a CHC, agreement by all Shs to limit board discretion … • Must be authorized by statute • Must be in articles • Must be in writing • 6. In a CHC, a minority Sh with veto power … • Must exercise the veto responsibly • Can veto as chooses • Cannot veto majority action • In a CHC, some shareholders: • Can agree how to vote their shares • Can agree to limit their discretion as Ds • Can bind selves as Ds, if part of Shs’ agreement • In a CHC, all shareholders can agree to having sole manager • If they agree in writing • If agreement does not jeopardize creditors • Only if statute allows • In a CHC, some Shs can agree to voting and mgmt … • Under modern common law • Under modern statutes • Provided other Shs and creditors not harmed Answers: 1-a / 2-b / 3-c / 4-c / 5-c / 6-a Chapter 29 Planning in CHC

  47. Close CorporationsUnfair agreements What if agreement -- deviates from model? does not comply with statute? is unfair? is incomplete (no liquidity)? Chapter 29 Planning in CHC

  48. Concord Auto Auction v. Rustin (D Mass 1986) Three entrepreneurial siblings -- brother Cox, sister Thomas and sister Powell -- invest in the exciting and glamorous business of auto auctioning.  They want an agreement to provide liquidity on death. If you were drafting for them, what issues should you address in the agreement? Chapter 29 Planning in CHC

  49. Shareholder purchase agreement – drafting issues • who buys?  • corporation / Shs?  • first-refusal / contingencies - death, withdrawal  • kind of right – “must / may”?  • call or put?  • contingencies - withdrawal, outside offer, death  • price?  • book value  • annual re-set  • arbitration / appraisal  • how funded?  • insurance / self-funded  • payment in installments?  • repurchase account  Chapter 29 Planning in CHC

  50. Shareholders' agreement  ¶2 If any shareholder dies, the shareholder's representative shall within 60 days tender all his shares and the corporation shall repurchase the decedent's shares at a price set by the parties as provided in paragraph 6. ¶6 The price is $672/$744. It shall be reviewed at least annually no later than the annual shareholders' meeting ... All parties may agree to a new price ... [which] shall remain in full force until changed... ¶7 To fund the corporation's repurchase obligation, the corporation shall annually purchase life insurance in a face amount equal to the price set by the parties. Signed, Cox / Thomas / Powell / Corporation Is this valid? Chapter 29 Planning in CHC

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