CORPORATE STRUCTURE June 6, 2007

CORPORATE STRUCTURE June 6, 2007
Mega Corporation Sub C Sub A Sub B Sub-Sub XYZ

Class Session Agenda Traditional and modern models of corporate structure Allocation of power and authority as among directors, officers, and shareholders Limited liability as a corporate characteristic and jeopardization of that critical characteristic

Traditional Model of Corporate Decisionmaking
Shareholders Board Officers

Traditional Model of Corporate Decisionmaking
SHAREHOLDERS Own and Control DIRECTORS “Big Picture” Manage and Make Policy OFFICERS Manage Day-to-Day, i.e., Implement Policy

Separation of Control and Ownership
This traditional model of owner shareholders also controlling the decisionmaking of the corporation has, however, been diluted as a result of the large number of shareholders and the dispersal of ownership of large corporations in modern corporate culture.

Separation of Control and Ownership
At least with regard to widely held public corporations—such as AT&T, GM, etc., with millions of shareholders—management is viewed as the holder of control (from a practical perspective) while shareholders remain owners. There is, therefore, a separation of control and ownership that belies the traditional model of corporate decisionmaking.

Modern Model of Corporate Decisionmaking
SHAREHOLDERS Own, but Don’t Control/Manage DIRECTORS “Big Picture” Direction and Authority; Make Policy OFFICERS Control/Manage Day-to-Day, i.e., Implement Policy

Corporate Structure Let’s revisit the corporate structure chart that we reviewed previously. Look again at the constituencies within a corporate structure for a visual reminder of those who have “contract” expectations (under the “Nexus of Contracts” Model) of the corporation and vice-versa.

ABC, Inc. Shareholders Advisors Board of Directors Customers Creditors
Management (CEO, COO, CFO, Secretary, VPs, etc.) Employees Suppliers The Government Other Constituencies, The “Community” Subsidiary

Corporate Structure Note that ABC, Inc., has a subsidiary corporation. It controls this subsidiary through stock ownership. ABC, Inc., is referred to as the “parent corporation” and the subsidiary is often referred to as the “sub.” As a shareholder, ABC, Inc., has shareholder rights and responsibilities with respect to the sub and responsibilities vis-à-vis the sub’s constituencies as its controlling shareholder.

A NOTE ON TERMINOLOGY THROUGHOUT OUR COURSE, I WILL USE TERMINOLOGY, e.g., “SUB,” “PARENT,” AND OTHER TERMS, THAT ARE PART OF A CORPORATE LAWYER’S VOCABULARY. I MAY FORGET THAT YOU MIGHT NOT BE FAMILIAR WITH THOSE TERMS.

BE SMART, LOSE YOUR PRIDE, RAISE YOUR HAND, AND ASK ME WHAT IT MEANS.
A NOTE ON TERMINOLOGY DO NOT JUST SIT THERE WONDERING WHAT IN THE WORLD I AM TALKING ABOUT. IF I USE A TERM YOU DON’T UNDERSTAND: BE SMART, LOSE YOUR PRIDE, RAISE YOUR HAND, AND ASK ME WHAT IT MEANS.

“And Now, Back to Our Regularly Scheduled Program…”
“And Now, Back to Our Regularly Scheduled Program…” Corporate Structure General oversight management responsibility lies with the Board of Directors, with powers and duties set forth in the corporate statutes, the articles of incorporation, and the bylaws (in that descending order of supremacy) as well as overriding fiduciary responsibilities to the corporation and its shareholders.

Corporate Structure The Board of Directors traditionally was responsible for managing the corporation. The modern statutory formula is that the corporation is managed “under the authority” and “under the direction” of the Board. See Ala. Code section 10-2B-8.01

Corporate Structure Section 10-2B-8.01
Requirement for and duties of board of directors. (a) Each corporation must have a board of directors. (b) All corporate powers shall be exercised by or under the authority of, and the business and affairs of the corporation managed under the direction of, its board of directors, subject to any limitation set forth in the articles of incorporation or in an agreement authorized under Section 10-2B-7.32.

Corporate Structure In Alabama, may shareholders eliminate all authority of the board of directors or restrict its discretion or powers to provide oversight management of the corporation?

Corporate Structure Yes
§ 10-2B-7.32 provides that, through a shareholder agreement, which is effective among the shareholders and the corporation—note that such an agreement is not effective with respect to the state, creditors, or other 3rd parties—the shareholders of a corporation may, among other things:

Corporate Structure (1) Eliminate the authority of the board of directors or restrict the discretion or powers of the board of directors; (2) Govern the declaration or payment of dividends whether or not in proportion to stock ownership, subject to certain limitations; (3) Dictate voting power; and

Corporate Structure (4) Otherwise govern the exercise of corporate powers or management of the business and affairs of the corporation or the relationship among the shareholders, the directors, and the corporation, or among any of them, so long as it is not contrary to public policy.

Corporate Structure These statutory shareholder agreements are for corporations whose shares are not publicly traded. This authority under the current ABCA replaces prior statutes pertaining to statutory “close corporations.” We will look at special characteristics of “close corporations” in the generic sense in a couple more weeks.

Election of Board The Board of Directors is elected by the shareholders. The number of the members of the Board is typically set forth in the corporation’s bylaws. In the event of a vacancy on the Board, the remaining Board may elect a person to fill the vacancy, subject to later shareholder election, or the number of members may be reduced.

Removal of Directors All states allow shareholders to remove a director for “cause.” Many states allow removal of directors without cause, but some require an enabling provision in the articles of incorporation.

Removal of Directors What does the Alabama Code provide regarding removal of directors?

Removal of Directors by Shareholders
Section 10-2B-8.08 Removal of directors by shareholders. (a) The shareholders may remove one or more directors with or without cause unless the articles of incorporation provide that directors may be removed only for cause.

Judicial Removal of Directors
Section 10-2B-8.09 (a) The circuit court of the county where a corporation's principal office (or, if none in this state, its registered office) is located may remove a director of the corporation from office in a proceeding commenced either by the corporation or by its shareholders holding at least 10 percent of the outstanding shares of any class if the court finds that (1) the director engaged in fraudulent or dishonest conduct, or gross abuse of authority or discretion, with respect to the corporation and (2) removal is in the best interest of the corporation.

Corporate Structure The corporation is managed on a day-to-day basis by its corporate officers, who have powers and duties set forth in articles of incorporation and bylaws as well as overriding fiduciary responsibilities to the corporation and its shareholders.

Corporate Structure Directors are entitled to rely upon, among others, officers of the corporation in the discharge of their duties as a director.

Corporate Structure Section 10-2B-8.30
(b) In discharging his or her duties, a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by: (1) One or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters….

Corporate Structure Officers of the corporation are employees and they serve at the discretion of the Board of Directors. Absent an employment agreement, in an “at will” employment state such as Alabama, an officer/employee may be discharged for any reason or no reason.

Corporate Structure Section 10-2B-8.43(b)
Resignation and removal of officers. (b) A board of directors may remove any officer at any time with or without cause.

Corporate Structure Given that the shareholders are the ultimate governing authority, do shareholders have an inherent right to remove officers for cause?

Charlestown Boot & Shoe Co. v. Dunsmore (N.H. Supreme Court 1880)
FACTS OF THE CASE

Charlestown Boot & Shoe Co. v. Dunsmore (N.H. S.C. 1880)
Dunsmore and Willard were directors of corporation Shareholders elected a committee, including Osgood, to act with directors to wind up corporation Directors refused to work with Osgood and neglected to follow his recommendations on several matters

Directors’ neglect caused corporation to incur losses Also, directors failed to cause corporation to obtain sufficient insurance against fire losses to corporation’s building and equipment despite notice they should do so, but there was no statute requiring the directors to keep the property insured

Corporation’s building and equipment were destroyed by fire Corporation sued corporation directors claiming negligence because they failed to implement “committee” non-director’s recommendation and they failed to maintain fire insurance

PRINCIPLE OF THE CASE: Directors are charged with the care and management of the corporation and they are not obligated to act with one who is not a director. Officers and agents are under the direction of the Board of Directors.

Traditional Corporate Model Concept:
Corporate shareholders elect directors, but they do not have the authority to micromanage the corporation nor do they have the legal right to act on behalf of the corporation. Directors do not need shareholders’ consent for ordinary corporate business. Shareholders do have statutory voting rights with regard to extraordinary transactions.

Auer v. Dressel (NYCA 1954) (referenced on p. 130):
FACTS: The requisite number of the corporation’s shareholders sought to compel a special meeting, as contemplated by the bylaws. The board refused, arguing that the 4 purposes for which the shareholders requested the meeting were improper.

Auer v. Dressel (NYCA 1954)(referenced on p. 130):
FACTS: While 3 of the proposals were a proper subject of shareholder action, a 4th proposed shareholder resolution regarding the reinstatement of a removed president was not. The state code clearly provided that election of officers was a board function.

ANALYSIS: The court noted that the election of corporate officers is the prerogative of the board and that shareholders cannot effect any change in the presidency, but the court ruled: “there is nothing invalid in [shareholders] expressing themselves and thus putting on notice the directors who will stand for election at the annual meeting.”

ANALYSIS: Emphasizing the “important right” of shareholders to call a special meeting even if simply to voice their opinions, Auer places very few, if any, constraints on the purposes for which a special meeting may be sought.

What’s the sense in letting shareholders voice their views in a special meeting at which they can’t determine the outcome? So long as a “proper purpose” exists for calling such a meeting, courts generally will not interfere with the “important right” of shareholders to call a meeting to voice their opinions.

It is worth noting here that this case involved a publicly held, not a closely held, corporation. The corporation had 6,000 shareholders. On the proposals sought to be presented for a shareholder vote, several hundred thousand affirmative votes would have been required. The directors sought to be removed had a right to be notified and an opportunity to to heard as to why they should not be removed.

Convening such a hearing and providing proper notice to satisfy the court’s concerns about “due process” would be very expensive and impracticable. In a public corporation, action by shareholders is and must be, as a practical matter, accomplished through the proxy voting mechanism.

The point is that public corporation shareholder initiatives are, as much as anything, political campaigns to get proxies or they are controlled by one dominant player or a closely knit faction with a persuasive campaign platform.

Given the way the system works, public company directors who do not have a legitimate and persuasive story for opposition of a removal campaign typically resign and leave quietly. In the case of those charged with fraud, dishonest conduct, or gross abuse of authority or discretion, there are statutory provisions for judicial removal when such directors refuse to resign.

Schnell v. Chris-Craft (Del. 1971)
This case involved dissatisfied shareholders who challenged the board of directors’ advancement of the annual meeting date to a date prior to that set forth in the bylaws.

In the context of a “proxy contest,” i.e., a battle for corporate control, this change would have reduced the time available for the plaintiffs to solicit proxies of stockholders adverse to the position of the corporation’s board of directors.

Directors are to exercise their powers in good faith and in the corporation's best interest. When bylaws state the date of an annual meeting, it should be assumed that those who want to contest an election will prepare with that date in mind. To shorten that time or extend that time is a red flag.

The court found that this acceleration of the annual meeting was obstructionist. Obstructionist of what?

The court found that management had used the corporate machinery and Delaware law for the purpose of perpetuating itself in office and to obstruct the legitimate efforts of dissident shareholders to undertake a proxy contest against management.

Here is a noteworthy principle that runs through many, many of the corporate law cases, especially in the takeover context: Management self-perpetuation as a primary purpose is always an illegitimate purpose. The court said, “[I]nequitable action does not become permissible simply because it is legally possible….”

Blasius Industries, Inc. v. Atlas (Del. Ch. Ct. 1988)
Blasius accumulated 9.1% of Atlas’s common stock. In its SEC Schedule 13-D—required to be filed upon acquiring more than 5% of a public company—Blasius stated its intent to (1) encourage a corporate restructuring and (2) seek control and board seat

Blasius Industries, Inc. v, Atlas (Del. Ch. Ct. 1988)
CLUE #1 to Impending Bad Behavior of Atlas This Schedule 13-D statement of intent would not have been perceived as a good thing by the Atlas board and management. Remember our self-perpetuation principle? But, it gets more suspicious!

Blasius Industries, Inc. v, Atlas (Del. Ch. Ct. 1988)
Blasius was controlled by Messrs. Lubin and Delano, who were assisted in taking control of Blasius through a junk bond transaction with Drexel Burnham Lambert, who were Wall Street’s most powerful and notoriously tenacious takeover financiers

CLUE #2 to Impending Bad Behavior of Atlas Blasius (i.e., Messrs. Lubin and Delano) are backed by all the money and power available to them—high-rate, junk bonds and investment banker Drexel Burnham Lambert

Immediately after filing its 13-D, Blasius proposed a leveraged restructuring involving a cash distribution, which was met with a “cool reception” from Atlas management.

Leveraged finance transactions were prevalent during the ’80s for takeover financing. They involve funding a company with much more debt than would be considered normal for that company or industry. More-than-normal debt implies that the funding is riskier, and therefore more costly, than normal borrowing.

As a result, leveraged finance is commonly employed to achieve a specific, often temporary, objective: to make an acquisition, to effect a buy-out, to repurchase shares or fund a one-time dividend, or to invest in a self-sustaining cash-generating asset.

Drexel, the kingpin of takeover financing at the time, was able to generate enormous sums of high-rate debt financing from investors to effectuate acquisitions and use a target’s earnings stream—that is, to “leverage” the target—to service this debt.

Following its restructuring proposal, Blasius then submitted a shareholder consent for amending the bylaws to increase the number of directors from 7 to 15, the maximum allowed under Atlas’ charter, and to elect 8 Blasius board candidates.

Atlas viewed the consent “as an attempt to take control of” Atlas. (Not much of a leap, I might add, since Blasius stated in its Schedule 13-D that this was its intent.) An emergency board meeting was called to increase the board number by 2 (i.e., to 9 members) and to fill the slots with Atlas’ candidates.

The effect of this action was to have 9 of the maximum 15 seats filled so that Blasius, if it elected the remaining 6 directors, would not control a majority of the seats on the board. The court found that this was the principal motivation of the Atlas board.

Importantly, however, the court found that the board took action to protect its incumbency to thwart a recapitalization that it thought was adverse to the corporation’s best interests.

THE QUESTION PRESENTED: May a board of directors, in good faith, validly act for the principal purpose of preventing shareholders from electing a majority of new directors? This is a question of authority, not one of subjective good faith.

The court decided that the “Business Judgment Rule” standard of review did not apply. This is the most basic and lenient standard of review of protection of board action.

Business Judgment Rule A legal presumption that a board of directors acted on an informed basis, in good faith, and with an honest belief that they acted in the best interests of the corporation. It is available where there is any rational basis for the board action taken.

The Court also decided that the “enhanced scrutiny” standard of review of board action that was first enunciated in Unocal Corp. v. Mesa Petroleum did not apply in a case where the primary purpose was to interfere with the effectiveness of a stockholder vote.

Unocal “enhanced scrutiny” standard: Defensive measures in response to a perceived threat to corporate policy and effectiveness must be proportionate to the threat posed. Proportionality requires that the measures must not be coercive or preclusive, but must fall with a range of reasonableness.

In light of the inapplicability of the protection of the business judgment rule and the inapplicability of the Unocal enhanced scrutiny standard of review, the court enunciated a new standard which has become known as “The Blasius Doctrine.”

The Blasius Doctrine The shareholder franchise is the ideological underpinning of director power and board action primarily designed to interfere with the shareholder vote will be upheld only with a “compelling justification.”

The Blasius Doctrine The “compelling justification” standard is stringent and virtually ensures that the board action will not stand. In fact, when I last researched the Delaware cases on this subject, I was unable to find a single case where a challenged board decision was upheld based upon a “compelling justification.”

The action taken by this board was a breach of the fiduciary duty of loyalty (which we will study in more detail later in the course). The application of the test set forth in the case is proper only when shareholders are not given a full and fair opportunity to vote.

The right of shareholders to vote is obviously sacred. Shareholders dissatisfied with directors under the modern corporate model basically have only 2 means of recourse: Vote to replace incumbent directors or Sell their stock

MM Companies, Inc. v. Liquid Audio, Inc. (SC Del. 2003)
This January 7, 2003, Delaware Supreme Court case clarified the limits of a target board’s ability to take defensive actions impairing stockholders’ voting rights when fending off a hostile takeover bid.

MM makes takeover offer to Liquid Liquid rejects offer MM notifies Liquid that it will nominate its 2 board candidates at next annual meeting MM proposes to increase board number by 4, fill them with MM candidates, giving MM control of the board

Liquid increases board number from 4 to 7 and fills the seats with Liquid appointments At annual meeting, MM’s 2 nominees were elected, but its other proposals were defeated

MM sued Alleged that MM board expansion and appointment of new directors frustrated its attempt to gain a board presence and guaranteed that it would not control the board for at least 2 years

The court found that the expansion of the board by Liquid and its appointment of its directors to ensure board control were taken “in response to some threat to corporate policy and effectiveness.”

In such a case, what is the standard of review? Hint—action “taken in response to some threat to corporate policy and effectiveness.” The Unocal “enhanced scrutiny” standard.

Unocal “Enhanced Scrutiny” Standard Action taken must be proportionate to the threat posed. Proportionality, in turn, requires that the action not be coercive (force a management sponsored alternative on stockholders) or preclusive (make it impossible for stockholders to vote in favor of the hostile proposal) and must be reasonable.

Once the court determined that Liquid’s conduct was neither coercive nor preclusive, it examined whether it was reasonable and it applied the test enunciated in Blasius.

When a board takes defensive action and the primary purpose is to impede the exercise of the stockholder vote, the board must demonstrate a “compelling justification.” (This is the Blasius test.) The court found no compelling justification and invalidated the measures.

Relevance of the Case: A board faced with a proxy fight cannot expand the board with the primary purpose of impeding shareholders from electing directors unless it can show a compelling justification. Shareholders retain the power of the ballot box absent a compelling justification for their disenfranchisement.

Straight Voting, Weighted Voting, and Cumulative Voting
Mechanisms for Enhancing Shareholder Voting Power

Straight Voting and Weighted Voting in Public Companies
Ala. Code § 10-2B-7.21(a): Except as provided in subsections (b) and (c) or unless the articles of incorporation provide otherwise, each outstanding share, regardless of class, is entitled to one vote on each matter voted on at a shareholders' meeting. Only shares are entitled to vote.

Weighted Voting in Public Companies
Preferred stock and even debt securities may have voting rights. Also, corporations may have two or more classes of a security, each with different voting rights. Such voting structures are called “dual class,” “super-voting,” or “weighted voting” structures. Such structures may be limited, e.g., the NYSE so limits as a condition to NYSE listing.

Cumulative Voting Straight Voting
A shareholder can cast for each board candidate the number of shares held by the shareholder. Majority elects the entire board. For example: S owns 100 shares 7 directors up for election S can vote his 100 shares for each of the 7 candidates, but no more than 100 for any one candidate

Cumulative Voting Cumulative Voting:
A shareholder can distribute his votes among one or more candidates. Minority may be able to beat majority. For example: 7 directors up for election S owns 100 shares = 700 votes T owns 200 shares = 1400 votes S and T can distribute their 700 and 1400 votes among one or more candidates

Cumulative Voting Cumulative voting peaked in the 1940s, when 20+ states mandated such voting. Since that time, there has been a movement toward optional cumulative voting. Now, only 4 states mandate cumulative voting.

Cumulative Voting Alabama Code § 10-2B-7.28 provides that shareholders do not have cumulative voting rights unless provided for in the articles of incorporation. There is also a notice requirements regarding an intention to cumulate votes. DGCL § 214 likewise requires an affirmative charter provision for cumulative voting.

What is the purpose of this notice?
Cumulative Voting Alabama Code § 10-2B-7.28(d)(2)/MBCA § 7.28(d)(2) requires 48 hours’ advance written notice to the corporation of a shareholder’s intention to vote cumulatively. What is the purpose of this notice?

Cumulative Voting The notice requirement is intended to give shareholders advance notice that one or more other shareholders intend to vote cumulatively and that they should adjust their voting pattern to maximize the effect of their votes, if they so choose.

Formalities of Action by Boards of Directors, Officers, and Shareholders of Corporations

Formalities of Action by Board of Directors
Directors can act only as a body. A single director has no legal power to cause board action Directors may act at a duly convened meeting where a quorum is present A “meeting” includes a telephone conference call or other means where all directors can hear one another

Unless otherwise provided in the articles or bylaws, special meetings of the board of directors may be held upon at least 2 days' notice. Action may also be taken through a unanimous written consent in lieu of a meeting A unanimous written must be unanimous

To duly convene a meeting, a “quorum” must be present—no quorum, no meeting! A quorum typically means a majority of the full board as if all vacancies had been filled A majority of states permit a greater number; a minority permit a lesser number If a quorum is present, the affirmative vote of a majority of the directors present is an act of the board of directors. However, the articles of incorporation or bylaws may require a greater number of directors to approve a transaction.

Alabama Code § 10-2B-8.24 sets forth the quorum requirements for board of directors

Notice of a regular meeting is required or not required as prescribed by the bylaws Special meetings require 2 days’ advance notice unless otherwise indicated in the articles or bylaws

A director may, however, waive notice of a meeting through a written waiver. What if a director receives no notice and does not sign a waiver, but he participates in the meeting and votes on the business items?

Failure to object to defective notice at the outset of the meeting or participation and voting on all or particular items of business constitutes waiver of notice. Ala. Code § 10-2B-8.23(b)

Formalities of Action by Officers
Officers’ actions are generally tested on the basis of their apparent authority under agency concepts to act on behalf of and bind the corporation. Most law relates to the office of president.

While the articles or bylaws typically list the powers of the various officers, there are varying gradations of apparent authority to act.

For example, the president is generally considered to have apparent authority to bind the corporation in ordinary transactions but not extraordinary transactions.

The corporate secretary and assistant secretaries would reasonably be assumed to have very limited authority and a review of the articles and bylaws for corporate authority would be prudent prior to reliance on their actions to bind the corporation.

For example, the articles might provide that the corporate secretary (and his assistant secretaries) are officers of the corporation with the power to not only certify the incumbency of other officers and certify corporate records, but also to sign contracts on behalf of the corporation.

Formalities of Action by Shareholders
Formalities here are substantially similar to those for boards of directors in terms of quorum, notice, waiver, etc. There are, however, a few notable differences…

(1) Shareholders may vote their shares either in person or by proxy, but directors may not vote by proxy. This is based on the theory that a director’s responsibilities are personal to him/her and are nondelegable

(2) On ordinary matters of business, a majority vote of a board or of the shares of shareholders is typically required, but certain actions on fundamental changes require a greater shareholder vote, e.g., articles amendment, merger, sale of substantially all assets. States have varying requirements on the requisite to carry such matters.

As we saw in the Auer case and the Schnell v. Chris-Craft case earlier, courts will overturn board action that interferes with the fundamental right of shareholders to vote. The fact is that shareholders of corporations do not really have broad voting rights under modern-day model business statutes, especially in public held corporations. Therefore, it is especially understandable why courts are very protective of the limited rights that do exist.

Shareholder Voting Matters
What kinds of things can shareholders vote upon under the model act? Elect or remove directors—majority Amend articles of incorporation—majority Amend bylaws—majority Approve mergers—2/3 Approve sales of assets not in the ordinary course of business—2/3

Dissolution—majority Ratify conflict of interest transactions—2/3 Authorize payments of indemnification—majority

Shareholders also have some non-statutory matters where they have traditionally voted, such as: Ratification of auditors Make recommendations to the board Authorize distributions from capital surplus

I encourage you to have a good understanding of the kinds of action on which shareholders can vote and the minimum vote to carry such action.

Special meetings of the shareholders may be called by the board of directors or holders of 10% or more of the outstanding votes. Shareholders must receive notice of an annual or special meeting of the shareholders no fewer than 10 and no more than 60 days prior to the day of the meeting. Notice of a special meeting must include a description of the purpose for which the meeting is called. Unless otherwise provided in statute or articles, purposes of annual meetings are not required in notices for such meetings.

Limited Liability & “Piercing the Corporate Veil”

Fletcher v. Atex, Inc., Walkovszky v. Carlton, Minton v. Cavaney, Sea-Land Services, and the Kinney Shoe Corp. v. Polan cases speak to the concept of piercing the corporate veil to find a deeper pocket behind the corporate entity to cover liabilities. A primary reason for operating through corporate entities is to limit liability of individuals to their investment in the corporation.

In Walkovszky, the plaintiff tried to pierce the veil and hold a shareholder personally liable for the negligence of a taxi driver on the grounds that a single business entity operating a fleet of taxis had been artificially divided into 10 separate enterprises, each owning 2 cabs.

The court ruled that the complaint failed to state a cause of action because the principle of liability was stated not as one of agency but one of fraud. On leave to amend, the complaint was found to state a claim.

The court’s holding states that limiting liability is a valid reason for incorporating. But dividing a single business into multiple parts to the extreme without cautious observation of corporate formalities may open one to piercing risks.

In such a case where shareholders used multiple corporations to operate, is it enough that the corporate entity sought to be pierced has an inability to pay a creditor? No. Mere inability to pay creditors is insufficient to justify a piercing of the corporate veil.

In the Sea-Land case, the 7th Circuit, looking to Illinois law, noted that a corporate entity will be disregarded if 2 elements are satisfied:

(1) There is a unity of interest and ownership such that there is no separation between the corporation and the individual. The individual and the corporation are “alter egos.” (2) Recognizing the corporation would sanction a fraud or subvert justice. There must be fraud or subversion of justice. This is a fairness test.

Under Alabama law, a subversion element is likewise required. Alabama cases suggest that the veil will be pierced only in circumstances which entail: Subversion of justice Fraud or unfairness to creditors A purpose subversive of the rights of others See Ala. Corp. L. 3rd (Thigpen) § 8.1

Factors that have been deemed relevant to disregard of the corporate entity: Failure to maintain corporate records or observe corporate formalities Commingling of assets or funds Undercapitalization One corporation or person treating other corporation’s assets as its/his own

For several reasons, close corporations tend to receive much greater scrutiny than large corporations when applying veil piercing theories. Small corporations generally start with little capital, owners are unsophisticated in legal matters and reluctant to pay for legal advice, and owners may treat corporate funds/assets as their own.

In fact, some relatively recent academic research reflects that: in the overwhelming majority of cases where the corporate veil is pierced, the corporation had only 1 or 2 shareholders, and that in no case where the corporate veil was pierced did the number of shareholders exceed 9

the plaintiffs win 40% of the time; distinctions in plaintiffs’ claims as based on contract versus tort doesn't appear to make much difference (probably due to the equitable nature of this remedy); and undercapitalization does not appear to be as major a factor as academics might think

With regard to undercapitalization as a reason for piercing, it makes sense to pierce where there was fraud or evasion of responsible behavior. But, if a corporation is adequately capitalized when it starts out (or when it begins a new business), it makes less sense to apply the piercing doctrine if the business thereafter loses money and uses up capital in a good faith effort to be profitable. Individuals do it all the time; why not corporations?

The Doctrine of Equitable Subordination or The “Deep Rock” Doctrine

Doctrine of Equitable Subordination
Alabama recognizes the doctrine of equitable subordination. “Its purpose is to disallow claims of shareholder-creditors in favor of claims of outside creditors, thus preventing shareholders from claiming a share of residual assets until all such outsider claims are satisfied.” Ala. Corp. L. 3rd § 8.8.

This remedy is typically applied where owners have purposely characterized equity capital as debt with a view to protecting themselves when the business fails. It is frequently seen in bankruptcies, but it is not limited to that context. Ala. Corp. L. 3rd § 8.8.

This doctrine is sometimes referred to as “The Deep Rock Doctrine.” This was the name of a corporation involved in the 1939 U.S. Supreme Court case of Taylor v. Standard Gas & Electric Co.

The remedy might be applied, for example, where a loan from a controlling shareholder failed to exhibit indicia of a true arms’ length loan transaction or where a corporation was undercapitalized yet had a shareholder loan that was used for asset purchases rather than payments to creditors.

Think about the result of imposition of personal liability that occurs from piercing the corporate veil and think about the result that occurs from equitable subordination. What is a significant difference in the results of the application of these equitable remedies?

When the corporate veil is pierced, the significant result is that shareholders are held liable for and must pay obligations of the corporation. Under equitable subordination, shareholders’ “loans” are treated as equity capital and are subordinated to payment of other creditors, but such shareholders are not liable for corporate debts.

END OF SLIDES

CORPORATE STRUCTURE June 6, 2007

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