You know if any of that comes up again we'll talk about it but I think we should move on to

talking about the DeWitt case I had a couple of couple of volunteers on question 33 which was
the only one for for towit so I think I'm going to ask mark derner to go first here and the
question I posed was was whether the Corporation into it was in fact undercapitalized and what
other what other theories might the plaintiff be able to use to recover I mean this is kind of a
softball question away because the court discuss is several theories but the court does does say
flat out that the Corporation is undercapitalized because I guess factually there was there was
some there was some representation that $5000 have been put in initially and that at some
point some stock had been retired I think $2000 worth so that the implication was that maybe
there was still $3000 worth of capital in the Corporation and that the court sort of indicated
that it didn't really even believe that in any event said that it was it was quite clear that the
Corporation was was undercapitalized and without really much analysis so the question is
where they write about that and you know assuming that there there you know there's some
problem with that theory what else might they might the court have relied on what else might
the plaintiffs if relied on to recover individually from this guy Ray Fleming I guess I didn't I didn't
say that Fleming is a is a fruit broker and he's being sued by the the trucking company that he
had contracted with to deliver the fruit to pick up the fruit at the market and take it to the
people who were buying it so Fleming is a classic middleman in the in the fruit business so
anyway with that lead in and a little bit of time to think about it what do you have to say mark
so yeah it was absolutely undercapitalized and it wasn't just the actual numbers because courts
really don't discriminate how much you're making as long as the business is legitimate and hear
it clearly wasn't he was taking out a salary he was retired in stock he wasn't observing the
corporate formalities that are required when you're looking at even though this was in South
Carolina not Delaware it still follows that same those same problems so the Corporation was
undercapitalized that said and it didn't really have any real capital he was the middleman here
but he was taking out a salary he wasn't observing the corporate formalities so in my personal
opinion there's a few numbers that he he was taking out he was taking out all the money there
was no operating capital whatsoever it was just his wages so so well I mean you know as soon
as I said it I thought better of having said it did I have the facts right about about the amount
that was put in initially in the amounts that were taken out yeah so there are five in 1962 there
is a capitalization of 5000 shares $1.00 each share approximately 2000 of those shares were
retired so he owned the remaining 90% of those 30,000 of those 3000 shares there was no
stock records of this he said that at Bernstein owned the rest however there was no there's no
minutes of any meeting there is no real proof that this man had anything to do so really what
the court relied on was that it was essentially fraud and that kind of possible injustice was also
another reason they were able to Pierce the corporate veil it didn't have to be so
undercapitalized in this scenario it was just a lot of different factors that allowed them for for
DeWitt to go after Fleming himself OK well let me just say this about about you know what
you've been saying all of which is quite correct I I think that the the the observance of the
corporate formalities stuff is tends to be a kind of a makeweight argument is something that
you that you throw in as an extra reason to Pierce the corporate veil I can't think of any case in
which simple failure too observe the formalities has been enough to get a court to ignore the
existence of a Corporation so if it hasn't then that strikes me that really it must be the other
stuff that matters more I mean I I think you know you gotta say that you've gotta add you gotta
throw that in if it's there and I think it's you know it's somewhat telling I suppose but it's always
you know kind of it's a second best argument at the very best so I had another Matt Nowak I
think also volunteered on this one I just want to see if he has anything different to different to
say on the subject do you mean the basic question was was the Corporation undercapitalized
that's that was the first question and I'm just curious whether you have some thoughts about
that yeah I don't disagree with anything mark said really but I would add it was kind of weird
there was a statement by the court said inability of the Corporation that paid dividend is
persuasive proof of this forms of capital so sort of using the fact that the court didn't pay
dividends to say like as proof that it was undercapitalized alright what do you I mean I'm glad
you raised that 'cause I forgot completely about that argument which I think is very interesting
but what do you what do you make of that does it make sense to you now because affectively
right the guy who's involved defendant was basically paying himself a dividend by extracting
funds from the Corporation so it was like they're saying he it's undercapitalized 'cause he's not
paying dividends but really that's all that's happening here is he's paying dividends to himself in
a fraudulent transfer right which ultimately is why I'm thinking like another theory of relief or
you know another which McCall it recovery another way of recovery would be through a
fraudulent transfer theory is really it's stabbing here yeah no no I like that too so I mean we've
got we've got formalities undercapitalization fraudulent transfer and I think you know buried in
what you were just saying is an argument that the dividend if we called it a dividend that he
was paying to himself was an illegal dividend becausw he paid himself a dividend that rendered
the Corporation in this particular instance rendered the Corporation unable to pay its legitimate
creditors namely the the trucking company so we don't even have to get into the fact that there
was a problem of balance sheet problem that is that the Corporation had you know had zero or
a negative number and for purposes of net assets that is it had liabilities that exceeded the
assets that it had but I'm still curious I think we've we there's the court seems to allow that
there might have been some money put in I think there's reason to doubt that any money was
ever even put into the Corporation but giving Fleming the benefit of the doubt on that question
I want to come back to this issue of how much capital does this business need I mean it's a in a
sense what we have here is a degenerate case becausw it appears that the business has no
capital if it ever had any capital than then Fleming has taken it out in the form of well he he
purported to take it out in the form of salaries but we're kind of saying that you know he was
just giving he was just taking whatever money was there so and so it's a degenerate case I used
the word degenerate not because I think Flemings that degenerate but because it's a it's an
easy case to say that the capital the company is undercapitalized 'cause there's no capital right I
mean the capital is gone and that you know that sort of let me just drop a footnote here and
say that one of the things that you run into in these cases sometimes is the question of whether
the business was adequately capitalized at the beginning and simply became uncapitalized
because it or undercapitalized becausw it loste money in the meantime I mean that's what
capital is for it's a cushion to let you you know sort of pay bills from the business the company
hasn't made enough money right but if you've run out of capital and then the business
becomes undercapitalized simply becausw of bad business luck strikes me that that is a
somewhat separate question from whether the business was undercapitalized from the getgo
right and you see that issue arising in in the cases with some frequency let me also sort of point
out that that piercing the corporate veil is probably notwithstanding the you know the litigation
that goes on in Delaware piercing the corporate veil is I would say by far the most common
theory asserted against a Corporation in the other 49 states it's not so common in Delaware
because Delaware doesn't like personal corporate bail but but piercing the corporate veil is a
big area of practice and you know if you have a small practice that deals with businesses or or
plaintiffs for that matter piercing the corporate veil is going to come up a lot so it's a it's a it's a
useful thing to know something about but let me get back to the basic to the basic question and
make sure that let me make sure that you understand that the question may differ depending
on whether the business was undercapitalized to begin with or if the business becomes
undercapitalized and the courts tend to be a little bit more sympathetic if that is to the business
if it if it's a situation where the business simply became undercapitalized because it didn't do as
well as expected they're a little stricter in situations where the business is not capitalized
adequately in the 1st place OK an I think that's just something to write down in your notes for
future reference I'm not sure that we've got either you know in this situation I think the
business is probably pretty pretty thinly capitalized to begin with but that brings me back to my
question which is just because the court says hey the business is undercapitalized do we need
to believe that I mean is that is what do they mean by that what does it mean for business to be
undercapitalized I mean as I say this is a degenerate case 'cause it doesn't look like the business
has any capital at all so you can certainly say that a business that has no capital is
undercapitalized right it's almost certainly the case we don't know how much capital you really
need but but in this case where there's no capital it seems like the answer is gotta be that
you're undercapitalized right so you know the court doesn't really it's kind of like going back to
the the the form of the argument in a no wind transaction right we don't know how we don't
know what what a good justification for we don't know what a bad justification for a business
transaction is but we're pretty sure but if you don't even try to make the profit that's not good
enough OK so it's a fault it's kind of a fall back as far as the court is concerned to say hey we
don't know how much capital you really need but you got but there isn't any here and therefore
we have no trouble saying that the business is undercapitalized my question is should we take
that assertion at face value I mean I know it's the 4th circuit but you know but you know 4th
Interestingly enough the 4th circuit there is and I don't know what accounts for this at all but
you know the 4th circuit runs from Maryland through South Carolina right and this isn't
especially true of Maryland but as far as Virginia and the Carolinas are concerned they were
kind of you know the last people to show up at the party in terms of modern Corporation law
they were those those states were quite resistant to recognizing a kind of free incorporation
doctrine I mean they they were the ones that that that they were the states that had in there
state constitutions and state laws requirements that specific amounts of capital B contributed
to a Corporation before the Corporation would be recognized now back in the back in the day
that is Once Upon a time Corporation law actually required that you put some specified amount
of money into the Corporation in order to have it recognized as a legitimate Corporation having
been formed most of those laws were gone by the 1930s but they persisted in this sort of swath
of state so you've got a kind of there's something there's something weird in the water down
there I'm not sure what's going on but they have a kind of a different attitude towards
corporations I'm just saying OK so just keep that just file out on the way to but let me go back
to my question how do we know how much capital business needs and specifically how much
capital would this business have needed um so I mean Matt Matt and mark I mean like I'll give
you a shot at that or at anybody else who wants to volunteer and perfectly happy to talk to
others I feel like in this scenario it didn't matter what the number was it was what he was doing
with that number it was clearly undercapitalized 'cause he couldn't pay his debts he couldn't
keep it going 'cause everything he put in he just gave to himself so I don't know I assume he
was like the soul soul worker there clearly he was no one else was objecting to him taking all
the money so in this case the fact that his salary is worth more this $15,000 per year is worth
more than the stock that he put in he was withholding payments that were due to do it and so
it was clearly undercapitalized because the minimum salary every year was just far more than
what he was making so yeah I mean you keep going back to that point and I think it's it's a
totally legitimate point I mean he's milking the Corp he's taking all the cash out of the
Corporation and he shouldn't be doing that but it doesn't really answer the question which is
let's assume that he was that he was behaving in all good faith that he taken a little cieli course
in corporate law and he had he knew what he was supposed to do and he tried to follow all the
rules how much capital and we finally got into this I mean we we some controversy arose about
whether the business was adequately capitalized I think we need to know how much capital
does business like this need I mean how do you go about thinking about that mad any ideas
anybody else any ideas a professor is Joe Joe just as a general tenant I mean you could always
look to like current ratio to help determine if you have enough working capital like to meet your
financial obligations something like the current ratio maybe to quick ratio just looking at your
last divided by your liabilities but that's that's just a general sense of you know determine how
much working capital you may need you're you're talking there about working capital which is
something that's good to have out on the table and to think about but working capital is
something that that sort of emerges after a businesses is up and running I mean working capital
is is the net value of things like inventory and cash and accounts receivable over accounts
payable so working capital is really the difference between amounts that you expect to take in
over the next year and amounts that you expect to have to pay over the next year and those
amounts I tried to say this last time but those amounts are things that simply emerge as a result
of the business operating what I'm thinking of what I'm trying to talk about here is is more
about how much money would you have to put in to the business in the you know to open the
doors in the first place and that's that's really what we mean in terms of whether the business
is adequately capitalized that is does it have enough equity and long-term debt forget the
current accounts things like bills we have to pay next month and checks we expect to get in the
Mail during the next month You know sort of leave that to the side the question is how much
money should the owners of this business have put into it in the first place in order for it to be
in order for it to be set up and started in good faith as it were do you see the the difference Joe
yeah OK I mean it's important to keep that distinction in mind because it's going to come up in
a couple more cases we're going to talk about over the next few weeks any other thoughts
looking at looking at other similar companies in our area yeah no no that's always a way to do it
I mean look at comparable companies that's that's always that's always a good fall back so John
Reed I see you have your hand up yeah I I think little bit of a question here presumably the
amount of the capitalization presumably would a good test would not be whether you could
pay your bills at any given moment 'cause presumably you could call in credits you have with
other places to satisfy those bills so would it be kind of misguided to say whether you can fulfill
all liabilities at any given time or at least most of them just as kind of a rough test I think you're I
think you're on the right track let me just let me just sort of do the big reveal here and that is
that frankly I don't think it takes much more capital to start this business to set this business up
in totally good faith then any of you probably has lying around right now in your wallet or
wherever it is that you keep ready cash right what does it take to set up the fruit brokerage
business that you've got here well let's think about how this business tested how this business
works basically Fleming gets orders from people who want to buy fruit and they say OK I'm
willing to pay you you know $5 a bushel for oranges or something and then he goes to the
market where you find somebody who's willing to sell oranges for $3 a bushel OK and then he
calls up the truck broker who will find him somebody who will pick those oranges up at the
market and take them to the people who have agreed to buy them and he cuts a deal with the
truck broker that says look I'm going to pay you when I get paid by the buyer and he cuts the
same deal with the people at the market and says you know I'll buy your oranges and and but
I'm not going to pay you until I get paid by the person who is buying them for me but I'll give
you that money as soon as I get it and so here's this his business basically involves finding
people to sell the oranges who are going to wait to get paid until he sells the oranges and then
finding a trucker who will take the oranges where they need to go who's also willing to wait to
get paid until Fleming gets paid how much capital do you need to set up a business like that
well I think the amount is roughly equal to the amount that it takes to to buy a phone right I
mean you've got all you have to all you need is a telephone number right so someplace where
people can call you and say hey I got some more just sell and somebody else can call you and
say hey I want to buy some oranges and you Simply put the two together and find a trucker
who's going who's willing to to move them from point A to point B and wait for his money I
mean if you can set that kind of business up I don't see why you need any capital at all right I
mean what what what capital do you need you need enough capital to you probably running
this thing out of your bedroom anyway right so you know that I don't know if you want to say
that you part of your capital is your house maybe it is or you know your phone because you
know you have to pay the phone bill in order to keep and you may have put down a deposit in
order to keep to get the phone in the 1st place if you're doing it in the name of the business but
I think the answer to my question is really this business doesn't need any capital you can set
this business up in all good faith if you've got if you found people who are willing to wait for
their money until you get paid you don't need capital to start a business invest sorry so I think
that although the you know the court seemed confident in saying this business is
undercapitalized 'cause it has no capital the problem is this is actually a case in which the
business didn't need any capital so in a sense maybe it was over capitalized when he put that
first $5000 into the business turns out he didn't need it so he took it back out there's there's
nothing that says you can't do that now mark you're completely correct that that's completely
you know taking all of the money out of the business because it happens to be in the checking
account when you owe when you owe that money to the truckers that's a different sort of
problem that's making that's paying yourself a distribution that's really an illegal dividend or as
we've already seen a couple of times that you could also call it a fraudulent conveyance
because quite frankly the rules relating to fraudulent conveyance to illegal dividends are
roughly the same they focus in on the same things they focus on whether or not assets exceed
liabilities and also whether or not you can pay your bills as they become do both of those things
running afoul of either of those propositions would probably be would be grounds for either
finding that the dividend was illegal or finding that there was a fraudulent conveyance now
whether you want to pursue one or the other of those theories gets into some technicalities of
the law out an illegal dividend in most jurisdictions I mean a claim for an illegal dividend is it
claimed that can only be made by the Corporation and therefore has to be made if it's not
made by the Corporation has to be made by a derivative action which means that it can only be
made in most places by a stockholder so that's not going to get the creditors anywhere to claim
that it was an illegal dividend unless somehow they're going to they can persuade the court
that they have standing to make that claim as creditors and as we we haven't seen it yet but
production resources the very last case in this in this chapter ascentia Lee says that if the
Corporation is insolvent yes indeed creditors can make that claim Delaware is is is unique that
way I mean other states might come to the same conclusion if they had to think about it but
Delaware is unique that in that way because they recognize that if the Corporation is insolvent
creditors can make claims that ordinarily would only be able to be made by stockholders but
that's more of an exception than the rule in other States and as I said before under the model
act which applies roughly speaking at about 35 states you have to be a stockholder to maintain
a derivative action that's not the rule in Delaware so that's that's the downside of making this
claim that it's an illegal dividend the fall back or or maybe the preferable way to proceed in the
1st place is to use the fraudulent conveyance statute which gives creditors standing to make
the same kind of claim OK the fraudulent conveyance is really the creditor sues seeking to
recover the money from the person who actually has the money so it's kind of a disgorgement
remedy right you you someone who knowingly receives the money when they shouldn't have
been receiving the money Mike Fleming in this case can be liable individually to the creditor as
long as the creditor can prove the elements of a fraudulent conveyance claim OK fraudulent
transfer I should say so I guess maybe we shouldn't be troubled in those other states where
where where creditors can't Sue for claims that are owed to the Corporation because in most
cases in the cases you where it's necessary you'll be able to use the fraudulent conveyance
statute to get your money from the person who's got the money OK and that's the difference
between the two claims who gets to Sue essentially alright so that's a lot to that's a lot to chew
on but it's really kind of review let's move on to talking about Costello and this is a well
question #34 I guess I'm going to call on I had two 2 volunteers on this one of whom was mark
Turner so I'm not going to call it new again right immediately although I'll invite you to
comment later but kilau can walk you you volunteered on this question too and so let's start off
with the easy bit which is who was castela so John Costello he was the trustee in the
bankruptcy of Leonard plumbing and heating so he had the duty to oversee the bankruptcy
proceedings and to ensure that there is an equitable equitable distribution and settlement of
the creditors claims OK so he's a do you do you always have a trustee in bankruptcy do you
know I believe that actually I'm not sure I believe that there are pointed but I'm not sure
honestly right so well alot of times I mean bankruptcy is a weird area and I don't claim to know
a whole lot about it but one thing I do know is that it's very common when a business is being
declared bankruptcy it's very common for the business to declare bankruptcy simply because
things have gotten a little out of control and they need the help of a court to you know to keep
the creditors from pressing them too hard and so sometimes if if the court thinks that the
business is being run in good faith they will allow the business the people who own the
business and run that have been running the business to continue to run the business during
the bankruptcy proceeding and that's called in that case they're called a debtor in possession
but if there's reason to think that the people who are running the business we're playing fast
and loose with the rules or you know otherwise kind of cheating the court will almost certainly
appoint a trustee to handle the the the proceeding from there on out usually appointing a
trustee means that the business is going to be liquidated if you've got a debtor in possession it
means that there's there's some possibility that the business will be able to be reorganized and
emerged from bankruptcy and then continue to function thereafter as an independent business
so the trustee is kind of a signal that as to whether or not there's any hope that the business
will survive the will survive the experience and in this case the trustee is there because it's
pretty clear that this business is not viable and Secondly it's pretty clear that there are serious
questions about whether or not the people who are running the business have done so in good
faith now I posted it a again slightly review slightly revised version of the slides today which you
may want to go back and look at but we talked last time about the fact that there's there every
state has a version of fraudulent transfer law there's also a separate and parallel fraudulent
transfer section in the Bankruptcy Code if you could take a look at that and I put a new slide in
that shows you that gives you the language from that section you'll notice that the that if a
business is in a bankruptcy proceeding the trustee in a proceeding can use the federal R
fraudulent transfer status statute let me just double check here and see what the it's 11 USC
548 and you can take a look at it I don't know if I'm going to put the slides up anytime soon but
eleven USC 548 says that if there is a trustee then the trustee has also a federal fraudulent
transfer right that reads pretty much the same as state fraudulent transfer remedies but
Interestingly enough that section doesn't apply if we have a debtor in possession that is if the
company is simply being run by the people who our who ran it in the 1st place then this remedy
of a fraudulent transfer right doesn't apply and why should it right because you're not going to
have him for excellent transfer in a situation where we're letting those people continue to run
the business so this section says in a sense it says only if there's a trustee in charge of the
business does the trustee get to use this fraudulent transfer theory so I mean that's an
interesting distinction that I really have never quite homed in on before but there it is so yeah
that's who Costello is and let me just say that the the classic phrase is the bank bankruptcy
trustee steps into the shoes of the Corporation and can assert claims that the Corporation could
have asserted at for the benefit of the creditors so that brings me to the second half of my
question which is how is it that the well let me put this slightly different way and just ask Kyle to
to sort of state this what did castelo want what what are we what's the controversy in this case
now we know now who Costello is what is Costello arguing in this case what does he want so
Costello wants equitable equitable subordination so he is arguing that there was pretty much
fraudulent loans to I'm sorry from Fazio that would put him on the same level as the as the
debtors so instead of getting like the final piece over like whatever is left of the company he
would be actually given you know the same like take away as as the creditor so he wanted
Costello wanted them to be on the same level so that or I'm sorry he wanted the general
creditors to be first so that Fazio didn't have the advantage of getting paid on the same level as
them when he had taken all the money out of the company OK so I guess given that you've said
this link pursue what one of the things you just said how was that he took all the money out of
the company was this another was this like Ray Fleming all over again so I'm I'm actually not
100% sure I know that there was there was the $50,000 in the company and then he I believe it
was like through a dividend or I guess a fraudulent transfer what we might call it but he was just
distributed the 45,000 of that 50,000 OK mark the oven any other thoughts on that I mean you
want to I actually know what happened 'cause are some of us are in the biz tax class today and
tomorrow and this is a 351 transaction where a partnership became a Corporation and the
Corporation can legally take on their liabilities and there's no taxes for the partner to become
incorporated so although there were varying amounts of how much they put in they were all
equal partners and because some of them had paid much more than the others they wanted to
be first in line to get that money back however the court didn't want that because they were in
control of this Corporation they could have made the decisions better for the company that
would have allowed them to overtime get back this money so it was more equitable than
anything that so the shareholder debt was subordinated to the claims out to the outside
creditors so basically it came second and it's think it's a equitable subordination kind of deal but
right about that let me just say that make a point that since we happen to be on the point right
now but this is different from piercing the corporate veil right in although the the elements of
the claim innocence are very similar I mean the question is the question is was the business
adequately capitalized but it's different from a piercing the corporate veil claim in that the court
does not find that the individuals involved are going to be required to dip into their own money
and pay back the creditors I mean the difference with Fleming in his case was he was held liable
for the deaths of the Corporation big cause he had played fast and loose with the rules in
essence Um and so he had to I mean the Holder in Fleming was that that Fleming or DeWitt
truck brokers was that Fleming had to pay the truck brokers out of his own pocket in this case
the holding is that the stockholders will not be able to be treated as creditors and will have to
wait they'll have to go to the back of the line as it were and get paid only after the real creditors
have been paid it doesn't mean they got to take anything out of their own pockets and give it to
the real creditors it simply means they have to wait for their money until everybody else has
been paid so I have a slide on this and I'm going to share my slides so we can look at this and
let's see here um or slide #92 there where I've I've reproduced the information from the
language of the federal fraudulent transfer rule that's that's in the Bankruptcy Code notice if
you read this you'll notice that there's no distinction between existing creditors and new
creditors like there is in the the uniform act which I think makes a whole lot more sense instead
you've just got four different rules about when the remedy is going to be available so you can
take a look at that on your own here's the slide relating to Costello and let me just say that that
the as far as the remedy is concerned what I'm assuming here just for purposes of discussion is
that maybe there is $100,000 left in this business after you know everything has been sold in
auction on the courthouse steps and we you know we Marshall the assets and get everything
together assume that there's $100,000 left to be distributed to the creditors out these first 2
bullet points essentially show you the results if they either if there is subordination in the first
instance or no subordination in the second instance so I kind of went through the case Once
Upon a time and figured out exactly how much the claims appeared to be and the claims
appeared of the outside creditors appear to be one 12,541 but if you add in the claims that are
made by the insight creditors namely Fazio mostly and then Ambrose who also has about $4000
or so that he thinks he's owed the difference is that the total creditor claims to be 100 and
58162 so if you count their claims and you have $100,000 to distribute that means that
everybody gets 63 cents on the dollar if you leave those claims out and you only pay the
outside creditors that means that everybody that means that all the creditors would get $0.89
on the dollar and of course the insiders Fazio and Ambrose would get 0 right so basically what
they would have gotten goes back into the pot for purposes of of the true outside creditors and
so that's you know that's what Costello is arguing for here and in the end the court says yes
that's that's that's the right answer that we're going to subordinate these to support Nate these
claims and require the inside stockholders to wait until everybody else has been paid so if you
want to take a look at it what I did here was I I constructed a balance sheet as best I could tell
based on the numbers that are shown in the decision that shows what the business looked like
as a partnership in 1952 and this is really quite scary because this this case is now like 80 years
old right in any event this is what it looked like as a partnership and and on the right hand side
is what it looked like as a Corporation so mark you did mention that this was a case in which the
partnership decided that it wanted to become a Corporation and I think it's fairly clear that the
reason this partnership wanted to become a Corporation was that it was circling the drain so to
speak which I think is an appropriate metaphor for plumbing supply business right I mean this
this this business was about to go under and they figured that if they turned it into a
Corporation they couldn't be held liable or would not be held liable individually on the
obligations of of the business if it remained a partnership now I that's I I think they got some
bad advice there because on the one hand to the extent that they have existed if their existing
claims against them as partners they're probably going to be other things equal there probably
going to be continue to be held liable as partners anyway because the creditors were doing
business with the partnership and therefore had claims against them as partners on the other
hand if you take a look at partnership law you'll see and I think it's in section 35 of the uniform
partnership act that is the old act that where in a partnership the creditors extend further
credit to the business after it has become well this this actually applies where some partner has
left the partnership but where the partner where the creditors extend further credit to the
partnership after a partner retires then the partner who retired is no longer liable on the claims
that were made or the claims that could have been made against that partner if the creditors
hadn't in effect agreed to look to the new partnership in the future that is implied Lee so by
virtue of continuing to do business with the partnership I take it that the same rule would apply
where the partnership becomes a Corporation so if the partnership becomes a Corporation and
then manage is to to survive long enough that its pre existing creditors will have extended
further credit you know by selling supplies and getting paid among 30 days later whatever
those creditors are going to be deemed to have agreed imply and Lita look only to the
Corporation this is by analogy to what would happen if a partner retired on the other hand if
you've got a creditor like for instance a let's say the business leases its store and the
partnership transfers the lease to the Corporation the Corporation then continues to pay the
lease but no changes are made to the terms of the least um and then the business goes
bankrupt at bankrupt after it has become a Corporation the the less or will still be able to Sue
the partners individually on the theory that they agreed to be liable when the lease was
entered into now of course if the partners get an agreement or get some kind of waiver from
the less or that says OK we agree to only look to the Corporation in the future then they're fine
but in the absence of some kind of explicit agreement on the part of the creditors only to look
to the Corporation the partnership will still also be liable right and the partners will individually
be liable so so others I mean bottom line here is that trade creditors and the people who do
business on the 30 days 6090 days at a time with the business will probably be stuck having to
Sue the Corporation but other people who may have entered into longer term deals with the
partners when it was a partnership will still be able to Sue the partners it doesn't make any
difference that the Corporation has also agreed to be liable on those claims if anything those
creditors are in better shape than they otherwise work as now they consume either the
individuals or the Corporation and get and get paid so I think from from the point of view of
business organization law the situation is a little bit different from the tax situation that that
mark was describing where where the Corporation can take on the liabilities and that's not
treated as if the you know the individuals who are being relieved of those liabilities have
income themselves that's a completely different question so anyway let me go back to the first
slide here do I want to go back to the first slide or do I not well now let's stick with the let's let's
stick with this slide and talk about one other aspect of this that I think is pretty important and
that is and and and mark you mentioned this when we're a partnership when when this
business was being run as partnership we've got three partners who are equal partners right
and we know from what we know about partnership law that every partner has an equal say in
operating the business irrespective of the amount of the partner has invested in the business
right so fazzio has $43,000 invested in the business Ambrose has 6400 and change Leonard who
the business is named after he's the face man in this business he only has 2000 so mark you
said that one of the reasons they did this deal was that when we when we become a
Corporation the problem is that control in a Corporation follows the number of shares that you
have and so we have three guys who have equal control because they are equal partners for
purposes of management rights it just so happens that they've invested different amounts of
money in the partnership but that's not crucial for purposes of who has control now that
they're going to become a Corporation all of a sudden it becomes crucial because if Fazio get
let's say we give everybody 11 share for every dollar they have invested if we do that facio will
have 43,000 shares Ambrose will have 6400 shares and Leonard will have 2000 shares fazzio
obviously is going to be the overwhelmingly controlling stockholder in a Corporation and
therefore will be able to do whatever he wants to do and Leonard basically has to just do what
he says so what they wanted to do was figure out a way to equalize the control and what they
hit upon was too well let's just say that everybody is going to get 2000 shares just like Leonard
and so when you see them as a Corporation here we've got common stock of 6000 OK we're
assuming a dollar a share right so 6000 divided equally three ways is 2000 each in the infezione
Ambrose are going to take out the difference in notes that is they're going to say OK instead of
owning 43,000 shares following today instead of owning 43,000 shares I'm going to own 2000
shares an have 41170 in stockholder debt now these numbers don't exactly match up from one
side to the other because some other things changed in the meantime in terms of you know
sort of earnings and so forth but this is the way they ended up according to the facts given in
the case in any event when we set the Corporation up fozia would would say in effect OK give
me back 2000 shares and then give me a note that says you owe me another 41,170 and that
way I'll still have my $43,000 interest in the business but I won't have any more shares than
Leonard has so basically what these guys say when Costello sues them is well you know it
wasn't we weren't trying to pull a fast on anyone what we wanted to do was just equalize are
controlling interest because we understood that it had to follow the number of shares that we
own in the Corporation so you know this wasn't you know there was nothing nefarious going on
here we just had to do this in order to become a Corporation which is our right right so that's
the excuse that they give and Costello comes back and he says well that may be true but
nevertheless what you did was you took out you took out in the $41,000 from a Corporation
that couldn't afford it the Corporation needed capital of well if you add this up it count comes
out to something like $51,000 right um maybe maybe closer to $52,000 in capital that the
business has when it's a partnership and now it has 6000 in capital and So what Costello argues
is word you know you took out forty 3044 thousand $45,000 worth of capital in a business that
needed ever all of that capital So what so that's that's castellos argument in this case my
question is is Costello right about that did these guys take did these guys withdraw capital from
the business at a time and leave it undercapitalized so we get back to the same question that
we had with respect to Ray Fleming in his fruit business right the question is how much capital
does this business need I mean the court says now the court's argument here is they go with I
can't hear what the guys Clifford a humbrecht I guess comes in as some sort of expert witness
and he says well I think this business needs at least as much capital as the partnership had and
therefore you know past practice is the best indication of what the business itself thinks it
needs and therefore this is bad faith on the part of the owners to take this capital out of the
business so says Clifford hambrecht is that did buy that argument Kyle what do you think of
that mark mark you seem to want to speak go ahead yes I mean I always want to speak that's
my lot in life so I was just curious that did it really matter the amount that it was I was I wasn't
sure if it was the capitalization amount that mattered as much as the fact that this was kind of
just really talking about the equitable subordination that because they made this shift because
they did things wrong this gave Costello the opportunity to kind of get a fiduciary duty through
the backdoor regardless of how much it would have been capitalized for because they made
this move to kind of save themselves as you and I have talked about how much how hard it is
for for partnerships to dissolve and how rough it can be I guess the irony of this case is that it
became even more difficult by changing to a Corporation so I was just a little confused with that
matter in any case where the capitalization would matter in any case where it's almost a
fraudulent change well I don't think that I I frankly I don't think it makes any difference whether
it's a partnership or a Corporation in terms of how much capital it needs obviously it matters to
the formalities but it doesn't really the amount of the businesses the business and therefore
needs however much capital a business of this sort would need so in that sense I think the
whole question of the form the organization kind of drops out of it but I was thinking I mean
what the question I posed is how much capital does this business need I I really should have
should have said do you agree with the argument that's being made by Costello that but the
owners of the business took the capital out I I I do agree because what do you think Kyle yeah I
also agree John John review you volunteered to talk about anything so I might as well ask you
too yeah can you could could you ask it again so I did do you agree as the as Costello argued
and the court seemed to agree that the owners of the business withdrew the capital at a time
with drew let's say too much capital at a time when the business could still afford it based on
the notion that the amount of capital they had as a partnership is the very least that they would
would they themselves knew they needed Yeah so one of the things that I was thinking about
and I know you had mentioned in previous classes was kind of that cushion that creditors look
for in terms of the owners or investors having some equity in the business so when I was
looking at that you know that the court kind of phrased the inadequacy of capital issue in terms
of not the overall capital was lacking but the stated capital was lacking but it does seem kind of
curious that you know that if anything it seems like that would kind of be the court protecting
the creditors in like a contract sense you know the in terms of the investors had kind of
manipulated I guess they had in for lack of a better term kind of changed the game on the
creditors midway through but presumably when the court says that it was for it was for the
protection of future creditors that was something that those creditors would know when
looking at the information so maybe I don't know if that's exactly what you're getting at but it
seems like there's there's almost too much hand holding of future creditors by the court when
you know the state of the business was what it was when those new creditors would you know
decide to lend money I wanted to I want to go back to something that you said at the very
beginning of your answer though and and pursue that just a little bit the I was I was trying to
focus this question on on whether it was a correct characterization that these guys had
withdrawn capital from the business when it couldn't you know and left it undercapitalized and
the it seems to me that the fact is they didn't take anything out of the business at all this is not
like they paid themselves a dividend right what they did was they tried to transform what
previously had been equity into debt but they didn't take it out of the business they left it in the
business so that really kind of changes the question doesn't it becausw one thing that the court
declines to notice or mention or discuss is that is that you can there is such a thing as debt
capital you know some businesses get start up by putting in some amount of equity and some
amount of debt they borrow the money from the bank and the bank you know because of the
banks willing to lend it I suppose and so you can you know there's there's nothing that says
capital has to be equity capital right this business and so why can't these guys come back and
say well yeah I mean we had to do this because of sort of adjusting the levels of control but we
didn't really take anything out of the business we left everything in the business that was in
there to begin with we just turned it into debt capital as a way of addressing this issue of
control having to follow the number of shares that you have and so forth I mean that's kind of a
bogus argument anyway because we could we could set up a capital we could set up a common
stock structure that says that all of these guys that fazio's that Fazio Ambrose and Leonard can
each elect one director to the Corporation and then they'll all have equal say despite the fact
that they have different numbers of shares and we could have three classes of shares class F
Class A class L and each class gets to elect one director and then then we've addressed this
control problem the court doesn't talk about this but it's perfectly easy to address the problem
that they're talking about without going through turning this stuff into debt so that you know
that makes us wonder whether they weren't up to something else but the fact of the matter is
you can have debt capital and so why couldn't they come back and say well look we left the
capital in the business we just turned it into death capital and businesses can be capitalized
with that so then the next question becomes as you answered in your answer well to have debt
capital you've got to have equity capital the question is did you have enough equity capital to
support the debt capital that you had and the answer then I think becomes probably not I mean
we've got if you did it sort of a debt equity ratio here you'd see that you've got $6000 worth of
equity and $50,000 or so 45 forty $5000 or so of debt that's a debt equity ratio of about
something on the order of eight to one and that's pretty highly leveraged 8 to one is as a rule of
thumb um if you well I'm getting off into a different area here and it's that's something we need
to talk about a little bit one reason that businesses like to capitalize themselves somewhat with
death is that the interest they pay on debt can be paid in pre tax dollars and so you can get
more money out of the business that way by being able to pay some of the return to
debtholders and this applies especially if those debt holders are insiders through if the debt
holders are also stockholders right so that's another reason for using some somdet no it's not a
reason in this case because this debt probably wasn't real debt this debt was a demand note
and no interest was ever stated or paid on the note so you know it's not like they could really
use that tax justification for using debt but even if they tried to do that The IRS will you know if
if if they audit you they'll like the likely say that's too much debt that's unrealistic nobody could
borrow that kind of money therefore it's not really dead and therefore the deductions you took
for interest or not really deductions and we're going to treat that as if what you really did was
the Corporation had income and then it paid a dividend to its stockholders so the Corporation if
it had income actually had to pay tax that it didn't it didn't pay because it claimed to be paying
out interest again in this Case No interest was ever actually paid so none of that happened and
it doesn't seem like you know it's not a good faith characterization of what was going on I mean
I've said a lot there but as far as the IRS is concerned a debt to equity ratio of something like
they're very liberal about this something on the order of four to one will usually pass muster
but anything in excess of four to one is going to look abusive now just for purpose since we're
you know I'm sharing my slides here anyway I this two slides down you'll see the a list that I put
together from 3 tax cases over the over the years of 13 factors that the IRS looks at to see
whether it agrees that debt is really debt for purposes of allowing things like the deduction of
the interest on the debt not that it applies in this case but you might want to take a look at
these factors that the tax courts or courts who are dealing with tax matters will look at when
when the courts trying to decide whether or not debt is really dead so that's not a situation in
which the question of is debt really that comes up in our case it's coming up in the context of
bankruptcy because we have reason to think that the stockholders are really trying to figure out
a way to to be treated as creditors and the court holds that they're not an the reason I mean
I'm John I think you really sort of hit the nail on the head but was that even though a
Corporation might be able to borrow some of the money that it needs for purposes of
capitalizing itself it that doesn't mean that you that that the company would be able to borrow
100% of it and so the question becomes is this a reasonable amount of debt to have as debt
capital in light of how much equity capital we have and so the real question becomes is there
enough equity capital in this business and I think the answer is pretty clearly no because as you
said John no no bank is going to lend this business $45,000 in in in you know kind of the form of
a debt instrument if the owners only put $6000 in to capitalize the business that's just you
know more than you would ever expect a real lender to lend now if these guys hadn't been so
greedy and leaving aside the fact they've got these other debts and so forth they've got a bank
loan that you know is is sitting out there too leaving aside all of that stuff these guys just got too
greedy if they had said for instance OK we're going to take it back we're going to leave half or a
third of what we had in the business in the business in the form of equity and we're going to
give ourselves notes with respect to 2/3 of it they probably would have been OK but what they
did was just too aggressive what they did was was to leave only $6000 in when previously the
business had had capital of something like $50,000 let me ask another question here just for
purposes of completeness that is bankruptcy is supposed to be about creditors getting paid as
much money as they can so the trustee is seeking to assert claims on behalf of ultimately on
behalf of the creditors but the argument that seems to be accepted by the court here is that
but these guys fazzio Ambrose and Leonard as the controlling stockholders and officers and
directors in the Corporation breached their fiduciary duty to the Corporation by withdrawing
capital at a time when the Corporation could still afford it now it seems to me that that and I
thought the court holds right that kind of builds in the notion that the Corporation is laughed
with too little capital so you've got the undercapitalization argument but you've also got an
argument that I think is the one that the court really accepts as the primary argument here
which is that these guys breached their fiduciary duty to the Corporation by taking too much
money out at a time when the Corporation needed all that capital now leaving aside the fact
that they didn't really take it out and then what we're really talking about here is whether or
not there's enough equity capital which is a somewhat different point strikes me as a problem
that the court says that they breached their fiduciary duty and therefore the creditors get
something doesn't that rather suggest that bet that creditors are able to assert a claim for
breach of fiduciary duty I mean I thought we already figured out that fiduciary duty runs only to
the stockholders so where does the court come off saying you breached their fiduciary duty and
therefore the creditors get something is that a problem I mean what's how can how can the
creditors or their representative in the form of the trustee rely on a fiduciary duty argument to
get some remedy for the creditors when the creditors aren't entitled to be protected by
fiduciary duty any thoughts on that I mean I think that so there are two thoughts on that but I
one is we don't really need to make that argument it's enough purposes of creditors that the
Corporation was undercapitalized and if you take a look at the bankruptcy version of fraudulent
transfer you'll see that one of the things that can be transferred fraudulently is an obligation of
the Corporation and clearly that's what's happened here you could say in a sense that this
stockholders distributed to themselves debt obligations of the Corporation and that falls within
the bankruptcy version of the fraudulent conveyance fraudulent transfer statute it's not really
mentioned in the uniform act so once again I think that the bankruptcy version is is is a lot
better drafted but we do have but aside from that point there is there is the fact that the
trustee steps into the shoes of the Corporation and if you see the fiduciary duty is something
owed to the Corporation I guess it's something that the trustee can assert so if the corporative
Corporation had paid an illegal dividend given that the trustee is is is you know occupies the
shoes of the Corporation as it were I guess he can bring a lawsuit that would ordinarily have
been one that should have been maintained as a derivative action because the trustee is the
Corporation so you have you get a strange kind of exception to this notion of fiduciary duty
running not running to creditors if the Corporation is in bankruptcy because if you've got a
bankruptcy trustee the bankruptcy trustee can assert claims that belong to the Corporation as a
way of getting stuff back into the corporate pot ultimately for the benefit of the creditors and I
don't know what to say about that other than that it is what it is right I mean if we I don't think
anybody would deny that the directores and major stockholders this Corporation oh a fiduciary
duty to the Corporation and the trustee can assert that duty it just so happens that that's kind
of an exception to this notion that it amounts to an exception to the notion that creditors can't
assert claims fiduciary duty and again that's not the rule in Delaware as we see in production
resources we haven't talked about yet The Delaware courts of have I have come around to
thinking that creditors can in fact assert claims for reaches the fiduciary duty if the Corporation
is insolvent which is really the same thing but it is problematic and all of those other
jurisdictions where only stockholders can make an assert claims for breach of fiduciary duty it's
just a if there's bankruptcy you've got it you know sort of an inherent exception to that alright
so we didn't get as far as I mean I seem to say this every every time but I think I guess this will
be a decent break before spring break we're not going to have class next Wednesday so we'll
talk about polius and top notch and production resources on Monday then we'll start the next
unit on the following Monday after that for after we come back from this this year's spring
break such as it is so um I guess I'll see you Monday and will talk about polius at that time again
I did not get any extra volunteers for questions I would like to have a couple more people to
talk to next time around so think about volunteering for one of questions 36 through 39 in the
meantime OK live long and prosper and Sidney cherkis I'm going to you and I need to talk and
we'll just stay on South see everybody else next Monday.