OKLAHOMA Business and Corporate Law 2012

recent DEVELOPMENTS in

OKLAHOMA business and corporate law 2012

Gary W. Derrick

Derrick & Briggs, LLP

1

recent DEVELOPMENTS in
OKLAHOMA business and corporate law 2012

Introduction

The economic recession and the Federal regulatory response have given us much to discuss. Since 2007, we have talked about the mortgage crisis, the derivatives markets, the collapse of global financial institutions, an unsettling, world-wide economic downturn, Federal bailouts and sweeping regulatory changes. One of the most startling aspects of this area of law is the rapid pace of change. Markets and industries have opened and closed and shifted in unexpected ways.[1] The combination of technological advances, increased information flows, greater productivity, and globalized expansion have produced a rate of global economic change not witnessed since the Industrial Revolution.[2] One could argue that the rapid pace of change within the financial markets –and the inability of investors and regulators to fully understand the changes – was a principal cause of the financial collapse and resulting recession.[3]

But we have talked enough about the collapse and regulatory response. Other developments have attracted much less notice, but are intriguing in their own right. We should examine some of these developments. We shall explore several developments on the national front, such as crowdfunding and socially responsible entities, before moving on to cover the Oklahoma developments.

National Developments

Crowdfunding

One of the most interesting parts of the JOBS Act was its endorsement of crowdfunding.[4] What is crowdfunding? It is an internet-based networking process that matches people willing to contribute funds to people pursuing an identified project. The matches typically provide seed capital for persons who presumably could not access conventional debt or equity funding. Its earliest iterations involved musicians and other artists who solicited funds from their fans to finance a tour or a recording or a film. The concept grew with websites that would aggregate the projects to facilitate matching. The better known websites include KickstarterandIndiegogo.[5]

The early projects tended to offer contributors tickets or t-shirts, but no true investment returns. But the success of the some projects indicated that crowdfunding could be an important vehicle for start-up capital. Many of these crowdfunding projects raised money from hundreds or even thousands of small contributors.[6] Federal and state securities laws were animpediment. Registration would be too burdensome for relatively small amounts of funding and the securities laws had no exemption from registration that would permit crowdfunding. Under the private offering exemptions –the common exemption for small offerings a broad-based, internet solicitation of funds would violate the exemptions’ prohibition on general solicitation and limits on the number of investors.[7] Whether and how a website could legally charge for its hosting was another regulatory problem. At issue was whether the website was acting as an unregistered broker by facilitating the offer and sale of securities.[8]

The regulatory impediments were addressed in the JOBS Act.[9] The JOBS Act permits companies to raise up to $1.0million over 12 months. The securities must be sold through an SEC-registered broker or a registered “funding portal”. Investors with a net worth or income of less than $100,000 may invest only $2,000 or 5% of their net worth or income. Investors with a net worth or income of $100,000 or more may invest up to 10% of their net worth or income, subject to a cap of $100,000. The company must file a simplified disclosure with the SEC describing its business, the risk factors, and its intended use of funds and providing financial statements. The number of investors is not limited and the offering may be advertised through the broker or funding portal.

The broker or funding portal acts as the “gatekeeper” to guard against abuse. They ensure that investors receive the disclosures, understand the investment and can bear the investment loss. They also must conduct background checks on the company’s owners and management to confirm the absence of regulatory infractions. The SEC is supposed to adopt implementing rules by December31, 2012.

Crowdfunding is an innovative concept. It expands social networking to the capital markets. It opens a new avenue for small businesses to access much needed, start-up capital from a broad pool of potential investors. The notion that a small business might raise money from large numbers of small investors without securities registration is unprecedented. Whether crowdfunding lives to its potential will rely on the willingness of brokers and funding portals to support the process. The gatekeeper function imposes much more responsibility than websites bear under the current Kickstarter or Indiegogo models, which do not deal with disclosures or investor suitability. Much will depend on the SEC implementing rules and whether the brokers and funding portals can realize sufficient compensation for the risks and responsibilities assumed.

Private Offering Changes

In addition to opening the crowdfunding door, the JOBS Act liberalized the rules for exempt private offerings. Under the current Rule 506 of Regulation D, a company can theoretically raise an unlimited amount of funds from an unlimited number of accredited investors and up to 35 non-accredited investors.[10] The company cannot, however, advertise its offering or publicly solicit investors.[11] As a practical matter, companies must have some pre-existing relationship with potential investors, which constrains their access to capital.

The JOBS Act removes the general solicitation and advertising prohibition on offerings sold only to accredited investors under the revised Rule 506. The removal is a startling development. In the statutory words, a private offering is one “not involving any public offering.”[12] Any general solicitation or advertising would seem necessarily to involve a public offering and thus would be incompatible with a private offering. Even before the general solicitation prohibition was explicitly stated under Rule 146 and later Regulation D,[13] legal authority had long held that private offerings could not engage in general solicitations.[14] Yetlegal authority has also long recognized that highly sophisticated investors have little need for the protections afforded investors generally and that broader solicitations among these investors should not destroy the private offering exemption.[15] With the JOBS Act opening the door to “accredited investor only” offerings, we can say that policy has chosen to follow this latter line of authority.

Benefit Corporations

For those who bemoan the loss of ethics in business, let me present “socially responsible entities”. These are entities spawned from the corporate social responsibility movement, which urges businesses to create a better society while doing business. CSR management principles rely upon a premise of moral responsibility to behave ethically and to improve the quality of life for the business’s workforce, its local community and the broader society. These principles believe that businesses can and should create a better society while doing business.

The socially responsible entities come in various forms – the most common being “benefit corporations” and “low-profit LLCs” or “L3Cs”. They are crosses between for-profit and not-for-profit entities. They are like for-profit entities, but with the stated purpose to create a general public benefit. This is a compulsory undertaking, not a permissive one. They are required to consider the public benefit. They differ from not-for-profit entities because they receive no tax benefits or other economic benefit and can distribute profits to their owners.[16]

Maryland was the first state to adopt benefit corporation legislation, which it did in 2010. Since then, benefit corporation legislation has been adopted in California, Hawaii, Illinois,Louisiana, Massachusetts, New Jersey, New York, South Carolina, Vermont andVirginia.[17] The California bill is typical.[18]

A California benefit corporation is a for-profit corporation whose purposes must include the creation of a “general public benefit,” which is defined as activity having a “material positive impact on society and the environment.”[19] In addition, the benefit corporation may state a specific public benefit, such as providing low-income or underserved individuals or communities with beneficial products or services, promoting economic opportunity for individuals or communities beyond the creation of jobs in the ordinary course of business, preserving the environment, and improving human health.[20]

Having stated its purpose, the directors must consider the effect of any action or proposed action upon the shareholders and employees, upon customers who are beneficiaries of the general or specific public benefit purposes, and upon the environment.[21]

The benefit corporation must prepare an annual benefit report, which includes the board’s opinion as to whetherthe benefit corporation fulfilled its public benefit, a description of the ways in which it pursued those benefits, and the extent to which those benefits were fulfilled.[22] The corporation must apply a “third party standard” for measuring its social and environmental performance and describe the process and rationale for selecting the standard.[23] The corporation must post its annual benefit report on its website and file it with the Secretary of State.[24]

As in a for-profit corporation, the officers and directors of a benefit corporation have fiduciary duties, which are owed to the shareholders. The officers and directors are specifically protected in considering the needs of constituencies other than shareholders.[25] They are subject to “benefit enforcement proceedings”.[26] A shareholder or beneficiary of the public purpose may claim that the benefit corporation is failing to pursue its stated public benefit. Neither the corporation nor the officers or directors can be monetarily liable for the failure, but a court could grant injunctive relief and the benefit corporation could be ordered to pay the plaintiff’s expenses, including attorney fees.[27]

While the altruistic underpinnings of the benefit corporation would seem to be universal, the concept is not without its critics. They have argued that the concept is premised on a flawed notion that existing law compels directors to elevate the profit-motive above all else and prevents directors from considering the impact of corporate decisions on other constituencies, the environment or the community. They say that businesses can and do act in socially responsible ways under the present law and that present law allows directors to consider a business’s long-term needs as well as its short-term needs, and the needs of other constituencies, such as the workforce, in addition to shareholder needs. They argue that to suggest present laws do not accommodate socially responsible action is counterproductive. It implies that regular corporations act in socially irresponsible ways and discourages the very conduct that the benefit corporation laws seek to promote.[28]

The benefit corporation laws have also been criticized for adding uncertainty in the discharge of fiduciary duties. Professor Stephen Bainbridge has noted that management could use the stated public benefits to entrench itself at shareholder expense. For example, management could use the stated benefits to discourage potential acquirors by arguing the acquisition bid would hurt nonshareholder constituencies or that the acquirer would act irresponsibly. If credence were given these arguments, it would diminish the existing standards of conduct applied directors when responding to acquisition bids.[29]

Oklahoma Developments

Legislation

There was little legislative activity dealing with business law in the 2012 Session. Two items warrant brief discussion.

The Business Activity Tax (BAT). The BAT is a tax in lieu of ad valorem taxes on intangible personal property.[30] It was enacted in 2010 to moot the decision in Southwestern Bell Telephone Co. v. Okla. State Bd. of Equalization,[31] which held that the constitutionally-based, intangible personal property exemption was much narrower than had been presumed.[32] The unexpected holding imposed ad valorem taxes on intangible property previously thought to be exempt and – if implemented would have effected a massive tax increase on Oklahoma businesses.

Two legislative acts in the 2012 Session dealt with this issue. One was Senate Joint Resolution52, which became State Question766.[33] If passed, State Question766 would amend the State Constitution to exempt all intangible personal property from ad valorem taxation. Another act was Senate Bill 1436, whichwas a backstop.[34] The BAT was set to expire after 2012. SB1436 would extend the BAT for an additional year – and thus defer the effect of the Southwestern Bell Telephone decision if State Question766 does not pass.

Annual LLC Reports. The Secretary of State requested Senate Bill1523.[35] The bill fixes the amount of the annual LLC certificate fee at $25. The superseded statute authorized an annual fee, but did not fix an amount. The bill also authorizes the Secretary of State to send the annual notice by email instead of by mail. To facilitate email transmission, the Secretary of State has changed the annual report form to collect email addresses.

New Cases

Several recent case decisions in Oklahoma deserve mention, three of which deal in some way with an agent’s capacity or liability or both. A fourth case deals with a pastor’s fiduciary duties.

Smoot v. B&J Restoration Services, Inc. is a well-reasoned case involving the sale of a business.[36] Larry and Connie Smoot, through their company, C&L Restoration Services, LLC, bought a cleaning and restoration business from B&J Restoration Services, Inc. and its owners, Brandon and Julie Hopper. The plaintiffs alleged that the Hoppers breached the purchase agreement and a restrictive covenant and defrauded plaintiffs by misrepresenting the business. The jury found that the B&J and the Hoppers were liable for the contractual breaches, but not for any fraud.

The Hoppers appealed arguing that they could not be personally liable for the contractual breaches as they were only acting in their corporate capacities. The Smoots countered that the Hoppers had signed the purchase agreement in their individual capacities and had initialed each page individually. The Hoppers presented testimony from the business broker’s counsel, who prepared the documents and stated that the lack of corporate capacity was an inadvertent omission. Faced with this ambiguity, the court reviewed the purchase agreement and noted that B&J was described in the preamble as the seller and the representations addressed the signer’s authority to bind B&J. Other closing documents indicated a corporate capacity, such as the corporate resolutions authorizing the sale, an assignment of the tradename, an agreement to split a franchise fee, and a settlement statement. Taken together, the court held that the Hoppers intended to sign in their corporate capacities and not individually.

This did not resolve, however, the issue of whether the Hoppers were individually liable. While an agent is not normally liable for acting as such, the court notes that officers or other corporate agents canbe individually liable if “they agreed to be bound, their conduct was tortious, or they exceeded their authority.”[37] Under the non-compete provisions of the purchase agreement, the agreements states, “Seller covenants not to compete as an individual, officer, employee, investor, or in any other capacity.” The applicable provisions closed with an undertaking that the non-compete obligations “extend to each officer, director and shareholder . . . of Seller, and Seller represents and warrants that it has the authority to bind such officers, directors [and] shareholders . . ..”[38] In light of these provisions, the court then held that the Hoppers had bound themselves individually even though they signed in their representative capacities.

The court then examined whether the Hoppers were personally liable because they engaged in tortious conduct or exceeded their authority. As to the tortious conduct, the court noted that the jury had rejected the fraud claims against the Hoppers and found only on the breach of contract claims. That finding indicated their conduct was not tortious.[39] Did they exceed their authority? Plaintiffs claimed the Hoppers did so by failing to disclose that B&J was doing business beyond the scope of the cleaning franchise, which inflated the business’s revenues. But this claim, the court reasoned, is an alleged misrepresentation about the business, not about the Hoppers’ capacities. The court further reasoned that B&J was not legally limited in the work it could do and neither were the Hoppers. B&J could remodel as well as clean and the Hoppers could carry out this work. Hence they did not exceed their authority. The Hoppers were personally liable for breach of the non-competes, but not for breach of the purchase agreement generally.[40]

The dissenting opinion in Smoot further examines the issue of when an officer can be personally liable. The dissent states that when an agent acts for a principal, the principal is bound but not the agent.[41] Since the Hoppers signed the purchase agreement, which included the non-competes, in their representative capacities, the dissent would hold that B&J was bound, but not the Hoppers. As officers, they are not bound individually and cannot be personally liable. The dissent cites the case of Carterv. Schuster.[42] In Carter, the court held that Schuster could not be compelled to arbitrate when he signed the arbitration agreement only as an officer, not as an individual. But the facts in Smoot differ. The arbitration provision in Carter was only between the parties and did not include the officers. In Smoot, the purchase agreement contained express language obligating the officers individually to the non-competes. Should the law permit an officer to sign an agreement knowing that it purports to obligate him and escape the obligation by claiming he signed only as an officer and not as an individual? The dissent would say yes. Others would say no: the result is inequitable.