Court: Court of Appeals for the D.C. Circuit; August 3, 1984; Federal Appellate Court
Circuit Judge Wilkey authored the opinion for the court, with Circuit Judge Mikva concurring in part and dissenting in part. Philander P. Claxton III established Bandeirante Corporation in December 1980, primarily to develop gold mines in Bolivia. In September 1981, Bandeirante's officers, Sparkle Diamond and Sharon Smith, authorized a sale of nearly all the corporation’s voting stock for $999,000 in promissory notes from Claxton, representing Nilge, Ltda. Claxton later convened a shareholder meeting in a District of Columbia jail, where he exercised Nilge, Ltda.'s proxy to elect new leadership, prompting the appellants to challenge the legitimacy of the stock sale and seek to oust these officers and directors.
The appellants argue the stock sale violates District of Columbia law, which prohibits selling stock for promissory notes, and that Claxton, bound by fiduciary duty, failed to demonstrate the transaction's fairness. The district court ruled against the appellants on both counts, but the court has since reversed that decision.
The case includes complex details involving a network of business ventures initiated by Claxton to explore Bolivian gold mining opportunities, initially estimated to be worth $100 million. Claxton created Tipuani Limited Partners to handle mining proceeds, raising approximately $7 million through limited partnerships. Bandeirante Corporation was formed as the general partner, authorized to issue 10,000 shares of Class A voting stock and 10,000 shares of Class B nonvoting stock. The Class A shares were initially sold to Donald and Mrs. Loveridge, but were repurchased shortly after due to their desire not to control the corporation. Subsequently, Claxton's wife acquired some Class B shares, while plaintiffs purchased 3,500 Class B shares for $350,000. The corporation's initial leadership was replaced by Claxton's associates, Diamond and Smith, who did not actively manage the corporation but followed Claxton's directions, while he served as a consultant for a monthly fee.
Claxton established an offshore corporation, Nilge, Ltda., while imprisoned at Eglin Air Force Base in January 1981, with the intention of avoiding U.S. taxes on overseas operations. The plaintiffs were uncertain about Nilge's existence, while Claxton claimed he did not conceal his involvement. Ownership of Nilge was unclear, although it was found that its shares were held by two Bolivian nationals involved in gold mining. Claxton had a broad power of attorney from Nilge and directed its North American actions, effectively making Nilge the operational vehicle for the mining venture instead of Bandeirante. Tipuani contracted Nilge for management services, which Claxton testified he provided.
In spring 1981, complications arose regarding the mining property's title, leading to litigation and missed payments from limited partners in Tipuani. Claxton did not pursue these payments due to the title issues. In September 1981, Nilge utilized $990,000 from promissory notes to acquire Class A shares in Bandeirante, transferring control of the mining operation to Nilge, which Claxton managed. This series of transactions allowed Claxton to control Bandeirante and the mining venture without using his own funds.
By January 1982, Claxton and others were replaced on Bandeirante's board, with Claxton resigning as consultant. Later that year, Claxton was indicted on unrelated federal felony charges, to which he pled guilty and received a lengthy sentence. Following his appointment, new president John Baringer raised concerns about Claxton's management, leading to scrutiny from the Loveridges and the appellants, while Claxton opposed Baringer’s actions.
Claxton, while detained in a D.C. jail, removed Baringer from the presidency of the corporation using a power of attorney from Nilge. He conducted a shareholder meeting from his cell, where he elected himself, his wife, and his father to corporate positions and also appointed directors, including a representative of Class B stockholders. The appellants aim to reverse this election, arguing that the sale of Class A stock to Nilge is void on two grounds: that promissory notes are not valid payment for shares, and that Claxton did not demonstrate the fairness and adequacy of the sale's consideration.
The concept of treasury stock, which refers to shares reacquired by a corporation after being sold, is central to the trial court's findings, which concluded that Nilge, Ltda. obtained treasury stock and that promissory notes are acceptable as consideration. Historically, legal opinions on treasury stock have varied. The British view advocates for the extinguishment of shares upon reacquisition, while the American majority view, prevalent when the D.C. corporation code was written, holds that treasury shares remain in a state of "suspended animation" and can be reacquired without being extinguished. The Model Business Corporation Act clarified the definition and treatment of treasury shares, allowing corporations to reacquire shares only using surplus funds and permitting resales at deemed adequate consideration.
The Model Act prohibits corporations from using certain types of consideration, including promissory notes, to pay for securities. The drafting committee intended to codify existing corporate law rather than fundamentally alter it, aiming to clarify the definition of treasury shares. The Model Act ambiguously prohibits issuing shares for promissory notes and future services, leaving open the interpretation regarding treasury shares, which are defined as already issued shares.
The District of Columbia Code closely follows the Model Act, using the term "issued but not outstanding" for treasury stock and allowing directors to resell these shares for adequate consideration, though promissory notes are explicitly excluded as valid payment. While the D.C. Code incorporates a more complex formula for share repurchase, it shares similar objectives with the Model Act, focusing on modernizing D.C. corporate law and aligning with the Model Act's principles.
Section 29-317 of the D.C. Code, which addresses the use of promissory notes, is ambiguous regarding treasury stock. It restricts promissory notes as payment, potentially applying only to new stock issuances. Some argue that the omission of a "consideration" requirement for treasury shares in 29-316 suggests flexibility in the type of payment accepted. However, others contend that the ban on promissory notes applies universally to any payment for shares, reinforcing anti-fraud measures to ensure reliable consideration for stock transactions. Treasury shares seem excluded from the Model Act's stated capital treatment but should not be considered outside the scope of anti-fraud provisions.
Judicial interpretation has not clarified the ambiguities in the Code and its legislative history, particularly regarding the application of section 317, which applies only to sales of shares by the corporation itself, excluding assignments of shares owned by individuals. This distinction acknowledges that the policies of section 317 do not apply when the corporate treasury is unaffected.
The structure of the Act indicates a coherent framework concerning treasury stock, which is linked to the concept of stated capital. Stated capital serves as a buffer for creditors in case of corporate failure and is based on the par value of shares issued. Most corporate statutes, including the one in question, prohibit the acquisition of treasury stock if it would diminish the stated capital. Acquisitions must typically be financed through capital surplus or earned surplus, not stated capital. Consequently, issuing treasury stock at par value is unnecessary, as the stated capital remains unchanged when stock is reacquired.
The distinction between authorized but unissued stock, which impacts stated capital, and issued but not outstanding stock, which does not, is established through treasury share provisions found in the Model Act. Modern statutes that eliminated concepts of stated capital and par value have also done away with the concept of treasury stock.
Section 29-317 aims to protect the stated capital account, as uncollectable promissory notes included in stated capital could mislead creditors and shareholders. Initially, the Model Act suggested that the sole purpose of such provisions was to prevent the watering of new stock; however, broader purposes may also be relevant to treasury share transactions.
The 1960 commentary to the Model Act indicated that its provisions applied solely to newly issued stock, a clarification later codified in a 1969 amendment to the Model Act, which the district court incorrectly treated as legislative history. This commentary, issued too late to influence the original drafting of the D.C. statute, can be used similarly to law review articles for interpreting unclear statutes. Both the 1960 commentary and the 1969 revision lack substantive reasoning for distinguishing treasury stock. The Model Act has since evolved, eliminating the concepts of stated capital and treasury stock, with current regulations banning stock sales for promissory notes, though a proposed Revised Model Act would allow such sales under stricter disclosure requirements. The California act similarly prohibits sales for unsecured promissory notes. These provisions suggest that the ban on promissory notes serves interests beyond protecting stated capital, emphasizing that stated capital alone is insufficient to prevent capital dilution. In modern contexts, creditors focus more on earnings metrics than on stated capital. Consequently, reliance on stated capital can be misleading, with fiduciary duties of corporate principals becoming a more crucial safeguard against misconduct. However, the 'business judgment rule' restricts the enforceability of these duties, necessitating specific bans on behaviors likely to cause harm. The D.C. Code's prohibition against selling stock for promissory notes serves as a preventive measure, as such transactions can mislead investors, dilute existing equity, and obscure the true value of corporate assets, especially when involving potentially worthless third-party notes.
A rationale for maintaining the ban on the sale of treasury shares relates to the market for corporate control. Selling treasury shares could transfer control of the corporation to a buyer, potentially aligned with existing management, thus solidifying their position without adequate risk. Such transactions, which may escape judicial review under the business judgment rule, could disrupt the corporate control market without providing substantial benefits. The law may favor a blanket ban on these sales to prevent potential misconduct without hindering legitimate transactions. This policy encompasses both treasury and newly issued shares, as excluding treasury shares would contradict the intentions of the D.C. Code and overlook vital legal principles.
In this case, the sale of treasury shares is effectively akin to an initial share issuance. The shares in question were mistakenly sold to two investors who quickly sought rescission. The corporation, retaining effective control, later sold these shares, which represented nearly all voting stock. The distinction between treasury and newly issued shares, while recognized, is not legally significant in this context, as the prohibition does not rely on concepts like par value or stated capital.
Additionally, the appellees argue that third-party promissory notes should be considered valid compensation for treasury shares. However, this argument is flawed because, while the D.C. Code allows intangible property as consideration, it explicitly excludes promissory notes. Thus, the court should adhere to this specific exclusion when evaluating the validity of such transactions.
Courts have consistently rejected the appellees' argument regarding unsecured first-party and third-party promissory notes, emphasizing that only secured notes are recognized as valid consideration. This distinction is grounded in the need to protect shareholders from fraud, as unsecured notes pose a risk of uncollectibility for creditors, regardless of their transfer history.
Plaintiffs sought a declaratory judgment to void an illegal stock sale to Nilge, which is voidable rather than void from inception. The illegality could have been remedied if the purchase price of $990,000 had been fully paid, although the record indicates no payments were made. The case is remanded to the district court for clarification on whether any payments were made.
Additionally, the plaintiffs requested the reinstatement of prior directors and officers, but the district court noted these individuals were also elected by Nilge and thus lack a stronger claim to office than those they would replace. The court did not identify which prior board should assume control, necessitating further determination upon remand.
The district court previously ruled that Nilge was not an indispensable party to the suit, a decision not contested on appeal. Various reasonable justifications for this ruling exist, such as the presence of Nilge's North American representative or the broad power of attorney held by Claxton. The relief granted by the court must consider Nilge's absence from the proceedings.
The district court’s judgment is reversed and remanded, focusing solely on the equitable relief sought by the plaintiffs, while leaving claims for damages for a future trial.
Claxton's imprisonment details are not provided in the record. At trial, Claxton indicated that the Bolivian nationals would return Nilge stock to him and the Loveridges once gold mine production commenced, suggesting he had an ownership interest in Nilge, which could lead to a conflict of interest, though it is not pertinent to the current decision. Sparkle Diamond's resignation as president stemmed from a U.S. Attorney's investigation into the corporation’s checking account, related to other charges against Claxton, but no charges arose from the investigation of Bandeirante. Claxton communicated with the court ex parte about holding a shareholders' meeting in prison and proposed trading notes from Nilge for shares in Tipuani, which would allow Tipuani limited partners to gain shares without cost. Claxton claimed this exchange would benefit Bandeirante. The text also references historical context and critiques of the Model Business Corporation Act, particularly regarding treasury shares.
The excerpt analyzes provisions of the District of Columbia Business Corporations Act regarding the issuance and repurchase of corporate shares. It highlights that the accounting complexities associated with a corporation purchasing its own shares are not relevant to the case at hand. According to D.C. Code § 29-302(9) and § 29-316(c), corporations may issue shares acquired at a consideration determined by the board of directors. Notably, payment for shares can be made in money, property, or services, but promissory notes and future services are explicitly excluded as valid forms of payment. Once the corporation receives payment equivalent to the par value of the shares, those shares are considered fully paid and nonassessable. The board’s judgment regarding the value of consideration received is conclusive in the absence of fraud.
The Act allows corporations to repurchase shares for various purposes, including eliminating fractional shares and compensating dissenting shareholders. Historical context is provided, noting that earlier statutes prohibited dividend payments that would reduce a corporation's assets below its stated capital. The distinction between treasury stock and authorized but unissued stock is clarified, emphasizing that treasury stock does not need to be issued at par value. Unlike Delaware law, which allows promissory notes under certain conditions, the D.C. Code lacks similar qualifications. The excerpt also notes that many cases related to promissory notes focus on the stated capital concept, which is a recurring theme in the legal interpretation of these statutes.
The excerpt addresses the multiple policies underlying the prohibition on issuing stocks and bonds that lack substantial value, emphasizing the need to protect the stated capital account. While the Model Act Amendment aimed to clarify existing law, it did not change it, despite the omission of "issuance" which could imply treasury shares were included. The Revised Model Business Corporation Act allows for the sale of treasury shares for promissory notes, requiring the board to assign a present value to the notes and informing shareholders about the shares issued and their valuation. The California Code permits stock sales for secured promissory notes and third-party notes, although previous beliefs regarding the permissibility of stock sales for all promissory notes have faced criticism. Additionally, most statutes prohibiting stock purchases with promissory notes also extend to future service promises, recognizing that promissory notes may present a higher risk for fraud. If a purchaser has good credit, they may obtain financing from other sources instead of relying solely on the corporation.
New sources are advancing funds to start-up companies based on services to be performed, leading at least one state, Virginia, to allow the sale of stock for future services (Va. Code. 13.1-17). Several court cases referenced indicate that shares of stock are not sufficient collateral for validating sales for promissory notes. The sale of stock for promissory notes raises potential valuation issues, particularly since both parties in a transaction valued their notes at face value, as evidenced by testimony from Claxton during the trial.
The case suggests that if Nilge’s ownership is voided, no directors elected by Nilge should remain in office. Additionally, Claxton's failure to demonstrate the fairness of the transaction could render it voidable. Although the district court ruled against the plaintiffs, it acknowledged that Claxton, despite not being an officer, director, or shareholder during the contested meeting, was the promoter of the corporation and thus owed a fiduciary duty. This duty typically ends once an independent board is established; however, if the board lacks true independence, the duty persists.
The district court noted that Claxton maintained control over the corporation and its management, with the officers and directors being merely nominal figures under his influence. Consequently, Claxton's fiduciary duty was not terminated, and he acted as a fiduciary for Bandeirante while representing Nilge, raising concerns about self-dealing.
Due to his fiduciary duty, Claxton is required to prove the "entire fairness and adequacy of the consideration" received by Bandeirante in the transaction. The district court initially found that Claxton fulfilled this obligation because the promissory notes were deemed "valid consideration." However, this conclusion was incorrect, as valid consideration pertains to contract law and does not directly address the complexities of self-dealing by a fiduciary. While a contract may technically involve low-value exchanges, such as a peppercorn for Blackacre, this raises concerns in the context of fiduciary relationships. The court determined that it need not evaluate whether the transaction involving "worthless promissory notes" for most of the corporation's voting stock would have occurred in an arm's length negotiation, nor whether the appropriate remedy would be rescission or money damages. Additionally, Claxton's potential fiduciary duty to Bandeirante could stem from his significant consulting role, wherein he managed the corporation's affairs without formally being an officer. However, this issue was also not addressed due to the court’s decision on the promissory note matter.
