Costello v. Fazio

FACTS:  Over the years, F,A, & L had built up capital accounts with the thought that if the business ever terminated they would get the $ money back.  Part of your liability is a return to partners.  They are at the end of the line.  F, A, & L – operated their business as a partnership.  Fazio invested $43,000; Ambrose $6,000; and Leonard $2,000.

How do you incorp. a partnership?  Fill out articles of organization of course and also dissolution of the partnership – change in the relation b/w or among the parties.  Partners by unanimous consent may always alter their partnership agreements.  Dissolution terminates the power but partners are given the authority in the winding down process – liquidation.

Problem – you destroy the very thing that you want to transfer – you destroy the business.  So, dissolution is probably not the best way to do this – don’t want to destroy the thing which you want to transfer.

Form a corp.What does it take?

Fill out the form

Promotors would be Fazio, Ambrose and Leonard

Incorporators would be the same people

Likely directors would also be same

Officers same

SH’s same

They in essence are the corp. – nothing wrong with 3 people wearing the same hats.  Now they are a corp. – represent 2 businesses – the partnership and a corp. business.

Problems Here?  Cannot adopt the partnership Ks.  Corp. has not been capitalized – all you have is a shell.  How will you capitalize this venture?  Could buy the partnership – bring in the partnership’s assets.  Could borrow funds but that creates instant debt – don’t want that.  Could issue stock, debentures – who would buy the stock? – F, A, & L – they did.

F, A, & L own a partnership business, they want to incorporate.  Somehow you have to get the partnership (means the assets, the people, the good will, the accounts – its tangible and intangible) over to the corp.

How?  Best way to do this would be to sell the partnership to the corp.  Corp. would buy everything both tangible and intangible.  Simple sale transaction – sale of assets from partnerships to corp.  Hopefully transactions are arms-length transactions – means fair.  Creditor care most.

Asset Acquisition Agreement:  The transfer of the partnership to the corp.  What @ consideration that is paid by the corp. to the partnership for the assets?  Parties to the K determine the consideration (Quid Pro Quo – requires that the consideration given must be roughly equal to that which is received).  Directors determine the value of the stock and buyers determine consideration.  So, F, A, & L will be deciding the value they will pay for the partnership.

How do you determine the value of business?  Deals with the valuation of the business and capitalization of earnings concept (to come later in the course).

Problem:  for creditors b/c they are sliding money back and forth – until transfer is made what is corp. paid – have the corp. issue stock.  Corp. will pay for the assets of the partnership in corp. stock.

They each own disparate interests in partnership – Fazio is owed more.  Issue him 43,000 shares – each valued at $1; issue Ambrose 6,000 shares; and issue Leonard 2,000 shares.  In order to recognize the disparate share, give them stock equal to what they put into the partnership.  This gives F overwhelming power – A & L can never outvote Fazio.  A & L can’t amass any power in the corp.  They may want this but it must be discussed.  They should each have their own atty’s so that each will be represented fairly.  This is not Quid Pro Quo – must come up w/something so that they can each have equal voting power.

Consideration:  transfer of the business for the stock.

What is wrong?  Are these voting shares?  Fazio has greater control – can change in the relationship from 3 equals to not equals.

W/partners, presumption is that everyone has equal control – basic feature – equality regardless of contribution; everyone will share equally in profits irrespective of what is owed them, losses and liability of partners.  The simple conversion of a business throws relationship off.  Disturbs basic relationship

In corp., corp. governance – SH’s control the corp. through vote power.  Fazio runs the show now.  Not desirable.  Want to maintain in the incorp. of a partnership the equality of a partnership.  That is what they did.

How do you incorp. a partnership w/out disturbing the basics of partnership?  Give them all the same amount of stock to maintain equality of control.  What happens to their balance – turn into promissory notes.  Ended up reducing to a common figure the stock ownership.  Each owned equal amount.

Prior to incorp. – they reduced their capital accounts to 2,000/a piece.  This reduces them all to the level of L.  The difference for F & A is put into a promissory note.  This gives them equal voting power.  They now have equality in management and control.

Preferred Stock:  cross b/w common stock and debt.  Cumulative, builds up. Resembles common stock in that it gives a voting right.  Stock is the basic way of capitalizing business.

They chose one particular way, there are many others.  Pre-incorp, they reduced capital accounts; issued promissory notes and transferred the whole package.

The business fails.  Insolvency is what they experience.  Liability exceeding assets.  Doesn’t necessarily lead to disastrous results.  What can they do?  Assignment (state redress) – turn their business over to creditors – try to keep the thing going – let them run the business.  Bankruptcy (federal redress) – only available at federal court on national level.  Not all bankruptcy procedures terminate the business – reorganization.

F, A, & L did not want to reorganize – they filed for bankruptcy to end the business, that was their goal.  The business itself can file for bankruptcy.

ISSUE:  Whether or not trustee should recognize the claims of F & A.

HOLDING:  If there were inadequate capitalization what would happen to these claims?  Claims would be disallowed b/c for purposes of this claim, there is no debt.  Sham, fraud, attempt to evade creditors.  F&A did risk something – they put something into the business – it wouldn’t be fair to give them nothing would it?  Should appeal to sense of fairness.  Equitable Subordination:  Subordination based on feelings of rightness and a subjective theory of fairness.  If trustee determines corp. to be an alter ego, F&A would be personally liable – that is why equitable subordination is a good choice here.  By pushing the claims to the bottom of the line, you are in essence, depriving them of their notes.  Giving them some satisfaction by not holding them personally liable but sanctioning them for undercapitalization, etc.  It is a choice, very subjective.  Feeling that people have based on what is presented.  Is the last approach if can’t get entity disregarded, subordinate.  Court said that Fazio and Ambrose could not stand way at the front of line of creditors; they were pushed back before preferred SH’s.

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