July 1997 NY Bar Exam
Questions & Sample Answers

Question Six

Marvin was a wealthy businessman and the sole incorporator and shareholder of Money, Inc, a New York business corporation. Initially, Money's sole asset was a bank account funded by Marvin for the purpose of making investments. Money kept no corporate records and observed none of the usual corporate formalities. Money's board of directors consisted of Jean, Mary and Beth, Marvin's three adult daughters, who were also the corporate officers, and, with Marvin, authorized signatories on the corporate bank account.

In 1990, at Marvin's direction, Jean retained Makeover, a professional investment manager, to manage Money's investments. Makeover's only contact with Money was through Jean, but Marvin made all the decisions concerning the investments suggested by Makeover.

In December 1993, Beth decided that she wanted to purchase a luxury car. Without seeking Marvin's consent, Jean and Mary, with Beth abstaining, voted to use Money's funds to make a $50,000 loan to Beth. The loan was to be repaid by September 1997, at an interest rate of nine per cent.

Beginning in early 1994, Money's investments began to lose money. Angered by the losses, Marvin accused Makeover of negligently managing the Money account. At that time Money owed Makeover $30,000 in unpaid commissions. On May 15, 1994, knowing that the commissions were due, Marvin liquidated the investments and withdrew all of the funds from the Money bank account, leaving Money with no assets. That same day, Marvin instructed Jean to terminate Money's relationship with Makeover.

On May 12, 1997, Makeover commenced an action against Money in Supreme Court, New York County, to recover the commissions owed. Money timely answered Makeover's complaint on June 1, 1997. In its answer, Money included a counterclaim seeking damages for Makeover's alleged negligent management of Money's funds in 1994. Makeover moved to dismiss Money's counterclaim on the grounds that it was barred by the applicable statute of limitations. The court denied the motion.

During discovery, Makeover learned of the foregoing facts with respect to Money's corporate structure and assets. Makeover would like to add Marvin as a defendant in the action and hold him personally liable for the commissions owed, but has been advised by its attorney that it can do neither.

Marvin recently became aware of the $50,000 loan to Beth. Marvin claims that the loan is unlawful and has demanded that the loan be repaid to the corporation immediately.

(1) Was the court's ruling correct?

(2) Was the attorney's advice correct?

(3) What liability, if any, do Jean, Mary and Beth have to Money as the result of the loan?

ANSWER TO QUESTION 6

1) The Court correctly denied Makeover's motion. The issue is whether on a counterclaim the defendant may relate back to the date of the original claims for statute of limitation purposes. Under the CPLR, the rule is that mandatory counterclaims by a defendant relate back to the date filed by the plaintiffs for statute of limitations purposes. Because negligence actions require three years, Money would have had to file by May 15, 1997, to be timely. That is three years from the end of the business relationship. However, Money can use Makeover's May 12 date because the counterclaim rises from the same transaction or occurrence. Therefore money may use Makeover's May 12 date, under which the action was timely. Because Money may relate back to May 12, the court properly dismissed the action.

2a)
The Attorney's advice that Marvin can be called as a defendant.

The attorney incorrectly advised Makeover. The issue is whether a plaintiff may permissively join a third party after discovery. The rule is that parties may join other parties after discovery. If the issues arise out of the same transaction or occurrence, a plaintiff may add another defendant. Because discovery has begun does not dismiss the plaintiff's action.

The plaintiff needs to receive permission from the court. The issue is whether the later learning of facts is sufficient reason to allow a party to join a third party. The rule is that a court should permit joinder unless there would be undue prejudice. Because Marvin knew about the suit and was already defending through Money, there would be no unfair prejudice in adding the claim after discovery. Therefore the attorney gave improper advice.

2b)
The Attorney's advice on Marvin's personal liability.

The attorney incorrectly advised Makeover that Marvin cannot be held personally liable. The issue is whether the court would pierce the corporate veil and hold Marvin personally liable. Courts normally do not hold shareholders personally liable. However the court will pierce the corporate veil. The corporation has no will of its own or it is severely undercapitalized and fraud has occurred. The court will also rely heavily on whether corporate formalities have been followed. Because Money kept no records and observed no formalities; because Marvin so dominated Money and ``made all the decisions concerning the investment''; and because Marvin liquidated the account knowing the commissions were due, the court will likely pierce the corporate veil and hold Marvin personally liable.

While courts are reluctant to pierce the corporate veil, they will do so under circumstances such as Marvin's and thus the Attorney's advice was incorrect.

3)
Liability of Jean, Beth and Mary on the loan.

The loan is void. Beth must repay the loan and all three directors will be personally liable.

Loans to directors must be approved by shareholders. The issue is who may approve loans to the directors. The rule is that under the BCL, only shareholders could approve the loan. Because only the directors approved the loan to the director, the loan is void. It is irrelevant that the interest rate may have been fair or that a majority or disinterested directors passed the resolution.

The loan is void. The issue is what effect does Board approval have on actions which have to be approved by shareholders. Under the BCL, the rule is that such transactions are void. Because the transaction is void, the money must be returned to Marvin on his demand.

Jean, Mary and Beth may be held personally liable. The issue is whether they have breached a fiduciary duty to hold them liable to the corporation. The rule is that all directors owe the duty of care a reasonably prudent person of ordinary skill and training would have. A reasonably prudent director would not have approved an invalid $50,000 loan to a director. Because they breached the duty they will be liable.

Beth will not be saved because she did not vote for the loan. The issue is how may a director prevent liability for illegal transactions. The rule is the director must abstain and write a letter to the secretary voicing her disapproval. Because Beth did not disapprove correctly and because she received the money she will be liable.

The directors may not seek indemnification. The issue is whether a director may seek indemnification when the corporation is seeking the money. The rule is that a corporation may not indemnify directors when the corporation seeks recovery of the money or damages. Because the money is to be paid to Money, they cannot go seek indemnification from Money. Therefore they will be held personally liable.

ANSWER TO QUESTION 6

1) The court was correct in denying the motion. The issue is the applicable statute of limitations for a negligence claim when it is made as a counterclaim.

Under CPLR, a negligence claim will be earned after three years from accrual if the statute of limitations is asserted as an affirmative defense. The date that satisfies the statute of limitations is normally the date of filing of process in the Supreme Court of New York. (This assumes that the other requirements such as service of process and filing of proof of service are met.) There are a few statutory exceptions to the date a claim is deemed interposed. One exception occurs within the third-party practice regime and is known as the ``relation lack'' doctrine. If a claim that would otherwise be barred is brought against a party when it would have been timely had it been brought when the other party's claim was brought, the counterclaim will be timely as long as it arises out of the same events as the original claim such that the party should have been aware that the claim was likely to be brought. Here, Money wants to bring a negligence claim against Makeover. The claim would be barred after three years from accrual. In this case we do not have a perfect sense of accrual but selecting the date May 15, 1994 seems reasonable, since that was the time Marvin liquidated the investments. (If the negligence should be considered to have occurred earlier -- early 1994 -- the claim will be barred despite the relation lack doctrine). Therefore, a claim brought on June 1, 1997 would normally be time-barred. However, on May 12, 1997, Makeover commenced an action against money that arises from the same events as Money's counterclaim. There is sufficient overlap in issues that Makeover should expect a counterclaim to be brought against her. Therefore, Money's June 1 counterclaim is deemed interposed on May 12 rendering it timely by three days. So, the court was correct in denying Makeover's motion.

2) The attorney's advice was incorrect. The issue is whether Makeover can amend her complaint to include Marvin as a defendant and whether Marvin, a shareholder of Money, can be held liable to Makeover.

A party is given one opportunity to amend her complaint as a matter of right. The amendment must be made within a certain time period and can be done if the claim could have been included in the original complaint. Even if not allowed as a matter of right, courts have discretion to allow amendments as long as it would not be unfair to the other party.

Here, the court would likely allow Makeover to amend her complaint even if not timely because there is no indication of any prejudice to the defendants and the information just became available during discovery. Courts give lots of leeway to changes owing to new information attained during discovery. In addition, it would not be unfair to Marvin because he should expect to be joined as a defendant given his active role in the corporation.

The second issue here is whether Marvin can be held personally liable. Generally, a shareholder is not personally liable for the debts of a corporation. However, if there has been fraud, illegality or such complete domination of the corporation by a shareholder such that it cannot be said that the corporation is acting independently, the courts may ``pierce the corporate veil'' and allow recovery against the shareholders. New York courts have traditionally been very reluctant to pierce the veil in the absence of gross misconduct.

It is likely that this situation meets the level that would convince a court to pierce Money's corporate veil. First, Money did not follow corporate formalities and it kept no corporate records. More critically, Marvin liquidated the investments and withdrew all the funds from the Money bank account leaving Money with no assets. This indicates that Marvin did not act as a simple shareholder -- he exerted such control over the corporation that a court would likely conclude that he dominated the corporation.

Therefore, it is possible that a court would pierce the corporate veil in this situation and Makeover's attorney should have advised her of such a possibility.

3) All three sisters are liable to the corporation for the $50,000. The issue is whether loan was properly made.

A loan to an interested director is the type of transaction that must be approved by the majority of the shares entitled to vote. Barring such approval, any director who participated in the improper loan situation will be liable to the corporation for the amount of the loan. It is irrelevant whether the terms of the loan are fair.

A director may absolve himself or herself from liability if he/she abstains from the vote or votes against the action and records his/her objection in writing with the corporate secretary or in the corporate minutes. Without this action, even an abstaining director will be liable.

Here, Beth asked Money to loan her $50,000 for the purchase of a luxury car. This is clearly a personal use and not for the benefit of the corporation. She therefore, needs to get shareholder, not director, approval. Beth only got approval from the two disinterested directors and did not get Marvin's approval (the sole shareholder). The loan was therefore invalid and the directors who participated in the loan arrangement can be held liable.

Jean and Mary are clearly liable since they approved the loan. Beth is also liable even though she abstained because she did not register her dissent (this would have been silly since she sought the loan). So, she too can be held liable.

Therefore, the three sisters can be held jointly and severally liable for the loan (each is liable for the full amount).

In addition, they will not be able to be indemnified by the corporation since they will be liable to the corporation.