Shareholder Oppression Blog

Shareholder Oppression Newsletter No. 2

noreply@blogger.com (Eric Fryar) — Thu, 14 Apr 2011 22:13:00 +0000

Earlier this month, Fryar Law Firm published its second issue of the Shareholder Oppression Newsletter, which contained four new articles dealing with issues raised in the Dallas Court of Appeals' recent significant minority shareholder oppression opinion: Ritchie v. Rupe.

The articles are available on line at www.ShareholderOppression.com.

To get future issues of the Shareholder Oppression Newsletter by email, please subscribe to the Shareholder Oppression Newsletter.

New Texas Shareholder Oppression Opinion -- Ritchie v. Rupe, No. 05-08-00615-CV, _ S.W.3d , 2011 WL 1107214 (Tex. App.—Dallas 2011, __).

noreply@blogger.com (Eric Fryar) — Sun, 03 Apr 2011 21:51:00 +0000

On March 28, 2011, the Dallas Court of Appeals issued a significant shareholder oppression opinion in Ritchie v. Rupe, No. 05-08-00615-CV, ___ S.W.3d ____, 2011 WL 1107214 (Tex. App.—Dallas 2011, ____). [Read Full Opinion] This is the first Fifth Court of Appeals case to recognize a cause of action for minority shareholder oppression. The prior case law on issues of shareholder rights in that court had left some doubt as to the viability of shareholder oppression claims in Dallas. See, e.g., Schoellkopf v. Pledger, 739 S.W.2d 914, 918 (Tex. App.–Dallas 1987), rev’d on other grounds, 762 S.W.2d 145 (Tex. 1988). The case involved a closely-held Texas corporation called Rupe Investment Corporation (“RIC”). The opinion does not indicate the nature of the business, but it had been founded by two gentlemen, and by the time of the dispute in question, all of the stock was owned by various trusts set up for the benefit of the founders’ descendants. The corporation was a very valuable asset for its shareholders. The court of appeals indicated that, as of 2007, the corporation had net sales of over $152 million and $55 million in assets. Moreover, the corporation regularly paid dividends to its shareholders. The Plaintiff was the wife of one of the founders’ children, who became the trustee for the trust holding her family’s shares after her husband died in 2002. The trust controlled by the plaintiff owned approximately 18% of the voting stock.

Plaintiff’s husband had been on the RIC’s board of directors, and dissension started appearing within months of plaintiffs’ husband’s death. In 2003, plaintiff announced her desire to sell her shares in RIC and initially offered them to the corporation. At first, the corporation declined to make an offer, but later offered to purchase all the stock for $1 million cash and subsequently raised the offer to $1.7 million, consisting of a combination of cash and debt. The book value on the shares was approximately $3.9 million. During this period, there were also discussions relating to the Plaintiff’s participation on the Board of Directors. There was no shareholders’ agreement or any other restriction prohibiting the sale of the stock to third parties, and so plaintiff decided to seek an outside buyer.

In 2004, Plaintiff hired a broker, a retired capital fund manager, to seek a third- party buyer for the stock. The broker met with the other shareholders and directors and sought their cooperation with his efforts to sell the stock. The broker testified that RIC’s president told him that no member of RIC's management would meet with any prospective purchasers of the Stock. The defendant confirmed this in writing on February 1, 2006. The broker testified that he offered the stock for sale at $3.4 million, a $500,000 discount off book value, but that the stock was impossible to sell because of the refusal of RIC management to meet with prospective buyers. Plaintiff filed suit on July 21, 2006 against three of the four directors, directly and as trustees of trusts owning the majority of RIC’s stock. Plaintiff also sued RIC on a claim for failure to permit inspection of corporate records. There appears to have been disputes and motions filed regarding the correct capacity in which the defendants should have been sued. Ultimately, claims were asserted and a judgment was rendered against the Defendants in both their individual capacities and as directors.

The case was tried to a jury, which returned a verdict in favor of plaintiff. The appellate court’s opinion does not make clear what liability questions were submitted to the jury. In addition to the jury verdict, the trial court also issued findings of fact and conclusions of law.

The trial court held that the conduct of the defendants constituted shareholder oppression as a matter of law. This holding was principally based on the defendants’ refusal to cooperate with Plaintiff’s attempts to sell the Stock to third parties. However the trial court also concluded that the Defendants had acted oppressively by causing RIC to withhold corporate books and records from plaintiff; making redemption offers to plaintiff that were not in accordance with RIC's policy (apparently meaning the low-ball offers for a fraction of book value); making plaintiff a conditional offer to be on the board of directors in exchange for her not pursuing legal action against another RIC shareholder; and causing RIC to pay some personal expenses for one of the defendants. The jury was instructed to find the “fair value” of plaintiff’s shares and was specifically instructed to exclude any discount for minority status or marketability. The trial court entered an order compelling the three defendants to cause RIC to purchase plaintiff’s shares for $7.3 million, the fair value found by the jury. The trial court also entered an award for a portion of the attorneys’ fees sought by plaintiff against RIC. The Dallas Court of Appeals reversed the valuation and award of attorneys fees, but affirmed in every other respect and remanded the case for a redetermination of the value of the Stock.

The court of appeals held that Texas law provides remedies for shareholder oppression. The court held that shareholder oppression was defined as either:

1. majority shareholders' conduct that substantially defeats the minority's expectations that, objectively viewed, were both reasonable under the circumstances and central to the minority shareholder's decision to join the venture; or

2. burdensome, harsh, or wrongful conduct; a lack of probity and fair dealing in the company's affairs to the prejudice of some members; or a visible departure from the standards of fair dealing and a violation of fair play on which each shareholder is entitled to rely.

These two non-exclusive definitions are intended to be broad and to cover “a multitude of situations dealing with improper conduct.” The opinion provides considerable insight as to how to submit a shareholder oppression claim. “The jury determines what acts occurred (assuming those facts are in dispute), but whether those acts constitute shareholder oppression is a question of law for the court.” Therefore, the appellate court saw no error in a judgment based on both jury findings and on the trial court’s findings of fact and conclusions of law.

The court of appeals held that oppression could be asserted against a controlling group of shareholders and that a single majority shareholder was not necessary. Significantly, the court also held that a claim of oppression may be asserted against directors based on the clear provision in the dissolution statute authorizing equitable intervention when “the acts of the directors or those in control of the corporation are illegal, oppressive or fraudulent.”

In analyzing the oppressive conduct, the court recognized that the law protects both specific reasonable expectations and general reasonable expectations of shareholders. Specific expectations are rights or privileges that are specifically agreed to or reasonably expected as arising from the circumstances and transactions involved in forming the corporation—such as the expectation of continued employment or a place on the board of directors. General expectations are those rights and privileges that are common to all shareholders and stem from the shareholder’s status as an owner—such as the right to vote, access to corporate information, a proportionate share of corporate earnings, and the like.

The court held that the buy-out remedy was available for shareholder oppression. Next, the court held that, absent a contractual limitation, the right of free alienation of one’s stock is a general reasonable expectation that all shareholders have as a matter of law. The court held that this reasonable expectation of share ownership prohibited, not only an overt effort by the controlling shareholders or directors to restrict or thwart a potential sale, but also any policies or actions that constructively did so by interfering with the minority shareholder’s ability to identify potential third-party buyers and to provide those buyers with sufficient information to allow them to conduct a reasonable due diligence as to the proposed transaction. In fact, the court went so far as to impose an affirmative duty on the majority to cooperate with the minority’s efforts to sell by meeting with potential buyers so long as the burden on the corporation was reasonable. The court also rejected the argument that the business judgment rule protected the decision of the majority not to affirmatively cooperate in the effort to sell.

Nevertheless, the court of appeals reversed the trial court’s award of $7.3 million as the “fair value” of the stock. The court noted that two measures of “fair value” may be utilized: “enterprise value,” in which the minority shareholder receives her percentage of the total value of the corporation without any discount for marketability or minority status, and “fair market value,” in which the plaintiff would received the amount a willing third-party buyer would pay a willing seller of the minority shares and which would ordinarily involve discounts for lack of marketability and minority status. The jury was instructed to find the enterprise value. The court of appeals acknowledged that the enterprise value would usually be the appropriate measure in a squeeze-out scenario where the minority shareholder could not be characterized as a willing seller; however, in this case the oppressive conduct was interference with efforts to sell to third parties, and the stock had in fact been offered at a discount to book value—a price roughly half the value found by the jury. Under the facts of this case, the court held that it would be inequitable—that the plaintiff would receive a windfall—if enterprise value were used. Despite the fact that the defendants had made low-ball offers to the plaintiff, the court held that these offers were not oppressive because the plaintiff had solicited them, and the corporation was under no obligation to purchase or to make an offer. The case was remanded to the trial court for further proceedings on the issue of valuation. The court also reversed the award of attorneys fees based solely on the corporation’s interference with the plaintiff’s right of inspection of corporate records because the court held that there was no evidence of interference.

Four articles analyzing significant holdings in the Shareholder Oppression Newsletter.

Vermont Supreme Court Affirms Breach of Fiduciary Duties by Corporate Officer and Director

noreply@blogger.com (Eric Fryar) — Tue, 15 Mar 2011 02:34:00 +0000

Vermont Supreme Court Affirms Breach of Fiduciary Duties by Corporate Officer and Director

J.A. Morrissey, Inc. v. Smejkal, 6 A.3d 701 (Vt. 2010). [Read full opinion]

In a recently reported case, the Vermont Supreme Court upheld a jury finding of breach of fiduciary duties against a corporate officer and director. The Defendant, Peter Smejkal was an officer and director of Plaintiff, J.A. Morrissey, Inc. (JAM), a construction company. Prior to his termination, Smejkal had started his own excavation business and secretly performed excavation work on JAM projects on his own behalf. The jury further found that Smejkal poisoned the relationship with three JAM clients while still an officer and director and then succeeded in obtaining those projects for his own company after his termination.

The Vermont Supreme Court held that a director may not profit at the expense or against the interest of the corporation. 6 A.3d at 706 (citing Lash v. Lash Furniture Co. of Barre, 130 Vt. 517, 522, 296 A.2d 207, 211 (1972)). The duties of good faith and loyalty require that a director must not allow personal interests to interfere with or supersede the interests of the corporation. Id.

The court held that Smejkal, as an officer and director, had fiduciary duties to act with the utmost good faith and loyalty for the best interests of JAM. Id. at 707; see also Vt. Dep't of Pub. Serv. v. Mass. Mun. Wholesale Elec. Co., 151 Vt. 73, 89, 558 A.2d 215, 224 (1988) (“directors of a corporation are regarded as fiduciaries and are required to exercise their own independent judgment for the highest welfare of the corporation”); Lash, 130 Vt. at 522, 296 A.2d at 211 (“The relationship of a director ... to his corporation binds him to use the utmost good faith and loyalty for the furtherance and advancement of the interest of that corporation.”).

The plaintiff had also sued the defendant and obtained a judgment for tortious interference with prospective business relationships. It is not clear why the plaintiff chose to pursue this theory of liability, as the burden was much higher than on the breach of fiduciary duty claims, and the damages were the same. The tortious interference claim would only be necessary to establish liability on a party who did not owe fiduciary duties. In fact, the Vermont Supreme Court, in upholding the judgment on this tort, reasoned that the defendant’s breach of his fiduciary duties demonstrated the wrongful nature of the interference. See id at 710.

Apparently, the plaintiff believed that the tortious interference claim was necessary to establish liability on the Smejkal ‘s corporation (which was incorporated after the termination) and on the Smejkal ‘s wife. While it is true that neither the corporation nor the wife owed fiduciary duties to the plaintiff, a much cleaner and easier theory of liability would have been based on their knowing participation in Smejkal’s breach of fiduciary duties. This theory appears not to have been pursued by the plaintiff.

Like most jurisdictions, Vermont recognizes joint and several liability for third parties who knowingly participate in a corporate officer’s or director’s breach of fiduciary duties. “‘Any one who knowingly participates with a fiduciary in a breach of trust is liable for the full amount of the damage caused thereby ....’ ” Cooper v. Cooper, 173 Vt. 1, 17, 783 A.2d 430, 443 (2001) (quoting Wechsler v. Bowman, 285 N.Y. 284, 34 N.E.2d 322, 326 (1941)).

While the jury found the corporation liable for tortious interference, the jury did not find the wife to have committed that tort—although the jury did award punitive damages against the wife, about which the trial court was forced to grant a judgment n.o.v. due to the absence of any tort liability. Presumably, the result would have been better for the plaintiff on a knowing participation claim.

Read entire case analysis of Morrissey v. Smejkal--Vermont Officer/Director Fiduciary Duties.

First Issue of Shareholder Oppression Newsletter

noreply@blogger.com (Eric Fryar) — Thu, 03 Mar 2011 06:59:00 +0000

First Issue of Shareholder Oppression Newsletter

Fryar Law Firm, P.C. has sent out its inaugural issues of the Shareholder Oppression Newsletter. We plan to send out these monthly newsletters, which will contain articles that are longer and more detailed than typically appear on this blog. Our first newsletter highlights three articles dealing with difficult issues involved in Texas general partnership litigation: Squeeze-Out Tactics in a Texas General Partnership; Record-Keeping Duties in a Texas General Partnership; and Statute of Limitations Issues in Extended Winding Up of Texas General Partnerships.

Read First Shareholder Oppression Newsletter

Subscribe to Shareholder Oppression Newsletter

Shareholder Oppression Cause of Action in Florida

noreply@blogger.com (Eric Fryar) — Wed, 23 Feb 2011 17:28:00 +0000

Shareholder Cause of Action in Florida

I recently had occasion research the availability of the shareholder cause of action and the buy-out remedy in Florida. There are no reported cases recognizing the shareholder cause of action in Florida and one federal case which deals with the pleading of that cause of action under federal law calls the claim a "misnomer." Nevertheless, all of the components and public policies that underlie the cause of action and remedy in other jurisdictions are firmly established in Florida law. Read the entire research memo on shareholder oppression in Florida law at the Shareholder Oppression website. Here is a summary of what we found:

Florida courts have held that controlling shareholders owe fiduciary duties directly to minority shareholders. E.g., Orlinsk v. Patraka, 971 So. 2d 796, 801 (Fla. App. 3rd Dist. 2007). In Tillis v. United Parts, Inc., 395 So2d 618 (Fla. App. 5th Dist. 1981), the minority shareholders sued the majority shareholders for having caused the corporation to buy back stock from the majority owners at an inflated price, where the same offer was not made to minority shareholders. The court held that the transaction was essentially a preferential dividend to the majority shareholders and violated fiduciary duties to the minority shareholders. Id. at 620‐21. The court of appeals reversed the dismissal of the plaintiffs’ claims, holding that the plaintiffs had stated claims for both breach of fiduciary duties to the corporation and for breach of fiduciary duties “as majority stockholders to not utilize their control of the corporation to their advantage as against the minority stockholders.” Id.

In Acoustic Innovations, Inc. v. Schafer, 976 So.2d 1139 (Fla. App. 4th Dist. 2008), the court of appeals affirmed the imposition of a buy‐out remedy. In that case, there was an agreement between the two founders of a corporation that they would each receive 50% of the shares. One of the founders handled the incorporation and issued himself all of the shares. Thereafter, he refused to issue shares to the other founder and ultimately fired him. The ousted founder sued for a declaratory judgment that he was a shareholder and for involuntary dissolution and for breach of fiduciary duties. The trial court found that the plaintiff was a 50% shareholder. The trial court awarded the plaintiff 50% of the distributions that the other shareholder had taken out of the corporation since inception and awarded him almost $2 million for the value of his shares. Although the relief requested was dissolution, the court did not order the corporation dissolved; rather the court ordered the defendant to purchase the plaintiff’s shares for the value found by the court and imposed a constructive trust on all the shares of the corporation until the purchase was accomplished. The court of appeals affirmed in all respects. Although this case was not called an oppression case, that is clearly what it was.

Two recent cases involving the appraisal remedy also recognize that, in the corporate context, the court has the equitable power to fashion remedies that go beyond the statute. See Foreclosure Freesearch, Inc. v. Sullivan, 12 So.3d 771 (Fla. App. 4th Dist. 2009); Williams v. Stanford, 977 So.2d 722 (Fla. App. 1st Dist. 2008).

Eric Fryar, Fryar Law Firm, P.C.

Shareholder Oppression and Rule 408

noreply@blogger.com (Eric Fryar) — Wed, 23 Feb 2011 03:36:00 +0000

The ultimate goal of every scheme of shareholder oppression is to eliminate the minority shareholder’s interest. Sometimes the majority shareholder attempts to so diminish the minority shareholder’s interest, income and participation that the minority shareholder simply “withers on the vine” and gives up. The problem with this strategy is that the minority shareholder is still a shareholder, and the majority shareholder will always face the possibility of a lawsuit. Furthermore, if the majority shareholder wants ever to sell the corporation, then he will have to deal with the minority interest sooner or later. Less patient oppressors will use the leverage that their oppressive pattern of conduct gives them to attempt to coerce the minority shareholder to sell at an unfairly low price. In my experience representing minority shareholders, these efforts usually commence immediately after I alert the majority shareholder to the fact that the minority shareholder is now represented by counsel and is asserting his rights as a shareholder—this usually occurs when I send a shareholder’s demand for inspection of corporate records.

Invariably, the communications and attempts to purchase the minority interest come from lawyers representing the majority shareholder and are couched as “settlement offers” seeking to take advantage of the strictures of Rule 408. Texas Rule of Evidence 408 provides as follows:

Evidence of (1) furnishing or offering or promising to furnish or (2) accepting or offering or promising to accept, a valuable consideration in compromising or attempting to compromise a claim which was disputed as to either validity or amount is not admissible to prove liability for or invalidity of the claim or its amount. Evidence of conduct or statements made in compromise negotiations is likewise not admissible. This rule does not require the exclusion of any evidence otherwise discoverable merely because it is presented in the course of compromise negotiations. This rule also does not require exclusion when the evidence is offered for another purpose, such as proving bias or prejudice or interest of a witness or a party, negativing a contention of undue delay, or proving an effort to obstruct a criminal investigation or prosecution.

Federal Rule of Evidence 408 is identical, and most states have essentially the same principle in their rules of evidence. Believing that settlement communications are “privileged” under this rule, counsel for majority shareholders often feel free to make all kinds of threats and to begin negotiations with extremely low-ball offers. I have always believed that this is an extremely fool-hardy approach and strongly counsel majority shareholders that I represent against it. We usually take the position that these threats and unfair offers are themselves acts of oppression dressed up as settlement offers and that the rule does not shield them. We very aggressively seek to inject these oppressive communications into the case.

There is a very strong public policy in favor of encouraging settlement, and this is the policy that underlies Rule 408. However, there is an equally strong public policy in favor of enforcing fiduciary duties. Therefore, when the defendant owes the plaintiff fiduciary duties, courts will set aside a settlement procured in breach of fiduciary duties, notwithstanding the public policy in favor of the finality of settlements. See Voskamp v. Arnoldy, 749 S.W.2d 113 (Tex. App.—Houston [1^st Dist.] 1987, writ denied); see also Johnson v. Peckham, 120 S.W.2d 786 (Tex. 1938). This situation is particularly acute in a minority shareholder oppression context. The classic oppression scenario is that “the majority first denies the minority shareholder any return and then proposes to buy the shares at a very low price.” Robert H. Thompson, The Shareholder’s Cause of Action for Oppression, 48 Bus. Law. 699, 703-04 (1993). The attempt to force the sale of shares for less than fair value is itself an act of oppression. See Nochlas v. Patton, 279 S.W.2d 848, 852 (Tex. 1955) (noting the majority shareholder’s suggestion that “he would not buy the stock of [the minority] for even a small fraction of its value”); Davis v. Sheerin, 754 S.W.2d 375, 383 (Tex. App.—Houston [1st Dist.] 1988, writ denied) (noting that prior attempts to purchase minority shareholder’s stock were evidence of majority shareholder’s “desire to gain total control of the corporation”). If such oppressive conduct were shielded from disclosure to the jury by the rules of evidence, then majority shareholders would have the ability to act oppressively with impunity. Fortunately, that is not the law.

Rule 408 provides an important exception: “This rule also does not require exclusion when the evidence is offered for another purpose, such as proving bias or prejudice or interest of a witness or a party, negativing a contention of undue delay, or proving an effort to obstruct a criminal investigation or prosecution.” Proof of oppressive conduct is such “another purpose.” As one court has noted: “Rule 408 is also inapplicable when the claim is based upon some wrong that was committed in the course of the settlement discussions; e.g. libel, assault, breach of contract, unfair labor practice, and the like.” Avary v. Bank of Am., N.A., 72 S.W.3d 779, 803 n.4 (Tex. App.--Dallas 2002, pet. denied) (quoting 23 Charles Alan Wright & Kenneth W. Graham, Jr., Federal Practice and Procedure § 5314 (1980)). In Avary v. Bank of America, the Dallas Court of Appeal held that neither Rule 408 nor the statute providing for the confidentiality of mediation communications would preclude a plaintiff from introducing evidence of settlement communications to prove that an executor had committed a breach of fiduciary duties during the course of settlement negotiations in a court-ordered mediation. Id. at 799. Similarly, Texas courts have long recognized that Rule 408 does not protect settlement communications by insurance companies that demonstrate their bad faith settlement practices. See State Farm Mut. Auto. Ins. Co. v. Wilborn, 835 S.W.2d 260, 261 (Tex. App.—Houston [14^th Dist.] 1992, orig. proceeding); Allstate Ins. Co. v. Evins, 894 S.W.2d 847, 849 (Tex. App.—Corpus Christi 1995, orig. proceeding); In re Foremost Ins. Co., 966 S.W.2d 770, 772 (Tex. App.—Corpus Christi 1998, orig. proceeding). Other jurisdictions have applied the rule in the same way. See C.J. Duffey Paper Co. v. Reger, 588 N.W.2d 519, 525 (Minn. Ct. App. 1999) (holding that Rule 408 did not preclude admission of a settlement letter used to prove that a corporate officer had acted in bad faith); Brademas v. Real Estate Dev. Co., 175 Ind. App. 239, 242, 370 N.E.2d 997, 999 (Ind. Ct. App. 1977) (holding that the rule “is not applicable to those situations where the offers of compromise are allegedly oppressive”).

Link v. LSI: South Dakota Supreme Court addresses Valuation and Payout Issues

noreply@blogger.com (Eric Fryar) — Mon, 21 Feb 2011 19:55:00 +0000

Link v. L.S.I., Inc., 793 N.W.2d 44 (S.D. Dec. 29, 2010).

The South Dakota Supreme Court recently reviewed issues relevant to shareholder oppression cases: valuation of shares, payment for those shares, and security when the trial court orders a payment plan rather than a lump-sum payment.

The Link case addresses the issue of valuation of shares when the corporation elects a buy-out to avoid dissolution pursuant to SDCL 47-1A-1434. The Court held that the value of the shares need not reduced for lack of marketability as the corporation serves as a market for the shares. A court has the authority to order a payment plan if a one-time payment would be too burdensome and the corporation is unable to obtain a loan for the payment amount. However, when a payment plan is in place, the court can also order that the corporation secure the payments, which can protect the shareholder as well as keep the corporation motivated to fulfill its obligation under the payment plan.

[Read Complete Cases Analysis of Link v. LSI]

Christina Richardson, Fryar Law Firm, P.C.

Direct vs. Derivative: Significant Opinion on shareholder oppression as a direct claim

noreply@blogger.com (Eric Fryar) — Sat, 19 Feb 2011 21:27:00 +0000

An issue that recurs with annoying frequency in our shareholder oppression cases is the argument that shareholder oppression claims are derivative claims and that our clients therefore have no standing to assert them. This argument shows a thorough misunderstanding of the nature of an oppression claim. A shareholder oppression claim is, by definition, a claim asserted by an individual shareholder in his capacity as a shareholder for injury done to his individual interests that arise out of his share ownership. It is entirely a direct and individual claim based on the breach of duties owed directly to the shareholder.

The Texas Court of Appeals put it this way:

[A] corporate shareholder has no individual cause of action for personal damages caused solely by a wrong done to the corporation. The cause of action for injury to the property of a corporation or for impairment or destruction of its business is vested in the corporation, as distinguished from its shareholders, even though the harm may result indirectly in the loss of earnings to the shareholders. The individual shareholders have no separate and independent right of action for wrongs to the corporation that merely result in depreciation in the value of their stock.
As a result, to recover for wrongs done to the corporation, the shareholder must bring the suit derivatively in the name of the corporation so that each shareholder will be made whole if the corporation obtains compensation from the wrongdoer. However, a corporate shareholder may have an individual action for wrongs done to him where the wrongdoer violates a duty arising from a contract or otherwise and owing directly by him to the shareholder. Such a principle is not so much an exception to the general rule as it is a recognition that a shareholder may sue for violation of his individual rights regardless of whether the corporation also has a cause of action. It is the nature of the wrong, whether directed against the corporation only or against the shareholder personally, not the existence of injury, which determines who may sue. Appellate courts have also recognized an individual cause of action for “shareholder oppression” or “oppressive conduct.”

Redmon v. Griffith, 202 S.W.3d 225, 233-34 (Tex. App.--Tyler 2006, pet. denied).

A claim for shareholder oppression is thus a direct claim—not a derivative claim. Therefore, an individual shareholder necessarily has standing to assert the claim on his own behalf, does not have to comply with the procedural peculiarities of a derivative action, does not lose the right to assert the claim if the corporation goes into bankruptcy, and gets to keep all the money that a court may award on the claim.

However, there is a significant complicating factor. Very frequently, the manner in which a majority shareholder goes about oppressing a minority shareholder involves conduct that also harms the corporation and also breaches fiduciary duties that are owed only to the corporation and not to the shareholder individually. University of Houston law professors Douglas Moll and Robert Ragazzo, in their excellent treatise The Law of Closely Held Corporations, describe the “classic oppression scenario” as follows:

(a) the majority uses its control over the board of directors to discharge the minority from employment and cut off access to dividends (which, as a practical matter, denies the minority any return on its investment); (b) the majority uses its shareholder voting power to remove the minority from the board of directors and otherwise cuts off all participation by the minority in the decision-making process (which may prevent the minority from being aware of misconduct by the majority); (c) the majority engages in acts of self-dealing (e.g., by paying excessive salaries or diverting business opportunities that belong to the corporation); and (d) the majority administers the coup de grace by offering to purchase the minority’s shares at a fraction of their true value. (2010 Supplement at 2-11).

Therefore, in order to prove shareholder oppression, the plaintiff must often allege conduct that sounds awfully like the pleading of a derivative claim. For example, a majority shareholder might use his power over the corporation to pay himself exorbitant bonuses, thereby leaving nothing for the minority shareholder. A majority shareholder might also take a corporate opportunity and place it in a company that he owns 100% thereby avoiding the sharing of the profits with the minority shareholder. In both instances, the majority shareholder did violate duties owed only to the corporation and thereby damaged the corporation. The corporation could certainly sue, and the minority shareholder can and should assert a derivative claim on behalf of the corporation seeking a monetary award of actual damages that were caused by the breach of fiduciary duties to the corporation. However, the minority shareholder can also point to those acts as evidencing a pattern of oppressive conduct whereby the majority shareholder has acted to enrich himself at the minority sharerholder’s expense, to diminish and violate the rights and interests that the minority shareholder has by virtue of share ownership, and otherwise to substantially frustrate the reasonable expectations of the minority shareholder. Nevertheless, a minority shareholder may not in his own capacity sue the majority shareholder seeking to recover the damages suffered by the corporation caused by the breach of fiduciary duties to the corporation. What the minority shareholder can do is to point to that same conduct as evidence of the majority shareholder’s pattern of oppressive conduct toward the minority.

Shareholder oppression is an equitable remedy. If the shareholder proves a pattern of oppressive conduct, the shareholder is not necessarily entitled to economic damages caused by that conduct. Rather, the court is required to fashion an equitable remedy designed to address the harm suffered by the minority shareholder’s rights and interests arising from share ownership. The most common remedy is a judicially-ordered buy out of the plaintiff’s shares at a fair price as determined by the court. There is absolutely nothing inconsistent about claiming, as a result of the majority shareholder’s misappropriation of corporate assets, that the corporation, on the one hand, is entitled to an award of actual damages for the amount of the misappropriated assets and that the minority shareholder, on the other hand, is entitled to have the majority shareholder buy the minority shares. The plaintiff could assert both claims in the same lawsuit, and we frequently do this. The only issue that must be addressed by the simultaneous assertion of the derivative claim and the oppression claim is whether the plaintiff should be awarded a pro rata share of the derivative claim damages or whether that amount should be reflected in the fair value of the shares.

Sometimes, the minority shareholder will not be able to assert the derivative claim. The corporation may be in bankruptcy, in which case the derivative claims are controlled by the bankruptcy estate. Or the derivative claims may have already been released or barred by res judicata. Or the defendants may be successful in blocking the derivative claims through various procedural maneuvers, such as appointment of a special committee. In those instances, the shareholder only has his direct claim for shareholder oppression, but the shareholder may still offer into evidence certain oppressive conduct of the defendant even though that same conduct would also give rise to a no-longer-assertable derivative claim—so long as the shareholder does not seek to recover the damages that would have been awarded under the derivative claim. The issue that faces the court in such an instance is not one of standing but one of evidence. So long as the plaintiff is only using conduct that breaches duties to the corporation as evidence of oppressive conduct toward the minority shareholder, he is not asserting a derivative claim. The issue is not whether the shareholder has standing to offer such evidence, but whether the specific conduct the shareholder seeks to prove is relevant to a claim of oppressing the minority shareholder.

A very significant decision was recently handed down in one of Fryar Law Firm’s cases that addressed these very issues. The United States Bankruptcy Court for the Southern District of Texas (Judge Bohm) issued a 108-page opinion on January 13, 2011, resolving exactly the direct vs. derivative issues described here. In re Skyport Global Communications, Inc., No. 08-36737, 2011 WL 111427 (Bankr. S.D. Tex. 2011). In that case, Fryar Law Firm filed a lengthy and complex oppression and fraud lawsuit in state court in Houston, Texas on behalf of four different groups of shareholders. The corporation had previously been through bankruptcy, and the majority shareholder had received releases of all derivative claims as part of the reorganization. Therefore, the plaintiffs could only assert whatever individual, direct claims survived the bankruptcy. The various defendants removed the case to federal bankruptcy court and asserted that all of plaintiff’s claims were derivative and moved to dismiss the lawsuit with prejudice in its entirety. The Court rejected that argument and acknowledged that many states have adopted the position stated here that oppression claims are inherently direct. However, Delaware law governed the claims in this case, and the Delaware courts had not ruled on that issue. Therefore, in an exhaustive and painstaking analysis, Judge Bohm’s opinion applies the Delaware test for derivative claims to each factual component of each of the plaintiffs’ claims. The Court did hold that certain allegations made would support only claims that were either derivative claims or were otherwise barred by the bankruptcy confirmation order. These claims were dismissed with prejudice. However, the Court found that the majority of plaintiffs’ claims for oppression and fraud were direct claims under Delaware law, and the Court ordered these claims to be remanded to the state court to proceed to trial.

Eric Fryar, Fryar Law Firm, P.C.

Interesting Award in Texas Shareholder Oppression Case

noreply@blogger.com (Eric Fryar) — Fri, 14 May 2010 20:36:00 +0000

Return of Investment as an Oppression Remedy:
Gage v. Rosenbaum, No. 09-4023, 2010 WL 1856344 (Bankr. E.D. Tex., May 7, 2010)

On May 7, 2010, the United States Bankruptcy Court in the Eastern District of Texas issued an unpublished memorandum and order that raises some very significant shareholder oppression issues. The shareholder oppression claim was tried before the Bankruptcy Judge to liquidate the minority shareholder's claim in the majority shareholder's personal bankruptcy and to determine dischargeability. The plaintiff had invested about $324,000 and received about 25% of the shares. The court found that the majority shareholder and his wife and daughter secretly took hundreds of thousands of dollars out of the corporation, ultimately rendering the corporation insolvent and worthless. The court held that the majority shareholder's use of the corporation as his "personal piggy bank" defeated the plaintiff's reasonable expectations and constituted shareholder oppression. There are three significant issues raised by the opinion. First, the court based its finding of oppression on conduct that violated fiduciary duties owed only to the corporation under Texas law. Yet the court found oppression because the effect of misappropriating corporate funds was to defeat the shareholder's reasonable expectations. Second, the plaintiff apparently did not request a forced buy-out at fair value, and such a remedy would have been useless because the basis of the suit was that the corporation had been stripped of its value. Rather, the court awarded the plaintiff the amount he initially invested. Third, the court held that shareholder oppression is a type of defalcation by a fiduciary and is not dischargeable in bankruptcy. Read the complete analysis of the Texas Shareholder Oppression opinion.

New Texas Shareholder Oppression Opinion

noreply@blogger.com (Eric Fryar) — Tue, 30 Mar 2010 20:34:00 +0000

United States District Court Judge Barbara M.G. Lynn issued a brief, unpublished opinion addressing Texas shareholder oppression law in Bulacher v. Enowa, L.L.C., Slip Copy, 2010 WL 1135958 (N.D.Tex., March 23, 2010). A minority shareholder in sued for oppression and other claims. The case was filed in state court. The defendants removed the case to federal court and moved to dismiss the shareholder oppression claim, apparently for failure to state a claim for which relief may be granted. The denied the motion on the following grounds:

"Bulacher contends that the Defendants engaged in oppressive conduct by launching a concerted effort to dilute and deprive Bulacher of the value of his 17% interest in the company. Specifically, Bulacher alleges that the Defendants used prepaid consultant fees to artificially lower the company's income performance, and thereby reduce Bulacher's quarterly income-based bonuses, before his termination; that his termination was intended to, among other things, prohibit his access to critical financial and/or business information related to the company; that the Defendants attempted to induce Bulacher to sign an agreement allowing Enowa to repurchase his 17% interest in the company at a price that was a mere fraction of its true market value; and that the Defendants paid excessive bonuses and/or distributions to themselves after his termination. Texas courts take a broad view of the application of oppressive conduct to a closely-held corporation such as Enowa. In this context, the facts alleged by Bulacher are sufficient to state a claim for shareholder oppression under Texas law."

For a more in depth analysis of Texas shareholder oppression doctrine, visit the resources maintained by Fryar Law Firm.

Eric Fryar

Personal Jurisdiction Issues in a Shareholder Oppression Case: Texva, Inc. v. Boone, No. 05-08-01564 (Tex. App.--Dallas, November 12, 2009)

noreply@blogger.com (Eric Fryar) — Fri, 26 Mar 2010 00:49:00 +0000

f a corporation formed under the laws of Texas operates in another state, can its directors, officers or majority shareholders be sued in Texas courts for shareholder oppression or breach of fiduciary duties even if they have no other contacts with Texas and none of the oppressive acts occurred in Texas? The Dallas Court of Appeals recently held that the answer to this question is yes; however, the Court based its decision on the specific facts of the case and not on a bright-line rule.

Read the rest of the article regarding personal jurisdiction issues in shareholder oppression and shareholder derivative suits in Texas.

Eric Fryar

Two Significant Decisions on Texas Derivative Actions

noreply@blogger.com (Eric Fryar) — Sat, 30 May 2009 17:22:00 +0000

In Re Schmitz, No. 07-0581, 2009 WL 1427184 (Tex.), 52 Tex. Sup. Ct. J. 772 (Tex. May, 22, 2009) [Download PDF]
Somers v. Crane, No. 01-07-00754-CV, 2009 WL 793751 (Tex. App.--Houston [1st Dist.] March 26, 2009).

Both of these cases involve challenges by shareholders of Texas corporations to proposed cash-out mergers. In Schmitz, the board of directors of Lancer Corp. accepted a buyout offer from Hoshizaki America, Inc. for $22 per share. About a month before the merger was to be submitted to shareholders for approval, a law firm purporting to represent an unnamed shareholder sent a demand to the Board of Directors that the merger be canceled because of the existence of a superior offer of $23 per share. Three days later, a derivative suit was filed seeking an injunction to halt the merger and declaratory relief against the board members. After the merger was approved and closed, and the plaintiff ceased to be a shareholder, the plaintiff amended her petition to seek rescission of the merger and damages against the former directors of Lancer. The defendants moved to dismiss for failure to send a proper pre-suit demand; the trial court denied the motion; the Court of Appeals denied mandamus relief; but the Texas Supreme Court granted a conditional writ of mandamus.

Somers involved a shareholder challenge to a proposed effort by the management of EGL, Inc. to buy the company and take it private. The board of directors approved the merger and also approved onerous "lock up" provisions, including a $30 million termination fee. The plaintiff filed a derivative suit seeking to block the proposed acquisition by management on the grounds that a higher bid had been submitted to the board by a third party buyer. A class action was also filed on behalf of the shareholders seeking essentially the same relief, but asserting breach of fiduciary duty claims directly on behalf of the shareholders rather than derivatively. After the lawsuits were filed, the Board of Directors did agree to the acquisition by the third party, but the management group was paid the termination fee. The lawsuits were then amended to assert claims for damages for payment of the termination fee. The trial court dismissed the derivative suit for failure to comply with the demand requirement in TBCA art. 5.14(c). The derivative plaintiff then sent a formal demand and waited 90 days per the statute. In the meantime, the merger with the third-party buyer was close, and all the shareholders were cashed out. Shortly thereafter, the 90-day waiting period expired, and the derivative plaintiff refiled the case seeking damages for breach of fiduciary duty for paying the termination fee. The trial court dismissed the class-action on the grounds that the shareholders had no standing to assert directly claims for breach of fiduciary duty against the Board of Directors. The trial court also dismissed the new derivative suit on the grounds that the plaintiff was no longer a shareholder and thus no longer had standing to maintain the action.

Adequacy of Presuit Demand

There were two complaints about the pre-suit demand in Schmitz: the demand letter did not identify the shareholder, and the demand letter was not sufficiently "particular" in its description of its complaints. Article 5.14 does not expressly state that a pre-suit demand must state the name the shareholder, but the Texas Supreme Court holds that the plain implication of the statute requires identification of the complaining shareholder. Furthermore, the court noted that a number of public policy reasons would also require that a shareholder demand could not be made anonymously. Among these was the concern that the use of anonymous demands could be abused and that the Board of Directors would need the shareholder's identity in responding to the demand. "In other words, a demand from Warren Buffett may have different implications than one from Jimmy Buffett."

Article 5.14 (c) does require that the demand set forth "with particularity" the matter about which the complaint is made. The Texas Supreme Court held that the Schmitz demand letter was not sufficiently particular in its description of the claim. The demand letter urged the board to stop the merger because it had received a "superior offer" of one dollar more per share. The Supreme Court's problem with the statement of the demand seems to be primarily that the statement was very short -- two sentences -- and that the demand did not state explicitly why one dollar less per share made the offer "inferior." However, the court gives almost no guidance as to how particular the statement must be in order to qualify as a pre-suit demand. "We do not attempt today to explore all the ways in which a demand might or might not meet article 5.14's 'with particularity' requirements. Whether a demand is specific enough will depend on the circumstances of the corporation, the board, and the transaction involved in the complaint. But given the size of this corporation and the nature of this transaction, this demand was clearly inadequate."

The court's holding and analysis raises many more questions than it answers. If the complaint in this case was that there were two offers, and one was more than the other, and that the shareholders would want a higher offer, but that the board took the lower offer, it is difficult to imagine how one could state that complaint with greater "particularity" than was done in this case. The Court acknowledges that "all things being equal" the greater offer would be preferred by the shareholders, but the court notes that in comparing competing offers for a merger, "all things are rarely equal." The court notes a host of reasons why a board might decide that the offer with a lower cash value is actually better for the shareholders. The court stated that a rule requiring the corporation always to accept nominally higher offers would result in harm sometimes to the shareholders and would subvert the business judgment rule in Texas. All of this is true, but all of it is completely irrelevant as to whether the demand stated its complaint with particularity. If a shareholder thinks the board should take the option that gives that shareholder more cash, then in responding to that complaints the board might justifiably decide that the complaint is unfounded for all the reasons and factors cited by the Court, but that does not mean that the board would not know the basis of the shareholders complaint, as the Court suggests. The purpose of a pre-suit demand is to give the board of directors the opportunity to determine whether the complaint is valid and to take corrective action. Inherent in this idea is the assumption that the board may disagree with the shareholder. the language used by the court seems to suggest that all the factors and evidence on which the plaintiff may ultimately base his case must be laid out in the demand letter, almost as if the Board of Directors would have no source of information or basis on which to respond other than the information contained in the demand letter. That is simply unrealistic. The Board of Directors will always have more and better information about a corporate transaction than is available to an individual shareholder. Demand futility is no longer a legal concept in Texas. Therefore, if the shareholder's complaint is that the Board of Directors is acting fraudulently or withholding information, under current Texas law, the shareholders still has to send the demand to the Board of Directors that it shoud sue itself and wait 90 days before filing suit. In that sort of situation, it will almost always be the fact that the shareholder does not have access to information, absent discovery, about the extent of management's wrongdoing.

The requirement of particularity in the demand simply cannot be as onerous as the language in the court's opinion seems to suggest. If, in the course of deciding between competing merger offers, a Board of Directors accepts a lower bid, and fully discloses to the shareholders the reasons for its decision, then clearly a demand merely stating that the board should have taken the higher offer is an adequate because any litigation will ultimately concern whether the board's reasoning was sound or falls within the business judgment rule. If the shareholder has a position as to why the board's evaluation of the offers was incorrect or not disinterested, then merely complaining that the price is lower does conceal the shareholder's true complaint. That may very well have been the situation in this case, but the opinion does not make that clear. However, if the board failed to disclose why it determined the lower offer was better or failed to disclose what about the non-cash provisions of the offers was deemed to be more valuable than difference in cash amounts, then truly all a shareholder can say is "you are not acting in the best interest of the shareholders because your decision gives us less money." If that is the real complaint, it is hard to get more particular.

One standard can be gleaned from the court's analysis. On appeal the plaintiffs had argued that it was proper to challenge the merger because there were personal benefits to the board of directors in the lower offer that may have induced them to violate their duty of loyalty in selecting that offer over the one that gave more benefit to the shareholders. The Supreme Court agrees that a derivative suit would be an important means of preventing a corporate board from enriching themselves at the shareholders' expense, but "the demand letter here said nothing about any of that." It would seem, at a minimum, that the particularity requirement would force a plaintiff to state in the demand letter all the claims, bases, and facts that are in the petition that is ultimately filed. Clearly, the board should be confronted at the demand stage with everything that the plaintiff is prepared to plead 90 days later at the litigation stage, and the plaintiff would have absolutely no legitimate reason to withhold that information. However, since Texas has no requirement that pleadings be stated "with particularity," something more is probably required. The Supreme Court's opinion makes clear that the plaintiff's basis for her complaint about the board's action must be fully disclosed. Hopefully, future courts will not interpret this decision as requiring a plaintiff to submit to the Board a document that could not possibly be created until after discovery in order to have standing to commence the suit and take the discovery.

Pace v. Jordan, 999 S.W.2d 615, 621 (Tex. App.—Houston [1st Dist.] 1999, pet. denied), had previously held that a demand must (1) identify the alleged wrongdoer, (2) describe the factual basis of the claim, (3) describe the corporation's injury, and (4) request remedial action. "A demand is sufficient if the board of directors had a fair opportunity to consider the shareholder's claims." Pace specifically held that the demand need not be as detailed as the plaintiff's pleadings in the lawsuit. The Supreme Court cites Pace on another point but does not even mention the opinion's discussion of this issue. However, Pace was determining the sufficiency of a demand under the version of art. 5.14 prior to the 1997 amendments, which did not have a requirement of particularity. The Supreme Court's ignoring of the Pace decision should probably be taken to mean that Pace is no longer good law on this point.

Procedural Issues in Presuit Demand

The Supreme Court also did address an important procedural issue. If a plaintiff's lawsuit is dismissed because the court determines that the plaintiff failed to give an inadequate pre-suit demand, then the plaintiff has an immediate right to appeal. However, if the trial court fails to enforce that demand requirements of the statute, the lawsuit goes on, and there is no right to an interlocutory appeal. However, the Supreme Court holds that mandamus review is available. The court notes that the availability of mandamus must be decided on a case-by-case basis. The court notes that mandamus might be inappropriate if another shareholder has made a proper demand, or if the lawsuit will go forward regardless on other non-derivative claims, or if recovery of expenses from the shareholder is an adequate remedy. In Somers, the derivative plaintiff's first action was also dismissed on the basis of an inadequate demand. The appellate court's opinion states that the plaintiff alleged that he had made a demand upon the board on January 4, 2007, pursuant to article 5.14, and that the plaintiff filed his lawsuit on April 11, 2007. The defendants filed a motion to dismiss and special exceptions, which the trial court granted. The trial court denied plaintiff's motion for leave to amend and his request for findings of fact and conclusions of law. The appellate opinion makes clear that the plaintiff had pleaded that he had complied with the demand requirements of article 5.14 and that he had made his first demand more than 90 days before the lawsuit was filed. It is a pity that the opinion does not deal with this issue. Given that the court was granting special exceptions, which are challenges to the pleadings, and that the plaintiff was appealing the trial court's refusal to allow him to amend his pleadings, the dismissal may have been based on the plaintiff's failure to comply with pleading requirements of article 5.14 (G) that the petition must allege with particularity facts that establish that the rejection of the demand was not made in accordance with the good faith and disinterestedness requirements of article 5.14 (F) and (H). There is an ambiguity in the statute. Under article 5.14 (C.), a plaintiff is required to wait 90 days after the date that the demand was made, "unless the shareholder has earlier been notified that the demand has been rejected by the Corporation..." It is not clear whether it the pleading requirements of article 5.14(G) apply if the plaintiff has not been informed of a rejection or if the corporation simply ignores the demand and makes no decisions whatsoever. It would seem a terrifically difficult burden on a plaintiff to plead with particularity the defects in the decision-making process when he has heard nothing from the Board of Directors and has no idea what they did. If that situation existed in this case, and the trial court granted special exceptions and dismissed the case on those grounds, it would be interesting indeed to see what an appellate court would have to say about that ruling.

Standing to Pursue Derivative Claim After Cash-out Merger

Somers held that the derivative plaintiff lost his standing to pursue the derivative claims as a result of having his stock cashed out in the merger. The common law rule is well-established that a shareholder loses his standing to maintain a derivative suit if the corporation undergoes a merger and the shareholder's stock is exchanged for cash, unless (1) the merger was fraudulent because its only purpose was to eliminate the defendant's liability in the derivative suit, or (2) the merger was really a reorganization in which the plaintiff retains an ownership interest in the company. See Lewis v. Ward, 852 A.2d 896, 902-04 (Del. 2004). In Zauber v. Murray Sav. Ass'n, 591 S.W.2d 932, 935 (Tex. Civ. App.--Dallas 1979), writ ref'd per curiam, 601 S.W.2d 940 (Tex. 1980), the defendant in a derivative suit argued that the plaintiff lost standing as a result of a reverse stock split that cashed out his resulting fractional shares. The court acknowledged that shareholder does lose standing if he ceases to be a shareholder at anytime during the pendency of the lawsuit, but that there would be an exception if the transaction's purpose was to get rid of the lawsuit. Somers argued that Zauber was construing a prior version of the statute and that the current article 5.14(C) only expressly requires ownership at the commencement of the lawsuit. The appellate court did not see any real difference as a result of the amendment of the TBCA and applied the prior case law. Because Somers did not attack the legitimacy of the merger, he lost his standing.

Somers also argued that TBCA art. 5.03(M) maintained his standing. Section M is part of the merger statute and provides: "To the extent a shareholder of a corporation has standing to institute or maintain derivative litigation on behalf of the corporation immediately before a merger, nothing in this article may be construed to limit or extinguish the shareholder's standing." That is a much tougher argument, and the federal judge in Marron v. Ream, No. CIV H-06-1394, 2006 WL 2734267 (S.D. Tex. May 05, 2006) had previously suggested that this section would preserve the plaintiff's standing in similar circumstances. The court holds that art. 5.03(M) clearly does not create standing, but merely preserves standing. Therefore, in Somers' second lawsuit, filed after he lost his stock, this section does not help. However, with regard to his first lawsuit, which was also on appeal, the court held that the statement that the merger would not "limit or extinguish the shareholders' standing" meant that the plaintiff had to be a shareholder after the merger as well as before, and therefore the provision's sole application was to mergers in which the plaintiff receives shares in the surviving entity. The court dismisses the statement in Marron as dicta. Frankly, that reading of the statute seems a little strained. The provision states that when "a shareholder" has standing immediately prior to the merger, then the law providing for the merger will not limit or extinguish "the shareholder's standing." The term "the shareholder" plainly refers the the person identified in the first part of the sentence. To say that this language imposes an additional condition so that the statute provides nothing more than the traditional common-law exception is a real stretch.

Fiduciary Duties of the Board in a Cash-out Merger

The class-action by shareholders in Somers asserted breach of fiduciary duty claims against the directors directly by the shareholders. The class plaintiffs did not have to worry about the adequacy of demand or any of the other requirements of article 5.14 -- if their theory of liability was correct. The defendants filed special exceptions seeking the dismissal of the claims for failure to state a cause of action recognized under Texas law. This was based on the argument that the fiduciary duties of corporate directors run only to the corporation and not to individual shareholders. The trial court sustained the special exceptions and dismissed the claim because amendment could not cure the defect. Technically, this was incorrect. The duties described by plaintiffs do exist under Texas law, and the cause of action for breach of the students does exist under Texas law. The problem was not that the plaintiffs failed to state a claim recognized by Texas law, it was that the plaintiffs lacked standing to assert that claim individually. Only the corporation or a shareholder suing derivatively on behalf of the corporation could assert that claim. Lack of standing, under Texas law, is a matter of subject matter jurisdiction and should have been challenged through a plea to the jurisdiction, not special exceptions.

The Court of Appeals affirmed, citing a string of Texas cases holding that a director's fiduciary duty runs only to the Corporation, not individual shareholders, except where there is a contract or a confidential relationship or "in certain limited circumstances" in the context of shareholder oppression claims. The class plaintiffs argued that in the context of a cash out merger where the corporation will no longer exist and the shareholders will be dispossessed of their stock, a special duty should arise from the directors to the individual shareholders. In other words, precisely because the law precluded the derivative plaintiffs from maintaining their lawsuit, a special duty should be created to allow the class plaintiffs to do so. The appellate court did not bite.

Actually this issue is much thornier then the appellate court's opinion would suggest. There should be a duty owed by the directors directly to the shareholders in the context of any transaction that involves the acquisition the shareholders' stock -- not because the corporation will cease to exist, but because in considering and negotiating merger and acquisition offers from third parties, the directors of the corporation are not acting on behalf of a corporation but are acting directly as agents for the shareholders. Texas courts have recognized that is, as a general matter, the corporate entity has no interest in its own outstanding stock. Alexander v. Sturkie, 909 S.W.2d 166 (Tex.App.-Hous. (14 Dist.) 1995 writ denied). When a Board of Directors negotiates a stock acquisition or merger, it is negotiating the sale of something that is owned by the shareholders individually, not by the corporation. When the board of directors accepts an offer from a third party, it must present that offer to the shareholders, and the offer is only accepted if approved by the shareholders. If the directors do a poor or dishonest job with respect to the transaction, it is the shareholders who suffer the loss directly, not the corporation. The only reason that the board of directors is involved at all in the sale of the shareholders' property, is that the law provides a mechanism for forcing minority shareholders to sell their property if the majority wants to enter in the transaction. However, the directors in performing those duties are representing the interests of the shareholders directly, not the interests of the corporation. As the agent of the shareholders, logically the board should owe fiduciary duties directly to the shareholders.

Ironically, the Texas Supreme Court in Schmitz, decided almost 2 months to the day after Somers, lends some credence to this argument. In footnote 34, the opinion states that one of the problem with the demand letter sent by the shareholders was that it did not "specify why accepting $22 rather than $23 would harm the corporation." The court cites the Marron opinion for the proposition that it was questionable whether claiming that board should have accepted an offer for $35.50 rather than an offer for $35 per share "was a derivative claim belonging to the corporation." It is almost as if the Supreme Court is hinting in the footnote that the plaintiff had blown it like bringing the action as a derivative claim rather than a direct claim and thus falling under the requirements of article 5.14. Obviously, the Court of Appeals in Somers did not have the Schmidt decision, and this argument was apparently not made to the court. It will be interesting to see whether any Texas courts address this particular issue in the future.

Shareholder Oppression buyout remedy affirmed in New York

noreply@blogger.com (Eric Fryar) — Fri, 29 May 2009 20:56:00 +0000

Lund v. Krass Snow & Schmutter, P.C., --- N.Y.S.2d ----, 2009 N.Y. Slip Op. 03996, 2009 WL 1406312 (N.Y.A.D. 1 Dept., May 21, 2009) [Download copy--pdf]

An intermediate appellate court in New York has affirmed a judgment in favor of the plaintiff in a shareholder oppression case. The lawsuit was among attorneys who were shareholders in a law firm professional corporation. The trial court found that the defendants were guilty of oppressive actions based primarily upon “the uncompensated disgorgement of petitioner’s 39% equity interest in the firm during his last year as a member.” The trial court awarded the plaintiff $569,010, representing a fair value of his equity interest in the law firm as of the date that the lawsuit was filed. The trial court also awarded the plaintiff prejudgment interest at a rate of 9% from the date that the lawsuit was filed. The appellate court affirmed the judgment but held that one of the assets included in the valuation was not a firm asset and remanded the matter for recalculation of the value without that asset.

Although there is very little legal analysis in the appellate court’s opinion, the description the trial court’s reasoning process, and the appellate court’s apparent approval of that process, sheds some light on the practical mechanics of a shareholder oppression case.

First, the opinion makes clear that the finding of fair value was based on testimony provided by the plaintiff’s valuation expert. Valuation for purposes of a forced buyout remedy in a shareholder oppression case is done through the adversary process. The appellate court comments that the defendants elected not to submit their own appraisal.

Second, the plaintiff’s expert’s appraisal, on which the trial court based its award, used a “cost/assets analysis” to arrive at a value. The court does not discuss the propriety of this particular appraisal analysis. Usually, and especially in a service company like a law firm, a plaintiff in a shareholder oppression case would want to use a going concern value based on the future stream of earnings. One would think that most law firms and similar professional service corporations would not have significant assets in the firm on which a valuation might be based. The opinion gives no clue as to why this appraisal method was chosen, but one would expect that, under the particular circumstances of this case, it gave the best results of the plaintiff, and the defendants did not offer an alternative. What is apparent from the opinion, however, is that neither the trial court nor the appellate court assumed that any particular valuation method was necessarily correct in a shareholder oppression case. Rather, he appraisal method, just like the appraisal values, are subject to proof based on the particular facts of each case.

Third, the appraisal value was determined as of the date that the lawsuit was filed. The correct valuation date is always a tricky issue in a shareholder oppression case, particularly when the value of the company is rapidly increasing or decreasing or when a part of the pattern of oppressive conduct resulted in a diminution of the value of the corporation over time. Because the court is acting as the court of equity in fashioning a remedy, from a legal standpoint, the court can determine a valuation date based on particular equities of the case. However, that is of little help to a lawyer trying to assemble evidence to prove his case. Some date will have to be chosen for the expert report long before the court will have an opportunity to determine the correct date. In Hollis v. Hill, 232 F.3d 460 (5th Cir. 2000), the Fifth Circuit grappled with the issue of a “retroactive buyout order.” In that case, the trial court had accepted the plaintiff’s argument that the valuation date should be immediately prior to the time that the pattern of oppressive conduct began. The problem was that the value of the corporation was rapidly decreasing because the market for its product was rapidly disappearing. That market condition was the very cause of the strife between shareholders. The Fifth Circuit accepted the defendant’s argument on appeal that the trial court’s reasoning unjustly enriched the plaintiff by placing 100% of the consequences of bad market conditions on the defendant. However, the court also rejected the defendant’s position that the correct valuation date should have been immediately before trial, at which time the corporation was essentially worthless. That court held that the presumptive date should be the date on which the lawsuit was filed, subject to adjustment by the trial court if necessary to do equity. The trial court and the appellate court in Matter of Lund also assumed that the correct valuation date was the day that the lawsuit was filed. The appellate court apparently used a voluntary buy-out under §1118 as the model for the forced buyout remedy. The appellate court noted that it was proper, in determining valuation, to include as part of the assets of the firm a sum of cash that had already been earmarked for bonus compensation to employees and was paid out within a month after the filing of the petition.

Fourth, the appellate court approved the trial court’s imposition of 9% pre-judgment interest on the amount of the award from the date that the lawsuit was filed—again based on §1118 as a model.

Finally, another open question that has not really been dealt with by the courts is whether an award to the plaintiff for the fair value of his shares in a shareholder oppression case is an award of damages that must be collected through the execution of the judgment or is an injunction ordering the defendant to pay that amount of money, which can be enforced through the contempt power of the court. The appellate opinion did not clarify that issue, but it did hold that on remand the judgment must provide that the defendants’ obligation to pay the judgment award is conditioned upon the plaintiff’s formal release of his equity interest in the firm—that sounds a lot more like an injunction than an award of monetary damages.

Eric Fryar
www.FryarLawFirm.com www.ShareholderOppression.com

New York Shareholder Oppression Elements

noreply@blogger.com (Eric Fryar) — Mon, 18 May 2009 13:52:00 +0000

Rusyniak v. Gensini, Slip Copy, No. 5:07-CV-0279 (GTS/RFT), 2009 WL 1269911 (N.D.N.Y. May 05, 2009)—In this recent case, the United States District Court for the Northern District of New York issued an unpublished opinion denying a host of motions to dismiss and granting leave to the plaintiffs to file a Second Amended Complaint. The case involves a complicated and involved set of allegations of misconduct by the controlling shareholders in a closely-held corporation. Among many other causes of action, plaintiff sued the controlling shareholders/directors for breach of fiduciary duties against them as minority shareholders. The court held the following allegations were sufficient to survive a motion to dismiss: that the actions by the defendants to annul the plaintiff’s stock interest in the corporation in order to increase their own interests oppressed the plaintiff by denying the plaintiff his share in the corporate earnings resulting from the sale of two parcels of land. It is curious that the court reviewed the sufficiency of the pleadings under New York substantive law. While all of the conduct from which the claims arose occurred in New York, the jurisdiction of incorporation was Panama. Under the internal affairs doctrine, Panamanian law should govern this cause of action. Nevertheless, the court gives a great summary of the elements of an oppression claim under New York law:

“'Shareholders in a close corporation owe each other a duty to act in good faith.' Patti v. Fusco, No. 10717-05, 2005 WL 3372976, at *2 (N.Y. Sup.Ct., Nassau County 2005) (citing Matter of Cassata v. Brewster-Allen-Wichert, Inc., 248 A.D.2d 710 [N.Y.App. Div., 2nd Dept.1998] ). 'The relationship of such shareholders is a fiduciary one.' Fusco, 2005 WL 3372976, at *2 (citing Brunetti v. Musallam, 11 A.D.3d 280 [N.Y.App. Div., 1st Dept.2004] ) [other citation omitted].
More specifically, it 'is the fiduciary duty owed by ... majority shareholder [s] in a closely held corporation to a minority shareholder, not to engage in oppressive actions toward minority shareholders.' McCagg v. Schulte Roth & Zabel LLP, No. 601566/04, 2008 WL 4065920, at *8 (N.Y. Sup.Ct., New York County 2008); see also In re Dissolution of Upstate Medical Assoc. P.C., 739 N.Y.S.2d 766, 767 (N.Y.App.Div., 3rd Dept.2002). 'Although the term ‘oppressive actions' is not statutorily defined, the Court of Appeals has held that ‘oppression should be deemed to arise when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner's decision to join the venture.' In re Dissolution of Upstate Medical Assoc. P. C., 739 N.Y.S.2d at 767 (citing Matter of Kemp & Beatley, Inc., 64 N.Y.2d 63, 73 [N.Y.1984] ['A shareholder who reasonably expected that ownership in the corporation would entitle him or her to ... a share of corporate earnings, ..., or some other form of security, would be oppressed in a very real sense when others in the corporation seek to defeat those expectations and there exists no effective means of salvaging the investment.'] ).
In addition, '[c]orporate directors and controlling shareholders of close corporations ... are held ‘to the extreme measure of candor, unselfishness and good faith.’ ' Harger v. Price, 204 F.Supp.2d 699, 707 (S.D.N.Y.2002) (citing Kavanaugh v. Kavanaugh, 226 N.Y. 185, 193 [1919] ). “They may not act ‘for the aggrandizement or undue advantage of the fiduciar [ies] to the exclusion or detriment of the shareholders.’ ' Harger, 204 F.Supp.2d at 707 (citing Alpert v. 28 Williams St. Corp., 63 N.Y.2d 557, 559 [1984] ). 'Surely they may not act if the sole purpose is reduction of the number of profit sharers, or ultimately to increase the individual wealth of the remaining shareholders.' Id. (citations and internal quotations omitted).”

Eric Fryar featured in Shareholder Oppression Article

noreply@blogger.com (Eric Fryar) — Fri, 03 Apr 2009 14:40:00 +0000

Eric Fryar and this blog were extensively quoted in an article by Jacqueline Bell, published April 1, 2009 on Law360.com - The Newswire for Business Lawyers. The article, "Rough Times May Breed Shareholder Oppression," explores the likelihood that the current economic downturn may increase the temptation on majority shareholders to squeeze out minority shareholders.

Pleading of Derivative Claims Under Texas Law

noreply@blogger.com (Eric Fryar) — Thu, 26 Mar 2009 18:58:00 +0000

Perry v. Cohen, No. 03-05-0078-CV (Tex. App.—Austin, March 26, 2009) [Read Opinion]

In this case, 14 shareholders of now-defunct RAMP Corporation sued the former directors alleging negligence, common law fraud, negligent misrepresentation, statutory fraud, and conspiracy. The defendants specially excepted seeking to have the plaintiffs plead specifically which defendants made what misrepresentations to which plaintiffs and what injury was caused thereby. The defendants also contended that the claims were derivative claims and specially excepted seeking to have the plaintiffs plead what injuries the plaintiffs suffered individually, as distinguished from injuries to the corporation. The court sustained the special exceptions and ordered the plaintiffs to replead. After two amendments, the court held that the plaintiffs had not complied with the order and dismissed the entire claim with prejudice.

[Texas civil procedure does not have a general demurrer or 12(b)(6) type motion. Defendants are required to make "special exceptions" to defective pleadings and to give the plaintiffs an opportunity to cure the defect. If the plaintiff fails to comply with a court's order sustaining special exceptions, then the court may dismiss the plaintiff's lawsuit.] The court of appeals affirmed the dismissal on the grounds that the plaintiffs had waived their grounds of appeal because they appealed only the special exceptions order and not the dismissal order. The Supreme Court granted review and reversed, holding that there was no waiver. Now on remand, the court of appeals affirms the dismissal.

The court of appeals held that the "general rule in Texas is that 'individual stockholders have no separate and independent right of action for injuries suffered by the corporation which merely result in the depreciation of the value of their stock.' Wingate v. Hadjik, 795 S.W.2d 717, 719 (Tex. 1990). As the supreme court explained in Wingate v. Hadjik, 'This rule is based on the principle that where such an injury occurs each shareholder suffers relatively in proportion to the number of shares he owns, and each will be made whole if the corporation obtains restitution or compensation from the wrongdoer.' Id. at 719. Accordingly, an action for such injury must be brought by the corporation, not individual shareholders. Id. (citing cases). This rule, of course, does not prohibit a shareholder from bringing a cause of action to recover damages for wrongs done to him individually where a wrongdoer violates a duty owed directly to the shareholder. Id."

All of the plaintiffs' various claims were manifestations of a claim for misrepresentation based on communications from the directors to the shareholders and the public on which the plaintiffs relied in purchasing and holding on to their stock. Specifically, the plaintiffs alleged:

The shareholders met with appellees Brown and Cohen through an internet conference call in which Brown and Cohen made false statements regarding RAMP Corporation, RAMP management, RAMP bookkeeping and accounting, RAMP stock, RAMP financing, and SEC filings concerning the company.
The shareholders met with Brown and Cohen on various occasions, and Brown and Cohen made false statements regarding RAMP Corporation, RAMP management, RAMP bookkeeping and accounting, RAMP stock, RAMP financing, and SEC filings concerning the company.
The defendants issued a series of press releases and other advertisements regarding RAMP Corporation that the defendants knew were false.
The defendants filed documents containing false statements with the SEC.
The defendants held a telephone conference with one or more shareholders in which the defendants made false statements concerning RAMP Corporation and RAMP stock.
Based on the acts, omissions, advice, promises, representations, and misrepresentations of the defendants, the shareholders were induced to continue to invest in and/or to retain their stock in RAMP.
These acts, omissions, advice, promises, representations, and misrepresentations were made with the intent that the shareholders rely on them and the shareholders did in fact rely on them in continuing to invest in and/or retaining their stock.

The court of appeals agreed with the trial court that the plaintiffs' claims were derivative claims and that the plaintiffs utterly failed to plead the specifics of the misrepresentations, the identity of the defendants uttering them, the particular plaintiffs who relied on them, and the individual transactions in which stock was bought and sold specifically as a result. In all likelihood, the plaintiffs failed to plead with the specificity demanded by the trial court because all of the misrepresentations were made after the plaintiffs bought their shares, and the pleading ordered by the court would have demonstrated problems with reliance and causality. However, the plaintiffs also pleaded on a "holder" theory of liability—in other words, that the plaintiffs could have and would have sold their shares and cut their losses but refrained from doing so and held their stock in reliance on misrepresentations made be the defendants.

There are a number of things that are strikingly odd about this opinion. First, the court is completely wrong about the claims being derivative claims. The court seems to be hung up on the language in Wingate that shareholders don't have standing to bring claims individually for "the depreciation of the value of their stock." However, this is a misreading of the Wingate opinion. What makes a claim a corporation's claim rather than a shareholder's claim is that the claim is for "injuries suffered by the corporation which merely result in the depreciation of the value of their stock." In other words, the duty breached must be a duty owed to the corporation, and the injury suffered must be harm suffered by the corporation. Shareholders are not allowed to sue for the diminution in value of their stock that is caused by harm done to the corporation by its directors. If the plaintiffs' claims were for the diminution in value of their shares that resulted from the directors' mismanagement or stealing from the corporation, the claim would belong solely to the corporation and could be brought be shareholders only derivatively. In this case, the acts creating liability were misrepresentations about the condition of the company made by the directors directly or indirectly to various shareholders. The making of these false representations did not violate any duty to the corporation and certainly did not cause any financial injury to the corporation. Rather the legal duty violated was a duty not to commit fraud, which is a duty owed to the shareholders individually, and not to the corporation. The harm suffered is not the diminution in value of the shares per se, but the loss of the opportunity to sell the shares at a higher price. [It is not important that the plaintiffs in this case never did sell, because the company is now defunct; the stock is worth zero and can't be sold. If the corporation was still in operation, and the plaintiffs continued to hold the shares after learning the truth, then there would be a problem.] Furthermore, the issue of whether a shareholder has standing to assert a claim that may be owned by the corporation should be raised by a plea to the jurisdiction and not bu special exceptions. The fact that the corporation and not the shareholder owns the cause of action is not a defect in the pleading of the claim or in the legal validity of the claim, but is a question of standing to assert the claim, which Texas law recognizes as a jurisdictional issue. A plea to the jurisdiction requires findings by the court, and the remedy is a dismissal without prejudice. From a procedural point of view, the trial court in this case dismissed the plaintiffs' suit with prejudice on the grounds that the court did not have jurisdiction to hear the claim but without ever considering or ruling directly on the actual jurisdictional issue.

Whether Texas would recognize a "holder's" claim of fraud is a very good question. Such a claim is probably not viable under federal securities fraud law. However, that issue was not before the court. The court of appeals contended that the plaintiffs failed to specify and correlate the dates of the misrepresentations and the dates of the purchases or sales in reliance. This reasoning is silly when applied to a "holder's" claim. There was no purchase or sale in reliance on any specific misrepresentation, rather the plaintiffs contended that they continued to hold their shares over a long period of time in reliance on a series of misrepresentations. The requirement of specific dates for misrepresentations does not comport with Texas law. Texas is a notice-pleading state. There is nothing equivalent to a Rule 9(b) requirement of particularity in pleading fraud. The wrongful conduct in the pleadings cited by the court seems reasonably specific, certainly specific enough to allow the defendants to move forward with discovery and a defense.

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

Valuation of Minority Shares in an Oppression Case

noreply@blogger.com (Eric Fryar) — Tue, 24 Mar 2009 16:21:00 +0000

Kaplan v. First Hartford Corp., --- F.Supp.2d ----, 2009 WL 737681 (D. Me. March 20, 2009) [Read Opinion]

This opinion states the findings of fact and conclusions of law of the United States District Court of the District of Maine regarding the valuation issues in a shareholder oppression case, the liability portion of which was analyzed here earlier. [See Case Analysis] Having determined that the minority shareholder had been oppressed and that buy-out was the appropriate remedy, the court proceeded to determine "fair value" pursuant to Maine's statutory oppression remedy. 13-C MRSA §1434. The Maine Law Court has not interpreted that particular provision, but it has interpreted the identical language in Maine's appraisal rights provisions (13-C MRSA §1301 et seq) available to dissenting shareholders. See In re Valuation of Common Stock of McLoon Oil Co., 565 A.2d 997 (Me.1989); In re Valuation of Common Stock of Libby, McNeill & Libby, 406 A.2d 54 (Me.1979).

Under Maine law, "[t]he question for the court becomes simple and direct: What is the best price a single buyer could reasonably be expected to pay for the firm as an entirety?" McLoon, 565 A .2d at 1004. The Maine Law Court instructs that there is to be no discount for minority shares, or for lack of marketability. Id. at 1003. The Law Court also has specified that the determination of value is not subject to "hard and fast rules." Libby, 406 A.2d at 60.

The company here, First Hartford Corporation, manages real estate development properties, primarily neighborhood or strip malls, through a number of subsidiaries. Although it is a publicly-held corporation, it is only thinly traded on the Pink Sheets, and the court held that it behaves much like a closely-held corporation. Although it has some similarities to a Real Estate Investment Trust (REIT), there are also many differences ( e.g., structure; tax status; requirements as to distributing profits; more focus on developing properties for sale). According to the District Court: "In a word, this is a difficult business to value."

At a bench trial on value, the court heard from three experts—one from the plaintiff and two from the defendants. Although the court's opinion is thoughtful and detailed, it does not really delve into the hard questions of the proper approach valuation—and perhaps this is entirely proper. As the court notes, a trial court does "not have a roving commission to make an ideal determination of First Hartford's fair value. Instead, I am bound by the record that the parties have presented me and the inadequacies it contains." The court also states that its opinion is not based on burden of proof in any way, and admits candidly, "I am not even sure what burden of proof would mean in this context: zero value until the plaintiff proves something higher?"

Maine case law constrains the federal court to determine value based on "the best price a single buyer could reasonably be expected to pay for the firm as an entirety." To that end, the plaintiff's expert, an experienced businessman in the same industry, relied primarily on a discounted cash flow analysis, which he calculated to yield a value of $48.3 million. He also did a net asset value, which yielded a $31.4 million value (to which he gave no weight), but he did not attempt any sort of market valuation. Defendant's first expert, an accomplished professional appraiser, did a weighted valuation based on three methodologies: asset-based valuation, income-based valuation, and market value. This expert's net asset valuation was $13.3 million, which was based primarily on third-party real estate appraisals, adjusted downward to deduct for capital gains taxes, transaction costs, and defeasance costs that she concluded would be incurred if a purchaser bought First Hartford's assets. The court acknowledged that there is case law support for subtracting such items. Bogosian v. Woloohojian, 158 F.3d 1, 6 (1st Cir.1998) (applying Rhode Island law). For the income approach, the defendants' first expert took the current reported net operating income and then added expenses for additional executive compensation (which she believed was currently below market) and debt service, thus yielding a value of $7.6 million. Finally, this expert calculated the market value based on Pink Sheet stock sales for First Hartford and comparisons of other publicly-traded similar companies, which yielded a value of $10 million. The expert weighted the three approaches and came up with a$9.3 million valuation. The defendants' other expert was a college professor who did a similar analysis but gave a much heavier weighting to the Pink Sheet sales, and arrived at a valuation of $9.8 million. It should be noted that both of the defendant's expert attempted both explicitly and implicitly to have their valuation numbers influenced by minority and marketability discounts, despite the clear law to the contrary.

The court had problems with all three of the experts. Because First Hartford is a real estate company and always has the ability to sell its some or all of its holdings, the court found that the net asset values to be the most significant factor in the reaching final value, and the court was particularly troubled by the defendants' first expert's analysis that the going concern value of the corporation was less than its net asset value—which suggests that the company is worth more dead than alive. The court also held that the sales of the company's own stock on the Pink Sheets was very persuasive, notwithstanding the plaintiff's argument that the market was too thinly traded to be of any probative value. The court essentially dismisses the plaintiff's expert's analysis with almost no discussion of the validity of his approach. The court plainly believed that the actual analysis done by the plaintiff's expert was inadequate. The court was also troubled by the fact that the plaintiff's expert failed to consider several important factors that would negatively affect the sale's price to a third party—such as the majority shareholder's willingness to make personal guarantees for the corporation's debt, which a third-party buyer might not be willing to do. In the end, the court found a value of $15 million, which was essentially based on a readjustment of the defendants' numbers—increasing the weight of the net asset value and grossing up to eliminate the improper minority and marketability discounts.

Allow me to use this case to suggest some ideas about the correct approach to valuation in shareholder oppression cases—although I admit from the outset that the existing law in Maine is not entirely consistent with these ideas and that the analysis as presented here might not have been feasible in the Kaplan opinion. Most jurisdictions that have recognized a buy-out remedy for oppression have stated that the number to be reached through valuation is "fair value" and not "fair market value." At one level, as noted by the court here, the concept of "fair value" as opposed to "fair market value" precludes the application of a minority interest discount. As the court also noted, the origin of this concept is in the appraisal remedies for dissenting shareholders. Typically, the appraisal remedy arises as a result of a merger approved by the majority of the shareholders that forces the dissenting minority to sell their shares along with everybody else. The idea is that the minority shareholders do not believe the price is fair and would not agree to sell their shares at that price absent statutory compulsion, and therefore the statutory remedy is to require the corporation to pay the minority shareholders the difference between the agreed value and the fair value found through an appraisal. In this context, the object of the valuation exercise is very clear and very logical. The corporation is being sold as a whole. All the shareholders are receiving their percentage interest in the sales proceeds. The chief danger is that the sale may not be at arm's length, and so the court pays the dissenting shareholders what they would have received in a hypothetical sale conducted at arm's length for a fair price. This hypothetical situation necessarily precludes any application of a minority discount because the dissenting shareholders are not selling their minority interests separately but as part of the sale of the entire company.

In a forced buy-out ordered as a remedy for shareholder oppression, there is no sale of the entire corporation, but a special sale of a minority interest. The application of a minority discount is inappropriate but for reasons different than those in the context of dissenter's rights. Take a typical oppression fact situation: two shareholders, one with 60% and the other with 40%. Both work in the corporation. They have a falling out. The 60% shareholder fires the 40%, refuses thereafter to allow the minority shareholder to know what is going on in the corporation, participate in management, or earn any economic return on his ownership interest. In effect, the 60% shareholder has already taken for his own benefit everything of value that the 40%'s share ownership represents. In such a case, a court of equity steps in to force the 60% shareholder to pay a fair price for what he has already taken. The goal of the court is to reconstruct a hypothetical sale between fiduciaries in which they acted equitably and in accordance with their duties. It is important to remember that the award in a shareholder oppression case is not an award of damages but is an award of restitution for the purpose of avoiding unjust enrichment. The transaction between the parties is a zero-sum game. The plaintiff may gain a monetary award, but he loses his ownership in the corporation. The defendant may be ordered to pay money, but that loss is balanced by the gain of the plaintiff's ownership interest in the corporation. The court should attempt to reconstruct the consideration for the plaintiff's interest that the defendant would have paid if he had acted with scrupulous honesty, utmost good faith, and absolute fairness, putting the interests of the plaintiff before his own.

Several implications are immediately apparent. First, the minority discount is completely inappropriate because the hypothetical transaction is not a third-party transaction. The 60% will not hold a minority interest as a result of the transaction, but will hold a 100% interest. In acquiring the 40%'s shares, the 60% is not faced with any of the risks or burdens that a third party might face by stepping into the 40%'s shoes. The question is not what 40% could have gotten if he had tried to sell his shares outside the corporation; the 40% did not choose to sell his shares at all, and the forced transfer of those shares to the 60% is not outside the corporation. Second, a host of discounts and other factors that influenced the valuation of the defendant's experts and the court in Kaplan are completely irrelevant. It is completely irrelevant whether a third party might be inclined to reduce the price because of the necessity of taking over the majority shareholder's personal guarantees. There will be no third party sale. The actual buyer has already given the personal guarantees and will not take on any additional burden by the transfer. (If the situation were that the minority shareholder would be relieved of personal guarantees for the corporation, then that is value conferred to the minority shareholder and should probably be reflected in the cash valuation.) The discounts for capital gains taxes, costs of transferring titles, and other frictional and transaction costs are improper because none of those costs will be incurred. And any attorneys' fees and litigation expenses incurred by the corporation should be credited to the minority shareholder, because those fees and expenses would not have been incurred had the defendant acted consistently with his duties. Furthermore, because the plaintiff's award will be taxable, any discount for tax consequences of the hypothetical sale necessarily involves double counting. The defendant's first expert in Kaplan artificially increased expenses to account for the fact that current executive compensation was below market, and presumably any third-party buyer would have to replace the executives at market value. However, there are no third-party buyers. The actual buyers have already agreed to work at the current rates, and after the sale they can pay themselves anything they want. Third, actual measures of market value, such as prior sales or comparable sales, are relevant, but only slightly so. Every sale to a third party necessarily includes discounts off the value that the buyer hopes to receive to account for risks, transaction costs, and the necessity of a fair return. In the forced sale from minority to majority shareholder, the majority shareholder should not be compensated for the risks or transaction costs. The majority shareholder will not face those risks or costs. The majority shareholder should not receive the benefit of any discount for a return. The majority shareholder has already chosen to acquire the shares; he does not need to be induced to make this investment instead of another, as would a third party. Furthermore, the goal of the remedy is to avoid enriching the majority shareholder for forcing an involuntary transaction on the minority shareholder. Any explicit or implicit allowance of a profit on the majority shareholder's part would be antithetical to that goal.

What the court should be attempting to achieve in placing a value on the minority shareholder's interest is to grant the minority shareholder the full and fair value of what is being transferred to the majority shareholder. The full and fair value is not what a third party would pay in an arm's-length, voluntary transaction. The full and fair value is the current cash value of all the benefits that are transferred to the majority shareholder. For the most part, shareholders in closely-held corporations get benefits from their ownership through having a mechanism to generate cash. An oppressive majority shareholder acts to deprive the minority shareholder and to acquire for himself that stream of income. Therefore, in most situations, a discounted cash flow analysis is the only realistic way to measure value. The analysis must be done from the perspective of economic benefit to the shareholders as a group—from which the minority shareholder would receive his percentage interest. The benefit to the shareholders is the amount of cash generated by the business to pay the shareholders, including any amounts that have been misappropriated or diverted to any of the owners. Depreciation and taxes (if the company is a pass-through entity or fully deducts all disbursement to shareholders) would necessarily be excluded. The cash-for-owners generating ability of the enterprise can be measured, reasonably projected into the future, and discounted to present value. Also any other value that would remain in the corporation and be available for distribution should be included. For example, if the corporation routinely keeps a cash balance in its bank or investment accounts or holds real estate or other property that will retain its value, then the minority shareholder's current interest in that value should be awarded in addition to his interest in the cash generated by operations.

Finally, the burden of proof does play a part in this analysis. As the benefiting fiduciary, the majority shareholder has the burden of proof. Therefore, the value is not zero until the plaintiff proves otherwise. Rather, the use of the burden of proof is similar to that in actions against a trustee. The majority shareholder has the burden of accounting for all the money and property of the corporation. Anything that cannot be accounted for, or any expense that can't be justified, is charged to the majority shareholder's account and thus increases the size of the cash generated for owners that is being measured.

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

Pleading of Demand Futility on a Claim of Failure to Monitor

noreply@blogger.com (Eric Fryar) — Sat, 21 Mar 2009 17:32:00 +0000

In re Citigroup Inc. Shareholder Derivative Litigation, 964 A.2d 106 (Del. Ch. February 24, 2009) [Read Opinion]

This derivative action was brought by shareholders against the current and former directors of Citigroup seeking to recover for the company its losses arising from exposure to the subprime lending market, on the theory that the officers and directors breached their fiduciary duties by failing to monitor and manage the company's risks and failing to properly disclose the company's exposure. Defendants moved to dismiss for failure to plead demand futility sufficiently.

The plaintiffs did not make a demand on the Citigroup Board prior to filing their derivative suit; therefore the lawsuit was subject to dismissal unless the plaintiffs' pleadings sufficiently demonstrated that demand would be futile. Ch. Ct. Rule 23.1 Pleading of futility is required to be done with particularity and is characterized as a "strict" rule. Therefore, although the court does take the plaintiff's well-pleaded factual allegations as true, Brehm v. Eisner, 746 A.2d 244, 253-54 (Del. 2000), the court's analysis much more resembles a decision on the merits than a review of sufficiency of the pleadings as the court applies "stringent requirements of factual particularity" requiring the plaintiffs to set forth "particularized factual statements that are essential to the claim." Under the test set forth in Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984), to show demand futility, plaintiffs must provide particularized factual allegations that raise a reasonable doubt that "(1) the directors are disinterested and independent [or] (2) the challenged transaction was otherwise the product of a valid exercise of business judgment." Where, however, plaintiffs complain of board inaction and do not challenge a specific decision of the board, there is no "challenged transaction," and the ordinary Aronson analysis does not apply. Rales v. Blasband, 634 A.2d 927, 933-34 (Del.1993). Instead, to show demand futility where the subject of the derivative suit is not a business decision of the board, a plaintiff must allege particularized facts that "create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand." Id. at 934. Such "reasonable doubt" is not created by the mere fact that the directors are deciding whether to sue themselves. Rather, demand will be excused based on a possibility of personal director liability only in the rare case when a plaintiff is able to show director conduct that is "so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists." Aronson, 473 A.2d at 815.

The plaintiff's principal claims were based on the board's failure to monitor the risks of the subprime market. Delaware courts recognized that such a failure can constitute a breach of the fiduciary duty of care in In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959 (Del.Ch.1996). Delaware law distinguishes between (1) "a board decision that results in a loss because that decision was ill advised or 'negligent'" and (2) "an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss." Caremark, 698 A.2d at 967. In the former class of cases, director action is analyzed under the business judgment rule, which prevents judicial second guessing of the decision if the directors employed a rational process and considered all material information reasonably available—a standard measured by concepts of gross negligence. Id. at 967. In the latter, directors could be liable for a failure to monitor, but only on a showing of bad faith: "[O]nly a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability." Id. at 971. In Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006), the Delaware Supreme Court approved the Caremark standard for director oversight liability and made clear that liability was based on the concept of good faith, which the Stone Court held was embedded in the fiduciary duty of loyalty and did not constitute a freestanding fiduciary duty that could independently give rise to liability. Based on these authorities, the court in Citigroup held: "to establish oversight liability a plaintiff must show that the directors knew they were not discharging their fiduciary obligations or that the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act." 964 A.2d at 123.

The plaintiffs in Citigroup argued that the directors were liable for failure to "make a good faith attempt" to monitor the business risks associated with the subprime market based on their ignoring numerous "red flags" that signaled the approaching crash. The court noted that this is a very different kind of claim than the lack of oversight claims in Caremark and Stone, which involved the board's failure to oversee the conduct of employees who were violating the law. The business judgment rule "is a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." Aronson, 473 A.2d at 812. The burden is on plaintiffs, the party challenging the directors' decision, to rebut this presumption. Thus, absent an allegation of interestedness or disloyalty to the corporation, the business judgment rule prevents a judge or jury from second guessing director decisions if they were the product of a rational process and the directors availed themselves of all material and reasonably available information. See id. Additionally, Citigroup's certificate of incorporation exculpated board members from personal liability except for acts or omissions not in good faith. Under Delaware law, "bad faith" conduct may be found where a director "intentionally acts with a purpose other than that of advancing the best interests of the corporation, ... acts with the intent to violate applicable positive law, or ... intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties." In re Walt Disney Co. Derivative Litig., 906 A.2d 27, 67 (Del. 2006). More recently, the Delaware Supreme Court has held that when a plaintiff seeks to show that demand is excused because directors face a substantial likelihood of liability where "directors are exculpated from liability except for claims based on 'fraudulent,' 'illegal' or 'bad faith' conduct, a plaintiff must also plead particularized facts that demonstrate that the directors acted with scienter, i.e., that they had 'actual or constructive knowledge' that their conduct was legally improper." Wood v. Baum, 953 A.2d 136, 141 (Del. 2008). Therefore, the Citigroup court held: "A plaintiff can thus plead bad faith by alleging with particularity that a director knowingly violated a fiduciary duty or failed to act in violation of a known duty to act, demonstrating a conscious disregard for her duties." 964 A.2d at 125. Furthermore, the court was extremely troubled by the necessary result of the plaintiffs' theories of liability that would require the court to decide whether the board had made the "right business decision" based on the benefit of hindsight. Such an exercise is absolutely forbidden by the business judgment rule. See id. at 126, 130.

The court held that the plaintiffs' complaint did not adequately allege futility for the claim of failure to monitor because the plaintiffs conceded that the Citigroup had in place procedures and controls to monitor the risk, and the court believed that the complaint did nothing more than make conclusory allegations to the effect that the board failed to prevent the company from suffering losses. Id. at 127. The court held that the allegations that the board failed to heed numerous red flags was not evidence of a conscious disregard of duties, but merely of bad business decisions. Id. at 128.

The court also dismissed the plaintiffs' claim for failure to disclose the risks to the shareholders. The Delaware common law duty of disclosure is based on shareholders' entitlement to "honest communication from directors, given with complete candor and in good faith," even in the absence of a request for shareholder action. In re InfoUSA, Inc. Shareholders Litig., 953 A.2d 963, 990 (Del. Ch. 2007). When there is no request for shareholder action, a shareholder plaintiff can demonstrate a breach of fiduciary duty by showing that the directors "deliberately misinform[ed] shareholders about the business of the corporation, either directly or by a public statement." Malone v. Brincat, 722 A.2d 5, 14 (Del. 1998). The court held that the complaint did not demonstrate a reasonable doubt that the director defendants faced a substantial likelihood of personal liability for three reasons: First, mere nondisclosure is insufficient. The claim must be based a communication that is false or misleading or that is made misleading because of a material omission. Id. at 132-33. Second, the complaint did not sufficiently allege participation by the director defendants in the preparation of the disclosures that plaintiffs claimed were inadequate. Id. at 134. Third, the complaint did not sufficiently allege that the defendants were personally aware that any disclosures were false or misleading or that they acted in bad faith in not adequately informing themselves. Id. at 134-45.

Finally, the complaint alleged a claim for corporate waste in the board's approval of a letter agreement providing a $68 million golden parachute for the CEO. The court noted that the standard of liability for waste is extremely high: "an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade." Id. at 138 (quoting Brehm, 746 A.2d at 263). Based on the face of the pleadings, the court held that the plaintiffs had raised a reasonable doubt as to the substantial likelihood of personal liability for waste. Id. The court also held that the waste claim survived a motion to dismiss for failure to state a claim under Rule 12(b)(6), as the issues are the same as in demand futility but the standard is lower. Id. at 139.

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

Indiana Decision Upholding Dismissal of Derivative Claim as a Result of Freeze-Out Merger

noreply@blogger.com (Eric Fryar) — Sat, 21 Mar 2009 14:13:00 +0000

Long v. Biomet, Inc., 901 N.E.2d 37 (Ind. App. February 13, 2009). [Read Opinion]

This recent case concerns a common tactic employed by majority shareholders or management to defeat shareholder derivative actions. If the majority shareholder or the current management (who can control or persuade a sufficient majority of the stock ownership) is faced with a derivative suit brought by a minority shareholder, one way of seeking to protect the defendants from liability is to engineer a "freeze-out" merger of the corporation, in which the stock of the existing corporation is sold to or merged into an acquiring corporation, and the minority shareholders are cashed out. If the minority shareholder bringing the derivative claim is subject to the cash-out, then that shareholder will lose his share ownership and thus his standing to prosecute the claim. "A plaintiff who ceases to be a shareholder, whether by reason of a merger or for any other reason, loses standing to continue a derivative suit." Lewis v. Anderson, 477 A.2d 1040, 1049 (Del. 1984). Theoretically, the derivative claim, like all assets of the corporation would pass to the surviving entity; however, if the defendants obtain sufficient control of the surviving entity, then they will not prosecute the claim. Even if the surviving entity is owned by a third party (not originally a shareholder), the existing claim will be deemed extinguished because the law presumes that whatever harm the prior owners or managers did to the corporation is accounted for in the purchase price, and thus new corporation will be precluded from suing the former owners or management. Bangor Punta Operations, Inc. v Bangor & A.R.Co., 417 U.S. 710-713 (1974) [Read Opinion]

In the Long case, shareholders of a publicly-held Indiana corporation commenced a derivative suit for back-dating stock options. While that lawsuit was pending, the management arranged for a merger is a third party in which the existing shareholders would be cashed out. After the merger became effective, the trial court dismissed the derivative action because the shareholders had no standing. The court of appeals affirmed.

The decision of the court of appeals turned on two prior Indiana Supreme Court cases: Gabhart v. Gabhart, 370 N.E.2d 345 (Ind. 1977), and Fleming v. International Pizza Supply Corp., 676 N.E.2d 1051 (Ind. 1977). In Gabhart, the plaintiff asserted that his four fellow shareholders in a closely held corporation had misappropriated corporate funds and wrongfully denied him access to corporate records, and he later added the claim that they had effected a "freeze out" merger for the sole purpose of stripping him of his interest in the resulting corporation. As to the latter claim, the Indiana Supreme Court held that "in a bona fide merger proceeding, a dissenting or non-voting shareholder is limited to the means provided by statute for the realization of his equity," specifically, the statutory appraisal process. Id. at 356. However, it held "that a proposed merger which ha[d] no valid purpose" could be challenged "by procedures other than those provided by statute for that purpose." Id. at 356. The Supreme Court cited the "well established" principle that "being a shareholder of the corporation whose cause of action is to be enforced in a derivative suit is a prerequisite for standing to sue," and held that "[w]hen a corporation is merged out of existence, ..., its assets and liabilities are transferred to the surviving corporation by operation of law, ... and the shareholders' interests in the merged corporation come[ ] to an end. … and [the cause of action] passes to the surviving corporation along with the other assets of the merged corporation." Id. at 357. However, there is an "equitable limitation upon a surviving corporation's right to succeed to a merging corporation's cause of action," specifically: when "each" shareholder of the surviving corporation "had participated in the wrong complained of." Id. Accordingly, the court held that "if a merger is effected solely for the purpose of shielding wrongdoers from liability, the merger may be attacked as devoid of a legitimate corporate purpose" by the former shareholder. Id. In such a case, Gabhart concluded, the trial court held equity jurisdiction to grant relief to the former shareholder.

Nine years after the Gabhart decision, the Indiana Legislature amended the Indiana Business Corporation Law, Ind. Code §23-1-44(8)(c). [Read Statute] The amendment basically tracks the Model Corporations Act, except that the Indiana Legislature deleted the language that provided that the appraisal remedy is the exclusive remedy for dissenting shareholders "unless the transaction is unlawful or fraudulent with respect to the shareholder or the corporation." In Fleming v. International Pizza Supply Corp., 676 N.E.2d 1051, 1055 (Ind. 1997), the Indiana Supreme Court held that this amendment was the Legislature's "conscious response" to the Gabhart decision. Therefore, subsequent to the enactment of the BCL, "in a merger or asset sale, the exclusive remedy for the value of the shareholder's shares is the statutory appraisal procedure"—which remedy included "the ability of dissenting shareholders to litigate their breach of fiduciary duty or fraud claims within the appraisal proceeding." Id. at 1056, 1057. In other words, if a merger results in the dismissal of a shareholder's derivative action, then the shareholder's sole remedy is to argue in an appraisal proceeding that the price for his stock should be higher because the merger price did not adequately reflect the value of the derivative claim as a corporate asset.

The shareholders in Long v. Biomet, Inc. received $46 per share for their stock. Apparently, they conceded that this was a fair price, but also wanted to receive their share of hundreds of millions of dollars by which Biomet's management had been unjustly enriched by backdating options. The shareholders argued that their claim for damages should not be transferred to the new corporation and their standing to bring the action should not cease because of the merger; rather, the action should pass to the old shareholders as a group. The plaintiffs relied on a statement in a footnote in Fleming that "the BCL did not intend to restrict any claims of wrongdoing that a corporation or shareholder brings before the corporate action creating dissenters' rights occurs." Id. at 1057 n.9. However, the court of appeals correctly pointed out that, read in context, the Supreme Court's statement clearly meant that the claims of wrongdoing brought prior to the merger must be adjudicated in the context of an appraisal of the dissenting shareholder's stock.

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

California Buyout statute must include value of derivative claims in the fair value of shares.

noreply@blogger.com (Eric Fryar) — Tue, 17 Mar 2009 20:23:00 +0000

Cotton v. Expo Power Systems, Inc., 89 Cal.Rptr.3d 112 (Cal. App. 2 Dist., February 09, 2009). [Read Opinion]

This case involves the application of California Corporate Code §2000 [Read Statute] The minority shareholder, who owned 1/3 of the shares in a California corporation, became convinced that the majority shareholder was diverting corporate assets and opportunities to his own benefit, with the eventual result that the corporation became essentially insolvent. A minority shareholder filed a derivative suit on behalf of the corporation seeking damages for breach of fiduciary duty but also seeking other equitable relief including dissolution of the corporation. The majority shareholder exercised his option under § 2000 of the California Corporate Code, which permits the corporation or a shareholder controlling 50% or more of the voting shares to avoid a voluntary or involuntary dissolution by purchasing the dissenting shareholders' stock for "fair value." If the parties cannot agree on a fair value, then the court is required to appoint three disinterested appraisers. The court has the power to order that evidence be submitted to the appraisers, and court is ultimately required to enter a decree, based on its review and confirmation of the appraisers' recommendation, which gives the corporation or majority shareholder the option of dissolution or purchase of the minority shareholder's shares at the price stated in the decree.

The controlling shareholder in this case sought to escape the claim for damages in the derivative action through the mechanism of § 2000. It should be noted that had the minority shareholder not sought dissolution in the same proceeding this gambit would not have been available to the majority shareholder. The court submitted the valuation to the appraisers, who determined that the liquidation value of the corporation was $100,000, but who declined to try to put a value on the derivative claims. The trial court recognized that the value of the corporation was severely diminished by the conduct that was the basis of the derivative claims. Therefore, the trial court entered a decree setting the buyout price at one third of $100,000, but deferred the buyout date until after the resolution of the derivative claims, presumably to allow the plaintiff recover his share of damages resulting from the derivative claims.

The Court of Appeals held that the trial court had misapplied § 2000. The Court of Appeals recognized that the derivative claims were assets of the corporation and not the property of the minority shareholder. However, the court also noted that the plaintiff would lose his standing to assert the derivative claims as a result of the buyout order. The Court of Appeals held that the trial court did not have the power under § 2000 to defer the buyout date until after the derivative claims were tried but was required to assign a value to the derivative claims. The Court of Appeals acknowledged that the appraisers in this case did not feel qualified to put a value on the derivative claims but held that, in the absence of an appraisal, the trial court was required to assign a value based on the evidence submitted to the court. The Court of Appeals noted that California courts had in the past considered potential liabilities from pending litigation against the corporation as a factor affecting the fair value under § 2000. See Brown v. Allied Corrugated Box Co. 91 Cal.App.3d 477, 482, 154 Cal.Rptr. 170 (1979). The court also noted that, in the context of a corporate merger, courts are required to determine whether or not conduct by the corporate officers and directors that is the subject of shareholder claims of fraud and breach of fiduciary duty diminished the value of the dissenting shareholders' stock, and if so to adjust the value in the appraisal proceeding. See Steinberg v. Amplica, Inc. 42 Cal.3d 1198, 1209, 233 Cal.Rptr. 249, 729 P.2d 683 (1986).

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

New Mississippi Shareholder Case

noreply@blogger.com (Eric Fryar) — Mon, 09 Mar 2009 02:41:00 +0000

Griffith v. Griffith, 997 So.2d 218 (Miss. App. December 02, 2008). [Download Opinion]

The Mississippi Court of Appeals has handed down an opinion in a lawsuit between two shareholders of a closely-held corporation. The Mississippi corporation was started by the father of two shareholders in the 1950s. The corporation manufactured a pecan picker. Most of the two brothers' shares were held in trust, but Tom held 3 shares individually and Harry held 2 shares individually. In 1998 board of directors appointed Harry the president. Tom was vice president. Over the ensuing years, the dividends of the corporation decreased, until Tom discovered that the reason the corporation's expenses were increasing was that Harry was charging personal expenses to the corporation and charging expenses of his two other businesses to the corporation. Tom sued Harry for conversion and breach of fiduciary duty. Tom obtained a temporary restraining order and was named temporary receiver of the corporation. A shareholders' meeting was held, and Harry was voted out as president. Thereafter, Harry went into business in competition with the corporation, importing cheaper Chinese knock-off pecan pickers. Tom contended that this was a usurpation of corporate opportunities because, several years before, Tom had proposed that the corporation import the less expensive Chinese pickers rather than manufacture its own product, and Harry had refused to pursue that opportunity. As a result of Harry's new business, Tom also sued Harry for usurpation of corporate opportunities.

The Chancellor ordered an accounting be performed by a certified public accountant appointed by the court. A CPA found that Kerry had charged $54,490 in personal expenses. Additionally, the CPA found that more than three hundred thousand dollars could not be accounted for because of the corporation's poor bookkeeping. The Chancellor awarded Tom $27,245 for breach of fiduciary duty, $50,000 punitive damages, and $5000 in attorneys fees, but nothing for usurpation of corporate opportunities. Both brothers appealed. A court of appeals affirmed.

The court of appeals noted that Tom had brought the lawsuit directly, claiming a breach of fiduciary duty to himself individually, and had not joined the corporation as party. This was not fatal to the breach of fiduciary duty claim, because Mississippi case law provides that, in a closely held corporation, the chancellor may treat a shareholder's derivative suit as a direct action and order an individual recovery so long as it does not prejudice the interests of the creditors, expose the corporation to multiple actions, or prejudice recovery for all other interested parties. See ERA Franchise Sys. v. Mathis, 931 So.2d 1278, 1281 (Miss. 2006) (citing Derouen v. Murray, 604 So.2d 1086, 1091 n.2 (Miss.1992)). Presumably, the plaintiff should have brought the lawsuit as a derivative action, naming the corporation as a party, and then requested the court to treat the derivative action as a direct action. However, the Court of Appeals held that the Chancellor had not erred because the plaintiff had "essentially" filed a shareholders derivative action. Therefore, the court of appeals held that the Chancellor had correctly awarded half the personal expenses charged the corporation by Harry. The court of appeals found that Chancellor did not abuse his discretion in finding Harry's explanation not credible that the expenses were legitimate. However, the court of appeals also held that the Chancellor did not err in refusing to award Tom any damages for the greater sum of money that could not be accounted for. The Chancellor had held that there was not sufficient evidence to prove that the money had been misappropriated. As the fiduciary that had control over the corporation, Harry should have had the burden of proof with regard to the accounting. Therefore the Chancellor's refusal to award damages due to a lack of evidence is clearly wrong. However, the court of appeals did not consider this issue.

The court of appeals also affirmed the Chancellor's refusal to award damages for usurpation of the corporate opportunity. The basis for the court of appeals' holding was that Harry did not have standing to assert a claim for lost profits based on usurpation of corporate opportunities, as this claim belongs solely to the corporation and could only be brought in a derivative suit. Of course, the exact same standing problem existed on the award that the court of appeals did affirm, and the court of appeals had held just a few paragraphs before that Tom had escaped the standing problem by virtue of the doctrine of allowing shareholders in a closely-held corporation to bring a direct action instead of a derivative action. These two holdings by the court of appeals constitute to a head-spinning contradiction, of which the court seems totally unaware.

The court of appeals also affirmed the Chancellor's award of punitive damages and attorney's fees. The court did not address the basis of an award of punitive damages in an equitable action, but seems to hold back the Chancellor has discretion to award punitive damages based on his assessment of the circumstances. See Aqua-Culture Techs., Ltd. v. Holly, 677 So.2d 171, 184 (Miss.1996). "[T]he question of whether punitive damages should be awarded depends largely upon the particular circumstances of the case." Id. The court also affirms the attorneys' fees award on the basis of the somewhat usual Mississippi rule that attorneys' fees may be awarded when the trial court has found that punitive damages are appropriate. See Aqua-Culture Techs., 677 So.2d at 184 (citing Greenlee v. Mitchell, 607 So.2d 97, 108 (Miss.1992)).

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

New Improved Website

noreply@blogger.com (Eric Fryar) — Thu, 05 Mar 2009 17:18:00 +0000

ShareholderOppression.com has had a total makeover and is greatly expanded and improved.

Also the author has launched a new firm website.

Can communications with corporate counsel be withheld from a director on grounds of privilege?

noreply@blogger.com (Eric Fryar) — Tue, 03 Mar 2009 20:26:00 +0000

Tritek Telecom v. Superior Court, 169 Cal.App.4^th 1385, 87 Cal.Rptr.3d 455 (Jan. 7, 2009).

Under California law, corporate directors have an "absolute right" to inspect and copy all corporate "books, records and documents of every kind." Cal. Corp. Code § 1602. This "absolute right" normally extends to documents otherwise subject to the attorney client privilege. 169 Cal.App.4th at 1387. In Tritek Telecom v. Superior Court, California Fourth Court of Appeals dealt with a particularly thorny issue in shareholder litigation involving closely-held corporations. The parties were two equal shareholders of a closely-held corporation, both of whom were directors. A third non-shareholder director apparently aligned with one of the shareholders thus giving that shareholder effective control. The controlling shareholder then proceeded to lock out the other shareholder, stop paying his salary, and misappropriate assets. The ousted shareholder sued the other two directors and the corporation alleging various causes of action and seeking the return of the shareholder's investment. Initially, corporation's lawyer represented both corporation and the individuals in the litigation. The trial court correctly disqualified corporation's lawyer from the dual representation and required new and separate counsel for both the corporation and the individual defendants. See, e.g., Bell Atlantic Corp. v. Bolger, 2 F.3d 1304 (3rd Cir. 1993); Clark v. Lomas & Nettleton Fin. Corp., 79 F.R.D. 658 (N.D. Tex. 1978); Cannon v. U.S. Accoustics Corp., 398 F.Supp. 209 (N.D. Ill. 1975), aff'd 532 F.2d 1118 (7th Cir. 1976); Messing v. FDI, Inc., 439 F.Supp. 776, 781-82 (D.N.J. 1977).

Thereafter, the plaintiff sought to inspect the documents and communications generated by corporation's attorney during the time of the dual representation. The defendants resisted the inspection on the grounds of attorney-client privilege. The trial court ordered the inspection. The appellate court reversed, holding that the plaintiff shareholder/director had no right to inspect attorney-client privileged documents that were generated in defense of the plaintiff's lawsuit filed against the corporation. 169 Cal.App.4th at 1392.

In reaching its conclusion the Court of Appeals acknowledged that the director's rights to access to corporate records is absolute, but then paradoxically noted that there are exceptions to its absoluteness. One California Court of Appeals had previously noted hypothetically that a director's absolute right of inspection might be denied where a disgruntled director announces his or her intention to violate his or her fiduciary duties to the corporation, such as by using inspection rights to learn trade secrets to compete with the corporation. Havlicek v. Coast- to-Coast Analytical Services, Inc., 39 Cal.App.4^th 1844, 1855 (1995). That court had held that the director was entitled to inspection but had ruled that §1603(a) of the Cal. Corp. Code, which provides that a court may enforce the right of inspection "with just and proper conditions," permits a court to grant a corporation a protective order denying or limiting a director's inspection, but only if the corporation demonstrates by an evidentiary showing that the protective order is necessary to prevent a tort from being committed against the corporation by the director. Id. at 1856. The Tritek court also cited La Jolla Cove Motel and Hotel Apts. Inc. v. Superior Court, 121 Cal.App4t 773, 787-88, 17 Cal.Rptr.3d 467 (2004), for the proposition that corporate counsel has no duty to disclose privileged information to a dissident director with which the corporation has a dispute. Actually, the court in La Jolla Cove Motel and Hotel Apts. Inc. v. Superior Court had dealt with a very different issue. In that case, non-director minority shareholders had brought suit against the majority shareholders. The minority shareholders had elected two directors to represent their interests, and those directors were aligned with the minority shareholders in the dispute. During the litigation, the majority shareholders moved to have the minority shareholders' lawyer disqualified or disciplined for contacting and taking statements from the minority-aligned directors without the permission of the corporation's counsel. The Court held that the corporation's lawyer could not be deemed the lawyer of the minority-aligned directors because there was an actual dispute among the shareholders and directors which would have precluded the corporation's lawyer from representing the dissident directors against the corporation. The court also noted, in passing, that the corporation's lawyer was free to use communications by the dissident directors prior to the dispute to further the interests of the corporation, even if those interests were adverse to the dissident directors. This is not the same thing as holding that the dissident directors are not entitled to access to privileged communications between the corporation and its counsel to which the directors aligned with the controlling shareholders would have had access.

In Tritek, the Court held that the dissidents director's "absolute right" to access to corporate records did not extend to privileged communications generated in defense of a suit that the director had filed against the corporation because the interests of the director were adverse to those of the corporation and because such access would violate the privilege between the controlling shareholder and the corporation's lawyer during the time that the corporation's lawyer represented the individual shareholder. 169 Cal.App.4^th at 1391.

The Court's reasoning is very troubling on a number of levels. First, the Court fails to consider whether the attorney-client privilege ever existed in the first place. A communication is subject to the attorney client privilege only if the communication is made with the expectation of confidentiality. Cal. Evid. Code §952. The attorney-client privilege may be held jointly by two or more persons, and the assertion or waiver by one of the joint holders does not affect the others. Cal. Evid. Code §912. The very nature of the corporation is that it is controlled and managed by its board of directors. The directors exercise their power and authority over the corporation only as a group, not individually. Therefore, while the corporation is the holder of the attorney-client privilege with its corporate counsel, the privilege is exercised by and through the directors, and no one director has any more claim to access to privileged communications than any other. Therefore, communications between a corporation and its corporate counsel cannot be made with the expectation that they will be kept confidential from any member of the Board of Directors. Therefore the question arises, as to the sitting members of the Board of Directors, what attorney-client privilege can be asserted against them? One previous California case held that meetings with corporate counsel by one group of shareholders in a closely-held corporation could be withheld from another group of shareholders on the grounds of attorney-client privilege, where the evidence showed that the meeting had served a corporate purpose. Holles v. Superior Court, 157 Cal.App.3d 1192, 1200, 204 Cal.Rptr. 111 (1984). However, that court neatly side-stepped the difficult issue posed by the fact that one of the dissident group of shareholders was also a director by noting that the lawsuit had been brought in director's capacity as a shareholder, not a director. Id. at 1202.

The Delaware courts have grappled with this issue, and their conclusions have been markedly different from that reached in the Tritek case. Under Delaware law, when a corporation employs legal counsel, each of the members of the board of directors has a status co-equal with the corporation as "client." "The issue is not whether the documents are privileged or whether plaintiffs have shown sufficient cause to override the privilege. Rather, the issue is whether the directors, collectively, were the client at the time the legal advice was given. Defendants offer no basis on which to find otherwise, and I am aware of none. The directors are all responsible for the proper management of the corporation, and it seems consistent with their joint obligations that they be treated as the 'joint client' when legal advice is rendered to the corporation through one of its officers or directors." Kirby v. Kirby, 1987 WL 14862 (Del. Ch. 1987). Therefore, communications with corporate counsel during a director's tenure on the board cannot be privileged as to her because, as a matter of law, such communications could not legally have been intended to be kept confidential from her. "Absent a governance agreement to the contrary, each director is entitled to receive the same information furnished to his or her fellow board members." Intrieri v. Avatex, 1998 WL 326608 (Del. Ch. 1998). In fact, Delaware corporate law is clear that attorney-client communications to which a director should have had access during her tenure continue to be available to her after she ceases to be a director. In Kirby v. Kirby, 1987 WL 14862 (Del. Ch. 1987), the Delaware Chancellor held that, as to attorney-client communications that occurred during the tenure of former directors, it is not possible for any privilege to have been created for those communications, and therefore, there is no basis for the invocation of the attorney-client privilege at a later date. Independently, under Delaware corporate law, the corporation is prohibited from asserting the attorney-client privilege as to information to which a director is entitled. A corporation may not "assert the privilege to deny a director access to legal advice furnished to the board during the director's tenure." Moore Business Forms, Inc. v. Cordant Holdings Corp., 1996 WL 307444 (Del. Ch. 1996).

Perhaps more troubling are the explicit reasons for the court's holding, that the plaintiff is adverse to the corporation and that access to privileged communications would violate a privilege held independently by the controlling shareholder. The opinion does not give great detail about the exact procedural posture of the case and the exact causes of action asserted by the plaintiff. If the plaintiff asserted a cause of action against the controlling shareholder for breach of fiduciary duties as a result of misappropriation of corporate assets, then this claim must almost certainly have been brought as a derivative claim, in which case the plaintiff would have been asserting claims on behalf of the corporation rather than against it. In almost every lawsuit between a controlling shareholder and a non-controlling shareholder for wrongdoing done by the controlling shareholder, the law governing standing and capacity will almost always require that some of the claims be brought against the corporation. This very often results in the strange situation in which a plaintiff is both suing and representing the interests of the corporation in the same lawsuit. Courts, however, generally view the situation as a matter of substance over form. The true dispute is between the shareholders, and regardless of how the complaint is stated, the gravamen of the complaint is the manner in which the controlling shareholder has exercised his power over the Corporation. There is absolutely no reason for a court to assume that the party that controls the corporation is therefore acting in the interests of the corporation. If the claims made by the plaintiff in Triteck are true, then the plaintiff was acting on behalf of the corporation, and the controlling shareholder was adverse to the corporation.

There can be little justification for protecting the confidentiality of communications between the corporation's lawyer and the controlling shareholder/director as against another director when the very act of establishing the attorney client relationship between the corporation's lawyer and the controlling shareholder was a breach of both of their duties to the corporation "[A]s attorneys for [a] corporation, counsel's first duty is to [the corporation]." Meehan v. Hopps 144 Cal.App.2d 284, 293, 301 P.2d 10 (1956). "These cases make clear that corporate counsel's direct duty is to the client corporation, not to the shareholders individually, even though the legal advice rendered to the corporation may affect the shareholders." Skarbrevik v. Cohen, England & Whitfield 231 Cal.App.3d 692, 704, 282 Cal.Rptr. 627 (1991). A corporation's attorney is not permitted, either during or after that engagement, to represent any shareholder or director against the corporation (or the other shareholders when that would entail acting contrary to his prior representation of the interests of all the shareholders). See Metro-Goldwin Mayer, Inc. v. Tracinda Corp., 36 Cal.App.4^th 1832, 1845, 43 Cal.Rptr.2d 327 (1995); Goldstein v. Lees, supra, 46 Cal.App.3d 614, 622, 120 Cal.Rptr. 253 (1975). Morover, a corporation is not permitted to defend a derivative action on the merits, Patrick v. Alacer Corp., 167 Cal.App.4^th 995, 84 Cal.Rptr.3d 642 (2008) [see case analysis], and the corporation's lawyer has a duty to refrain from taking part in any controversies or factional differences among shareholders as to control of the corporation, so that he or she can advise the corporation without bias or prejudice. See Goldstein v. Lees 46 Cal.App.3d at 622. As for the controlling shareholder who elected to use the corporation's lawyer to defend claims brought against him personally based on his individual breach of duties to the corporation and to the other shareholder, the controlling shareholder has misappropriated corporate assets (the services and independence of the corporation's lawyer, not to mention the fees incurred by the corporation) for his individual benefit, and has directed the corporation's lawyer to violate his duties to the corporation and to cause the corporation to take a position that it is not legally permitted to take. It is very difficult to understand why the Tritek court believed that this was a valid exercise of the attorney-client privilege worthy of the court's protection, and the opinion does not address the issue.

Of course, if a dispute arises between a two groups of shareholders or between the corporation and one of its directors, the corporation may very easily preserve the attorney-client privilege and the integrity and confidentiality of the legal advice from the corporation's lawyer by establishing an independent litigation committee to consult with corporate counsel. As the Chancellor held in Moore Business Forms, inc. v. Cordant holdings Corp., 1996 WL 307444 (Del. Ch. 1996): "Holdings had alternative means to enable its directors (other than Mr. Rogers) to receive confidential attorney advice not discoverable by Moore. Holdings could have bargained for such protections in the Stockholders Agreement. Alternatively, and independent of the Stockholders Agreement, the Holdings board could have acted, pursuant to 8 Del.C. § 141(c) and openly with the knowledge of Moore and Rogers, to appoint a special committee empowered to address in confidence those same matters. Under either scenario the special committee would have been free to retain separate legal counsel, and its communications with that counsel would have been properly protected from disclosure to Moore and its director designee. Neither approach was followed here." Of course, this approach assumes that there are independent directors and that the corporation (as apart from the shareholders involved in the lawsuit) has some legitimate, independent reason for legal advice. This alternative would not have been possible in the Tritek case, where there were only two shareholders, no independent directors, and no reason for the corporation or the corporation's lawyer to be actively involved in defending one or the other shareholder. It is unfortunate that the California court of appeals seems to have validated a misuse and misappropriation of corporate resources by controlling shareholders.

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

Proof of Shareholder Status

noreply@blogger.com (Eric Fryar) — Sat, 21 Feb 2009 19:15:00 +0000

Jardine v. McVey, 276 Neb. 1023, 759 N.W.2d 690 (Jan. 9, 2009).

The Supreme Court of Nebraska has addressed the sometimes difficult question of proving shareholder status in a closely-held corporation. Many times small corporations operate informally and by verbal agreement. Frequently the "corporate book" is purchased when the company is set up and is never opened again. Consequently, once a dispute among the owners arises, there may be a real question of whether the person claiming to be an oppressed shareholder is really a shareholder at all. Sometimes, a controlling shareholder will try to take advantage of the shareholders' failure to use the stock ledger or failure to actually issue shares by falsely denying the plaintiff's share ownership.

The Jardine v. McVey case arose out of a divorce settlement, the plaintiff and his former wife. During the marriage, the plaintiff had worked at one of three family-owned corporations controlled by his wife's father. During the marriage, the father made a gift of a substantial block of shares in the three corporations to his daughter. Later, during the divorce, the plaintiff claimed that the shares were marital property and demanded half. The parties settled without resolving the ownership issue, but with the plaintiff being paid about $350,000 for any interest that he claimed in the stock. Plaintiff negotiated the settlement price directly with the father-in-law and the president of the three corporations, and plaintiff had specifically asked his father-in-law whether the companies were trying to be sold, and the father-in-law answered that they were not.

In fact, the companies had received serious offers from two potential buyers at that time and were engaged in discussions of a potential sale. About eight months after the divorce was final, the corporations were sold to a third buyer for a sum substantially in excess of the value on which the plaintiff's settlement was based. The plaintiff sued the directors of the three corporations for breach of fiduciary duties in failing to disclose the on-going sales talks, and plaintiff sued his former father-in-law for fraud. The trial court granted summary judgment in favor of the defendants. The Supreme Court affirmed.

In the Supreme Court's analysis, the issue of fiduciary duties rested solely on the question of whether the plaintiff had been a shareholder at the time of the divorce. The court held that the officers and directors owe fiduciary duties both to the corporation and to the shareholders. The defendants maintained that the plaintiff was not a shareholder because the stock in which he claimed an interest had been issued solely to his former wife, that the certificates were solely in her name, and that the stock register did not record any ownership by the plaintiff. The court agreed with the plaintiff that the fact that his name was not on the stock register and the fact that he had not been issued a stock certificate did not preclude his being a shareholder. However, in the absence of such conclusive proof, the plaintiff must have evidence of "some sort of subscription or contract, express or implied, …, whereby the person obtains the right to (1) hold stock or, upon some condition, demand stock; and (2) exercise the rights of a stockholder." The court cited its earlier opinion in Evans v. Engelhardt, 246 Neb. 323, 518 N.W.2d 648 (1994), in which the court had held that the plaintiff was a shareholder despite the absence of a stock certificate or stock ledger entry because the other shareholders had acknowledged his share ownership for years by making distributions based on his percentage of ownership, reflecting him as an owner on company tax returns and on the plaintiff's K-1, and giving him notice of shareholder meetings. The plaintiff in Jardine had no evidence of this sort. The court noted that the stock had been a gift and therefore was not marital property, and nothing done by the corporation or the other shareholders acknowledged plaintiff's share ownership. Plaintiff never signed a stock transfer agreement; he never signed the shareholders' buy-sell agreement; he never received or endorsed a dividend check; he never served as an officer or director; he never attended any shareholders' meetings; he never voted any of his shares, participated in any elections, or served as a proxy for the corporations. Against this, the plaintiff argued "(1) He received payment for the stock in the divorce proceeding; (2) [the wife] obtained the stock during their marriage; (3) during the divorce negotiations with [the father] and [president of the corporation], they 'acknowledged' [plaintiff's] one-half ownership in the stock; (4) [the president's] statement that if [plaintiff] had not worked for the corporations, [the wife] may not have received the stock when she did; and (5) when the corporations were sold, all shareholders were either employees or former employees of the corporations except [the wife]." The court held that this evidence was not sufficient to raise an issue of genuine fact as to whether plaintiff had been a shareholder.

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

Discussion of Valuation in Forced Buyout

noreply@blogger.com (Eric Fryar) — Fri, 12 Dec 2008 21:14:00 +0000

Encompass Teleservices, Inc. v. Scheets, Slip Op. No. 04-821-HU, 2008 WL 5156561 (D. Ore. Dec. 9, 2008).

The United States District Court for the District of Oregon has entered a judgment for shareholder oppression in favor of a minority shareholder. The case was originally filed in June 2004 by the corporation against the minority shareholder, but the minority shareholder counterclaimed and filed a third-party claim against the majority shareholders in July 2006. The corporation declared bankruptcy in 2007. The case was tried to the court. The minority shareholder asserted that the majority shareholders breached their fiduciary duties to him by 1) diverting funds to themselves or to entities in which they had a direct or indirect financial interest; 2) providing or causing the provision of false, incomplete and/or fraudulent information with the intent of depriving the plaintiff of his shareholder rights; and 3) wrongfully withholding from the plaintiff benefits enjoyed by other shareholders or controlling persons, including dividends, distributions, loans, reimbursement of expenses, and payments sufficient to pay their (S-corporation) tax liabilities on income allocated to shareholders. Under Oregon law, "[m]ajority shareholders, officers and directors owe the fiduciary duties of loyalty, good faith, fair dealing and full disclosure to a minority shareholder. Delaney v. Georgia-Pacific Corp., 278 Or. 305, 310-11; Baker v. Commercial Body Builders, 264 Or. 614, 629 (1973). These duties are owed to both the corporation and the other shareholders." The court notes that oppression and breach of fiduciary duty to a minority shareholder are essentially the same thing. "Because many things can constitute oppressive conduct or a breach of fiduciary duties what matters is not so much matching the specific facts of one case to those of another but examining the pattern and intent of the majority and the effect on the minority of those specific acts." Quoting Cooke v. Fresh Express Foods Corporation, Inc., 169 Or.App. 101, 108-09 (2000). "When shareholders of a closely held corporation use their control over the corporation to their own advantage, and exclude other shareholders from the benefits of participating in the corporation, in the absence of a legitimate business purpose, the actions constitute a breach of their fiduciary duties of loyalty, good faith and fair dealing." Citing Cooke 169 Or.App. at 108, citing Noakes v. Schoenborn, 116 Or.App. 464, 472 (1992). The Court held that over a five-year period, the majority shareholders withheld accurate financial information about the corporation from the minority shareholder and provided false financial information to the minority shareholder, primarily for the purpose of hiding mismanagement, misappropriation and usurpation of corporate opportunities. The Court held that the majority shareholders had committed oppression and ordered a buy out.

The plaintiff's business valuation expert testified that the plaintiff's minority interest was worth $2.4 million as of the valuation date, which the parties stipulated was July 2004. The court did not find the expert testimony to be credible. The expert used in income approach and a market approach to reach a valuation, and the expert testified that he weighted the income approach at 75% and the market approach at 25%. The Court stated: "In the end, these approaches, which Mr. Partin finds to be completely different in terms of their reliability, differ in their valuation prediction by only $25,000 on an overall valuation of $2,400,000. That is a discrepancy of approximately 1% between two methods that, according to Mr. Partin, differ in their reliability by a factor of three. I find this so unlikely as to call into question the manipulations of the assumptions, approximations and conclusions reached by Mr. Partin under one or both methods. This is simply 'too good to be true.'" This statement is absolute nonsense. If the court believed that the expert was manipulating the assumptions, one would certainly hope that there was a more convincing example than the one the court cited. Presumably the court would have been convinced by the expert testimony if the expert had said that both approaches were equally valid because they came to almost the same number. The court also rejects the expert's exclusion of various one-time extraordinary expenses associated with the fraud committed by the defendants, the excessive distributions to the defendants, and the shareholder litigation. The Court holds that the plaintiff's expert's assumptions regarding the stability and growth of the company are disproven by the very misconduct challenged in the lawsuit. "Indeed, Mr. Cargal's fraud and the excessive distributions to the Boyles create a disquieting picture of a company that was not well managed and doomed to early failure on the path it had chosen." Ultimately the Court holds that the plaintiff's interest was worth $900,000 and orders the majority shareholders to pay that amount.

Aside from the very strange reasoning given by the court for doubting the expert's credibility, the Court's reasoning regarding valuation is extremely troubling. Seemingly, while the misconduct of the defendant's was held to be illegal and warranted an equitable remedy, the defendants were given approximately a $1.6 million benefit in the calculation of the remedy as a result of that same misconduct. What the court misses in his analysis is that the valuation number is not really about what the plaintiff's interest is worth in reality. In imposing a buyout remedy and conducting an evaluation for purposes of that buyout, the court is attempting to construct a hypothetical purchase that equity determines should have taken place. When a majority shareholder has oppressed a minority shareholder, a majority shareholder has effectively taken the value of the minority shareholders ownership interest. The equitable remedy of a buyout makes the majority shareholder pay for the interest he has taken to prevent unjust enrichment. Therefore, the goal of a valuation is to determine the number that the defendants would have paid had they been acting in accordance with their fiduciary duties and which accounts for all the value that the defendants would have received in such a transaction. The goal is not to determine the value that a third party might pay the plaintiff for that interest. What third-party would want the interest? When the defendant acquires the interest, the defendant is acquiring something that a third party would not acquire, namely the defendant does not face the prospect of dealing with a hostile, dishonest, greedy majority shareholder whose interests are adverse to the buyer. For the same reason, it is totally inappropriate in a shareholder oppression case to apply a minority shareholder discount because the buyer is not a minority shareholder. The value that the defendants acquire in the hypothetical transaction is not and should not be diminished by their own misconduct. If the defendant steals from the corporation, then he has (from the perspective of the defendant) suffered no net loss. The fact that the defendant chooses to run the company into the ground, also should not diminish the value. The defendant could have chosen to sell the company to a third party, in which case the defendant's future mismanagement would not affect value. Certainly, the existence of shareholder lawsuits arising from the defendant's misconduct should not be a factor to diminish the valuation. Had the hypothetical transaction taken place, then the need for litigation would never have arisen.

Eric Fryar

Shareholder Oppression Blog

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