Litle v. Waters, Civ. A. No. 12155, 1992 WL 25758, 18 Del. J. Corp. L. 315 (Del. Ch. Feb. 11, 1992.)
Plaintiff and defendant founded to subchapter S corporations. Defendant was the majority shareholder and had control the board of directors. Defendant also provided substantially all the capital by way of personal loans to the corporations. Plaintiff was the president and provided management to corporations. After several years, defendant fired plaintiff and merged to corporations into a new Delaware corporation. The surviving corporation maintained the subchapter S. status. Plaintiff contended that he agreed to the subchapter S. election on the condition that the corporations would always make distributions sufficient to cover the tax liability. After the plaintiff was fired, the defendant caused the corporation to stop making tax distributions, resulting in substantial tax liability to the plaintiff. Defendant compensated Flemming, the remaining board member, with stock appreciation rights ("SARs"), which were tied to the value of the corporation's stock but did not share in the tax burden. Plaintiff sued for breach of fiduciary duty, and defendant moved to dismiss for failure to state a claim.
Defendant characterized the claim as one attacking decisions by the board with respect to declaration of dividends and sought invoke the protections of the business judgment rule. Defendant argued that "the declaration and payment of a dividend rests in the discretion of the corporation's board of directors in the exercise of its business judgment; that, before the courts will interfere with the judgment of the board of directors in such matter, fraud or gross abuse of discretion must be shown." Gabelli & Co., Inc. v. Liggett Group, Inc., 479 A.2d 276, 280 (Del. 1984). Further, defendant argued, the mere existence of funds from which the entity could pay dividends does not prove fraud or abuse of discretion by a board in its determination not to declare dividends. See Baron v. Allied Artists Pictures Corp., , 337 A.2d 653, 659 (Del.Ch. 1975), appeal dismissed, 365 A.2d 136 (Del. 1976). Defendant argued that the action must be dismissed because the Board's decision to not declare dividends is not "explicable only on the theory of an oppressive or fraudulent abuse of discretion." Eshleman v. Keenan, , 194 A. 40, 43 (Del.Ch. 1937). Plaintiff argued that the claim was not an attack on the board's decision with regard to dividends, but that the defendant breached fiduciary duties by a pattern of conduct, including the dividend decisions, designed to squeeze out the minority shareholder and force him to sell his stock for a price below fair value.
The Court held that the business judgment rule does not apply in transactions where an interested directors stand on both sides of the transaction or expect to derive a material financial benefit from the transaction in the sense of self-dealing, as opposed to a benefit which devolves upon the Corporation or all shareholders generally. Aronson v. Lewis, 473 A.2d 805, 812 (Del.1984). The Court held that the entire fairness standard applied, and not the business judgment rule, because of the defendant's self interest in the challenged transactions. The Court noted that the defendant served his own personal financial interests in making the decision not to declare dividends because he was then able to receive a greater share of cash available for corporate distributions via loan repayments and because he was thus able to pressure the minority shareholder to sell his shares at a discount, since the shares became only a liability to the plaintiff who received no corporate distributions yet owed taxes on the company's income. With respect to Fleming, the other director, the Court held that his independence was compromised by the fact that he depended upon the majority shareholder's support to continue in his lucrative position as an officer of the company and that the value of his SARs was dependent upon the majority shareholder's continuation of the policy against distributing dividends. Therefore, these facts, if proven, would establish that Fleming was an interested director because he could not exercise his judgment independent of Walters' interests without jeopardizing his substantial financial interest. See In re Radiology Associates, Inc., C.A. No. 9001, (Del.Ch.May 16, 1990). "Therefore, the burden shifts to defendants to demonstrate that the decision to not declare dividends and to repay the company's debt to Waters was intrinsically fair."
With respect to plaintiff's claim that he consented to the subchapter S. election only on the condition that the Corporation would make funds available by distributions to the stockholders sufficient to cover the taxes, the Court held that the plaintiff had failed to plead an enforceable contract, and that the arrangement could not be enforced under theories of promissory estoppel or quantum merit.
Plaintiff's third claim for minority shareholder oppression was specifically based on the refusal to declare dividends. Based on the plaintiff's concession, the Court accepts without analysis, that the entire fairness standard does not apply to a claim of oppression, and that the plaintiff bears the burden of proof. The Chancellor notes that no Delaware case has defined the legal standard for oppression and therefore utilizes non-Delaware cases which define oppression in the context of statutory claims for judicial dissolution based on oppressive conduct. The Chancellor rejects the defendant's argument that these non-Delaware cases are not good authority in the context of the plaintiff's non-statutory claim under Delaware law. The Court states that these cases "address what constitutes oppressive behavior to minority shareholders. Since I am not aware of a Delaware case that has found oppressive behavior, I look to decisions, such as these, that found oppression for guidance as to whether I can interpret defendants conduct as oppressive abuse of discretion." The chancellor noted that if he finds oppressive conduct, and he can order any number of equitable remedies, including an order to declare dividends.
In defining the legal standard for oppression, the Court relied in particular upon the New York case of Gimpel v. Bolstein, 477 N.Y.S.2d 1014, 1017 (N.Y. Supr 1984), which recognized the principal standard for oppression as violation of the "reasonable expectations" of the minority. The chancellor excepted the definition of "reasonable expectations" as "the spoken and unspoken understandings on which the founders of a venture rely when commencing a venture," citing Gimpel, 477 N.Y.S.2d at 1019. The Court noted that the Gimpel case did not use the reasonable expectations test because the shareholders in the case were not original shareholders, and that court had instead applied the "secondary definition" of "burdensome, harsh and wrongful conduct, a lack of probity and fair dealing in the fears of a company to the prejudice of some of its members, were visible departure from the standards of fair dealing, and a violation of fair play on which every shareholder who entrust his money to a company is entitled to rely."
The chancellor found that the complaint adequately alleged oppression under either definition. The chancellor characterized the defendants' scheme as a "classic squeeze out situation" noting that the failure to pay dividends can be especially devastating in a subchapter S. Corporation setting. Under the "reasonable expectations" test, the Court held that "it is only reasonable to believe that when Waters and Litle entered into these ventures that neither expected that the other would use their power so as to make the stock a liability when the company was making money in order to effectuate a squeeze out." Under the "burdensome, harsh and wrongful conduct" test, the Court noted that the attempt to squeeze out a minority shareholder by failing to pay dividends when the company was able to pay dividends "was a visible departure from the standards of fair dealing and fair play." The Chancellor acknowledged that few, if any, cases have involved a set of facts egregious enough to meet the "fraudulent, repressive or gross abuse of discretion" standard required in challenging a decision regarding the declaration of dividends. However, the chancellor held that for purposes of a motion to dismiss on the pleadings, the plaintiff had adequately stated a claim for oppression.
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