Case Analysis: Reserve Solutions v. Vernaglia: Oppression Claim Involving Delaware Corporation

Reserve Solutions, Inc. v. Vernaglia, 438 F. Supp.2d 280 (S.D.N.Y. 2006).

A Delaware closely-held Corporation brought suit against a minority shareholder and former officer and director. The minority shareholder counter claimed for shareholder oppression and other claims and brought third-party claims against the majority shareholders for oppression. The counterclaim-defendants moved to dismiss for failure to state a claim. Vernaglia formed Reserve Solutions, Inc. with three other shareholders who were members of the same family. Vernaglia received 45% of the stock in exchange for his agreement to devote his efforts to managing to Corporation and to developing software for the Corporation, applying for patents, and assigning his intellectual property to the Corporation. Vernaglia was requested to make a capital contribution in the amount of $132,000, which he did. The remaining shareholders also agreed to make a capital contribution in the amount of $3 million, but recorded it as a loan from the shareholders. The majority shareholders also transferred the administration of the Corporation's finances to a related Corporation that they controlled. After several years, Vernaglia began investigating financial improprieties, eventually concluding that $20 million of corporate money had been misappropriated by the majority shareholders. Shortly thereafter, Vernaglia was terminated on the grounds that he had misappropriated corporate funds to pay personal credit card bills. Vernaglia contended that each of the payments was authorized by the other shareholders, and each was either compensation owed to him by the Corporation or reimbursement for business expenses.

The Court held that Delaware law recognizes a cause of action for minority shareholder oppression, citing Litle v. Waters, 1992 WL 25758 (Del. Ch. 1992). The Court held that shareholder oppression under Delaware law is satisfied by proof of a violation of the reasonable expectations of the minority shareholder or "a visible departure from the standards of fair dealing and fair play." On the basis of the facts pleaded by Vernaglia, the court denied the motion to dismiss.

"Accepting the facts as alleged by Vernaglia as true for the purposes of this motion, Vernaglia had a reasonable expectation of continued participation in the management of Reserve and in the exploitation of the patents he developed. On the same basis, the Bents had no good faith grounds to believe that Vernaglia was converting corporate funds for his personal use. Instead, they persuaded Vernaglia to contribute the $132,000, duped him into believing that his shares had been diluted, and ousted him from the company in retaliation for his legitimate investigation into corporate waste and mismanagement and for the purpose of consolidating their control of the company, and against any interest of the corporation. Thus, if the evidence bears out Vernaglia's pleadings, the Bents' behavior departed significantly from the standards of fair dealing and fair play expected between co-fiduciaries. Vernaglia has properly stated a claim for oppression of a minority shareholder under Delaware law." 438 F. Supp.2d at 290.

Case Analysis: Sokol v. Ventures Education Sys. Corp.: Oppression Claim Involving Delaware Closely-Held Corporation

Sokol v. Ventures Education Systems Corp., 10 Misc.3d 1055(A), 809 N.Y.S.2d 484, 2005 WL 3249447 (N.Y.Sup. June 27, 2005).

The plaintiff minority shareholder sued the defendant majority shareholder in a closely-held a Delaware corporation for oppression, claiming that she terminated his employment, excluded him from management, refused to provide him with financial information or keep him informed of corporate affairs, improperly diluted his share interest by issuing new shares, and was guilty of mismanagement and misappropriation of corporate assets. Plaintiff claimed violation of his reasonable expectations of employment and continued participation in management and sought judicial dissolution or a forced buyout of his shares at fair value. The defendant moved for summary judgment on plaintiff's claims.

As an initial matter, the court held that a Delaware corporation could only be dissolved by an order of a Delaware court and dismissed claims for appointment of a liquidating receiver and for dissolution; however, the court held that it did have jurisdiction to award other relief sought by the plaintiff under Delaware law. In reviewing any plaintiff's claim for oppression, the Court acknowledged Nixon v. Blackwell and held that because the Corporation had not elected close corporation status under Delaware statutory law, the dispute would be governed by the same law that applies to corporations generally. Relying on Litle v. Waters, the court held that Delaware law recognizes two definitions for oppression: "violation of the reasonable expectations of a minority," and "burdensome, harsh and wrongful conduct, a lack of probity and fair dealing in the affairs of a company to the prejudice of some of its members, or a visible departure from the standards of fair dealing."

The court held that plaintiff's claims were not sufficient to raise a triable issue regarding the existence of oppression under Delaware law. Citing Gagliardi
v. TriFoods International, Inc., 683 A.2d 1049, 1051 (Del. Ch.. 1996), the Court held that the Board of Directors of the Corporation has no duty to furnish information to a shareholder other than to comply with Section 220 of the Delaware corporate law, which provides the sole remedy. Further, the Board of Directors has no legal or other duties to enter into arrangements with the plaintiff or to avoid transactions that will have the effect of diluting plaintiff's proportional shareholding, so long as it acts in good faith for the benefit of the Corporation. The court held that the plaintiff had produced no evidence of written or oral agreement or Delaware law providing him the rights and privileges that he claimed that defendant denied him. The court also noted that the application of the "entire fairness" test to the alleged misconduct did not require a different conclusion. Plaintiff had participated in some of the transactions that he challenged, and the Court held that there was no evidence that the private sale of stock to individual shareholders was in any way unfair to plaintiff. The court also held that plaintiff's expectations of continued employment were neither reasonable nor well-founded. The court noted that plaintiff did not have and employment contract that that Delaware law provides that a corporation owes no special fiduciary duty to a shareholder who is an at-will employee with respect to continued employment, citing Ueltzhoff v. Fox Fire Dev. Co, 17 Del. J. Corp. L 1297 (Del. Ch. 1991), aff'd su nom Fox Fire Dev. Co. v. Hans, 618 A.2d 90 (Del. 1992). The court held that various statements allegedly made to plaintiff, that defendant would keep him in management so long as she had control of the corporation and that the corporation would make distributions when cash was available, were too vague and indefinite to constitute enforceable contracts.

The court also grant summary judgment on plaintiff's close of corporate waste, mismanagement, and self-dealing because these claims belong to the Corporation on plaintiff failed to allege than any derivative action.

New Case: Georgeson v. DuPage Surgical Consultants, Ltd: Illinois oppression case

Georgeson v DuPage Surgical Consultants, Ltd., Slip Copy, 2007 WL 914219 (N.D.Ill. Mar 22, 2007)

A doctor-shareholder in an Illinois professional corporation sued the two other doctor-shareholders who controlled a majority of shares of the corporation. Plaintiff had purchased his shares in 1998 for $150,000 (which was paid over time through salary reduction), but was never issued actual share certificates. Plaintiff left the practice in 2002. He contacted the other shareholders twice about purchasing his shares but received no response. Although there was no shareholders' agreement providing for the purchase of shares of departing shareholders, on two prior occasions the corporation had bought out other shareholders leaving the practice by returning their paid-in capital. The defendants decided that, because plaintiff had not been issued share certificates, he was not a shareholder. Therefore, they removed his name from the corporation's tax return as a shareholder and ceased to make distributions. Plaintiff sued for oppression and breach of fiduciary duty under the Illinois corporations statute which prohibits "directors or those in control" from acting in a way that is "illegal, oppressive, or fraudulent with respect to" the other shareholders. 805 Ill. Comp. Stat. 5/12.56(a)(3).

Th court noted that under Illinois law conduct is oppressive if it is "arbitrary, overbearing and heavy-handed," citing Compton v. Paul K. Harding Realty Co., 285 N.E.2d 574, 499 (Ill.App.Ct.1972). In Compton, the court had held that the defendant had oppressed a minority shareholder by "failing to call meetings of the board of directors or to consult with plaintiff Compton regarding management of corporate affairs." In other words, the defendant oppressed the minority shareholder by shutting him out of the corporation's affairs. Id. See also Gidwitz v. Lanzit Corrugated Box Co., 20 Ill.2d 208, 170 N.E.2d 131, 138 (Ill.1960) (shareholder of closely-held corporation used his position as president to oppress the other shareholders by denying them their "rights and privileges," including the right to participate in the management of the corporation); Notzke v. Art Gallery, Inc., 84 Ill.App.3d 294, 39 Ill.Dec. 860, 405 N.E.2d 839, 843 (Ill.App.Ct.1980) (conduct that "allegedly affect[ed] an individual shareholder's control over corporate matters" was oppressive).

The court held that plaintiff had presented evidence that the defendants shut him out of the corporate affairs of the corporation. According to plaintiff, upon his departure the defendants eliminated his shares (as reflected on corporate income tax returns which no longer listed Georgeson as a shareholder), and refused to compensate him for those shares even though they had compensated the other shareholders who had left. The court held that plaintiff's evidence, if true, shows that the defendants completely denied him the incidents of ownership of his shares in the corporation, and therefore the evidence is sufficient to withstand summary judgment on plaintiff's claim of oppression.

The first defense offered was that plaintiff lacked standing because the claims belong to the corporation. Plaintiff had alleged a variety of misconduct that involved primarily breaches of duties owed to the corporation, such as failure to keep records and excessive salaries, but plaintiff agreed not to rely on these facts. The court further held that plaintiff was directly injured by the failure to maintain corporate records and that the oppression claims, particularly that claim that "the defendants stripped him of all incidents of ownership," clearly belonged to the plaintiff individually. While the court holds that the attempt to deny plaintiff's share ownership was oppressive, the court also indicates that plaintiff has asserted a valid claim for the failure to buy back plaintiff's stock as had been done for all previous shareholders who left the practice. Presumably, this claim would be based on plaintiff's reasonable expectations, although the court does not use that terminology.

Next, defendants argued that plaintiff lacked standing because his Illinois medical license had lapsed and therefore plaintiff was prohibited from continuing to own stock in an Illinois medical corporation. The court rejected the conclusion that the statute automatically divested plaintiff of his shares and pointed out that the statute provided a procedure for buying out plaintiff with which the defendants had failed to comply. See Illinois Medical Corporation Act, 805 Ill. Comp. Stat. 15/13.

Next, defendants invoked the business judgment rule, which the court rejects as inapplicable to a claim of oppression. "The presumption that normally shields defendants for their business decisions does not apply if the plaintiff presents evidence of fraud, bad faith, or self-dealing." See Shlensky v. Wrigley, 237 N.E. 776, 779-80 (Ill.App.Ct.1968); see also Sharper v. Bryan, --- N.E.2d ----, No. 1- 05-3849, 2007 WL 703547, at *4 (Ill.App.Ct. Mar. 8, 2007) ("This presumption applies when there is no evidence of fraud, bad faith, or self-dealing in the usual sense of personal profit or betterment on the part of the directors.") (applying Delaware law). The court noted that the other shareholders would benefit personally by eliminating plaintiff's ownership in the company without payment. Finally, the court rejects the defense of laches because the defendants did the demonstrate any prejudice from delay.

The court also denied summary judgment on plaintiff's claim for breach of fiduciary duty; holding that shareholders in a close corporation owe a fiduciary duty to deal fairly, honestly, and openly with each other. See Rexford Rand Corp. v. Ancel, 58 F.3d 1215, 1218 (7th Cir.1995); Hagshenas v. Gaylord, 199 Ill.App.3d 60, 145 Ill.Dec. 546, 557 N.E.2d 316, 321-22 (Ill.App.Ct.1990). The defendants argued only that there was no evidence of mismanagement. The court noted that plaintiff's claims were not breach of the duty of care, based on mismanagement, but breach of the duty of loyalty based on oppressive conduct, citing See Rexford Rand, 58 F.3d at 1218 (oppressive conduct by controlling shareholder is evidence that the controlling shareholder breached its fiduciary duty to the minority shareholder).

Finally, the court denies summary judgment on the claim of civil conspiracy. The court acknowledges that officers and employees of a corporation cannot be considered to be conspirators under the intracorporate conspiracy doctrine as long as they were acting within the scope of their authority. See Payton v. Rush-/ Presbyterian-St. Luke's Med. Ctr., 184 F.3d 623, 632 (7th Cir.1999). However, the doctrine is inapplicable if the employees or officers acted outside the scope of their authority, or acted in their own self-interest. See United States v. All Meat & Poultry Prods. Stored at LaGrou Cold Storage, --- F.Supp.2d ----, No. 02 CV 5145, 2007 WL 30542, at *8 (N.D.Ill. Jan.3, 2007). Because plaintiff has brought forward evidence of self-dealing by defendants, the court holds that plaintiff has a conspiracy claim.

Case Analysis: Litle v. Waters: Delaware case upholding oppression cause of action

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.