New Indiana "Freeze Out" Claim Opinion

Haag Trucking Co., Inc. v. Haag, --- N.E.2d ----, 2008 WL 5006541 (Ind. App. November 26, 2008).

The Indiana court of appeals has issued an oppression opinion recapping the state of that cause of action in Indiana. The case involved a break-down in a family after the death of the father, that concerned the three family corporations. The son sued is mother in a case tried to the court. The court entered a judgment for damages based on breach of fiduciary duties against one of the corporations and the mother in favor of the son and another of the corporations but found against the son on his claim of freeze out.

Under the Indiana analysis of duties in a closely-held corporation, "[s]hareholders in a close corporation owe a fiduciary duty as well. A close corporation is one which typically has few shareholders and whose shares are not generally traded in the securities market. W & W Equipment Co., Inc. v. Mink, 568 N.E.2d 564, 570 (Ind.Ct.App.1991). The fiduciary duty owed is the same whether it arises from the capacity of a director, officer, or shareholder in a close corporation. G & N Aircraft, Inc. v. Boehm, 743 N.E.2d 227, 240 (Ind.2001). "The fiduciary must deal fairly, honestly, and openly with his corporation and fellow stockholders." Id. (quoting Hartung v. Architects Hartung/Odle/Burke, Inc., 157 Ind.App. 546, 301 N.E.2d 240, 243 (1973))."

The court of appeals upheld the trial court's judgment against the son on his freeze out claim basically because the evidence was disputed. The court noted that the plaintiff has the burden of proof on a freeze out claim: "A freeze-out is the use of corporate control vested in the statutory majority of shareholders or the board of directors to eliminate minority shareholders from the corporation or reduce the minority shareholders' voting power or claims on corporate assets to relative insignificance. Mink, 568 N.E.2d at 574 (citing Gabhart v. Gabhart, 267 Ind. 370, 370 N.E.2d 345, 353 (1977)). A freeze-out implies a purpose to force upon the minority shareholder a change which is not incident to any other business goal. Id. Courts faced with freeze-out issues must reconcile conflicting policies: maximizing shareholder benefits and treating shareholders equally. Id. "On the one hand is the necessity to provide adequate protection for the interests and expectations of minority shareholders, and the other is the necessity of allowing sufficient corporate flexibility, as is required by modern commerce." Gabhart, 370 N.E.2d at 353-54."

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

New Shareholder Litigation opinion--declaratory judgment, receivership, attorneys fees

Fortenberry v. Cavanaugh, No. 03-07-00310, ___ S.W.3d ___, 2008 WL 4997568 (Tex. App.—Austin November 26, 2008). [Click here to read slip opinion]

 

The Austin court of appeals has decided a new case highlighting issues over attorneys' fees and the use of the declaratory judgment procedure in shareholder litigation. The case involved a drawn-out and costly battle over control of a family corporation. The corporation, Fortune Products, Inc., manufactured and sold knife sharpeners. The corporation was originally owned and managed by the father and mother. When the father became ill with cancer, the corporation was restructured to provide equal stock ownership to the son and his wife, on the one hand, and to the daughter and her husband the son-in-law, on the other. Both children and their spouses were on the board of directors. The son was named president. The son-in-law was named vice-president, and the daughter was named secretary-treasurer. It seems that the intent of the restructuring was to have the two families run the corporation cooperatively, with neither exercising control over the other. While the corporation remained solvent and profitable, the two families fell to bickering over management very shortly after both parents died. After several years of squabbling, with built-in deadlock at both the board and shareholder levels, the son purported to exercise his "inherent authority" as president to change the duties of the son-in-law and to bar his involvement in management, participation in the business, access to information, and even presence on the premises. However, both the daughter and son-in-law retained their share ownership, directorships, corporate offices and salaries. Litigation ensued instantly over the extent of the president's actual authority.

The case was tried to a jury, and the trial court entered a judgment based both on the jury findings and on the court's interpretation of the corporation's unambiguous by-laws. Attorneys' fees were tried to the court. The court entered a series of declaratory judgments, appointed a receiver for the corporation, and awarded the daughter and son-in-law almost $800,000 in attorneys' fees. The son appealed. As described in the court of appeals' opinion, the case was characterized primarily as declaratory judgment action, and the principal issue became the award of attorneys fees; however, the declaratory judgment procedure really seems to be the tail wagging the dog. The issue was one of whether the actions taken by the son were proper or improper, whether damages should be awarded on the derivative claims, and whether a receiver should be appointed. Attorneys' fees would certainly have been recoverable under the derivative actions statute and, at least in part, under the inspection of records statute. The court's focus on this case as one for declaratory judgment makes the litigation seem like a bit of an abuse of that procedure, of using the declaratory judgment procedure solely as a mechanism to manufacture a right to recover attorneys fees. However, that challenge was not raised by either party and was not addressed by the court of appeals.  In part, this focus is the result of the jury's findings in which the son's assertions of authority over the son-in-law were clearly wrong, but the jury failed to award damages.  Also, the court of appeals may be faulted for focusing on declaratory judgment aspect of the case as the easiest way to affirm a judgment that seems to have been correct.  However, the danger is that litigants relying on this opinion will seek to cast their disputes principally as requests for declaratory judgments, under circumstances that abuse that procedure and will not be upheld on appeal.

The son attacked the attorneys' fees award on the grounds that the son-in-law was not the prevailing party, given that some of the jury's findings were also against the son-in-law. The court of appeals held that attorneys' fees were recoverable under the declaratory judgment act and did not address the alternative bases of recovery, TBCA art. 5.14(j) (for the derivative actions) and TBCA art. 2.44(B), (D) (for violation of inspection rights). Pursuant to Tex. Civ. Prac. & Rem. Code Ann. § 37.009, "the court may award costs and reasonable and necessary attorney's fees as are equitable and just." The court held that, although the son-in-law did not prevail on every theory, he prevailed sufficiently that the court's determination that the award of attorneys' fees was just and equitable would not be an abuse of discretion. The court also noted, but did not base its holding on, the authorities that a party does not have to substantially prevail to recover fees under the UDJA. See, e.g., Barshop v. Medina County Underground Water Conservation Dist., 925 S.W.2d 618, 637 (Tex. 1996) (fee award not dependent on finding that a party "substantially prevailed"); G. Prop. Mgmt., Ltd. v. Multivest Fin. Servs. of Tex., Inc., 219 S.W.3d 37, 53-54 (Tex. App.—San Antonio 2006, no pet.) ("The Declaratory Judgment Act does not limit an award of attorney's fees only to a prevailing party."). The son also attacked the son-in-law's failure to segregate attorney's fees. The attorneys' fees expert had testified that the declaratory judgment claim on the president's authority was the central issue in the case, that all other matters were inextricably intertwined, and that segregation was therefore not required. The court held that the son had not preserved the issue for appeal because no objection had been made at the time that the evidence was presented to the trial court. See, e.g., Green Int'l, Inc. v. Solis, 951 S.W.2d 384, 389 (Tex. 1997) ("if no one objects to the fact that the attorney's fees are not segregated as to specific claims, then the objection is waived"); McCalla v. Ski River Dev., Inc., 239 S.W.3d 374, 383 (Tex. App.—Waco 2007, no pet.) (to preserve complaint that the opposing party failed to segregate its attorney's fees, "[g]enerally, such an issue is preserved by objection during testimony offered in support of attorney's fees or an objection to the jury question on attorney's fees"); Hong Kong Dev., Inc. v. Nguyen, 229 S.W.3d 415, 454 (Tex. App.—Houston [1st Dist.] 2007, no pet.) (objection to failure to segregate preserved through objection to charge); Apache Corp. v. Dynegy Midstream Servs., 214 S.W.3d 554, 566 (Tex. App.—Houston [14th Dist.] 2006, pet. granted) (failure to object waives opposing party's failure to segregate). However, the court also held that the evidence was sufficient to sustain the implied finding (the son failed to request finding of fact) that segregation was not required. Pursuant to the supreme court's guidelines, a claimant must segregate attorney's fees between claims for which attorney's fees are recoverable and those for which fees are not recoverable. Tony Gullo Motors I, L.P. v. Chapa, 212 S.W.3d 299, 313 (Tex. 2006). When legal services advance both recoverable and unrecoverable claims, however, the services are so intertwined that the associated fees need not be segregated. Id. at 313-14. The need to segregate fees is a question of law, while the extent to which certain claims can or cannot be segregated is a mixed question of law and fact. Id. at 312-13.

The issue of a president's authority comes up frequently in shareholder litigation where the parties are in a position of deadlock. When the shareholders each own 50% of the shares or when the board of directors is evenly divided with no tie-breaking mechanism, then the shareholder who exercises actual managerial control over the business will be in a position of control and will have the ability to oppress the remaining shareholders. However, this ability to control is not necessarily nefarious. When the owners of a corporation are in a position of deadlock, the party with control may be the one acting in the best interest of the corporation, and as a practical matter, somebody has got to continue running the business. The facts in this case certainly indicate that the son believed he was acting in the best interest of the corporation in acting to seek a practical solution to the deadlock over management and that his conduct did not result in the other shareholder's loss of any economic benefits of stock ownership. In this case, the son clearly over-reached his authority under the by-laws of that corporation. While the court agreed that the president did have general day-to-day management authority, it did not include redefining the duties of the vice-president. The by-laws provided the board of directors with the authority to hire officers and employee and to set the terms of their employment, and further expressly stated duties of the vice president. In San Antonio Joint Stock Land Bank v. Taylor, 105 S.W.2d 650, 654 (Tex. 1937); the supreme court had held that "the rule is generally accepted that the president of a corporation may be entrusted by the board of directors with the management of the business of such corporation, and he may perform for the corporation the business it is authorized to transact." The issue, however, was "not whether a board of directors may delegate its authority to a president, but the extent of any such delegation." In Ennis Bus. Forms, Inc. v. Todd, 523 S.W.2d 83, 86 (Tex. Civ. App.—Waco 1975, no writ), the court held that the president had authority to execute an employment contract with a non-officer employee because the bylaws authorized the president to execute contracts "in the ordinary course." In Miller v. A.&N. R.R. Co., 476 S.W.2d 389, 393 (Tex. Civ. App.—Beaumont 1972, writ ref'd n.r.e.), the court determined that the president was authorized to hire the general manager because the bylaws specifically "provided for the appointment of a General Manager by the President." In Mr. Eddie, Inc. v. Ginsberg, 430 S.W.2d 5, 10 (Tex. Civ. App.—Eastland 1968, writ ref'd n.r.e.), the court recognized the general rule that "the president of a corporation has the authority to hire and discharge employees." However, the employees in that case were non-officer employees. The court held that all of these cases are distinguishable because the by-laws governing this corporation provided that the hiring, firing, and delegation of duties to the vice-president were to be exercised by the board. The court held that the by-laws must be read as a whole, and therefore neither the general authority of the president nor the specific delegations of authority permitted the actions taken against the son-in-law. see also Templeton v. Nocona Hills Owners Assn, Inc., 555 S.W.2d 534, 538 (Tex. Civ. App.—Texarkana 1977, no writ) ("settled rule in Texas is that a corporation president, merely by virtue of his office, has no inherent power to bind the corporation except as to routine matters arising in the ordinary course of business"); see also Tex. Bus. Corp. Act Ann. art. 2.42(B) (West 2003) ("All officers . . . , as between themselves and the corporation, shall have such authority and perform such duties in the management of the corporation as may be provided in the bylaws, or as may be determined by resolution of the board of directors not inconsistent with the bylaws.").

The court also upheld the appointment of a receiver. The court indicated that in addition to TBCA arts. 7.05 and 7.06 the court had authority to appoint a receiver in this case under Tex. Civ. Prac. & Rem. Code Ann. § 64.001(a)(3), (6), which provides that a court may appoint a receiver in an action between "partners or others jointly owning or interested in any property or fund" or "in any other case in which a receiver may be appointed under the rules of equity." The court held that it lacked jurisdiction to hear the appeal regarding the appointment of the receiver because the trial court had issued an interim order appointing the receiver before it issued a final judgment, and the son had not brought an interlocutory appeal within 20 days of the interim order. The only remedy available was a motion to terminate the receiver. See Sclafani v. Sclafani, 870 S.W.2d 608, 611 (Tex. App.—Houston [1st Dist.] 1993, writ denied) (distinguishing between an action to terminate a receivership with an action to set aside the receivership). See also Benningfield v. Benningfield, 155 S.W.2d 827, 827-28 (Tex. Civ. App.—Austin 1941, no writ) (court lacked jurisdiction to hear appeal filed 22 days after original order appointing a receiver, but within 20 days of subsequent order appointing different receiver); Long v. Spencer, 137 S.W.3d 923, 926 (Tex. App.—Dallas 2004, no pet.) (because the initial appointment of the receiver was by agreed order, the court concluded that the "general receiver-based complaints and complaints concerning the original receiver were appealable after entry" of the agreed order, and "[a] challenge to the receivership order after twenty days has passed is untimely and will be dismissed by the appellate court.").  This aspect of the court's opinion highlights a real trap for the unwary any time a receiver is appointed.  The filing of an interlocutory appeal to challenge the appointment of a receiver when a final judgment is anticipated in the very near future may seem counter-intuitive and wasteful, but the party desiring to challenge the receivership may otherwise lose that ability.

Finally, this case provides some insight into the proper way to submit jury issues in Texas shareholder oppression cases. While this case was not prosecuted as an oppression case, and the definition of "reasonable expectations" was not submitted, the court did submit the following question regarding an unwritten agreement among the shareholders:

Question 1A

Did the Plaintiff Cavanaughs and the Defendant Fortenberrys agree that as of August 1, 2000, the company would be operated on a 50/50 basis, with neither party having final authority over the other, or did they agree that Dale Fortenberry, Jr., as President, would have final authority on all corporate decisions.

Agreements may be expressed or demonstrated by the course of dealings between the parties. You may consider all of the evidence admitted in this case, including the parties' conduct, the bylaws of Fortune Products, Inc. and the history of the company.

Furthermore, the court submitted a litany of specific acts that would be similar to those submitted in an oppression case:

Do you find that Dale Fortenberry, Jr., engaged in any of the following actions?

* * *

You are instructed that Dale Fortenberry, Jr., is responsible for his actions as well as those persons, if any, who acted with him with knowledge of, agreement with, and intention to accomplish a common objective or course of action.

You are instructed that Jay and Dianna Cavanaugh, as directors of Fortune Products, Inc., are entitled to have access to and inspect all books and records of Fortune Products, Inc.

A. Misapplied the assets of Fortune Products, Inc.?

B. Maliciously suppressed dividends from Fortune Products, Inc.?

C. Excluded Jay or Dianna Cavanaugh from participation in the day to day operations of the company?

D. Excluded Jay Cavanaugh from contact with the Company's sales people, distributors, or customers?

E. Prevented Jay Cavanaugh from performing his duties as Vice President?

F. Withheld information from Jay and Dianna Cavanaugh about Fortune Products, Inc. operations?

G. Altered Fortune Products, Inc.'s computer system to deny Jay Cavanaugh access?

H. Usurped corporate opportunities for Fortune Products, Inc. for himself?

I. Received benefits that other shareholders of Fortune Products, Inc. did not receive?

J. Acted to deliberately reduce the value of the Cavanaughs' stock?

K. Made purchases or entered into contracts not authorized by the Board of Directors of Fortune Products, Inc.?

L. Changed the locks in order to deny Jay and Dianna Cavanaugh access to Fortune Products, Inc. property?

M. Signed checks on Fortune Products, Inc. without authority from the Board of Directors?

N. Violated orders of the Court regarding Fortune Products, Inc. operations?

O. Used Fortune Products, Inc. funds to pay personal expenses?

 

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

Does a minority shareholder have a duty to preserve "S" tax status? Sery v. Federal Business Centers, Inc., Slip Copy, 2008 WL 4934034 (D.N.J. November 14, 2008).

Sery v. Federal Business Centers, Inc., Slip Copy, 2008 WL 4934034 (D.N.J. November 14, 2008).

The United States District Court for the District of New Jersey has released an opinion disposing of summary judgment motions on a claim that a minority shareholder's sale of shares is a breach of fiduciary duties where that sale destroys the corporation's subchapter S tax status. The case arose out of a dispute among the shareholders of a closely-held New Jersey corporation. The minority shareholders originally sued for shareholder oppression and breach of fiduciary duties. The court relates that it had granted summary judgment on those claims and that the minority shareholders intended to appeal; however, that opinion is not currently available. During the course of the litigation, the minority shareholders disclosed that they had pledged some of their shares to a lender to finance the litigation and intended to transfer those shares, which transfer would destroy the corporation's subchapter S status. The majority shareholders counterclaimed for breach of fiduciary duties based on that intended transaction. Ultimately, the court dismissed the counterclaims as not ripe because, in the period of more than a year that the counterclaim had been on file, the transaction still had not taken place.

The situation presents a very interesting application of the concept of fiduciary duties in a closely-held corporation. Typically courts hold that officers, directors, and controlling shareholders owe duties to minority shareholders because these individuals are in a position to control the corporation so as to disadvantage the minority. However, the ability of any minority shareholder to destroy a corporation's Subchapter S tax status by transferring his shares to a non-qualified person or entity is one of the very rare instances in which a minority shareholder, acting solely in that capacity, has the ability to detrimentally affect the corporation and the other shareholders. If a minority shareholder transfers his shares to a foreign national, or to a corporation, or any other person or entity not qualified to own a corporation having elected to be taxed under subchapter S, then the corporation will become a subchapter C corporation; it will pay taxes on its income rather than being taxed on a pass-through basis like a partnership; losses will no longer be treated as tax deductions by the shareholders, and distributions to shareholders will be subject to double taxation. Therefore, a minority shareholder acting to further self-interest by selling his shares can cause significant financial loss to the other shareholders. Does the minority shareholder have an obligation to put the interests of the other shareholders first? Usually fiduciary duties are applied in the closely-held corporation context to protect the ownership interests of minority shareholders. What could be more central to the ownership interests of any shareholder than the ability to sell his property?

In A.W. Chesterton Co., Inc. v. Chesterton, 128 F.3d 1 (1^st Cir. 1997), the First Circuit, applying Massachusetts law, had held that a minority shareholder does violate fiduciary duties in entering into a transaction that causes the corporation to lose its subchapter S status. In that case, a minority shareholder became disenchanted with the management of a closely-held corporation which was consistently losing money. The minority shareholder sought to buy out the other shareholders in order to restructure the corporation and make it profitable, but the other shareholders declined. The minority shareholder then sought to sell his shares to the other shareholders or to an outside party but was unsuccessful. Finally, the minority shareholder came up with a scheme to force the corporation or other shareholders to purchase his shares. He created two corporations, wholly owned by himself, and proposed to transfer his shares to those corporations. The effect of the transaction would be to destroy the corporation's subchapter S status. Pursuant to a shareholder's agreement granting the corporation a right of first refusal, the minority shareholder offered his shares to the corporation, but the corporation was financially unable to exercise the option. The minority shareholder then proceeded to consummate the transaction. See id. at 3-5. The other shareholders sued to enjoin the transaction. The Massachusetts federal district court granted the injunction, and the First Circuit affirmed.

The First Circuit held that, under the law in Massachusetts, shareholders in a closely-held corporation owe enhanced fiduciary duties of utmost good faith and loyalty to each other to the same extent as partners do in a partnership. Id. at 5, citing Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 328 N.E.2d 505 (Mass. 1975). The court noted that the Massachusetts courts had held that these duties apply to minority shareholders just as they do to controlling shareholders. 128 F.3d at 6, citing Zimmerman v. Bogoff, 402 Mass. 650, 524 N.E.2d 849 (Mass. 1988), and Smith v. Atlantic Properties, Inc., 12 Mass. App. Ct. 201, 422 N.E.2d 798 (Mass. App. 1981). The court held that the reasonable expectations of the shareholders arising from the Subchapter S election had to be taken into account in determining the scope of the duties owed, notwithstanding the fact that the plaintiffs had originally argued that the a contract restricting the transfer had been created by the election but subsequently had abandoned that claim. See 128 F.3d at 6-7, citing Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842, 353 N.E.2d 657, 663 (Mass. 1976). The minority shareholder argued that the conduct of a non-managing shareholder should be judged by a lower standard and the transaction should be permitted if a "legitimate business purpose" could be demonstrated. The court held that Massachusetts law did not recognize this lower standard, and that a "legitimate" albeit self-interested purpose would not excuse a breach of the duties of utmost good faith and loyalty by harming the interests of the other shareholders. 128 F.3d at 7, citing Smith, 422 N.E.2d at 800 (holding that minority shareholder's misuse of veto on dividend to the disadvantage of the other shareholders was not excused by his own asserted "legitimate" purpose of tax avoidance). This is perhaps a bit of an overstatement, as the same court later clarified: "The Massachusetts Supreme Judicial Court (SJC) has articulated a two-part test for determining if this fiduciary duty has been violated. First, the defendant must show a legitimate business purpose for its action that allegedly is a breach. If the defendant makes such a showing, the burden shifts to the plaintiff to show that 'the proffered legitimate objective could have been achieved through a less harmful, reasonably practicable, alternative mode of action.' Zimmerman, 524 N.E.2d at 853. Then the court 'must weigh the legitimate business purpose, if any, against the practicability of a less harmful alternative.' Wilkes v. Springside Nursing Home, 370 Mass. 842, 353 N.E.2d 657, 663 (1976)." Medical Air Tech. Corp. v. Marwan Inv., Inc., 303 F.3d 11, 20 (1^st Cir. 2002). However, the court also clearly held that there was no evidence in the record of any legitimate purpose on the part of the minority shareholder. 128 F.3d at 7-8.

Other courts have disagreed. In Hunt v. Data Management Resources, Inc., 26 Kan.App.2d 405, 985 P.2d 730, 732-33 (Kan. App. 1999), the court held that under Kansas law (which follows Delaware) a minority shareholder was under no special duty that would prevent a transfer that would destroy subchapter S tax status. "The law does not impose a strict fiduciary duty on a shareholder to act in the best interests of the corporation; a shareholder is free to act in his or her own self-interest." Id. at 732. In Merner v. Merner, 129 Fed.Appx. 342, 2005 WL 658957 (9^th Cir. 2005), the Ninth Circuit, in an unpublished opinion applying California law, held that a minority shareholder's sale of his shares did not violate any fiduciary duties even though the sale destroyed the corporation's subchapter S status. The court reasoned that California law did not follow the Massachusetts rule and does not recognize any fiduciary duties on shareholders of closely-held corporations that are different from those duties on shareholders in other corporations. Id., citing Stephenson v. Drever, 16 Cal.4th 1167, 69 Cal.Rptr.2d 764, 947 P.2d 1301, 1302, 1307-08 (Cal. 1997).

I have argued that the logic and consequences of the Massachusetts analysis are not satisfying and would not be followed under Texas law. [read article] This is a good example. A shareholder owns his shares and holds his ownership rights and interests arm's length to all other owners and those rights and interests are not subverted by any duty to the corporation or other shareholders. I believe the only party that owes duties is the corporation to the shareholder—in so far as the rights and interests inherent in stock ownership are concerned. Officers, directors and controlling shareholders may be liable to minority shareholders only to the extent that they misuse their power over the corporation to cause the corporation to violate duties owed individual shareholders. Therefore, absent a contract restricting the transferability of shares, a minority shareholder should be able to transfer ownership of his shares without regard to his motive or the effect of the transfer on the other shareholders or corporation. In Medical Air Tech. Corp. v. Marwan Inv., Inc., 303 F.3d 11, 20 (1^st Cir. 2002), the First Circuit faced a situation in which the majority shareholders sued a minority shareholder for voting against a merger. Even though the case was decided under the Massachusetts rule, the court struggled with the notion that other shareholders could second-guess or limit the ability of a minority shareholder to vote. The court ultimately held that, even though the other shareholders were disadvantaged by the vote, the minority shareholder had not violated any fiduciary duties in casting his vote against the merger. Nevertheless, the facts presented in A.W. Chesterton Co., Inc. v. Chesterton, 128 F.3d 1 (1^st Cir. 1997), are extremely troubling. Why should a minority shareholder, having agreed to the subchapter S election, be permitted to blackmail the remaining shareholders for his financial advantage? I think the best solution is to acknowledge that there are situations in which a minority shareholder may be placed in a position where he is able to control the corporation's relationship to its other shareholders, and the minority shareholder use of that power will be subject to fiduciary duties if it infringes on the ownership rights and interests of the other shareholders. Therefore, ordinarily, absent an agreement to the contrary, every shareholder has the right to transfer or sell his shares, but as in A.W. Chesterton Co., Inc. v. Chesterton, 128 F.3d 1 (1^st Cir. 1997), if the minority shareholder is in a position of control over the corporation by his ability to nullify the corporation's subchapter S election, which would directly affect the financial interests of the other shareholders, then fiduciary duties would govern the transaction if the facts established that maintenance of the subchapter S status was an objectively reasonable expectation of the shareholders. In that case, the minority shareholder would breach his fiduciary duties if the transaction were undertaken in bad faith or for the purpose of depriving other shareholders in order to benefit the minority shareholder. Likewise, if a minority shareholder has been given a contractual right to veto dividends, then the use of that control in bad faith or for the purpose of harming the other shareholders will be a breach of fiduciary duties. See Smith v. Atlantic Properties, Inc., 12 Mass. App. Ct. 201, 422 N.E.2d 798 (Mass. App. 1981). However, the right of a shareholder to dissent a fundamental change in the corporation is solely a right of the shareholder and not a matter of controlling the relationship of the corporation to the other shareholders. Therefore, a minority shareholder should always have the right to withhold consent to a merger, dissolution, or sale of substantially all the assets of a corporation without having to justify his motives, even if the other shareholders contend that they were harmed by the inability to complete the transaction. See Medical Air Tech. Corp. v. Marwan Inv., Inc., 303 F.3d 11, 20 (1^st Cir. 2002),

The New Jersey federal court in Sery v. Federal Business Centers, Inc., Slip Copy, 2008 WL 4934034 (D.N.J. November 14, 2008), acknowledged that a New Jersey appellate court had held that New Jersey would follow the Massachusetts rule of applying enhanced fiduciary duties to shareholders of closely-held corporations based on partnership law. See Balsamides v. Perle, 313 N.J. Super. 7, 712 A.2d 673 (N.J. App. 1998), aff'd in part, reversed in part on other grounds, 160 N.J. 352, 734 A.2d 721 (N.J. 1999). However, the federal court expressed some reluctance in following the Massachusetts authorities because the New Jersey Supreme Court had not yet spoken on the issue. The court reasoned: "Here, Defendants would have the Court hold that the duties of good faith and loyalty imposed upon all shareholders of a close corporation would be breached by any sale or transfer of stock that would have the effect of destroying the S corporation's Subchapter S status, regardless of whether the sale was executed in good faith for a reasonable business purpose. This Court does not predict that the New Jersey Supreme Court would find that New Jersey common law is so broad. Conversely, the Court is unwilling to accept Plaintiffs' argument that any fiduciary duties that may normally apply are completely abrogated by provisions of the NJBCA. The Court sees no reason why the common law duties of good faith and loyalty cannot complement the statutory provisions governing restrictions on the transferability of S corporation stock. Indeed, the Court is satisfied that the New Jersey Supreme Court would hold that the fiduciary duties of good faith and loyalty restrict the sale or transfer of S corporation stock to the extent that these duties bar a shareholder from entering into a bad faith or sham transaction which destroys the corporation's Subchapter S status for the primary purpose of injuring fellow shareholders. However, where the shareholder sells or transfers their S corporation shares in good faith in an economically reasonable manner, even if that entails a sale to an unqualified entity, this Court is satisfied that the New Jersey Supreme Court would uphold the sale." The court noted that there were allegations of bad faith on the part of the minority shareholders, that these shareholders had threatened to "go nuclear," by causing the corporation to lose its favored tax status and diminishing the value of the corporation to all the shareholders. However, the court held that until the minority shareholders actually did enter into a real transaction, any holding would merely be advisory.

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

May a corporation defend a derivative suit on the merits? Patrick v. Alacer Corp., 167 Cal.App.4th 995, 84 Cal.Rptr.3d 642 (Cal.App. 2008).

Patrick v. Alacer Corp., 167 Cal.App.4th 995, 84 Cal.Rptr.3d 642 (Cal.App. 4 Dist., October 22, 2008).

The California court of appeals has decided an issue of first impression in California regarding the ability of a corporation to present a defense to a derivative action. Let me first note that the procedural posture of the typical shareholder derivative action can create extremely confusing scenarios that are ripe for abuse. Assume that a shareholder believes that the controlling majority on the board of directors is looting the corporation—violating their duties of loyalty to the corporation to enrich themselves. The controlling majority is able to do this because they are in control of the corporation. They will ignore any plea by a shareholder to stop. They will claim (and perhaps believe) that any effort by a shareholder to have the corporation seek redress for the wrongdoing is not in the best interest of the corporation. The principles of equity in every jurisdiction allow the shareholder in this situation to bring a derivative claim on behalf of the corporation, which claims the shareholder would otherwise not have standing to bring on his own behalf. The shareholder sues as the plaintiff, but the shareholder is only a nominal plaintiff—the real plaintiff is the corporation. It is the corporation whose rights are being vindicated and who will receive the benefit of any recovery. The plaintiff is acting as a fiduciary on behalf of the corporation. However, the law requires that the corporation be joined as a party to the litigation, if for no other reason than to ensure that res judicata applies to any judgment obtained on behalf of the corporation. Therefore, the corporation is an indispensable party, and the nominal plaintiff shareholder is required to sue the corporation as a defendant—but only as a nominal defendant because the corporation is really the plaintiff. Meanwhile, the controlling directors will naturally want the corporation to defend the lawsuit against them, to claim that the lawsuit is frivolous and not in the best interest of the corporation, and to pay for the expense of the defense—yet another example of taking corporate assets for their own personal benefit. Therefore, the poor shareholder often finds himself paying his own money to litigate against his own corporation (which is defending that lawsuit using money ultimately belonging to the shareholders) in an uphill battle to get money for that same corporation.

This was the situation that the California court of appeal recently encountered. The corporation had been started by a husband and wife, both of whom worked in the business, but the husband was the only record owner. The corporation was extremely successful, and the husband at one point transferred all his shares into a trust with instructions to distribute 46% of the stock to the wife upon his death to satisfy her community property interest. The trustees of the trust and others in league with them held a meeting when the 90-year-old husband was deathly ill, and persuaded the husband and the wife to cooperate with a scheme to place these individuals on the board of directors. Three weeks later the husband died; the trustees did not distribute the shares to the wife, but used their control over the stock to oust her from the board, fire her as an employee and officer, and install themselves as the corporate officers. Thereafter, they systematically looted the corporation through excessive compensation and self-dealing transactions. The wife ultimately brought a shareholder derivative action as a beneficial owner. (She also brought an individual action for defrauding her into voting for the election of the board; however the court held that this was properly dismissed for lack of causation because her votes ultimately would not have changed the outcome. She did not sue for shareholder oppression.) The trial court dismissed the case with prejudice on the basis of a demurrer filed by the corporation.

The court of appeals reversed the dismissal of the derivative claims on the grounds that the corporation was not permitted to contest the derivative claims on the merits:

"The issue arises from the basic nature of a shareholder derivative action. 'The management [of a corporation] owes to the stockholders a duty to take proper steps to enforce all claims which the corporation may have. When it fails to perform this duty, the stockholders have a right to do so.' Jones v. H.F. Ahmanson & Co., 1 Cal.3d 93, 107, 81 Cal.Rptr. 592, 460 P.2d 464. (1969). 'The shareholders may ... bring a derivative suit to enforce the corporation's rights and redress its injuries when the board of directors fails or refuses to do so.' Grosset v. Wenaas, 42 Cal.4th 1100, 1108, 72 Cal.Rptr.3d 129, 175 P.3d 1184 (2008). But 'the particular stockholder who brings the suit is merely a nominal party plaintiff.' Klopstock v. Superior Court, 17 Cal.2d 13, 21, 108 P.2d 906(1941). It is the corporation that "is the ultimate beneficiary of such a derivative suit.' Id. Thus, '[t]he corporation [is] the real party plaintiff in the action.' Russell v. Weyand, 5 Cal.App.2d 259, 260, 42 P.2d 381. (1935). Though the corporation is essentially the plaintiff in a derivative action, '[w]hen a derivative suit is brought to litigate the rights of the corporation, the corporation ... must be joined as a nominal defendant.' Grosset, 42 Cal.4th at p. 1108, 72 Cal.Rptr.3d 129, 175 P.3d 1184. The corporation must be joined because 'its rights, not those of the nominal plaintiff, are to be litigated Beyerbach v. Juno Oil Co., 42 Cal.2d 11, 28, 265 P.2d 1 (1954), and to offer the real defendants res judicata protection from later suits. Gagnon Co., Inc. v. Nevada Desert Inn, 45 Cal.2d 448, 453, 289 P.2d 466 (1955). Naming the corporation a defendant, not a plaintiff, follows from the joinder rules: 'If the consent of any one who should have been joined as plaintiff cannot be obtained, he may be made a defendant.' Code Civ. Proc., § 382. So 'although the corporation is made a defendant in a derivative suit, the corporation nevertheless is the real plaintiff....' Jones, 1 Cal.3d at p. 107, 81 Cal.Rptr. 592, 460 P.2d 464. The question now arises-if the corporation is the real plaintiff in a derivative action and the potential beneficiary of any recovery, how can it oppose the action? A demurrer may be filed only by '[t]he party against whom a complaint ... has been filed....' § 430.10. The complaint in a derivative action is filed on the corporation's behalf; not against it. Jones, 1 Cal.3d at p. 107, 81 Cal.Rptr. 592, 460 P.2d 464; Beyerbach, 42 Cal.2d at p. 28, 265 P.2d 1. It is only a 'nominal defendant.' Grosset, 42 Cal.4th at p. 1108, 72 Cal.Rptr.3d 129, 175 P.3d 1184. The only reason the corporation is named a nominal defendant is its refusal to join the action as a plaintiff. § 382. 'The corporation has traditionally been aligned as a defendant because it is in conflict with its stockholders over the advisability of bringing suit.' Note, Federal Courts-Diversity of Citizenship: Corporations-Corporation in Derivative Suit Must Be Realigned as Plaintiff When Not Dominated by Individual Defendants 68 Harv. L.Rev. 193, 194 (1954). In a real sense, the only claim a shareholder plaintiff asserts against the nominal defendant corporation in a derivative action is the claim the corporation has failed to pursue the litigation." 84 Cal.Rptr3d at 651-52.

The court held that the corporation may not defend a claim on the merits, when the claim is brought on behalf of the corporation—although the corporation may assert defenses contesting the shareholder's right to bring the claim on behalf of the corporation, such as lack of standing or the defense that a special litigation committee should control the litigation. See id. at 652. The question was one of first impression in California, but the court noted that other jurisdictions and authorities had reached the same conclusion. See id. at 653, citing Swenson v. Thibaut, 39 N.C.App. 77, 250 S.E.2d 279, 293-294(1978); Sobba v. Elmen, 462 F.Supp.2d 944, 947-950(E.D.Ark.2006); Rowen v. Le Mars Mut. Ins. Co. of Iowa, 282 N.W.2d 639, 645(Iowa 1979); Meyers v. Smith, 190 Minn. 157, 251 N.W. 20-21 (1933); accord Note, 68 Harv. L. Rev. at 194 ("in no case may the nominal defendant [in a derivative action] raise defenses of the real defendants"); Note, Defenses in Shareholders' Derivative Suits-Who May Raise Them 66 Harv. L. Rev. 342, 343 (1952) ("the proper party to invoke a given defense should be the party whom the defense is designed to protect"); see also id. at p. 345 ("The right of the corporation to defend, however, should be limited to those aspects of the case in which it is a real defendant").

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

Damages for Breach of Fiduciary Duties--Norwood v. Norwood, No. 2-07-244-CV (Tex. App.--Fort Worth, November 13, 2008).

Norwood v. Norwood, No. 2-07-244-CV (Tex. App.—Fort Worth, November 13, 2008). Read Opinion

Yesterday, the Second Court of Appeals released an opinion dealing with breach of fiduciary duties to a corporation. The case arose out of a divorce. The husband owned 60% and the wife owned 40% of a corporation that provided catering services to corporate aircraft. The corporation was formed prior to the couple's marriage. Later, the couple filed for divorce but continued to run the business while seeking a purchaser. While the divorce was still pending, the husband discovered that the wife was using company vehicles to steal large amounts of company inventory and equipment and to deliver them to a competitor's place of business. The husband called the police and had the looting stopped, and he fired the wife and barred her from admittance to the corporation's place of business. Four days later, the wife resigned as an employee and director, citing the lock-out. Shortly thereafter, the wife started a new company with the competitor. In addition to the physical materials previously stolen by the wife, she also took the corporation's customer list (and changed the password on the corporation's computer to prevent the husband from utilizing the same information). The wife's new company was then able to hire away all of the corporation's employees, including its chef, and to persuade all the corporation's customers to switch. As a result, the husband shut down the business and sold the remaining equipment. The trial court ultimately entered a judgment against the wife and in favor of the corporation for breach of fiduciary duties as a result of death penalty sanctions for violating discovery orders. The court of appeals affirmed the sanctions and held that the evidence was sufficient to support the judgment.

 

Apparently, the liability theory advanced at trial was based on the wife's fiduciary duties as an employee. The court does not discuss her position as a director at all. The court holds that there was sufficient evidence of the wife's use of the corporation's proprietary information. What is interesting about the opinion is the court's affirmance of the damages award. The award was based solely on the diminution in the going-concern value of the business. On appeal, the wife argued that only out-of-pocket damages were recoverable for breach of fiduciary duties and that there was no evidence of such losses. The court of appeals held that damages resulting from breach of fiduciary duties were not limited to out-of-pocket losses. The evidence supporting the damages award was the testimony of a CPA that the going-concern value of the corporation was $235,000 immediately prior to the wife's leaving and zero afterwards. The court of appeals held that this testimony was sufficient to support a judgment of $235,000 to the corporation. This is an interesting concept because the corporation does not actually suffer the loss of its own value. That loss would be suffered solely by the shareholders, who would not ordinarily have standing to recover that amount directly for a breach of fiduciary duty to the corporation. See Commonwealth of Massachusetts v. Davis, 168 S.W.2d 216, 221 (Tex. 1943) ("Ordinarily, the cause of action for injury to the property of a corporation or the impairment or destruction of its business, is vested in the corporation, as distinguished from its stockholders, even though it may result indirectly in loss of earnings to the stockholders. Generally, the 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.").If this opinion is not reversed, then shareholders may be able to calculate damages in derivative suits based on a diminution in value, which measure will sometimes be more easily calculated than other measures.

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

New Jersey federal court rejects oppression claim under Delaware law.

Nightingale & Associates, LLC v. Hopkins, Slip Copy, 2008 WL 4848765, (D.N.J., November 05, 2008).

In an unpublished opinion, the United States District Court for New Jersey has granted a motion to dismiss an oppression claim for failure to state a claim under Delaware law. The case involved a dispute among the members of a Delaware limited liability company arising from efforts by the company to force a member into retirement. The company sued the minority owner, who then counterclaimed for oppression. The minority owner resided in New Jersey and the events giving rise to the cause of action apparently occurred in New Jersey. And the lawsuit was filed in New Jersey federal court. The minority owner argued that New Jersey law should control, and apparently asserted a statutory oppression claim under New Jersey corporate law. The federal court held that Delaware law governed because the limited liability company was formed in Delaware and because the operating agreement provided for Delaware law. The court then dismissed the oppression claim, stating that Delaware did not have a statutory oppression cause of action and citing the Nixon v. Blackwell, 626 A.2d 1366, 1380 (Del. 1993), for the proposition that "the Delaware Supreme Court has refrained from applying remedies for alleged oppression, finding that a person buying into a minority position can bargain for certain protections." This is a gross misstatement of the holding and reasoning in Nixon v. Blackwell. See Nixon v. Blackwell, 626 A.2d at 1380-81 (holding that claims of minority shareholder oppression in a closely-held corporation may be pursued through the "entire fairness test, correctly applied and articulated"). The court's opinion does not give any analysis of the case or consider any of the numerous authorities holding that Delaware does and would apply equitable remedies for oppressive conduct under a breach of fiduciary duties cause of acgtion. See Clemmer v. Cullinane, 815 N.E.2d 651, 652-53 (Mass. App. 2004) (holding that the Nixon decision did not foreclose a shareholder oppression cause of action, but merely required that the claim be pursued through Delaware's "entire fairness" test, and on that basis held that the plaintiff had stated a claim for shareholder oppression under Delaware law); see, e.g., Hollis v. Hill, 232 F.3d 460, 465, 469 n. 28, 470-71 (5th Cir. 2000); Mroz v. Hoaloho Na Eha, Inc., 410 F.Supp.2d 919, 934-35 (D. Hi. 2005); Minor v. Albright, 2001 WL 1516729 (N.D. Ill. 2001) [review case analysis]; Reserve Solutions, Inc. v. Vernaglia, 438 F.Supp.2d 280, 290 (S.D.N.Y. 2006) [review case analysis]; Sokol v. Education Sys. Corp., 809 N.Y.S.2d 484 (N.Y. Sup. 2005) [review cases analysis]; see also Gagliardi v. TriFoods Int'l, Inc., 683 A.2d 1049, 1051 (Del. Ch. 1996) ("I need not address the general question whether Delaware fiduciary duty law recognizes a cause of action for oppression of minority shareholders; I assume for purposes of this motion, without deciding, that under some circumstances it may."); Litle v. Waters, 1992 WL 25758 (Del. Ch. Feb. 11, 1992) (applying "reasonable expectations test" and holding that plaintiff had stated a claim for minority shareholder oppression) [review case analysis]. Perhaps the court's holding is correct if the minority owner did not plead a claim for breach of fiduciary duty under Delaware law, but the reason given is clearly wrong.

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

Burford-type abstention in federal shareholder oppression cases: Kermanshah v. Kermanshah, --- F.Supp.2d ----, 2008 WL 3338369 (SDNY August 11, 2008).

Kermanshah v. Kermanshah, --- F.Supp.2d ----, 2008 WL 3338369 (SDNY August 11, 2008).

 

A recent shareholder oppression case decided in the United States District Court for the Southern District of New York raises an interesting federal procedure question involving oppression claims. Certainly, there is no shortage of federal cases involving oppression claims, yet in this recent case, the federal court exercised its equitable power to abstain from jurisdiction over the minority shareholder's claim for oppressive conduct. New York is somewhat unusual in that the compulsory buy-out remedy arises under the state's dissolution statute. McKinney's Business Corporation Law §1104-a. New York case law has required plaintiffs to request dissolution in the pleadings in order to invoke the buy-out remedy. In Kermanshah v. Kermanshah, the Southern District of New York abstained from jurisdiction of the plaintiff's oppression claim under Burford v. Sun Oil Co., 319 U.S. 315, 332-34, 63 S.Ct. 1098, 1106-07 (1943), on the grounds that judicial dissolution of corporations is a matter uniquely to be addressed by the New York state courts. The Second Circuit has recognized that dissolving a New York corporation implicates the Burford abstention doctrine, in which "[a] federal court may abstain from hearing a case or claim over which it has jurisdiction to avoid needless disruption of state efforts to establish coherent policy in an area of comprehensive state regulation." Friedman v. Revenue Management of N.Y., Inc., 38 F.3d 668, 671 (2d Cir.1994) (noting the "comprehensive regulation of corporate governance and existence by New York."). The court cited to other cases reaching similar conclusions under the Burford doctrine, noting that courts within the Second Circuit "have almost uniformly ruled that even if federal courts have subject matter jurisdiction over claims for corporate dissolution, they should abstain from exercising it." Feiwus v. Genpar, Inc., 43 F.Supp.2d 289, 296 n. 6 (E.D.N.Y.1999); see, e.g., Astroworks, Inc. v. Astroexhibit, Inc., 257 F.Supp.2d 609, 619 n. 14 (S.D.N.Y.2003) (finding it "doubtful that this Court would have been able to hear" a § 1104-a dissolution claim); Nutronics Imaging, Inc. v. Danan, No. Civ. 96-2950, 2000 WL 33128504 at *1 (E.D.N.Y. July 27, 2000) (abstaining from exercising jurisdiction over claim for corporate dissolution without ruling on subject matter jurisdiction); Zamer v. Diliddo, No. 97-CV-32, 1999 WL 606731 at *5 (W.D.N.Y. Mar. 23, 1999); Kuo v. Kuo, 96 Civ. 5130, 1999 WL 123379 at *7 n. 1 (S.D.N.Y. Mar. 4, 1999) (abstention appropriate even if court has jurisdiction), aff'd, 216 F.3d 1072 (2d Cir.2000); Langner v. Brown, 913 F.Supp. 260, 270-71 (S.D.N.Y.1996) (same); Harrison v. CBCH Realty, Inc., No. 92-CV-434, 1992 WL 205839 at *l-4 (N.D.N.Y. Aug. 13, 1992); Cuddle Wit, Inc. v. Chan, No. 89 Civ. 7299, 1990 WL 115620 at *1-2 (S.D.N.Y. Aug. 7, 1990); In re English Seafood (USA) Inc., 743 F.Supp. 281, 286-89 (D.Del.1990) (holding that the court has subject matter jurisdiction over the plaintiff's claim for corporate dissolution, but that the court should abstain from exercising it); Codos v. Nat'l Diagnostic Corp., 711 F.Supp. 75, 78 (E.D.N.Y.1989); see also Boucher v. Sears, No. 89-CV-1353, 1997 WL 736532 at *16-19 (N.D.N.Y. Nov. 21, 1997) (finding supplemental jurisdiction over state claim to dissolve corporation but abstaining from exercising jurisdiction over dissolution claim). The same result was reached by the Sixth Circuit in Caudill v. Eubanks Farms, Inc., 301 F.3d 658, 663 (6^th Cir. 2002), and by the federal district court in Neary v. Miltronics Mfg. Serv., Inc. 534 F.Supp.2d 227 (D.N.H. 2008).

 

While the Burford abstention doctrine arguably makes sense regarding dissolution of a corporation, its application is far less obvious in the case of an individual shareholder seeking equitable remedies, particularly a compulsory buy-out, for shareholder oppression. Equitable remedies for shareholder oppression are certainly grounded in the same powers as the equitable power of judicial dissolution; yet in actual practice, these lawsuits are much more like an individual claim for damages for breach of fiduciary duties. However, the court in Kermanshah did not make any distinction. The Eastern District of New York case, Feiwus v. Genpar, Inc., 43 F.Supp.2d 289, 299 (E.D.N.Y.1999), explicitly dealt with the question and abstained from hearing requests to dissolve corporation, appoint receiver, compel buy-out of minority shareholder, compel accounting, and void results of shareholders' meetings. Likewise, the district court in Neary v Miltronics Mfg. Serv., Inc., held that it would abstain from hearing not only plaintiffs' dissolution claims, but their other claims for equitable relief as well. 534 F.Supp.2d at 231 (abstaining from claims to compel inspection of corporate records, injunction to prevent ouster of certain directors, and a claim for an accounting). However, both Feiwus v. Genpar, Inc. and Neary v. Miltronics Mfg. Serv., Inc. held that abstention was not required for damages claims for breach of fiduciary duties. Both courts held that the appropriate resolution for the damages claims was to stay those claims pending resolution of the equitable claims in state court. Feiwus, 43 F.Supp.2d at 301; Neary, 534 F.Supp.2d at 232.

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

New Article on Texas Shareholder Oppression

A new article, entitled Shareholder Oppression Cause of Action in Texas—Theoretical Basis, has been posted on www.shareholderoppression.com. [Click here to read] This article explores the nature and source of the duties under Texas law that are protected by the shareholder oppression cause of action. Three more substantial articles regarding the Texas law of shareholder oppression are in the works: One on establishing liability and defending against oppression claims, one on shareholder oppression remedies, and a procedural guide to the oppression cause of action which will include a discussion of the how to submit jury questions in an oppression case. These articles will be posted shortly.

 

 

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

Derivative Suit Standing: Asshaser v. Wells Fargo Foothill, 263 S.W.3d 468 (Tex. App.--Dallas 2008, no pet.).

Derivative Suit Standing: Asshaser v. Wells Fargo Foothill, 263 S.W.3d 468 (Tex. App.—Dallas 2008, no pet.).

 

The Dallas Court of Appeals recently upheld the granting of a plea to the jurisdiction based on a limited partner's lack of standing to bring a claim individually that belongs to the limited partnership. The case held: "Without a breach of a legal right belonging to a plaintiff, that plaintiff has no standing to litigate." 263 S.W.2d at 471 (citing Nauslar v. Coors Brewing Co., 170 S.W.3d 242, 249 (Tex. App.—Dallas 2005, no pet.); Cadle Co. v. Lobingier, 50 S.W.3d 662, 669-70 (Tex. App.—Fort Worth 2001, pet. denied). "Only the person whose primary legal right has been breached may seek redress for an injury." 263 S.W.3d at 471 (citing Nauslar, 170 S.W.3d at 249; Nobles v. Marcus, 533 S.W.2d 923, 927 (Tex.1976) ("Without breach of a legal right belonging to the plaintiff no cause of action can accrue to his benefit.")). A Plea to the Jurisdiction is one of the very few motions under Texas Civil Procedure that can result in the dismissal of the lawsuit based solely on the plaintiff's pleadings. "The plaintiffs have the burden of alleging facts, if taken as true, affirmatively demonstrating a court's jurisdiction to hear a case." 263 S.W.3d at 471 (citing Nauslar v. Coors Brewing Co., 170 S.W.3d at 248). "Standing, as a component of subject matter jurisdiction, cannot be presumed, and the burden of alleging facts affirmatively showing the trial court's subject matter jurisdiction lies squarely with appellants." 263 S.W.3d at 473 (citing Bowles v. Wade, 913 S.W.2d 644, 649 (Tex. App.—Dallas 1995, pet. denied), abrogated on other grounds by Essenburg v. Dallas County, 988 S.W.2d 188 (Tex. 1998)). However, the court construes the pleadings in favor of the plaintiff. 263 S.W.3d at 471 (citing Nauslar, 170 S.W.3d at 249).

 

The plaintiffs were individuals who invested a total of $30 million in several Texas limited partnerships for the purpose of constructing a shopping mall. The project ran short of money, and Wells Fargo was asked to provide additional financing. That loan was later restructured, and Wells Fargo became a limited partner. Later a new lender was brought in, who provided additional financing but also bought out Wells Fargo's interest. Eventually, the project failed, and the plaintiff's lost their entire investment. Plaintiffs sued everyone associated with the project asserting individual claims for fraud and breach of fiduciary duty. Wells Fargo filed a plea to the jurisdiction, claiming lack of standing. The trial court sustained the plea, and the appellate court affirmed, holding that the breach of fiduciary duty claims asserted against Wells Fargo belonged to the limited partnerships and could not be brought by the limited partners individually. 263 S.W.3d at 472, reaffirming the holding in Nauslar v. Coors Brewing Co., 170 S.W.3d 242, 251 (Tex. App.—Dallas 2005, no pet.). The court stated: "We concluded Nauslar did not have a separate, individual right of action for injuries to the limited partnership that diminished the value of his ownership interest in the entity. Id. Willow, as the limited partnership, was the entity who suffered the direct injury from the harm to the limited partnership's worth and any loss to plaintiffs was both 'indirect to and duplicative of' the entity's right of action. Id. at 251. We concluded by noting '[t]he right of recovery is Willow's alone, even though the economic impact of the alleged wrongdoing may bring about reduced earnings, salary, or bonus.' Id." The court held that the plaintiff's complaint was that the money they invested in the limited partnerships was "squandered." The court held that these claims belong to the limited partnerships.

 

The plaintiff's predicament in this case is reminiscent of that in the landmark corporate law case of Cates v. Sparkman, 11 S.W. 846 (Tex. 1889), in which the plaintiff owned lands with coal deposits and entered into an agreement with the defendants to develop the deposits. The defendants formed a corporation, and the plaintiff placed the land into the corporation in exchange for stock. The project failed, and the plaintiff lost his land and was left with worthless stock. Similarly, the plaintiffs in Asshauser v. Wells Fargo Foothill, placed their money into the companies in exchange for limited partnership units for the purpose of developing a shopping mall; the project failed, and the plaintiffs lost their money and were left with worthless paper. In both situations, the representations, commitments and agreements that induced the plaintiffs to enter into the transactions were made to them in their individual capacities, and therefore they argued that the failure to keep those commitments was a wrong done to the plaintiffs individually, and certainly the plaintiffs felt the pain of the financial losses as individuals. However, both courts held, in essence, that once the money or property goes into the company, the duties regarding the management and use of those assets also go into the company. The plaintiffs in Asshauer attempted to persuade the court that the standing rule should apply only to preexisting entities, and that the limited partners should be able to sue individually if the fraud and breach of fiduciary duties was somehow involved in the creation of the limited partnership. The court of appeals did not bite, holding that there was no such exception that would confer standing where it did not otherwise exist. 263 S.W.3d at 472.

 

The plaintiffs also argued that the limited partnerships should be ignored entirely because they were from the start a sham to perpetrate a fraud. The court rejected that argument out of hand as contrary to the limited partnership statute. Id. at 473. The court did state that if Wells Fargo had acted to control the partnership, then it might be liable as a general partner, but that the plaintiffs had not alleged facts that would establish this theory. Id. (Actually, even if Wells Fargo was a de facto general partner, that would not change the lack of standing of the limited partners to sue on claims belonging to the limited partnership.) Finally, the court held that the limited partnership could not be pierced or ignored under an "alter ego," "sham to perpetrate a fraud," or similar theory because such a theory is not available for a limited partnership, for the reason that there is no "veil" to pierce in a limited partnership because a general partner is always primarily liable. Id. at 474 (citing Pinebrook Props., Ltd. v. Brookhaven Lake Prop. Owners Ass'n, 77 S.W.3d 487, 499-500 (Tex. App.—Texarkana 2002, pet. denied)). The court concludes: "Appellants further argue to refuse them standing to pursue their claims will result in an incurable injustice and provide a roadmap for other 'fraudsters' to entice other unsuspecting investors into a scheme that defrauds them of millions. Although appellants' allegations, if true, may amount to an egregious tale of mismanagement or deception, we refuse to alter the clear language of the limited partnership act and case law to afford them standing to sue."

 

The court's analysis is somewhat confused and misleading on these last points. If the plaintiffs were defrauded into entering into the partnership transaction in the first place, that is if they relied on false representations in exchanging their money for limited partnership units, then obviously the limited partnership form would not shield the fraud. In that case, the plaintiff's individually would have claims for fraud, and there would be no standing issue whatsoever. And, of course, the formation of the limited partnerships (or at least the investment transactions in which the plaintiffs participated) could be rescinded. The issue of "piercing" the "veil" of the limited partnership for the purpose of allowing one limited partner to sue another is a complete nonsequitor. If Wells Fargo had participated in the fraud or conspired in the fraud, then the plaintiffs would have individual claims against Wells Fargo without regard to whether or not Wells Fargo was a limited partner. The appellate opinion indicates that the plaintiffs did make these kinds of fraud claims in the lawsuit. Apparently, however, (although the court does not disclose this) Wells Fargo's participation in the challenged transaction came well after the plaintiffs had allegedly been defrauded into participating. If so, then any fraud that Wells Fargo committed in connection with the funding of the project would have been a fraud solely on the limited partnership.

 

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com