Discussion of Valuation in Forced Buyout

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

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

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

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

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

New York Derivative/LLC case

Bartfield v. Murphy, 578 F.Supp.2d 638 (S.D.N.Y. Sep 29, 2008).

The United States District Court for the Southern District of New York has delivered an opinion that highlights several important procedural issues having to do with LLCs and derivative suits. This case involved a New York LLC that had two members, each with 50% ownership, and who had agreed to participate equally in management. The business involved underwriting medical stop-loss insurance policies. The breakdown in the relationship came over a series of business missteps that one of the members attributed solely to the other, which hurt the company financially and ultimately lead to a complete breakdown between the members. The Plaintiff was a citizen of Florida. The Defendant was a citizen of New York. The Plaintiff sued the Defendant individually in New York federal Court and did not name the LLC as a party.

The issue confronting the Court was whether it had subject matter jurisdiction. (It should be noted that it appears the Court raised this issue sua sponte and that the Defendant was content with proceeding in federal Court.) Jurisdiction was based solely on diversity, and the two members of the LLC had diverse citizenship. However, LLCs (unlike corporations) have the citizenship of each of their members. 578 F.Supp.2d at 644; Bischoff v. Boar's Head Provisions Co., 436 F.Supp.2d 626, 634 (S.D.N.Y. 2006); Carden v. Arkoma Assoc., 494 U.S. 185, 195-96, 110 S.Ct. 1015, 108 L.Ed.2d 157 (1990) ("[C]itizenship of an artificial entity ... in a suit by or against the entity depends on the citizenship of 'all the members,' 'the several persons composing such association,' [or] 'each of its members.' "). Therefore, the LLC was a citizen of both New York and Florida and could not be joined as a party, as joinder would destroy diversity.

The question of whether the LLC was required to be joined depended on whether the Plaintiff's claims were direct or derivative. The Court noted that the New York Court of Appeals had only recently resolved a split among the lower Courts, holding that a member of an LLC has standing to sue derivatively on behalf of the company. 578 F.Supp.2d at 646, citing Tzolis v. Wolff, 10 N.Y.3d 100, 105-106, 855 N.Y.S.2d 6, 884 N.E.2d 1005 (2008). Under New York law, an individual only has standing to bring suit when a wrongful act injures a legal right or property interest he holds. See, e.g., Warth v. Seldin, 422 U.S. 490, 500-01, 95 S.Ct. 2197, 45 L.Ed.2d 343 (1975). However, a shareholder in a corporation or a member and an LLC may bring a derivative claim on behalf the entity. When a derivative claim is brought, the entity is an indispensable party. 578 F.Supp.2d at 645. New York law follows the "direct injury test" to determine if a claim must be raised derivatively. Id. at 645. The issue is whether the "primary injury" for which relief is sought directly affects an interest the Plaintiff holds, or if it injures the legal entity's interests, which then derivatively injures the Plaintiff. See, e.g. Excimer Assocs. v. LCA Vision, Inc., 292 F.3d 134, 139-140 (2d Cir. 2002). ("[T]he critical question posed by the direct injury test is whether the damages a Plaintiff sustains are derivative of an injury to a third party. If so, then the injury is indirect; if not, it is direct."); Lenz ex rel. Naples Tennis Resort, 833 F.Supp. 362, 379-80 (S.D.N.Y. 1993) ("[T]he determination of whether a suit is derivative or direct turns on the nature of the injury alleged and the entity which sustains the harm.").

The Plaintiff alleged thirteen breaches of fiduciary duties, which he contended were individual claims rather than derivative claims. Almost all of these claims had to do where poor business decisions that damaged the company financially or destroyed the company's "book of business" and thus injured Plaintiff's "direct, indirect, or residual interest" in the Company's "book of business and/or its benefits." The Plaintiff also alleged claims for misappropriation of the company's assets, which the Plaintiff argued were direct claims since the misappropriation interfered with his individual ability to benefit from those assets. The Court held that all these claims were derivative. Id. at 647-48. The assets that were misappropriated belonged to the company; the business that was damaged was the business of the company. Plaintiff suffered only as a result of his ownership interest in the company. The Plaintiff also claimed that the Defendant had violated his individual rights by assuming control of the company and excluding the Plaintiff from his right of management. The Court acknowledged that this could be an individual claim, but the only damages alleged to result from this violation of the Plaintiff's individual rights was harm to the company. Plaintiff also alleged that there was a failure to disclose. This claim is a little more complex because there is an individual duty to disclose as between members of an LLC. Salm v. Feldstein, 20 A.D.3d 469, 470, 799 N.Y.S.2d 104 (2d Dep't 2005) (failure to disclose third party offer for LLC prior to Defendant member's purchase of Plaintiff's shares). However that duty to disclose is an individual duty only when it involves individual interests. For instance, a member would have a duty to disclose material facts to another member before buying or selling ownership units in the company. But the duty to disclose as to matters relating to be company's business, such as the existence of a corporate opportunity, is a duty that would be owed to the company – even though the duty in this case would be complied with by making disclosure to the other member. Because the pleadings did not state whether the failure to disclose involved a duty of disclosure to the company or a duty of disclosure to the Plaintiff, the Court ordered the Plaintiff to replead.

Because all of the Plaintiff's claims, with one possible exception, were claims belonging to the company, the Court held that the LLC was an indispensable party. The Court also held that the LLC was an indispensable party on the Plaintiff's declaratory judgment claims because the rights and interests about which a declaratory judgment was sought belonged primarily to the company. Under rule 19, the Court was then required to determine whether the case must be dismissed. Based primarily on the fact that the Plaintiff had an adequate remedy in state court, the Court held that "equity and good faith preclude adjudicating the derivative claims among the existing parties." 578 F.Supp2d at 650. Therefore, the Court dismissed all claims except failure to disclose claim, and ordered the Plaintiff to replead that claim. As the Court related the facts of the case, it seems highly unlikely that the Plaintiff's failure to disclose claim could relate to anything other than a matter about which the duty to disclose ran only to the company.

The rule that a corporation or LLC is an indispensable party in a derivative suit is one that tends to be strictly followed by the Courts. It must be admitted, however, that this rule in many cases is really one of form over substance. In this case, there were only two owners. 100% of the ownership interests were parties to the case. If the Plaintiff recovers on behalf of a company on the derivative claims, as a practical matter, he would be the only party receiving the benefit of the judgment. No other absent parties' interests were at risk. The Court states: "CFE [the company] may wish to contend that Murphy should pay more than Bartfield demands or that it has other obligations that should be evaluated when determining what is due Bartfield. Unless joined, CFE would either be unable to make such arguments, or could only do so in a separate lawsuit thereby exposing Defendants to a risk of subsequent, inconsistent obligations. As the requested judgment would directly determine the rights of CFE, the Court finds that CFE has an interest sufficient to require joinder and would suffer prejudice if not joined." While these statements would undoubtedly be true in a case where there were other non-party shareholders or members, it is most certainly not true in this case. Apart from one or both of the members, the company in this case would not have the ability to make any such assertion. If the Plaintiff recovered in this case, the Plaintiff would certainly be precluded from causing the company thereafter to bring another claim against the Defendant. Any third party that bought the company would also be precluded from doing a claim against the Defendant under the Bangor Punta doctrine. See Banfor Punta Operaations, Inc. v. Bangor & A.R. Co., 417 U.S. 703, 94 S.Ct. 2578 (1974).

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

Texas Executive Compensation Decision--Carbona v. CH Medical, Inc.

Carbona v. CH Medical, Inc., 266 S.W.3d 675 (Tex. App.—Dallas, October 23, 2008)

The Dallas Court of Appeals recently issued an executive compensation decision. The defendant executive was the former chief executive officer of C.H. Medical, and a director of CH Industrial, Inc. He was sued by the two corporations for breach of contract and breach of fiduciary duties relating to his calculation of his exit bonus at the time of termination. C.H. Medical was a wholly-owned subsidiary of CH Industrial, Inc., which was itself entirely owned by a single shareholder who was actively involved in management and had hired the defendant. At the time the defendant was hired, he signed an employment agreement that provided for a schedule of bonuses. When the opportunity arose to sell the subsidiary, which would necessarily involve the termination of the defendant, the bonus arrangement in the employment agreement was replaced with a new bonus agreement providing for the calculation of an exit bonus based on the net sales price of the subsidiary. Ultimately, the subsidiary was sold, the defendant was terminated, and the defendant calculated and was paid an exit bonus under the terms of the bonus agreement. However, the shareholder of the parent corporation became concerned over the size of the bonus, which he believed was inflated by the exclusion of a $7 million intercompany payable from the bonus calculation. The trial court held that the bonus agreement was ambiguous and submitted the interpretation of the agreement to the jury. A jury found that the intent of the parties was to include the intercompany payable and found that the defendant had failed to comply with the contract in calculating his bonus. The jury also found that the defendant committed breach of fiduciary duties and fraud in failing to disclose the fact that the intercompany payable was not explicitly included in the bonus calculation. The trial court granted a motion to disregard the jury findings on fraud and breach of fiduciary duties, but entered a judgment in favor of the corporations for breach of contract in an amount of more than $2 million.

The Court of Appeals reversed a breach of contract judgment. The Court of Appeals held that the terms of the bonus agreement were explicit and unambiguous and that as a matter of law the contract did not include the intercompany payable in the bonus calculation. While the express terms of the bonus agreement contemplated the inclusion of accounts payable to reduce the amount of the bonus in the calculation, each of the accounts payable was separately listed, and the intercompany payable was not on the list. The Court of Appeals affirmed the trial court's refusal to render a judgment on the fraud and breach of fiduciary duty findings, holding that there was not sufficient evidence of a misrepresentation or nondisclosure. The companies contended that the defendant had failed to disclose the fact that the intercompany payable was not included in the formula for calculating the bonus, and the jury apparently agreed. The Court of Appeals held that there was no failure to disclose because the non-inclusion of the intercompany payable was patently obvious on the face of the written agreement.

What is interesting about this case is that the Court of Appeals' analysis pays absolutely no attention to the fact that the defendant, as an officer and director, was subject to fiduciary duties to the corporations with respect to the negotiation and performance of the bonus agreement. The Court of Appeals' analysis treats the contract as if it were an ordinary, arms-length transaction. It is likely that the original employment agreement was an arms-length transaction and was not subject to fiduciary duties, but the bonus of agreement that replaced the original contract was most certainly negotiated, executed, and performed while the defendant owed fiduciary duties to both corporations. Based on the Court's statement of the facts in the record, the result is not necessarily wrong, but the analysis most certainly is wrong.

In order for an officer and director to seek compensation, even under a written contract with the corporation, the transaction must be fair to the corporation and executed in good faith. Even if the terms of the contract were not ambiguous, the defendant would still have had the burden of proving that the agreement was signed with full disclosure, in good faith, and was fair to the corporation in all respects. There must be some question as to whether the defendant could have satisfied this burden given that (1) the exclusion of the intercompany payable, according to the jury, was not intended by the parties and (2) all of the accounts payable were included in the calculation to reduce the size of the bonus, except for the single largest account payable which was larger than the other accounts payable by a factor of ten. Even if the transaction was not fair for corporations, the shareholder of each corporation could certainly agree to the transaction or ratify the transaction with full knowledge of the unfairness and a conscious decision to disregard the unfairness, but the defendant would have to prove that the shareholder was made aware of the exclusion and consciously intended to approve that exclusion and that he acted in good faith. Even if the shareholder should have figured out that the written contract did not accurately reflect the intent of the parties, a fiduciary is not permitted to take advantage of a mental lapse by the shareholder, and the defendant surely could not have signed the agreement in good faith knowing that the terms of the contract did not reflect the intent of the parties, unless the demonstrate that it was reasonable for him to assume that the shareholder had changed his mind about the intent of the agreement. Such an assumption by the defendant, however, could hardly be reasonable without full, explicit disclosure of the change or some form of communication of approval of the change by the shareholder.

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

Liability of attorneys for aiding and abetting breach of fiduciary duties--Span Enterprises v. Wood

Span Enterprises v. Wood, No. 01-07-00364-CV (Tex. App.—Houston [1^st Dist.] December 4, 2008). [click here to read opinion]

Triumph Healthcare, LLP was a startup venture seeking investors, and was formed as a limited liability partnership. Triumph reached an agreement with Span to invest $500,000, of which $200,000 would be capital and $300,000 would be a loan. Triumph was represented by attorney Ivan Wood. Triumph consulted with Wood prior to reducing the agreement with Span to writing. Woods suggested that Triumph issue span "Series A preferred partnership units" instead of incurring $300,000 in debt. The idea was proposed to Span, which agreed on the understanding that the $300,000 would be paid back, the preferred units would be converted to common units, and Span would end up with a 10% ownership interest in Triumph. Triumph and Span signed a "Preliminary Agreement" which stated that Triumph would incorporate the terms of the preliminary agreement into the partnership documents. Ultimately, when Wood drew up the final documents, however, he changed the terms to provide that Span's ownership would be diminished as the preferred units were paid off. The change was not disclosed to Span, which signed the final documents, apparently without reading or understanding the changes.

When the $300,000 was paid off and the preferred units were redeemed, Span found itself with a much lower ownership interest than it had agreed to. Span sued Wood for "knowing participation/aiding and abetting" in Triumph 's breach of fiduciary duties. The trial court granted a summary judgment on the grounds that Texas does not recognize a cause of action against an attorney for "aiding and abetting" his client's alleged breach of fiduciary duties. The Court of Appeals affirmed.

The Court of Appeals first held that there was no attorney-client relationship, explicit or implied, between Wood and Span. Word was Triumph's attorney, and the only evidence proffered to establish a duty to Span was the subjective belief of Span's general partner that the statement in the Preliminary Agreement requiring Triumph's attorney to incorporate the terms of the preliminary agreement into the partnership documents created a duty to Span. There was no evidence that this subjective belief was ever communicated to Wood; therefore, the court held that the evidence did not raise a fact issue as to the existence of an attorney-client relationship between Wood and Span. The Court does not address the issue of fiduciary duties between Span and Triumph, but without question Triumph did owe its partner fiduciary duties under Texas law, and these duties would be violated by changing the terms of the partnership interests without disclosure and knowingly taking advantage of the partner's ignorance of the change. The question was whether the partnership's attorney could be held liable individually as the person who effected that change.

The Court of Appeals held that the attorney could not be held personally liable because the attorney's conduct constituted nothing more than providing legal advice to his client: "Texas courts have refused 'to expand Texas law to allow a non-client to bring a cause of action for 'aiding and abetting' a breach of fiduciary duty, based upon the rendition of legal advice to an alleged tortfeasor client.' Alpert v. Crain, Caton & James, P.C., 178 S.W.3d 398, 407 (Tex. App.—Houston [1st Dist.] 2005, pet. denied)." Span argue that Wood's conduct establishing liability was (1) coming up with the scheme of issuing preferred partnership units in lieu of common, (2) failing to advise Span that they should have a lawyer review the final documents, and (3) failing to comply with the preliminary agreement in drawing up the final documents. The court of appeals held that this conduct did not constitute conduct "independent of Wood's representation of Triumph."

As related by the court of appeals opinion, the facts of this case were not very compelling in establishing liability on the lawyer. However, imagine a slightly different scenario (and one that happens all the time). What if a majority shareholder, who manages the business and controls the board of directors, requests that his attorney help him devise a scheme to squeeze out a minority shareholder? The majority shareholder consults counsel to find out how he can accomplish his objective with minimum risk of liability. The lawyer proposes a plan to use the powers and prerogatives the law confers on the majority shareholder to squeeze out the minority. However, the lawyer should know that the very objective of the scheme is a breach of the majority shareholder's fiduciary duties. Every action in the scheme devised by the attorney, even if in other circumstances legal and legitimate, would be undertaken in bad faith and to accomplish an illegal objective. Often the attorney will advise the majority shareholder to do things that are actually illegal—frequently because the attorney is himself ignorant of some aspects of the law governing shareholders' rights or because the attorney believes that the majority can "sell" a legitimate pretext for the conduct. Also, frequently, the lawyer becomes an active participant in the scheme to defraud or oppress the minority shareholders. There are additional issues if the lawyer is the attorney for the corporation and thus may be violating duties he owes to his client or allowing the corporation to pay for services that only benefit the majority shareholder personally, or if the facts establish an implied attorney-client relationship with the minority shareholder.

Should a majority shareholder's attorney be personally liable for devising and implementing a scheme to force a minority shareholder to sell for an unfair price? The majority shareholder's lawyer owes no duty directly to the minority shareholder; however under Texas law, "where a third party knowingly participates in the breach of duty of a fiduciary, such third party becomes a joint tortfeasor with the fiduciary and is liable as such." Kinzbach Tool Co. v. Corbett-Wallace Corp., 160 S.W.2d 509, 514 (Tex. 1942); see also Cotten v. Weatherford Bancshares, Inc., 187 S.W.3d 687, 701 (Tex. App.—Fort Worth 2006, pet. denied); Baty v. ProTech Ins. Agency, 63 S.W.3d 841, 863 (Tex. App.—Houston [14th Dist.] 2001, pet. denied); Cox Tex. Newspapers, L.P., v. Wootten, 59 S.W.3d 717, 721 (Tex. App.—Austin 2001, pet. denied); S.W. Tex. Pathology Assoc., L.L.P., v. Roosth, 27 S.W.3d 204, 208 (Tex. App.—San Antonio 2000, pet. dism'd w.o.j.); Thompson v. Vinson & Elkins, 859 S.W.2d 617, 624 n. 5 (Tex. App.—Houston [1st Dist.] 1993, writ denied); Kirby v. Cruce, 688 S.W.2d 161, 166 (Tex. App.—Dallas 1985, writ ref'd n.r.e.). Furthermore, instigating, aiding, or abetting the wrongdoing constitutes participation. Cotten v. Weatherford Bancshares, Inc., 187 S.W.3d at 701; Pabich v. Kellar, 71 S.W.3d 500, 508 (Tex. App.—Fort Worth 2002, pet. denied); Portlock v. Perry, 852 S.W.2d 578, 582 (Tex. App.—Dallas 1993, writ denied).

On the other hand, there are equally strong public policies in Texas to limit an attorney's liability to third parties for zealously advocating his client's interest. At common law, the rule of privity limits an attorney's liability to those in privity with the attorney. McCamish, Martin, Brown & Loeffler v. Appling Interests, 991 S.W.2d 787, 792 (Tex. 1999). A lawyer is authorized to practice his profession, to advise his clients, and to interpose any defense or supposed defense, without making himself liable for damages. Morris v. Bailey, 398 S.W.2d 946 (Tex. Civ. App.—Austin 1966, writ ref'd n.r.e.); Kruegel v. Murphy, 126 S.W. 343, 345 (Tex. Civ. App. 1910, writ ref'd). Therefore, an attorney in Texas cannot be liable to non-client third parties for legal malpractice. McCamish, Martin, Brown & Loeffler v. Appling Interests, 991 S.W.2d at 792; see also Barcelo v. Elliott, 923 S.W.2d 575, 577 (Tex. 1996). Moreover, Texas courts recognize a "qualified immunity" that protects attorneys from liability to third parties who are injured as a result of the attorney's performance of his professional duties, particularly in the course of litigation. See Alpert v. Crain, Caton & James, P.C., 178 S.W.3d 398, 405-06 (Tex. App.—Houston (1^st Dist.) 2005, pet. denied); Butler v. Lilly, 533 S.W.2d 130, 131-34 (Tex. App.—Houston [1st Dist.] 1976, writ dism'd). This qualified immunity generally applies even if conduct is wrongful in the context of the underlying lawsuit. Renfroe v. Jones & Assocs., 947 S.W.2d 285, 288 (Tex. App.—Fort Worth 1997, writ denied) ("Under Texas law, attorneys cannot be held liable for wrongful litigation conduct."). Thus, an attorney's conduct, even if frivolous or without merit, is not independently actionable if the conduct is part of the discharge of the lawyer's duties in representing his or her client. Alpert v. Crain, Caton & James P.C., 178 S.W.3d at 406; Chapman Children's Trust v. Porter & Hedges, L.L.P., 32 S.W.3d 429, 441 (Tex. App.—Houston [14^th Dist.] 2000, pet. denied).

Exception exists to the rules protecting attorneys. If an independent duty to the non-client exists, "based on the professional [attorney's] manifest awareness of the non-client's reliance on the misrepresentation and the professional's intention that the non-client so rely," then an attorney may be liable for negligent or fraudulent misrepresentation. See McCamish, 991 S.W.2d at 792 (allowing a cause of action for negligent misrepresentation by a non-client under the Restatement (Second) of Torts § 552). A lawyer may also be held liable for conspiring with his client to commit fraud on a third party. The leading case on this exception is Likover v. Sunflower Terrace II, Ltd., 696 S.W.2d 468 (Tex. App.—Houston [1^st Dist. 1985, no writ), which held that an attorney could be held personally liable for conspiracy to defraud where the attorney had actively participated in a fraudulent scheme to get plaintiff to execute a deed. The Likover court noted: "However, an attorney is liable if he knowingly commits a fraudulent act that injures a third person, or if he knowingly enters into a conspiracy to defraud a third person. Hennigan v. Harris County, 593 S.W.2d 380 (Tex. Civ. App.—Waco 1979, no writ). Over 100 years ago, the Supreme Court of Texas held that where a lawyer acting for his client participates in fraudulent activities, his action in so doing is 'foreign to the duties of an attorney.' Poole v. Houston & T.C. Ry, 58 Tex. 134, 137 (1882). The Court held that a lawyer could not shield himself from liability on the ground that he was an agent, because no one is justified on that ground in knowingly committing a willful and premeditated fraud for another. Id. at 137-38." Id. at 472. The court held that in order to find an attorney engaged in a conspiracy with his client to defraud a third party, the evidence must show that the attorney had knowledge of the object and purpose of the conspiracy; that there was an understanding or agreement to inflict a wrong against, or injury on, the third party; that there was a meeting of minds on the object or cause of action; and that there was some mutual mental action coupled with an intent to commit the act that resulted in the injury. Id., relying on Great National Life Insurance Co. v. Chapa, 377 S.W.2d 632, 635 (Tex.1964); Schlumberger Well Surveying Corp. v. Nortex Oil & Gas Corp., 435 S.W.2d 854 (Tex.1968); see also Querner v. Rindfuss, 966 S.W.2d 661, 666 (Tex. App.—San Antonio 1998, pet. denied); Mendoza v. Fleming, 41 S.W.3d 781, 787 (Tex. App.—Corpus Christi 2001, no pet.); McKnight v. Riddle & Brown, P.C., 877 S.W.2d 59, 61 (Tex. App.—Tyler 1994, writ denied). Kirby v. Cruce, 688 S.W.2d 161, 164 (Tex. App.—Dallas 1985, writ ref'd n.r.e.), held that the attorney and client are liable to injured parties as co-conspirators where it can be inferred that (1) an attorney has knowledge of deception being practiced by a client, and (2) the lawyer participated in the scheme and intended to participate in sharing any ill-gotten gains. See also Dallas Ind. Sch. Dist. v. Finlan, 27 S.W.3d 220, 234 (Tex. App.—Dallas 2000, pet. denied), cert. denied 534 U.S. 949 (2001).

Greenberg Traurig of New York, P.C. v. Moody, 161 S.W.3d 56, 89 (Tex. App.—Houston (14^th Dist.) 2004, no pet.), held evidence sufficient to affirm jury verdict on attorney's role in scheme to defraud investors where stock was sold on the promise of a forthcoming IPO and the law firm took an active and visible role in preparing for the IPO, thus creating the illusion that the IPO was real, even though the law firm knew that an IPO could not take place. The court held that the evidence must establish that the attorney specifically intended to agree to accomplish an unlawful purpose or lawful purpose by unlawful means, that there must be "indications" that the attorney knowingly agreed to defraud a third party. Id. at 88-89.

Nevertheless, courts have sought to limit the scope of the exception. Bernstein v. Portland Sav. and Loan Ass'n, 850 S.W.2d 694 (Tex. App.—Corpus Christi 1993, writ denied), overruled on other grounds in Crown Life Ins. Co. v. Casteel, 22 S.W.3d 378, 43 Tex. Sup. Ct. J. 348 (Tex. Jan 27, 2000), held that Likover would not govern when the basis of the attorney's liability was his failure to disclose confidential information about his client to a third party. The court held that no such duty could be imposed on a lawyer. Id. at 701-02.

One would think that an attorney who devised and actively implemented an oppression scheme would be personally liable under the Likover line of cases, given the well-established doctrine that a breach of a fiduciary relationship can constitute fraud because the fiduciary relationship imputes higher duties, such as duties of good faith, candor, and "full disclosure respecting matters affecting the principal's interests and a general prohibition against the fiduciary's using the relationship to benefit his personal interest, except with the full knowledge and consent of the principal." Chien v. Chen, 759 S.W.2d 484, 495 (Tex. App.—Austin 1988, no pet.). At common law, the term "fraud" means an act, omission, or concealment in breach of a legal duty, trust, or confidence justly imposed, when the breach causes injury to another or the taking of an undue and unconscientious advantage. Id.; Russell v. Industrial Transp. Co., 258 S.W. 462 (Tex. 1924); Kellum v. Smith, 18 Tex. 835 (1857). Common-law fraud includes both actual and constructive fraud. "Actual fraud" usually involves dishonesty of purpose or intent to deceive. Archer v. Griffith, 390 S.W.2d 735, 740 (Tex. 1964). "Constructive fraud" encompasses those breaches that the law condemns as "fraudulent" merely because they tend to deceive others, violate confidences, or cause injury to public interests, regardless of the actor's mental state. Id. When one has a duty to speak the truth, a false representation of a past or present material fact is fraudulent when another relies thereon to his detriment. Many Texas courts have held that breach of fiduciary duties is a species of fraud when the breach involves any misrepresentation, nondisclosure, or deception. See, e.g., In re Estate of Kuykendall, 206 S.W.3d 766, 770 (Tex. App.—Texarkana 2006, Flanary v. Mills, 150 S.W.3d 785, 795 (Tex. App.—Austin 2004, pet. denied); Jones v. Tex. Dept. of Protective and Reg. Serv., 85 S.W.3d 483, 491 (Tex. App.—Austin 2002, pet. denied); Connell v. Connell, 889 S.W.2d 534, 542-43 (Tex. App.—San Antonio 1994, writ denied).

However, as in the First Court of Appeals decision today in Span Enterprises v. Span, courts have been reluctant to extend attorney liability to knowing participation/aiding and abetting of breach of fiduciary duties. See also Thompson v. Vinson & Elkins, 859 S.W.2d 617, 624 n. 5 (Tex. App.—Houston [1^st Dist.] 1993, writ denied) (noting that, "while an attorney could be individually liable for conspiracy to defraud, the same would not be true of a knowing participation in a breach of fiduciary duties, as this application would violate the privity rule"); Kastner v. Jenkens & Gilchrist, P.C., 231 S.W.3d 571, 580-81 (Tex. App.—Dallas 2007, no pet.) ("The supreme court has not extended the reach of McCamish to include an aiding and abetting breach of fiduciary duty claim asserted by a non-client based upon the rendition of legal advice to a tortfeasor client."); McConnell v. Ford & Ferraro, LLP, 2001 WL 755640 (Tex. App.—Dallas 2001, pet. denied) (declining to extend the exceptions to the privity rule to create individual liability on an attorney who knowingly participated in the breach of fiduciary duties by the directors of a corporation in a "freeze out" merger).

All of these cases follow Alpert v. Crain, Caton & James, P.C., 178 S.W.3d 398 (Tex. App.—Houston (1^st Dist.) 2005, pet. denied). In this case, the plaintiff was a businessman who managed several businesses and several trusts set up for his children. For a period of four years, the plaintiff was represented and assisted by an attorney named Riley. After the professional relationship between the plaintiff and attorney Riley terminated, the attorney sued the plaintiff in probate court (presumably for nonpayment of fees), and the plaintiff counterclaimed against the attorney. The attorney had retained the law firm of Crain, Caton & James, P.C. to represent him in the litigation in probate court. Thereafter, the plaintiff brought this action in District Court solely against the law firm alleging that the law firm's conduct in the course of the probate court litigation aided and abetted Riley's breach of fiduciary duties. Of course, a law firm only began to represent Riley after the date that he no longer owed fiduciary duties to the plaintiff. Not to be deterred, the plaintiff contended that the law firm had concealed Riley's past malpractice and breach of fiduciary duties, had filed a frivolous lawsuit against Alpert the plaintiff in probate court, and had disparaged the plaintiff's reputation in the business community. Id. at 402-03. The law firm specially excepted and argued that there was no Texas cause of action for an attorney's aiding and abetting a client's breach of fiduciary duties based solely on a lawyer's performance of his professional duties. The trial court sustained the special exceptions and dismissed the lawsuit when the plaintiff refused to amend. While the appellate court affirmed the trial court's dismissal, it is apparent that the decision was influenced by the monumental stupidity of the plaintiff's legal theory. The Court held: "Absent any allegation that Crain Caton committed an independent tortious act or misrepresentation, we decline Alpert's invitation to expand Texas law to allow a non-client to bring a cause of action for 'aiding and abetting' a breach of fiduciary duty, based upon the rendition of legal advice to an alleged tortfeasor client." Id. at 407.

Based on these authorities, a plaintiff should be able to allege a cause of action against the majority shareholder's attorney for knowing participation in the scheme of oppression, but only in narrow circumstances. First, the plaintiff should plead the claim as civil conspiracy, rather than mere aiding and abetting or knowing participation. The elements of the claims are not the same; civil conspiracy has a higher burden of proof. See Floyd v. Hefner, 556 F.Supp. 617, 659-60 (S.D. Tex. March 31, 2008): ("Aiding and abetting a breach of fiduciary duty and conspiracy are two separate claims with different elements of proof.); Days Inn Worldwide, Inc. v. Sonia Investments, No 3:04-CV-2278-D, 2006 WL 3103912, at *19 n. 20 (N.D.Tex. 2006) ("Civil conspiracy is a separate cause of action that requires, interalia, an underlying tort and a 'meeting of the minds' among the coconspirator 'on the object or course of action' to be taken. By contrast, a cause of action under Cox and Kinzbach requires only the knowing participation of a party in a breach of a fiduciary duty and does not require a conspiratorial agreement."). Second, the breach of fiduciary duties or scheme of oppression must involve misrepresentations, failure to disclose, or deceptive conduct so that breach of fiduciary duties constitutes fraudulent conduct. See Flanary v. Mills, 150 S.W.3d 785, 795 (Tex. App.—Austin 2004, pet. denied); Chien v. Chen, 759 S.W.2d 484, 495 (Tex. App.—Austin 1988, no pet.); cf. Hoggett v. Brown, 971 S.W.2d 472, 487 (Tex. App.—Houston [14^th Dist.] 1997, pet. denied) (holding that fraud claim could only be supported by finding of fiduciary duty to shareholder). Third, the plaintiff must plead and prove that the attorney had knowledge of the object and purpose of the conspiracy; that there was an understanding or agreement to inflict a wrong against, or injury on, the third party; that there was a meeting of minds on the object or cause of action; and that there was some mutual mental action coupled with an intent to commit the act that resulted in the injury. Likover v. Sunflower Terrace II, Ltd., 696 S.W.2d 468, 472 (Tex. App.—Houston [1^st Dist. 1985, no writ). Additionally, the plaintiff must plead and prove objective "indications" of this agreement. Greenberg Traurig of New York, P.C. v. Moody, 161 S.W.3d 56, 89 (Tex. App.—Houston (14^th Dist.) 2004, no pet.). Finally, the plaintiff must plead and prove that the attorney's conduct went beyond mere fulfillment of his professional duties to the majority shareholder. Span Enterprises v. Wood, No. 01-07-00364-CV (Tex. App.—Houston [1^st Dist.] December 4, 2008); Alpert v. Crain, Caton & James, P.C., 178 S.W.3d 398, 407 (Tex. App.—Houston (1^st Dist.) 2005, pet. denied). Certainly, personal benefit from the proceeds of the fraud would certainly satisfy this burden. Kirby v. Cruce, 688 S.W.2d 161, 164 (Tex. App.—Dallas 1985, writ ref'd n.r.e.). The plaintiff could also plead and prove conduct by the attorney necessary to the accomplishment of the fraudulent scheme, such as meaningless work designed to convey a false impression. Greenberg Traurig of New York, P.C. v. Moody, 161 S.W.3d 56, 89 (Tex. App.—Houston (14^th Dist.) 2004, no pet.). In the hypothetical situation described above, where the attorney is central in devising and implementing a scheme to squeeze out a minority shareholder and obtain his stock at an unfair price, the attorney's activities (assuming the intent elements described above are met) should satisfy this final element. The attorney will argue that everything done in devising and implementing a scheme to oppress a minority shareholder is merely the rendering of legal services; however the plaintiff should counter that these particular services are "foreign to the duties of an attorney." Poole v. Houston & T.C. Ry, 58 Tex. 134, 137 (1882).

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com