Pleading of Derivative Claims Under Texas Law

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

Valuation of Minority Shares in an Oppression Case

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

Pleading of Demand Futility on a Claim of Failure to Monitor

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

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

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

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

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

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

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

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

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

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

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

 

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

 

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

 

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

 

 

Eric Fryar

www.FryarLawFirm.com www.ShareholderOppression.com

 

New Mississippi Shareholder Case

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

 

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

 

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

 

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

 

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

 

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

 

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com

 

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

Also the author has launched a new firm website.

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

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

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

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

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

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

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

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

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

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

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

Eric Fryar

www.fryarlawfirm.com www.shareholderoppression.com