Shareholders in Close Corporations May Bring Both Derivative and Individual Claims If All Shareholders are Parties to the Action
Aggrieved corporate shareholders may pursue individual or derivative claims to redress wrongs against themselves and the corporation but, traditionally, a shareholder could not join both types of claims in the same action. In the recent decision of Tuscano, et al. v. Tuscano, et al., Ch. Div. Mercer Cty. June 8, 2011, the Chancery Court, declined to follow the traditional rule in a case involving a close corporation and relied on a minority rule espoused by the American Law Institute to permit both individual and derivative claims to proceed in the same action.
The parties in Tuscano were brothers who each owned 50 percent of four corporations engaged in the business of operating collection bins designed to receive products, including used clothing, for recycling to benefit charitable organizations. Richard and Ronald Tuscano had operated the businesses for about 25 years, and were the only shareholders and members of the corporations' Boards of Directors, with Ronald serving as President and Richard as Vice President.
Richard filed the New Jersey action in May 2010, and alleged several state-law claims including minority oppression, and breaches of fiduciary duty and the duty of loyalty; requested a court-ordered buyout of his ownership interests in the four corporations; and included a derivative action on behalf of the corporations for breach of fiduciary duties. Richard alleged that Ronald surreptitiously founded a competing business in April 2008, and that Ronald was wasting corporate assets by paying excessive fees to a shipping company owned by Ronald's son.
This was not a new dispute; in fact, in April 2005 Richard had filed a complaint in a New York federal court asserting similar state-law claims as well as federal RICO claims. The New York action was dismissed without prejudice because Richard failed to join a necessary party for the RICO claims, and therefore the federal court lacked jurisdiction. Subsequently, the New York action was dismissed with prejudice and a judgment was entered in favor of Ronald.
The New York action became an issue in the New Jersey action in January 2011, when, about eight months after the complaint was filed, Ronald filed a motion to amend his answer to include four additional affirmative defenses and, simultaneously, to dismiss the case based upon those defenses. Ronald claimed that the New Jersey action was barred under res judicata, collateral estoppel and entire controversy doctrines because of the dismissal of the prior New York action. Ronald further argued that the New Jersey complaint must be dismissed on the merits for failing to join the corporations as defendants and for joining individual and derivative claims simultaneously.
While the court determined that the res judicata, collateral estoppel and entire controversy doctrines would not bar the New Jersey lawsuit, we focus here only on the two pleading issues: (1) whether the corporations were necessary parties and (2) the appropriateness of bringing both individual and derivative claims in the same action.
With respect to the alleged failure to join the corporations as a party, the court observed that, although the corporations were not listed in the caption, or specifically identified as defendants, they were all listed as "parties" in the body of the complaint. In light of New Jersey's liberal notice pleading rules, which also provide that defects in the caption and format of pleadings may be corrected by amendment, the court permitted Richard to amend his pleadings to name the corporations as defendants for the purposes of the derivative claims.
The issue of whether Richard could maintain both individual and derivative claims was more difficult to resolve. The Chancery Court first narrowly defined the issue as "whether derivative and direct claims can be joined in a case involving a closely held corporation where there are only two shareholders." The traditional rule is that aggrieved shareholders may only sue for individual injury when they sustain a unique harm not suffered by other shareholders, and that all other claims are derivative in nature. The New Jersey Supreme Court follows that rule, but has not addressed the corollary rule that an inherent conflict exists when a party asserts both individual and derivative claims in the same action. Accordingly, the Chancery Court looked to an Appellate Division case, Brown v. Brown, 323 N.J. Super. 30 (App. Div., 1999). That case relied on Section 7.01 of the "American Law Institute's Principles of Corporate Governance" (2005) (ALI Section 7.01) and "held that under certain circumstances where the corporation in question is closely held, a court, in its discretion, may treat an action raising derivative claims as a direct action and exempt it from those restrictions and defenses applicable only to derivative actions, and order an individual recovery." The Brown court also observed that, in the setting of a close corporation, "because of the difficulty in determining if a suit must be brought as a direct or derivative action, an increasing number of courts are abandoning the distinction between a derivative and a direct action because the only interested parties are the two shareholders."
The Tuscano court found that ALI Section 7.01 would permit parties to "commence and maintain direct and derivative actions" in the context of closely held corporations. First, the usual policy reasons for encouraging derivative actions are to avoid exposing the corporation to multiple suits by each injured shareholder, to protect corporate creditors and to protect all shareholders because a corporate recovery would benefit all equally. Those factors are either not present or are less weighty in the context of close corporations, particularly because "the concept of a corporate injury that is distinct from any injury to the shareholders approaches the fictional in the case of a firm with only a handful of shareholders." Second, wrongful acts often "deplete corporate assets and deprive shareholders of a personal right attaching to their shares," and shareholders should not be forced to elect between remedies. Third, allowing the combination of direct and derivative actions conserves judicial resources, protects against inconsistent verdicts and serves the interests of shareholders who may not be parties to the direct action.
Those factors favored application of ALI Section 7.01 to the Tuscano case, where Richard and Ronald were the only two shareholders and the traditional concerns governing the distinction between individual and derivative claims were not present. Moreover, allowing both types of claims to proceed would not subject the corporations to duplicative litigation or interfere with the fair distribution of any recovery, given that only two shareholders existed. Finally, the wrongful acts alleged by Richard have potentially harmed the corporations and shareholders, and allowing both claims to proceed in one case would conserve judicial resources and promote consistent verdicts. Thus, the court held "that it is appropriate for one 50% shareholder to bring both derivative and individual claims in one action where the only other shareholder is also a party." It is likely that aggrieved shareholder plaintiffs will attempt to apply the rationale of Tuscano and ALI Section 701 in other close corporation claims involving very few shareholders.
New Jersey Court Enforces 'Buy-Sell' Provision, Allowing Surviving Partner to Buy Deceased Partner's 50 Percent Interest for 1 Percent of Fair Market Value
A New Jersey Appellate court has upheld use of a buyout formula in a partnership agreement, despite the fact that it left the deceased partner's estate with a mere fraction of fair market value. In Estate of Cohen v. Booth Computers (Appellate Division, July 13, 2011), the estate of Claudia Cohen appealed a judgment awarding the estate $178,000 for Claudia's 50 percent share in the Booth Computers partnership, even though the partnership's fair market value had been estimated at approximately $23 million. Booth Computers, created in 1978, is a family-owned partnership originally comprised of three partners: Claudia, Michael and James Cohen. The partnership's assets consist of three real estate properties whose value has grown exponentially over time.
The Booth Computers partnership agreement provides that, in the event of the death of any one partner, the surviving partners must purchase the shares of the deceased partner according to a specific formula. The parties had also agreed that the value of a deceased partner's interest would equal his or her own proportionate share of the partnership's net worth plus $50,000. Net worth was defined as the net book value of the company as shown on the most recent partnership financial statement, which pegged the value of the company based on the costs of its assets and did not reflect increases or decreases in asset values. Thus, under the partnership agreement, a surviving partner would benefit from increases in asset value over time.
When Michael died in 1997, James and Claudia invoked the buyout provision and Michael's estate was paid $34,503.08 for his one-third interest in Booth Computers. When Claudia died in 2007, James once again attempted to rely on the buyout provision. Due to the large disparity between the net book value and fair market value of the partnership, Claudia's estate filed a lawsuit seeking to recover one-half of the partnership's fair market value. At trial, the trial court rejected the estate's arguments that fair market value was the proper methodology to utilize and awarded a judgment based on the partnership's book value.
The estate subsequently filed an appeal with the Appellate Division in which it contended that the trial court erred in enforcing the buyout provision because (1) the term "net book value" is sufficiently ambiguous to encompass fair market value, (2) the judge failed to utilize the gap filling provisions of the Uniform Partnership Act, and (3) the buyout price was unconscionable given the gross disparity between the cost approach utilized and the fair market value. The Appellate Division rejected the notion that net book value and fair market value are synonymous. Net book value was clearly defined in the partnership agreement as the value of the company based on its book value as set forth in the partnership's financial statements (which utilized a historic cost approach). The court next upheld the trial court's decision not to apply the Uniform Partnership Act (UPA). Where a partnership fails to set a buyout formula, the UPA will require a buyout price based on the partnership's "fair value" The Appellate Division reasoned that there was no need to "fill the gap" here because the partnership agreement set forth a specific fair value formula in the event of a buyout. Finally, the court rejected the estate's argument that the buyout provision should be disregarded altogether because it is unconscionable. The court noted its reluctance to make an unambiguous contract better for either of the contracting parties simply because, in one party's view, changed circumstances had made that agreement disadvantageous. The Appellate Division held that a disparity in price between book value and fair market value, where a buyout provision is clear on its face, did not mean the agreement was unconscionable.
Cohen demonstrates that a partnership agreement's buyout formula will be strictly construed by New Jersey courts even if it leads to a very unfair result. There are common sense reasons why "net book value" provisions continue to be used in such agreements, including the partners' desire not to require the sale of the business by the survivors in order to pay a substantial sum for the buy-out of a deceased partner. On the other hand, partners should recognize that valuations based on book value could provide a windfall to a sole surviving partner if the partnership's assets appreciate in value over time and if that appreciation is not reflected in the partnership's financial statements.
There are a number of practical ways to address these issues. The parties can agree to periodic re-assessments of value. The parties can also provide that they will purchase insurance policies that can fund the purchase by the surviving parties of the deceased partner's share and still continue the business. However, where the parties have clearly chosen net asset value as the basis for value, Cohen shows that the courts will respect those agreements.
New Jersey Poised to Enact Trade Secrets Act
In late September the New Jersey Senate passed a bill that would supplant the common law with new statutory remedies for misappropriation of trade secrets.
The Trade Secrets Act (S-2456/A-921), which is predicted to pass the Assembly as well, would impose civil liability for the improper acquisition or disclosure of a trade secret. The Act provides for injunctive relief to prevent the disclosure or use of a trade secret as well as damage remedies, including actual loss, unjust enrichment or recovery of a "reasonable royalty" for the use of the trade secret. Punitive damages in the amount of twice the damages would be available in instances of willful and malicious misappropriation, as well as legal fees and expert witness costs. The Senate bill defines trade secret more broadly than the Uniform Trade Secrets Act, which has been adopted in 46 states. The Senate would encompass "a formula, pattern, business data compilation, program, device, method, design, diagram, drawing, invention, plan, procedure, prototype or process" if it derived independent economic value from not being generally known or ascertainable, and if it was subject to reasonable efforts to maintain its secrecy. The bill also clarifies what conduct could not be the basis for liability and defines "proper means" for acquisition of trade secret information to include reverse engineering, independent invention, discovery under license from the owner, observation of the information in public use or from review of published literature.
The original draft of the bill had included a presumption in favoring of granting protective orders to protect trade secrets during discovery. That provision did not survive lobbying by the New Jersey Press Association, and the bill now provides for the protection by reasonable means consistent with the court rules. The Senate bill would take effect immediately, but would not apply to misappropriations that occurred before its effective date, even if the conduct was continuing.
In Pari Delicto And Imputation Defenses Are Alive And Well in New York
New York's highest court has held that the in pari delicto and imputation defenses remain available to a corporation's outside auditor who allegedly failed to detect the malfeasance of the corporation's executives. Kirschner v. KPMG, LLP, and Teachers' Retirement System of Louisiana v. PricewaterhouseCoopers, LLP (October 21, 2010) (Kirschner). The New York Court of Appeals decision reaffirms New York's public policy to limit auditor liability, even where the corporation's innocent employees, stockholders and creditors may have been harmed.
The decision also clarified the exceedingly narrow scope of the "adverse interest exception" to the imputation doctrine under which auditor liability may still exist. The Court reserved this exception for the rare case where a corporate executive's misconduct "benefits only himself or a third party; i.e., where the fraud is committed against a corporation rather than on its behalf," such as "outright theft or looting or embezzlement."
New York's law is now one of the most favorable to auditors and other third party professionals. It is much more protective than New Jersey law, which bars auditors from asserting the imputation defense and leaves the culpability of corporate insiders to be resolved as a matter of comparative fault. See NCP Litigation Trust v. KMPG, LLP, (N.J. 2006).
Kirschner grew out of the collapse of Refco, a leading brokerage and clearing house. Refco was forced into bankruptcy after it was disclosed that its president and chief executive officer hid hundreds of millions of dollars of uncollectible debt from the public and regulators for years, creating a falsely positive picture of Refco's financial condition. A Litigation Trust, established as part of Refco's Chapter 11 bankruptcy plan, brought suit against Refco's third party professionals (its outside auditors, lawyers and investment banks) for aiding and abetting the fraud and failing to discover it. The District Court dismissed the case, finding that such claims were barred under New York's in pari delicto doctrine because Refco's insiders' misconduct was imputed to the corporation. The Litigation Trust appealed the dismissal to the Second Circuit Court of Appeals. Finding New York law on the point unclear, the Second Circuit certified two questions to the New York Court of Appeals as to the scope of New York's adverse interest exception: (1) "whether the adverse interest exception is satisfied by showing that the insiders intended to benefit themselves by their misconduct" and (2) "whether the exception is available only where the insiders' misconduct has harmed the corporation."
In Teachers' Retirement System, a companion appeal decided with Kirschner, a derivative action had been filed on behalf of AIG in Delaware Chancery Court against AIG's outside auditor, PricewaterhouseCoopers (PwC). The derivative plaintiffs alleged that PwC was negligent in its audit and failed to detect or report a fraud perpetrated by AIG's senior officers. The derivative plaintiffs, however, did not allege that PwC conspired with AIG or its officers to commit accounting fraud. The Chancery Court dismissed the claims on the grounds that, since the wrongdoing of AIG's senior officers was imputed to AIG, New York's in pari delicto doctrine barred the claims. On appeal, the Delaware Supreme Court certified one question to the New York high court: whether the in pari delicto doctrine bars a claim against an outside auditor where the auditor "did not knowingly participate in the corporation's fraud," but instead negligently failed to detect the fraud and "failed to satisfy professional standards in its audits of the corporation's financial statements."
In addressing this question, the Court of Appeals discussed the rationale behind New York's in pari delicto doctrine, the imputation doctrine and the adverse interest exception to the imputation doctrine.
The Court noted that the in pari delicto doctrine serves two important public policy purposes: (1) it deters illegality by denying judicial relief to an admitted wrongdoer and (2) it avoids entangling courts in disputes between wrongdoers. The Court emphasized that "the principle that a wrongdoer should not profit from his own misconduct is so strong in New York that the [the court has] said the defense applies even in difficult cases and should not be 'weakened by exceptions.'"
The Court then went on to discuss the important role traditional agency principles play in the in pari delicto doctrine and how engrained the imputation doctrine is in New York law. The Court noted that for over a century, New York courts have found the acts of agents and the knowledge they acquire while acting within the scope of their authority to be presumptively imputed to their principals, even where the agent exhibits poor judgment or commits fraud. The Court stated that this legal presumption does not depend on an ad hoc assessment but instead governs in every case, except where the corporation is the agent's intended victim. The Court explained that "as with in pari delicto, there are strong considerations of public policy underlying this precedent: "imputation fosters an incentive for a principal to select honest agents and delegate duties with care."
Finally, the Court set out the narrow parameters of New York's adverse interest exception to the imputation doctrine. That exception will only apply "where the corporation is actually the victim of a scheme undertaken by the agent to benefit himself or a third party personally, which is therefore entirely opposed (i.e., 'adverse') to the corporation's own interests." Thus, "for the adverse interest exception to apply, the agent 'must have totally abandoned his principal's interests and be acting entirely for his or another's purpose,' not the corporation." After Kirschner, so long as the corporate wrongdoer's conduct benefits the corporation (e.g., enables the business to survive, to attract investors and customers and raise funds for corporate purposes) the exception will not apply.
The Court declined to make the adverse interest exception hinge on "showing that the corrupt insiders intended to benefit themselves personally and actually received personal benefits and/or that the company received only short term benefits but suffered long term harm." The Court noted that "to recast the adverse interest exception in this fashion ... would 'explode' the exception, turning it into a 'nearly impermeable rule barring imputation in every case."
The Court then discussed whether to adopt either the New Jersey rule announced in the NCP Litigation Trust v. KPMG, LLP, 187 N.J. 353 (NJ 2006) or the Pennsylvania rule announced in Official Committee of Unsecured Creditors of Alleghany Health Education and Research Foundation v. PricewaterhouseCoopers, 989 A2d 313 (Pa 2010) (AHERF). Unlike New York, both the New Jersey and Pennsylvania Supreme Courts chose to fashion a exception to traditional agency law that would deny the in pari delicto defense to negligent or otherwise culpable outside auditors (New Jersey) and collusive outside professionals (Pennsylvania).
The New Jersey Supreme Court's NCP decision held that in pari delicto could not be applied in an audit malpractice case because auditors, whether alleged to be negligent or otherwise culpable, were by definition not the kind of "innocent" third parties meant to be protected by the doctrine. Rather than apply the doctrine in a way that would bar many "innocent" parties (including shareholders and creditors) from recovery, the New Jersey rule requires the relative faults of the corporate plaintiff and the auditors to be sorted out as matters of comparative negligence and apportionment by the fact finders.
The Pennsylvania Supreme Court in AHERF took a different approach to the issue. It concluded that the in pari delicto defense would continue to be available in the negligent-auditor context, but that it would be unavailable where an auditor had not acted in good faith or had colluded with corporate executives to defraud their principal.
The New York Court of Appeals rejected both the New Jersey and Pennsylvania rules, finding they would negate the policy reasons behind the in pari delicto defense. In criticizing the New Jersey rule that requires the in pari delicto defense to be treated as a matter of comparative fault, the Court of Appeals observed that "comparative fault contradicts the public purposes at the heart of in pari delicto — deterrence and the unseemliness of the judiciary 'serving as payment of the wages of crime.'"
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
