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Oppressive Conduct By Majority Shareholders Warrants Judical Dissolution of a Closely Held Virginia Corporation
A recent decision by Judge Jane Marum Roush of the Fairfax Circuit Court in Virginia is a must read for shareholders in closely held Virginia corporations. The case, Colgate, et al. v. The Disthere Group, Inc.,(August 30, 2012, Case No. CL-11-117, Buckingham County, Virginia) arose when minority shareholders sued under Section 13.1-747 of the Code of Virginia seeking dissolution of the defendant corporation as a result of oppressive and fraudulent conduct by the majority shareholders. Virginia law allows judicial dissolution where a minority shareholder proves that "the directors or those in control of the corporation have acted, are acting, or will act in a manner that is illegal, oppressive or fraudulent; or ... the corporate assets are being misapplied or wasted..." Where a director has a personal interest in the transaction at issue, the burden of proving that the transaction was fair and reasonable to the corporation shifts to the director whose conduct is challenged.
After a lengthy trial, Judge Roush issued a 41 page opinion, Click Here, finding that the corporation should be dissolved based upon the majority shareholders' conduct. Preliminarily, she noted that the business judgment rule does not apply where it is shown that a director "has acted on his or her own account, and contrary to the interests of the corporation." She concluded that, in this case, the directors were motivated by their personal best interests and that "dissolution is the appropriate remedy in that the corporation is controlled by a domineering shareholder who is unlikely ever to treat the minority shareholders fairly."
So what did the majority shareholders/ directors do wrong? Well, they suppressed dividends to retaliate against the minority shareholders who had instituted earlier litigation alleging that a majority shareholder had looted a marital trust. At the same time, the majority shareholders gave themselves pay raises and bonuses nearly equal to the amount by which the dividends had been cut. In addition, they consistently redeemed minority shares based upon "'misrepresentations and half-truths' as to the true value of the company," which the court found violated the standards of fair dealing and fair play.
The court also found that the majority shareholders' compensation was excessive when compared to the company's net income. And the senior majority shareholder provided employment at significant salaries to a number of members of his own immediate family while either terminating or refusing to hire his sister's children, the minority shareholder plaintiffs.
In addition, the defendants used corporate assets for personal purposes prompting a finding that they had misapplied and wasted corporate assets. And, the company paid over $6.5 million in life insurance premiums that the court found was intended to provide liquidity to the estate of the insureds so that the company stock could be kept in the majority shareholders' immediate family. The payments also depleted corporate assets to keep share prices low and to move money to the majority shareholders' families without declaring dividends that would have benefitted the minority shareholders.
At the end, the court held these facts supported findings of oppression, waste and misapplication of corporate resources that merited the dissolution of the company. The opinion should be a cautionary tale to majority shareholders of Virginia corporations. When coupled with Judge Roush's prior opinion in Greenfeld v. Stitley, et al., 2007 Va. Cir. LEXIS 7 (January 5, 2007)(See blog post of March 2, 2009) involving a partnership divorce that resulted in successful claims involving business conspiracy, breach of fiduciary duty, and intentional interference with contract and business expectancy, there are now two lengthy opinions in Virginia that analyze, in detail, the types of conduct that can support oppression type claims in the corporate and partnership settings.
The plaintiffs in the Colgate matter were represented at trial by several of my partners in LeClairRyan. The matter is now on appeal.
Recently in the case of 21st Century Systems, Inc. v. Perot Systems Government Services, Inc. ("Perot Systems") (available here), the Virginia Supreme Court overturned a multi-million dollar goodwill damages award. On appeal, the Virginia Supreme Court found that Perot Systems did not present adequate proof of the value of its lost goodwill.
The facts in Perot Systems are forthright, Perot Systems alleged that Defendants, former Perot Systems employees, conspired to "destroy [Perot Systems] and steal away tens of millions of dollars a year of [Perot Systems] business by unfairly and improperly using [Perot Systems'] confidential and proprietary information." The case centered on a group of ex-Perot Systems' employees who left the company to join 21st Century Systems, a rival government contracting firm. Perot Systems filed suit, alleging violation of Virginia's business conspiracy act, violation of Virginia's Uniform Trade Secret Act, breach of fiduciary duty, breach of non-disclosure agreements, and breach of non-compete and non-solicitation agreements. After the employees left but before the trial, Perot Systems was sold to Dell for $3.878 billion. As part of the sale Dell assigned $1.6 billion in goodwill to Perot Systems. Perot Systems' valuation expert used the Dell sale as a benchmark for assessment purposes when calculating the total loss of goodwill resulting from the defendants' actions. The jury ultimately accepted this assessment in awarding Perot Systems damages.
When dealing with tangible assets the valuation of a company is often more easily understood; firm values can be assessed to real estate, machinery and equipment, inventory and receivables. But businesses are not valued solely based upon tangible assets. Goodwill is a non-tangible asset that a business can earn over time. It is the benefit and advantage of the good name, reputation and connection of a business, the attractive force which brings in customers. Goodwill has been defined as "the excess of the sales price of a business over the fair market value of the business’ identifiable assets." Advanced Marine Enters. v. PRC Inc., 256 Va. 106, 501 S.E.2d 148 (1998). Valuation of this asset is subjective and difficult to clearly calculate. When a business is sold, goodwill can greatly enhance the sales price.
On appeal the Virginia Supreme Court overturned the jury's award of lost goodwill damages. The Court held that Perot Systems failed to use any data concerning the sales of comparable business. It also faulted Perot Systems from failing to demonstrate that the sale price was negatively affected as a result of the defendants' actions. And merely taking the later sales price attributed to goodwill and applying that amount to the defendants' prior conduct is insufficient to support a claim for loss of goodwill.
The court did acknowledge, however, that "damages for loss of goodwill may be recovered if proven" even if it is "impossible of valuing with mathematical precision . . . ." Like many things in life, proving loss of goodwill can be done- you just have to do it the right way.
Last month the Virginia Supreme Court issued two significant opinions relating to the judicial dissolution of partnerships and closely held corporations. Both cases addressed issues of first impression. The opinion addressing the corporate issues also considered the propriety of a shareholder not only seeking a judicial dissolution but also pursuing a derivative suit under Va. Code § 13.1-672.1 at the same time.
Russell Realty Associates v. C. Edward Russell, Jr. involved the standard for judicial dissolution of general partnerships under § 50-73.117(5) of the Virginia Uniform Partnership Act. Here are the facts. In 1978, Charles E. Russell, Sr. created an irrevocable trust dividing his estate into two separate trust shares, one for the benefit of his son, Eddie, and the other for the benefit of his daughter, Nina, and her children. The partnership was created to fund the trust. Its purpose was to acquire, hold, invest in, lease and sell investment properties. As Charles Russell withdrew from the partnership his son took over its active management. After Charles’ death the management of the partnership and the trust became acrimonious, specifically as to the future of the partnership and trust distributions. Those disagreements prevented the sale of certain partnership assets. The two partners and their counsel unsuccessfully tried to resolve the issues for years. Over that period, Nina began to insert herself in the management and operations of the partnership to a significant degree.
Ultimately, Eddie filed suit seeking a judicial dissolution of the partnership. He alleged (1) serious and irreconcilable conflicts with his sister and her son; and (2) that those conflicts had frustrated the partnership’s economic purpose and made management of its assets and affairs not reasonably practicable. Nina responded seeking an accounting and alleging that Eddie had violated his fiduciary duties. She also sought aid, guidance and a declaration regarding her son’s rights to distributions from the trust as well as Eddie’s removal as co-trustee. After trial, the Court found in Eddie’s favor and granted dissolution of the partnership. Nina appealed.
The sole issue on appeal was whether Eddie met the strict standards for judicial dissolution of a partnership under the Virginia Code. The Code provides, inter alia, that a court may dissolve a partnership where “(a) the economic purpose of the partnership is likely to be unreasonably frustrated; (b) another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business and partnership with that partner; or (c) it is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement.” Va. Code § 50-73.117(5). A court may dissolve a partnership where it finds that any of those three conditions have been satisfied.
In Russell, the trial court granted dissolution based upon (a) and (c) above, the economic purpose and business operations tests, respectively. Because the Supreme Court had never addressed the legal standard for dissolution in the partnership context, it adopted the test applicable to dissolution actions that involve limited liability companies. See The Dunbar Group, LLC v. Tignor, 267 Va. 361, 593 S.E.2d 216 (2004).
On appeal, Nina argued that dissolution under the economic purpose prong of the statute required a showing of “truly poor financial performance” and that the trial court’s conclusion that the partnership was not run as a “model of business efficiency” was insufficient justification for dissolution of a profitable business. The Court rejected Nina’s argument noting: “[T]he purpose of the change [in the Revised Uniform Partnership Act] was to allow continuation of a partnership that was not financially profitable based on an inquiry into the partners’ expectations in determining the economic purpose of the partnership.” It concluded that a partnership need not be a financial failure to support a judicial dissolution under the economic purpose prong of the statute.
In Russell, the Supreme Court found evidence in the record that: (1) the relationship between the siblings frustrated the ability of the partnership to take advantage of economically favorable offers to sell certain properties; (2) the “disruptive relationship between the partners had resulted in the partnership incurring substantial added costs” including the need for attorney intervention to facilitate communications and decision making; and (3) despite the provisions of the Partnership Agreement that vested decision-making authority in Eddie, the parties’ relationship imposed unnecessary economic costs “preventing the partnership from taking advantage of and conducting its business in a timely and efficient manner.” According to the Supreme Court those facts were sufficient to satisfy the economic purpose test and warrant the judicial dissolution ordered by the trial court.
The second suit, Cattano v. Bragg, involved a tempest between the only two partners/shareholders in a law firm structured as a corporation. Among other complaints, after discovering that checks had been written on the firm’s escrow/trust account to Cattano’s wife and children, Bragg sought inspection of all corporate records. Cattano responded by firing Bragg and attempting to remove her as director at a special meeting of the shareholders.
Bragg filed suit seeking a judicial dissolution and an accounting and division of assets. She later amended the Complaint adding derivative claims against Cattano for breach of fiduciary duty and conversion.
The Circuit Court appointed a Receiver and directed that the Receiver perform a complete accounting of the books and records of the firm.
At trial, the jury found in Bragg’s favor on the derivative conversion count and awarded the firm $234,412.18. It also awarded Bragg monetary damages for breach of contract and judicial dissolution. It did not find in Bragg’s favor, however, on the claim for breach of fiduciary duty. In a separate trial the Circuit Court awarded Bragg $269,813.00 in attorneys’ fees, plus costs and expenses of $19,415.71, finding that the conversion claim had “yielded a substantial benefit to the corporation.”
Cattano appealed raising a number of corporate issues.
First, Cattano objected that Bragg did not have standing under Va. Code § 13.1-672.1(A) to bring the derivative claim on the basis that she did not “fairly and adequately represent the interests of the corporation in enforcing the right of the corporation.” Noting that in Virginia there is no exception to the rule that actions for injuries to a corporation must be brought derivatively rather than directly by a shareholder, the court found that a single shareholder could pursue a derivative claim on behalf of the corporation. Because it had never addressed the standard to apply in determining whether a plaintiff fairly and adequately represented the interests of the corporation in a corporate derivative claim, the Court adopted the factors it had used in Jennings v. Kay Jennings Family Limited Partnership, 275 Va. 594, 659 S.E.2d 283 (2008) which it borrowed from Davis v. Co-Med, Inc., 619 F.2d 588, 593-94 (6th Cir. 1980). Those factors are:
“ (1) economic antagonisms between the representative and members of the class;
(2) the remedy sought by the plaintiff in the derivative action;
(3) indications that the named plaintiff is not the driving force behind the litigation;
(4) plaintiff’s unfamiliarity with the litigation;
(5) other litigation pending between the plaintiff and defendant;
(6) the relative magnitude of plaintiff’s personal interests as compared to his interests in the derivative action itself;
(7) plaintiff’s vindictiveness toward the defendant; and
(8) the degree of support plaintiff is receiving from the shareholders he purports to represent.”
Jennings, 659 S.E.2d at 288
The Court noted that these factors “are not exclusive and must be considered in the totality of circumstances found in each case.” (quoting Jennings, 659 S.E.2d at 288.)
Significantly, the Cattano court noted:
"While the present case contains economic antagonism as well as apparent animosity between the firm’s only two shareholders, we do not find this to be a determinative factor when evaluating a closely held corporation; nor do we find it determinative that the sole other shareholder does not support the derivative suit. To so hold would be to enact a de facto bar on derivative suits in two shareholder corporations. . . . In closely held corporations, we must look beyond the mere presence of economic and emotional conflict, placing more emphasis on whether the totality of the circumstances suggest that the plaintiff will vigorously pursue the suit and that the remedy sought is in the interest of the corporation."
Applying the appropriate factors, the Supreme Court held that Bragg fairly represented the interests of the corporation in that she sought a return of funds that had been misappropriated by an officer. Such a claim was highly appropriate for a derivative action. Given that she would be entitled a portion of the funds returned to the corporation suggested that her interests were aligned with the corporation and she would vigorously pursue the claim.
Second, Cattano argued that Bragg was pursuing her own interest given the possibility of an award of attorneys’ fees and costs, whereas with pure judicial dissolution no such fee shifting mechanism was available. The Court rejected the argument finding that, because the fee shifting mechanism in the context of a derivative claim was a deliberate policy choice on the part of the General Assembly, the claim should not be barred.
Third, Cattano asserted that Bragg could not act in the firm’s interest in pursing a derivative claim at the same time she was seeking to dissolve the corporation. That argument, too, was unpersuasive. Instead, the Court held that, not only was it in the interest of the corporation to have the misappropriated funds returned, but “judicial dissolution is a remedial mechanism that exists in addition to, rather than as a substitute for, shareholder’s rights.” It is not a per se bar to a derivative claim.
Finally, the court examined the appropriateness of awarding attorneys’ fees to Bragg as a result of her prevailing on the derivative claim. Va. Code § 13.1-672.5(1) provides that: on termination of a derivative proceeding, the court shall: (1) order the corporation to pay the plaintiff’s reasonable expenses (including counsel fees) incurred in the proceeding if it finds that the proceeding has resulted in a substantial benefit to the corporation. . .” Prior to this opinion, no Virginia court had interpreted that provision of the Code. Because there was no Virginia precedent as to the standard to be applied, the Court borrowed from the United State Supreme Court’s decision in Mills v. Electric Auto-Lite Company, 396 U.S. 375 (1970) where that Court held:
"[A] substantial benefit must be something more than technical in its consequence and be one that accomplishes a result which corrects or prevents an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholder’s interest."
Mills, 396 U.S. at 396. In Cattano, the Court found, as did the Circuit Court, that the recovery of over $234,000 of misappropriated funds was a substantial benefit to the firm.
These opinions are welcomed additions to the limited case law in Virginia addressing judicial dissolution and derivative actions. In particular, they suggest that both partners and 50% shareholders in closely held corporations have significant remedies they can use to protect against abuses by other owners. They should serve as cautionary tales.
Wider Latitiude Given to Noncompetes in Business Sales and Settlement Agreements than to Noncompetes in Traditional Employer/Employee Agreements
A noncompete entered into as part of a settlement agreement to end litigation between an employer and former employee receives more latitude than a traditional noncompete signed before or during the employment period.
In a recent case, Plaintiff McClain & Co. Inc. sued a former employee for breach of an agreement not to compete that was included in a post-employment settlement and release contract to which the two parties agreed.
McClain accused the former employee of misappropriating $285,793 of McClain’s funds while he was an employee by submitting false payroll records for employee services that the employees did not actually perform. The parties then entered into a Settlement Release and Agreement a few months after the former employee was no longer employed by McClain where McClain released him from claims relating to his supposed misconduct in exchange for a payment of $250,000, and his compliance with a noncompete restrictive covenant, among other things.
The covenant provides:
The former employee agrees that for a period of thirty (30) months immediately following the Termination Date . . . , he shall not provide perform or undertake any Competing Services anywhere in the territory . . . (ii) instruct, hire, engage, or contract with any other person or entity to provide, perform, or undertake any Competing Services anywhere in the Territory; and (iii) own . . . , serve as director, officer or manager of, or control . . . any entity or business that provides, performs or undertake Competing Services anywhere in the Territory.
McClain accused the former employee of establishing a competing business, MPT, just six days after signing the settlement agreement. As a result, McClain sued for breach of contract against the former employee for violation of the non-competition covenant in the contract as well as conversion and tortious interference with contract.
The former employee moved to dismiss on the ground of failure to state a claim for which relief can be granted because the noncompete is unenforceable as a matter of law. His motion was denied as to the breach of contract and conversion counts.
The court decided that McClain’s allegation that the former employee established a business on a certain date that competed with McClain’s business is sufficiently specific and factual in nature to pass muster under Federal Rule of Civil Procedure 8. The court also held that the phrase “upon information and belief” can be used when the factual basis supporting a pleading is only available to the defendant at the time of the pleading.
The former employee’s other attack on the breach of contract is a claim that the non-competition clause is unenforceable. “In considering the enforceability of restraints on trade, Virginia courts focus on the reasonableness of the restraint because the law looks with favor upon the making of contracts between competent parties upon valid consideration and for lawful purposes and therefore courts are averse to holding contracts unenforceable on the ground of public policy.” Opinion at 7 (internal citations omitted).
The court held that agreements not to compete in the employer/employee context as part of an employment contract are subject to more careful scrutiny. The test is whether the contract is narrowly drawn to protect the employer’s legitimate business interest, and is not unduly burdensome on the employee’s ability to earn a living, and is not against public policy. Id., quoting Omniplex World Servs. Corp. v. U.S. Investigations Servs., 270 Va. 246, 249 (2005).
The court noted that a noncompete like the one in this case which is part of a post-employment agreement has yet to be reviewed in Virginia. The court stated that greater latitude is allowed in determining a convenant’s reasonableness when it’s a covenant not to compete between a vendor and buyer than when it’s related to an employment contract.
Restraints are given more leeway for being acceptable when the noncompete is between a buyer and seller than between an employer and employee because “employees often have comparatively little bargaining power and less leverage for negotiating a fair deal, while the sale of a business more typically involves sophisticated parties coming to an agreement after an arms-length negotiation process.” Op. at 9, citing Centennial Broad., LLC v. Burns, 2006 U.S. Dist. LEXIS 70974, at *27-29 (W.D. Va. Sept. 29, 2006). “Restrictions on an employee’s means of procuring a livelihood for himself and his family” are more likely to threaten public policy interests than restrictions on a seller . . . .” Op. at 9, citing Centennial Broad., 2006 U.S. Dist. LEXIS 70974, at *28-29. The court noted that this same reasoning applies with the noncompete is between partners in a professional firm. Op. at 9.
In the instant case, the court held refused to hold the noncompete to the more restrictive standard applicable in employment cases because the former employee was not an employee when it was made and it was negotiated at arm’s length while the former employee was represented by counsel. There was consideration for both parties and it was not a “take it or leave it” situation where the former employee was concerned with securing a job. The court concluded that bargaining power was more equally distributed and reasonable in general. Therefore the noncompete was sufficiently circumscribed to survive the former employee’s facial attack on a motion to dismiss.
As we begin to see more categorization of noncompete agreements, Virginia courts are giving wider discretion to noncompetes in business sales and settlement agreements than to traditional noncompetes in employer/employment agreements. This raises the question whether a different standard may be applied to even more potential categories of noncompetition agreements.
A recent opinion out of the Eastern District of Virginia states that “unusual circumstances” must be shown to grant a party expedited discovery. And the court adopted two prongs of the prior test for granting a preliminary injunction to determine when sufficient unusual circumstances exist: a strong showing on the merits and a showing that irreparable harm is likely.
A software development company, ForceX, Inc., sued its former vice president for allegedly forming a competing company that violated a noncompete agreement. ForceX’s complaint alleged (1) beach of duty of loyalty and fiduciary duty, (2) breach of contract, (3) violation of the Virginia uniform trade secrets act, and (4) intentional interference with contract. ForceX filed a Motion for Expedited Discovery seeking discovery in the form of requests for production of documents and a deposition to determine the extent of competitive activities. Plaintiff argued for two standards of review: one for an expedited deposition and another for expedited document requests, but the court found that “all requests for expedited discovery should be governed by the same standard....”
“Courts have found that immediate discovery ‘should be granted when some unusual circumstances or conditions exist that would likely prejudice the party if he were required to wait the normal time.’” Opinion at 5-6, quoting Fimab-Finanziaria Maglificio Biellese Fratelli Fila, S.p.A. v. Helio Import/Export, Inc., 601 F. Supp. 1, 3 (S.D. Fla. 1983).
It is not clear when these “unusual circumstances” exist. The court looked to a history of cases for guidance. Before 2008, the first two prongs of the Blackwelder test for a preliminary injunction—(1) the likelihood of irreparable harm to the plaintiff if the preliminary injunction is denied and (2) the likelihood of harm to the defendant if the preliminary injunction is granted—were weighed against the third prong—the likelihood that the plaintiff will succeed on the merits—to determine whether “unusual circumstances” existed. Opinion at 6. This test was a sliding scale so that as the plaintiff’s showing of a likelihood of irreparable harm grew weaker, their showing of success on the merits would need to be stronger to gain a preliminary injunction.
But after the Supreme Court decision in Winter v. Natural Resources Defenses Council, Inc., 555 U.S. 7 (2008), the Fourth Circuit determined that the Blackwelder test was replaced with the Winter test but did not say which portions of the Winter test a court should use when deciding a motion for expedited discovery. As a result, courts have considered two different standards in evaluating expedited discovery motions: (1) a modified preliminary injunction factors test and (2) a reasonableness or good cause test. The court in this instance rejected the reasonableness test, saying it is most logical to treat the motion for expedited discovery under a standard similar to the preliminary injunction standard.
Finding no clear answer as to when “unusual circumstances” exist, the court in the instant case used a variation of Blackwelder and considered two elements that were emphasized by the Fourth Circuit and the Supreme Court: a strong showing of the merits and a showing that irreparable harm to plaintiff is “likely” and not simply “possible.”
The court ultimately found that the ForceX was not entitled for expedited discovery. Plaintiff did not show it was likely to suffer irreparable harm in the absence of the expedited discovery. Despite Plaintiff’s argument that expedited discovery was necessary to find out about defendants’ products and potential customers in order to prevent loss of customers and business before it occurred through improper means, the court held that a potential loss of customers causing a decrease in revenue is not an unusual type of harm.
In many business litigation cases, lost profits can be a critical component of damages. Damaged companies may also be required to take steps that would mitigate their damages. But it can be difficult to take mitigating steps before discovering information about which clients were impacted by the defendant’s tortious conduct. This factor, however, must be balanced to protect a potentially innocent company from being bombarded by litigation pressure. So plaintiff companies in fast action cases, such as those involving business conspiracies, tortious inference and trade secrets, must be prepared in some courts to explain why their particular case is unusual in needing expedited discovery.
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