Filed: February 24, 2016
Opinion by: Andrea M. Leahy
A court may consider the purpose of an asset sale and the adequacy of consideration as factors in the analysis of whether the “mere continuation” exception to the rule against successor liability should apply.
Plaintiff is the sole owner of a small lumber distribution business (“Plaintiff LLC;” “Plaintiff” shall refer to Plaintiff in his individual capacity). Until 2010, Plaintiff LLC also manufactured roof trusses and other engineered wood products (“EWP”). Defendant is a lumber retailer who was a customer of Plaintiff LLC.
Plaintiff LLC and Defendant negotiated a partnership for their mutual benefit. Defendant was to acquire assets from Plaintiff LLC, combine them with its own, and form a new LLC (“Predecessor”). Defendant, through its wholly-owned subsidiary (“Subsidiary”), would also contribute money to Predecessor. Subsidiary would own the majority interest in Predecessor, and Plaintiff would be an employee.
The parties agreed that Plaintiff would be employed for two years following the asset purchase in March 2010. Plaintiff was to work part-time and be compensated $10,000 per month over two years ($240,000 in total). Plaintiff’s responsibilities included integration of the roof truss and EWP businesses, sales and marketing. Plaintiff was also to supply Predecessor with lumber from Plaintiff LLC. The agreement provided that if Plaintiff was terminated by Predecessor “without cause,” he would still be owed the $10,000 monthly salary; however if he was terminated “for cause,” neither Predecessor nor Defendant would be obligated to pay the remaining salary.
Defendant also agreed to purchase a number of assets from Plaintiff LLC, including equipment, inventory, intellectual property and customer records in exchange for $139,570 and a 7.5% membership interest in Predecessor. Defendant provided employees for “back office” operations such as hiring, IT and accounting, while Plaintiff managed Predecessor’s sales force and occasionally referred to himself as “President” of Predecessor. Per Predecessor’s Operating Agreement, Subsidiary had authority over Predecessor’s managers, which included Plaintiff.
Predecessor struggled after its formation. In October 2010, Plaintiff’s salary was cut by $4,670 per month. Subsidiary lent Predecessor $425,000 in March 2011, but Predecessor was out of cash by the end of May and could not secure another loan. In May, Defendant began absorbing accounting, administrative and labor costs. Predecessor’s managers considered bankruptcy, but Plaintiff was strongly opposed because Predecessor owed $300,000 to Plaintiff LLC for its lumber supply.
Late in May 2011, it was determined that Plaintiff was no longer employed with Predecessor, although there is disagreement between the parties as to whether Plaintiff voluntarily resigned or was fired. Plaintiff continued to act as a commissioned salesman for Predecessor, however, and he still supplied Predecessor with lumber through Plaintiff LLC.
Predecessor’s management sold the company’s assets to Defendant in August 2011. At that time, Plaintiff agreed to release his membership interest to Subsidiary. Defendant acquired all of Predecessor’s assets and assumed $1,162,000 in liabilities—including $300,000 owed to Plaintiff. Defendant continued in the business of truss design and manufacture in the same location, with some of the same work force and customers. However, testimony demonstrated that the ownership structure, operation and management had changed.
Plaintiff sued Predecessor for breach of contract, alleging that he received only $147,000 of his agreed-upon total compensation of $240,000. Plaintiff sought to recover the remaining $93,000 along with treble damages. Plaintiff also alleged that Defendant was liable under the theory of successor liability because Defendant’s operation was a “mere continuation” of Predecessor’s enterprise.
The trial court declined to hold Defendant liable for nonpayment of wages or breach of contract by Predecessor, finding that (1) there was no evidence that the transaction was for the purpose of avoiding liability to Plaintiff; (2) Defendant provided Predecessor adequate consideration in the asset transfer; and (3) the overlap in management, control and ownership between Predecessor and Defendant was not alone enough to find that there was a “mere continuation.” Plaintiff appealed, arguing that the trial court erred by examining the purpose of the transaction and the adequacy of consideration in its “mere continuation” analysis.
The court observed that in general, a corporation which acquires the assets of another corporation is not liable for the debts and liabilities of the predecessor corporation. Maryland law recognizes four exceptions to the general rule: (1) when there is an expressed or implied assumption of liability; (2) when the transaction amounts to a consolidation or merger; (3) the purchasing corporation is a mere continuation of the selling corporation; or (4) the transaction is entered into fraudulently to escape liability for debts.
The court explained that the “mere continuation” exception permits recovery against the successor corporation where the successor is essentially the same corporate entity as the predecessor. Furthermore, the exception is designed to prevent transactions where the specific purpose “is to place those assets out of the reach of predecessor’s creditors.” The exception had been addressed in only three previous opinions by Maryland appellate courts: Baltimore Luggage Co. v. Holtzman
, 80 Md. App. 282 (1989), Nissen Corp. v. Miller
, 323 Md. 613, 617 (1991), and Academy of IRM v. LVI Envtl. Servs. Inc.
, 344 Md. 434 (1997).
In Baltimore Luggage
, the court explained that “the underlying theory of the [‘mere continuation’ exception] is that, if a corporation goes through a mere change in form without a significant change in substance, it should not be allowed to escape liability.” The court instructed that the “indicia of continuation” are “common officers, directors, and stockholders” and “only one corporation in existence after the completion of the sale of assets.” The court added that “[o]ther factors, such as continuation of the seller’s business practices and policies and the sufficiency of consideration running to the seller corporation” may also be considered in determining whether the exception should be applied.
, the court drew a distinction between the “mere continuation” exception and “continuity of the enterprise” theories, the latter of which is not recognized in Maryland. In drawing the distinction, the court observed that “[t]he mere continuation . . . exception applies where there is a continuation of directors and management, shareholder interest and, in some cases, inadequate consideration.”
In Academy of IRM
, the court also considered an additional relevant factor to the “mere continuation” exception: the purpose of the asset sale. The court stated that “successor liability does not lie” where the transaction is not fraudulent as to unsecured creditors. The court also cited Jackson v. Diamond T. Trucking Co.
, 241 A.2d 471, 477 (N.J. 1968),* which held that when deciding when to apply the “mere continuation” exception, “[m]any facts and policy factors must be weighed in the balance, most importantly, the policy protecting corporate creditors must be weighed against the equally important policy respecting separate corporate entities.”
The court reasoned that the combined effect of Baltimore Luggage
, and Academy of IRM
is that five factors may be considered in determining whether to apply the “mere continuation” exception in Maryland: “(1) any change in ownership and management, (2) the continued existence of the selling corporation, (3) the adequacy of consideration, (4) the transfer of any ‘instrumental’ employees from the predecessor to the successor, and (5) the purpose of the asset sale.” Thus, the court concluded that the trial court did not err in examining the adequacy of consideration and purpose of the asset sale in its analysis of the “mere continuation” exception.
The court then reviewed the trial court’s application of the factors to the case before it. While there was substantial overlap in management, control, and ownership, this alone was not determinative, because the transaction involved more than simply a single entity “chang[ing] hats.” Indeed, the ownership and management had changed following the asset sale. Furthermore, the evidence showed that Predecessor’s decision to sell its assets was not for the purpose of placing its assets beyond Plaintiff’s reach, but rather it was to salvage a failing business. Defendant also agreed to assume nearly $1.2 million of Predecessor’s liabilities—including its $300,000 trade debt to Plaintiff—which constituted adequate consideration for the transfer of assets. Finally, the underlying purpose of protecting creditor rights would not be served if Defendant were held liable for Predecessor’s obligations in this case: for example, Plaintiff himself was protected as a creditor when Defendant assumed Predecessor’s liabilities rather than allowing Predecessor to file for bankruptcy.
The full opinion is available in PDF.
*Editorial note: the court mistakenly identifies Jackson as "decision of the Supreme Court of Rhode Island;" however, Jackson was in fact decided by the Superior Court of New Jersey Law Division. See 241 A.2d 471, 100 N.J. Super. 186. In a decision called H.J. Baker & Bros., Inc. v. Orgonics, Inc., 554 A.2d 196 (R.I. 1989), the Supreme Court of Rhode Island did adopt the five factors provided in Jackson.
Filed March 7, 2016
Opinion By: Sonia Sotomayor
A real estate investment trust organized under Maryland law is subject to the long-standing rule that an unincorporated entity possesses the citizenship of all its members, which includes its shareholders under § 8-101(c) of the Maryland REIT Law (the "MRL"), for diversity jurisdiction purposes.
Plaintiffs, three corporate citizens of Delaware, Nebraska and Illinois, filed an action over a contract dispute in a Kansas court. Defendant, a real estate investment trust organized under the MRL, removed to the Federal District Court for the District of Kansas. The Court accepted jurisdiction and found for defendant. On appeal, the Tenth Circuit raised the jurisdiction issue and determined that the parties failed to demonstrate diversity of citizenship. The Court applied two different tests to determine the citizenship of the corporate plaintiffs and the unincorporated defendant. It found that the corporate plaintiffs were citizens of the states where they were chartered and had their principal places of business. The unincorporated defendant’s citizenship must be based on that of its members, which include its shareholders. Having failed to provide a record of the shareholders’ citizenship, the parties failed to prove they were citizens of different states. In a unanimous decision, the U.S. Supreme Court affirmed.
Historically, only humans were considered citizens for diversity jurisdiction purposes. Eventually, the Court created a limited exception for corporations to be considered citizens of the states where they were incorporated; an exception Congress later codified and expanded to include the states where the principal place of business was located. Congress never expanded this exception to any artificial entities other than corporations. The long-standing rule for unincorporated entities is that diversity jurisdiction in a suit by or against the entity depends on the citizenship of all its members.
The Court noted that it has not expressly defined “members.” Here, absent anything in the record to indicate who defendant’s members are, Maryland law establishes its membership. The Court found that the MRL establishes that a real estate investment trust is an unincorporated business trust or association for the benefit and profit of its shareholders, who possess ownership interests and voting power. MRL §§ 8-704, 8-101. As such, these shareholders have powers and position analogous to the shareholders of a joint-stock company or the partners in a limited partnership, both of whom the Court has previously found to be “members” of their entities.
Defendant argued that anything called a “trust” possesses the citizenship of its trustees alone, and not its shareholders. The Court found that defendant is not a traditional trust, however. In Maryland, a real estate investment trust is a separate legal entity that can sue or be sued. MRL §§ 8-102, 8-301. Like in other states, the label “trust” is applied to entities that bear little resemblance to the traditional trust. A traditional trust is not a distinct legal entity at all, but rather a “fiduciary relationship” that could not be haled into court. The opinion is available in PDF.
Filed February 1, 2016
Opinion By: Judge Nazarian
The amended class action settlement reviewed by the trial court was procedurally and substantively fair, interpreting Md. Rule 2-231(h) consistently with the interpretation by federal courts of Federal Rule of Civil Procedure 23(e), which requires that a reviewing court approve class action settlements that it finds are "fair, adequate and reasonable."
Cole Real Estate Investments, Inc. ("CREI") (previously known as Cole Credit Property Trust III ("CCPT III") is a non-traded real estate investment trust that owns real estate throughout the United States. American Realty Capital Properties, Inc. ("ARCP") is a publicly-traded company that acquires and owns single-
tenant freestanding commercial real estate, principally subject to medium-term net leases.
ARCP had initially made an offer to acquire CCPT III in 2013. However, CCPT III's board elected instead to acquire a subsidiary and create CREI. This acquisition triggered a shareholders derivative and class action lawsuit, along with a federal securities claim filed in federal district court. The acquisition closed in April, 2013, and the pending lawsuits were dismissed following settlement of the shareholders' claims.
ARCP again approached CREI about a merger which culminated in an announcement on October 23, 2013 that the entities intended to complete an $11.2 billion merger. Shortly thereafter, another series of lawsuits were filed by certain shareholders challenging the legality of the merger. Negotiations were opened with the shareholders, and an agreement was reached that permitted the plaintiffs to take additional discovery, while permitting the merger to be approved. This settlement agreement was presented to the circuit court and preliminarily approved by it on August 25, 2014.
However, in October, ARCP unexpectedly announced certain irregularities concerning its financial statements back to 2013. This resulted in a dramatic drop in ARCP's share price and an SEC investigation and several federal lawsuits by the shareholders, essentially alleging that ARCP engaged in fraud to induce the merger with CREI. "The complaint asserts that the defendant-directors’ wrongful conduct inflated ARCP securities prices and resulted in the subsequent decline in value of those securities when the fraud was revealed."
The parties engaged in further settlement negotiations and reached an amended settlement that carved out ARCP's officers and directors from release from all claims associated with the merger. This amended settlement was then presented to the trial court for approval. Following a full day trial, the trial court found that the amended settlement was fair, adequate, and reasonable. Five shareholders, including Mr. Shenker objected. This appeal followed.
Analysis:Class action settlements in Maryland must be approved by the trial court under Md. Rule 2-231(h). This rule is interpreted in parallel with Federal Rule 23(e), which requires that class action settlements be both procedurally and substantively fair. On appeal, a reviewing court applies an abuse of discretion standard to a trial court's decision concerning a class action settlement.
As to procedural fairness, Federal Rule 23 provides several steps that must be taken concerning notice of the proposed settlement. The Court found that, in accord with the applicable federal and state procedural rule, "[n]otice of the proposed settlement was sent to all class members; the parties filed and the court reviewed briefs in support of and against the revised settlement; and the court heard objections from opposing class members, both in writing and at a hearing (without subject or temporal limitation) designed to address the settlement’s reasonableness, fairness, and adequacy." In addition, the appellate court's role is "to determine whether the circuit court was well-informed to determine the fairness and adequacy of the settlement, and that it reached a well-reasoned decision." A review of the trial court memorandum and record supported the conclusion that the trial judge had carefully reviewed the evidence and deposition testimony, along with the pleadings and filings of the parties concerning the merger, before approving the amended settlement.
As to substantive fairness, the trial court is to evaluate the merits of the amended settlement to determine if the settlement is fair and adequate. A "fair" settlement is one that is not the product of collusion among the parties, which includes factors such as the posture of the case at the time of settlement, the extent of discovery that has been conducted, and the circumstances of the negotiations and the experience of counsel. The Court found that the trial judge had sufficient information to evaluate the claims of the parties and that the settlement was not the result of collusion among the parties. The Court held here that further discovery or time would not have yielded more evidence of the absence of evidence of more due diligence to detect the irregular financial statements prior to the merger.
An "adequate" settlement is one where the trial court has weighed the likelihood of the plaintiff's recovery on the merits against the amount offered in settlement. The trial court is to consider these factors: “‘(1) the relative strength of the plaintiffs’ case on the merits, (2) the existence of any difficulties of proof or strong defenses the plaintiffs are likely to encounter if the case goes to trial, (3) the anticipated duration and expense of additional litigation, (4) the solvency of the defendants and the likelihood of recovery on a litigated judgment, and (5) the degree of opposition to the settlement.’” (quoting In re Montgomery Cty., 83 F.R.D. at 316). The Court found that the plaintiff's securities claims were speculative, and the damages that might be obtained from them remote, and concluded that the trial court did not abuse its discretion in determining that the settlement was adequate, particularly as ARCP's directors and officers were not released from liability related to the false financial statements under the amended settlement.The Court also dismissed appellant's due process argument on essentially the same grounds stated above. The Court affirmed the trial court's approval of the amended settlement. The opinion is available in pdf.
Filed: January 28, 2016
Opinion by: Stuart R. Berger
Holdings: (1) A majority-disinterested and majority-independent board of directors’ unanimous decision to refuse a shareholder demand is not subject to the “special litigation committee” (“SLC”) exception but enjoys the protection of the business judgment rule. (2) Absent a particularized rebuttal, statements made by a majority-disinterested and majority-independent board of directors within a letter refusing demand are presumed true and may properly be considered by the court. (3) In a derivative action, a shareholder’s right of discovery as to the issue of whether a board of directors acted appropriately in refusing demand is denied unless shareholder has met her burden of proof under the business judgment rule of showing bad faith, bad judgment, or lack of independence.
Facts: Defendant-Appellees (“Appellees”) include a registered Maryland corporation and its current and former Board of Directors (“Board”) and members of senior management. Appellants are two shareholders (“Shareholders”).
In 2009, Appellees sought and obtained shareholder approval of an executive compensation plan which issued additional shares of common stock to (1) ensure the ability to settle existing performance-based awards in shares instead of cash, and (2) thereby reduce Appellee’s tax burden. Following a near-miss of share price performance targets in late 2010, Appellees became concerned that certain key employees might leave for better-paying opportunities with competitors. After a 6-month review, the Board converted the performance-based awards to service-based awards. The modification reduced the award amount by 25% and apportioned it into three installments over the years 2012 to 2014, so long as the employee remained employed.
In 2013, Shareholders issued a demand letter requesting Appellees to investigate and institute claims against responsible persons relating to the award modifications. Shareholders demanded rescission of all shares issued under the 2009 plan, forbearance from issuing any additional shares-as-compensation, and any other appropriate relief due to damages sustained from the Board’s misconduct.
In response, the Board formed an investigative committee of a single, outside, non-management director. The Board also retained outside counsel which was not then otherwise representing Appellee or its Board members. After thorough review, the committee recommended refusal of Shareholders’ demand. The Board unanimously voted to refuse the demand and informed Shareholders that the proposed litigation was not in the corporation’s best interest because Appellee would likely lose, suffer substantial harm, pay both sides’ legal fees, and incur substantial costs even in the event it won due to the millions of dollars required to generate new executive compensation awards.
In 2014, Shareholders began the instant litigation, alleging three derivative claims (breach of fiduciary duty, waste, and unjust enrichment) and two direct claims (breach of contract and promissory estoppel). Appellees moved to dismiss, contending that because all five counts were essentially derivative claims and because Shareholders had failed to plead sufficient facts to overcome the presumption that the Board had acted in the best interest of the company, the Board was entitled to the protections of the business judgment rule. Appellees further asserted that were the court to reach the merits, Shareholders had failed to state a claim on any of the five counts. The circuit court agreed and dismissed Shareholders’ complaint in its entirety. Shareholders timely appealed.
Analysis: On appeal, Shareholders sought to establish that the circuit court had erred in two areas: first, by granting motion to dismiss the derivative claims, and secondly by dismissing those claims styled as direct claims.
A derivative action requires the corporation’s board of directors to conduct an investigation into the shareholders’ allegations to determine whether pursuing the demanded litigation is in the best interests of the corporation. Should the corporation fail to so litigate and the shareholder bring a “demand refused” action, the court is typically tasked with reviewing whether the board acted independently, in good faith, and with sound business judgment.
On this point, Appellees sought the protections afforded by the presumption of business judgment rule.
Meanwhile, Shareholders argued that the court should apply an exception to the rule developed by the Court of Appeals in Boland v. Boland
The Shareholders maintained that because the Boland
court had established that a demand refusal was not entitled to business judgment rule protection, then Shareholders were entitled to discovery as to the process by which the Board had made its decision not to litigate leaving the burden to fall on Appellees to provide evidence of acting in good faith and reasonableness.
However, the court distinguished the instant case from Boland
, noting that the demand refusal there was made by a special litigation committee (“SLC”) appointed in light of a minority of disinterested directors.
In this case, the decision to refuse demand was made unanimously by a board consisting of a majority of disinterested and independent directors.
As a result, the court found the business judgment rule to apply, and not the Boland
So finding, the court placed the burden on Shareholders to establish sufficient facts that the directors had failed to act on an informed basis, in good faith, and with honest belief that actions taken were in the best interests of the corporation. In each instance, the court found Shareholders’ arguments unpersuasive. Shareholders’ allegation that the demand rejection was tainted by one director having received benefits under the contested executive compensation plan was insufficient because the other 5 directors remained disinterested. Shareholders’ bald allegations of impropriety in the demand investigation were also insufficient in light of the committee’s 40 years of business experience and use of highly respected and experienced outside counsel. Further, allegations of a mere personal friendship, outside business relationship, or compensation for services – standing alone – were insufficient to raise an inference of lack of independence.
The court was similarly unpersuaded by Shareholders’ next contention that the Board had acted in contravention of authority granted by shareholders in the 2009 plan. Finding express discretionary language in the text of the 2009 plan, Appellees were clearly entitled to modify the 2008 executive compensation awards. The court then doubled down: assuming arguendo that the compensation plan modification was improper, the Board acted properly because any remedy would have been detrimental to the best interests of the corporation by incurring considerable additional compensation or tax liabilities.
Shareholders next maintained the lower court had erred by considering facts contained within the Board’s letter refusing demand, arguing that the court should have permitted discovery or, at minimum, made independent factual determinations. Finding no Maryland precedent, the court looked to Delaware law; pursuant to the business judgment rule, statements contained within a letter refusing demand are presumed true absent a particularized rebuttal. Here again, the SLC exception did not apply because the demand refusal was approved by Appellee’s majority-disinterested and majority-independent Board. Because a court’s decision to grant discovery in a demand-refused derivative action would undermine the business judgment rule by obviating the Board’s authority to decide whether litigation was pursuant to the corporation’s best interest, the lower court did not err by denying discovery. Accordingly, Shareholders failed to meet their burden of establishing sufficient facts and the court held that the lower court did not err by granting motion to dismiss the derivative claims.
Finally, the court turned to the “direct” claims. Here, the court noted that to maintain direct claims, shareholders must allege sufferance of an injury separate and distinct from that suffered directly by the corporation or derivatively by the shareholder due to injury to the corporation. Because the injuries allegedly suffered would have been sustained by the corporation (by incurring compensation or tax liability), any claims would have properly been derivative. The court further found no merit to either claim because the 2009 proxy statement did not constitute a contract, and because no detriment could have been avoided by its enforcement (nullifying a claim of promissory estoppel). The remaining “direct” claims were therefore derivative and properly subject to dismissal.
The full opinion is available in PDF
: James K. Bredar
: The U.S. District Court for the District of Maryland, declining to import the doctrine of presumed reliance from federal securities-fraud cases, held that to succeed on a negligent misrepresentation theory involving audit reports made in connection with a 401(k) Plan, employees must prove, among other matters, justifiable action was taken in reliance on the alleged misrepresentation.
: Plaintiffs were former employees of a transportation contractor. The company established a 401(k) Plan as an employee benefit plan governed by ERISA. Defendant-auditor was retained to perform an audit of the Plan’s financial statements for 2009, 2010 and 2011, as required by ERISA’s detailed reporting requirements.
By year-end 2011, the company’s contributions to the Plan were several quarters behind, such that the company owed over $700,000 to the Plan. Plaintiffs alleged that the Defendant’s audit reports for 2010 and 2011 contained material omissions regarding the Plan.
: A plaintiff asserting a claim for negligent misrepresentation must prove that, among other factors, the plaintiff took justifiable action in reliance on the statement. The Court stated that for purposes of the Plaintiff’s negligent misrepresentation theory, it was not enough that the audit reports may have contained omissions or even misinformation. The Plaintiffs must demonstrate that they relied on the reports to their detriment. The Court highlighted that four of the five Plaintiffs admitted that they had no independent recollection of reading or reviewing the audit reports.
Plaintiffs urged the Court to import the doctrine of presumed reliance from federal securities-fraud cases into this state law claim. The Court noted precedent indicating that the “most prominent distinction between common law fraud and a [10b-5] violation is that the latter permits recovery based on a … theory which presumes reliance, while the former requires proof of actual reliance.” The Court, noting that it was a federal court sitting in diversity, declined to expand tort liability under Maryland law and granted summary judgment on the negligent misrepresentation claim.
Plaintiffs also alleged breach of professional negligence. The Court stated that a professional negligence claim, similar to any negligence claim, requires the plaintiff to establish: (i) a duty was owed to Plaintiff; (ii) a breach of that duty; (iii) causation between the breach and the harm; and (iv) damages. Maryland courts recognize the “but for” test and the substantial factor test when analyzing whether causation exists. The Court noted that the Defendants, as auditors, were not directly responsible for the over $700,000 deficiency in the Plan. The Court also noted that the Plaintiffs cannot contend they would have taken action to remedy the deficiencies in the Plan because four of five of the Plaintiffs never saw the reports.
Plaintiffs argued that the audit reports serve a dual purpose of alerting the Plan participants and the Department of Labor of irregularities and that “but for” the inaccurate audit reports the DOL would have been on notice of the deficiencies and able to correct the arrearage. The Court stated that the DOL was already conducting an investigation at the time of the 2011 report and that “a careful study of the documents [from the 2010 report] shows the numbers reconcile.” The Court granted summary judgment on the professional negligence claim.
The opinion is available in PDF.