Reasonable Expectations Of Minority Shareholders Frustrated By Dilution of Ownership, But Not By Termination Of Employment

The "reasonable expectations" of minority shareholders as to continued employment and continued stock ownership were the issue in Vernon v. Cuomo, 2009 NCBC 6 (N.C. Super. Ct. March 17, 2009), decided yesterday by the North Carolina Business Court.

Judge Tennille ruled after a one week trial that the Plaintiffs did not have a reasonable expectation of continued employment, given extreme animosity that had developed among the shareholders of the Company. 

On the dilution issue, however, the Court ruled that Plaintiffs had a reasonable expectation that their ownership interest in the Company would not be diluted, at least not through the means that the Defendants chose to accomplish that dilution. Plaintiffs were restored by the Court to their original ownership position and the Court ordered dissolution of the Company.

The Plaintiffs were two shareholders with a 40% ownership in TriboFilm, Inc., which was developing technology to eliminate silicone as a necessary lubricant in syringes.  They had a serious falling out with the Defendants, five other shareholders who controlled the remaining 60% of the Company.  The Court described the situation as "intolerable" and "dysfunctional."

The majority stripped the Plaintiffs of their status as employees, officers, and directors. Then, after each faction rejected an offer by the other to be bought out, the Defendants implemented a plan to virtually eliminate the Plaintiffs' ownership interest.  Here's what happened as the Court described it:

  • Defendants voted themselves "unrealistic" and "inflated" salaries (most of them had not had any salary at all before this) or salary increases.  The Company did not have the financial ability to pay these salaries.
  • The Defendants then agreed to defer a substantial portion of their new salaries.
  • None of this information regarding salaries and deferral was disclosed to Plaintiffs.
  • Next, the Directors voted to convert a portion of the deferred salary into Company stock at a penny per share, much less than they had been offered by Plaintiffs.
  • Defendants, in their capacities as Board members, then recommended to the shareholders that the number of outstanding shares be increased from 1 million shares to 15 million shares to permit the deferred salary conversion.
  • The Defendants informed the Plaintiffs that the reason for the new shares was to raise additional capital and pay certain obligations.  They did not disclose their plan to exchange their deferred salaries for some of the new stock.
  • The share issuance resolution was approved by the shareholders, over Plaintiffs' objections.
  • The Defendants then each forgave $15,000 of deferred salary (an essentially worthless claim, given the financial state of the Company) in exchange for 1,500,000 shares of Company stock.
  • The effect of the transfer was to immediately reduce each Plaintiff's ownership interest in the Company from 20.2% to 2.4%.

Plaintiffs sued, asserting that their "reasonable expectations" as shareholders to continued employment and continued ownership of their stock had been frustrated.  They lost on the first point, but won on the second.

There Were No Reasonable Expectations To Continued Employment

The Court rejected the argument that the Plaintiffs had a reasonable expectation of continued employment with TriboFilm, at least once they became at odds with their fellow shareholders.  It held:

While shareholders may hold reasonable expectations as a result of their ownership of a small, closely held company, those expectations may be subverted to the overall business interest of the company or may become unsustainable under certain circumstances. At the outset of their involvement, Vernon and Williams had a reasonable expectation that they would continue to work with TriboFilm. That expectation ceased to be reasonable when the Company and the relationships among the shareholders became dysfunctional. It is undisputed on this record that by fall 2005, all trust among the parties had disappeared. The Company could not operate and fulfill its function. There was no communication or cooperation among the small group of researchers who were required to work closely together. A company is not required to fulfill once-reasonable expectations of continued employment where that employment may be detrimental to the ongoing survival of the business. Something had to be done to keep the Company alive and functioning. A majority of shareholders agreed on how to accomplish that goal. The majority was within its rights to terminate the employment of Vernon and Williams, and it did not breach a fiduciary duty by doing so under the circumstances that existed in this case.

Op. ¶78.

There Were Reasonable Expectations Of Undiluted Stock Ownership

The reasonable expectations of the Plaintiffs regarding their continued stock ownership were different.   The Court observed that while startup companies "often have to issue new stock to angel investors," Vernon and Williams "had reasonable expectations that their ownership percentage in TriboFilm in relation to the Individual Defendants' ownership percentage would not be changed without their consent,"  at least not "purely to benefit other shareholders."  Op. ¶72. 

The Court held that the Defendants had been engaged in self-dealing through the transactions which diluted the ownership interest of the Plaintiffs.  It rejected the argument that the Defendants were entitled to the protection of N.C. Gen. Stat. §55-8-31(a), which allows for conflict of interest transactions under certain defined circumstances.

Given the receipt by the directors of a personal financial benefit from the transaction, the Court held that the directors were not entitled to the benefit of the Business Judgment Rule.  And in light of the self-dealing nature of the transaction, the burden of proof fell on the Defendant to prove that the transactions were fair, just, and reasonable. They were unable to carry that burden.

The remedy ordered by the Court was to rescind the issuance of additional shares to the Defendants, restoring the Plaintiffs to their previous ownership percentages.  The Court also held that the actions taken by the Defendants showed "the majority is not operating, and will not operate, the Company in the best interest of all the shareholders."  Op. ¶91.  It therefore ordered the dissolution of the Company, subject to the right of the Company to purchase the Plaintiffs' shares at fair value.

 

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