North Carolina Business Litigation Report : North Carolina Business Litigation Lawyer & Attorney : Mack Sperling : Brooks Pierce Law Firm : Greensboro, Raleigh, Winston-Salem, Charlotte

If you are a derivative action plaintiff, and you make a demand on an LLC to take action which is then considered and rejected, may you still pursue your claims?  Judge Murphy answered that question, and others relating to derivative actions under Delaware law in this week's opinion in  Scott v. Lackey, 2012 NCBC 58.

By the way, the reason that I am writing today about Delaware law, instead of North Carolina law, is that the entities involved in the Scott case were formed in Delaware, so Judge Murphy ruled that Delaware law controlled.

Derivative Action After Rejected Demand

In North Carolina, the answer is in G.S. §57C-8-01. If the Court appoints a committee of "two or more disinterested managers, directors, or other disinterested persons, acceptable to the limited liability company, to determine whether it is in the best interest of the limited liability company to pursue a particular legal right or remedy."  Then, if the committee determines that it would not be in the best interests of the LLC to pursue the claim, the Court can dismiss it.

In Delaware, the answer is a bit more complicated, as borne out by the Business Court's decision  in the Scott case. 

Delaware law in this niche implicates the business judgment rule.  Three issues arise:

'(1) whether the [managers] acted independently and not self interestedly; (2) whether the [managers] reasonably investigated the basis for the proposed litigation; and (3) whether the [managers] refused to act in good faith.  Seaford Funding Ltd. P’ship v. M & M Assocs. II, 672 A.2d 66, 70 (Del. Ch. 1995) (citing Spiegel, 571 A.2d at 777).

Op. ¶52.

in Delaware, by making a demand, the derivative plaintiff "tacitly concedes the independence of a majority of the board to respond."  Op. ¶52.  But Delaware law does not imply a concession that the managers of an LLC will act in a disinterested way in considering a demand.  Op. ¶53.

Judge Murphy found a "reasonable doubt" as to whether two of the managers had acted in good faith in responding to the demand.  He noted that they had refused to meet with the Plaintiff to discuss his concerns.  He also observed that they stood to benefit directly from the challenged transactions, and he denied the Motion to Dismiss the derivative claims.

Adequacy Of Derivative Plaintiff

A Delaware derivative Plaintiff "must be qualified to serve in a fiduciary capacity as a representative of a class, whose interest is dependent upon the representative's adequate and fair prosecution."  Op. ¶93.

The Defendants in the Scott case said that Scott was an inadequate Plaintiff because he had a personal interest in gaining control of the LLC.

Judge Murphy disagreed, holding that "selfish motives alone will not mandate Plaintiff's disqualification as an inadequate representative."  Op. ¶96.  He added that "it is hardly unusual for derivative plaintiffs to have their own interests in mind when bringing a derivative action."  Id.

The Defendants pointed to a defamation claim lodged against them by the Plaintiff as evidence of Plaintiff's vindictiveness towards them.  Judge Murphy shot down that argument as well, again looking to Delaware law:

absent some concrete fact revealing a conflict between Plaintiff and BHCM, 'amorphous hostile feelings against defendants [are] not in [themselves] relevant.' Emerald Partners, 564 A.2d at 677 (quoting Vanderbilt v. Geo-Energy Ltd., 590 F. Supp. 999, 1001 (E.D. Pa. 1984)).

Op. ¶99.

Defendants also argued that the Plaintiff's derivative action did not have the support of other members of the LLC.  That too was an insufficient argument  Judge Murphy observed that "[a] derivative claim may be maintained . . . without the support of a majority or ownership or even the support of the entire minority."  Op. ¶100.

Breach of Fiduciary Duty

Judge Murphy found that the Defendants owed a fiduciary duty to the Plaintiff, stating that "unless otherwise stated in the LLC agreement, 'the member-managers of a Delaware limited liability compan[y] owe traditional fiduciary duties to the LLC and its members."  Op. ¶69.

For a long time, that appeared to be the law of Delaware, but recent developments show that it is not.  In Gatz Properties LLC v. Auriga Capital Corp., No. 148, 2012 (Del. Supr. Nov. 7, 2012), the Delaware Supreme Court said that the issue of a "default fiduciary duty" remained an "open question," 

It chastised the Chancey Court Judge for saying otherwise, stating 

We feel compelled to address this dictum 'because it could be misinterpreted in future cases as a correct rule of law,' when in fact the question remains open. Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 167 (Del. 2002).

Gatz, supra, at n.62 (emphasis added).

Would it have made a difference to Judge Murphy's opinion if Delaware law had been clear on the fiduciary duties of managers?  Probably not, as it seems inevitable that the Delaware Supreme Court will reach the conclusion that managers have a fiduciary duty to their LLC.  The North Carolina Court of Appeals  ruled three years ago that LLC managers owe such a fiduciary duty to the LLC, in  Kaplan v. O.K. Technologies, LLC.

I wrote about the differences between Delaware and North Carolina on the point of LLCs and fiduciary duty in April 2009.

*   *   *

If you are wondering what I want for Christmas, it would be a decision from the North Carolina Business Court on an open question of North Carolina's corporate law to write about.  I'm tired of writing about Delaware law.  

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 If you dip in to Judge Murphy's Wednesday opinion in Blue Ridge Pediatric & Adolescent Medicine, Inc. v. First Colony Healthcare, LLC, 2012 NCBC 51, you'll find a little bit of everything.  It's a ruling on a Motion to Dismiss a Complaint that alleged everything under the sun.  Here are the high points:

Quick Facts

The Plaintiffs entered into a deal with the Defendants for them to develop office space for the Plaintiffs' medical practice.  Plaintiffs were to share in the profits from the sale of the property, but none were ever paid.  There were also allegations of misrepresentations by the Defendants as to their financial stability and claims of unauthorized changes to the transaction documents.

The Complaint sets out 23 causes of action against multiple defendants.

Piercing the Corporate Veil

The lesson here is that rote pleading won't get you there on a piercing the corporate veil claim.  Plaintiffs recited the bare bones of the "instrumentality rule" in their Complaint, but Judge Murphy said that "these bare legal conclusions are not entitled to the presumption of truth afforded factual allegations on a motion to dismiss."  Op. ¶37.  Plaintiffs needed to point to specific acts of control or domination to state a valid claim.

Fraud

Plaintiffs said they relied on Defendants' representations of their financial stability.  The truth was that Defendants were teetering on the brink of insolvency.

Judge Murphy nevertheless dismissed the claims for fraud, fraud in the inducement, negligent misrepresentation and negligence.  He found that the Plaintiffs had failed to show reasonable reliance because they had failed "to allege facts in support of their own investigation and due diligence."  Op. ¶48.

Securities Fraud

After determining that the Plaintiffs had stated a claim for securities fraud under the North Carolina Securities Act, Judge Murphy ruled that the individual defendants, employees of the corporate defendants, could be personally liable for the securities fraud, notwithstanding their argument that they had acted as corporate agents.

He held:

Defendants misapprehend the well-settled rule that 'one is personally liable for all torts committed by him, including negligence, notwithstanding that he may have
acted as agent for another or as an officer for a corporation.' Strang v. Hollowell, 97 N.C. App. 316, 318, 387 S.E.2d 664, 666 (1990) (citing Palomino Mills, Inc. v.
Davidson Mills Corp., 230 N.C. 286, 52 S.E.2d 915 (1949)).

Op. ¶64.

What about the lack of justifiable reliance which doomed the common law fraud claim, you may be thinking.  Judge Murphy disposed of that in a footnote, saying: "The Court is unaware of any case law asserting that the common law fraud requirement for alleging justifiable reliance extends to statutory claims for securities fraud. And, the Court declines to extend such a requirement to this claim at this stage."  Op. ¶63 & n.2.

Derivative Action

A member of an LLC who wants to file a derivative action is required by statute to allege "with particularity the efforts, if any, made by [him] to obtain the action [he] desires from the  managers, directors, or other applicable authority and the reasons for [his] failure to obtain the action, or for not making the effort."  N.C. Gen. Stat. §§ 57C-8-01(a)–(b) (2011). 

The efforts of these Plaintiffs to make the LLC aware of their claims were limited to sending a letter outlining their claims along with the contemporaneously filed Complaint.  Judge Murphy found that to be "insufficient" to meet the requirements of the statute and he therefore dismissed the derivative claims.

And More

There are many more claims discussed in this Opinion, including an unfair and deceptive practice claim, a civil conspiracy claim, and a constructive trust claim.  There is also discussion of equitable estoppel and a request for an accounting.

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The Fourth Circuit delivered a lump of coal right before Christmas to a Wachovia shareholder whose 100,000 shares of the Bank's stock, once worth about $5.6 million, sank into near worthlessness when Wachovia failed.  The case, decided December 23rd, is Rivers v. Wachovia Corp., and it affirms the dismissal of all of Rivers' claims.

Rivers sued Wachovia and its top officers and directors for misrepresenting the Bank's  financial condition in the months leading up to its failure in 2008.  He said that he would have sold his shares but for the positive statements made by  the Bank about its soundness and stability, which he said amounted to fraud.

Judge Wilkinson said that although Rivers sought to cast his claims as belonging personally to him (i.e. "individual"), they were in fact derivative claims (which belonged to the corporation). 

It is almost impossible in North Carolina for a shareholder to sue an officer or director for the loss in value of stock.  The Fourth Circuit said that in North Carolina and in South Carolina as well, "[t]he well-established general rule is that shareholders cannot pursue individual causes of action against third parties for wrongs or injuries to the corporation that result in the diminution or destruction of the value of their stock."

The reasons that such individual actions are precluded include that they prevent "self selected
advocate[s] pursuing individual gain rather than the interests of the corporation or the shareholders as a group,[from] bringing costly and potentially meritless strike suits."  All Wachovia shareholders were equally injured by the misrepresentations of which Rivers complained.

So, " [a] derivative lawsuit is . . . the vehicle for a shareholder to litigate injuries that result in the diminution in value of the corporation’s stock." The North Carolina Supreme Court has recognized two exceptions to its solidly established rule: "(1) where there is a special duty, such as a contractual duty, between the wrongdoer and the shareholder, and (2) where the shareholder suffered an injury separate and distinct from that suffered by other shareholders."

No Fiduciary Duty Was Owed By Wachovia's Officers To Rivers As A Shareholder

Rivers argued that the defendants owed him a "special duty," which Rivers said was met by the fiduciary duty owed to him by the officers and directors of Wachovia.

Judge Wilkinson quashed that argument, stating  that "[u]nder North Carolina law, officers and directors of a corporation owe a fiduciary duty to the corporation which does not create an individual cause of action."  In other words, the fiduciary duty of an officer/director is owed to the corporate entity, not to the shareholders individually.  Note that the answer can be different with a closely held corporation. 

There Is No Valid Claim For A "Lost Profit Opportunity"

Rivers' argument that he had a "special injury" met with the same result.  He argued that he "meant to sell his shares in Wachovia before the decline in share price but forwent the opportunity to sell based on the false statements of defendants."  Rivers characterized this as a "lost profit opportunity," but the Court said this argument was "indistinguishable" from the argument that every Wachovia shareholder might make.  Judge Wilkinson said the "effort to disguise a classic derivative claim for the decline in stock value as a 'lost profit opportunity' " was "too clever by half."

Judge Wlkinson also pointed out what he termed a "troublesome paradox" in Rivers' claim.  Rivers was saying that the fraudulent scheme caused his injury, but the same scheme had inflated the value of the stock in the first place.  He said that "[t]he failure to sufficiently capitalize on the effects of an alleged fraudulent scheme is not an injury we are prepared to credit." 

There is also a hypothetical aspect to a shareholder saying he would have sold his shares.  When? How many shares?  At what price?  Judge Wilkinson said that "[u]nlike a typical securities claim involving a precise date, number of shares, price, and profit or loss," such claims "involve only a hypothetical transaction."

So that's Rivers' lump of coal.  And if the Rivers case seems like "deja vu all over again," it is.  The North Carolina Business Court dismissed identical claims (brought by the same Plaintiff's counsel) early in 2011 in Harris v. Wachovia Corp., 2011 NCBC 3. In fact, that last quote from the Rivers case is straight  from Judge Jolly's opinion in Harris. But be aware that Mr. Harris suffered more pain than Mr. Rivers.  He owned 900,000 shares of Wachovia stock.  And he didn't even get a lump of coal for Christmas. 

And for the rest of us, we did better than a lump of coal because it's not all that often that the Fourth Circuit decides a derivative action case.  There's now a clearly articulated opinion on the issues decided in Rivers.  It's a must cite if you are moving in federal court to dismiss a derivative claim masquerading as an individual claim.

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It’s hard to call a client and have to tell her that the case you filed for her was dismissed. But it must be even harder to tell a client that she now has to pay the defendant for his legal fees in winning the dismissal. And think how much worse that would be if the defendant were her ex-husband.  And it's even worse if it's Thanksgiving!

That hasn’t happened to me (at least not yet), and I hope it hasn’t happened to you, but it is the phone call that the lawyers representing Jane Sutton in Sutton v. Sutton, 2011 NCBC 43 probably had to make after Judge Jolly’s ruling in her case on the Tuesday before Thanksgiving.

Jane Sutton became a shareholder in her husband’s business, Sutton’s Tree Service, Inc. during their marriage. She filed a derivative action against her ex-husband on behalf of the corporation for conversion, breach of fiduciary duty and the “improper filing of income tax returns.” Op. ¶1.

There were two fatal flaws in this turkey of a lawsuit which led to its dismissal. The first was that there had been no demand on the corporation to take the action against Mr. Sutton. Section 55-7-42 makes a demand a precondition to the filing of a derivative action. It says:

No shareholder may commence a derivative proceeding until:

(1)        A written demand has been made upon the corporation to take suitable action; and

2)        90 days have expired from the date the demand was made unless, prior to the expiration of the 90 days, the shareholder was notified that the corporation rejected the demand, or unless irreparable injury to the corporation would result by waiting for the expiration of the 90‑day period.

There’s also a statutory requirement that the person filing the derivative action must have been “a shareholder of the corporation at the time of the act or omission complained of….” N.C. Gen Stat. §55-7-41(1). He or she must also be able to “[f]airly and adequately represent[] the interests of the corporation in enforcing the right of the corporation.” Id. At 55-7-41(2).

The second fatal flaw was that in addition to not making a demand, Mrs. Sutton hadn’t been a shareholder of the corporation since her divorce from Mr. Sutton, which was undoubtedly before the alleged misconduct had taken place. There had been a Consent Judgment by which Mrs. Sutton had “surrendered to Defendant any and all interest she had in the Corporation.” Op. ¶11.

Judge Jolly said that her lack of ownership was established as a matter of res judicata and collateral estoppel, since the “Consent Judgment constitutes a valid, final judgment determining the respective rights of Plaintiff and Defendant regarding ownership of the Corporation.” She therefore had no standing to maintain the suit, and Judge Jolly ordered that it be dismissed,

So what about the fees, you are wondering. The statute on fees in derivative actions says that “On termination of the derivative proceeding, the court may:. . .  Order the plaintiff to pay any defendant's reasonable expenses, including attorneys' fees, incurred in defending the proceeding if it finds that the proceeding was commenced or maintained without reasonable cause or for an improper purpose.” N.C. Gen. Stat. 55-7-46(2).

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This week, Judge Jolly permitted a 50% shareholder to pursue derivative and individual claims against her co-shareholder. He found that the plaintiff had satisfied the demand requirement of G.S. sec. 55-7-42, and that she fit an exception to the general rule that a shareholder cannot pursue an individual cause of action for the diminution or destruction of the value of her stock.

The decision came in LeCann v. Cobham, a long running bitter dispute between dentists who operated a number of entities providing dental care.  LeCann said that Cobham had diverted funds from a practice in which they shared ownership to another dental practice operated solely by Cobham.

G.S. sec 55-7-42 says that a shareholder "may not commence a derivative proceeding" without having made a written demand "upon the corporation to take suitable action."  In discussing the adequacy of LeCann's demand, Judge Jolly quoted Russell Robinson, who says that no specific form of demand is required by the statute:

except to require that it be in writing; but to serve its purpose it should set forth the facts of share ownership and  describe the redress demanded with enough particularity to allow the corporation either to correct the problem, if any, without a lawsuit or to bring its own direct action.

ROBINSON ON NORTH CAROLINA CORPORATION LAW, § 17.03[1] (7th ed. 2009).

There is no appellate North Carolina authority evaluating the sufficiency of a demand. The form of the LeCann written "demand" was several emails from LeCann to Cobham telling her to quit taking corporate funds for her own benefit  and to return what had been taken.  You can read one of the emails here. The Court said that these demands were "clear and particular enough to put Defendant Cobham reasonably on notice as to the substance of Plaintiff's objections." 

Now, why did LeCann have the right to sue Cobham on an individual basis, especially in light of the NC Supreme Court's opinion in Barger v. McCoy Hillard & Parks, 346 N.C. 650 (1997), where it held:

that shareholders cannot pursue individual causes of action against third parties for wrongs or injuries to the corporation that result in the diminution or destruction of the value of their stock.

Id. at 658.  Those types of claims affect all shareholders equally, and belong to the corporation.

LeCann said that she could pursue her claims on an individual because Cobham owed her a "special duty," a recognized exception to the Barger rule, as she was the only other shareholder in the companies.  Judge Jolly remarked that Cobham had asserted herself in her Answer that LeCann owed her a "duty of care, good faith, loyalty, fair dealing, full disclosure, [and] avoidance of self dealing."  He said given that each party claimed the other party owed her a fiduciary duty of care, that there was a genuine issue of material fact precluding a dismissal of LeCann's claims.  He also equated the co-equal shareholders to partners, who certainly owe a fiduciary duty to one another.

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In one of his final actions as a Business Court Judge, Judge Tennille threw down the gauntlet for lawyers representing class action plaintiffs who are seeking approval of settlements.  Last week in Ward v. Lance, Inc., Judge Tennille condemned what he called "stinky fees," which he said "just smell bad and have no economic justification."

Stinky fees, from Judge Tennille's observation, are paid because "[w]e have come to the point in this country that whenever a merger is announced, some lawyer with a client holding a small number of shares rushes to file a lawsuit containing class action allegations."

But it wasn't just the plaintiffs' lawyers who got a lashing from Judge Tennille.  He included the lawyers defending these cases, the investment bankers who arrange the deals, and also the companies engaging in the transactions.  Here's what he said:

For their part, defense lawyers, investment bankers, and the companies are willing to pay these fees to get the deal done, regardless of the merits. Defense lawyers get paid to handle them. The fees are not significant in light of the amounts involved in the deal. Defendants are, in effect, complicit in the economically valueless charade. Our overburdened courts do not have the time or adequate information to review the settlements. If we continue to impose these unnecessary financial burdens of our legal system on financial transactions, these transactions will eventually move to London, Hong Kong, or Munich, or some other venue outside the United States. . . .The Court suspects that investment bankers bake that fee into the anticipated costs of the transaction.

In a non-binding request to judges hearing fee petitions in future cases, Judge Tennille said
Ihat they "should decline to approve any settlement that does not benefit shareholders in a material way." 

There's no way to tell if that request will be followed, but there are multiple cases pending which challenge the Duke Energy-Progress Energy merger.  In the absence of a material benefit to shareholders of those companies from the cases, it might be a good time for the Business Court to take a stand against what Judge Tennille called "an economically valueless charade."

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If you are bringing or defending a derivative action in North Carolina, you may have to look to the law of another state to determine whether a pre-filing demand on the board of directors to pursue the claim is a prerequisite and whether there are any exceptions to the need for a demand.  The law depends on the corporation's state of incorporation.  In a case decided by the North Carolina Business Court on Friday, Smith v. Raymond, 2010 NCBC 18, the application of Delaware law resulted in the dismissal of  a derivative action against the directors of a Delaware corporation because of the Plaintiff's failure to establish that the demand should have been excused because a demand would have been futile.

Delaware and North Carolina disagree on the futility exception to the demand requirement.  North Carolina does not recognize a futility exception.  In a 1998 decision in Greene v. Shoemaker, Judge Tennille observed "it is absolutely clear that the [North Carolina] legislature intended to adopt the universal demand requirement and eliminated the futility exception when it passed the 1995 North Carolina Business Corporation Act."  Delaware. with a different point of view, recognizes futility as an excuse to the demand requirement.

So do North Carolina's lawyers need to know about demand futility when it has been rejected as an exception to demand in North Carolina?  Sure, because when a Delaware corporation is the defendant in a derivative action, the application of Delaware law to resolve issues is required by North Carolina statute.  The General Statutes provide that "in any derivative proceeding in the right of  foreign corporation, the matters . . . shall be governed by the laws of the jurisdiction of incorporation of the foreign corporation."  N.C. Gen Stat Sec. 55-7-47 (2009). The failure to make a demand before filing  a lawsuit against a Delaware corporation resulted in the dismissal  on Friday in Smith v. Raymond.

The defendants in the Smith case were outside directors of Horizon Lines, Inc.  Other directors had previously pled guilty to price-fixing charges, and the Complaint in the North Carolina case asserted that the outside directors had "knowingly conspired" in the illegal price-fixing plan and that a demand upon them would therefore have been futile.

Judge Diaz held that the allegations of the Complaint "fell far short of what is required under Delaware law to excuse demand."  He described those allegations as "blanket allegations that the directors participated in or approved the alleged misconduct."  A 1993 Delaware Supreme Court decision, Rales v. Blasband, 634 A.2d 927 (Del. 1993) requires "particularized factual allegations" as to why a demand would have been futile.

Demand can also be excused under a standard set forth in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), which applies when a particular transaction is being challenged.  In such a case, the questions are:

i) whether a reasonable doubt is created that the directors are disinterested and independent; and (ii) whether the pleading creates a reasonable doubt that the challenged transaction was anything other than the product of a valid exercise of business judgment.

The Aronson standard didn't apply, according to Judge Diaz,  because the Complaint did not allege a decision by the Horizon board of directors which would implicate the business judgment rule.

The best place to keep up Delaware law regarding corporations  is Francis Pileggi's Delaware Cororate and Commercial Litigation Blog.

Brief in Support of Motion to Dismiss

Brief Opposing Motion to Dismiss

Reply Brief in Support of Motion to Dismiss

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The alleged efforts of a board of directors to entrench itself – which included refusing to permit dissent shareholders to vote at a shareholders meeting and issuing additional shares to give the board majority control of the company – were the subject of the Business Court’s opinion last Friday in Green v. Condra, 2009 NCBC 21 (N.C. Super. Ct. August 14, 2009).

Among other things, the Court held that a shareholder can maintain an individual (i.e. not derivative) claim for breach of fiduciary duty when his right to vote his shares is disallowed, and also let the Plaintiffs go forward on derivative claims for gross mismanagement and unjust enrichment.

Background

The parties were shareholders and/or directors of MedOasis, which provided billing services to anesthesiology practices. In November 2005, the Board removed the Plaintiffs, Green and Ellington, as directors and also fired Plaintiff Green as CEO. The company offered Green a buyout of his shares. He refused.

The other Plaintiff, Ellington, had been an anesthesiologist at MedOasis’ first and largest client, AAA. In May 2008, the company terminated its management contract with AAA. It then told Ellington that it was as a result required to repurchase his shares. It based the right to repurchase on a bylaw provision saying that MedOasis shareholders had to be members of medical practices under contract with MedOasis.

Other AAA shareholders had been offered redemption, and had also refused the offer. Twenty of those shareholders gave Ellington their proxies, giving him control over 481,000 shares. Combined with Green’s shares, the two Plaintiffs had control over 707,000 shares of the company’s 1,147,109 shares outstanding, a clear majority.  The members of the board held the remaining 440,109 shares that had been issued.

The Board Actions At Issue

Green then called a shareholders’ meeting. The Board, concerned about its minority position and the impending vote, called an emergency meeting at which it took a number of defensive steps which formed the basis for the lawsuit.

First, the board decided that it would not let Ellington and Green vote the shares they controlled. Next, it issued an additional 280,000 shares to two of the defendants at a below market value price. Those additional shares gave the board members a majority of the outstanding shares. Last, it decided that it wouldn’t give notice of the shareholders meeting to Ellington and Green or the shareholders whose shares they controlled.

Ellington and Green showed up at the shareholder meeting notwithstanding the lack of notice. The company refused to let them vote their shares or the shares over which Ellington held a proxy. It did count the newly issued shares, and defeated motions proposed by Green to change the composition of the board.

The Plaintiffs then made a written demand on the company for it to take “suitable action.”  The board refused to act. The lawsuit, raising a fusillade of individual and derivative claims, followed.

In the opinion on Defendants' motion to dismiss, which for the most part denied the motion, Judge Diaz dealt with a series of corporate law issues:

Exculpatory Provision

The Defendants first said that they were immune from suit based upon an exculpatory provision in the company’s articles of incorporation. That provision, however, didn't extend to claims arising from “any transaction from which the director derived an improper personal benefit.”

Judge Diaz held that Plaintiffs’ allegations regarding the issuance of the new shares “at a stated price well below its market value or fair value” in order to “ensur[e] that the board could protect itself from being unseated,” did not fall within the scope of the exculpation clause.

Individual Claims For Breach Of Fiduciary Duty

Most of the claims asserted by the Plaintiffs were derivative in nature, but Plaintiffs also raised their own individual claims for breach of fiduciary duty and constructive fraud. Defendants asserted that all of the claims were derivative in nature and that they could not be maintained on an individual basis.

Judge Diaz acknowledged that the fiduciary duty owed by the MedOasis directors was owed to the corporation as opposed to the individual shareholders, and that such claims are generally derivative, but nevertheless held that Plaintiffs could proceed on their individual claims.

The Court focused on the refusal of the board to permit the Plaintiffs to vote their shares, ruling that the right to vote “is specifically recognized by statute” per G.S. §55-7-21(a). Judge Diaz referenced Delaware precedent holding that when “a plaintiff shareholder alleges that Company stock was issued for grossly inadequate consideration and primarily for entrenchment purposes, the claim “may state either an individual or derivative claim.” (quoting Avacus Partners, L.P. v. Briani, Civil Action No. 11001, 1990 Del. Ch. LEXIS 178, at *22 (Del. Ch. Oct. 24, 1990)). Op. ¶158.

Judge Diaz concluded by holding that the individual claims raised “statutory violations of Plaintiffs’ right to vote their shares at the 18 August 2008 shareholders’ meeting,” and that claims of this nature “are properly pled as individual claims.” Op. ¶159.

Derivative Claim For Breach Of Fiduciary Duty

The Court held that the derivative allegations regarding the board’s efforts to entrench itself made out a claim for breach of fiduciary duty. It said that this conduct would be “a breach of their fiduciary duty to discharge their duties in ‘good faith,’ which includes a responsibility to act with undivided loyalty to the Company.” Op. ¶122. 

Furthermore, the Court held that the Defendants were not protected by the Business Judgment Rule because the “sole purpose” of the challenged conduct was to “thwart a shareholder vote.” Op. ¶123. The claimed misconduct amounted to bad faith, which “rebutt[ed] the deference normally afforded a Board by the business judgment rule.” Op. ¶124.

The Court further held that Plaintiffs could proceed on their claim for constructive fraud based upon the same allegations.

Derivative Claims For “Abuse Of Control,” Corporate Waste, and “Gross Mismanagement”

Derivative claims made by the Plaintiffs for abuse of control and corporate waste were dismissed by Judge Diaz, who ruled these claims were “not recognized as independent torts in North Carolina.” Op. ¶¶127-28. He said, however, that these claims were embraced by the derivative claims for breach of fiduciary duty, gross mismanagement, and constructive fraud.

The claim for gross mismanagement survived. The Court ruled that this was essentially a claim for a violation of the statutory duty of care under G.S. §55-8-30(a)(2), which requires a director to exercise his duties “with the care an ordinarily prudent person in a like position would exercise under similar circumstances.” It observed that North Carolina “courts have recognized that a claim for gross mismanagement against a director is a proper derivative claim.” Op. ¶133.

Derivative Claim For Unjust Enrichment

The alleged conduct of the Defendants in entrenching themselves on the board also made out a derivative claim for unjust enrichment. The Court held:

Plaintiffs allege that Defendants unlawfully circumvented Plaintiffs’ voting rights so as to retain their seats on the Board, and, as a result, Defendants will continue to receive salaries, benefits, bonuses, stock issues, etc., at the Company’s expense and ‘under circumstances where it would be unfair for [Defendants] to retain [these benefits] without [the Company] being repaid or compensated.’ These allegations are sufficient to make out a claim for unjust enrichment. 

Op. ¶¶145-46.

Brief in Support of Motion to Dismiss

Brief in Opposition to Motion to Dismiss

Reply Brief in Support of Motion to Dismiss

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Can you have a default entered against you if you aren't a proper party to the lawsuit?  The answer is yes, at least on the unique facts before the Business Court in its opinion Friday in the derivative action Regional Property Development Corp. v. Carpenter.

Regional Property, a member of Lancaster Industrial Park, LLC, had filed a derivative action on behalf of the LLC against three other members of Lancaster, and also the lender to the LLC, Regions Bank. 

In a March 25th Order, the Business Court dismissed the derivative claims, ruling that Regional Property wasn't entitled to sue on behalf of Lancaster because of it hadn't made a demand on the managers of the LLC to file the suit.  The Court allowed Regional Property leave to amend to assert demand futility.

But right before that ruling, Regions Bank had counterclaimed against Lancaster, asserting that Lancaster was in default on its loan obligations to the Bank.  Lancaster, whose derivative claim had been dismissed by the time the answer deadline had run, didn't answer.  (Or rather, Regional Property, which had brought the lawsuit, didn't answer on behalf of the LLC).  Regions Bank then moved for entry of default.

The other defendants, the members who had moved to dismiss the derivative action, objected to the Motion for Entry of Default and said that default was not proper because the LLC wasn't a party to the litigation.  They said in their Opposition that "Lancaster cannot be in default in this matter for the simple reason that it is not a party."  They also argued that Regions Bank should be estopped from arguing that Lancaster was a party, because it also had taken the position there was no authority for Regional Property to file the lawsuit on behalf of Lancaster.

Judge Diaz entered default over that objection.  He said that once the counterclaims were filed, Lancaster "was bound to respond to the counterclaims or risk default, regardless of whether it should have appeared in the action to begin with."  Also, given that Regional Property had moved after the dismissal of its derivative action to amend the Complaint to excuse its lack of demand, the Court held:

where a party seeks to pursue a claim derivatively on behalf of a limited liability company, the LLC is a necessary party and is normally joined as a defendant. See generally Russell M. Robinson, II, Robinson on North Carolina Corporation Law § 17.05[2] (7th ed. 2008) (citing relevant cases with respect to derivative actions filed on behalf of a corporation). Thus, even if Lancaster now disavows any role in this case as a party-plaintiff, because Regional Property’s Second Amended Complaint asserts derivative claims on Lancaster’s behalf, Lancaster remains a party.

If you are going to fire off a derivative action, you need to be prepared to defend against whatever might get shot back in the way of a counterclaim. 

[Update: The Court set aside this entry of default in an Order dated September 23, 2009, permitting the members of the LLC to adopt after the fact a response to the counterclaims filed by the Plaintiff when it did not have authority to act for the LLC in filing the lawsuit].

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The Court of Appeals split yesterday on whether a Plaintiff and his lawyers who continued with a lawsuit after they should have determined that it was not well grounded in fact or law could be hit with non-monetary sanctions.  The majority reversed, saying that the trial court should not have considered events occurring after the filing of the Complaint in awarding sanctions.

The case decided by the Court of Appeals is Egelhof v. Szulik.  The case arose in the Business Court, and was a shareholder derivative action against the technology company Red Hat.  Judge Tennille dismissed the case in 2006 due to Plaintiff's failure to make a proper demand under Delaware law. 

After that, Defendants moved for sanctions and attorneys fees.  In the 2008 decision appealed from, Judge Tennille sanctioned Plaintiff and his lawyers by barring Plaintiff from serving as a representative plaintiff for five years and by barring the lawyers from being admitted pro hac in North Carolina for a like period.  Judge Tennille refused to award monetary sanctions.

Plaintiff appealed, arguing that there was no basis for Rule 11 sanctions because there had been no finding by the Business Court that their Complaint was "neither well grounded in fact nor warranted by existing law" at the time it was filed.  They were right, as the Business Court had expressly stated that the Complaint, standing alone, did not warrant Rule 11 sanctions.  Defendants appealed too, arguing that they were entitled to monetary sanctions.

The Business Court's sanctions ruling was based on post-filing events which it said should have led the Plaintiff to conclude that it should no longer pursue its action, including the dismissal of another case (Pozen) brought in the Business Court by the same lawyers, for the same reason that the Egelhof case was dismissed a few months later: failure to make a demand under Delaware law. 

The Court of Appeals majority concluded that a Court cannot consider matters outside the face of the Complaint in determining whether the Complaint lacked factual or legal support so as to warrant Rule 11 sanctions.  It relied on Bryson v. Sullivan, 330 N.C. 644, 412 S.E.2d 327 (1992), in which the Supreme Court held that "in determining whether a pleading was warranted by existing law at the time it was signed the court must look at the face of the pleading and must not read it in conjunction with responsive pleadings."

Judge Calabria dissented, holding that "sanctions are not limited when later filings reveal the case has become meritless.  The trial court may look beyond the face of the pleading when considering whether litigation was continued for an improper purpose."  Judge Calabria found that sanctions were appropriate not only under Rule 11, but also under the inherent power of the Court.

And Judge Calabria took it one step further, holding that the trial court had erred by not giving proper consideration to an award of monetary sanctions under N.C. Gen. Stat. §6-21.5.  Relying on Sunamerica Financial Corp. v. Bonham, 328 N.C. 254, 400 S.E.2d 435 (1991), she held that a "trial court is required to evaluate whether the losing party persisted in litigating the case after a point where he should reasonably have become aware that the pleading he filed no longer contained a justiciable issue."

The Supreme Court will sort out this disagreement if the case goes forward, but there are two other Rule 11 tidbits in this opinion on which the majority and majority agreed:

The Court held that Rule 11 permits sanctions to be imposed against a party and his attorney attorney even though they didn't sign the Complaint.  (Here, out-of-state counsel had never signed the Complaint, but were sanctioned by the trial court.) 

The Court of Appeals also held that due process does not require that a party against whom sanctions are sought be put on notice of the specific type of sanctions which may be ordered, rejecting a due process challenge by the Plaintiff.  All that is required is notice of the bases of the sanctions and an opportunity to be heard.

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The United States District Court for the Middle District of North Carolina dismissed an LLC member's fiduciary duty claims against a manager based on grounds of standing in Morris v. Hennon & Brown Properties, LLC.

The Defendant LLC was an investor and member of three limited liability companies.  It alleged in a counterclaim that the Plaintiff, the manager of three of the LLCs, owed it a direct fiduciary duty, and that Plaintiff had violated that duty by comingling funds of the LLCs and using them for his personal benefit. 

Plaintiff pitched its Motion to Dismiss on the argument that a co-manager of the LLC does not have a fiduciary duty to its members under N.C. Gen. Stat. Sec. 57C-3-22, which sets out the duties of LLC managers.  The Court declined to decide the case on this basis, noting that there was no North Carolina state court authority on the point and stating that it had an obligation to approach an issue of first impression cautiously, and to avoid it if possible. 

The Court instead framed the issue as follows: "the more important question in this case is to whom is that duty owed-to the LLCs or to the member individually."  The Court found that the breaches of duty alleged by the Defendant would have affected all of the members of the LLC, not just the Defendant, and that the Defendant therefore was not entitled to assert a direct claim for breach of fiduciary duty.

The Court concluded as follows in granting the Motion:

In the instant case, Defendant fails to make any allegations of a special duty owed only to it and not the other members of the LLCs, nor has it shown that it suffered a special loss, separate and distinct from the harm to the LLCs and other members of the LLCs. Consequently, Defendant has no standing to bring a direct or individual action against a member-manager of the LLCs. For this reason, Defendant's claims alleging breach of fiduciary duty should be dismissed.

This case was decided about a month ago, I picked it up from this week's North Carolina Lawyers Weekly.

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Regions Bank v. Regional Property Development Corp., 2008 NCBC 8 (N.C. Super. Ct. April 21, 2008) (Diaz)

The Business Court ruled today that a member of a North Carolina LLC could not sue the LLC's lender for aiding and abetting a breach of fiduciary duty, because that claim was derivative, not direct.

Here are the facts: The LLC had defaulted on its loan.  The Bank then sold the loan to the other members of the LLC.  The Defendant asserted in a counterclaim that the Bank had done so knowing that the other LLC members would use their ownership of the defaulted loan as leverage to obtain a substantial cash distribution to which they were not entitled.

The Court relied on “[t]he well-established general rule . . . that shareholders cannot pursue individual causes of action against third parties for wrongs or injuries to the corporation that result in the diminution or destruction of the value of their stock.”   That principle applies "equally to suits brought by members of a limited liability company."

The unlawful distribution claim was "just another way of saying that the Individual Members wrongfully diverted Company assets."  That was a derivative claim belonging to the Company, not to its members.  The Motion to Dismiss the Counterclaim was therefore granted.

The Court did not resolve a parallel ground for the Motion to Dismiss: whether North Carolina still recognizes a claim for aiding and abetting a breach of fiduciary duty in light of the United States Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).  That question has come before the Business Court a number of times in recent years, but has not been resolved by North Carolina's appellate courts.

Brief In Support Of Motion To Dismiss

Brief In Opposition To Motion To Dismiss

Supplemental Brief In Support Of Motion To Dismiss

Supplemental Brief In Opposition To Motion To Dismiss

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Egelhof v. Szulik, 2008 NCBC 2 (N.C. Super. Ct. Feb. 4, 2008)(Tennille)

It’s hard to imagine a more inadequate plaintiff than Egelhof to undertake the fiduciary responsibility of being a plaintiff in a derivative action against Red Hat, a publicly traded company. Egelhof was only 24 years old, and held only a few hundred dollars of Red Hat's stock. He had become a plaintiff in response to a solicitation on the internet. As the Court described Egelhof, "[h]e had little investing experience, no experience in litigation, no prior connection with the [his] law firm, no personal knowledge of [the corporation] and its operations, and a minor criminal record."

The Court concluded that this plaintiff "lacked any credentials to act as a fiduciary for a company in multi-million dollar litigation." Noting Egelhof’s paltry stake in Red Hat, the Court held that "[w]hile the size of ownership is not determinative of standing, a potential plaintiff's lack of a real financial stake in the litigation is a warning sign that he or she may not be willing or able to devote the time necessary to fulfill the fiduciary obligations imposed by law on a shareholder derivative plaintiff."

These factors alone would probably not have warranted sanctions, but Egelhof was completely uninvolved in his case. He relocated, more than once, and never gave his lawyers a forwarding address. He sold his stock during the course of the lawsuit, creating a significant standing issue, but never mentioned this to his lawyers. He had never even met his lawyers until the night before his deposition and had spent a total of five hours on the case by the time he was deposed.

The Court's sanction to Egelhof was to prohibit him from being a plaintiff in a class action or derivative action in North Carolina for the next five years. The lawyers came in for an equally harsh sanction.

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