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

In what Judge Tennille described as a "close case," the Business Court reconsidered and reversed the prior dismissal of a breach of fiduciary duty claim, but the principles it outlined should not give litigants high hopes for reconsideration motions in general.

Charlotte-Mecklenburg Hospital Authority v. Wachovia Bank, N.A. involved an investor suing its advisors over investments gone bad.  The Hospital Authority asserted a number of claims against Wachovia, including a breach of fiduciary duty claim that the Court dismissed last October on a Rule 12(b)(6) motion.

Discovery ensued, and at the end of discovery Plaintiff moved to reconsider the dismissal of the fiduciary duty claim under Rule 54(b).  Several points from the order are worth noting.

First, the Court adopted the federal Rule 54(b) standard, which allows for reconsideration of interlocutory orders at any time before final judgment, but which has judicially-created, policy-based limitations to situations:  "(1) where there has been an intervening change in controlling law; (2) where there is additional evidence that was not previously available; or (3) where the prior decision was based on clear error or would work manifest injustice.”

Second, the plaintiff did not argue an intervening change in controlling law, but instead asserted a new legal theory -- that as a federally registered investment adviser, one of the Wachovia defendants was a fiduciary as a matter of law.  Rather than new law, this argument was based on a 1963 U.S. Supreme Court case and a 2003 decision from the Eastern District of Virginia.  The Court was troubled by the assertion of a new theory on a motion to reconsider:

Motions for reconsideration do not serve as an avenue for a party to “present a better and more compelling argument that the party could have presented in the original briefs.”   Madison River Mgmt. Co. v. Bus. Mgmt. Software Corp., 402 F. Supp. 2d 617, 619 (M.D.N.C. 2005).  Generally, when a party “fails to present his strongest case in the first instance,” he loses the “right to raise new theories or arguments in a motion to reconsider.”  Duke Energy Corp., 218 F.R.D. at 474.  Nonetheless, had Plaintiff presented this newly raised argument initially, it would have affected the Court’s decision.  Metropolitan’s status as a federally registered investment advisor provides the strongest case for asserting clear error of law in the Court’s October 9, 2010 Order.  However, the fact that a party did not make its strongest and best case on prior submissions will not, standing alone, justify reconsideration.

Third, Plaintiff also asserted that newly discovered facts justified reconsideration.  The Court did not believe Plaintiff's argument that the defendant's status as a federally registered investment advisor was a fact not available until discovery.  On the other hand, Plaintiff provided facts adduced during discovery that demonstrated the existence of a special relationship of trust and confidence.

The Court was troubled by the fact that discovery occurred on a dismissed claim, but determined that justice required reconsideration and reversal of the dismissal:

This Court is not inclined to encourage parties to conduct discovery on claims that have already been eliminated in hopes of finding grounds for reconsideration.  Litigation is complex and expensive enough as it is without conducting discovery on claims that have already been dismissed.  Furthermore, viewing Plaintiff’s position charitably, many of the “new” facts adduced could have related to Plaintiff’s breach of contract claim as well as its breach of fiduciary duty claim.

However, the newly discovered facts, if true, would have impacted the Court’s earlier decision.  These new facts contradict the facts on which the Court previously relied.  The Court, therefore, will set aside the concerns expressed herein and hold fast to its ultimate responsibility—reaching “the correct judgment under law.”

In reconsidering the dismissal, however, the Court noted the inequity of allowing Plaintiff to take discovery on the dismissed claim while Defendants relied on the dismissal by not seeking discovery relevant to that claim.  To remedy the situation, the Court ordered discovery by Plaintiff to be closed, but allowed Defendants a 90-day period to conduct discovery on the revived fiduciary duty claim.

Full Order

[Ed. note:  The Business Court has been busy this week issuing orders at a rate faster than your humble author has been able to comment upon them.  Stay tuned for more posts in the coming days on some other recent orders of interest.]

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The insolvency of prominent contractor Bostic Construction, Inc. has been a fertile source of Business Court litigation over the last couple of years in three cases against the company's officers and directors.  A recent Bankruptcy Court decision from the Middle District permits the Business Court cases to proceed, holding that they are not barred by a settlement between the bankruptcy trustee and those officers and directors.

The procedural history is complicated (as you would expect with three cases in Business Court and one in Bankruptcy Court) but the underlying facts are not.  Bostic Construction was formed by one of the "Hogs," former Redskins guard Jeff Bostic, and his brother, former St. Louis Cardinals guard Joe Bostic, both Greensboro natives.  In its heyday, Bostic was the nation's second-largest apartment builder, with over $200 million in revenue.  Bostic Construction's operating model focused on construction management, delegating most or all of the labor, materials, and equipment to subcontractors.

During the 1990s, Bostic Construction performed most of its work for unrelated third parties, but at the turn of the millenium, the company transitioned to projects for LLCs owned or controlled by company insiders.  Those insiders also formed other LLCs to provide labor and materials to Bostic Construction at a profit for the LLCs.  Bostic Construction's financial condition deteriorated in 2003 and 2004, and the company's creditors allege that the insiders began acting to ensure the profitability of the LLCs rather than Bostic Construction itself.

Bostic Construction's creditors filed an involuntary Chapter 7 petition in January 2005.  The trustee settled the company's claims against the insiders in 2007.  Three cases then were filed in Superior Court against the insiders:  the Phillips & Jordan case in January 2008, and the American Mechanical and Yates Construction cases in October 2009. 

The insiders moved for Judge Diaz to dismiss the American and Yates cases and moved the Bankruptcy Court for an interpretation that its order approving the 2007 settlement barred the creditors' claims against the insiders.  (By that time, Judge Diaz had already ruled that the plaintiffs in the Phillips & Jordan case had direct claims against the insiders which were not impacted by the trustee's settlement).  Judge Diaz stayed the American and Yates cases pending the Bankruptcy Court's ruling.

The Bankruptcy Court held that the settlement did not bar the Business Court claims.  The key question was whether the creditors' claims were personal, direct claims against the insiders or whether they were derivative claims that could be asserted only by the trustee.  That question is determined by state law. 

Judge Waldrep cited North Carolina cases for a familiar series of propositions:  

Although the general rule is that directors of North Carolina corporations do not owe a fiduciary duty to the creditors of the corporation, an exception exists when there are circumstances amounting to a winding up or dissolution of the corporation. . . .  If the directors and officers continue to operate an insolvent corporation only to recover the amounts owed to them, to the detriment of the corporation’s other creditors, North Carolina courts equate that to a winding up or dissolution and find that the directors and officers owe a fiduciary duty to creditors. . . . However, no duty is owed to creditors, even if the corporation is balance sheet insolvent, when the directors and officers are acting in good faith in running the business.

The claims of constructive fraud, aiding and abetting constructive fraud, and violations of the NC RICO statutes were personal to the creditors, not derivative.  The circumstances of Bostic Construction amounted to a winding up or dissolution of the business, creating a fiduciary duty from the directors to each creditor to support the constructive fraud and aiding and abetting claims.  (The Court noted the ongoing doubt over whether any aiding and abetting claims exist under North Carolina law anymore, but ruled that if they existed at all, they were direct claims).  Similarly, the Court examined the text of Chapter 75D, which includes the element that RICO defendants personally benefit from the illegal conduct.  Based on that element, the Court concluded that the RICO claims were direct, not derivative, and were not barred by the settlement.

Bankruptcy Court Opinion

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For almost 30 years, minority shareholders in North Carolina have sought relief from corporate oppression via so-called Meiselman actions.  An important Business Court opinion released Tuesday discusses the limits of Meiselman claims, which will be less appropriate the larger the number of shareholders and the greater the corporate governance in operation.

In the Meiselman case itself, the Supreme Court permitted minority shareholders in closely-held corporations to seek judicial relief to enforce those shareholders' reasonable expectations, such as employment or participation in management.  Meiselman characterized closely-held corporations as "little more than 'incorporated partnerships,'" often formed due to family or friend relationships, in which the minority shareholders are not practically able to bargain for protection (or to recognize the need for protection) when the corporation is formed.  Meiselman involved seven such corporations -- all part of a family business formed by the father of the two brothers who found themselves on opposite sides of the lawsuit.

The Business Court decision confronted a different situation, and those differences determined a different outcome.  In High Point Bank & Trust Co. v. Sapona Mfg. Co., at issue were the plaintiff's rights as minority shareholder of three corporations.  Although the corporations originated as family businesses -- the youngest of which was over 75 years old -- the shareholder and employee base had expanded significantly over time.  Acme-McCrary, a hosiery manufacturer, now has 81 shareholders and 892 employees; Sapona, a yarn processor, now has 51 shareholders and 200 employees; Randolph Oil, a petroleum wholesaler and convenience store owner, now has 25 shareholders and 49 employees.  The shares of these corporations were unmarketable and functionally locked the shareholders into ownership absent some company action.  Two of the three corporations had issued tender offers to their shareholders on one or two occasions in the last 20 years.

Following the death of the individual plaintiff, the daughter and granddaughter of the companies' founders, her executor asked the three companies to redeem her shares at a market value established by an appraisal that the executor commissioned.  Each company's board of directors met and considered the request, but declined.  The executor sued under a Meiselman theory, arguing that the companies' refusal to repurchase the shares was coercive and oppressive conduct leaving a minority shareholder without rights.  The question for the Court was whether the right to have stock repurchased was an enforceable right or interest under Meiselman.  If so, the corporations' refusal to repurchase rendered that right in need of protection.

Judge Tennille began his analysis by discussing the broad Meiselman remedies and the limitations on those remedies from more recent statutory amendments.  Under the old N.C.G.S. § 55-125, a court had equitable discretion to fashion a number of remedies besides dissolution of the corporation -- remedies such as repurchase at fair value, altering corporate bylaws provisions, or prohibiting certain corporate actions.  Section 55-14-30, the modern replacement, eliminates those alternative remedies.  With liquidation as the only remedy, judicial dissolution required a "strong showing" because such a remedy conflicted with the business judgment rule and other traditional judicial deference to corporate governance. 

The Court viewed this case as significantly different from Meiselman and the Court's own 1999 decision in Royals v. Piedmont Elec. Repair Co. (which found a right of redemption for a minority shareholder) for several reasons.  First, there was no loss of ownership benefits here.  Plaintiff was not denied an opportunity to work; the trust now holding her shares continued to receive the same benefits that she enjoyed while living; no assets were diverted; no excessive salaries were paid, but regular dividends were paid to all shareholders.  The Court held that there was no mandatory right of redemption of stock in closely-held corporations.  Such a right "would place the other shareholders in close corporations at financial risk upon the death of any shareholder."

Second, there was no personal or familial antagonism of the sort experienced in Meiselman.  The plaintiff was never an employee or involved in management, and thus was not being deprived of such opportunities.  The majority of shares in the three companies were owned by non-employees.

Third, there was no controlling shareholder and the shares were diffused to a much greater extent than in Meiselman.  Each corporation observed corporate formalities.  The majority of the companies' officers were not related to the founders.  In short, these corporations were not the same as a corporation with three shareholders being run like a partnership.

The Court was not willing to create a bright-line number of shareholders that would remove a corporation from Meiselman analysis.  Nevertheless, the more diffuse the ownership of a company, the more important "the number, composition, and rights and interests of the non-complaining shareholders" become.  "Where, as here, there is no impediment to the majority of shareholders exercising their voting rights, the courts should not intervene on behalf of a minority shareholder."

Judge Tennille also held that the plaintiff had no reasonable expectation of a right of redemption.  There was no written agreement establishing such a right.  The limited activities of the corporations with a one-time tender offer and a one-time repurchase of the shares of a deceased shareholder were not sufficient to create a future right of redemption.  Most importantly, there was no evidence that any shareholder other than the plaintiff or any officer or director had any notice of or expected that plaintiff would have such a right of redemption.

The expectation also was unrealistic on two grounds:  first, that the redemption of plaintiff's minority interest would be at fair market value with no minority discount, and second, that the redemption would be personal to plaintiff.  The latter, in particular, would have created "stiff fiduciary challenges" from the other shareholders.  Although the plaintiff had some minimal evidence of oppression, "oppression is not the standard for determining rights and interests.  It is applicable only when determining the need for protection."

Meiselman likewise requires consideration of the impact of the plaintiff's claim on other shareholders.  Here, dissolution would impose stock value and tax losses on all of the other shareholders and displace hundreds of employees.

After High Point Bank & Trust, it would be an overstatement to declare Meiselman dead for corporations with more than a handful of shareholders.  Nevertheless, the larger the shareholder base and the more significant the formal corporate governance, the less likely it is that a corporation will have created unwritten "expectations" for shareholders or that the corporation will face dissolution in the name of shareholder protection.

Full Order & Opinion

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An award of damages for breach of a noncompete agreement, like any other damages award, requires evidentiary support.  In a judgment issued yesterday after a bench trial, the Business Court awarded the plaintiffs nominal damages absent such evidence.

In HILB Rogal & Hobbs Co. v. Sellars, the Court faced a common factual scenario:  a former vice president of the plaintiffs resigned and went to work for a direct competitor.  The businesses in question were insurance companies targeting building materials suppliers.  The plaintiff and defendant executed an employment agreement that contained standard restrictions on post-employment competition and on the use of confidential business information.

Two days after interviewing for the competitor's job, the defendant

copied the entire hard drive of his work computer, which contained, among other things, confidential and proprietary information about [plaintiffs'] Lumber Program accounts and business strategies, including account files and lists, policy expiration dates, policy terms, conditions and rates, internal and external pricing and profit margins, information relating to accounts’ risk characteristics, and carrier information.

He resigned two weeks later and went to work for the competitor, taking the confidential information with him.  (The Court ordered him to return the confidential information in 2008).

Plaintiffs asserted claims for breach of fiduciary duty, breach of contract, and unfair & deceptive trade practices, and defendant counterclaimed for breach of contract for unpaid salary.  Judge Diaz applied New York law to the claims.

During the lawsuit, the defendant took two Rule 30(b)(6) depositions of the plaintiffs concerning their claimed damages.  At those depositions, the witness, another vice president of plaintiffs, disclaimed lost profits, as did counsel for the plaintiffs.  The witness did not know of the origin or calculation of two summary exhibits that plaintiffs attempted to use at the bench trial -- those exhibits were prepared by other employees, none of whom testified at trial.  Judge Diaz noted at least eleven unexplained discrepancies between the two exhibits.  Moreover, the Rule 30(b)(6) witness "could not rule out the possibility that the damages exhibits contained amounts for lost revenues for business that Plaintiffs could not underwrite, irrespective of [defendant's] alleged breach of the Employment Agreement."

The damages witness suddenly became unavailable for trial due to the pre-trial but post-discovery termination of his employment -- he declined to appear voluntarily, and he was outside the Court's subpoena power.  The plaintiffs attempted to notice a de bene esse deposition less than one month before trial.  The Court quashed the notice of deposition based on a month-long delay between plaintiffs' awareness of the witness's unavailability and the issuance of the notice, as well as the fact that the Court already had continued the trial once to allow de bene esse depositions to occur.  Thus, plaintiffs had to rely upon his deposition testimony.

Although the plaintiffs proved that the defendant breached his fiduciary duty and breached the employment agreement by copying the contents of his hard drive before resigning, the Court held that there was insufficient evidence of damages.  Under New York law, breach of fiduciary duty damages "are limited to profits lost from the actual diversion of customers," a damages theory that the plaintiffs waived. The Court awarded $1 in damages for the breach of contract claim.

Although the plaintiffs attempted to rely on a liquidated damages formula in the employment agreement, the Court similarly held that they had not provided sufficient evidence of the components of that formula.  Specifically, the Court rejected the argument that the summary exhibits were admissible business records under Rule 803(6) because the Rule 30(b)(6) witness did not lay any foundation for admissibility or for the reliability of the figures contained in the exhibits.  The Court awarded $1 in damages for the breach of contract claim.

The Court rejected the unfair and deceptive trade practices claim, holding that North Carolina's Chapter 75 was inapplicable under the "most significant relationship test" and that, even if it applied, the lack of actual damages was fatal to a UDTP claim.  Likewise, the Court found no basis to award punitive damages or attorneys' fees.

As for the counterclaim, the employee asserted that he was entitled to over $94,000 in unpaid salary.  The plaintiffs responded that an interim $50,000 payment constituted an accord and satisfaction.  The Court rejected plaintiffs' defense on the grounds that they failed to prove that the $50,000 was intended to settle all compensation claims or that the defendant was informed of that intention before he accepted the check.  Instead, the Court offset the $50,000 payment from the employee's salary claim and awarded him the balance.

Although the claims on both sides arose under New York law, there is no apparent reason why the result would be different under North Carolina law.  In either event, enforcement of a noncompete provision can prove to be an expensive proposition (here, two and a half years of litigation), particularly where the former employee has counterclaims.

Full Order and Judgment

[UPDATE:  In an Order dated July 6, 2010, Judge Diaz denied the company's motion to reconsider the ruling on the employee's counterclaim].

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In modern business litigation in North Carolina, it is increasingly rare to see a complaint that does not contain a claim under G.S. § 75-1.1 for unfair or deceptive trade practices.  Courts that have prevented the statute from having almost unlimited application have done so by determining that particular activities are not "in or affecting commerce."  The Supreme Court continued that pattern last week, holding that a dispute between partners did not trigger Chapter 75 liability.

In White v. Thompson, partners in a Bladen County fabrication and welding business enjoyed initial success, but "eventually fell victim to disagreements and infighting among the partners."  Two partners filed suit alleging that the third partner started a competing business that diverted the business of the original partnership.  The plaintiffs asserted that their partner's conduct constituted breach of fiduciary duty and unfair and deceptive trade practices.  The jury found in plaintiffs' favor and awarded judgment in the amount of $138,195 against the former partner.  The trial court ruled that the acts were unfair and deceptive and trebled the judgment amount pursuant to G.S. § 75-16.

Both defendants appealed, and a divided panel of the Court of Appeals reversed as to the former partner.  (Mack Sperling reported the Court of Appeals' decision to you last May).  Plaintiff appealed to the Supreme Court as of right based on the dissent in the Court of Appeals.

Justice Newby examined several prior Chapter 75 cases, including HAJMM Co. v. House of Raeford Farms, Inc., 328 N.C. 578, 403 S.E.2d 483 (1991).  HAJMM established that securities transactions and other "capital-raising activities" are not "in or affecting commerce" so as to trigger Chapter 75 liability.  The Court also cited Bhatti v. Buckland, 328 N.C. 240, 400 S.E.2d 440 (1991), for the proposition that the General Assembly intended to regulate conduct between market participants in two categories:  "(1) interactions between businesses, and (2) interactions between businesses and consumers."  (The Business Court has relied on the HAJMM line of cases to reject internally-generated Chapter 75 claims on several occasions,  including J Freeman Floor Co., LLC v. Freeman (May 14, 2009) (unpublished) (usurpation of LLC opportunities, dismissed on basis of Court of Appeals' opinion in White); Reid Pointe, LLC v. Stevens, 2008 NCBC 15, 2008 WL 3846174 (Aug. 18, 2008) (discharging LLC manager and demanding capital call); Kaplan v. O.K. Technologies, LLC (June 27, 2008) (unpublished) (dispute among LLC members), and Maurer v. Slickedit, Inc., 2005 NCBC 1, 2005 WL 1412496 (May 16, 2005) (dismissal as CEO, denial of board participation, and failure to take action to sell company)).

As the Supreme Court stated, Section 75-1.1 "is not focused on the internal conduct of individuals within a single market participant, that is, within a single business. . . .  As a result, any unfair or deceptive conduct contained solely within a single business is not covered by the Act."  Because the dispute was between partners, the Court affirmed the decision of the Court of Appeals reversing the trial court judgment.

Justice Hudson, joined by Justice Timmons-Goodson, dissented.  She criticized the majority's holding for relying on an outdated statement of purpose contained in a disco-era version of the statute.  She also distinguished HAJMM  on the grounds that the capital-raising activities in that case were not the core function of the company, whereas the disputes in White involved two partnerships competing for the business of a particular customer.

The bottom line is that, although White doesn't exactly break new ground given that HAJMM has been the law of North Carolina for nearly 20 years, the Supreme Court declined the opportunity to retreat from HAJMM and expand the scope of the unfair and deceptive trade practices statute.  The upside for North Carolina businesses is that treble damages should continue to be unavailable in internal corporate disputes.

Supreme Court Opinion

Court of Appeals Opinion

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I'm not sure we've ever had the opportunity to describe a Business Court opinion as "epic" before, but here we are.  On Friday, in State v. Custard, the Court delivered a 70-page, 4-appendix opinion that's the corporate governance equivalent of The Ten Commandments or Ben-Hur.  In addition to a thorough discussion of directors' duties under North Carolina and Delaware law, the opinion answers four previously unanswered questions posed in the Robinson on North Carolina Corporation Law treatise that occupies a prominent shelf in every North Carolina business lawyer's library.

Custard was a breach of fiduciary duty case brought by the Commissioner of Insurance as the liquidator of Commercial Casualty Insurance Company of North Carolina ("CCIC") against three directors of CCIC.  To make a long story short, CCIC focused on "artisan" liability insurance policies for small contractors and tradesmen in California.  For a period of time, it also offered non-standard auto policies in North Carolina and redomesticated itself from Georgia to North Carolina in 2001, thus becoming subject to NCDOI regulation.  In hindsight, CCIC set its premiums too low and wrote too many policies.  As the Court tactfully phrased it, "CCIC’s growth outperformed the Company’s ability to generate policyholder surplus."  It became insolvent in 2004.

Key points from Judge Tennille's opinion include:

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A minority shareholder who said he was forced to resign as an officer and director of the company got past a Motion to Dismiss challenging his claims for breach of fiduciary duty, breach of the duty of good faith and fair dealing, conspiracy, and punitive damages in the Business Court's opinion last Friday in Oakeson v. TBM Consulting Group, Inc.

Plaintiff had been TBM's Vice President of Global Consulting, a board member, and owned a 13.5% interest in the company. He was party to both a Shareholders Agreement and an Employment Agreement. The latter agreement had a five year term, running through 2009, and specified that Plaintiff could only be terminated for defined "cause."

The Plaintiff alleged that Sharma, the majority shareholder of TBM, began demanding, insistently, that Plaintiff resign. Plaintiff refused to do so. Sharma told Plaintiff that he and the other defendants had the votes to remove Plaintiff as an officer and director of the company, and that they were "resolute in [their] decision to remove [him]." He told Plaintiff that he shouldn't bother to attend the board meeting at which the vote would be taken.

Plaintiff gave in and resigned as a director, but not as an officer and employee. Sharma then continued his pressure on Plaintiff to obtain a full resignation, to which Plaintiff finally agreed. Plaintiff then filed suit against the company raising a variety of claims resulting from his ouster.

Breach of Fiduciary Duty: Judge Jolly, denying the motion as to the claim for breach of fiduciary duty, said that "our courts long have recognized that a controlling shareholder owes a fiduciary duty to minority shareholders not to misuse his management power to promote his personal interests." Op. ¶44. The opinion has a brief history of appellate cases recognizing the duty of the majority to the minority, beginning with White v. Kincaid, 149 N.C. 415 (1908), and continuing through Gaines v. Long Manufacturing Co., 234 N.C. 331 (1951) and Freese v. Smith, 110 N.C. App. 28 (1993).

Breach of Covenant Of Good Faith and Fair Dealing: Defendants argued that a tort action which arises from a breach of contract couldn't be maintained. Judge Jolly disagreed, and said "the allegations go beyond a pure and simple contract claim. Rather, they raise implications of the respective fiduciary duties, if any, between shareholders in a closely-held corporate setting, and of possible civil conspiracy." Op. ¶40.

Civil Conspiracy: In response to the motion to dismiss the conspiracy claim, the Court recognized that "North Carolina does not recognize an independent cause of action for civil conspiracy," Op. ¶48, but Judge Jolly went on to say that "where there exists a separate but underlying claim for unlawful conduct, a plaintiff also may state a claim for civil conspiracy by alleging that two or more persons came together in agreement to carry out the unlawful conduct complained of in the separate cause of action, and that injury to the plaintiff proximately resulted from the agreement." Op. ¶48. The Complaint, said the Court, "alleges that the Defendant shareholders agreed upon a combined course of various actions designed to force Plaintiff out of TBM in all his corporate capacities, one of those actions resulting in beach of Plaintiff's Employment Agreement." Op. ¶49.

Punitive Damages: The claim for punitive damages also survived the Motion to Dismiss. Judge Jolly ruled that "when a breach of contract claim reflects potential fraud or deceit, or other aggravated or malicious behavior, a claim for punitive damages may lie." Op. ¶52. He said also that "the North Carolina courts will recognize a claim for punitive damages arising from a breach of fiduciary duty when it is coupled with the requisite aggravating factors." Op. ¶53.

The opinion is premised on the liberal pleading standard of the U.S. Supreme Court's decision in Conley v. Gibson. The Conley standard has been rejected by the Supreme Court, but remains the law of North Carolina based on a recent North Carolina Court of Appeals opinion.

Brief in Support of Motion to Dismiss

Brief in Opposition to Motion to Dismiss

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Directors of corporations verging on insolvency can owe fiduciary duties to creditors under certain circumstances.  Whether those duties were owed -- and whether the claim for their breach had been released as a part of the corporation's bankruptcy proceeding -- were the main issues yesterday in Phillips and Jordan, Inc. v. Bostic, 2009 NCBC 13 (N.C. Super. Ct. June 2, 2009).

The Plaintiff claimed that the Defendant directors had diverted money through "a web of sham entities" for their own personal benefit during a time when the corporation faced "deepening insolvency" and that they were liable to it under a theory of constructive fraud.

Here's how Judge Diaz described North Carolina law on the duties of directors of a corporation in financial difficulty:

In certain circumstances. . . corporate directors may owe a fiduciary duty to creditors of the corporation. The circumstances under which a director’s fiduciary obligations extend to creditors have been limited to those situations 'amounting to a "winding up" or dissolution of the corporation.'

'Once the fiduciary duty arises, a director must treat all creditors of the same class equally by making any payments to such creditors on a pro rata basis.'

Where a creditor can show constructive fraud by a director at a time when the corporation 'is in declining circumstances and verging on insolvency,' or 'where such facts establish circumstances that amount "practically to a dissolution,"' the claim is one that 'belongs to the creditor and not the corporation.'

Op. ¶¶42-45.

The Court denied the Defendants' motion to dismiss the Plaintiff's claim for constructive fraud.  It also rejected arguments that the claim had been settled as a part of the corporation's bankruptcy proceeding, ruling that "where . . . the claim arises from a purported breach of a fiduciary duty owed by a corporate director to a creditor, and where the claim, therefore, properly belongs to the creditor and not the corporation, 'it is not a part of the bankruptcy estate, and the trustee in bankruptcy does not have authority to bring [or settle the] claim.'"  

In another part of the Opinion, the Court granted a motion to dismiss a fraud claim because it failed to comply with Rule 9(b).  The Complaint, which asserted the fraud claim against a group of individuals, did not identify the specific person who made the alleged misrepresentations.  The Court allowed leave to amend.

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The fiduciary duties owed by members and managers of limited liability companies are very different under North Carolina and Delaware law.  In a bit of judicial serendipity, the North Carolina Court of Appeals and the Delaware Court of Chancery each issued opinions on those issues last week, just a day apart. 

The North Carolina case is Kaplan v. O.K. Technologies, LLC (April 21).  the Delaware Court of Chancery case is Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC (April 20).  The two cases highlight the differences in the nature and scope of fiduciary duties in the LLC context.

The Delaware View

The Delaware view, crisply stated in the Emery Bay decision, was summed up by the Delaware Corporate and Commercial Litigation Blog (which you should absolutely be reading) as follows:

On the point of the fiduciary duty of a manager to the members: 'in the absence of a contrary provision in the LLC Agreement, the manager of an LLC owes the traditional fiduciary duties of loyalty and care to the members of the LLC.'

On the point of the fiduciary duty of a member to other members: 'the LLC cases have generally, in the absence of provisions in the LLC Agreement explicitly disclaiming the applicability of default principles of fiduciary duty, treated LLC members as owing each other the traditional duties that directors owe a corporation.'

North Carolina on Fiduciary Duties of LLC Members

North Carolina goes off in a different direction entirely on the fiduciary duty of an LLC member to another member.  There is none, though there can be exceptions.  But the general rule, stated in the Kaplan case, is that:

The North Carolina Limited Liability Company Act, N.C. Gen. Stat. § 57C-1-01 et seq., does not create fiduciary duties among members. Members of a limited liability company are like shareholders in a corporation in that members do not owe a fiduciary duty to each other or to the company.

The exception is when the member has majority control.  Then, "a controlling shareholder owes a fiduciary duty to minority shareholders," and an LLC member with control would owe a fiduciary duty to the minority members.

North Carolina on Fiduciary Duty of LLC Managers

A manager of a North Carolina  LLC does owe a fiduciary duty, as does a manager of a Delaware LLC.  But in North Carolina, the fiduciary duty is not owed directly to other members, as it is in Delaware.  It is instead owed to the LLC:

Managers of limited liability companies are similar to directors of a corporation in that '[u]nder North Carolina law, directors of a corporation generally owe a fiduciary duty to the corporation, and where it is alleged that directors have breached this duty, the action is properly maintained by the corporation rather than any individual creditor or stockholder.' Thus, like directors, managers of a limited liability company also owe a fiduciary duty to the company, and not to individual members.

The principles described above are default rules, applied by the North Carolina and Delaware courts in the absence of provisions in the LLC Operating Agreement as to the duties of members and managers.  The members are free to provide for the imposition of fiduciary duties (which the Court found they had in the Emery Bay case); or to provide for no or limited fiduciary duties (as they did in the Kaplan case).

It's pretty common for North Carolina attorneys to be advising clients regarding Delaware LLC issues, because so many corporate attorneys opt for formation under Delaware law.  There were 111,820 LLCs formed in Delaware in 2007, and 81,923 in 2008.  The North Carolina numbers show significantly fewer LLC formations here: there were 33,212 LLCs formed in NC in 2007 and 29,384 formed in 2008.  These numbers were provided by the Division of Corporations at the Delaware Secretary of State and by the Director of Corporations at the North Carolina Secretary of State.

I originally wrote about the Kaplan case when it was decided by the Business Court in June 2008.  You can find that post here.

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Ken Lewis, Bank of America’s CEO, has testified under oath to threats by former Secretary of the Treasury Hank Paulson to remove the Bank’s Board of Directors and its management if the Bank didn't close its deal to acquire Merrill Lynch, and secret promises to support the Bank with federal funds if it did close the transaction. 

Those statements are contained in Lewis’ deposition, portions of which were released yesterday by New York's Attorney General. 

Lewis testified that the financial deterioration of Merrill in the fourth quarter of 2008 was "staggering,"  Dep. 13, and the acquisition  was turning out to be "a $15 billion hole" for the Bank. Dep. 60.  Lewis told Paulson that the Bank "was strongly considering" invoking the Material Adverse Change provision (the "MAC") in the Merger Agreement with Merrill.  Dep. 34, 58. The action of "calling a MAC" would have permitted Bank of America to terminate the Merrill transaction or at least to negotiate a better deal.  Paulson didn't like that idea, and asked Lewis to temporarily "stand down."  Dep. 42.

The Threat And The "Undisclosable" Promise Of Federal Funds

Lewis followed with a personal call to Paulson (who was out riding his bike at the time) and told Paulson, again, that the Bank was considering the invocation of the MAC.  According to Lewis' testimony, Paulson responded that the government "does not feel it's in your best interest for you to call a MAC" and that if the Bank did so or maybe even intended to do so, that the Treasury Department "would remove the board and management" of Bank of America.  Dep. 52. 

Paulson, testified Lewis, promised government support for the growing burden of the acquisition, but was unwilling to put that promise in writing.  He said to Lewis that a written commitment for federal funds "would be a disclosable event and we [the Treasury] do not want a disclosable event."  Dep. 80.

Lewis Reports To The BofA Board On The Threat And The Promise

Lewis reported to the Bank's board, shown in the minutes of the December 22, 2008 meeting, that if the Bank were "to invoke the material adverse change clause in the merger agreement with Merrill Lynch and fail to close the transaction, the Treasury and Fed would remove the Board and management of the" Bank.   He also reported on the verbal assurances provided by Paulson and also by Fed Chair Ben Bernanke.

In a bit of corporate minutekeeping that will undoubtedly become pivotal in the flood of shareholder suits already filed over this merger and those yet to come, the December 22 minutes say that "the Board concurred it would reach a decision that it deemed in the best interest of the Corporation and its shareholders without regard to this representation by the federal regulators."  In other words, the Board minutes says the Board wasn't influenced at all by Paulson's threat.  (How, well, fiduciary-like of them.)

Lewis Still Wants To "Call A MAC," But Reports To The Board On "Detailed" -- But Secret -- Assurances From Federal Regulators

Merrill's condition worsened over the eight days before the next Bank board meeting.  The minutes of that December 30th meeting show that Lewis reported he had told federal regulators "were it not for the serious concerns regarding the status of the United States financial services system and the adverse consequences of that situation to the Corporation articulated by the federal regulators, the Corporation would, in light of the deterioration of the operating results and capital position of Merrill Lynch, assert the material adverse change clause in its merger agreement with Merrill Lynch and would seek to renegotiate the transaction."

Lews reported at that meeting that he had "obtained detailed oral assurances from the federal regulators with regard to their commitment and has documented those assurances with e-mails and detailed notes of management's conversations with the federal regulators."  Those e-mails and notes haven’t yet been made publicly available, but they will certainly provide interesting reading when they are.

The Treasury Comes Through, Post-Closing, With Billions Of Dollars Of Funds

The Merrill transaction closed two days after the December 30th board meeting, on January 1, 2009.  The oral promises made by Paulson and the "federal regulators" weren't disclosed in connection with the transaction. 

But about two weeks after the closing, the Treasury showered Bank of America with an additional $20 billion in TARP funds and a $118 billion "backstop" on the assets acquired from Merrill.  That's more than enough to fill a "$15 million hole,"  as long as you aren't still digging. 

There's already a shareholder derivative action pending in the North Carolina Business Court over the Bank of America/Merrill Lynch merger, Cunniff v. Lewis.

The photo is from Rainforest Action Network's photostream.

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Three decisions from the North Carolina Business Court were affirmed today by the North Carolina Court of Appeals.  They involve fiduciary duties of members of LLCs, the right of limited partners to sue directly for injury to a partnership, and the obligation of the personal representative of an estate to give notice to creditors.   They are:

Kaplan v. O.K. Technologies, LLC, in which the Court of Appeals ruled that a member of an LLC without majority control does not have a fiduciary duty to the other members of the LLC or to the LLC itself.  Nor does a manager have a fiduciary duty to the other members, as that duty is owed directly to the LLC.  The Court also affirmed the Business Court's ruling that the Plaintiff's control over the funding of the LLC did not create a fiduciary duty. The Business Court ruling was by Judge Tennille, Judge Stephens wrote the appellate opinion.

Gaskin v. Proctor, ruling that a limited partner was not entitled to bring suit in his personal capacity for claimed injury to the partnership in the absence of "a special duty or a separate and distinct injury."  The Court rejected the argument that the limited partner was entitled to maintain his suit due to "the closely held nature of the company, and the domination of the company by the defendants and resulting powerlessness of the plaintiffs." The Business Court ruling was by Judge Diaz, Judge Stroud wrote the appellate opinion.

Azalea Garden Board & Care, Inc. v. Vanhoy, holding that the personal representative of an estate was not obligated under N.C. Gen. Stat. Sec. 28A-14-1(b) to give personal notice to a creditor because the creditor's claims were not "actually known" or "reasonably ascertain[able]" by her.  The claims of the Plaintiff were barred because it failed to assert its claim by the date specified in the notice of the estate administration published in the newspaper.  The Court said that the initial burden should be with the claimant "to produce a forecast of evidence demonstrating that a material issue of fact exists as to whether its identity and its claim were reasonably ascertainable" a standard which the Plaintiff was unable to meet.  The Business Court ruling was by Judge Tennille, Judge Robert C. Hunter wrote the appellate opinion.

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The North Carolina Court of Appeals ruled today on cases involving the statute of repose applicable to legal malpractice actions, fiduciary duties of trustees, and the waiver of the right to arbitration.

On the fiduciary duty issue, the Court affirmed the decision of the Business Court in Heinitsh v. Wachovia Bank on an obscure point of trust law for which it observed there was "surprisingly little guidance." The trustee in Heinitsh was caught between the income beneficiaries and the remaindermen of a substantial trust over a dispute whether millions of dollars from the sale of property should be categorized as income or principal. During the dispute, the trustee took the disputed funds and invested them in a money market account. The plaintiff, an income beneficiary, argued that the trustee's duties required it to maximize income in her favor, and that the trustee had breached its fiduciary duties by placing the funds in a low-yielding money market account. The Court of Appeals held that "holding the retained funds during the pending litigation was reasonable in light of the circumstances and defendant did not breach its fiduciary duty to plaintiff." The Court suggested, however, that "the better practice may be to interplead the funds. . . ."

The legal malpractice case is Goodman v. Holmes & McLaurin Attorneys at Law. The plaintiff had sued outside the four year statute of statute of repose contained in N.C. Gen. Stat. §1-15(c), but contended that the law firm was equitably estopped from asserting the statute given a lawyer's active conduct in trying to hide the fact of his malpractice.  The Court of Appeals found that conduct of concealment to be "particularly egregious," but held that "this Court has consistently refused to apply equitable doctrines to estop a defendant from asserting a statute of repose defense in the legal malpractice context. . . ."  It found plaintiff's claims therefore to be barred by the statute of repose.

In Gemini Drilling and Foundation, LLC v. National Fire Insurance Co. of Hartford, the Court found that the defendant had waived its right to arbitration. The defendant had filed a motion to compel arbitration, and lost. Instead of taking an immediate interlocutory appeal, which it had the right to do, it participated in discovery and then a bench trial of the claim. The Court held that the purpose of arbitration "would be defeated if a party could reserve its right to appeal an interlocutory order denying arbitration, allow the substantive lawsuit to run its course (which could take years), and then, if dissatisfied with the result, seek to enforce the right to arbitration on appeal from the final judgment."

There's another case from today's opinions, Odell v. Legal Bucks, LLC, which I'll deal with separately. You can find all of the Court of Appeals opinions today here.

The photo of the Court of Appeals building is from Juliet Sperling.

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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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Today, the Business Court entered an Order granting summary judgment against members of a limited liability company who contended that an investor who was the principal source of funding to the LLC had a fiduciary duty to the LLC and its members.

The case, Kaplan v. O.K. Technologies, arose following the dissolution of a company formed to commercialize a process for filtering hog waste.  Kaplan, a minority member of the LLC, was its only source of funds and controlled the LLC's checkbook.  Over time, he lent the LLC nearly $2 million, which the company used to pay salaries and legal expenses, among other things.

When the company's prospects faded, Kaplan stopped funding the company and asked for repayment of his loans.  The other members responded by voting to dissolve the LLC, which was placed in receivership.  Kaplan sued to collect his substantial debt.

The other members of the LLC claimed that because Kaplan had "complete control over all expenditures," and because he knew that the LLC was completely reliant on his contributions, he had an "enhanced fiduciary duty" to the LLC and the other members.

Judge Tennille held:

Being an investor in a company does not create a fiduciary relationship. . . . Kaplan, as a minority shareholder, had no fiduciary duty to the other shareholders even though he was the sole financial contributor to O.K.  Like an investor in a corporation, Kaplan's position as the holder of the purse strings did not create a fiduciary duty.  At all pertinent times, Kaplan was a minority shareholder without dominance or control over either O.K. or any of the other shareholders and therefore without a fiduciary duty.

Op. at 5-6. Judge Tennille stated that, in any event, it was "unclear what Defendants believe Kaplan's fiduciary duty required him to do."  (Op. at 9).  The Court held that Kaplan was not required to provide "limitless funding" and he was entitled to seek to collect the debt owed to him.

The LLC members also contended that Kaplan had not followed the procedures set forth in the LLC's Operating Agreement in making his loans.  The Court ruled, however, that these claims were barred by ratification and estoppel.  It held "Defendants are estopped from objecting to the loans by their continued acceptance of reimbursement and salary made possible by the loans, as well as their inaction when O.K. creditors were paid with the loaned money."  (Op. at 8).

Two other claims made by the Defendants, for negligent misrepresentation and unfair and deceptive practices, are worth mentioning.

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The case of  Land v. Land is a minority shareholder dispute among shareholders of a family business. 

The Business Court sees these kinds of disputes regularly, and there's not much novel in the Court's Order today denying summary judgment in a fight over a masonry business involving two brothers and their father.

The part of the Order that warrants a mention, however, has to do with the Plaintiff's claim of a breach of fiduciary duty by his brother Eddie, the majority shareholder of the business.  Eddie had an unusual defense to this claim by his brother, Alan.

The defense was that Eddie had an affair with Alan's wife, that Alan had discovered the affair, and that Alan therefore could not have had any expectation of a fiduciary duty being owed to him by Eddie.  According to Eddie, Alan therefore could not have relied on the allegedly false statements made to him by Eddie regarding the affairs of the Company.

The Court rejected the argument, holding:

Eddie claims that Alan could not have reasonably relied upon any actions of Eddie’s because Alan caught Eddie in a compromising position with Alan’s then wife in the mid-1980s. (Def. Br. Summ. J. Alan 11.) Eddie asks the Court to hold that that circumstance alone defeats any claim to reasonable reliance or a fiduciary relationship between the two. Alan claims that his knowledge of the situation (which he kept secret until discovery in this case) gave him more leverage and reason to trust Eddie in business. (Alan Br. Opp’n 19; Def. Mot. Summ. J. Alan 4.) While the Court may have its own personal view of the wisdom of one brother trusting another under these circumstances, the Court believes that the overall question of whether there was a fiduciary relationship between Eddie and Alan is one for the jury after it sorts out all the sordid facts.

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Does North Carolina recognize a claim for aiding and abetting breach of fiduciary duty?  The North Carolina Court of Appeals shed a little bit of light on the question this week., but it wasn't very illuminating.

The linchpin for this frequently made claim has been the twenty year old case of Blow v. Shaughnessy, 88 N.C. App. 484, 364 S.E.2d 444 (1988), in which the Court of Appeals recognized the tort.  It held simply that "a cause of action on this theory has been recognized by federal courts in securities fraud cases based on violations of section 10(b) of the Securities Exchange Act of 1934."

But six years after Blow was decided, in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), the United States Supreme Court held that there was no liability for aiding and abetting under the securities laws, thus eviscerating the underpinning of the Blow case. 

Since then, the North Carolina Business Court has expressed doubt about the continuing vitality of claims for aiding and abetting breach of fiduciary duty.  Judge Diaz noted the issue most recently in Regions Bank v. Regional Property Development Corp., 2008 NCBC 8 and in Battleground Veterinary Hospital, P.C. v. McGeough, 2007 NCBC 33; and Judge Tennille wrote on the subject in Sompo Japan Insurance Inc. v. Deloitte & Touche, LLP, 2005 NCBC 2.  In none of these cases, however, did the Business Court dismiss the claim on the basis that it is not recognized in North Carolina.

This week, the Court of Appeals decided the case of Hinson v. Jarvis, in which it made a passing reference to Blow which might be interpreted as giving some life to that case.  In a footnote, the Court stated:

In addition to the cases discussed in this section, plaintiffs also rely on Blow v. Shaughnessy, 88 N.C. App. 484, 364 S.E.2d 444 (1988). That case, however, involved the imposition of liability on a defendant that encouraged a third party to breach his fiduciary responsibility -- a securities law violation -- owed to the plaintiff. Id. at 489, 364 S.E.2d at 447. This case, however, does not involve any fiduciary relationship between Mr. Jarvis and plaintiffs. We therefore find Blow distinguishable from the instant case.  

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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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Voyager Pharmaceutical Corp. v. Bowen, April 15, 2008 (Jolly)(unpublished)

Voyager, a company engaged in pharmaceutical research directed at slowing or halting Alzheimer's disease, was attempting a $100 million public offering in 2005.  It alleged in its Complaint that it was unable to complete the IPO due to the actions of one of its directors, Bowen, and one of its employees, Atwood.  It made a variety of claims, including claims for breach of fiduciary duty.

The allegations as to what Bowen had done are pretty interesting.  Here's how the Court characterized some of them:

While Voyager's management was in the 4:30 p.m. conference with Hambrecht, Bowen was in a hospitality suite in the Marriott Marquis Hotel that had been set up to accommodate Voyager's shareholders. (Compl. ¶ 66.)  There, Bowen told one or more shareholders that the IPO was not going to proceed because "God had told him so," and because Voyager had refused to add "the glorification of God" to its mission statement.  (Compl. ¶ 66.)  Bowen also told the shareholders present that day that any further attempts to complete the IPO would fail until his demands were met, including giving credit to God in Voyager's mission statement.  (Compl. ¶ 66.)  Bowen also asked one of the shareholders whether he would be willing to serve as a director of Voyager "when I regain control of the Company."  (Compl ¶ 66.)  Bowen also falsely told one or more shareholders that there was a problem with the Phase I data that had not been resolved and also falsely stated that when he raised this issue with management, management had locked him out of his office.  (Compl. ¶ 68.)

The Court first confronted the issue of choice of law on Voyager's claims for breach of fiduciary duty. The Court noted that there was little guidance in North Carolina as to the proper application of the internal affairs doctrine.  It determined that it would apply the law of Delaware, the state of Voyager's incorporation, to those claims.

It then rejected Bowen's argument that his actions were protected by the business judgment rule.  It held:

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