Business Judgment Rule

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-HurIn 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:

Continue Reading Business Court Blockbuster: If You Only Read One Corporate Governance Case This Year, Make It This One

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

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

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

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

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

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

Plaintiffs sued, asserting that their "reasonable expectations" as shareholders to continued employment and continued ownership of their stock had been frustrated.  They lost on the first point, but won on the second.Continue Reading Reasonable Expectations Of Minority Shareholders Frustrated By Dilution of Ownership, But Not By Termination Of Employment

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:

Continue Reading Fiduciary Duty Claims Can Proceed Against Director And Employee Who Allegedly Sank $100 Million IPO