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.