2015 Corporations - Class 14 PowerPoint

HOLDEN v. CONSTRUCTION MACHINERY COMPANY

An action in equity was instituted, individually and derivatively, by the holder of 49.976% of the outstanding stock of a corporation, against the corporation, its officers and directors. The Black Hawk District Court held in part adverse to the defendants, and they appealed. The minority shareholder cross-appealed. The

Supreme Court held that where the majority shareholder was found to be a constructive trustee of another company's stock, purchased with a check from the corporation, an award to the corporation of the shares including shares acquired

by stock split and cash dividends appropriately stood as a judgment for restitution. The Court also held that where the majority shareholder, as president and general

manager of the corporation, personally engineered every phase of the deal by which the stock in the other company was acquired by a check from the

corporation, appropriated to his own use all dividends issued upon such stock, directed falsification of corporate records and other documents, and subsequently

endeavored to impress upon the whole transaction a coloration of honesty and also did all in his power to isolate the minority holder from any rights or privileges

pertaining to management, assessment of exemplary damages was compelled.

Affirmed on defendants' appeal; reversed in part, affirmed in part, affirmed in part as modified on plaintiff's cross appeal, and remanded with instructions.

HOLDEN v. CONSTRUCTION MACHINERY COMPANY (cont’d)

• Equity holds officers and directors of corporate entity, particularly management-controlling directors of closely held corporations, strictly accountable as trustees.

• Majority shareholder of corporation who was also president and general manager was strictly accountable to corporation for another company's stock purchased with check from corporation, or for fair market value of such stock, and for all increases, income, proceeds or dividends realized.

HOLDEN v. CONSTRUCTION MACHINERY COMPANY (cont’d)

Where majority shareholder, as president and general manager of corporation, personally engineered every phase of deal by which stock in another company was acquired with check from corporation, appropriated to his own use all dividends issued upon such stock, directed falsification of corporate records and other documents, and subsequently endeavored to impress upon whole transaction a coloration of honesty and also did all in his power to isolate minority holder of 49.976% of outstanding stock from any rights or privileges pertaining to management, assessment of exemplary damages was compelled.

In shareholder's derivative action, equity court may, in its discretion, award exemplary damages upon showing that some legally protected right has been invaded, such as by intentional act of fraud or other wrongful conduct.

Shareholder Derivative Litigation

Lec. 6 Sem 2, pp 785-835 Corps Prof. McCann

• An action by shareholders to remedy an alleged wrong to the corporation.– A wrong by the directors or controlling shareholders

or– A wrong by a third party, such as a supplier

– The action is “founded on a right of action existing in the corporation itself, and in which the corporation itself is the appropriate plaintiff.” Daily Income Fund, Inc. v. Fox 464 US 523, 528 (1984)



• Two actions in one:

• A. A suit to compel the corporation to sue and• B. A suit by the corporation (asserted by the

shareholder –plaintiffs) against those liable to it



The stockholder’s right to litigate is secondary to the corporate right until such time as the corporation has refused to bring suit.

So…

Shareholder must first demand the corporation take action



• In addition to demand requirement, shareholders filing derivative action must first

• (in certain states) post a bond to pay the defendants’ costs if the plaintiffs lose or abandon the litigation;

• establish they are “adequate representatives” of the shareholder s in general and counsel is able to prosecute the action

Whose Ox Was Gored?


• Is the action “direct” or “derivative”?

• A direct action is available where– There is a special duty (such as a contract) between

the shareholder and the wrongdoer.– The shareholder suffers injury “separate and

distinct” from that suffered by other shareholders.

Direct vs. Derivative


Claim Direct Derivative

Δs conpired to deplete corporate assets √

Δs diverted corporate assets √

Δs paid dividends to only certain shareholders in class √ √

Δs conduct caused share value to decline √

Δs diluted minority shares for benefit of majority s/h √

Δs refused to allow inspection of corporate records √

Δs prevented shareholder from voting √

Δs proposed action is ultra vires √

Δs wrongfully failing to dissolve the corporation √

Δs are acting fraudulently √

Demand Futility


• Demand requirement waived if “futile”• Test is whether there is a reasonable doubt that– The directors are disinterested and independent (as

to the action proposed by the plaintiff) and – The transaction being challenged was the product of

the valid exercise of business judgment

The Corporate Response


• BJR shields directors as to – 1. Their response to the demand– 2. Decision to dismiss the derivative suit – 3. If suit is directed against them, the directors have the BJR

shield as a defense.

– PROVIDED:

– 1. Directors are disinterested as to any decision in question– 2. The directors have not been grossly negligent with respect

to their duty to inform themselves regarding the decisions(s)

Approaches to Demand Futility


• Model Business Corporation Act: Absent a showing of irreparable harm if demand is required, a demand must always be made before a derivative action can be pursued. “Universal Demand.”

• New York: Demand required unless plaintiff shows:– 1. Majority of board are not disinterested as to the

transaction– 2. Board did not inform themselves as to the transaction; or– 3. Transaction is so egregious could not have resulted from

sound business judgment.

The Corporate Response


• Auerbach (case for the next class): BJR shields directors as to – 1. Their response to the demand– 2. Decision to dismiss the derivative suit – 3. If suit is directed against them, the directors have the BJR shield

as a defense.

– PROVIDED:

– 1. Directors are disinterested as to any decision in question– 2. The directors have not been grossly negligent with respect to

their duty to inform themselves regarding the decisions(s)

The Rise of the ILC


Corp Gets Named in Shareholder Derivative

Action (SDA)

Board Votes to Create Independent Litigation

Committee (ILC)

Board Expands Itself to Add Members and appoints only new

board members to be the ILC

Corporation seeks Stay of SDA proceedings in court to “investigate” the merits of the SDA

ILC “investigates” and reports back to the

board that the SDA is not in “best interests of the corporation”

Corp files motion to dismiss the SDA and/or for summary judgment

along with report.

The “Structural Problem” of the ILC


• The “Independent Litigation Committee”– Who appointed them?– What will the appointees be doing once the ILC

disbands?– Whose Country Club do they belong to? Plaintiffs or

defendants?– How do they feel about rabble-rousing

shareholders?– “There but for the grace of God go I.”

Security Requirement

• In around 1/3 of states (though not Delaware), a derivative claimant with “low stakes” must post security for corporation’s legal expenses.

• Why do you think this requirement exists?– Effects on strategic or incentive problems among relevant parties (Shareholders, Managers, Attorneys)?

Demand Requirement

• Most states require S/hs in derivative suits first to approach Board of Directors and demand that they pursue legal action…

– … unless the S/h can claim a valid excuse.• When is demand requirement excused?• If not excused, what recourse does S/h have if Board

decides not to pursue?– Does making the demand affect one’s

subsequent rights to bring a derivative action?

EISENBERG v. The FLYING TIGER LINE, INC.

Action by stockholder, on behalf of himself and all other stockholders of corporation similarly situated, to enjoin effectuation of plan of reorganization and merger. The United States District Court for the Eastern District of New York dismissed the action after stockholder failed to post security for corporation's costs and stockholder appealed. The Court of Appeals held that action seeking to overturn reorganization and merger the effects of which was that business operations were confined to a wholly owned subsidiary of holding company whose stockholders were the former stockholders of defendant corporation was a "personal action" and not "derivative" within meaning of New York statute requiring posting of security for corporation's costs.

Reversed.

EISENBERG v. The FLYING TIGER LINE, INC. (cont’d)

• Action by stockholder, suing on behalf of himself and all other stockholders of corporation similarly situated, seeking to overturn reorganization and merger the effect of which was that business operations were confined to a wholly owned subsidiary of holding company whose stockholders were the former stockholders of defendant corporation, was a "personal action" and not "derivative" within meaning of New York statute requiring posting of security for corporation's costs.

• If the gravamen of the complaint is injury to the corporation the suit is derivative, but "if the injury is one to the plaintiff as a stockholder and to him individually and not to the corporation," the suit is individual in nature and may take the form of a representative class action.

EISENBERG v. The FLYING TIGER LINE, INC. (cont’d)

Eisenberg’s Complaint:– Deprivation of voting rights to former Flying Tiger

S/hs with respect to operating company.FTL’s Counter-argument:

– Eisenberg’s claim is derivative. Must post security under NY law.• Trial court:

– Held that Eisenberg was required to post security (as per NY’s law and FTL’s pre-trial motion)– Eisenberg refused to pay. Complaint dismissed.

Marx v. Akers

Appeal, by permission of the Court of Appeals, from an order of the Appellate Division of the Supreme Court in the Second Judicial Department, entered May 15, 1995, which affirmed an order of the Supreme Court granting motions by defendants to dismiss the amended complaint.

Affirmed.

Marx v. Akers (cont’d)In a shareholders' derivative action, plaintiff failed to state a cause of action with

respect to the allegations of the complaint that the board of directors wasted corporate assets by awarding excessive compensation to the corporation's outside directors, consisting of a retainer of $55,000 plus 100 shares of the corporation's stock over a five-year period which bore little relationship to duties performed or to the cost of living.

An allegation that directors have voted themselves compensation does not give rise to a cause of action, as directors are statutorily entitled to set those levels.

Moreover, a complaint challenging the excessiveness of director compensation must--to survive a dismissal motion--allege compensation rates excessive on their face or other facts which call into question whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment.

Here, there are no factually based allegations of wrongdoing or waste which would, if true, sustain a verdict in plaintiff's favor. Plaintiff's bare allegations that the compensation set lacked a relationship to duties performed or to the cost of living are insufficient as a matter of law to state a cause of action.

Marx v. Akers (cont’d)In a shareholders' derivative action, a demand that the board of directors

initiate a lawsuit, Business Corporation Law § 626 [c], was excused as to the allegations of the complaint that a majority of the board was self-interested in setting the compensation of the corporation's outside directors because the outside directors comprised a majority of the board.

Directors are self-interested in a challenged transaction where they will receive a direct financial benefit from the transaction which is different from the benefit to shareholders generally.

A director who votes for a raise in directors' compensation is always "interested" because that person will receive a personal financial benefit from the transaction not shared in by stockholders.

Consequently, a demand was excused as to plaintiff's allegations that the compensation set for outside directors was excessive.

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2015 Corporations - Class 14 PowerPoint