January 22, 2014

Legal Briefs: A Periodic Summary of Judicial Decisions Affecting Accounting and Financial Services Professionals - January 2014

Professional Services Liability Newsletter

Minority Shareholder Oppression Remedies Do Not Apply in LLC Dispute

New Jersey’s Appellate Division recently issued a notable decision in a case involving a dispute over ownership rights in a Limited Liability Company (LLC). Tutunikov v. Markov, Docket No. A-1827-10T3 (N.J. Super. Ct. App. Div., August 1, 2013) (unpublished). In Tutunikov, the plaintiffs were two minority shareholders in a predecessor entity to two LLCs, Markov Processes International, LLC- NJ and Markov Processes International, LLC- DE (collectively, MPI). The plaintiffs had voluntarily left their positions with the predecessor corporation, which was then dissolved. Thereafter, the two LLCs were formed to carry on similar business activities. Although the plaintiffs did not actively work for those entities, there were written resolutions setting forth the percentages of their minority ownership interests. There was no executed operating agreement and the ownership percentages in the draft document differed from the resolutions. Years later, after the two LLCs were merged into a single entity and a third party agreed to invest in the company, the plaintiffs were offered a buyout at a price that they considered inadequate. The two minority members alleged oppression and sued, raising complaints about excessive salaries taken by the majority members and the majority’s assertion of ownership over an additional 4.5 percent interest in the prior corporation that the plaintiffs believed were to be "treasury" shares.

After a bench trial, the trial judge agreed that the plaintiffs had proven oppression and ordered an equitable buyout at fair value. Because the Limited Liability Company Act had no provisions regarding member oppression, the court applied the oppressed minority shareholder provisions of the New Jersey Business Corporations Act (N.J.S.A. 14A:12-7). The trial court also awarded attorneys’ fees and costs, as those remedies were available under the Business Corporation Act (BCA). The Appellate Division unanimously reversed, finding that the plaintiffs had no oppression claim. The appeals court found that the plaintiffs had each voluntarily removed themselves from the prior corporation in which they had been shareholders, and that the prior corporation was then dissolved. The plaintiffs then became members of an LLC, and the LLC Act (unlike the BCA) did not allow a statutory claim for oppression. The Appellate Division found the absence of an equivalent provision in the LLC Act to be no accident but, instead, a deliberate legislative decision. The court noted that, when the LLC Act was repealed in 2012 in favor of the Revised Uniform Limited Liability Act, the new statute included an "oppression" provision but specified dissolution as the only remedy.

Moreover, the court found that the plaintiffs had known about the alleged excessive salaries and the defendants’ claims of ownership of the treasury shares long before MPI had been formed. And, even though the defendants’ arrogation of the treasury shares was inconsistent with a number of documents, the appeals court held that it could not be the basis for a shareholder oppression claim once the prior corporation had been dissolved and the new LLC formed. "We do not believe that . . .the alleged act of majority shareholder oppression—the misappropriation of treasury shares—translates into a continuing cause of action after a new entity, not subject to the BCA, was formed." Slip op. at 28. In addition, the plaintiffs’ reasonable expectations were essential to evaluating whether defendants’ conduct was oppressive, and here the plaintiffs’ "reasonable expectations" could not have been frustrated because they would not have derived any benefit (either in increased distributions or percentage ownership) from the additional treasury stock. Accordingly, the appeals court held that there was no basis for a statutory oppression claim, and consequently no basis for the trial court’s award of attorney fees.

The Appellate Division then addressed the trial court’s determination of the fair value of the plaintiffs’ interest in the LLC. The Appellate Division approved the trial court’s use of the independent third party’s purchase of 9.09 percent of MPI for $500,000 on October 31, 2005, as a measure of the value of MPI. Both sides’ appraisal experts agreed that the purchase price incorporated a marketability discount of 35 percent because MPI was not a publicly traded company. The appeals court agreed that a marketability discount was appropriate in valuing MPI as an entity, rather than in valuing the plaintiffs’ particular interests, quoting Balsimides v. Protameen Chems, 160 N.J. 352, 373-74 (1999): "Discounting at the corporate level may be entirely appropriate if it is generally accepted in the financial community in valuing businesses." The Appellate Division then approved the trial court’s decision to add back the amount of the discount before calculating the value of the plaintiff’s interests, but noted that the trial court had incorrectly applied the discount factor and should have divided the $5,000,000 price by 0.65. Reversing the discount seems inconsistent with Balsimides’ pronouncement that "discounting at the corporate level" may be appropriate. The end result in Tukunikov was to confer on the plaintiffs more than their pro rata share of the real value of MPI, which was $5,000,000.

Appeals Court Finds No Oppression but Affirms Breach of Fiduciary Duty by Majority Shareholder

A recent unpublished decision from New Jersey’s Appellate Division shows that a breach of fiduciary duty owed by the controlling shareholders in a close corporation will not necessarily constitute oppression of the minority shareholders. In Goret v. H. Schultz & Sons, Inc., Docket No. A-4281-10T1 (N.J. Super Ct. App. Div. Sept. 10, 2013), the court also highlighted the extent to which controlling shareholders must disclose significant corporate information to the minority.

The shareholders in Goret were all third-generation family members who held shares in a distributor of household products and cookware (the Company). Although the Company had historically generated healthy profits, over the past 10 years shareholder distributions had decreased and eventually ceased. Both sides agreed that this was largely due to a changed market in which "big box" stores had become the dominant forces and generally did not buy from middleman distributors. The Company held periodic shareholder meetings during which the minority holders consistently asked to be bought out, although the shareholders’ agreement did not provide for any buy-out right except in the event of the death of a shareholder. The minority holders also asserted that Robert Schultz, an officer and the majority shareholder, had unilaterally and without notice to them, summarily rejected a third-party offer to purchase the Company’s warehouse and offices for $7.4 million. When the majority shareholders refused to agree to purchase their shares, the minority shareholders filed a lawsuit in the chancery court under the oppressed minority shareholder statute (N.J.S.A. 14A:12-7), seeking the appointment of a receiver and the liquidation of the Company.

The trial court held that the minority did not prove their oppression claim and the Appellate Division affirmed that decision. The appeals court agreed with the trial judge that the measure of "oppression" was whether the majority shareholders had frustrated the "reasonable expectations" of the minority shareholders. In Goret, the record established that the minority shareholders did not take an active role in the Company and were given the opportunity to voice their desires for the liquidation of the Company or a buy-out. The lack of distributions did not result from fraud or waste but rather from difficult market forces, which the majority owners had a plan to address. Characterizing the issue as a "[m]ere disagreement between stockholders," the court ruled that the minority’s expectations must give way against "the corporation’s ability to exercise its business judgment and run its business efficiently." Slip op. at 17.

However, the court also sustained the trial court’s finding of breach of fiduciary duty based on Robert’s failure to disclose, and his "on the spot" rejection of a fair market $7.4 million offer to purchase the Company’s real property. The Appellate Division quoted approvingly from the trial judge’s opinion, which noted that Robert was not candid with his fellow officers about the offer nor his reasons for rejecting it. Calling Robert’s actions "a unilateral wielding of power that is inconsistent with his [fiduciary] duties," the court found that all shareholders had "a right to be informed and consulted before decisions are made that could impact the Company’s bottom line and viability." Slip op. at 18-19. As a remedy for this breach, the trial court had ordered that, until dividend payments were resumed, the shareholders should be "provided with information and documentation on the Company’s investments, potential acquisitions, and major business decisions." Slip op. at 20. The Appellate Division agreed but chose not to impose any time period on that remedy. Thus, Goret can be read to impose on controlling shareholders and officers a duty to disclose all potentially significant corporation transactions.

Frivolous Counterclaim Against Minority Owners Leads to Attorney Fee Award Against Majority Owners

Lawsuits among closely held shareholders are notoriously acrimonious, and many litigation strategies have been tried to increase the leverage of one side over the other. A trial court has recently rejected one strategy, holding that majority owners generally cannot defend against a minority investor’s lawsuit with a counterclaim alleging that the minority’s lawsuit constitutes a breach of the minority’s fiduciary duty or a waste of corporate assets. A New Jersey trial court judge has deemed such a counterclaim frivolous and has sanctioned the majority owners by ordering them to pay the minority’s attorneys’ fees.

In Baratta v. Deer Haven, LLC, L-3682-09 (N.J. Super. Ct. Law Div. July 12, 2013), the plaintiffs, three limited partners in a Pennsylvania real estate venture, sued the general partners to recoup their entire $1,900,000 investment and alleged that the general partners had usurped partnership opportunities. The general partners filed a counterclaim seeking $1,000,000, asserting that the plaintiffs’ lawsuit constituted corporate waste, a breach of their fiduciary duties, and a breach of the covenant of good faith and fair dealing. After discovery and on cross motions for summary judgment, the court dismissed the entire counterclaim. The plaintiffs then moved for sanctions under New Jersey’s Frivolous Litigation statute (N.J.S.A. 2A:15-59.1) and Rule 1:4-8. Both the statute and court rule provide that a prevailing party may recover reasonable attorneys’ fees and costs from a party who has filed a frivolous pleading or a pleading solely for the purpose of harassment, delay or other improper purpose. The court granted the plaintiffs’ motion and awarded sanctions and attorneys’ fees.

After discovery revealed no support for defendants’ counterclaim, the court found the counterclaim to be nothing more than "an attempt to gain litigation leverage – to force the plaintiffs to expend more money, while also serving as a potential trade-off on settlement talks[.]" According to the trial court, the plaintiffs were simply passive minority investors who owed no fiduciary duty to the defendants, who were the managing partners. The court emphasized that, among owners in closely held businesses, "the fiduciary duty rests on the majority owners." However, had the plaintiffs been directors, officers, or attorneys of the business, they would have owed fiduciary duties to the defendants. The court identified only a few instances in which a counterclaim against a minority investor’s lawsuit could be viable:

  • Where the operative ownership agreements forbid litigation, relegating the investor to an arbitral or other forum;
  • Where the defendants offer the investors a stand-still agreement, pursuant to which the statute of limitations does not run on any cause of action (and all possible remedies of the investor remain viable);
  • Where the minority owner is an attorney for the business and/or a director or officer of the enterprise; and
  • Where the trial court concludes that all claims of the minority investors are without merit.

None of those situations applied to the Baratta case. Thus, the defendants’ attempt to intimidate the plaintiffs with their aggressive litigation strategy ultimately backfired when the counterclaim itself was deemed frivolous and the defendants had to pay the plaintiffs’ attorneys’ fees as a sanction.

Discovery Delayed is Not Discovery Denied for Purposes of Sanctions

A recent unpublished Appellate Division decision holds that even a party’s willful refusal to produce documents demanded in discovery may not be a basis for dismissal of the party’s claims or defenses in a lawsuit. In Liberty Mutual Insurance Company v. Viking Industrial Security, Inc. et al., Docket No. A-6297-10T3 (N.J. Super. Ct. App. Div. January 8, 2014), an insurance fraud case, Liberty Mutual and the State of New Jersey (collectively, "Liberty Mutual") had obtained an order granting discovery sanctions against a group of defendants affiliated with the Viking Group, Inc. (Viking defendants). The trial court had found that the Viking defendants had engaged in "a calculated method of discovery misconduct," had acted in "enormous bad faith," and had "really done everything in their power to impede discovery in this matter." As a result the trial court entered a sanctions order, which established certain facts, allowed the jury to draw negative inferences against the Viking defendants, and awarded more than $108,000 in attorneys’ fees and costs. With the sanctions order, Liberty Mutual was then able to prevail on its claims and, ultimately, obtained a judgment against the Viking defendants for damages, penalties, interest, and attorneys’ fees. The Viking defendants then appealed, challenging the sanctions order as unwarranted.

The facts at issue involved the payroll of the Viking companies, which the defendants had under-reported for several years in order to receive lower premiums for workers’ compensation insurance issued by Liberty Mutual. As a result of the under-reporting, Liberty Mutual calculated Viking’s premiums using only the smaller payroll. Eventually, the State Office of Insurance Fraud Prosecutor contacted Liberty Mutual to report that an anonymous caller had alleged that Viking was not disclosing its actual payroll. In response to Liberty Mutual’s investigation, the Viking defendants’ accountant only provided the investigators with the smaller payroll and did not reveal that Viking maintained a complete payroll on its QuickBooks program.

Liberty Mutual suspected that Viking had not provided accurate payroll records and estimated a new premium. When Viking failed to pay the new premium, Liberty Mutual terminated its workers’ compensation policy. Viking’s accountant subsequently worked with Liberty Mutual to determine the correct premium and provided the complete payroll amount but he did not furnish the detailed QuickBooks records. Ultimately, Liberty Mutual and Viking reached an agreement under which the workers’ compensation policy would be reinstated in exchange for Viking’s $563,744 payment secured by a promissory note. Viking made a few payments on the note before defaulting. Liberty Mutual then sued.

During the course of the lawsuit, Liberty Mutual requested that the Viking defendants produce any payroll records maintained in electronic form. The Viking defendants did not provide the QuickBooks records, claiming that the payroll records were not kept in electronic form. Eventually, one of Viking’s bookkeepers testified about the QuickBooks records. Liberty Mutual then obtained an order compelling the Viking defendants to produce those records.

Once the records were produced Liberty Mutual was able to use the Quickbooks records in depositions and in preparing for trial. Liberty Mutual also obtained sanctions against the Viking defendants for their delay in producing the records, including attorneys’ fees, and a "spoliation order," which conclusively established certain facts in Liberty Mutual’s favor and allowed the jury to draw negative inferences against the Viking defendants.

On the Viking defendants’ appeal from the judgment, the appellate court reversed the trial court’s sanctions order. The Appellate Division did not equate the Viking defendants’ failure to turn over the records for almost a year to a spoliation situation in which a party "has hidden, destroyed, or lost relevant evidence and thereby impaired another party’s ability to prosecute or defend the action." It reasoned that, however recalcitrant the Viking defendants were, the QuickBooks records were eventually provided intact during the lawsuit and Liberty Mutual was able to use the records at depositions in preparing expert reports and at trial. Because the party seeking discovery ultimately received it, the court considered the extreme sanctions in the spoliation order to be inappropriate. However, the Appellate Division did approve the use of lesser sanctions, including the payment of Liberty Mutual’s attorneys’ fees, to level the playing field and eliminate any prejudice to Liberty Mutual from the delayed production.

The Viking Industrial Security case shows that, as long as the prejudice against a party by another party’s failure to make timely discovery can be cured by those lesser measures, courts will be reluctant to impose the severe sanctions of dismissal of a party’s claims or defenses.

District Court Dismisses Individual Owners of Company Who Were Not Personally Involved in Alleged Wrongdoing

What conduct by corporate owners and officers will subject them to individual liability? A recent decision from the federal district court in the District of New Jersey shows it must be something more than actions that are consistent with normal, routine business operations. In Circuit Lighting, Inc. v. Progressive Products, Inc., Civil Action No. 12-5612 (D.N.J. Aug. 23, 2013), the court ruled that two individual corporate owners and officers could not be held liable for acts of the corporation without some evidence that they personally participated in the alleged wrongful conduct. The court denied a motion to amend Circuit Lighting’s complaint to add as defendants Robert and Todd Allison, two owners and officers of the defendant corporations. The plaintiffs alleged that the two men had participated in the acts of fraud, conspiracy and conversion alleged in the complaint. The court ruled that the proposed amended complaint contained no valid basis for imposing individual liability on the two men. The only basis for their involvement was an ambiguous email that had been sent by a third party to the two men, and Todd Allison’s later invoice indicating that certain repairs to Circuit Lighting were not covered under warranty. The court found these allegations were not enough to establish that they affirmatively engaged in any of the wrongful conduct alleged in the complaint. Without any personal involvement or any basis for "piercing the corporate veil" to impose the corporation’s liability on the individuals, the court held that the proposed amended complaint against the two corporate officers was futile.

Accounting Firm Partner Cannot be a Whistleblower Under New Jersey’s Conscientious Employee Protection Act

The district court for the District of New Jersey recently ruled that an accounting firm partner may not claim he was a whistleblower who was improperly fired by his firm. In Largie v. TCBA Watson Rice, Civil Action No. 10-cv-0553 (D.N.J. Aug. 20, 2013), the court considered the plaintiff Largie’s claim that he had been wrongfully terminated in retaliation for his attempted disclosures about alleged fraudulent practices at his accounting firm. The firm contended that it had fired Largie for his chronic absences and for attributing fees from the firm’s clients to another accounting firm. Largie was the director of the firm’s taxation department and an equity partner, holding a 10.5 percent interest in the firm. He also set his own schedule and did not report to anyone else. Without reaching his claims of fraudulent practices, the court found that Largie was not an employee who was entitled to protection under the CEPA statute. Largie’s ability to influence the operations and activities of the accounting firm meant that he had the power to save himself from the kind of unlawful retaliatory actions the CEPA statute was intended to prevent.

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