The Delaware Supreme Court last week refused to rehear its affirmance of Chancery Court’s post-trial decision in a case called Zutrau v Jansing. The Appellate Division of the New York Supreme Court last May affirmed a post-trial decision in a closely related case involving the same parties. The two appellate decisions effectively close out a tenaciously fought, seven-year litigation saga involving a minority shareholder’s largely unsubstantiated, multi-faceted attack on the majority shareholder’s management and financial stewardship of a small, New York-based Delaware corporation specializing in proxy servicing.
The litigation history includes an initial books-and-records proceeding in New York followed by serial suits in New York and Delaware asserting a variety of claims for unlawful termination of the minority shareholder’s employment; direct and derivative claims for breach of fiduciary duty; breach of contract; and a challenge to the validity and fairness of a reverse stock split that cashed out at fair value the minority stockholder’s shares while litigation was pending concurrently in New York and Delaware courts. [Disclosure: The defendants are clients of my firm which served as co-counsel in the New York litigation and acted as lead counsel in connection with the reverse stock split.]
The case spawned a plethora of pretrial motions, lengthy trials in New York Supreme Court and Delaware Chancery Court, and appeals in both jurisdictions. Ultimately, the courts rejected the plaintiff’s claims for unlawful termination of her employment and contract breach, rejected the bulk of her claims against the majority shareholder for breach of fiduciary duty, upheld the validity of the reverse stock split, and upheld the company’s fair value appraisal with modest adjustments.
The Zutrau case can be added to the many examples of high intensity business divorce marathons about which I’ve written on this blog, in which, for whatever reasons, unreasonable demands on one side or the other foreclose the usual buy-out settlement, leaving no choice but to litigate to the bitter end, with the costs of litigation often far exceeding the amounts at stake.
Of the multitude of issues litigated in Zutrau, I’m going to focus on the two that likely are of greatest interest to business divorce practitioners: (1) the New York court’s dismissal of the plaintiff’s claim for common-law shareholder oppression under Delaware law, and (2) Chancery Court’s rejection of the plaintiff’s claim that the reverse stock split was effected for the sole purpose of depriving her of standing to pursue her derivative claims.
One of Delaware corporate law’s distinguishing features is the absence of a statutory, judicial dissolution remedy for frozen-out or otherwise oppressed minority shareholders of close corporations, such as the one found in § 1104-a of New York’s Business Corporation Law.
But this has not stopped some minority shareholders of Delaware close corporations from asserting claims for shareholder oppression under Delaware common law, usually citing a 1992 Chancery Court decision in Litle v Waters, 1992 WL 25758 [Del Ch Feb. 11, 1992], where the court declined to dismiss such a claim. Opponents cite the Delaware Supreme Court’s decision a year after Litle in Nixon v. Blackwell [626 A2d 366] which seemingly squelched any common-law basis for shareholder oppression claims.
Adding to the mix, since Nixon a handful of courts outside of Delaware have tackled the issue in cases involving Delaware close corporations, with arguably inconsistent results, such as Clemmer v Culliname, 815 NE2d 651 [Mass. App. 2004] (Nixon does not preclude common-law claim), Reserve Solutions, Inc. v Vernaglia, 438 F Supp 2d 280 [SDNY 2006] (same), and Nightingale & Associates v Hopkins, 2008 US Dist LEXIS 90204 [DNJ Nov. 5, 2008] (Nixon precludes common-law claim).
In Zutrau, the plaintiff’s complaint in her New York lawsuit for unlawful termination and fiduciary breaches also included a claim for common-law shareholder oppression. The claim did not seek a dissolution remedy. Rather, the plaintiff alleged that the defendants violated her “reasonable expectations” of continued employment and participation in the company’s management and profits, and sought restitution for allegedly lost distributions and employment compensation.
The claim invited a defense motion to dismiss, which was granted by Suffolk County Commercial Division Justice Elizabeth Hazlett Emerson in an unpublished May 2010 decision (read here). Justice Emerson’s decision observed that subsequent to Litle, which she referred to as the only Delaware case that “squarely addresses the issue of shareholder oppression,” the Delaware Supreme Court in Nixon “in dicta, expressed a distaste for special, judicially created rules to protect the minority shareholders of non-statutory, closely held Delaware corporations.”
Instead of relying soley on Delaware case law, however, Justice Emerson cited as dispositive a 1996 decision by New York’s Appellate Division, First Department, in Kikis v McRoberts Corp., 225 AD2d 455 [1st Dept 1996], in which that court rejected a lawsuit brought by a minority shareholder of a Delaware corporation whose employment had been terminated. As Justice Emerson explained,
In [Kikis], the First Department held that a minority shareholder of a closely held Delaware corporation was not entitled to any special protection against being terminated by reason of his status as a minority shareholder. The First Department, citing Nixon, dismissed the plaintiff’s complaint, finding that the Delaware Supreme Court had unequivocally rejected the notion that there are any special, judicially created rules to protect the minority shareholders of Delaware corporations. Since Kikis is the only New York Appellate Division precedent on the issue of minority shareholder oppression in closely held Delaware corporations, this court is bound to follow it. Accordingly, the third cause of action is dismissed. [Citation omitted.]
Since Justice Emerson’s ruling there have been further case law developments in Delaware supporting the outcome in Zutrau. For those interested I recommend reading Vice Chancellor Noble’s 2013 opinion in Blaustein v Lord Baltimore Capital Corp. which I wrote about here.
Reverse Stock Split and Derivative Standing
At a later phase of the New York case, in October 2011, Justice Emerson applied Delaware law in granting a summary dismissal of the plaintiff’s shareholder derivative claims due to her conflicting direct claims for recovery against the corporation. The decision (read here) provided that the dismissal was without prejudice to recommencing a separate derivative action, which the plaintiff did in Delaware six months later, in April 2012.
Meantime, however, in late 2011, the company engaged counsel for the purpose of accomplishing a reverse stock split the effect of which was to cash out the minority shareholder as authorized by Sections 155 and 242 of the Delaware General Corporation Law. In January 2012 the company through counsel engaged an appraiser to determine the fair value of the company’s shares.
The reverse stock split was consummated in early June 2012, i.e., about six weeks after plaintiff filed her new derivative action in Delaware. The company tendered approximately $500,000 to the plaintiff for the appraised value of her 22% minority interest. Defendants in the Delaware action thereupon took the position, based on the continuous ownership rule, that the plaintiff no longer had standing to litigate derivative claims and that her exclusive remedy was a fair value appraisal proceeding. Importantly, the defendants stipulated to include in any such appraisal proceeding the value, if any, of the derivative claims.
In opposition, relying on Lewis v Anderson, 477 A.2d 1040 [Del Sup Ct 1984], and its progeny, the plaintiff contended that the reverse stock split was effectuated for the “sole” and “fraudulent” purpose of eliminating her standing to maintain her derivative claims originally brought in New York and later re-filed in Delaware, and on that ground should be rescinded.
Vice Chancellor Parson’s 113-page post-trial decision issued in July 2014 (read here) at pages 88-93 discusses and rejects the plaintiff’s challenge, finding that depriving the plaintiff of derivative standing “was not a primary motivation for the Reverse Stock Split.” He gives three reasons for his finding:
- First, the defendants “articulated a credible business justification for the Reverse Stock Split” the primary purpose of which “was to bring an end to the turbulent relationship between the parties and to allow both of them and the Company to move on.”
- Second, the process that led to the reverse stock split “began before the filing of this action” at a time when there were no outstanding derivative claims against the majority shareholder “and it was unclear when or whether” the plaintiff would reassert those claims.
- Third and, according to the court, “most significantly,” the defendants consistently maintained they had no objection to plaintiff “effectively litigating her derivative claims for purposes of valuing her [shares] in connection with the Reverse Stock Split” which “approximates, at least in part, the monetary relief that [plaintiff] could have obtained if she still had standing to assert the derivative claims.”
As discussed elsewhere in the decision, the court rejected the bulk of the plaintiff’s derivative claims seeking to recover damages on the company’s behalf for alleged breaches of fiduciary duty by the majority shareholder. In the end the court modestly enhanced the appraised fair value of the plaintiff’s shares in regard to certain salary increases and perquisites taken by the majority shareholder.
Readers familiar with the Zelouf case about which I’ve written several posts may recall a similar outcome — albeit generating a much greater monetary reward for the Zelouf plaintiff — after the defendants in that New York case effectuated a freeze-out merger on the eve of trial of the minority shareholder’s derivative lawsuit. There, too, the controlling shareholders waived any objection to the plaintiff’s assertion of the derivative claims as a basis for appraisal of the company’s shares (read here).
As noted at the top of this post, the Delaware Supreme Court recently affirmed summarily Vice Chancellor Parsons’ post-trial rulings and, last week, denied the plaintiff’s motion to rehear her appeal, finally allowing the parties and the company, as the judge put it, “to move on.”