Shareholder derivative actions play an important role in monitoring abuses by corporate managers, by giving those with an indirect stake in the corporation’s welfare (the shareholders) an incentive and vehicle to seek judicial redress on the corporation’s behalf for managerial misconduct that the corporation’s board of directors fails to pursue because of conflicted interests or other circumstances impairing the board’s business judgment.
At the same time, statutory and case law impose rigorous standing requirements in derivative actions. In addition to making a pre-suit demand on the board (or alleging demand futility), the derivative plaintiff must own shares at the time of the alleged wrongdoing (the contemporaneous ownership requirement) and throughout the course of the litigation (the continuous ownership requirement).
Particularly in closely held corporations, the contemporaneous and continuous ownership requirements incentivize controlling owners to utilize a cash-out merger (a/k/a freeze-out merger) to defeat shareholder standing to assert derivative claims, leaving the would-be derivative plaintiff with the exclusive remedy of an appraisal proceeding if not satisfied with the board-determined share price, and arguably leaving the corporate managers unaccountable.
Have the courts been able to reconcile the conflicting interests at stake in the two bodies of law governing standing in derivative actions and mergers? Not according to a recently published article by one commentator who, examining Delaware law, concludes that “the existing framework of overlapping rules and exceptions [are] both structurally and doctrinally unsound.” S. Michael Sirkin, Standing at the Singularity of the Effective Time: Reconfiguring Delaware’s Law of Standing Following Mergers and Acquisitions (available on SSRN).
Which brings me to a most interesting court decision late last month by a Manhattan judge in a shareholder derivative action in which, almost literally on the eve of trial in a four-year litigation, the defendant controlling shareholders initiated a cash-out merger openly designed to convert the derivative lawsuit into an appraisal proceeding.
The Zelouf Case
Last month’s decision by Manhattan Commercial Division Justice Shirley Werner Kornreich in Zelouf v Zelouf Int’l Corp., 2013 NY Slip Op 32073(U) [Sup Ct NY County Aug. 30, 2013], involves a dispute among shareholders of a family-owned business.
In 2009, the widow of one of the founder’s sons, as 25% shareholder, filed an action asserting direct and derivative claims against the controlling shareholders. In January 2013, Justice Kornreich granted summary judgment dismissing the direct claims, but ordered a trial of the derivative claims.
Three weeks before jury selection and trial were scheduled to begin in September 2013, the defendants’ counsel notified Justice Kornreich of a special meeting of the shareholders scheduled at the end of August to vote on a proposed plan of merger into a new corporation owned 100% by defendants, and requiring the plaintiff to surrender her shares for $62,500 each. Justice Kornreich summed up the plan thusly:
The purpose and effect of the merger is quite simple: defendants, who control a supermajority of the Company’s shares, would vote to buy out plaintiff’s shares so that she would lack standing to maintain her derivative claims. The Company would be merged into a new entity, called ZIC, which would be wholly owned by defendants. If the merger occurred, the trial would be cancelled. Plaintiff’s only recourse would be to seek an appraisal of her shares under BCL § 623.
On August 22, 2013, Justice Kornreich signed an Order to Show Cause filed by the plaintiff seeking to enjoin the merger. Plaintiff’s supporting papers contended that the merger was an attempt by defendants to avoid a jury trial of her claims. The defendants’ opposing papers countered that, as 75% shareholders, defendants “are entitled by law to carry out the plan of merger” which could only be blocked by “a showing of extraordinary circumstances involving fraud, illegality, and economic unfairness of the proposed transaction,” and that the plan of merger “will guarantee the dissenting minority [shareholder] . . . the entitlement to receive fair value in cash for her shares, including value she can prove was improperly wasted or diverted”.
Justice Kornreich conducted oral argument on August 30, 2013 at which she focused on whether, if she permitted the merger to proceed, plaintiff’s derivative claims would be part of any subsequent appraisal proceeding. In response, defendants’ counsel stipulated that the appraisal court could “consider the conduct of management” and “if the conduct of management merited some increase in value to the plaintiff for her shares, she [would get] it.” Justice Kornreich also asked the parties’ counsel to brief the issue of plaintiff’s entitlement to recover her attorney’s fees in an appraisal proceeding, considering that the statute governing derivative actions expressly awards fees to the successful plaintiff.
Justice Kornreich’s Ruling
Justice Kornreich’s analysis in her August 30th written decision begins with the following quotation from the New York Court of Appeals’ landmark opinion in Alpert v. 28 William St. Corp., 63 NY2d 557 (1984):
Generally, the remedy of a shareholder dissenting from a merger and the offered “cash-out” price is to obtain the fair value of his or her stock through an appraisal proceeding. This protects the minority shareholder from being forced to sell at unfair values imposed by those dominating the corporation while allowing the majority to proceed with its desired merger The pursuit of an appraisal proceeding generally constitutes the dissenting stockholder’s exclusive remedy. An exception exists, however, when the merger is unlawful or fraudulent as to that shareholder, in which event an action for equitable relief is authorized. [Citations omitted.]
Justice Kornreich then frames the issue as whether a freeze-out merger on the eve of trial is permissible under New York law which, she adds, “appears to be an unsettled question.” Although, she continues, “[u]nder most circumstances, plaintiff would have a legitimate concern about losing the ability to maintain her derivative claims once the merger was consummated,” the issue need not be decided based on defendants’ stipulation at the August 28th hearing in which they agreed that any alleged diminution in value of plaintiff’s shares can be factored into the court’s appraisal.
Justice Kornreich also highlights the practical benefits of proceeding with an appraisal:
Additionally, if plaintiff prevailed at trial, defendants would have to repay the Company and plaintiff could only obtain a cash recovery if she were bought out afterward. Instead, under defendants’ proposal, the Company would pay plaintiff immediately after an appraisal. Defendants, in actuality, would be the effective payors since, as the sole owners of the Company, they, in the end, would realize the loss. This is a more efficient process since it saves all parties – plaintiff, defendants, and the Company – the cost of a jury trial, an appeal, and a subsequent appraisal (either in a dissolution proceeding or in a buy-out), which would far exceed the cost of conducting an appraisal at this time.
The decision also addresses the two, specific concerns raised by plaintiff: the loss of her right to a jury trial with respect to her derivative claims, and the recovery of legal fees. As to the former, Justice Kornreich states that “the right to a jury trial really belongs to the Company” and therefore “plaintiff’s individual rights are not impacted.” She also finds that a jury trial is “not remotely in the best interest of the Company” and that “plaintiff has no legitimate grievance about not going forward with a jury trial.”
As to plaintiff’s legal fees, Justice Kornreich states, first, that the appraisal statute permits recovery of the costs of the appraisal proceeding itself and, second, because the appraisal of plaintiff’s shares will factor in the valuation of her derivative claims, “[s]uch valuation necessarily would include her legal fees because derivative claims inherently contain the expectation that a meritorious plaintiff will recoup legal fees.” Therefore, Justice Kornreich writes, “the court will incorporate the legal fees that plaintiff would have recovered in her derivative action into the valuation of her shares.”
A Few Closing Observations
- The outcome in Zelouf, if not the underlying legal rationale, resembles what often occurs in cases involving parallel derivative actions and stockholder buy-out valuation proceedings in dissolution cases, where courts have ordered that the derivative claims be subsumed within the valuation. The big difference, of course, is that the shareholder continues to be a shareholder pending the valuation proceeding whereas a shareholder ceases to be a shareholder upon the consummation of the merger.
- It’s interesting to contrast Zelouf with Delaware case law addressing freeze-out mergers amidst derivative litigation, in which the rule has evolved, as articulated by the Delaware Supreme Court in Lewis v. Anderson, 477 A.2d 1040 (Del. 1984), that a merger whose sole purpose is to divest the plaintiff of derivative standing falls within the “fraud exception” to the general rule denying standing to a derivative plaintiff who ceases to be a shareholder as a result of a merger (see discussion at page 17 of Mr. Sirkin’s article mentioned above.) In Zelouf, the defendants readily admitted that the sole objective of their eve-of-trial merger was to negate plaintiff’s standing and thereby abort the trial of plaintiff’s derivative claims.
- Only 11 days passed from the time Justice Kornreich was notified of the proposed merger to the date of her written decision. In those 11 days, she entertained an Order to Show Cause and temporary restraint application; received and read the parties’ motion papers and supplemental letter briefs; and conducted a hearing. Whatever you think of the outcome, the speed with which the court resolved the difficult and novel issues, and the amount of attention devoted to it as just one of hundreds of cases assigned to Justice Kornreich, exemplify at their best the purpose and capabilities of the Commercial Division formed over 20 years ago to meet the needs of New York’s business community for efficient adjudication of complex cases by a knowledgeable judiciary.