Do controlling shareholders of a close corporation have an affirmative duty of financial disclosure when negotiating a buy-out of a minority shareholder? If so, what’s the source of the duty? Is it part of, or appurtenant to, a common-law fiduciary duty of loyalty or care? Or might it derive from the statutory right to seek judicial dissolution for the controllers’ oppressive acts?
Those weighty questions are prompted by a decision last month in which the court denied a motion to dismiss a minority shareholder’s counterclaim against the majority shareholders for breach of fiduciary duty in connection with a disputed buy-out agreement. The court’s decision in PF2 Securities Evaluations, Inc. v Fillebeen, 2015 NY Slip Op 30436(U) [Sup Ct NY County Mar. 26, 2015], invoked in tandem the majority shareholders’ fiduciary duty and the minority shareholder’s rights to be “free of oppressive conduct” and “in the event of a consensual buy-out . . . to receive a fair market value for his stock after fair and complete disclosure and valuation.”
The case involves a financial consulting firm called PF2 that uses mathematical models to evaluate collateralized debt obligations (CDOs). The defendant co-founded the company in 2007 and held a one-third stock interest. According to PF2’s complaint (read here), the defendant was responsible for developing the mathematical models and collecting data to evaluate CDOs. The complaint alleges that in 2012, as a result of the defendant “failing to fulfill his role as a director/partner of PF2,” the company negotiated “a generous buyout and employment contract” with the defendant “through various conversations and emails.” The complaint’s gravamen is that the defendant wrongfully competed with PF2 and misappropriated its proprietary information both before the buy-out when he was still a shareholder and afterward while he was in PF2’s employ.
The defendant counterclaimed against PF2 and its two controlling shareholders (read here). The counterclaims allege that in 2012 the controllers “devised a plan to provide [defendant] with false information in order to induce him to sell his shares in PF2 for significantly less than fair market value in order to avoid having to include him in the distribution of PF2 profits in the future.” Allegedly, they “falsely stated that PF2’s finances were in a dire state, and therefore PF2 was only able to pay [defendant] a fraction of the value of his PF2 shares.” The counterclaims, including one for breach of fiduciary duty, further allege that as a result of the controllers’ “false statements” concerning PF2’s value, the defendant “agreed to accept payment for his PF2 shares in an amount that was significantly less than the agreed upon and/or actual fair market value of his PF2 shares.”
Neither the complaint nor the counterclaims specify the agreed purchase price for the buy-out. The only hint of what the defendant contends is the true value of his shares is his allegation that “at various times during the parties’ relationship, the total value of PF2 was set . . . at a sum between $500,000 to $1,800,000.”
The plaintiffs’ brief in support of their motion to dismiss (read here) argued that the defendants’ counterclaim for breach of fiduciary duty was “nothing more than a laundry list of misconduct without proper support” and therefore failed to give adequate notice of the claim’s particulars. The defendant’s opposing brief (read here) merely cited general fiduciary principles.
Neither side’s argument on the point mentioned the allegedly false information given to the defendant in connection with the buy-out, which makes all the more curious the court’s central reliance on that allegation in the portion of its decision at pages 10-12 finding that the defendant “has sufficiently stated a cause of action for breach of fiduciary duty regarding valuation of his stock.” The pertinent part of the court’s discussion follows [citations are omitted]:
There is a plethora of authority in New York that a minority shareholder in a closely-held corporation is owed a fiduciary duty by majority shareholders or by those in control of the corporation and must be treated fairly and be free of oppressive conduct or unlawful freeze-out merger. In the context of involuntary corporate dissolution under BCL § 1104-a, the First Department has observed, “While . . . ‘oppressive’ conduct is not defined in the statute, the Court of Appeals has noted it is distinct from illegality and refers to conduct that substantially defeats the ‘reasonable expectations held by minority shareholders in committing their capital to the closed corporation.”
Although the pleadings here do not allege a freeze-out or petition for a corporate dissolution, a common theme runs through the weight of legal authority in New York: a minority shareholder in a close corporation must not be unlawfully compelled to sell his shares or be “cashed out,” and in the event of a consensual buy-out, he is entitled to receive a fair market value for his stock after fair and complete disclosure and valuation.
. . . [Defendant] was responsible for the technical side of PF2’s services, and the sole source of his information regarding PF2’s financial standing came from [one of the controllers]. [Defendant] alleges that [the controllers] wanted to alter PF2’s business model and to remove him from its operation. As [defendant] consensually agreed to sell his shares in PF2, [the controllers] had a fiduciary duty to make accurate financial disclosures to enable fair valuation of [defendant’s] shares.
Although [defendant] does not specify the price of the agreed Buy-Out or the amount by which he claims his shares were undervalued, the demand that he sell at least eight of his ten shares at the initial offering price, together with a unilateral declaration that he was no longer a shareholder, is sufficient to suggest bad faith. Inspection of PF2’s books and records will enable the parties to determine the fair value of PF2’s shares and whether there is sufficient evidence to support [defendant’s] allegations.
There’s an awful lot going on the above paragraphs, so I’ll try to break it down:
- Do controlling majority shareholders in a close corporation owe a fiduciary duty to minority shareholders? Unquestionably, under an unbroken line of case precedents.
- Do minority shareholders have a “right” to be free of “oppressive” conduct by the majority? In my own view, the answer is “yes” but only in the limited sense that shareholder oppression, a statutory creation under BCL § 1104-a, enables the oppressed shareholder to seek a judicial dissolution remedy, which is not what the defendant sought in PF2 involving a counterclaim seeking damages for fiduciary breach. As I’ve previously written, whereas conduct by a controller constituting breach of fiduciary duty may also satisfy the reasonable-expectations test for oppressive conduct, it is not necessarily true that oppressive conduct equates with fiduciary breach.
- Is a minority shareholder “entitled” to receive “fair market value” for his or her stock in the event of a “consensual” buy-out? I’ve not seen that exact proposition supported in any other case law. Certainly an argument can be made that the price and terms negotiated at arm’s length by the outgoing and remaining shareholders, neither under a compulsion to buy or sell, is not subject to judicial review under a fiduciary or any other standard.
- Is a minority shareholder entitled to receive from the controllers “fair and complete disclosure and valuation” in connection with the consensual negotiation of a voluntary buy-out agreement? Again, I’ve not seen other case law support for such a broad proposition. There may be circumstances in which the controllers have a fiduciary duty to disclose non-public information to the minority shareholder at the time of buy-out negotiations, such as the existence of a third-party purchase offer for the company or its assets, but recent jurisprudence from the New York Court of Appeals — here I’m referring to the Pappas-Arfa-Centro trilogy of cases — arguably supports the contrary view particularly where, as appears to be alleged by both sides in PF2, there was acrimony between the shareholders at the time of the buy-out negotiations such that the selling shareholder could not reasonably rely on value-related information provided by the purchasing shareholders.