The case I’m about to describe involves an unusual clash of two fundamental principles of corporate governance for closely held corporations:
Principle No. 1: Stock transfer restrictions may be used to preserve continuity of ownership and management within a family or other control group, without violating the common law rule against unreasonable restraints on alienation of property.
Principle No. 2: Controllers owe a fiduciary duty to treat all shareholders fairly and evenly when authorizing and issuing new shares, and must have a bona fide business purpose for any departure from precisely uniform treatment.
The clash came to a head in a decision this month by Brooklyn Commercial Division Justice Lawrence Knipel involving 4C Foods, a well-known, fourth generation, family-owned business that manufactures and markets under the 4C® brand grated Italian cheeses, bread crumbs, iced tea, and drink mixes. The suit pits Nathan Celauro, a non-managing, minority owner holding directly or beneficially about 22% of 4C’s voting and non-voting shares, against his cousin John Celauro, the managing majority shareholder who controls or has aligned with him the remaining 78%. (Disclosure: Farrell Fritz represents the minority shareholder in the case.)
The case and Justice Knipel’s decision in Celauro v 4C Foods Corp., 2016 NY Slip Op 31917(U) [Sup Ct Kings County Oct. 12, 2016], is the latest in a series of litigations and court rulings between two factions of the Celauro family beginning around 2005, following the death of Nathan’s father the year before. About 20% of the father’s voting and non-voting shares passed to his wife either directly or to trusts under her control, with the remaining 2% going directly to Nathan.
The Transfer Restrictions
In 2005, all of the 4C shareholders entered into a shareholders agreement containing stock transfer restrictions and put rights designed to maintain family ownership and control. Later that year, after Nathan’s mother filed suit accusing her nephew, John Celauro, of certain financial improprieties while running the business, John used his super-majority control to initiate a series of amendments to the 2005 agreement which, in sum and substance, (a) required any shareholder desiring to transfer shares to a permitted transferee to give notice of intent to transfer, (b) gave the majority shareholders the right to approve or reject the transfer, or — as later became crucial because of 4C’s capitalization with voting and non-voting shares — a portion thereof, and (c) required the transferring shareholder to sell to the company any shares for which transfer approval was not given.
The amendments triggered a new lawsuit by Nathan’s mother, claiming that the amendments constituted an unreasonable restraint on alienation of her and the trust’s shares which, upon her death, she intended to bequest or transfer to her son, Nathan, giving him outright ownership of 22% of 4C’s voting and non-voting shares. That suit culminated with a 2010 ruling, affirmed on appeal, rejecting the challenge to the transfer restrictions.
The 2011 Increase in Non-Voting Shares
Late the following year, and shortly before the death of Nathan’s mother, the directors and a super-majority of the shareholders led by John authorized an amendment to the company’s certificate of incorporation and to the shareholders agreement, quadrupling the number of authorized non-voting shares and declaring a dividend of four non-voting shares for each non-voting share held. The increase did not alter the equity percentages of any of the shareholders.
Initially, Nathan filed another lawsuit contending that the amendment adversely affected redemption and voting rights and therefore triggered dissenting shareholder appraisal rights under Section 623 of the Business Corporation Law. The court disagreed and dismissed the claim in late 2012.
Nathan’s Proposed Stock Transfer
Around that same time, Nathan as executor of his mother’s estate gave the required notice under the shareholders agreement of his intent to transfer to himself all 4C voting and non-voting shares formerly held by his mother or held in trusts under her control. In response, John and the other majority shareholders consented to the transfer of the non-voting shares, but not the voting shares which, under the amended shareholders agreement, would have to be sold to the company.
There followed a flurry of litigation claims and court rulings, the details of which I’ll skip over, all of which ultimately teed up Nathan’s filing of an amended complaint in what had started as the appraisal action, now reframed as a damages action attacking the majority’s rejection of his proposed transfer of voting shares on two, primary grounds:
- First, under the agreement’s appraisal formula, the increase in non-voting shares dramatically diluted, by almost 80%, the value of the voting shares to be purchased by the company.
- Second, by barring the transfer to Nathan (who owned in his own name only about 2% of the voting shares) of the approximately 20% voting shares held by his mother’s estate and the trusts, the majority aimed to deprive Nathan of standing to commence a judicial dissolution proceeding as an oppressed minority shareholder under BCL Section 1104-a which sets a minimum threshold of 20% voting shares.
Nathan’s amended complaint alleged that the combined effect of (1) the amendment to the shareholders agreement allowing the majority to block transfer of all or some of the shares from the estate of a deceased shareholder to a beneficiary; (2) the increase in the number of non-voting shares and its dilutive effect on the value of the voting shares; and (3) the majority shareholders’ forced sale to the company of the voting shares held by Nathan’s mother’s estate, violated the majority’s fiduciary duty owed to the minority shareholder and also violated the implied duty of good faith and fair dealing.
Justice Knipel’s Ruling
The company and majority shareholders moved to dismiss Nathan’s amended complaint based on procedural objections and also contending that the pleading failed to allege facts from which damages attributable to defendants’ conduct may be reasonably inferred.
In his 28-page decision denying the motion, Justice Knipel’s analysis went considerably further than the narrow grounds for dismissal raised by the defendants in finding that:
the plaintiffs have stated claims that the defendant shareholders breached the implied covenant of good faith and fair dealing and fiduciary duties and the 4C Foods’ directors breached their fiduciary duties in manipulating the number of 4C Foods’ non-voting shares in order to allow 4C Foods to purchase the voting shares for which transfer has been denied . . ..
Justice Knipel’s holding rested primarily on two legal principles, the first dealing with the standard of review of controller action and the second with the controller’s good faith, set forth at pages 14-16 of the decision:
- First, the fiduciary duty owed by directors and majority shareholders “to treat all shareholders, majority and minority, fairly and evenly” requires courts to “closely examine director or majority shareholder actions that upset a minority shareholder’s proportionate interest in a corporation,” and any departure from “precisely uniform treatment” requires a “bona fide business purpose.”
- Second, while case authorities generally enforce transfer restrictions in shareholder agreements, “they do not suggest that majority shareholders can manipulate share ownership to their benefit in applying the terms of the transfer and share repurchase provisions.”
Applying those principles to the allegations in Nathan’s amended complaint, Justice Knipel made the following noteworthy observations at pages 17-18 of the decision:
- While, viewed independently, the stock transfer restrictions and increase in non-voting shares may not give rise to a claim, “when considered together, [they] allow an inference that defendants approved the amendment increasing the number of non-voting shares in order to purchase the estate’s voting shares at a significantly lower price and have actually acted to do so by only electing to purchase the voting shares at issue.”
- “[T]here does not appear to be any obvious business purpose associated with altering the number of non-voting shares,” i.e., the company received no additional capitalization and the shareholders received no apparent benefit such as increased distributions.
- The timing of the increase in non-voting shares, on the eve of Nathan’s mother’s expected death after a long illness, also supported an inference of a discriminatory, non-bona fide justification “to depress the purchase price of the voting shares at the expense of plaintiffs for the benefit of the majority shareholders.”
The case will now go forward on the merits of plaintiffs’ claims that the various amendments to the shareholders agreement and the increase in the number of non-voting shares entitles them to recover damages in excess of $30 million for intentionally depriving plaintiffs of their ownership of over 20% of the voting shares of 4C and, as a result, intentionally depriving plaintiffs of their protection under provisions of the Business Corporation Law authorizing judicial dissolution upon application by an oppressed shareholder owning at least 20% of the voting shares and providing a buy-out at “fair value.”
In the end, whatever the outcome, Celauro stands as a reminder to controlling owners and especially their counsel that actions affecting minority interests which, standing alone, pass legal muster, when combined with the effects of other such actions whether concurrent or separated in time, may cross the bounds of fiduciary impropriety under close inspection by a court, even more so when the action has no apparent purpose beyond protecting the majority’s interest at the minority’s expense.