Secret Profits Derived by Corporate Officer = Breach of Fiduciary Duty

Secret Profits Derived by Corporate Officer = Breach of Fiduciary Duty

      A recent decision by the 6^th Circuit Court of Appeals has further ratified the rule that a corporate officer, being a fiduciary to the corporation, is precluded from enjoying any secret profits related to that corporation.  Mazak Corp. v. King, No. 11-5561 (6^th Cir. Aug. 22, 2012). 

      King was Mazak’s Vice President and Controller from 1990 until 2005.  Timothy Fisher, another Mazak employee, reported to King.  In 1997, Louise Seta formed United International of Cincinnati, LLC, which provided consulting services to Mazak; Seta was Fisher’s brother-in-law.  Ultimately, Seta, through United, proposed that it and Mazak set up an LLC to finance purchases by Mazak’s customers.  This proposal ultimately led to the formation of Mazak Financial Group, LLC, it being 50% owned by Mazak and 50% by United.  Not disclosed to Mazak was the fact that King, while still a Mazak officer, acquired an ownership interest in United and as well an ownership interest in W.T. Financial, a subcontractor of Mazak.  Although the opinion is not express on the point, it would appear Fisher was as well an owner in one or both of those ventures.

      After King’s separation from Mazak, reflected in a written separation agreement containing a release, Mazak learned, through United K-1s that King had an ownership interest in United.  Mazak then sued King for various claims including breach of fiduciary duty and having aided and abetted Fisher’s breach of fiduciary duty.  As the trial was about to begin, the trial court (Judge Bertelsman) determined, as a matter of law, that Mazak was entitled to an award of damages, and judgment was entered against King in the amount $3,472,896.

      The Court of Appeals ruling considers numerous Kentucky decisions as to the obligations of a fiduciary to disclose any conflicting interest.  For example, Aero Drapery is cited for the principle that:

If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all of its stark significance.

      Based upon the fact that “King failed to disclose that he was simultaneously serving as a corporate officer and receiving payments from a company with which the corporation did substantial business,” “[t]he District Court correctly concluded that King breached his fiduciary duties to Mazak.”  Relying upon cases including Stewart v. Ky. Paving Co., the Court made clear that the corporation need not show actual damages from the relationship (here, the companies in which King held an interest were not its competitors) in order to receive a disgorgement of the benefits realized by the disloyal fiduciary.

            As to King’s assertion that the release in the separation agreement protected him from liability on the breach of fiduciary claims, the 6^th Circuit was of the view that Kentucky courts would not read the release as sufficient to preclude a claim for breach of fiduciary duty when the facts as to the conflict transaction had been concealed from the corporation:

Accordingly, we believe that Kentucky courts would decline to enforce the release here.  King did not disclose his ownership interest in United and W.T. Financial during his employment with Mazak or during the period when he served as a Mazak consultant.  This information was clearly material to Mazak’s willingness to release King of all known and unknown conflicts of interest.  Because King did not tell Mazak about his ownership interests in W.T. Financial and United while procuring the Separation Agreement, the mutual releases and covenants not to sue contained therein are unenforceable.

      In addition, King’s effort to rely upon KRS § 271B.8-310(1) and its safe harbor from liability on conflict of interest transactions where it is shown that the transaction was “fair to the corporation” was rejected on the basis that the statutory provision relates to a conflict of interest between a corporation and one of its directors.  King was not a director of Mazak, and the statute does not extend to officers.

      The Mazak opinion is a useful reminder of the critical importance of disclosure obligations of fiduciaries in general, particularly its directions as to the measure of damages and the absence of a need by the corporation (or other beneficiary of the fiduciary obligation) to demonstrate actual damages.  However, sadly unexplored by the opinion was the question of controlling law.  Based upon a brief discussion with Mazak’s counsel, all parties to the dispute proceeded through both the trial and the appeal on the basis that Kentucky law would control.  Mazak Corporation, however, is incorporated under the laws of New York, and under the internal affairs doctrine King’s obligations as an officer of the corporation would be determined under that law (whether the analysis would be materially different under New York versus Kentucky law remains to be determined).  In contrast, as a common-law agent of the corporation, and to the extent those obligations were not modified by the New York law, Kentucky law would apply.  Regardless of that issue, however, it is simply inconceivable that King’s actions would ever be considered appropriate.