Tuesday, December 29, 2015

Will No One Rid Me of This Turbulent Priest?

Will No One Rid Me of This Turbulent Priest?

            Today marks the anniversary of the murder in 1170 of Saint Thomas Becket.  This murder has always been the most serious stain upon the reign of King Henry II

            Of Norman descent (the movie Becket inaccurately has Henry referring to Becket as a Saxon), Becket rose to be appointed Lord Chancellor of England.  While Chancellor Henry nominated Becket (who at this time was not a priest) to the position of Archbishop of Canterbury, clearly hoping that Becket would use his power as primate of England to mold ecclesiastical policy in favor of royal interest.  Becket failed to do so, rather becoming an ascetic and placing the interests of the Church over those of the crown.  Eventually he was forced to resign as Lord Chancellor.

            The contest of wills between Henry and Becket over the Constitutions of Clarendon, they seeking to increase the power of the civil state over the Church and its constituents, led to a final break in the relationship, with Becket even fleeing England for France.  Eventually he would return to Canterbury.

            While in France and likely well into his cups, Henry made a statement (exactly what was said is lost to history – there are conflicting accounts) that was interpreted by four knights as a direction to kill Becket.  They crossed the Channel and challenged Becket in Canterbury Cathedral, there killing him.  Becket was canonized barely three years later, and the four assassins were excommunicated and ordered to go on pilgrimage to the Holy Land (at least one of them thereafter became a Templar).  Henry would later do public penance at Becket’s shrine in Canterbury Cathedral.

            There is a passing reference to Becket in The Lion in Winter. 

Suit Dismissed; Plaintiff Hoist on the Petard of the Direct versus Derivative Distinction

Suit Dismissed; Plaintiff Hoist on the Petard of the Direct versus Derivative Distinction

            A recent decision from the Kentucky Court of Appeals reinforces the importance of understanding and properly pleading a derivative (as contrasted with a direct) action  In this instance the efforts of one shareholder/director to bring a direct action against the other shareholder/director were set aside because the cause of action was in fact derivative.  Gross v. Adcomm, Inc., No. 2014-CA-001031-MR, 2015 WL 8488900 (Ky. App. Dec. 11, 2015).

            Sam Gross and Christopher Pearson formed Adcomm in 2001; each was a 50% shareholder and a director.  Gross was appointed president while Pearson was elected vice president.  In 2004 Pearson submitted to the Secretary of State documents identifying himself as the corporation’s president and as well changing the corporation’s registered agent to himself.  In 2005, a complaint by Adcomm as the plaintiff was filed against Gross alleging financial misconduct, seeking an accounting, and seeking as well an order removing Gross from all positions with Adcomm.  This suit was initiated “at the direction and upon the authority of Pearson as its ‘director and vice-president.’” I guess Pearson forgot about his 2004 filing saying he was the corporation’s president.

In response,

Gross moved to dismiss Adcomm's complaint for lack of standing. Specifically, Gross pointed out that no resolution from the board of directors had appointed Pearson as the president of Adcomm; authorized Adcomm to engage in litigation that was effectively against half of the directors on its own board; or authorized Adcomm to hire an attorney to prosecute its suit. Gross would later reassert this argument, or variations of it, in several other motions to dismiss Adcomm's suit or to disqualify Adcomm's counsel from prosecuting its suit over the course of the next several years of litigation that would follow. Nevertheless, on the only occasion that the circuit court made a ruling upon one of Gross's motions to this effect, the circuit court denied it without further explanation.

Slip op. at 2-3.

Various counter-claims were as well filed, and eventually the matter was referred to a master commissioner to effect an accounting.  This appeal was from that master commissioner report.

            On appeal, Gross argued two points, namely:

(1) Adcomm lacked standing to file suit against him so this litigation should have been dismissed at its inception; and (2) Adcomm's counsel, Jeffrey Stamper, has had a irreconcilable conflict of interest from the inception of this twelve-year-long litigation and should have been disqualified.

Slip op. at 6.

After classifying the various claims and counter-claims as belonging to Adcomm and its assets and noting that corporate officers and directors owe their fiduciary obligations “to the corporation, not the shareholders” (Slip op. at 6), it was observed that a corporation may initiate legal action on its behalf pursuant to to vote of a majority of the board of directors.  From there the Court of Appeals characterized the question as:

Who is entitled to assert and litigate the rights of an aggrieved corporation when, as here, the party who allegedly injured the corporation is a 50% shareholder, controls half of the corporation's board of directors, and does not want the corporation to pursue litigation? 

Slip op. at 7.

Pearson/Adcomm claimed that Pearson had the capacity to initiate the suit in the basis that Gross had a conflict of interest as to whether or not the suit should be brought against himself which precluded him from taking part in that determination.  As Pearson was the only non-conflicted director, so went the argument, he acting unilaterally was a majority of the board and could direct the corporation.  In support thereof there was cited KRS 271B.8-310(4), which precludes an interested director from voting as to whether to approve a related party  transaction.

After noting that KRS § 271B.8-310 relates to the ability of a corporation to avoid a conflict of interest transaction, the Court of Appeals wrote that the statute is not mandatory and has no impact upon the decision making structure of a corporation:

Nothing in KRS 271B.8-310 alters the manner in which a corporation decides to exercise and vindicate such a right (i.e., through a majority vote of its directors at a meeting of its board).  Likewise, nothing in KRS 271B.8-310 disqualifies any director—self-interested or otherwise—from voting against the corporation exercising such a right.

Slip op. at 9 (footnote omitted).

            From there the Court considered an argument based upon the futility of making a demand upon the board for it to bring suit against Gross, noting that he would never endorse a suit being filed against himself.  All of that may be well and good, but the Court of Appeals observed in response that “the most noticeable flaw of Adcomm’s argument is that it misunderstands the posture of this case.”  Slip op. at 11.  Rather, this was a direct action by Adcomm against Gross, not a derivative action.

With this in mind, Sahni and its interpretation of the rule regarding the "futility" of making a demand for suit upon a board of directors have no bearing upon whether Adcomm had standing to sue Gross. This is because the "futility" rule applies to derivative actions, not direct actions. And, despite Adcomm's insinuation that "Pearson" had a "position regarding [Gross's] Motion to Dismiss," Pearson did not file a derivative action against Gross on behalf of Adcomm. Rather, Adcomm purported to file a direct claim on behalf of itself, and Pearson (as reflected in his several depositions, his testimony before the master commissioner, and in Adcomm's multitude of pleadings in this matter) repeatedly stated that he was acting at all times as Adcomm's authorized representative in causing Adcomm to file the instant litigation.  Further underscoring this point are the facts that (1) "Adcomm, Inc." has always been the sole individual plaintiff suing Gross during the twelve years of this litigation; and (2) Adcomm hired its own attorney to prosecute its case against Gross and to defend this appeal. Consequently, this argument also does not support that Adcomm had standing to directly sue Gross. Instead, as italicized above, it demonstrates that Adcomm does not appreciate the difference between a direct corporate action and a derivative corporate action.

Slip op. at 13 (footnote omitted).

            Which brings us to the culmination of this dispute, namely:

Who is entitled to assert and litigate the rights of an aggrieved corporation when, as here, the party who allegedly injured the corporation is a 50% shareholder, controls half of the corporation's board of directors, and does not want the corporation to pursue litigation?


Which was answered as follows:


[T]his action purported to be a direct corporate action. There is no resolution of Adcomm's board of directors that authorized Adcomm to file the instant litigation against Gross, or to hire and pay any attorney to prosecute it. In light of Gross's twelve years of objections to this litigation; his 50% interest in Adcomm; and his role as the second of Adcomm's two directors, it is also obvious that no such resolution would have ever been forthcoming. Absent such a resolution, Adcomm lacked authorization to file this litigation, was never properly a party to it, and its claims should have been dismissed as a matter of law.

Slip op. at 14-15.

            This decision needs to be carefully considered by both attorneys and the bench when considering lawsuits by and among business entities and their constituents.  The waste of corporate and other assets, as well as the time of the courts, that has followed from this 12 year journey, ultimately for no resolution, is unjustified and unjustifiable.  Precise pleading of claims as either direct or derivative, and clear demonstration of authority to bring them, should be an enforced obligation, and interlocutory appeal of those determinations should as well be allowed in order to avoid the time and expense of improperly plead actions.


Monday, December 28, 2015

Your Ways Are Not Our Ways

Your Ways Are Not Our Ways

“Your ways are not our ways” are words said by Dracula in the movie Bram Stoker’s Dracula; Transylvania and Victorian London being rather dissimilar.  They apply as well today when assessing the law of other states; different states can have entirely different, but each equally legitimate, rules.  This principle applies when assessing a recent decision out of New York and considering if the same result would happen in Kentucky.

Peter Mahler, in his excellent New York Business Divorce blog, recently reviewed a New York decision on minority shareholder oppression, Matter of Digeser v. Flach, 2015 NY Slip Op 51609(U), a case in which the heirs of the founders of a pair of companies had a falling out.  The minority shareholder found his management position and employment in the corporations terminated, and brought suit seeking judicial dissolution on the basis of oppression.  Flach, the majority shareholder, also terminated the employment of Digeser’s sons and engaged in a variety of other actions that Digeser asserted were oppressive.  Ultimately both the trial court and the court of appeals would determine that oppression had taken place, allowing the action for judicial dissolution of the corporations to proceed. Peter excellent review of the case, through which the decision itself can be assessed, is available AT THIS LINK.

But is this good law in Kentucky?  Probably not.  The New York law governing corporations includes, at § 1104-a(1), “oppression” as a basis for seeking judicial dissolution.  Kentucky, at KRS § 271B.14-300(2)(b) does not include oppression as a basis for dissolution.  In fact, when this provision was drafted, the MBCA included “oppression” as a basis for dissolution; that term was removed from the final Kentucky act.  While no Kentucky court has yet addressed the matter, it would seem that whether or not particular conduct is “oppressive” as to the rights of a minority shareholder is a pointless determination; even in the face of oppression there is no statutory basis for judicial dissolution.

Jury Finds Breach of Fiduciary Duties Where Corporation Used as Personal Piggy-Bank of 51% Shareholder

Jury Finds Breach of Fiduciary Duties Where Corporation Used as Personal
Piggy-Bank of 51% Shareholder

As reported in the Kentucky Trial Court Review, a jury found that a corporate director and 51% shareholder violated his fiduciary obligations by, inter alia, using the corporation’s assets as his personal piggy-bank.  Liberty Rehabilitation v. Waide, 19 KTCR 10 at 7 (October 2015).

Forrest “Ben” Waide was the the 51% shareholder in Liberty Rehabilitation; Lawrence Holmes and Jason Myers were the minority shareholders therein.  Waide was elected to the Kentucky General Assembly in 2010 and reelected in 2012.  Also in 2012 Holmes and Myers became concerned about how corporate funds were being used.  For example, the company paid for Waide to attend the Republican National Convention, a trip to St. Louis with his wife, and some $20,000 went to Waide’s reelection campaign. Ultimately Waide’s diversion of corporate funds to his campaign led to his indictment for campaign finance violations; he pled guilty and resigned from the General Assembly.  See KRS § 121.025 (forbidding corporate contributions to political campaigns); see also http://state-journal.com/local%20news/2015/04/14/forrest-ben-waide-pleads-guilty-avoids-jail-sentence.

Holmes and Myers initiated a derivative action on behalf of Liberty Rehabilitation seeking to recover $504,304 of diverted funds.  Waide argued that (a) there were benefits to the corporation at least sought in the trip to St. Louis and (b) while there were errors, they were not sufficient to justify a finding that he violated his fiduciary obligations.  The jury was apparently having none of that.  It awarded compensatory damages in the amount of $456,500 and punitive damages of $225,000. 

At this juncture I do not know if an appeal has been filed.

This decision should be a wake-up call to corporate officers and directors and all others charged with fiduciary obligations.  A fiduciary is obligated to use the entrusted assets for the benefit of the principal, and it is the fiduciaries obligation to be able to make that demonstration.  A personal benefit is a red flag, and a failure to disclose is doubly a red flag.  Had Waide sent to Holmes and Myers an email before the St. Louis trip saying “I’m going to St. Louis, taking my wife along, to try to get work from Peabody Coal.  Trip expected to cost $______.  Let me know if you have a problem with me doing so.”, at least that aspect of the dispute likely could have been avoided.  That is not to say that prior approval is required; it is, however, an easy way to diffuse any subsequent question.



Termination for Non-Performance Upheld

Termination for Non-Performance Upheld

In a recent decision, the Sixth Circuit Court of Appeals upheld the termination of the executive director of a non-profit corporation when she failed, over several years, to balance the budget.  In doing so her assertions that she was terminated on the basis of her sex and that she was held to a stricter standard than was her male successor were rejected.  Gunn v. Senior Services of Northern Kentucky, No. 15-5320 (6th Cir. Dec. 7, 2015).

Gunn was in 2000 hired as the Executive Director of Senior Services of Northern Kentucky (“SSNK”); eventually she as well accumulated the titles of President and CEO.  By 2006 the corporation was operating at a deficit; losses were being covered by a related endowment.  In 2006 the operating deficit was $101,000 and in 2008 it was $81,653. The Board, in June, 2008, directed that management’s goal was “to react to the [funding] cuts and achieve a balanced budget in 2009.”  Slip op. at 2.  Instead, in 2009 the deficit was $93,000, and the estimate for the 2010 budget was estimated to be as high as $150,000.  The Board reiterated its direction that a balanced budget needed to be achieved. In July, 2010 a new Board Chair told Gunn that her number-one priority is a balanced operating budget.  Still, on May 25, 2011 an operating budget deficit of $183,223, along with a projected deficit for the year of $281,417, were reported to the Board.  Gunn submitted a 2012 budget showing a $164,000 deficit, an action “That signaled the end of Gunn’s tenure at SSNK.”  Slip op. at 4. Gunn responded by bringing suit under the Civil Rights Act of 1964 and Kentucky’s similar law, asserting, inter alia that she was terminated on the basis of her sex.  SSNK moved for summary judgment, which was granted by the trial court.  That determination would be upheld by the Court of Appeals.
Claims of discrimination on the basis of sex move through a three stage analysis: first, does the plaintiff make out a prima facia case of discrimination; second, does the defendant offer a legitimate, non-discriminatory basis for the action taken; and third, can the plaintiff demonstrated that the proffered legitimate basis is a pretext?  Slip op. at 6, citing McDonnell Douglas Corp. v. Green, 411 U.S. 792 (1973).

In this case SSNK pointed to the repeated failures to achieve a balanced operating budget as a nondiscriminatory basis for Gunn’s termination.  In response thereto the burden shifted to Gunn to establish pretext, which requires that the plaintiff show:

[T]hat (1) the employers stated reasons for terminating the employee have no basis in fact, (2) the reasons offered for terminating the employee were not the actual reason for the termination, or (3) the reasons offered were insufficient to explain the employers action. Imwalle v. Reliance Med. Products, Inc., 515 F.3d 531, 545 (6th Cir. 2008). “[A] reason cannot be a pretext for discrimination unless it is shown both that the reason was false, and that discrimination was the real reason.” Seeger, 681 F.3d at 285 (alteration omitted) (quoting St. Marys Honor Ctr. v. Hicks, 509 U.S. 502, 515 (1993)). Thus, regardless of which rebuttal method a plaintiff uses, “he always bears the burden of producing sufficient evidence from which the jury could reasonably reject the defendants explanation and infer that the defendant intentionally discriminated against him.” Id. at 285 (alterations omitted).

Gunn attempted to proceed under the second option, namely that “the reasons offered for terminating the employee were not the actual reason for the termination.”    This she was not able to do.  While she profered favorable evaluations, they largely pre-dated the declining economic health of SSNK.  Positive comments on balanced projections did not alter the fact that those projections did not come to pass and the deficits were the reality.  Assertions that she was not afforded enough time to fix the problem were likewise rejected; in fact she had been told for several years that achieving a  balanced budget was her obligation. 

A back-up argument that SSNK failed to follow its own internal discipline procedures failed when it was noted that they did not apply to the executive director. 

As for the claim that her male successor was not treated the same way, while he continued to operate SSNK at a deficit, he reduced the $200,000 deficit of Gunn’s last year to a deficit of $65,000 in his first year and projected only a $14,000 deficit in the next year. 

In closing, the Sixth Circuit observed:

“Time and again we have emphasized that [o]ur role is to prevent unlawful [employment] practices, not to act as a super personnel department that second guesses employersbusiness judgments.” Corell v. CSX Transp., Inc., 378 F. Appx 496, 505 (6th Cir. 2010) (first alteration in original). The evidence cited by plaintiff shows an organization struggling to make ends meet, a Board of Directors looking to their chief executive for answers, and an executive who was ultimately unable to produce tangible results. It does not, however, demonstrate pretext.



Wednesday, December 2, 2015

Recent Developments in Diversity Jurisdiction for LLCs and Other Unincorporated Forms

Recent Developments in Diversity Jurisdiction for LLCs
and Other Unincorporated Forms
      The Journal of Passthrough Entities has just released my article Recent Developments in Diversity Jurisdiction for LLCs and Other Unincorporated Forms. This article addresses a trio of developments.
      First, it reviews the decision of the Third Circuit Court of Appeals rendered in Lincoln Benefit Life v. AEI Life, LLC, it providing important guidance as to how diversity may be plead on “information and belief” and facial challenges thereto.
      Second, it reviews a number of decisions addressing how to classify a non-US entity as being either incorporated or unincorporated, that classification in turn determining which test will be utilized in assessing citizenship for purposes of diversity.
      Third and last, there is considered a proposal from the American Bar Association that Congress amend the diversity jurisdiction statute to apply the current rule for corporations to, as well, unincorporated entities.
      HERE IS A LINK to this article.