Wall Street LAWYER. The Intersection of Fiduciary Duties & Shareholder Rights. Content HIGHLIGHTS. Securities in the Electronic Age

Transcription

1 LAWYER Securities in the Electronic Age Wall Street The Intersection of Fiduciary Duties & Shareholder Rights B y M i c h a e l J. Z d e b & M i c h a e l A. G r i l l Continued ON PAGE 4 Content HIGHLIGHTS Complete Table of Contents listed on page 2. July 2012 n Volume 16 n Issue 7 Michael Zdeb is a partner in the Chicago office of Holland & Knight LLP, where he represents closely held businesses and their owners in the firm s Business and Private Wealth Groups, and heads the firm s Shareholder Rights, Relations, and Dispute Resolution Group. Michael Grill is a commercial litigation associate in the firm s Chicago office and is a member of the firm s Shareholder Rights, Relations, and Dispute Resolution Group. Contact: michael.zdeb@hklaw.com or michael.grill@hklaw.com. Trusts frequently hold interests in closely held businesses. The interests may represent control positions but more often constitute minority interests. Trustees may also have beneficiaries who have direct interests in the same business. The level of ownership in the business and the involvement by the trustee in the decisions regarding the business can raise issues regarding the trustee s duties. On one hand, a trustee of a trust that holds all the equity of an enterprise would not need to consider any other equity-holding constituency in the trustee s decisions. Such trustees could likely consider their decisions only by reference to the fiduciary duties owed to the trust beneficiaries. But often times, trustees with the ability to control the business either outright or as part of a control group will need to consider duties owed to the trust, to the business, and potentially other equity holders, even if they are not beneficiaries of the trust. 1 And, in situations where the trustee has no control or a limited voice in the entity, the trust may nevertheless be embroiled in conflict. The trust may find its interests directly affected, or may find that a beneficiary is being squeezed out or oppressed in an individual capacity. These are just a few points where trustees fiduciary duties intersect with the developing law regarding equity holders relations and duties in closely held businesses. In the following article, these intersections are viewed from two primary perspectives: The Newest Horizon for Pay-to-Play: Swap Dealers & the CFTC By Kenneth A. Gross, Ki P. Hong, Tyler Rosen & Charles M. Ricciardelli Delaware Court of Chancery Expedites Proceedings to Enjoin Enforcement of Advance Notice Bylaw By Jeff Chapman, Brian Gingold & Rachel Harrison

2 July 2012 n Volume 16 n Issue 7 Wall Street Lawyer Continued FROM PAGE 1 A trustee holding a minority position, and lacking control or participation with the control group; and A trustee holding a controlling position, or who participates in the exercise of control with other interest-holders. Minority Position/Lack of Control The hallmarks of interests in closely held businesses are the lack of a ready market for the interest and the long-standing doctrine of majority rule. 2 In addition, such businesses are distinguished by the fact that equity holders often participate directly in the management and activities of the venture. 3 Shareholders holding minority interests are subject to the decisions of the majority regarding operations and fundamental business decisions, but have no ability to exit or liquidate the interest. In many respects, the interest is trapped, or frozen in. 4 Oppression as an Equitable Doctrine The law has developed doctrines and techniques to provide remedies to the otherwise trapped minority holder in instances where the majority abuses its control. 5 The label frequently applied to such abusive behavior is oppression. Because the application of the doctrines varies among the jurisdictions, the actionable conduct and remedies also vary. 6 As the holder of a minority interest, a trustee could find that the interests of the trust are oppressed. The oppression can take many forms and need not be wrongful conduct in and of itself. 7 Generally, actionable conduct can be characterized as that which is harsh or unfair to the minority, or that which frustrates the reasonable expectations of the minority. 8 The conduct may also be subject to the application of the entire fairness doctrine. 9 This doctrine typically applies where those in control stand on both sides of a transaction or derive a benefit not afforded to other shareholders, and requires the controlling parties to prove their fair-dealing and the fair price of the action. 10 Examples of oppressive conduct include ignoring the formalities of the business, paying excessive compensation to those in control or related parties, stealing corporate opportunities, firing the minority shareholder, refusing to pay dividends, eliminating perquisites and benefits afforded to other shareholders, wasting assets, refusing to allow participation in decision-making, refusing to provide financial information, and condoning improper related-party transactions. 11 Such actions typically occur in various combinations and to varying degrees. Thus, a court s finding of oppression will turn on the unique facts of each situation. Trustee Responsive Actions & Equitable Relief If the trustee believes the interests of the trust are being oppressed, the trustee likely has a duty to address the situation. 12 Early on, the trustee has a few options to consider. Aside from asserting its position to those in control by seeking corrective behavior, the trustee could bring a lawsuit asking for one or more remedies including a fair value buyout of its interest, a provisional director, the appointment of a receiver, and the correction of a specific action. 13 While the courts have a wide variety of nonexclusive remedies, the one frequently sought or ordered in the face of oppression is the fair value buyout of the interest. 14 The Fair Value Standard in the Buyout Remedy The most noteworthy aspect of this buyout remedy is that the interest is generally valued at its fair value not the fair market value. 15 Fair value is an equitable concept employed by the courts. It is not the more familiar appraisal or financial concept. As a result, a significant body of law exists regarding the determination of fair values, and that law varies among jurisdictions. It is particularly important that a trustee understands the implications of the fair value standard in its Thomson Reuters

3 Wall Street Lawyer July 2012 n Volume 16 n Issue 7 decision-making where asserting the rights of the trust and the remedy to be sought. Two considerations of the fair value standard highlight its importance and its impact: first, whether the interest will be discounted for its minority position (lack of control); and second, whether it will be discounted by the lack of a market. 16 These two discounts can depress the value by substantial amounts. And while both discounts may be used in the annual determination of the value of the interest as part of the corpus, it is likely that neither will apply overtly in fair-value appraisals. 17 Such lack of discounting in appraisal actions can result in a substantial increase in both the carried value of the corpus and the liquidity of the trust following such a buyout. Dissenters Rights & Fair Value The same type of valuation considerations should exist whenever a trustee faces a decision to exercise the statutory right of dissent in a shareholder vote. 18 That is, neither continuing as a shareholder nor accepting the offered purchase amount relating to a fundamental decision for the enterprise may sufficiently capture fair value for the trust. Whether a trustee can ignore such opportunities presents difficult questions regarding the discharge of the trustee s duty of care and prudence. Additional Considerations for a Minority Position Trustee Aside from a trustee s attentiveness to the prospect of direct oppression of the trust interest (or the ability to dissent), the state of the law regarding intra-equity relations presents a trustee with at least two other matters to consider. First, does the trustee have a duty to address oppressive conduct if the conduct is directed to a beneficiary, individually? And second, does a trustee have a duty as a minority shareholder to those in control? 19 Oppression of a beneficiary presents a trustee with a number of difficult issues. Is the interest of the trust and the beneficiary such that the oppressive conduct affects the beneficial interest? Should or can the trustee join an action with, or assert one on behalf of the beneficiary? What if other beneficiaries are not interested in the outcome or are potential adversaries? How is the cost of any such action financed or allocated? The answers will likely be a function of the expectations created in connection with the beneficial interest, as well as the particular jurisdiction s view of what constitutes oppressive conduct. Only a few reported decisions exist discussing whether a minority shareholder owes duties to a majority shareholder. 20 Two trends do appear to be developing: those courts following the Delaware approach are likely to conclude no such duty exists, while those following the development of law in Massachusetts and Illinois may well find such a duty. 21 Consequently, a trustee in a position of blocking corporate action, voting or attempting to transfer shares or participating with a beneficiary in conduct likely to injure the interests of the other shareholders could find itself liable for having breached a duty to those other shareholders. 22 Oppression Action by an Unrelated Party & Impact on the Trust Where oppressive conduct primarily affects an unrelated equity holder who pursues judicial remedies and a buyout, the trustee will face a series of issues to consider. For example, should the trustee join in the action with the other shareholder and seek a buyout? Obviously, the cost of such actions and likelihood of success must be evaluated along with the impact on the beneficiaries (some of whom may be defendants and others not). On the other hand, if the trust does not join as a petitioner or plaintiff, and the court orders those in control to buy out the petitioner, what is the potential impact on the trust? The trustee should at least consider a motion to join such a purchase in order to maintain or improve its relative ownership position. In some actions, the trustee may have a right to do so and would need to evaluate its ability to make such an investment. In others cases, the trustee may wish to negotiate the alternative with the other shareholders Thomson Reuters 5

4 July 2012 n Volume 16 n Issue 7 Wall Street Lawyer Majority or Controlling Position of Trustee The interest of the trust may also represent control of the enterprise. This control can vary from a near-absolute ownership position to a simple majority position (51% or greater). It also can arise by the trustee participating with others in asserting control through voting or participation in the management, such as the trustee functioning as a director or officer. In any event, such control or participation may expose the trustee to a conflict between duties as trustee and the duties it may owe to minority equity holders. 23 Conflicting Duties of a Trustee in Control or Participation in Control A trustee in the position of control, or participating in control or management, must consider the effect of its actions on those in the minority. This duty may run contrary at times to decisions believed in good faith to be in the best interests of the trust. 24 It is also possible that a trustee could use its position or control to further an interest of the trustee, individually. 25 Such examples include voting the trust s interest to remove another director with whom a personal dispute exists, entrenching the trustee or a related party individually in management, approving compensation or benefits for the trustee as an officer, director or shareholder, or approving a transaction involving the trustee and the enterprise. 26 In such circumstances, the mere exercise of authority may readily result in a breach of duty to the beneficiaries, the minority shareholders or the enterprise itself. Frequently, however, such conflicting duties are acceptable if the grantor of the trust created the conflicts in establishing the trust and the trustee s roles. 27 In effect, by creating a conflict, the grantor accepted it. But even where the mere existence of a conflict does not constitute a breach, the manner in which the conflicting duties are discharged may nevertheless lead to an actionable breach. 28 If the trustee employs sound business judgment in its grantor-created corporate role, it is less likely that a court will find the trustee in breach of its duties to the trust beneficiaries. However, whether the appropriate standard of review of a trustee/ director is the heightened scrutiny of a trust fiduciary or that of a corporate director is a matter of some controversy. 29 Trustee as a Defendant in an Oppression Action Trustees in positions of control, or who participate with others in control, or who are involved in management, must consider whether their actions, or those they approve, result in the oppression of a minority. 30 Many statutes allow actions to be brought against those in control, without differentiating between types of control. 31 As a result, even absent express involvement in a particular decision, a trustee could find itself among the parties in control, and thus, a defendant in litigation. As such, depending on the facts, the costs of defense and any damage award may not be chargeable to the trust. Rather, such costs could become an obligation of the trustee, without reimbursement by the trust or indemnification by the enterprise. 32 Moreover, as a defendant, the trustee may encounter conflicts in the defense strategy. In particular, disagreements may arise in evaluating the respective defendants conduct. The trustee may then find itself having to confront not only a plaintiff, but also codefendants with starkly different views from its own. Complicating matters, the possibility exists that the individual plaintiff and codefendants are beneficiaries of the trust. If the plaintiff is a beneficiary at the time, it is likely that the trustee will be named as a partyin-control, and accused of breaching its fiduciary duties. And, even if the breach of the trustee s duties is not raised initially in the matter, it is possible that a conflict will develop during the litigation, as the parties assert positions regarding conduct and value. For example, if the plaintiff should successfully assert a position on value, the trustee must evaluate how the awarded amount will affect the carried value of the interest in the corpus of the trust Thomson Reuters

5 Wall Street Lawyer July 2012 n Volume 16 n Issue 7 Buyout Remedy As discussed above, in addition to the prospect of damages for breaches of fiduciary duties, many courts can and do order buyouts of the oppressed interest. In addition, under many shareholder oppression statutes, an option exists for the defendants to elect a buyout early in the action. 33 If exercised, the action immediately becomes one for a fair value appraisal and buyout. The theory underlying the option is to avoid a lengthy and costly dispute about the underlying conduct. 34 Trustee as a Party Defendant A trustee named as a defendant must evaluate such issues as the likelihood of a buyout, how to exercise a buyout if ordered, the decision to elect a buyout to avoid the disruption to the business and the cost of a defense or prosecution of the appraisal action. For example, if a buyout is sought or elected, should the trustee participate in a proportionate purchase and at what price? Should the trustee advocate a redemption and not a cross-purchase to avoid directly having to use trust assets? And can the trustee finance a purchase and how will the financing of the purchase be handled or secured? Additionally, if the actions of the trustee are personal and not on behalf of the trust, what buyout could even be considered? Would the trustee nevertheless have to contribute to the remedy and satisfaction of it by the entity or other defendants? The courts have yet to address these questions. And in each instance, the decision will be further complicated if the plaintiff is also a beneficiary. In such situations, the trustee in each of its decisions will have to contend with the fiduciary duty to the beneficiary. These considerations are especially sensitive because, as explained, the purchase price of any shares is based on fair value, which may well be in excess of the carried value on the accountings of the trust and thus involve financing or the use of other trust assets. Trustee Not Directly a Party If the trustee is not a party to the action, the trustee still must consider the effect of any buyout whether elective or ordered. For example, can or should the trustee intervene to protect its interest in any election or fair-value determination? This would be especially important if the corporate defendants are considering a purchase as a redemption. The trustee as a continuing shareholder will have an interest in the impact of the redemption on the value of the enterprise and the trust s dependent equity. Also, if a cross-purchase is ordered, or an elective buyout is considered by other parties, will the trustee want to participate as a purchaser to avoid dilution, and at what price? As with the redemption, the price and terms of the buyout will be of great importance to the prudent trustee. Thus, intervention in the action may be required. Not the least of reasons is because the fair-value price may well demand a purchase price in excess of fair market value, therefore requiring an evaluation of the price in terms of a waste of trust assets. Mitigation of Exposure & Avoidance of the Issues Given the nature of closely held companies and the close relationship of the owners, particularly with family ownership, there will be times when conflict is unavoidable. But strategies exist to mitigate the likelihood and protect trustees from becoming embroiled in legal actions. Since oppression tends to be a function of the frustration of reasonable expectations, 35 the trustee/shareholder can work with the other owners to ensure that the expectations are articulated and honored. 36 This may well involve addressing issues and topics not part of the typical shareholder buy/sell or voting agreements. For example, a trustee can insist on adherence to best practices in the decision-making. It appears that findings of oppression are less likely when decisions are founded on best practices in corporate governance. 37 Thus, when a decision presents the prospect of self-interest, the presence of independent decision-makers, as well as full and complete disclosure by the potentially selfinterested board member or shareholder, can be critical Thomson Reuters 7

6 July 2012 n Volume 16 n Issue 7 Wall Street Lawyer A trustee as a minority may also mitigate potential issues by obtaining protection of its position with approval-rights upfront, or as part of the trust s design and implementation. These rights could include the ability to veto or advise on actions related to compensation of other owners, sales of businesses, or related-party transactions. Whether in a control position or not, the trustee may wish to consider that as part of its engagement, a family or investment advisor will be appointed. 39 The advisor or advisors would then provide direction when matters arise that have the potential to fundamentally affect the enterprise or raise issues of conflicting duties. Conclusion The development of the concepts of oppression and direct duties among equity participants in closely held enterprises presents trustees with a new level of complexity in the discharge of their fiduciary duties. When in a minority position, a trustee should consider whether the trust s interests are oppressed by actions that directly affect the equity or impact a beneficiary. If in control or participating in management, a trustee also should be aware of the potential of its actions, and the actions of those with whom it participates, on the rights of minority holders, some of whom may be beneficiaries. And even when the trust is neither in control nor oppressed, the trustee must consider the impact that disputes among other equity holders will have on the trust. NOTES 1. See, e.g., Hagshenas v. Gaylord, 199 Ill. App. 3d 60, 145 Ill. Dec. 546, 557 N.E.2d 316 (2d Dist. 1990). 2. Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 328 N.E.2d 505 (1975). 3. Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 328 N.E.2d 505 (1975). 4. Robert A. Rabbat, Application of Share- Price Discounts and Their Role in Dictating Corporate Behavior: Encouraging Elected Buy-Outs Through Discount Application, 43 WILLAMETTE L. REV. 107, , n.40 (2006). 5. E.g., Ill. Bus. Corp. Act, 805 ILCS 5/12.56; N. J. Bus. Corp. Act, N.J.S.A. 14A: The term oppression is typically not defined by state statutes, but has instead been left to the courts to define. With respect to remedies, compare, e.g., Ill. Bus. Corp. Act, 805 ILCS 5/12.56; N. J. Bus. Corp. Act, N.J.S.A. 14A: 12-7, and Cal. Corp. Code 1800, Additionally, many state Limited Liability Company (LLC) statutes provide only for the remedies of dissolution or dissociation. See, e.g., N.Y. Ltd. Liab. Co. Law 702; Illinois Limited Liability Company Act, 805 ILCS 180/ Brenner v. Berkowitz, 134 N.J. 488, 634 A.2d 1019 (1993) (the majority s actions need not be illegal, fraudulent, or even wrongful, to constitute oppression). 8. Matter of Kemp & Beatley, Inc., 64 N.Y.2d 63, 484 N.Y.S.2d 799, 473 N.E.2d 1173 (1984) [co]nduct which substantially defeats the reasonable expectations of the minority shareholder when committing capital to the enterprise. ); Pankratz Farms, Inc. v. Pankratz, 2004 MT 180, 322 Mont. 133, 95 P.3d 671 (2004) ( burdensome, harsh and wrongful; a lack of fair dealing in the affairs of a company to the prejudice of some of its members; or a visible departure from the standards of fair dealing, and a violation of fair play on which every shareholder who entrusts his money to a company is entitled to rely. ). 9. Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993). 10. Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993). 11. Charles W. Murdock, Squeeze-Outs, Freeze- Outs, and Discounts: Why is Illinois in the Minority in Protecting Shareholder Interests?, 35 LOY. U. CHI. L.J.737, (2004); Witters v. Hicks, 335 Ill. App. 3d 435, 269 Ill. Dec. 241, 780 N.E.2d 713 (5th Dist. 2002); Gimpel v. Bolstein, 477 N.Y.S.2d 1014, 1021 (S. Ct. N.Y. 1984). 12. Uniform Trust Code 801, 802, 804 (2003) (trustees bear duties to administer trusts according to their terms, solely for the interests of their beneficiaries, and with the same reasonable care and skill as a prudent person). 13. E.g., Ill. Bus. Corp. Act, 805 ILCS 5/12.56(b)(11). 14. Douglas K. Moll, Shareholder Oppression And Fair Value : of Discounts, Dates, and Dastardly Deeds in the Close Corporation, 54 DUKE L.J. 293, (2004). 15. Cavalier Oil Corp. v. Harnett, 564 A.2d 1137 (Del. 1989); Advanced Communication Design, Inc. v. Follett, 615 N.W.2d 285 (Minn. 2000). 16. Murdock, supra note 13, at 746, 746 n.38, app. tbls Murdock, but see Advanced Commc n, 615 N.W.2d at 293 (applying the extraordinary circumstances exception to impose a substantial marketability discount on the fair value of petitioner s shares) Thomson Reuters

7 Wall Street Lawyer July 2012 n Volume 16 n Issue Model Bus. Corp. Act 13.01; Ill. Bus. Corp. Act. 805 ILCS 5/11.70; Cavalier Oil Corp. v. Harnett, 564 A.2d 1137 (Del. 1989). 19. Rexford Rand Corp. v. Ancel, 58 F.3d 1215, Fed. Sec. L. Rep. (CCH) P (7th Cir. 1995) (rejected by, Hunt v. Data Management Resources, Inc., 26 Kan. App. 2d 405, 985 P.2d 730 (1999))(minority shareholder owed fiduciary duties to the corporation, even after being frozen-out ). 20. Rexford Rand Corp. v. Ancel, 58 F.3d 1215, Fed. Sec. L. Rep. (CCH) P (7th Cir. 1995) (rejected by, Hunt v. Data Management Resources, Inc., 26 Kan. App. 2d 405, 985 P.2d 730 (1999)); Hagshenas v. Gaylord, 199 Ill. App. 3d 60, 145 Ill. Dec. 546, 557 N.E.2d 316 (2d Dist. 1990). 21. Compare Nixon v. Blackwell, 626 A.2d 1366 (Del. 1993), with Donahue v. Rodd Electrotype Co. of New England, Inc., 367 Mass. 578, 328 N.E.2d 505 (1975), and supra, note See Ritchie v. Rupe, 339 S.W.3d 275 (Tex. App. Dallas 2011), reh g overruled, (Apr. 27, 2011) and review denied, (Aug. 12, 2011) and reh g of petition for review granted, (Mar. 2, 2012) and order vacated, (Mar. 2, 2012). 23. Some commentators assert that the courts should, and effectively do, apply different degrees of fiduciary duties to professional trustees versus amateur trustees (e.g., a family member). Karen E. Boxx, Distinguishing Trustees and Protecting Beneficiaries: A Response to Professor Leslie, 27 Cardozo L. Rev. 2753, 2755 (2006). Additionally, conflicts may be ameliorated, at least to some degree, where the settler explicitly or impliedly authorized the trustee s conflict of interest or self-dealing, and the trustee otherwise acted in good faith or pursuant to the business judgment rule. Boxx at 2755, 2755 n.10; Goldman v. Rubin, 292 Md. 693, 441 A.2d 713 (1982). The conflicts can also be exacerbated, for example, where the trustee is also a remainder man or beneficiary of the trust. Russel v. Russel, 427 S.W.2d 471, (Mo. 1968). 24. Russell v. Russell, 427 S.W.2d 471 (Mo. 1968),. 25. E.g., Russel, 427 S.W.2d at See generally, Childs v. National Bank of Austin, 658 F.2d 487 (7th Cir. 1981). 27. Childs, 658 F.2d at Russel, 427 S.W.2d at Russel, 427 S.W.2d at 479; Goldman, 292 Md. at ; Wood Prince v. Lynch, 2005 WL (R.I. Super. Ct. 2005); see generally, Megan L. Reuwer, Wood Prince v. Lynch: Opening the Door for Subsequent Misapplications of the Business Judgment Rule to Claims Alleging that a Trustee Has Breached His Fiduciary Duty of Loyalty, 1 J. BUS. & TECH. LAW 633 (2007). 30. See generally, Ritchie v. Rupe, 339 S.W.3d 275 (Tex. App. Dallas 2011), reh g overruled, (Apr. 27, 2011) and review denied, (Aug. 12, 2011) and reh g of petition for review granted, (Mar. 2, 2012) and order vacated, (Mar. 2, 2012). 31. E.g., Ill. Bus. Corp. Act, 805 ILCS 5/ See Restatement (Third) of Trusts 100, 106 (2011). 33. E.g., ALASKA STAT (providing an election procedure); CAL. CORP. CODE 2000 (same); ILL. BUS. CORP. ACT, 805 ILCS 5/12.56(f) (same); MINN. STAT. ANN. 302A.751 subd. 2 (same); N.J. STAT. ANN. 14A:12-7(8) (same); N.Y. BUS. CORP. LAW 1104-a, 1118 (same); N.D. CENT. CODE (same); MODEL BUS. CORP. ACT (same). 34. See MODEL BUS. CORP. ACT 14.34, official comment (noting that most dissolution proceedings result in a buyout, and that therefore it makes sense to provide for an orderly procedure to terminate the proceedings upon payment of the fair value of the petitioner s shares. ). 35. Supra, note See, e.g., Linda C. McClain, Family Constitutions and the (new) Constitution of the Family, 75 FORDHAM L. REV. 833, (discussing the implementation of family constitutions or family mission statements to guide behavior). 37. See Pankratz Farms, 95 P.3d 671, 685 (Mont. 2004); Davis v. Brockamp & Jaeger, Inc., 216 Or. App. 518, 174 P.3d 607 (2007), (Or. App. Ct. 2007); Willis v. Bydalek, 997 S.W.2d 798 (Tex. App. Houston 1st Dist. 1999) (minority shareholder s expectations must be balanced against the corporation s need to exercise its business judgment and run the business efficiently). 38. See, e.g., Ostrowski v. Avery, 243 Conn. 355, 703 A.2d 117 (1997). 39. Dennis T. Jaffe and Sam H. Lane, Sustaining a Family Dynasty: Key Issues Facing Complex Multigenerational Business- and Investment- Owning Families, 17 FAMILY BUSINESS REVIEW 5, 11 (2004) Thomson Reuters 9