CORPORATIONS Copyright February State Bar of California

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1 CORPORATIONS Copyright February State Bar of California Adam owns 100% of the stock of Sellco, a corporation that sells houses. Sellco's board of directors consists of Adam and his wife Betty. Sellco owns 90% of the stock of Buildco, another corporation. Pat owns the remaining 10% of Buildco's stock. Buildco's business is home construction. Buildco's board of directors consists of Adam, Betty and Evan. Betty is the president of Buildco and, as such, is a salaried employee. Neither Adam nor Evan is an officer or employee of Buildco. Adam urged Buildco's other directors (Betty and Evan) to approve an arrangement whereby Buildco would build houses and sell them to Sellco at cost. Sellco, in turn, would sell the homes for a profit. Based solely upon Adam's representation that the arrangement "made sense," Buildco's board unanimously approved this arrangement. Buildco thereafter commenced constructing homes exclusively for the purpose of selling them to Sellco. Buildco sold the houses at cost to Sellco, and Sellco sold the houses for a considerable profit. Pat objects to this arrangement because it deprives Buildco of the only source of money with which to pay dividends. What personal and/or derivative claims can Pat reasonably assert against Sellco, Adam, Betty and/or Evan, and is he likely to succeed on each claim? Discuss.

2 CORPORATIONS Copyright February Scott F. Pearce, Esq. Outline I. Pat v. Sellco 1. To Compel a Dividend 2. To Dissolve Buildco 1. Sellco s breaches as majority shareholder of Buildco 2. Remedies: Rescission / Reformation and Damages II. Pat v. Adam III. Pat v. Betty 1. Breach of Corporate Duties 2. Fraud IV. Pat v. Evan

3 CORPORATIONS Copyright February Scott F. Pearce, Esq. Answer I. Pat v. Sellco Pat owns 10% of Buildco stock. Sellco owns the other 90%. Pat objects to a deal in which Buildco would build houses and sell them to Sellco at cost, because it deprives Buildco of the only source of money with which to pay dividends. Pat will sue Sellco personally, and he also will bring a derivative action on behalf of Buildco. 1. To Compel a Dividend The Buildco / Sellco deal has been very successful - for Sellco. Buildco has built homes for Sellco at cost, and Sellco sold the houses for a considerable profit. Pat will argue that he should receive an appropriate return on his investment in 10% of Buildco. After all, Sellco s profits are based on Buildco s construction work. Sellco, as majority shareholder in Buildco, has a fiduciary duty to Pat, the only other shareholder. The Sellco / Buildco deal denies dividends to Pat and could damage the value of the 10% stock he holds. As discussed below, Pat has strong personal claims against the other defendants. Although under these facts it is certainly within a court s power to order payment of a dividend, other remedies are more likely to be awarded. 2. To Dissolve Buildco Pat can argue persuasively that Buildco has merely become a shell company for Sellco. Although it is not unreasonable for Pat to ask for the liquidation of Buildco, the more likely result would be an order for Sellco to buy out Pat s interest in Buildco at a price that could compensate Pat for the sweetheart deal that is at the heart of this dispute. Pat can bring a derivative action against Sellco on behalf of Buildco, because Pat owned stock throughout the period of the dispute. He will not be required first to make a demand on the board because, as discussed below, Adam and Betty are profiting from the arrangement at issue and they constitute a majority of the board. Again, Pat s suit is based on Sellco s breaches as the majority shareholder of Buildco. The

4 arrangement between Sellco and Buildco guarantees that Buildco never will earn a significant profit. It is clear that Sellco has breached its fiduciary obligation to Buildco. Pat s can seek to have the Sellco / Buildco contract rescinded altogether, plus damages for an amount that would constitute a reasonable profit to Buildco. It probably would be better to merely reform the agreement. After all, the relationship is generating considerable profits. The relationship between the companies could continue, so long as Sellco s profits were shared reasonably with Buildco. Sellco has not lived up to its fiduciary duties owed Buildco. The most efficient remedy would be for Sellco to buy out Pat s interest in Buildco - including a reasonable return on his investment - and to continue the Sellco / Buildco arrangement. Once Pat is compensated, no other party is harmed by the relationship between the companies. II. Pat v. Adam Adam owns 100% of Sellco, which in turn owns 90% of Buildco. Pat owns the remaining 10% of Buildco. Pat will seek to pierce the corporate veil and sue Adam personally, as well as derivatively on behalf of Buildco for breach of corporate fiduciary duties. 1. Breach of corporate duties. Adam s company is profiting at Pat s expense. As discussed above, the Sellco / Buildco arrangement wholly profits Sellco. Buildco gets nothing out of the deal. At a minimum, the same facts which justify an award of damages from Sellco to Pat also support a compensatory damages award against Adam. A majority shareholder owes fiduciary duties to minority shareholders. Adam s bad faith deal breaches these duties. 2. Fraud To prevail on a fraud claim, Pat must show a material misrepresentation, reliance, and damages. Here, Adam represented that the arrangement between Buildco and Sellco made sense from the perspective of Buildco. This is false. Buildco will be forever unprofitable if the deal is allowed to proceed. The Buildco board of directors, Adam Betty and Evan, unanimously approved the deal, based solely on Adam s misrepresentation. This establishes reliance. Pat clearly has suffered damages, thought the facts presented do not allow us to know the precise amount. If Pat prevails on his fraud claim, he will be entitled to compensatory and punitive damages from Adam.

5 Pat can sue Adam derivatively, on behalf of Buildco. He will contend that Adam s conduce breaches the duties Adam owes Buildco. Through Sellco, Adam controls 90% of Buildco s stock. A majority shareholder must not allow his personal interests to prevail over the interests of the company to which he owes a duty of loyalty. To the extent that Adam has been unjustly enriched at Buildco s expense, he will be required to make restitution. A majority shareholder owes a duty to act with prudent business judgment when doing business with or on behalf of the company. All of Adam s deliberate misconduct also qualifies as a breach of his duty of care. All of Pat s claims against Adam will succeed. Pat will win compensatory and punitive damages from Adam for fraud. Pat s claim that Adam violated his duties as majority shareholder of Buildco also will succeed, both for himself and derivatively on behalf of Buildco. III. Pat v. Betty Betty is a director of Sellco. She also is both president and a director of Buildco. Pat will pursue personal and derivative actions against Betty. Pat s claims against Betty will be identical to those he will bring against Adam. He will allege that Betty stood to profit personally in the disputed transactions even though she was not a named shareholder, because as Adam s wife she had a community interest in any profits made by Adam. These facts will allow Pat to pierce the corporate veil and proceed against Betty personally for breaching her corporate duties. Furthermore, Betty faces possible punitive damages for fraud. She had to know that Adam s representation to the Buildco board that the proposed arrangement made sense was false. She remained silent and voted to approve the set-up at issue. Thus, she helped Adam s fraud succeed. She profited personally at the company s expense.

6 Again, Pat s derivative claims against Betty on behalf of Buildco are essentially the same as those alleged against Adam. Betty is president of Buildco. She is on Buildco s board of directors. She owes duties of loyalty and care to Buildco which she breached when the participated in an illegitimate scheme to profit at Buildco s expense. She will have to make restitution to Buildco to prevent her unjust enrichment. Pat s claims against Betty will succeed. She will be liable to Pat for compensatory and punitive damages for fraud, and she will have to disgorge to Buildco her wrongful profits. IV. Pat v. Evan Evan is on the Buildco board of directors. Evan voted to approve the deal at issue. Pat will sue Evan personally and derivatively. Evan did not profit from the relationship between Buildco and Sellco. He did not knowingly participate in any wrongdoing. Consequently, Pat will be unable to pierce the corporate veil and pursue personal claims against Evan. Evan owes duties of loyalty and care to Buildco as a director. He had to appreciate that the proposed transaction would render Buildco permanently unprofitable. Evan had a duty to inquire further, and not merely to rely on Adam s representation that the arrangement made sense. Pat s derivative action against Evan on behalf of Buildco will succeed. Evan breached his duty of care and faces liability for compensatory damages. Adam has no viable personal claims against Evan.

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