When shareholders of a company believe the leaders of the company have breached their fiduciary duties to it, they can bring a lawsuit against those leaders in one of two ways. Shareholders can bring the suit in their own names (a direct suit), or they can bring it on behalf of the company if the company failed to bring claims against the leaders on its own (a derivative suit). If the injuries the shareholders are alleging were only suffered by the company, they cannot move forward with any direct claims.

When bringing a derivative claim in federal court, the plaintiffs must comply with Federal Rule of Civil Procedure 23.1. The rule, besides explaining what a derivative complaint must include, prevents a plaintiff from bringing a derivative lawsuit if the plaintiff “does not fairly and adequately represent the interests of shareholders or members who are similarly situated in enforcing the right of the corporation or association.”

In shareholder derivative lawsuits brought by shareholders of large public or private companies, rarely does this “adequate representation” element pose a problem. Plaintiffs’ attorneys spend an inordinate amount of time vetting would-be derivative suit plaintiffs to ensure that, based on the factors courts look at, the shareholder(s) they represent will almost certainly pass this test. And with hundreds or thousands of shareholders to choose from in these situations, plaintiffs’ attorneys often have the luxury of never having to settle for an “inadequate” shareholder.

But in the closely held company world, derivative lawsuits are a whole other ballgame. With a smaller number of shareholders, there’s a greater risk that the relationships between potential shareholder plaintiffs and the leaders of the company—who may be other shareholders—or the company itself cloud the ability for those potential plaintiffs to pass the “adequate representation” test.

A recent decision out of the Eastern District of Pennsylvania deals with this scenario. In it, the judge held that the minority shareholders failed the test. Interestingly, had the minority shareholders brought the claims in a Pennsylvania court, they likely would have received a passing grade thanks to Pennsylvania’s more minority-shareholder-friendly approach to derivative claims.

The students become the teacher[’s adversaries]

In Jannuzzio v. Danby, James Jannuzzio and Trevor Nix, two minority shareholders of Greenville Ventures, an e-commerce jewelry seller, sued Peter Danby, the owner of a corporate entity that owns the 70% of Greenville. James was Peter’s student at the University of Delaware when they met in 2017. James began working for one of Peter’s companies, and in 2018 recruited Trevor, a fellow University of Delaware Blue Hen, to do so too.

Eventually, the three co-founded Greenville and signed an operating agreement in 2019. Peter’s corporate entity contributed 70% of the initial equity, while James and Trevor contributed 25% and 5% respectively. Greenville quickly became a multi-million dollar company. However, James and Trevor alleged Peter began defrauding them and Greenville in violation of his fiduciary duties.

They alleged he made more than $7 million in improper payments from Greenville to himself, the mother of his child, and other companies he owned; made more than $1 million in unaccountable “loans” to himself and his other companies; caused Greenville to enter unfair agreements with his other companies; and failed to pay James and Trevor the profit distributions they were entitled to.

In March 2022, James and Trevor sued Peter as individuals and on behalf of Greenville in a derivative capacity. Among their legal claims, they alleged Peter violated both the Racketeering Influenced and Corrupt Organizations Act (“RICO”) and his fiduciary duties to them and Greenville.

In deciding Peter’s motion to dismiss the claim, the judge held James and Trevor did not adequately plead their RICO claim brought in their individual capacities, and then dismissed the derivative federal claims because James and Trevor did not pass Federal Rule of Civil Procedure 23.1’s “adequate representation” test.

The wrong people for the job

As to the RICO claim, the judge ruled James and Trevor failed to properly allege they suffered a concrete loss to their personal business or property. The judge noted that James and Trevor’s allegations of harm caused by Peter are derivative of harm to Greenville, not of harm to them personally. The judge also ruled that James and Trevor failed to plead facts that show RICO violations were the proximate cause of their injuries. Again, the judge focused on the fact that their allegations of harm caused by RICO violations were harms to Greenville and did not cause the injuries to them they alleged had occurred.

(James and Trevor could have probably saved a fair bit of their attorneys’ fees by reading this post from October 2020 in which I discussed the interplay between direct and derivative claims in closely held corporate disputes, and this post from May 2021 in which I explained why civil RICO claims in business divorce cases are a hard sell in Pennsylvania federal courts.)

The judge next turned to determining whether James and Trevor satisfied Rule 23.1’s “adequate representation” test. The test has two prongs. The first is whether the plaintiff’s attorney is “qualified, experienced, and generally able to conduct the proposed litigation.” The second is whether the plaintiff has “interests antagonistic to those of the class.” The court focused on the second prong because the first prong wasn’t at issue.

As a starting point, the judge noted that James and Trevor, as the only minority shareholders of Greenville, were not automatically entitled to bring a derivative suit on behalf of it. They still had to prove they would adequately enforce the rights of Greenville in a lawsuit against Peter.

The judge then held that significant conflicts of interest existed between James, Trevor, and Greenville that prevented them from doing so—despite them being the only minority shareholders. According to the judge, those conflicts included:

  • James and Trevor resigned from Greenville and launched a competing e-jewelry retailer, creating direct economic antagonism between them and Greenville;
  • James and Trevor sought remedies in their individual capacities, requiring Greenville to pay that money out of whatever it recovered from the suit (instead of the company being able to keep its recovery);
  • James and Trevor sought a court order requiring Greenville to distribute profits in proportion to the shareholders’ ownership interests even though whether they were entitled to those distributions was an open question, and that money would have come from the same pool of money Greenville would recover in the lawsuit;
  • Ongoing separate litigation between James, Trevor, Peter, and Greenville, and another defendant in which James and Trevor are alleged to have “looted” Greenville on their way out and infringed the copyrights of the other defendant; and
  • James and Trevor prioritizing their personal interests and agendas over Greenville’s interests by seeking profit distributions from money they’d recover in the lawsuit and by seeking a buyout of their ownership shares in the company.

As a result, the judge dismissed the derivative claims without prejudice, allowing James and Trevor to file an amended complaint.

When stymied by Federal Rule 23.1, minority shareholders have an alternative path under Pennsylvania law

Despite the contentious relationship between James, Trevor, Peter, Greenville, and the other parties to the lawsuit—which is par for the course in disputes inside closely held companies—forbidding the only minority shareholders from being able to bring a derivative claim seems like it could lead to a worse result than Greenville having to pay profit distributions to James and Trevor.

If Peter and his corporate entity that owns 70% of Greenville do not respond to James and Trevor’s demand to investigate Peter’s/his corporate entity’s alleged wrongdoing, and they will not allow the company to sue itself and him, who, exactly, is left to advance any claims on behalf of Greenville? Preventing the only minority shareholders from bringing a derivative claim allows a majority shareholder to skirt any legal repercussions for their wrongdoing.

Luckily for James, Trevor, and any other minority shareholders who find themselves in this predicament, Pennsylvania Rule of Civil Procedure 1506 provides an alternative path if they were to bring their derivative claims in Pennsylvania state court. The relevant part of Pa. Rule 1506 states, with my emphasis added:

If it appears that the plaintiff does not fairly and adequately represent the interests of the shareholders or members similarly situated in enforcing the right of the corporation or association, an appropriate person shall be substituted as plaintiff or, if an appropriate person is not substituted, the action shall be dismissed [as stated in the rule].

Though neither the rule nor Pennsylvania courts provide any guidance as to who this “appropriate person” can—or must—be, there is no requirement that this person must be another shareholder of the company. This is significant for groups of minority shareholders who, like James and Trevor, are prevented from bringing derivative claims in federal court under Federal Rule 23.1 but are the only minority shareholders in a position to bring such claims.

To take advantage of Pa. Rule 1506, minority shareholders would need to file their derivative claims in Pennsylvania state court, which could bring with it particular strategic advantages or disadvantages given their situation and other claims they might include in their lawsuit. But given the decision in Jannuzzio v. Danby, if minority shareholders and their counsel believe they’ll have an uphill battle passing Federal Rule 23.1’s (and Pa. Rule 1506’s) “adequate representation” test, they may have no choice but to file their lawsuit in Pennsylvania state court to give them the flexibility to substitute in an “appropriate person” as permitted by Pa. Rule 1506.

In certain situations, it might be minority shareholders’ only shot at holding a majority shareholder liable for their alleged wrongdoing.

There is perhaps no richer vein of literary gold than conflict between fathers and sons. Hamlet, Robinson Crusoe, multiple characters drawn by Charles Dickens, not to mention the mother of all family contretemps, Oedipus Rex, touch on this deeply human power struggle.

One such conflict was the backdrop for the Pennsylvania Superior Court’s recent decision in MBC Development, LP v. James W. Miller, 281 A.3d 332 (Pa. Super. Ct. 2022). The decision serves as an important reminder that courts overwhelmingly favor arbitration as a means of dispute resolution, and gives us an opportunity to think about the virtues of arbitration provisions in organizational documents like limited partnership and operating agreements.

In for a penny, in for a pound with arbitration agreements

In MBC Development, the appellant, James W. Miller (“Little James”) was a limited partner in two partnerships with James L. Miller (“Big James”), his father. Big James owned over fifty percent of each of the partnerships.

In the summer of 2019, Little James made a written demand on the partnerships, asking they bring legal action against Big James. The partnerships invoked the special litigation committee (“SLC”) process provided for by the Pennsylvania Uniform Limited Partnership Act (“the LPA”) to evaluate Little James’s demands. (Pennsylvania’s Limited Liability Company Act has a nearly identical provision; more about the SLC process here: Can Closely Held Companies Investigate Shareholder Complaints without Breaking the Bank?)

The SLC produced a report that the partnerships should not initiate litigation against Big James. This, of course, made Big James happy. But Little James? Not so much.

Relying on the arbitration clauses in the partnership agreements, Little James then filed a demand for arbitration against Big James and the partnerships, among others, asserting derivative claims for breach of fiduciary duty, and a direct claim against one of the partnerships for failing to make a mandatory distribution to him.

In their response, Big James and the partnerships sought a stay of the arbitration, arguing that Little James’s challenges were actually challenges to the SLC’s determinations under the LPA and not claims arising under the partnership agreements. Thus, they argued, Little James’s challenges could not be arbitrated. In addition, they argued the LPA requires a court—and not an arbitrator—to determine whether an SLC’s determination concerning a legal claim prevents a derivative action regarding that same claim.

The trial court issued an order in favor of Big James permanently staying the arbitration. The court concluded Little James’s claims were within the partnership agreement’s arbitration clauses, but that his claims could not proceed through arbitration because: (1) the dispute over the SLC’s findings was a statutory matter that was not arbitrable, and (2) the language of the LPA requires a court to determine whether an SLC’s rejection of derivative claims must be enforced.

In a matter of first impression, the Superior Court reversed, vacating the trial court’s decision that Little James’s claims were not arbitrable. The Court adopted a broad reading of the “any dispute or controversy” arbitration provision in the partnership agreements and held that Little James’s derivative claims were within the scope of the partnership agreement. In arriving at its decision, the Court referenced the comments to the LPA which recognize that derivative actions may be subject to arbitration as well as decisions in other jurisdictions.

The Court further held that just because a defense or restriction on an arbitrable claim “is statutory, rather than based on the language of the parties’ agreement, does not change the fact that it must be determined by an arbitrator and not by a court.” The court noted that whether a “prerequisite or limitation bars a claim that is within the scope of a valid arbitration agreement is a question that must be resolved by the arbitrator, not an additional requirement for arbitration that a court may be determine before allowing arbitration to proceed.”

As to the trial court’s ruling that the LPA requires a court—and not an arbitrator—to determine whether an SLC’s rejection of derivative claims must be enforced, the Superior Court explained that the LPA’s reference to a court as an adjudicator does not require that only a court can make an adjudication or prohibit arbitration of a claim or issue. The Court noted there were no provisions of the LPA that suggested its reference to a court as an adjudicator required only courts to decide these issues or barred arbitrators from doing so.

Arbitration provisions in operating agreements? You could convince me.

The Superior Court’s decision here is yet another reminder how broadly Pennsylvania courts interpret arbitration provisions. The broader question of whether to include an arbitration provision in a company’s organizational documents at all is an interesting one. I generally don’t like arbitration for several reasons, but a well drafted provision may be prudent for certain types of Pennsylvania closely held companies.

Arbitration is not always the low-cost option for resolving legal disputes its advocates often make it out to be. But an operating agreement with an arbitration agreement and provisions eliminating the demand and SCL procedures could net a real savings.

In MBC, Little James made a pre-suit demand and Big James invoked the SCL procedure in response. I’ve mentioned previously how the demand requirement is a trap for the unwary and is generally pointless in the context of closely held companies. An SCL can add significant cost to a dispute and often, as it did in MBC, generates additional litigation in the form of challenges to the committee’s independence.

Both Pennsylvania’s LPA and LLC act allow organizational documents to modify the statutory default to eliminate the possibility of an SCL and the demand requirement, although the partnership agreements in MBC did not do so. See e.g.,15 Pa.C.S.A. § 8815(c)(17)-(18). The removal of such provisions offer an opportunity to reduce the procedural and substantive complexity of business divorce litigation. Such benefits could be particularly helpful in 50/50 ownership disputes where the rationale for a demand requirement breaks down or lower value companies where the organization of an SCL would be difficult to justify.

Arbitrators with commercial litigation backgrounds also offer the possibility of helpful subject matter expertise. With some exceptions (notably, Philadelphia’s commerce program), complex business divorce cases make up a microscopic percentage of the state court docket in Pennsylvania. In some counties, there may be years between cases involving complex shareholder litigation.

An arbitration provision in an organizational document? You could convince me.

Image a home buyer finally finds their dream house. There’s just one problem.

During their home inspection, they discover the foundation is cracked. But they buy the house anyway, fully aware of the issues with the foundation.

In the sale agreement, there’s a clause stating the house’s foundation is flawless.

Should the seller be liable to the buyer for breaching the sale agreement, even though the buyer knew the foundation was not flawless at the time they signed the agreement?

In other words, and to have some fun with legal terminology, should the buyer be able to “sandbag” the seller?

The unsatisfying answer is that it probably depends on if the sale agreement addresses sandbagging.

“Sandbagging” is the term used to refer to what happens when a buyer, who enters an agreement knowing that one or more of the seller’s representations or warranties are not true, brings a post-closing lawsuit against the seller regarding a breach of those same terms.

With sandbagging, it isn’t easy to determine who the bad actor is.

Is it the seller? They made an inaccurate representation which could have mislead the buyer.

Or is it the buyer? They knew the truth but decided to lie in wait for an opportune time to use it against the seller.

Like most legal disputes, sandbagging isn’t always black and white. That’s why different jurisdictions have differing views on the legality of it.

In this post, we’ll briefly explore how sandbagging is viewed in Delaware and Pennsylvania. The key takeaway is that any contract you sign should not be silent on sandbagging.

The “modern” and “traditional” sandbagging rules

In the mergers and acquisitions context, sandbagging provisions in a purchase agreement are often a source of contention between a buyer and seller.

The buyer will push for a “pro-sandbagging” provision, which would ensure the buyer would lose none of their remedies under the agreement, even if the buyer knew, either before or at the closing of the deal, about the facts or circumstances giving rise to their breach claim.

On the other hand, the seller will push for the agreement to include an “anti-sandbagging” provision, so that the buyer cannot turn around post-closing and seek indemnity for a breach of a representation or warranty that the buyer knew not to be true.

If the agreement is silent on the issue, then the sandbagger’s fate is at the mercy of the governing choice of law. Jurisdictions take one of two approaches toward sandbagging.

“Modern rule” jurisdictions are pro-buyer and pro-sandbagging. They believe a buyer has a right to rely on negotiated contractual obligations. In these jurisdictions, if a seller represents something is true, but it isn’t, a buyer should be able to hold the seller accountable for that misrepresentation—whether or not the buyer knew it wasn’t true when they entered the agreement.

“Traditional rule” jurisdictions are pro-seller and anti-sandbagging. In these jurisdictions, a buyer must show it relied on the allegedly breached representation or warranty of the seller. Reliance can be difficult to prove, if not impossible, when the buyer knew the representation or warranty was false before entering the agreement.

Delaware’s stance is clear: Pro-Sandbagging

A recent decision by the Delaware Court of Chancery, John D. Arwood et al. v. AW Site Services, LLC, C.A. No. 2019-0904-JRS (Del. Ch. March 24, 2022), made it clear that Delaware is a modern rule jurisdiction that is pro-buyer and pro-sandbagging. The case involved a buyer who, after purchasing the assets of a waste disposal business, discovered an alleged sham billing scheme, among other issues. The buyer then sought indemnification from the seller for breach of contract.

The seller argued the buyer’s reliance on the representations in the asset purchase agreement was not reasonable, but the court held it did not matter whether the buyer knew those representations were false prior to the closing because Delaware law allows a buyer to sandbag a seller. (The court made clear that sandbagging did not occur in this case.)

The court traced Delaware’s stance back to its “strong contractarian propensities.” Notably, this includes the rights of contracting parties to allocate the risk of sandbagging in the contract. As the court emphasized, anti-sandbagging clauses are “effective risk management tools that every transactional planner now has in her toolbox.”

In short, Delaware’s view is that sandbagging is fair and square, so long as the governing agreement does not expressly prohibit it.

Pennsylvania’s stance opens the door for sandbaggers

A recent Third Circuit decision, SodexoMAGIC, LLC v. Drexel Univ., 24 F.4th 183, 214 (3d Cir. 2022), sheds some light on how Pennsylvania courts would view sandbagging.

SodexoMAGIC provided on-campus dining services at Drexel University for nearly twenty years when their business relationship—but hopefully not the food the company provided—soured. In 2014, after receiving an unsolicited offer from a SodexoMAGIC rival, Drexel kicked off a heated bidding process for its on-campus dining contract, estimated to be worth up to $300 million over its full term.

SodexoMAGIC was one of several bidders for the contract. During the solicitation process, Drexel highlighted that its strategic plan called for a roughly 30% increase in its overall student population over the course of the next several years but noted that only first-year undergraduates were required to have all-inclusive meal plans. Drexel projected a first-year class size of 3,100 students for the then-upcoming 2014-2015 school year.

Internally, however, the school was singing a different tune. For internal budget purposes, Drexel estimated the size of that same class to be 2,800 students.

SodexoMAGIC ultimately won the contract, but the worst of the problems between SodexoMAGIC and Drexel was yet to come. As SodexoMAGIC continued to provide on-campus dining services for the 2014-2015 school year, it engaged in rocky negotiations with Drexel regarding the finalization of the new contract.

One obstacle centered on Drexel’s first-year student enrollment numbers. SodexoMAGIC wanted Drexel to guarantee annual enrollment increases. Instead, the parties ultimately agreed they would renegotiate in good faith if Drexel’s enrollment did not increase by at least two percent annually.

At last, both parties executed the new contract on May 28, 2015. That same day, The Philadelphia Inquirer reported that Drexel’s first-year class was down by nearly 200 students compared to the prior year. Shortly thereafter, Drexel’s president informed stakeholders, including SodexoMAGIC, that the university was focused on the quality, rather than quantity, of its students, and that class sizes would be smaller than in previous years.

SodexoMAGIC expressed shock over the shrinking enrollment. Through internal correspondence, a Drexel official shrugged it off, stating: “I guess they were going to find out sooner or later.” In the end, Drexel enrolled seven percent fewer first-year students for the 2015-2016 school year. This reduction had an immediate effect on SodexoMAGIC’s revenues.

The parties continued to battle over various aspects of the new contract, with each party trying to exercise the termination options it provided. Ultimately, Drexel replaced SodexoMAGIC with a new vendor effective after the Fall 2016 semester. In the meantime, SodexoMAGIC sued Drexel in federal court.

The parties brought a plethora of claims against each other. Of relevance to us here was SodexoMAGIC’s fraudulent inducement claim against Drexel. The claim alleged Drexel misrepresented and concealed its future student-enrollment projections, leading SodexoMAGIC to bid more favorably on the new contract than if Drexel’s projections were truthful.

The district court tossed out the claim, but, as discussed below, the Third Circuit appellate court put that claim back into play.

Drexel tried to defeat the claim by pointing to the new contract’s integration clause, which stated that the agreement contained all agreements between the parties on the subject matter of the agreement. Drexel argued that Pennsylvania’s “parol evidence” rule prohibits SodexoMAGIC from using any extrinsic evidence (i.e., evidence of prior discussions or agreements outside the parties’ written agreement that contradict or change any contractual terms) to prove that Drexel misrepresented or concealed any information concerning first-year student enrollment numbers.

The Third Circuit disagreed.

According to the court’s unanimous decision, the parol evidence rule prevents the use of extrinsic evidence to alter the terms of an integrated contract—which the one at issue in this case was because it included an integration clause. But the court explained extrinsic evidence that a party wants to bring in regarding fraudulent inducement claims is used for a different purpose: “to prove a precontractual misrepresentation or concealment.”

The court noted that when an integrated contract contains “fraud-insulating” clauses—referred to as an “integrated-plus” contract—the parol evidence rule would block the use of extrinsic evidence to vary the fraud-insulating term.

For illustration, the court mentioned several types of fraud-insulating clauses:

  1. No-Reliance Clauses. One party disclaims any reliance on the other party’s precontractual representations.
  2. Joint Responsibility Clauses. The parties assume joint responsibility for precontractual representations.
  3. Superseding Reps Clauses. The representations in the contract supersede all prior representations or are the only representations made.

These clauses effectively prevent sandbagging. That’s because under the parol evidence rule, a party to a contract can’t bring in outside evidence regarding earlier conversations to counter the language of these fraud-insulating clauses. These clauses state a party can’t rely on those prior conversations. As a result, a party will not be able to establish they relied on those prior conversations to prove their fraud claim.

Regarding the contract at issue in the case, the court held the parol evidence rule did not prevent the use of extrinsic evidence to prove Drexel’s alleged precontractual representations because the contract did not include a fraud-insulating provision. Here, SodexoMAGIC wasn’t using parol evidence to change contractual terms—it was using it to prove Drexel’s alleged fraud.

For that reason, by being allowed to bring in outside evidence about Drexel’s enrollment numbers, SodexoMAGIC could have sandbagged Drexel if SodexoMAGIC knew those enrollment numbers were untrue when it signed the new contract.

(As with the Delaware case we mentioned earlier, there doesn’t appear to have been any sandbagging here.)

The Third Circuit ultimately remanded SodexoMAGIC’s fraudulent inducement claim to the district court. More importantly for our purposes, the court’s decision indirectly gives sandbaggers the green light in Pennsylvania—unless an “integrated-plus” contract is involved.

It’s might always be sandbagging season in Pennsylvania and Delaware

 Based on the two court decisions discussed above, both Pennsylvania and Delaware appear to allow sandbagging. However, both jurisdictions also allow contracting parties to include anti-sandbagging provisions in their governing agreements.

The Third Circuit’s holding arguably takes Pennsylvania law to the “we love sandbagging” level by holding that not even the parol evidence rule—a substantive rule of contract law which may vary from state to state—can prevent sandbaggers from succeeding on their legal claims.

(Of course, the Third Circuit doesn’t have final say over Pennsylvania law; the Pennsylvania Supreme Court does. The latter could decide a case with sandbagging implications differently than the Third Circuit did in the SodexoMAGIC case and create new law regarding the issue.)

For now, there are two takeaways about sandbagging that owners of closely held companies need to keep in mind.

First, choice of law matters. Before signing contracts, know how the jurisdictions governing those contracts view sandbaggers. Do they follow the modern rule or the traditional rule?

Second, do not stay silent. Address sandbagging in your contracts.

If you’re the buyer, push for pro-sandbagging provisions that would allow you to use what you learned before signing the agreement against the seller if there is a misrepresentation.

If you’re the seller, push for integration and anti-sandbagging provisions to create “integrated-plus” contracts that prevent a buyer from using what they learned against you.

Because, according to these two recent judicial opinions, it’s might always be sandbagging season in Pennsylvania and Delaware, the owners of closely held companies who enter into agreements covered by either state’s laws need to be aware of sandbagging and know how to avoid being the one left holding the bag.

Over the past few years, the term “receipts” has entered the pop culture lexicon to mean something broader than its traditional definition of a document that acknowledges either the receiving of a product or service, or money in exchange for a product or service.

These days, if you hear “receipts” mentioned in a song, television show, or movie, or see it on social media, there’s a good chance it is being used to mean proof that something is how a speaker claims it to be. For example, someone might claim to have the “receipts” that another person cheated on their spouse—perhaps in the form of screenshots of now-deleted social media posts or direct messages.

Well, when it comes to proving ownership of a closely held business, receipts—in the trendiest sense of the word—are a good thing. In fact, receipts are required.

A recent case out of the U.S. District Court for the Eastern District of Pennsylvania, Salvitti v. Lascelles, deals with this very issue. While the case doesn’t break any new legal ground, it serves as a reminder of the evidence a purported owner of a business must show to prove they are, in fact, an owner of the business.

Sharp knives, dull business planning?

Salvitti involves a dispute over who owns an LLC established to facilitate the management of Colonel Blades, a company that designs and sells knives. In 2013, Alfred Salvitti and Nico Salvitti patented and designed the Colonel Blade knife, and partnered with John-David Potynsky to produce it. At the end of 2013, Alfred, Nico, and John-David brought on Scott Lascelles to assist with the marketing and sales of the knives.

Since 2013, Scott has managed the day-to-day operations of marketing Colonel Blades, including overseeing internet sales, manufacturing, and distribution. He brought on his wife, Dana DiSabatino, to help develop a business plan.

In early 2014, Scott was advised by his accountant that it would be beneficial to form an LLC to better manage Colonel Blades.

In March 2014, Alfred, Nico, John-David, Scott, and Dana agreed to form an LLC. Soon after, Scott registered The Colonel, LLC with the Pennsylvania Department of State and listed himself on the registration documents as the sole member. He managed the day-to-day operations of the LLC and maintained a bank account on behalf of it. The tax liability of the LLC flowed through his personal taxes. Dana continued to be involved in the LLC’s operations, including marketing and contracting with vendors.

In 2015, a draft agreement was circulated among the five individuals that proposed a new legal entity be established to sell Colonel Blades, with all five as members. They did not execute that agreement. Nor did they execute an agreement in 2018 that proposed that Alfred, Nico, and John-David would become members of The Colonel, LLC.

Nor did Alfred, Nico, John-David, Scott, and Dana ever agree in writing about how they would split the LLC’s profits. Instead, there was only an understanding of how the profits would be distributed: in equal thirds.

After roughly five years of not distributing profits and instead investing them back into the business, Scott distributed profits in Spring 2018. Alfred and John-David both received $10,000, and Dana received $15,500 that was, according to Scott, intended to cover his distribution and the work Dana did for the LLC.

In February 2019, Alfred, Nico, and John-David sued Scott and Dana alleging several causes of action centering on the fact that the three men believed they were co-owners of the LLC and that Scott and Dana had violated their legal rights as co-owners of the LLC.

 The plaintiffs’ ownership claims are cut down to size

Unfortunately for Alfred, Nico, and John-David, U.S. District Judge Eduardo Robreno was not persuaded that they and Scott had ever actually agreed they would become equal co-owners of The Colonel, LLC. For that reason, he dismissed most of their legal claims.

Judge Robreno held that, despite Alfred, Nico, and John-David’s arguments, there was never a true agreement for they, Scott, and Dana to become co-owners of the LLC.

Alfred, Nico, and John-David claimed they came to such an agreement during a March 2014 conference call when they, Scott, and Dana decided to form the LLC for Colonel Blades. They argued that during that call, they, Scott, and Dana agreed to form the LLC—as co-owners.

In addition, Alfred, Nico, and John-David argued that four other pieces of evidence showed there was an agreement with Scott and Dana to be co-owners of the LLC:

  1. An unsigned meeting agenda prepared before a meeting with Scott that said he “need[s] to set up an LLC in all our names”;
  2. The unsigned ownership agreement from 2015 mentioned above;
  3. Scott’s deposition testimony during which he agreed the “ownership agreement should reflect equal ownership interest;” and
  4. A 2015 email from Scott to a potential business partner regarding an agreement involving Colonel Blades that noted he had to have a discussion with Alfred, Nico, and John-David as they had a vote regarding whether to move forward with the agreement.

Scott argued he, Alfred, Nico, and Jean-David never agreed to be co-owners of the LLC. In addition, he pointed to the fact that Jean-David testified he knew Scott was the sole member of the LLC according to the LLC’s registration documents as early as when the LLC was formed, and Alfred testified he knew this as early as 2015.

Based on the parties’ evidence and the factual record in the case, Judge Robreno ruled that none of the evidence in the case supported Alfred, Nico, and Jean-David’s claim that they, Scott, and Dana agreed or consented to the three being members of the LLC. For that reason, Judge Robreno ruled there was no evidence that could lead a reasonable jury to find the parties entered into a membership agreement in 2014 under which they’d be co-owners of the LLC.

As for a claim that Scott breached an oral agreement about how to distribute the LLC’s profits, Judge Robreno ruled that Alfred, Nico, and Jean-David could not point to any evidence in the case’s factual record that showed the four of them came to a specific agreement about what constituted “profits” and when they were to be distributed.

(Scott never disputed their argument that the four of them orally agreed to share the profits from the LLC at some point and in some manner. But he argued the four of them never agreed to the specifics of what that profit sharing would look like. He cited Jean-David’s deposition testimony in which Jean-David admitted there was no agreement on how the profits would be calculated or distributed.)

Therefore, Judge Robreno denied Alfred, Nico, and Jean-David’s motions for summary judgment regarding all but one of their legal claims.

As for that claim, Judge Robreno held there was evidence that supported a legal claim, and thus a reasonable jury could find, that Scott and Dana unjustly benefitted from being the sole members of the LLC. The benefits came in the form of commingling company and personal funds, failing to maintain books and records for the LLC, and failing to observe customary LLC formalities when operating the LLC.

Any way you slice it, receipts matter for LLC co-ownership

Judge Robreno did not exactly break new legal ground. But his decision is a reminder of the relatively high bar someone claiming co-ownership of an LLC must clear before a court will rule they were a co-owner. Although oral and implied operating agreements are permissible under the Pennsylvania LLC statute, courts and especially juries will often demand that a putative plaintiff-owner show the receipts in the form of a signed operating agreement to establish ownership.

Business partnerships are built on the trust and loyalty of their participants. Without mutual coordination and honesty among all involved, tensions will inevitably arise that could derail a partnership’s success. The resulting fallout could be costly in several ways, as lost profits, ruined business opportunities, protracted litigation, and busted personal relationships would surely follow.

Given the dark clouds that quickly form overhead as tensions increase among partners in a partnership, one would assume it would make good business sense, if not common sense, for those partners to look out for each other.

It certainly would make legal sense to do so because partners in a partnership, and, generally speaking, co-owners of all businesses, will typically be deemed to owe a fiduciary duty to each other. At its core, a fiduciary duty is the legal duty of a fiduciary (i.e., one business owner) to act at all times in the best interests of the beneficiary (i.e., the other owner(s) of a business). This requires partners in a partnership to act loyally toward each other, with care, with good faith and fair dealing, and to disclose material information to each other.

In most instances, the interests of partners in a partnership will be aligned with each other and with those of their business. Presumably, the co-owners will be unified in their desires to maximize their business’s profits and value and their own salaries and distributions, and minimize their and their business’s tax burdens.

But what happens when a partner lies to their partners about sales transactions, withholds material information about key business opportunities, and engages in self-serving transactions that did not consider the wishes of other partners? Sounds like a recipe for a breach of fiduciary duty lawsuit, right?

Now consider if it is still a breach of fiduciary duty if the partner in question’s actions not only complied with the agreement governing the partnership but also benefited the other partners?

Would the partner’s actions still constitute a breach of fiduciary duty?

The Pennsylvania Superior Court recently tackled this question, issuing a decision that has implications for business partnerships where the partners are given autonomy to act unilaterally on behalf of their partnerships.

A series of unilateral moves by a partner passes legal muster—at first

In Slomowitz v. Kessler, 2021 Pa. Super. 230 (2021), the namesake plaintiff, Marvin Slomowitz, served as a general partner with two of his colleagues, Stuart Kessler and John Rosenthal, in three limited partnerships that ran and maintained Section 8 apartment buildings for elderly and low-income tenants. All three partnerships were established in the 1970s. Rosenthal actively managed all three partnerships from their establishment until his death in 2008.

After Rosenthal’s death, as the remaining partners grappled with their responsibilities, disputes arose between Slomowitz and Kessler regarding their respective roles. Slomowitz believed the governing partnership agreements allowed him to act unilaterally on behalf of the partnerships without securing any other partner’s approval. Kessler, on the other hand, believed he and Slomowitz were general partners on equal footing. Therefore, Kessler believed any decisions made on the partnerships’ behalf required the consent of both him and Slomowitz to move forward and bind the partnerships.

Naturally, this tension led to substantial friction between Slomowitz and Kessler. In the ensuing years, Slomowitz engaged in actions that he felt were necessary to maintain or increase the profitability of the partnerships. Many of those actions, however, were taken against Kessler’s wishes. Some actions Slomowitz took included:

  • Excluding and failing to communicate with Kessler about critical partnership matters and transactions he knew Kessler would have quashed;
  • Securing necessary approvals from limited partners to sell off all partnership real estate assets without Kessler’s knowledge or consent;
  • Misleading Rosenthal’s estate into believing that the sale of a specific partnership property was the only option available to consider, without raising or discussing Kessler’s preferred option of refinancing the property; and
  • Knowingly misleading a limited partner into moving forward with the sale of a partnership property by misrepresenting to that partner that Rosenthal’s estate supported a sale when it was merely open to considering the idea absent other options.

The trial court, the Court of Common Pleas of Luzerne County, acknowledged that Slomowitz’s conduct “may have been repugnant,” as well as “offensive and un-businesslike.” However, the court noted that all three of the partnership agreements that governed Slomowitz’s activities granted each general partner the individual and complete authority to execute documents and other instruments on a partnership’s behalf. It further found that no partner needed to secure mutual consent in the process.

Therefore, the trial court concluded, based on its interpretation of the partnership agreements and Pennsylvania’s statute governing partnerships, that Slomowitz acted within his authority as a general partner and that nothing appeared wrong with the disputed transactions. Thus, he did not breach his fiduciary duty to Kessler.

The Pa. Superior Court sees things differently

As was to be expected, Kessler appealed the trial court’s ruling. On appeal, the Pa. Superior Court disagreed with several aspects of the trial court’s ruling.

Although the Superior Court acknowledged that all three governing partnership agreements gave each general partner unfettered authority to act unilaterally on behalf of each partnership, the court noted the specific language in the agreements requiring the general partners to exercise their responsibilities in a “fiduciary capacity” at all times to maximize relevant tax advantages. Since none of the partnership agreements defined what the term “fiduciary capacity” meant, the court determined that the fiduciary duties owed by Slomowitz under the partnership agreements were actually a combination of duties provided for by (i) Pennsylvania statutes, (ii) the partnership agreements, and (iii) common law by application of agency principles, i.e., the duty of loyalty, care, good faith and fair dealing, and the duty to disclose.

The court found that under the statutes that govern Pennsylvania partnerships, “a partner must account to the partnership for any benefit and hold as trustee for it any profits derived by him without the consent of the other partners.” Even more critically, the court noted that at least one of these statutes simultaneously subjects partners’ fiduciary duties to Pennsylvania agency law.

As for the applicable partnership agreements, the court noted that, as set forth in the agreements, Slomowitz owed a fiduciary duty to Kessler because he was required to perform actions under the agreement in a “fiduciary capacity.”

And finally, under agency law principles, the court noted each partner is considered an agent of the partnership. Thus, each partner owes duties of loyalty and care to their fellow partners. Additionally, each partner also owes a duty to act in good faith and fair dealing and disclose material information.

Underlying the court’s discussion of partners’ fiduciary duties under Pennsylvania law was Meinhard v. Salmon, a 1928 New York State Court of Appeals decision written by then-Chief Judge Benjamin N. Cardozo (four years before he joined the U.S. Supreme Court) that the Supreme Court of Pennsylvania followed and adopted in a 1970 decision. In Meinhard, Judge Cardozo wrote that

A [co-owner of a business] is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the ‘disintegrating erosion’ of particular exceptions. * * * Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. It will not consciously be lowered by any judgment of this court.

The Superior Court observed that this duty was not grounded in contract or in statute, but in a more elementary basis: trust.

Guided by the applicable statutes, language in the partnership agreements, and Meinhard’s tenets, the court found Slomowitz’s acts did not rise to the fiduciary standard he needed to satisfy, as he should have been more forthright, honest, and transparent with Kessler and his other partners. Notably, Slomowitz’s actions may have caused Kessler to incur more tax liability than if Slomowitz pursued an alternative option that Kessler preferred—thus contradicting one of the goals of the partnership agreements to maximize tax advantages. The court, therefore, remanded the case back to the trial court to make findings regarding damages stemming from Slomowitz’s breach of fiduciary duty.

What Slomowitz means for partners in Pa. partnerships moving forward

The Superior Court’s decision here does not break new ground as much as it reminds partners in business partnerships that the fiduciary duties they owe to each other will not allow favorable business results to excuse the “repugnant,” “offensive[,] and un-businesslike” actions that led to those results. That Slomowitz might have unilaterally engaged in actions that benefited the partnerships did not, in the court’s eyes, mean that he could avoid complying with his fiduciary duty to Kessler.

Going one step further, the court appears to honor the “Spider-Man Rule”: With great power comes great responsibility. The trial court focused on Slomowitz’s full, exclusive, and complete right under the applicable partnership agreements to directly control the business of a partnership in holding that he didn’t breach his fiduciary duty to Kessler. After all, the trial court presumably believed if Slomowitz had the right to do whatever he wanted, he could do whatever he wanted without concern about how it would affect Kessler.

The Superior Court, however, made clear that because Slomowitz had to act in a fiduciary capacity under the partnerships’ agreements, he still had a responsibility to rein in his unilateral powers and employ them in a way that did not breach his fiduciary duty to Kessler.

For some owners of closely held companies, installing a board of directors may seem more painful than cutting off one of their pinkie fingers.

They’d have to give up control of their business.

They’d have to share confidential information.

They’d have to waste time on the formalities of having a board.

They’d have to waste money on compensating directors.

Putting aside for a moment whether these concerns are valid (they’re not), for many owners of closely held companies, installing a board could be one of the best things they do for their companies—and their sanity.

The guidance, knowledge, and wisdom provided by a board, and the healthy separation a board creates between a closely held company and its owner(s), can be invaluable to the maturity and growth of the company.

The kinds of boards closely held companies could install

Before we go deeper into the benefits the owners of a closely held company can realize by installing a board, let’s look at the kinds of boards a closely held company could install.

Compliance board

On one extreme is the compliance board. Many states require incorporated companies (but not LLCs) to have boards. A compliance board is a non-functional board meant to meet legal requirements—and little to nothing else. Often, the only members of a compliance board will be the owners of a business.

Insider board

One step away from a compliance board and toward a functioning board is the insider board. An insider board will often include family members of the owner(s) and members of the company’s management team. The insider board may be created by the founder(s) but is designed to involve the family and senior management in big-picture planning for the company. However, the owner(s) will retain the authority to make decisions.

Inner circle board

Moving past a board stocked with family members of the owner(s), the inner circle board contains directors the founder(s) or owner(s) know well and who possess knowledge and wisdom beyond that possessed by the owner(s) that can guide the company toward growth—and perhaps challenge the thinking of its owner(s). An inner circle board may even establish committees, such as an audit committee. However, the owner(s) will retain decision-making authority.

Quasi-independent board

Finally, the most independent board structure we’re likely to see in a closely held company is the quasi-independent board. With this structure, there will be outside/independent directors who have no tie—employment, familial, or otherwise—to the company aside from their roles as directors. With no ties to the company, these directors are likely to be more objective and less deferential to ownership than their counterparts in the above three board structures. They will expect their input will be considered when decisions are made. With a quasi-independent board, the owner(s) may not retain full decision-making authority like they would with the other board structures.

Why owners of closely held companies should consider installing a board

As a lawyer representing closely held companies and their owners, I have seen firsthand the advantages a board of directors can provide.

Yes, having a board will help closely held companies comply with the laws of their states where those laws require corporations to have boards.

Yes, having a board will help streamline the process of establishing a special litigation committee (as we described a while back in this post).

Yes, (and as I mentioned above), directors bring with them knowledge and wisdom beyond that possessed by the owners. Directors’ experience and their areas of expertise—sales, marketing, operations, legal, finance, whatever—can only add to whatever experience and expertise the owner(s) and their employees are already bringing to the table.

But most importantly, a board can help the owners of closely held companies get of out of their own way. A board can provide much needed separation between owners and their businesses. Separation that is necessary for both the owners and their businesses to prosper.

Directors bring the perspective of strategic, big-picture thinkers who are not mired in the day-to-day operations of a business. They have a bird’s eye view of the business, the company’s industry, and (hopefully) relevant trends that will impact both. This separation is something owners of closely held companies are unlikely to have until they’ve scaled their business and have a management team in place to handle day-to-day operations and firefighting. Spared from having to play WHAC-A-MOLE®, directors can focus on strategic initiatives that would have otherwise been impossible to conceive and implement if left to the owners given the stress they’re under simply to keep the business running.

Equally as important, directors don’t take personally the issues that arise in the day-to-day operations of a business that owners often do.

There is a tendency for owners of closely held companies to view their companies as extensions of themselves. If something bad happens to their company, then something bad has happened to the owner too. This emotional involvement creates an unduly stressful environment in which it becomes increasingly difficult to make sound, rational business decisions.

When a customer doesn’t pay, it’s as if someone mugged the owner.

If an employee sues the business, it’s as if the owner is under personal attack.

The business’s problems become the owner’s problems—and both are worse for it.

It is far healthier and more functional to view the business for what it is: a tool. If a farmhand breaks a tractor wheel, the owner of the farm doesn’t react as though a part of them had been destroyed. The broken tool is not a personal affront; it is merely a problem that needs to be addressed.

If we apply this mindset to the ownership of closely held companies, the stress similarly begins to melt away.

If a customer refuses to pay, perhaps the business needs to adjust how it handles its accounts receivable, or change its payment structure.

If an employee sues the company, maybe the company ought to consider Employment Practices Liability insurance in the future.

Good business decisions can’t be based on fleeting passions and grievances. They should be grounded in a rational and impersonal assessment of the situation. A board can help ensure such an assessment is the norm.

Obviously, this is easier said than done. One can’t simply flip a switch and instantly separate business from emotion. But having a board of directors is tremendously helpful in creating that separation. A healthy separation between closely held companies and their owners reminds owners they are not their companies, and vice versa. Directors don’t take delinquent customers or lawsuits from problem employees personally, and their presence helps owners not take such things personally either.

Dispensing with the perceived drawbacks of a board

I’d be remiss if I didn’t revisit the drawbacks I mentioned at the beginning of this post that owners of closely held companies fear come with installing a board. I can dispense with each of them easily.

Owners who fear they’d have to give up control of their businesses if they install boards will be happy to learn that so long as they are the controlling shareholders, they remain in control of their businesses no matter how independent their boards are.

Owners who fear they’d have to share confidential information with board members can have directors sign nondisclosure agreements or choose to have only insiders on their boards.

Owners who fear they’d have to waste time on the formalities of having boards can bring in coworkers to compile agendas and materials and take notes. (The goal, of course, would be for boards to provide so much value to the owners and their businesses that any administrative costs of having boards is a small price to pay for unlocking such value.)

Finally, owners who fear they’d have to waste money on compensating directors can provide equity to their directors. (Again, hopefully the directors create the kind of value that dwarfs their compensation.)

Bringing boards aboard closely held companies

I assume that when many owners of closely held companies think about boards of directors, they envision mahogany-lined boardrooms at huge, publicly held companies filled with people in suits methodically proceeding through an agenda before enjoying an exquisitely catered dinner. They might shudder at what they believe are the time and financial investments required to install and maintain a board at their own companies.

Given what I’ve seen in my legal practice, those owners stand to lose more by standing pat than if they were to bring aboard a board of directors.

For owners of closely held companies serious about growth and increasing their revenues while also being serious about creating healthy separation between them and their businesses, installing a board of directors may be the kind of investment that provides an incalculable—and indispensable—return on investment.

 

“Piercing the corporate veil” is one of those legal terms that makes a legal action seem more romantic than it really is. When a party to a legal dispute attempts to pierce the corporate veil of a corporate adversary, they are asking a court to move aside the metaphorical veil created by the adversary’s corporate structure and hold the owners of the corporate entity personally liable for the entity’s actions or debts.

Corporate veil piercing—or at least attempts to pierce a corporate veil—arise more frequently in closely held businesses than in other settings. That’s because the owners of closely held businesses tend to be intimately involved in their businesses’ operations and are more likely to attempt to use the limited liability created by their businesses’ corporate structures to shield them from legal liability for the wrongdoing they or their businesses engage in.

We haven’t discussed veil piercing much on the blog. But a recent Pennsylvania Supreme Court decision, in a case captioned Mortimer v. McCool, et al., provides us with an excellent excuse to do so. That’s because with its ruling, the court took a major step towards making closely held businesses more vulnerable to having their corporate veils pierced, and in turn making their owners more vulnerable to being held personally liable for their businesses’ wrongdoing.

A suspicious liquor license transfer

The Mortimer case arose from the collection of a judgment obtained in a personal injury action. Ryan Mortimer obtained a $6.8 million judgment against various individuals and corporate entities in connection with injuries she suffered after her car was hit by a drunk driver. McCool Properties, LLC, owned the restaurant in question that served the intoxicated driver. Another entity, 340 Associates, LLC, owned the liquor license used by the restaurant. Both entities had common owners.

During Mortimer’s personal injury lawsuit, 340 Associates transferred the liquor license to another entity, 334 Kayla, Inc.—an entity with no affiliation with the owners of McCool Properties or 340 Associates—in exchange for a $75,000 note. 334 Kayla also signed a lease with McCool Properties for the restaurant space.

After the entry of the judgment in her favor, Mortimer filed a lawsuit against 340 Associates and 334 Kayla, alleging the liquor license transfer was fraudulent and an attempt to shield it from Mortimer recovering it in her original lawsuit. Mortimer was successful in that action, took possession of the liquor license, and sold it for $415,000. Mortimer then filed actions against 340 Associates and McCool Properties to collect the rest of the judgment and to pierce 340 Associates’ corporate veil in order to reach both the McCool Properties assets and those of their shared individual owners.

An enterprising attempt to pierce a corporate veil

Historically, Pennsylvania has had a strong presumption against piercing the corporate veil, as the Pa. Supreme Court recognized: “There appears to be no settled rule . . . as to exactly when the corporate veil can be pierced and when it may not be pierced,” such that it “seems to happen freakishly. Like lightning, it is rare, severe, and unprincipled.”

The trial court in this case, relying upon two separate decisions, recognized a series of factors to consider in Mortimer’s claims. The trial court noted a corporate structure may be disregarded “whenever one in control of a corporation uses that control, or uses the corporate assets, to further his or her own personal interests.” Additional factors include “undercapitalization, failure to adhere to corporate formalities, substantial intermingling of corporate and personal affairs, and use of the corporate form to perpetrate a fraud.” The trial court decided to apply these additional factors to Mortimer’s claims against 340 Associates, and determined none of them allowed her to pierce that entity’s corporate veil.

Regarding her claims against McCool Properties, Mortimer advanced two separate veil-piercing theories at the trial level: the “alter ego” theory and the “enterprise liability” theory. The trial court quickly dismissed the alter ego theory, which applies only where the individual or corporate owner controls the corporation to be pierced and the controlling owner is to be held legally liable for wrongdoing, as not applicable because McCool Properties had no ownership interest in 340 Associates.

Moving on to the enterprise liability theory, which allows two or more corporations to be treated as one if five factors are met, the trial court recognized that Pennsylvania had yet to adopt the theory. But it didn’t let that stop it. It considered the theory’s five factors:

  • Identity of ownership;
  • Unified administrative control;
  • Similar or supplementary business functions;
  • Involuntary creditors; and
  • Insolvency of the corporation against which the claim lies.

While it indulged Mortimer and considered the enterprise liability theory, the trial court did not find in her favor. It ruled that she did not show there was identical ownership and unified administrative control among McCool Properties and 340 Associates.

The Pennsylvania Superior Court later affirmed the trial court’s rulings in all respects.

A moral victory for Mortimer

Mortimer appealed her case to the Pa. Supreme Court on multiple grounds, but the court only granted review of whether the court should adopt the enterprise theory of piercing the corporate veil “to prevent injustice when two or more sister companies operate as a single corporate combine.”

Mortimer re-emphasized the application of the enterprise theory’s five factors to her case, and cited cases from multiple jurisdictions that have already adopted enterprise liability as models for Pennsylvania’s adoption of the theory. After looking at decisions from courts in Alabama, Indiana, Connecticut, Massachusetts, Colorado, and South Carolina, among other states, the Pa. Supreme Court determined “most jurisdictions that recognize an enterprise liability variant also retain a requirement of wrongdoing and resultant injustice no less stringent than that which applies in any piercing case.” That being said, the court noted that “[e]nterprise liability cases in which relief is granted seem to be very few and far between, and typically involve some truly egregious misconduct.”

In laying out its version of the enterprise liability theory, the court explained that in its most logical form, it “requires an alter ego component” from which substantial common ownership can arise; effectively the affiliate corporations are “siblings – of common parentage.” Thus, according to the court, there must be “common owners and/or an administrative nexus above sister corporations.”

From there, the court said that “enterprise liability in any tenable form must run up from the debtor corporation to the common owner, and from there down to the targeted sister corporation(s)” in a “triangular” fashion. But the court noted this “requires a mechanism by which liability passes through the common owner to the sibling corporation” and acknowledged the theory of “reverse-piercing,” where a plaintiff suing the owner of a corporation must establish the misuse of corporate form to protect the owner’s personal assets.

The court then settled on a two-pronged test for using the enterprise theory to pierce a corporate veil. First, there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and adherence to corporate fiction under the circumstances would sanction fraud or promote injustice. Second, there must be some fraud, wrong, or injustice.

Unfortunately for Mortimer, the Pa. Supreme Court relied on the trial court’s findings and held that Mortimer did not satisfy either prong of the two-pronged test the court established. The court did, however, signal that lower courts in Pennsylvania were free to apply the two-pronged test in the future, stating that “it remains for the lower courts in future cases to consider its application” consistent with prior case law and the guidance provided by the court.

A new weapon in business divorce litigation?

While the Pa. Supreme Court has adopted what appears to be a broad version of the enterprise theory for corporate veil piercing, it remains to be seen whether lower courts in the state will take up the court on its invitation to apply it, and under what circumstances.

But based on the Pa. Supreme Court’s decision here in Mortimer v. McCool, it seems enterprise liability is now a viable theory in Pennsylvania through which a party to a business divorce lawsuit could attempt to pierce the corporate veil of an adversary. Interestingly, the enterprise theory may be an effective weapon with which to hold the owners of “just-out-of-reach structures”—which we covered on the blog a while back—liable for wrongdoing if an opposing party can show a unity of interest and ownership that eviscerates separate personalities of the companies and the individuals, and there is fraud, wrong, or injustice on their parts.

Corporate attorneys advising closely held businesses should be aware of the potential for enterprise liability to arise. They should strongly consider indemnification provisions and adequate insurance for directors and officers as necessary.

Additionally, litigators should also evaluate the viability of this theory in preparing their claims and choosing appropriate defendants. Litigators will need to conduct an in-depth investigation into their adversaries’ corporate ownership to allow their clients to show a court they’ve satisfied the shiny new two-pronged test for enterprise liability established by the Pa. Supreme Court in Mortimer v. McCool.

There is arguably no more prevalent legal claim in business divorces than a claim of breach of a fiduciary duty. Simply put (and I do mean simply), when one person owes a fiduciary duty to another, the person with the duty must act in the best interests of the person to whom they owe the duty.

When the co-owner of a closely held business owes a fiduciary duty to another shareholder of the business, the co-owner must act in the best interests of that shareholder. That means, among other things, treating the other shareholder in a way that allows them to realize the value of their interest in the business.

Fiduciary duties owed by 50% co-owners under Pennsylvania law

Under Pennsylvania law, equal shareholders in a business tend not to owe fiduciary duties to each other. That makes perfect sense. It is awfully difficult (though not impossible) for a 50% co-owner of a business to railroad their fellow 50% co-owner. Assuming each co-owner has the same power, control, and rights over the business as the other, neither co-owner should be able to abuse their authority. After all, each co-owner should have the power to stop the other’s abuse.

But when shareholders are not co-equal, Pennsylvania imposes a fiduciary duty on majority shareholders to protect the interests of minority shareholders. Without this duty, majority shareholders could use their power to elbow out minority shareholders and take a disproportionate share of their businesses’ profits or take advantage of other benefits provided by their businesses at the expense of those minority shareholders.

This majority-to-minority fiduciary duty exists when shareholders have equal ownership of the company but not equal power or control. In situations where there are two 50% co-owners of a business, but one has more voting power than the other or has greater authority to run the business than the other, Pennsylvania courts will likely rule that the more powerful 50% co-owner owes a fiduciary duty to the less powerful 50% co-owner.

But what about when two 50% co-owners with equal power, control, and rights have a falling out and one tries to terminate the other’s employment? It would seem neither would owe a fiduciary duty to the other given that they’re on equal footing.

But a recent decision from the U.S. District Court of the Eastern District of Pennsylvania suggests that once that firing occurs, the co-owner doing the firing has more power and control than the co-owner who was just fired and, therefore, would owe a fiduciary duty to the fired co-owner.

Crossing the equality chasm

In Meyers v. Delaware Valley Lift Truck, Inc. et al., No. 18-1118, E.D. Pa. (May 13, 2021), two brothers, Jack and Jim, each owned half the shares of a closely held industrial equipment rental business, Delaware Valley Lift Truck, founded in 1985 by their father John. A shareholder agreement between the brothers contained a clause (albeit a sloppily drafted one) that allowed John to break any ties between them in the event of disagreements about “major decisions.” The brothers had equal power, control, and rights to make business decisions.

In late 2017, the relationship between Jack and Jim soured. They clashed over whether to fire a particular employee. Jack, the president, was intent on terminating this employee, believing that his conduct cost the company an important business deal. Jim, the secretary and treasurer, was close with the employee and tied his own continued employment at the company to the continued employment of the person about to be fired.

John apparently gave his blessing to Jack to “to do what he had to do that was best for the company and the employees” and supported whatever decision Jack made about whether Jim would continue working at DVLT. But John did not attend the meeting between Jack and Jim where their dispute came to a head. Thus, as the court recognized, it wasn’t clear if John broke the tie. The two brothers had differing views about what happened at the meeting, but agreed that Jack fired Jim.

According to the brothers’ shareholder agreement, Jim’s firing triggered a provision where the remaining brother had the legal right to buy out the one who was fired using a particular formula. However, Jack and Jim had different opinions on how the formula was to be applied. Again, the shareholder agreement did their arrangement no favors thanks to poor drafting. The two brothers could not agree on the purchase price, so the recently fired Jim kept his 50% ownership stake in the company.

In deciding whether to grant either party’s motion for summary judgment regarding Jim’s breach of fiduciary duty claim against Jack, U.S. District Judge Wendy Beetlestone broke some new legal ground. After walking through Pennsylvania law on breach of fiduciary duty, Judge Beetlestone determined that there were two separate stages of the brothers’ relationship with each other. When they had equal authority, and John had the tie-breaking power between the two, the court held Jack did not owe Jim a fiduciary duty.

But according to the court, this absence of a fiduciary relationship changed the moment Jack fired Jim. At that point, Jack clearly had more power than Jim, power that he used to bar Jim from the premises and deny him access to corporate records. Ironically, the court imposed a relationship of trust on Jack only after he seemingly broke trust with his brother by firing him.

After explaining that Jack owed Jim a fiduciary duty in this situation, the court held Jim’s breach of fiduciary duty claim against Jack should proceed to trial to determine whether Jack breached that duty.

A new paradigm for equal shareholders in closely held Pennsylvania businesses?

The key holding in Meyer, that a fiduciary duty between co-equal shareholders can come into existence based on shifts in the balance of power between them, is potentially a significant one.

There was no change in the number of shares owned by Jack or Jim, no new operating agreement, no new allocation of voting shares or rights, and no change in corporate structure. The only thing that changed was one co-equal shareholder fired the other co-equal shareholder in connection with a disagreement over a personnel issue that snowballed into a much larger disagreement.

Yet the court looked at that termination as an event that took the brothers off equal footing despite no change in their ownership of their business. When Jack fired Jim, Jack suddenly became, in the court’s eye, the majority shareholder.

Interestingly, Jim alleges Jack breached his fiduciary duty by doing certain things—barring Jim from their business’s premises, denying him access to corporate records, denying him a voice in running the company, misappropriating corporate funds for Jack’s own personal benefit, and initiating bankruptcy proceedings on behalf of the company in bad faith—that seem to be lifted straight out of the playbook for misbehaving majority shareholders. Had Jack simply taken more than his fair share of profits, the court might have ruled differently. But Jack’s actions seem like those of a majority shareholder acting without fear of accountability or reprisal from a less powerful minority shareholder.

The Meyer decision could transform how 50% co-owners interact with each other. Should the balance of power become imbalanced, a court adopting Judge Beetlestone’s reasoning could hold that the imbalance created a fiduciary duty owed by the more powerful 50% co-owner. Additionally, courts may want the parties to develop a more detailed factual record in these cases because the cases will turn on specific facts regarding the relative power, control, and rights a co-owner had and used at the expense of the other.

The ink on the Meyer decision is barely dry, so we will have to wait and see what impact the decision has on business divorce cases in Pennsylvania. But for now, Meyer has injected some uncertainty into what many Pennsylvania businesses thought was not up for interpretation: whether co-equal owners of those businesses are equal in the eyes of the law.

When legal disputes between owners of closely held companies turn the corner past “Let’s resolve this issue without litigation” and head toward “See you in court,” the owners and their lawyers typically begin jockeying for the upper hand in a potential lawsuit. The most effective way to grab the upper hand is to be the party that files the lawsuit. That party gets to shape the lawsuit to their liking—both in terms of which court they decide to file the lawsuit in and the legal claims and supporting facts they include in the lawsuit.

These legal claims and supporting facts often signal what kind of legal battle the parties are looking at. The more incendiary the legal claims and supporting facts, the more contentious the lawsuit will be.

A lawsuit alleging a breach of a company’s operating agreement supported by straightforward factual allegations will have a much different feel than one alleging fraud and embezzlement supported by factual allegations seemingly ripped from a movie script.

And then there are civil RICO claims.

RICO primer

RICO stands for the Racketeer Influenced and Corrupt Organization Act signed into law by President Richard Nixon in 1970. RICO was part of the Organized Crime Control Act of 1970. Congress’s purpose in bringing the law was to:

seek the eradication of organized crime in the United States by strengthening the legal tools in the evidence-gathering process, by establishing new penal prohibitions, and by providing enhanced sanctions and new remedies to deal with the unlawful activities of those engaged in organized crime.

RICO was conceived as a new way to fight the mob and other illegal criminal enterprises by targeting the underlying activities that criminals took part in to keep their enterprises going. Through RICO, Congress defined racketeering activity broadly to include both violent crimes such as kidnapping, bribery, extortion, and counterfeiting, as well as white-collar crimes such as wire fraud and mail fraud.

In criminal RICO cases, prosecutors must prove beyond a reasonable doubt that a RICO “enterprise,” defined as “any individual, partnership, corporation, association, or other legal entity, and any union or group of individuals associated in fact although not a legal entity,” engaged in at least two related racketeering activities, known as “predicate acts,” in furtherance of that enterprise.

In addition to criminal RICO claims, Congress also created new civil RICO claims. Civil RICO claims can be brought in private litigation like litigation between owners of closely held companies. The winning party in a civil RICO case is entitled to treble (that is, 3x) damages and to have their adversary pay their attorneys’ fees.

A hammer in search of a nail?

When an owner of a closely held company lobs RICO allegations against their co-owner(s) in a lawsuit, they are throwing down the gauntlet as part of their jockeying for the upper hand. RICO allegations are the kind of legal claims that may arouse the interest of media outlets, get a company’s clients, vendors, employees, and shareholders buzzing (not in a good way), and cause significant reputational and business damage to closely held companies.

Thus, the thinking goes, if a party can allege RICO claims that survive multiple attempts to dismiss the lawsuit, those claims become strong leverage in settlement negotiations down the road. Knowing that your co-owner could have you dead to rights on a civil RICO claim will bring even the most stubborn co-owner to the settlement table given the treble damages and attorneys fees waiting for them on the other side of an unfavorable jury verdict.

But just how potent are civil RICO cases in the business divorce context in Pennsylvania?

Apparently, not very.

Few civil RICO cases in the business divorce context have been litigated in Pennsylvania. Of those that have, the plaintiffs have generally been unsuccessful with their claims. As you will see shortly, the nature of the events that tend to lead to business divorces do not fit nicely within the kind of factual allegations needed in a RICO case to survive judicial scrutiny.

Because of this, the parties against whom RICO claims are alleged in the business divorce context know their adversaries are going to have a tough time getting those RICO claims to survive attempts to dismiss them. With few successful civil RICO claims in the business divorce context, the claims’ effectiveness as a hammer used to jockey for position in a potential or newly filed lawsuit is greatly reduced.

The following four Pennsylvania cases show just how hard of a sell civil RICO claims are in the business divorce context.

In Domico v. Kontas, No. 3:12CV1449, 2013 WL 1248638 (M.D. Pa. Mar. 26, 2013), Dennis Domico, an investor in a corporation that operated the Hollywood Diner in Hazle Township, Pa., claimed he was tricked into investing $145,000 in the company for 50% ownership of it through his co-owner’s use of doctored bank statements, fraudulent invoices, and altered bank checks. While a state court business divorce lawsuit was pending between Domico and his co-owner, he brought a federal civil RICO case against the co-owner and a number of the co-owner’s business associates, alleging both a civil RICO claim and a conspiracy to commit civil RICO claim. The relevant predicate acts were wire, mail, and bank fraud.

Unfortunately for Domico, the court determined the predicate acts actually formed the basis of a claim for securities fraud because they all related to his investment in the corporation that operated the diner. This was a problem because the Private Securities Litigation Reform Act of 1995 eliminated securities fraud as a predicate act for a civil RICO claim. The court ruled that all of the defendants’ actions were part of a single fraudulent scheme to trick Domico into purchasing securities in the corporation that owned the diner. As a result, the court dismissed both civil RICO claims.

In Gintowt v. TL Ventures, 226. F. Supp. 2d 672 (E.D. Pa. 2002), Kristoff Gintowt, a co-owner of a successful staffing company claimed that after his company was merged into a new company, Broadreach, his equity in it was wiped out due to fraud and misrepresentations by the defendants who were corporate executives of, and entities affiliated with, Broadreach. Gintowt brought civil RICO claims against the defendants, alleging that the defendants committed various predicate acts of mail fraud and wire fraud, such as when they assured Gintowt that he and his co-owners would have a seat on the board of Broadreach and when the company made misleading statements about its business to potential buyers.

The court dismissed Gintowt’s complaint. While noting that Gintowt adequately alleged the existence of an enterprise (Broadreach) and damages in support of his RICO claim, the court held that Gintowt failed to do so when it came to how the alleged fraudulent acts committed against him furthered the scheme to defraud him or were related to an essential part of that scheme. According to the court, because Gintowt did not tie the alleged fraudulent acts together, he did not properly allege that the acts constituted “a pattern of racketeering activity” required by RICO (which is often properly alleged by claiming those acts are part of an ongoing entity’s regular way of doing business).

In Bardsley v. Powell, Trachtman, Logan, Carrle & Bowman, P.C. et al., 916 F. Supp. 458, 463 (E.D. Pa.), aff’d, 106 F.3d 384 (3d Cir. 1996), Norman Bardsley, a shareholder and director of Inofast, a manufacturer and distributor of fasteners, claimed that a number of Inofast’s minority shareholders—including his twin brother and father!—concocted a scheme involving a number of improper and fraudulent transactions to divest him of his majority shareholder status. The scheme was allegedly hatched to thwart Bardsley’s attempts to replace Inofast’s management after the company found itself in financial trouble. As was the situation in the Domico case I discussed above, while a state court business divorce lawsuit was pending between Bardsley and a number of Inofast shareholders, two of their outside lawyers, and their law firm, he brought a federal securities fraud and civil RICO case against those defendants.

The court dismissed the securities fraud claim on the basis that Bardsley did not bring his claim within the required period of time under the federal securities laws. The court also dismissed Bardsley’s civil RICO claim. The court held that Bardsley did not show that the defendants’ alleged fraudulent scheme included a pattern of racketeering activity as required by RICO. Specifically, he did not allege that the defendants’ scheme was continuous. According to the court, he alleged the scheme lasted seven or eight months, was directed only toward him, and was implemented for a single purpose. The court determined that the defendants’ alleged misconduct fell short of RICO’s “continuity” requirement.

(Note that this case was decided soon after the Private Securities Litigation Reform Act of 1995 was passed. Though the PSLRA was not mentioned, it would not have changed the ultimate result.)

Finally, in Ferdinand Drexel Inv. Co. v. Alibert, 723 F. Supp. 313, 326 (E.D. Pa. 1989), aff’d, 904 F.2d 694 (3d Cir. 1990), Vernon Alibert, the co-owner of a number of family-owned companies, claimed he was fraudulently divested of his ownership in them thanks to their majority shareholders (who were his family members). Alibert brought securities fraud claims against the majority shareholders, as well as a civil RICO claim with predicate acts of securities fraud and of mail fraud.

The judge dismissed the securities fraud claims, in part because Alibert could not have relied on allegedly false statements in certain documents because he refused to accept those documents when the United States Postal Service delivered them to him. Regarding the RICO claims, the judge dismissed them as well, focusing on the mail fraud claim because he had already dismissed the securities fraud claim. He held that even if the notices mailed to the plaintiff were fraudulent, there were only two of them and they were sent within the same month. This fell short of RICO’s “continuity” and “pattern” requirements for predicate acts. In addition, the judge held that Alibert could not have been injured as a result of the shareholders’ alleged racketeering scheme because he did not detrimentally rely on the alleged fraudulent mailed notices because (as was the case with his securities fraud claim) he never read them.

(Note that this case was decided six years before the PSLRA was passed. As with the Bardsley case I mentioned above, the PSLRA would not have changed the ultimate result.)

No go, RICO

There have not been many civil RICO cases in Pennsylvania arising in the business divorce context to begin with, let alone ones where the plaintiff has prevailed. That civil RICO cases are so few and far between suggests to me that lawyers and their clients involved in business divorces understand that civil RICO claims are tough hills to climb in that context.

Given the lackluster track record of previous plaintiffs in civil RICO cases in the business divorce context, would-be plaintiffs likely do not want to spend the required time and money for their lawyers to draft the kinds of detailed legal complaints necessary to properly allege RICO claims—assuming the facts of a particular business divorce support such claims—only to stand a good chance of those complaints being dismissed early in the litigation process. Thus, fewer civil RICO cases in the business divorce context are being filed.

Perhaps there are those rare business divorces that provide the factual and legal basis for a dead-to-rights civil RICO claim. But short of that, I do not expect many co-owners of closely held companies in Pennsylvania to raise civil RICO claims in Pennsylvania federal courts to complement, or in place of, bread-and-butter business divorce lawsuits in Pennsylvania state courts. The chances of winning a civil RICO case are simply too low to justify the likely expense of mounting one.

For these reasons, when co-owners of closely held companies and their lawyers begin jockeying for the upper hand in a potential lawsuit regarding a business divorce, it seems a civil RICO claim will almost certainly be a hammer without a nail.

Last month, we tackled Pennsylvania’s “universal” demand requirement. As a refresher, unlike many states, Pennsylvania will not excuse the shareholder of a company who wants the company to sue its executives or directors from making a written demand on the company’s board of directors prior to filing a lawsuit even when doing so would be futile. “Futility” means that the composition of the company’s board makes it incapable of impartially deciding whether to bring suit on behalf of the company based on the wrongful conduct alleged by that shareholder in their demand. Normally, if such a demand would be futile, a would-be shareholder-plaintiff can skip the written demand and move straight to filing their lawsuit.

As I explained in that blog post, this “universal demand” requirement makes sense in Pennsylvania because the Commonwealth’s laws allow a company’s board to appoint a special litigation committee (known in legal circles as an “SLC”) composed of independent third-party members to investigate the complaining shareholder’s allegations and determine whether bringing a potential lawsuit based on those allegations would be in the best interests of the company. A demand in Pennsylvania should never, strictly speaking, be futile because it is always possible for a board to take good faith action in response to a demand, even if the entire board is conflicted.

Not every company jumps at the chance to commence these investigations, especially a closely held company that might not have the cash flow or balance sheet needed to fund one. But there may be a way for closely held companies to carry out these investigations and reap the benefits of doing so without breaking the bank.

Spend money on an investigation now, save money on litigation later

In publicly held companies and private companies with many shareholders, it is common for a board of directors to appoint an SLC after receiving a shareholder’s complaint. Usually, the SLC then retains an outside law firm to help it investigate the complaint. Most times, those law firms will thoroughly and independently investigate the complaint and issue a report, dozens of pages long, explaining why the shareholder’s allegations are without merit, and thus why the board should not file the lawsuit the shareholder is asking it to file.

The boards at these companies know that whatever they pay for the investigation and report —likely anywhere from the low six figures to the high seven figures—will provide a meaningful return on investment on the backend. That’s because the investigation and report could be a proper basis, according to a court, on which a board can rely to not pursue a lawsuit against its own company, thus putting an early end to litigation over the shareholder’s complaints. The cost to the company of litigating the shareholder’s complaints to the bitter end would inevitably be multiples of what that investigation and report cost.

But when it comes to closely held companies, in my experience, the controlling owners/shareholders rarely appoint an SLC to investigate a complaining shareholder’s claims. The funny thing is, they probably should. By not doing so, they are missing an opportunity to show Pennsylvania courts that a complaining shareholder’s allegations of wrongdoing were investigated by a law firm and found to be without merit, and thus related litigation should be dismissed as early as possible. Moreover, the cost of most litigation means that disputes over relatively small amounts (500k to 2 MM) would not be in a company’s best interests, thereby creating an additional justification for dismissal of a plaintiff’s claim. The board of a closely held company that fails to appoint an SLC misses these opportunities to end litigation early and the potentially significant ROI that an SLC’s investigation can bring.

So why don’t more closely held companies appoint SLCs to investigate a complaining shareholder’s allegations of wrongdoing?

It might seem to closely held companies that the cost of conducting such an investigation would be prohibitive. The price to hire an outside law firm to conduct this kind of investigation at a closely held company likely begins in the mid-five figures and tops out in the mid-six figures.

But Pennsylvania courts have held that a board’s decision to not pursue litigation against its own company is subject to the business judgment rule (under which a court will uphold a board’s decisions if they are made in good faith, using reasonable care, and with the best interests of the company in mind). The business judgment rule focuses on process. Therefore, how the board of a closely held company arrived at its decision not to pursue litigation against its company regarding a complaining shareholder’s allegations of wrongdoing is what counts, not necessarily who its SLC hired to help it investigate those allegations.

So how can a closely held company’s SLC investigate these allegations without breaking the bank? A 2008 Pennsylvania appellate court suggests a path worth following.

LeMenestrel v. Warden: A roadmap for DIY SLC investigations

The dispute at the center of LeMenestrel v. Warden, 964 A.2d 902 (Pa. Super. Ct.  2008) is common amongst closely held companies. The LeMenestrel siblings, who were minority shareholders of Superior Group, brought a breach of fiduciary duty claim in a derivative action against the company’s SLC, controlling shareholders, and controlling officer. The SLC was formed in response to a demand letter sent by the LeMenestrels regarding losses to some of Superior Group’s subsidiaries, and business decisions by the majority shareholders relating to the sale and liquidation of other subsidiaries. The LeMenestrels also claimed that the SLC breached its fiduciary duty to Superior Group’s shareholders in its investigation of the self-dealing allegations.

The trial court granted the defendants’ motion to dismiss the lawsuit. The court held that the SLC formed by Superior Group’s board of directors in response to the LeMenestrels’ demand letter “was disinterested, independent, impartial and adequately informed in reaching its good faith conclusion that it was not in the best interests of [Superior Group] to proceed with the LeMenestrels’ shareholders’ derivative suit.”

The LeMenestrels appealed that decision to the Pennsylvania Superior Court. In its decision, the Superior Court upheld the trial court’s decision.

LeMenestrel is one of the few Pennsylvania court cases that evaluated the actions of an SLC. In its decision, the Pennsylvania Superior Court explained why Superior Group’s SLC’s deference to its attorney was proper and why the committee was “adequately informed” when it decided not to pursue the LeMenestrels’ lawsuit. The court focused on the work of the committee’s lawyer, John G. Harkins, Jr.:

  • Harkins was independent, had no conflict of interests, and was “an eminently qualified practitioner” who conducted an “extensive investigation”;
  • He developed an investigation plan and met regularly with the committee to discuss matters regarding the investigation, including the scope of the investigation, the general procedures to follow, the kinds of claims raised in the demand letter and which claims could be subject to a lawsuit based on particular legal theories;
  • He reviewed thousands of documents, including deposition transcripts from a related litigation and documents provided by the LeMenestrels’ lawyer;
  • He interviewed at least eight witnesses knowledgeable about facts relevant to the LeMenestrels’ claims;
  • He interviewed the LeMenestrels’ lawyer, met with him regarding the scope of the investigation to ensure that it considered issues his clients felt were significant, and tailored the scope of the investigation after talking with the lawyer; and
  • His investigation took five months, resulting in a 106-page final report that explained “in a thorough, evenhanded manner, the background and events leading up to the LeMenestrels’ claims, the response of Superior Group’s board and formation of the committee, the scope of the investigation, and findings and recommendations in light of the fiduciary duties owed by the defendant directors and officers.”

Following the roadmap without paying a fortune

Based on the LeMenestrel court’s description of the Superior Group’s SLC’s investigation, the company probably spent somewhere between $200,000 and $400,000 on it. That cost was likely justified by the fact that potentially tens of millions of dollars were at stake.

But rarely is that amount of money at stake in legal disputes between the shareholders of closely held companies. In those disputes, a more likely amount at stake is $500,000 to $2 million. At those amounts, a $200,000 to $400,000 investigation does not make much financial sense. But a $20,000 or a $40,000 investigation might.

If that’s the case, how could a budget-minded SLC at a closely held company conduct a process-driven and thorough investigation like John Harkins did for Superior Group that is strong enough to pass judicial muster and serve as the appropriate basis for the dismissal of a shareholder’s lawsuit early in the litigation process?

Here’s one possible way: hire “an eminently qualified” lawyer to lead the investigation and be the “quarterback” of it, but assign company personnel and other qualified non-lawyers the brunt of the legwork. That will cut down on the fees charged by a lawyer because it reduces the time they will spend investigating.

To be clear, an SLC should hire a lawyer to lead the investigation. Only a lawyer can determine, based on what the investigation finds, whether the SLC and ultimately its company’s board should agree to the shareholder’s demand to bring a derivative lawsuit on behalf of the company. This decision will be a result of the facts uncovered during the investigation and the law of the company’s jurisdiction regarding whether those facts constitute legal wrongdoing. That is the exclusive domain of a lawyer.

But uncovering the facts is not. If we look at the aspects of the Superior Group’s SLC’s investigation that the LeMenestrel court lauded, we see many tasks that can be delegated to non-lawyers partially or entirely, including directors on the SLC, disinterested executives, and disinterested third parties:

  • Developing an investigation plan;
  • Meeting with the SLC to update them on the investigation;
  • Reviewing documents, including deposition transcripts;
  • Interviewing witnesses; and
  • Drafting a final report

Surely, the lawyer hired by the SLC will be intimately involved with the investigation, guiding the non-lawyer(s) and assisting them. But the lawyer need not be the person sitting for an interview with a witness—they can help the interviewer prepare for one. Same thing for the first draft of a final report. Merely by reducing the amount of “doing” by a lawyer while maintaining the same amount of strategic thinking they provide, SLCs at closely held companies can reduce the cost of an investigation of a shareholder’s demand. This cost reduction could lead to a wider adoption of investigations at these companies, which as I mentioned above, would generally be a good thing for them.

A few dollars of prevention is worth exponentially more of cure

When faced with shareholder demands regarding significant alleged wrongdoing at their companies, the boards of Pennsylvania closely held companies may be doing themselves and all of their shareholders a disservice when they fail to convene an SLC to investigate the allegations. An SLC’s investigation and subsequent report can provide the means to an early exit from what could end up being a costly lawsuit.

If cost is a factor, the LeMenestrel case provides a roadmap for closely held companies to follow that could help them obtain the litigation benefits of an SLC without breaking the bank.