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.

 

Attorneys that represent shareholders of publicly traded companies in securities litigation are intimately familiar with the pre-suit demand required by the corporate law of many states. The purpose of the demand is to give the board of a company an opportunity to investigate and remedy alleged wrongdoing on the company’s behalf before a shareholder is permitted to bring a derivative action. In many states, including Delaware, a potential plaintiff is not required to make a pre-suit demand when the board is not capable of making an independent decision—typically because board members are accused of wrongdoing themselves. Pennsylvania’s business corporation law (“BCL”) does not include a “futility” exception and requires the prospective derivative plaintiff to make a pre-suit demand in nearly all circumstances.

Whatever the merits of Pennsylvania’s universal demand requirement for litigation involving companies with many shareholders, its justification breaks down in disputes involving closely held businesses. Absent a persuasive justification, it amounts to a procedural trap for the unwary practitioner. A recent decision from the Eastern District of Pennsylvania is a reminder of the hazard.

Pennsylvania’s “Universal Demand” Requirement

A fundamental principle of Pennsylvania corporate law is that a corporation’s board – not its shareholders – is responsible for the management of the company. This includes the decision to initiate litigation on behalf of the company against those who have damaged it. Pennsylvania’s corporate law, however, recognizes that members of the board and corporate officers themselves may cause harm to the company and are unlikely to cause the company initiate litigation against themselves. It allows shareholders to initiate derivative claims on behalf of the company in limited circumstances.

The 2016 revisions to the BCL require a prospective derivative plaintiff to make a written demand on a company’s board of directors prior to initiating suit. 15 Pa.C.S.A. § 1781(a). Upon receiving a demand, the board may choose to appoint an independent committee to investigate what action, if any, the corporation should take in response to the demand. For example, the committee might choose to have the corporation bring an action in its own name based on some or all the claims in the demand, or to allow the prospective derivative plaintiff to do so on its behalf. The committee is a surrogate decisionmaker for the board that allows it to make a business decision – whether and under what circumstances to initiate litigation. The demand is intended to give the board time to form a litigation committee and make this business decision prior to litigation.

Many states will excuse a plaintiff from the demand requirement when it would be futile. “Futility” means that the composition of the board is such that it is incapable of making an independent decision regarding the alleged wrongful conduct that would have been included in a pre-suit demand. For example, a demand would be futile if it alleged the entire board were engaged in self-dealing and there were no disinterested directors able to make a good faith decision on behalf of the company.

Litigating whether a demand is futile can be a complex, time consuming and expensive task. It is also ancillary to the merits of the ultimate issue of whether the corporation suffered harm because of a defendant’s conduct. For that reason, some states, including Pennsylvania, have no futility exception and require a pre-suit demand in nearly all circumstances. The BCL only excuses the demand requirement “if the plaintiff makes a specific showing that immediate and irreparable harm to the business corporation would otherwise result.” 15 Pa.C.S.A. § 1781(b)(1).

This “universal demand” requirement is defensible because the BCL allows the board to appoint a litigation committee comprised of independent third-party members. 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. In contrast, many states require that a litigation committee be comprised of board members.

The Practical Reality in Closely Held Company Disputes

Practitioners that focus their practice on disputes among the owners of closely held companies may have trouble recalling a time where a client made a demand on a corporate board, which then diligently appointed an independent committee, retained independent counsel and performed a good faith investigation into the alleged wrongdoing. The practical reality is that demand futility is the norm in shareholder disputes involving closely held companies.

The prototypical fact pattern is a company with a majority / minority ownership structure. The majority owner is the sole director, president, treasurer and secretary of the company. The minority owner believes the majority owner is skimming from the company by having it pay him excessive compensation and his personal expenses. Notwithstanding the common-sense conclusion that the majority owner is unlikely to cause the company to hire an attorney to sue him or form a special committee to investigate his conduct, the BCL requires the minority owner to demand that he do just that. In fact, the BCL’s demand requirement appears to apply even when the board is deadlocked—which is common in closely held company litigation— and incapable of appointing a litigation committee.

Prior to the BCL’s 2016 amendments, Pennsylvania courts recognized that demand futility is common in closely held company disputes. The Superior Court put it bluntly: “[T]he demand requirement appears to be the very type of procedural rule that makes little sense in the context of a dispute between shareholders in a closely held corporation.” Hill v. Ofalt, 85 A.3d 540, 556 (Pa. Super. Ct. 2014)

A Trap for the Unwary

The 2016 amendments to the BCL leave no room for a futility exception. The Eastern District recently confirmed the same.

In Julabo USA, Inc. v. Juchheim, two brothers battled over how each of them ran their respective parts of the family business. One brother asserted a derivative claim against the other brother and an employee. The brothers each owned 50% of the company but the defendant brother served at the sole member of the board of directors, president, secretary and treasurer. The plaintiff brother did not make a demand prior to initiating the derivative action.

The Court, in what appears to be the first reported case on the issue, granted the defendant brother’s motion for summary judgment on that basis. In reaching its conclusion, the Court engaged in a plain-language reading of the BCL to conclude that it “does not include an exception [to the demand requirement] for closely-held corporations[;] And the Court has no basis to infer one.” The Court further rejected the plaintiff brother’s argument that pre-2016 cases, including Hill, predicted the Pennsylvania Supreme Court would adopt a futility exception as inconsistent with the 2016 amendments to the BCL. The Court ultimately concluded that the demand “requirements apply whether [a company] is a closely-held family business or a Fortune 500 company.”

Sidestepping the Trap

The demand requirement in the context of a closely held company dispute is the kind of procedural formality that keeps lawyers up at night. It is not intuitive and can have big consequences if ignored. Given that nearly all such demands will be ignored, the most efficient and safest way to comply with the requirement is to prepare a demand that references and attaches a copy of the complaint the derivative plaintiff intends to file.

When reading a recent New Jersey court’s opinion regarding an employee of an LLC claiming to have been given a share of ownership of the company by its sole owner, I couldn’t help but think of method acting – the technique in which “an actor aspires to encourage sincere and emotionally expressive performances by fully inhabiting the role of the character.” (Cite). Dustin Hoffman, Heath Ledger and Daniel Day-Lewis all used method acting to deliver outstanding performances. Although a putative LLC owner doesn’t need an agent, “fully inhabiting the role of” an LLC owner is a critical part of getting a court to recognize an ownership interest in the event of a dispute.

The murkiness of employees being offered ownership in the LLCs they work for

Before we look at that New Jersey case, let’s talk about LLC ownership for a moment.

It would probably not surprise you to learn that LLC ownership is not always cut and dry. I frequently receive calls from potential clients who claim they were promised equity in a company they have been working at, only to come to realize that the company did not and does not recognize their ownership interest.

(When I receive these calls, one of my first questions is, “Were you given a K-1 earlier this year?” As I have previously discussed, Schedule K-1s are helpful in identifying the owners of a business because entities taxed as partnerships or S-corporations must prepare a Schedule K-1 for each of their owners.)

Obviously, whether someone is an equity owner of an LLC is a big deal on its own in terms of compensation and power. But in the context of Pennsylvania business divorces and the litigation that often accompanies them, equity ownership of an LLC confers certain rights and privileges on owners that non-owners do not have. For example, LLC owners can file derivative claims against their LLC for breach of fiduciary duty. They can also demand the LLC’s books and records for inspection.

Things tend to get murky when employees of an LLC claim to have been given equity in the company. That’s because many employment arrangements have profit-sharing provisions that are designed to provide the benefits of ownership without actually giving an employee ownership. When you add in the fact that these relationships are not always well-documented or are captured in DIY-ed agreements penned (i.e. downloaded from the Internet) by business people, it is easy to see how confusion can reign.

Two guys, an email, and an unchanged LLC operating agreement

Interestingly, there have not been recent notable Pennsylvania court decisions on this issue. But thankfully, judges in the Commonwealth’s neighbor to the east recently decided a case that shows why supposed grants of LLC ownership to an employee can easily become murky.

In Funsch v. Procida Funding, LLC, et al., No A-3899-18T4 (N.J. Super. Ct. Dec. 3, 2020), Kyle Funsch sued his former boss Billy Procida, Billy’s real estate investment company, Procida Funding, LLC, and another employee, John Mullane. Billy was the sole member of Procida Funding.

At the heart of the case was what Kyle believed was an equity share of Procida Funding that he claims Billy promised him in May 2011 but never gave him by the time he left the company in December 2015.

A trial court ruled against Kyle in April 2019. According to the court, the evidence showed that he did not have and knew he never had an equity interest in Procida Funding. Kyle appealed the ruling to the New Jersey Superior Court.

As proof that he was given an equity share of Procida Funding, Kyle relied heavily on a May 2011 email from Billy to him and another employee (the other defendant, John Mullane) that said:

[Y]our work to date has been admirable and your skill sets improve daily. I am proud to work with you both (despite that I beat you to the office today) therefore I am making you partners. [T]he terms of which are as follows: for as long as you work here, you will each own and be entitled to 12.5% of the combined  companies [sic] net earnings. [Y]ou will receive a draw against those  earnings  .  .  net income will be calculated by all income less all expenses exclusive of interest income on my investments. [S]hould either of you leave the firm you will forfeit any rights to future earnings or ownership. [S]ince talk is cheap I wanted to put something in writing, so we can consider this legally binding. [A]s we’ve got many things to do save this email.

[I]f I die or become disabled it is my wish that you guys own 50% and send the balance to my kids. [Y]ou are now to refer to yourselves as my partners. [W]e will fine tune this over time. [W]e will do a press release to announce this shortly.

Seems like reasonably strong evidence of ownership. Kyle claimed further support for Billy giving him an ownership share by pointing to Procida Funding’s public announcements regarding his becoming a partner, as well as references to him being a partner on Procida Funding’s website, a private placement memorandum, in Billy’s emails to clients and to a Procida Funding attorney, and in a business magazine story.

Unfortunately for Kyle, both the trial court and the New Jersey Superior Court found what happened after the May 2011 email, or perhaps more accurately, what didn’t happen, to be more persuasive. The Superior Court affirmed the trial court’s ruling against him.

First and foremost, Billy provided Kyle with four proposed amendments to the Procida Funding LLC operating agreement. Kyle rejected each one. Had he signed one of them, the agreement would have admitted him as a member. According to both courts, this was an indication that Billy and Kyle never came to an agreement about Kyle becoming a co-owner of Procida Funding.

Second, the May 2011 email lacked “core, basic, and material terms” related to Kyle’s claimed co-ownership that would have been expected in a document admitting a new LLC member. The email did not address important co-owner responsibilities and obligations such as capital contributions and loss sharing. The May 2011 email was deemed by the trial court to be merely a notification to Kyle about his promotion and the new way his compensation would be calculated. According to the courts, further supporting the fact that the May 2011 email did not grant co-ownership to Kyle was an email Billy sent just two months later to Kyle and others outside of the company in which Billy stated he was the 100% owner of Procida Funding and referred to Kyle as a “cash flow partner.”

Third, Kyle testified that he was paid as a W-2 employee and did not receive any Schedule K-1s reflecting owner distributions.

Finally, both courts did not view Billy’s references to Kyle as a “partner” as an indication that Kyle was a co-owner. They relied on Billy’s testimony that he used “partner” imprecisely to give Kyle authority for negotiation purposes—not to confer LLC ownership on him.

As a result, Kyle was unable to use the court system to do what he could have done with a stroke of his own pen if he signed one of those four amendments to Procida Funding’s operating agreement: create an ownership interest for himself in Procida Funding.

Sign the darn papers, or at least, walk the walk

As the Funsch case shows, whether someone is an owner of an LLC is ultimately a question of contract law. When deciding a case involving an employee claiming to have been given an ownership interest in an LLC, the first place a court will look will be the LLC’s operating agreement. If it was amended to include the employee as an owner, and signed by the required parties, a court would almost certainly rule in favor of the employee because the signed agreement shows the parties had a “meeting of the minds” regarding the employee’s newfound ownership.

But what about when an LLC does not have an operating agreement? Pennsylvania, for one, does not require an LLC to have a written operating agreement in order for the LLC to be officially formed in the Commonwealth. (New Jersey also does not have such a requirement).

In those situations, any oral agreement regarding an employee supposedly being given an ownership interest, and the employee’s subsequent conduct after any agreement, will be closely examined. In the absence of an amended written operating agreement, a court is going to want to see whether the supposed new owner took on the responsibilities and obligations an owner would take on. In other words, did the new owner walk the walk?

If Billy Procida’s LLC was a Pennsylvania LLC without an operating agreement, and Kyle Funsch brought a similar case against Billy in a court that applied Pennsylvania law to the dispute, chances are good that Kyle would lose that case as well. He did not walk the walk.

According to the New Jersey Superior Court’s opinion, Kyle:

  • Received W-2s from Procida Funding and never any Schedule K-1s—which would have provided a record of his share of Procida Funding’s profits;
  • Never asked why he did not receive Schedule K-1s;
  • Never received membership certificates;
  • Never made capital contributions to the company;
  • Never shared in the company’s losses;
  • Never possessed any voting rights; and
  • Never managed the company.

In other words, he did not act like a co-owner of Procida Funding.

For Pennsylvania LLC owners and would-be owners alike, when a question arises over whether an employee was actually granted ownership of an LLC, Kyle Funsch’s failed legal campaign provides a clear takeaway.

If there are changes in the ownership of an LLC that has an operating agreement, the operating agreement should be amended to reflect the change and then signed by all of the LLC’s owners.

When an LLC has no such agreement, the would-be owner must show by their subsequent actions after supposedly being granted the ownership share that they walked in the shoes of an owner.

In other words, if they want to be treated like an LLC owner, they need to have acted like one.

I recently covered whether parties can be liable for a claim of aiding and abetting breach of fiduciary duty in Pennsylvania.

In that post, I explained the two different frameworks for these claims that have been established by Pennsylvania courts. Both contain a knowledge requirement. One framework requires “knowledge of the breach by the aider and abettor.” The other requires that the alleged aider and abettor “knows that the other’s conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other so to conduct himself.”

With knowledge of a breach of fiduciary duty such an important factor in aiding and abetting claims, when under Pennsylvania law will an alleged aider and abettor be deemed to know that the underlying breach was occurring?

When that party has actual knowledge of the breach.

Actual knowledge > Circumstantial evidence

When I discussed aiding and abetting breach of fiduciary duty claims in Pennsylvania, I noted that the first time an aiding and abetting claim in this context was recognized in Pennsylvania was by the Pennsylvania Superior Court in Potok v. Rebh, 2017 WL 1372754 (Pa. Super. Ct. Apr. 13, 2017). In that case, a minority shareholder claimed that the majority owners breached their fiduciary obligations to him by, among other things, improperly allocating the proceeds of the sale of the company’s assets. Specifically, the plaintiff alleged that those in control of the company sold the company’s assets to a third party and improperly allocated a significant portion of the purchase price as compensation to the majority shareholders for their non-competes.

In addition to initiating litigation against the majority owners, the minority shareholder sued the third-party purchaser of the company’s assets under the theory that the purchaser aided and abetted the majority’s breach of fiduciary duty. While the court recognized this cause of action, it upheld the trial court’s finding that the plaintiff failed to prove the claim.

One of the reasons the claim failed was because the plaintiff did not sufficiently show that the purchaser had actual knowledge of the breach. The plaintiff argued that circumstantial evidence, including the structure of the transaction which the plaintiff believed indicated self-dealing, supported “a compelling inference” that the third party knew the majority owners were breaching their fiduciary duty.

The Superior Court wasn’t buying it. It distinguished an “evidence-based inference” from “speculation and conjecture,” noting that the minority shareholder could not point to any evidence beyond his own speculation that the third-party purchaser actually knew of the breach. Given that the case at that point was past the discovery phase, simply claiming that the purchaser knew about the breach was not going to be enough. In order for his aiding and abetting claim to be successful, the minority shareholder had to come to the table with actual evidence obtained before or during discovery that showed the purchaser knew about the breach. In other words, as the kids say today, the plaintiff had to show receipts.

He could not. So his aiding and abetting claim failed.

Is Pennsylvania more demanding than Delaware about knowledge of a breach?

A Delaware Chancery Court decision from just last month suggests that the Pennsylvania Superior Court’s “actual knowledge” requirement is the standard approach courts take, especially when a third party is alleged to have aided and abetted a breach. But the Delaware decision also suggests Pennsylvania requires a higher showing of knowledge than Delaware does.

In Jacobs v. Meghji, 2020 WL 5951410 (Del. Ch. Oct. 8, 2020), a minority stockholder challenged a recapitalization that saw another minority shareholder partner with a company’s controlling stockholder on the capital infusion. The company, IEA, a publicly held infrastructure construction company, was facing a severe liquidity crisis and retained an investment bank to find additional investors.

Ultimately, IEA’s board selected an investor, Ares. Oaktree, IEA’s majority shareholder, made a corresponding investment as part of IEA’s deal with Ares.

The plaintiff, on behalf of himself and other IEA shareholders, sued a number of IEA board members and Oaktree over the transaction, alleging that the Ares/Oaktree investment was inferior to competing offers in part because that investment diluted IEA’s outstanding shares. The plaintiff and shareholders also sued Ares, claiming that it aided and abetted the IEA board members’ breach of fiduciary duty.

In a decision granting Ares’ motion to dismiss the claims against it, the Chancery Court held that the plaintiffs did not establish that Ares had actual knowledge of the board members’ alleged breaches. According to the court, under Delaware law, a plaintiff alleging a claim of aiding and abetting a breach of fiduciary duty must show that the aider and abettor had actual or constructive knowledge that their conduct was unlawful.

The Chancery Court looked for “specific facts” from which it could “reasonably infer” that Ares had knowledge of the board members’ alleged breach. It found none. No specific facts about Ares’ awareness of, or involvement in, decision making by IEA’s board or the investment bank. And no specific facts regarding Ares’ knowledge of flaws in, or control or influence over the IEA board’s Special Committee handling negotiations over the transaction.

As a backdoor approach to attempting to hold Ares liable for aiding and abetting the IEA board members’ alleged breach of fiduciary duty, the plaintiffs alleged that Ares had constructive knowledge of the breach because Ares had actual or constructive knowledge of Oaktree’s wrongdoing. The court was not persuaded. Neither the fact that the IEA board member negotiating with Ares had a connection to an Ares principal, nor the fact that Ares was involved in a transaction with Oaktree which Ares knew to be the controlling shareholder of IEA, nor the fact that the transaction included terms that were not “commercially typical,” supported an inference that Ares constructively knew that IEA board members were allegedly breaching their fiduciary duties. As with their actual knowledge argument, the plaintiffs’ constructive knowledge argument was a loser.

It is important to note here that the Chancery Court’s acceptance of either actual or constructive knowledge as satisfying the “knowledge” element of an aiding and abetting claim is a different approach than that taken by Pennsylvania courts. According to the Pennsylvania Superior Court’s decision in Potok, constructive knowledge is not enough to show knowledge of a breach. Potok only spoke of actual knowledge. In fact, the word “constructive” does not appear once in the Potok decision. For this reason, it appears parties in Delaware will have an easier time alleging or proving knowledge because Delaware allows for constructive knowledge.

(In case you are at a loss for what “constructive” means, a well-known legal dictionary defines it in this context as “legally imputed; existing by virtue of legal fiction though not existing in fact.”)

A little (actual) knowledge goes a long way

 When shareholders of a Pennsylvania corporation claim a third party has aided and abetted a breach of fiduciary duty, those shareholders must prove that the third party had actual knowledge of the breach. Circumstantial evidence will not cut it.

While this requirement is not unusual, it appears that for the time being in Pennsylvania actual knowledge is the only knowledge a court will accept. Unlike in Delaware where constructive knowledge is acceptable, Pennsylvania courts will deem an alleged aider and abettor to have the requisite knowledge of a breach only when plaintiffs allege (early in a case) or prove (later in a case) that the alleged aider and abettor actually knew that a breach of fiduciary duty was occurring.

The American Law Institute recently announced its plans to draft a Restatement of the Law of Corporate Governance. (https://www.ali.org/projects/show/corporate-governance/#_participants). This is ALI’s second attempt at such a restatement.

Stephen Bainbridge, a professor at the UCLA School of Law and a widely respected voice on corporate governance, pejoratively describes the first effort in the early 1990s as legislative sausage making, marked by pointed conflict among academics and practitioners. (https://www.professorbainbridge.com/professorbainbridgecom/2020/10/the-american-law-institute-is-going-to-try-writing-a-restatement-of-corporate-governance-again-oh-jo.html). Ultimately, the restatement the ALI set out to draft was downgraded to The Principles of Corporate Governance: Analysis and Recommendations, (1994) (“ALI Principles”).

Much ink has been spilled regarding the ALI Principles, their creation, and their influence on corporate governance. Much of it critical. I have never had particularly strong feelings about the ALI Principles themselves, but their application in Pennsylvania to cases dealing with closely-held companies has been, at best, unhelpful.

Although our Supreme Court gave them a hearty endorsement shortly after their creation, most Pennsylvania courts (including that same Supreme Court) since then have found them to be inconsistent with Pennsylvania law. This ambiguity enhances the possibility of procedural quagmires and litigation sideshows that can be the hallmarks of contentious business divorces.

The genesis of the problem stems from the Supreme Court’s 1997 decision in Cuker v. Mikalauskas (692 A.2d 1042). Cuker involved a derivative claim initiated by shareholders of a public company. Consistent with the law in many other states, the Supreme Court held that the business judgment rule applies to disinterested directors’ decisions to terminate derivative litigation.

(The business judgment rule, as a refresher, is the well-accepted legal presumption that the directors of a corporation, when making business decisions that do not involve self-dealing or self-interest, act in good faith, are informed about those decisions, and believe that their actions are in the best interests of the corporation.)

In reaching its decision, the Court expressly adopted various sections of the ALI Principles to provide “specific guidance” to lower courts on how to manage derivative litigation. It was complimentary of ALI scholarship, characterizing it as “consistently reliable and useful”, and the Principles as “generally consistent with Pennsylvania precedent.” In a footnote, it further encouraged lower courts to utilize the Principles:

The entire [Principles] publication, all seven parts, is a comprehensive, cohesive work more than a decade in preparation. Additional sections of the publication, particularly procedural ones due to their interlocking character, may be adopted in the future. Issues in future cases or, perhaps, further proceedings in this case might implicate additional sections of the ALI Principles. Courts of the Commonwealth are free to consider other parts of the work and utilize them if they are helpful and appear to be consistent with Pennsylvania law.

Cuker, 692 A.2d at 1049 n.5.

Given the Supreme Court’s resounding endorsement and holding that they are generally consistent with Pennsylvania precedent, the ALI principles would appear to be a helpful roadmap through Pennsylvania’s underdeveloped corporate jurisprudence.

But as I mentioned above, most courts since Cuker, including the Supreme Court itself, that have addressed the ALI Principles have rejected them as inconsistent with Pennsylvania law. See e.g. Hill v. Ofalt, 85 A.3d 540, 556 (Pa. Super. Ct. 2014) (“We believe that our Supreme Court might adopt the more procedural aspects of Section 7.01(d) [of the Principles] … Yet, we conclude that our Supreme Court would not adopt the substantive aspects of Section 7.01(d)”); Pittsburgh History & Landmarks Found. v. Ziegler, 200 A.3d 58, 78 (Pa. 2019) (“[W]e conclude that this Court’s adoption in Cuker of Section 7.13 does not equate to an adoption of the Garner test, which we consider and ultimately reject in the next sections of this opinion.”).

The result is the legal equivalent of scrapple (for those not from Pennsylvania, this will help you digest the metaphor: https://en.wikipedia.org/wiki/Scrapple)—likely to lead to procedural wrangling and litigation sideshows that make it frustrating for counsel plotting a course though business divorce litigation.

Whether the next ALI effort ultimately clarifies the law in Pennsylvania or adds to the confusion remains to be seen.

In Pennsylvania, can you be liable for someone else’s breach of their fiduciary duty to a co-owner of a closely held business if you knew about the breach, were somehow involved with it, and assisted or encouraged that person’s breach?

Section 876 of the Restatement (Second) of Torts addresses the civil tort (but not the criminal act) of “aiding and abetting.” The Pennsylvania Supreme Court has never expressly adopted the tort, but both the Pennsylvania Superior Court and Commonwealth Court have recognized it in various contexts, including encouraging drunk driving, marketing a defective product, and encouraging horseplay.

Historically, the tort of aiding and abetting has not been applied in Pennsylvania to cases involving a breach of fiduciary duties associated with closely held businesses.

But that changed in 2017.

In the unreported decision of Potok v. Rebh, 2017 WL 1372754 (Pa. Super. Ct. Apr. 13, 2017), a minority shareholder claimed that the majority owners breached their fiduciary obligations to him by, among other things, improperly allocating the proceeds of the sale of the company’s assets. Specifically, the plaintiff alleged that those in control of the company sold the company’s assets to a third party and improperly allocated a significant portion of the purchase price as compensation to the majority shareholders for their non-competes.

In addition to initiating litigation against the majority owners, the minority shareholder sued the third-party purchaser of the company’s assets under that theory that the purchaser aided and abetted the majority’s breach of fiduciary duty. The Superior Court recognized the cause of action, albeit while affirming the trial court’s finding that the plaintiff failed to prove the claim. Although the court referenced Section 876 of the Restatement, its formulation of the elements of a claim for aiding and abetting in this context deviated slightly from the Restatement version:

In order to establish … liability for aiding and abetting the … breach of fiduciary duty, [a plaintiff is] required to prove the following: (1) a breach of a fiduciary duty owed to another; (2) knowledge of the breach by the aider and abettor; and (3) substantial assistance or encouragement by the aider and abettor in effecting that breach.

Potok, 2017 WL 1372754, at *4.

The Superior Court further solidified the tort of aiding and abetting breaches of fiduciary duties in closely held businesses in its reported decision in Lind v. Lind, 220 A.3d 1119 (Pa. Super. Ct. 2019).

Lind involved a family business dispute where the majority owner froze out a minority sibling owner from the company. In addition to bringing claims against the majority owner, the minority owner asserted aiding and abetting claims against six key employees of the company that the majority owner had placed on the company’s board of directors. Although the six employees each owned a small percentage of the company, they did not collectively posses a majority interest. Thus, they could not owe the same kind of fiduciary duty to the minority sibling as the majority owner did.

The court evaluated the minority owner’s claim pursuant to the Section 876 framework:

For harm resulting to a third person from the tortious conduct of another, one is subject to liability if he:

(a) does a tortious act in concert with the other or pursuant to a common design with him, or

(b) knows that the other’s conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other so to conduct himself, or

(c) gives substantial assistance to the other in accomplishing a tortious result and his own conduct, separately considered, constitutes a breach of duty to the third person.

Linde v. Linde, 220 A.3d 1119, 1145 (Pa. Super. Ct. 2019) (quoting Restatement (Second) of Torts § 876). The Superior Court affirmed the trial court’s finding that the six key employees were liable for aiding and abetting a breach of fiduciary duty when they removed the minority shareholder from her corporate officer positions. This appears to be the first time that the Superior Court recognized the tort in a reported decision and affirmed liability against a party for violating it.

These developments are important for owners of closely held businesses in Pennsylvania. The existence of the tort of aiding and abetting breach of fiduciary duty, and its application to shareholder disputes, creates a panoply of issues that have yet to be addressed by Pennsylvania courts.

Most significantly, the availability of the tort allows minority owners the ability to reach a variety of deep-pocket parties that would otherwise be protected by multi-level corporate structures. As a result, majority owners will have to contend with an erosion of the protection that thoughtful corporate structuring might otherwise provide against breach of fiduciary claims.

(I recently scratched the surface of this issue here:  https://www.pabusinessdivorceblog.com/2020/10/getting-your-hands-around-a-just-out-of-reach-structure/).

The application of the tort also impacts how in Pennsylvania—if at all—the business judgment rule applies to individuals alleged to have aided and abetted a breach of fiduciary duty. (The business judgment rule is the presumption that directors act in good faith when making business decisions that do not involve their self-interests or self-dealing.)

It is further unclear whether all corporate fiduciary duties can support an aiding and abetting claim. For example, the minority shareholders in Potok and Lind sought to hold their defendants responsible for the breach of the duty of loyalty and majority-minority duty of fair treatment. There does not yet appear to be any cases addressing whether the tort could be applied to a breach of the duty of care.

Assuming the tort of aiding and abetting a breach of fiduciary duty continues to be recognized by Pennsylvania courts, its mere existence is likely to make business divorce litigation in the Commonwealth much more interesting.

When two or more people become owners of a limited liability company and embody their relationship in an operating agreement, they usually see sunshine and rainbows in their future. They have an idea, they have a corporate structure, and they have each other.

But there comes a point in the life of many a multi-member LLC where that sunshine and those rainbows from the early days turn into a large stop sign. Disagreements about some aspect of the LLC’s operations or a personal conflict sometime lead to deadlock and an inability to operate the LLC together—and consistent with their operating agreement. As a result, at least one of the owners wants to end the relationship.

A well-crafted operating agreement will provide provisions that allow co-owners to resolve disputes without invoking the nuclear option of dissolving the entity. These dispute resolution devices often come in the form of call and put options triggered by a variety of events. Delaware LLC law is protective of the parties’ buy-out provisions by allowing waiver of the right to “judicial dissolution,” which is a fancy way of saying a court-ordered dissolution of an LLC. The Pennsylvania LLC statute, however, prohibits waiver of the right to judicial dissolution, creating a potential end run around bargained-for buy-out provisions contained in the operating agreement.

Judicial dissolution of an LLC

 When the owners of an LLC dissolve it, they terminate its operations, pay off its debts, and fairly distribute whatever is left among themselves. Once the dissolution process plays out, the LLC ceases to exist.

Many LLC owners dissolve their corporate entities without having to step foot in court. But the Pennsylvania LLC statute allows for judicial dissolution of an LLC when it is “not reasonably practicable” to continue operating the company in accordance with the original certificate of organization and operating agreement. The Delaware LLC statute provides for judicial dissolutions in a similar way.

Pennsylvania’s LLC statute expressly prohibits waivers of judicial dissolution in an LLC operating agreement (Pa. C.S.A. § 8815(c)(15)). In other words, Pennsylvania LLC owners cannot take judicial dissolution off the table when describing in their operating agreements the circumstances in which their LLCs can be dissolved. This means that in Pennsylvania, LLC owners always have a judicial dissolution option when they no longer see eye-to-eye with their co-owners.

Things are different a few miles south on I-95. Unlike Pennsylvania, Delaware allows LLC owners to agree to waive the right to judicial dissolution in their operating agreements. Thus, Delaware LLC owners can explicitly state in their operating agreements that the LLC cannot be dissolved through a court proceeding.

In Delaware, no (judicial dissolution) means no (judicial dissolution)

A 2013 case in the Delaware Chancery Court, Huatuco v. Satellite Healthcare, 2013 WL 6460898 (Del. Ch. Dec. 9, 2013), aff’d, 93 A.3d 654 (Del. 2014), illustrates the Chancery Court’s unwillingness to rewrite the language of an LLC operating agreement to allow judicial dissolution when the parties, through that language, appeared to have waived their rights to it.

Despite the plaintiff in the case appearing to have a solid argument that the defendant breached their LLC agreement (giving him a contractual right under the agreement to purchase the defendant’s interest in the company), he instead filed a complaint with the court seeking judicial dissolution.

The court, relying on the following language of the LLC agreement, held that the plaintiff waived his right to a judicial dissolution:

“Except as otherwise required by applicable law, the Members shall only have the power to exercise any and all rights expressly granted to the Members pursuant to the terms of this Agreement.”

Not only was this provision silent as to the parties’ ability to seek judicial dissolution, the court noted that the parties considered and addressed dissolution rights in other sections of the LLC agreement but did not mention judicial dissolution as an option.

Looking at the LLC agreement as a whole, the court found that the agreement contained other provisions, including cross-purchase provisions, that allowed the plaintiff to terminate his business relationship with his co-owner without judicial dissolution. Ultimately, the court respected the parties’ bargained-for contractual language and was unwilling to read the terms of the LLC agreement to allow for a judicial dissolution option when none was suggested by the parties.

In Pennsylvania, it is not possible to waive judicial dissolution

 Given the difference between the Pennsylvania and Delaware LLC statutes, if the parties in the Huatuco case were co-owners of a Pennsylvania LLC, we might be looking at a different outcome.

It is likely that the judge in the case would have found the language of the LLC agreement I highlighted above to be an invalid waiver of the right to judicial dissolution. As a result, the plaintiff would have been able to seek judicial dissolution and potentially avoid the agreed-upon provisions in the LLC agreement that provided ways for him to terminate his business relationship with his co-owner other than through judicial dissolution.

This alternative ending can be problematic because it negates the purpose of including buy-out provisions in the operating agreement—to avoid dissolving a viable business.

But is Pennsylvania that disrespectful of bargained-for buy-out provisions? Is Delaware that rigid?

If a party can seek judicial dissolution in Pennsylvania notwithstanding buy-out provisions in the operating agreement, why bother including them?

In practice, Pennsylvania courts are loath to dissolve a viable company and try to avoid doing so. The existence of buy-out provisions in an operating agreement offer courts an avenue to avoid dissolution. For example, a court might determine that it is “reasonably practicable” for deadlocked owners to operate a company in accordance with its operating agreement when that operating agreement contains buy-out provisions. See e.g., Potter v. Brown, 195 A. 901, 903–04 (Pa. 1938); Staiger v. Holohan, A.3d 622, 624 (Pa. Super. Ct. 2014) (applying Potter to dissolution pursuant to 15 Pa.C.S.A. § 8871 (A)(4)(ii) and concluding that “[t]he partnership [in Potter] was operating according to the agreed-upon terms, and, thus, dissolution was not warranted.”).

Delaware’s statute appears to create the possibility of locking feuding members in perpetual combat if the operating agreement waives judicial dissolution but provides no buy-out provisions. The court in Huatuco left open the possibility that it could judicially dissolve an LLC over a waiver if the operating agreement failed to provide any alternative to leaving members “locked away together forever like some alternative entity version of Sartre’s Huis Clos.” (https://en.wikipedia.org/wiki/No_Exit) Huatuco, 2013 WL 6460898, at *1, n. 2.

The Takeaway: Non-Judicial Dispute Resolution Provision Remain the First and Best Way to Avoid Judicial Dissolution

The ultimate takeaway here is the most obvious. Robust buy-out provisions in an operating agreement are the best way to avoid the nuclear option of judicial dissolution. Consistent with Delaware’s general preference to honor the agreements of the parties, its LLC statute and courts expressly permit the wavier of judicial dissolution. Even in Pennsylvania, most courts would prefer to avoid judicial dissolution if possible. Well-crafted buy-out provisions give them a viable way to do so.

Many transactional attorneys view the fiduciary duties that flow from those in control of a company—officers, directors, managers, general partners and majority shareholders—to those not in control to be a nuisance because of the uncertainty they introduce into corporate transactions. To these attorneys, those duties are particularly problematic in the context of limited liability companies, limited liability partnerships and similar non-corporate entities because their contours are less defined than in a traditional corporation.

This uncertainty around fiduciary duties in non-corporate entities is where transactional lawyers who represent controlling owners tend to square off with litigators who represent minority owners. Transactional lawyers develop and refine corporate structures that allow their controlling clients to run businesses without liability to minority owners. Litigators look for ways to charge those in control of the entity with breach of fiduciary duty when they perceive self-dealing or mismanagement.

The practical implications of this conflict are particularly felt in the context of closely-held entities, where the existence of a fiduciary duty owed by a “deep-pocket” party can mean significant individual liability for a defendant and the difference between a successful outcome or a worthless judgment for a plaintiff.

Just-Out-Of-Reach Structures

A “just-out-of-reach” corporate structure attempts to place deep-pocket individuals and companies in a position where they can control an entity without owing any fiduciary duty to non-controlling owners of the entity. For example, assume Widget LLC is a manager-managed company. The relevant statute imposes various fiduciary duties on the manager of Widget LLC. If the manager of Widget LLC were an individual, the minority owners of Widget LLC could assert a derivative claim and recover from the individual’s assets. A just-out-of-reach structure adds an additional corporate layer to prevent the individual manager from owing any duty to Widget LLC. Under such approach, the manager would be another entity—Widget Manager LLC—wholly owned by the individual. Widget Manager LLC owes a statutorily imposed duty to Widget LLC but the individual only owes a duty to Widget Manager LLC. The individual still controls the operations of Widget LLC because he or she controls Widget Manager but owes no statutorily imposed duty to Widget LLC. If the owners of Widget LLC successfully assert a derivative claim against Widget Manager, they are likely to have an uncollectable judgment. The bad actor here—the individual behind Widget Manger—is just out of reach of plaintiffs’ claims. This concept can be used with any entity that does not require that those in control of the entity be individuals.

It is easy to see the implications of a structure that allows individuals to operate a business to the detriment of its owners without consequence. Conversely, such a structure does nothing more than use the benefit of the corporate veil created by legislatures and regularly enforced by courts. For decades, Delaware courts have partially resolved this tension in favor of the out-of-control party. Pennsylvania’s jurisprudence is less clear but potentially even broader.

Delaware’s Approach: In re USACafes

The Chancery Court’s decision In re USACafes LP. Lit. establishes that the fiduciaries of fiduciaries can be held responsible for certain breaches of fiduciary duty. 600 A.2d 43 (Del. Ch. 1991). USACafes was a limited partnership with a corporation acting as its general partner. Plaintiffs were a class of the limited partners of USACafes and the defendants were, among others, the owners and directors of the corporate general partner. Plaintiffs alleged that these defendants engaged in self-dealing by selling the assets of USACafe to a third party at an artificially low price in exchange for payments to themselves. The owner and director defendants moved to dismiss, arguing that they owed no duty to USACafes. The court, relying on general principles of fiduciary law, rejected the argument. It reasoned that “the principle of fiduciary duty, stated most generally, [is] that one who controls property of another may not, without implied or express agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the property or its beneficial owner.” Delaware courts have extended the USACafes framework to other non-corporation entities, such as limited liability companies and statutory trusts.

Although the USACafes court recognized that the owners and officers of a corporate general partner owe a fiduciary duty to the partnership, it limited its holding to the fiduciary duty of loyalty and did not address the existence of a duty of care under such circumstances. Subsequent decisions from the Chancery Court have declined to extend USACafes beyond the duty of loyalty to the duty of care. See e.g., Feeley v. NHAOCG, LLC, 62 A.3d 649, 671–72 (Del. Ch. 2012); Bay Ctr. Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451, at *10 (Del. Ch. Apr. 20, 2009).

Pennsylvania’s Approach: Aiding and Abetting

Although Pennsylvania courts do not appear to have directly addressed the fiduciary obligations of the owners and directors of a corporate fiduciaryboth the Superior Court and Commonwealth Court recognize a cause of action for aiding and abetting in the breach of fiduciary duty. To establish liability for aiding and abetting breach of fiduciary duty, a plaintiff must show “(1) a breach of a fiduciary duty owed to another; (2) knowledge of the breach by the aider and abettor; and (3) substantial assistance or encouragement by the aider and abettor in effecting that breach.” Potok v. Rebh, 2017 WL 1372754, at *4 (Pa. Super. Ct. Apr. 13, 2017); see also Koken v. Steinberg, 825 A.2d 723, 732 (Pa. Comwlth. Ct. 2003). Unlike the Chancery Court’s analogy to the general law of fiduciaries, the Pennsylvania cause of action sounds in the tort of aiding and abetting. Koken, 825 A.2d at 732 (citing Restatement (Second) of Torts § 876).

Pennsylvania courts do not appear to have yet applied the aiding and abetting cause of action in the context of a just-out-of-reach structure. Notwithstanding, such a claim appears to offer a strong basis to access liability against just-out-of-reach defendants. If a corporate fiduciary breached its obligations to a company, the controlling owners of a corporate fiduciary would certainly be aware of the breach and provide substantial assistance in effecting it. Indeed, the breach would have resulted from their decisions and actions taken through the corporate fiduciary.

The Takeaway

Both the Delaware and Pennsylvania approaches to just-out-of-reach corporate structures may be a significant departure from the expectation that the corporate veil prevents individual liability in most circumstances. Corporate counsel advising closely held businesses should consider the inclusion of robust indemnification provisions in the company’s organizational documents and the recommendation to purchase directors and officer’s insurance rather than attempting to rely exclusively on a just-out-of-reach structure.

Litigators should carefully evaluate the possibility of including the individuals behind a just-out-of-reach structure to reduce the risk of obtaining an uncollectable judgment. Even in Pennsylvania, where the duties of a fiduciary’s fiduciary are not as well defined as under Delaware law, the existence of the aiding and abetting cause of action justifies the inclusion of a larger cadre of potential defendants.

 

Reprinted with permission from the September 25, 2020 issue of The Legal Intelligencer. © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.