Eastland Redux: Do Close Corporation Shareholders Have a Direct Claim Against Directors For Taking Disguised Distributions?
September 11, 2023
Earlier this year, using as a springboard the Maryland intermediate appellate court’s decision in Eastland Food Corp. v Mekhaya, I posted about a topic on which there’s little or no New York law, viz., whether a complaint for minority shareholder oppression stated a valid claim centered on allegations that the directors/majority shareholders, instead of declaring profit distributions for all shareholders, were taking disguised distributions in the form of excessive compensation and year-end bonuses.
The appellate court answered the question in the affirmative. The plaintiff, a frozen-out 28% shareholder of a family-owned business founded by his father, also won on appeal reinstatement of his complaint’s direct claims for breach of fiduciary duty and unjust enrichment.
The defendants appealed to the Maryland Supreme Court. Last month, that court handed down a 35-page majority opinion affirming the lower appellate court’s decision upholding the oppression claim, but dismissing the claims for fiduciary breach and unjust enrichment.
Two of the court’s seven Justices, including its Chief Justice, concurred in a 50-page opinion in which they agreed with the outcome on all three counts, but disagreed with the majority’s analysis of the fiduciary breach claim, contending that the law supports a direct claim against directors for paying themselves disguised distributions, and inviting the plaintiff to pursue the claim upon remand by seeking remedies other than money damages.
Both Opinions Uphold the Oppression Claim
The majority and concurring opinions, while offering greater detail and depth of analysis (especially the concurring opinion which reads as if intended to serve as the court’s opinion), essentially mirror the intermediate appellate court’s reasoning in upholding the oppression claim. All three opinions conclude that the plaintiff’s allegations,
that he gave up his existing career and joined the family business with the expectation of continuous employment, a voice in management, and a share of the profits;
that before his ouster as director, officer, and employee, he and the other shareholders received year-end bonuses in lieu of profit distributions;
that shortly before his ouster they discussed undertaking a “dividend study” to consider shareholders getting dividends based on ownership instead of receiving salaries “as if they were dividends”;
and that after his ouster, the remaining directors abandoned the idea and, in ensuing years, drew excessive compensation and diverted corporate funds for personal use to reduce the company’s profits while refusing to pay dividends,
met the reasonable expectations test for pleading a claim of minority shareholder oppression under Maryland statutory and case law providing for a judicial dissolution remedy as well as other equitable remedies short of dissolution.
Since the Supreme Court’s two opinions broke no significant new ground concerning the oppression claim vis-à-vis the prior appellate ruling that I posted about previously, in this post I’m going to focus instead on the more interesting clash of the majority and concurring opinions over the plaintiff’s direct claim for breach of fiduciary duty.
The Breach of Fiduciary Duty Claim
The plaintiff alleged that after his removal as a director, officer, and highly paid employee (his employment was at-will), the directors (two of the three being his brother and mother):
authorized the company to pay excessively high salaries and other compensation to his brother and mother to divert company profits from plaintiff;
authorized company profits to be paid to his brother and mother without payment of profits to plaintiff;
did not act in good faith nor in a manner reasonably believed to be in the best interests of the company, nor with the care that an ordinarily prudent person in a like position would use under similar circumstances.
The plaintiff sought only compensatory damages in an amount to be determined at trial.
The Majority Opinion
The majority opinion addressed two separate arguments raised by the defendants for dismissal of the fiduciary breach claim.
The first argument, which the majority rejected, is that the business judgment rule bars judicial scrutiny of the board’s discretionary authority to declare dividends. The majority held that plaintiff’s allegations that the directors permitted his brother and mother to “loot” the company by taking corporate funds for personal use and taking profits through excessive compensation overcame the business judgment rule’s presumptive shield at the pleading stage.
The second argument, which the majority accepted, was that familiar bane of minority shareholder lawsuits: the direct vs. derivative claim distinction. The majority held that the complaint failed to state a viable direct claim for breach of fiduciary duty for compensatory damages for the alleged excessive payments to his family members (in the form of “compensation or otherwise”) because:
any injury flowing from such payments was sustained by the company, not the plaintiff, and
any claim for a share of the profits would be against the company “as the party statutorily responsible for making that payment,” i.e., not against the directors who authorized and/or took the payments.
In short, the majority wrote, “[c]laims for excessive compensation and other misuses or diversions of corporate funds belong to the corporation, not the stockholders.” Therefore, because the plaintiff “did not have a viable claim for compensatory damages and did not pursue [his claim for breach of fiduciary duty] as a derivative claim on Eastland’s behalf, the circuit court correctly dismissed [the claim] with prejudice and without leave to amend.”
The Concurring Opinion
The concurring opinion prefaces its analysis of the fiduciary breach claim with a lengthy explication of the statutory framework and interpretive case law under the Maryland General Corporation Law. As concerns the fiduciary breach claim, the opinion focuses on the MGCL’s provision establishing the director’s standard of conduct for corporate acts which, as amended in 2016, is expressly made “the sole source of duties of a director to the corporation or the stockholders” and “[a]pplies to any act of a director . . ..”
The standard of conduct provided in the statute is what you would expect: the director must act in good faith, in a manner the director believes to be in the best interest of the corporation and with the care that an ordinary prudent person in a like position would use under similar circumstances. (All in all, not materially different from the duties of directors set forth in Section 717(a) of New York’s Business Corporation Law. One can also find New York case law for the proposition that directors of New York corporations owe fiduciary duties to both the corporation and its shareholders.)
The concurring opinion agrees with the majority that the complaint’s allegations concerning excessive compensation and withheld distributions overcome the presumption of the business judgment rule. It also agrees with the second part of the majority’s analysis, requiring dismissal of plaintiff’s fiduciary breach claim since it only sought compensatory damages and was not advanced derivatively.
So where does the concurring opinion depart from the majority, you rightly ask? Essentially, it boils down to two intertwined questions:
Does the complaint allege an injury to the plaintiff from the alleged improper payments distinct from any injury to the company ?
If so, is there a remedy available to the plaintiff other than compensatory damages?
The concurring opinion answers both questions in the affirmative.
As to the first question, it concludes that the plaintiff’s allegations, if true, “are sufficient to establish that the directors are paying Eastland’s profits in a manner that does not treat all shareholders equally and in furtherance of two director/stockholders’ personal interest or benefit” and, the opinion goes on,
that [the plaintiff] has alleged that he has suffered a distinct injury separate and apart from any injury suffered by Eastland. In other words, the directors’ decision to pay Eastland’s profits to its stockholders (other than to [plaintiff]) as bonus payments instead of in the form of distributions, is causing a separate and distinct injury to [plaintiff]. That is, unlike the other Eastland stockholders, [plaintiff] is not receiving Eastland’s profits, and is therefore not being treated equally as far as the receipt of corporation profits.
Stated otherwise, the concurring opinion contends that the plaintiff has standing to assert a direct claim for breach of fiduciary duty arising from the majority shareholders/directors’ excessive compensation in lieu of dividend payments to all the shareholders.
As to the related question of remedy — arguably the more pronounced point of departure from the majority opinion — the concurring opinion offers a two-step analysis. First, it cites Maryland case law for the general proposition that the remedy for breach of fiduciary duty depends on “the type of fiduciary relationship and the historical remedies provided by law for the specific type of fiduciary relationship and specific breach in question, and may arise under a statute, common law, or contract.”
Second, it points to the equitable remedies short of dissolution sought by the complaint’s statutory claim for shareholder oppression,
in the nature of the continued payment of corporate profits that he alleges he historically received while a stockholder/employee, which are personal to him as a stockholder, and not Eastland, as a corporation. . . . [W]here the stockholder can establish a direct claim through a distinct personal harm, . . . I would look to traditional remedies historically provided for this type of injury, which a trial court could then apply on a case-by-case basis.
In other words, the concurring opinion not only draws an equivalency between the “type of injury” plaintiff alleges in both his oppression claim and his fiduciary breach claim, it also fills the trial court’s remedial toolbox for the latter claim with the full panoply of equitable remedies (short of judicial dissolution) available for the former claim. That non-exclusive, hefty list of equitable remedies endorsed by the Maryland Supreme Court in its 2015 Bontempo decision that I wrote about here, which it borrowed from the oft-cited Oregon Supreme Court’s 1973 opinion in Baker v Commercial Body Builders, Inc., includes in parts relevant to the allegations in Eastland:
an injunction prohibiting continuing acts of oppressive conduct, including reduction of salaries and bonus payments found to be unjustified or excessive;
requiring declaration of a dividend or a reduction and distribution of capital; and
ordering an accounting by the majority in control of the corporation for funds alleged to have been misappropriated.
The concurring opinion added to the list its own suggestion, that to the extent the plaintiff “claims that the directors diverted to themselves profits to which he was entitled, he may be able to establish that he is entitled to the equitable remedy of disgorgement.”
Where does that leave the plaintiff? As the concurring opinion’s author would have it, and “[g]iven that this case is the Court’s first opportunity to consider a stockholder’s direct claim for a violation of the directors’ statutory standard of conduct,” on remand, “if the [plaintiff] seeks leave to amend his prayers for relief on [his claim for breach of fiduciary duty], the court may consider such a request in its discretion.”
Some Closing Thoughts
If, as the concurring opinion posits, the equitable remedies available to the plaintiff in Eastland for a direct claim for breach of fiduciary are coextensive with those available to plaintiff for his oppression claim, and given that (a) the factual allegations underlying both claims are essentially the same and (b) the plaintiff’s burden to establish oppression arguably is lighter than proving breach of fiduciary duty by the directors, does the debate between the majority and concurring opinions have any practical effect if and when the case goes to trial on the oppression claim alone?
The majority opinion’s decretal provision directs dismissal of plaintiff’s claim for breach of fiduciary duty “with prejudice and without leave to amend” which seemingly pulls the rug out from under the concurring opinion’s invitation to the plaintiff on remand to move for leave to amend the claim to seek different relief.
The plaintiff’s complaint in Eastland apparently does not seek a compulsory buyout nor did the defendants elect to purchase the plaintiff’s shares for fair value. Were the court to compel a fair value buyout, presumably the plaintiff could obtain full relief by means of his business appraiser’s adjustment of Eastland’s historical financials and projected net income to enhance its equity value by normalizing any excessive compensation to the defendants and by taking into account any other impact on value from the alleged disguised distributions and “looting.”
The fact pattern in Eastland is a common one. As discussed in my prior post on the case, for various reasons including tax planning, many closely held companies distribute excess cash to their shareholder/employees as compensation rather than declaring dividends — especially C corporations where dividends effectively are subject to double taxation. The lengthy, scholarly, well-reasoned opinions in Eastland are highly recommended reading for business divorce practitioners everywhere.