N.C. Supreme Court Holds that Dilution of Shareholders’ Voting Power is an Injury Giving Standing to Sue, but Leaves Open Whether a Minority Shareholder Exercising Actual Control Owes Fiduciary Duties to other Shareholders.


In December 2018, the Supreme Court of North Carolina decided the appeal of Corwin v. British Am. Tobacco PLC in 4-3 decision by Chief Justice Martin, joined by Justices Newby, Ervin, and Jackson.  See 2018 WL 6437701, 821 S.E.2d 729, 730 (N.C. Dec. 7, 2018), reh’g denied, 822 S.E.2d 648 (N.C. 2019).

The matter arose from a shareholder dispute concerning Reynolds American, Inc.’s agreement to purchase Lorillard, Inc.

Defendant British American Tobacco, PLC (BAT) owned 42% of the stock of Reynolds and agreed to fund part of the Lorillard transaction by purchasing enough of the newly acquired shares to maintain that 42% ownership interest.  The terms of this agreement diluted the voting power of Reynolds’ other minority shareholders, including plaintiff [who] filed a putative class action suit on behalf of similarly situated stockholders asserting a claim for breach of fiduciary duty against, among others, BAT.

Corwin, at *1.

The Business Court had dismissed the case on Defendants’ Rule 12 motions.  The Court of Appeals reversed.  After taking the case on discretionary review, the Supreme Court reversed the Court of Appeals.

The case presented issues of first impression in North Carolina: (1) whether the dilution of shareholders’ voting power is a distinct injury to allow a direct claim by minority shareholders against another minority shareholder; (2) whether a minority shareholder who exercises actual control of the corporation owes a fiduciary duty to other minority shareholders; and (3) whether the plaintiff adequately allege control by a minority shareholder in this case.

The Supreme Court responded: (1) Yes; (2) definitely Maybe; and (3) No.

Shareholder had Standing to Bring a Direct Claim Against BAT

The Defendants argued that the action was derivative and, therefore, required a pre-suit demand on the corporation.  Since Plaintiff had not made a demand prior to suing, Defendants contended that dismissal was mandated.

The Court cited the general rule that shareholders “may not bring individual actions to recover … their share of the damages suffered by a corporation.” 2018 WL 6437701, at *4 (citing Green v. Freeman, 367 N.C. 136, 142 (2013)).  But, it noted the two familiar exceptions: when the wrongdoer owes the shareholder a special duty, and when the shareholder suffers a personal injury that is “distinct” from the corporation.  Id.

The Court looked to the Delaware for guidance on what makes an injury “distinct.”  The Delaware Court of Chancery has recognized that a shareholder’s claim for voting power dilution is distinct from the corporation “where a significant stockholder’s interest is increased at the sole expense of the minority.” Id. at *5 (citing In re J.P. Morgan Chase & Co. S’holder Litig., 906 A.2d 808, 818 (Del. Ch. 2005). That test was apt because, here, the Plaintiffs belonged to a group of Reynolds’ shareholders whose percentage ownership interest would necessarily decrease as a result of the transaction.  Applying this Delaware standard, the Court decided that voting power dilution is a distinct injury suffered by shareholders, not the corporation.

The Plaintiffs’ alleged injury was sufficient to confer standing to bring a direct claim against BAT.

Plaintiff did Not Allege a Breach of Fiduciary Duty

Next, the Court considered whether a minority shareholder with actual control could owe a fiduciary duty to another shareholder who lacks control.

When the Business Court considered this issue earlier in the case, it was reluctant to determine whether a “bright-line rule of majority ownership” should prevail over a more flexible factual inquiry that might reveal dominance “without majority ownership or voting control.”  Corwin, 2015 NCBC 74, 2015 WL 46128780 ⁋ 46 (N.C. Super. Ct. Aug. 4, 2015).  The latter test was advocated by Defendants and embodied by Delaware law.  Id.  While the Business Court acknowledged that a bright line rule would establish predictability, it cautioned that it could also lead to abuse.  Id. ⁋ 54.  Judge Gale believed that a bright line test would be better adopted by the legislature or the appellate courts.  Id.  He predicted that if North Carolina appellate courts “elect[ed] not to impose the rigid requirement of majority ownership … , they would, at a minimum, impose a strong presumption that a minority shareholder owes no fiduciary duty absent detailed facts evidencing actual control equivalent to majority ownership.”  Id. ⁋ 60.

When the Court of Appeals decided the matter, like the Business Court, it declined to impose a bright line test of majority ownership.  It held that “that a minority shareholder exercising actual control over a corporation may be deemed a ‘controlling shareholder’ with a concomitant fiduciary duty to the other shareholders.”  Corwin, 796 S.E.2d 324, 330 (N.C. Ct. App. 2016), rev’d, 821 S.E. 2d 729 (2018).  But, it loosened the Business Court’s predicted standard.  The Court of Appeals required that a claim based upon shareholder liability “allege specific facts demonstrating or allowing for the reasonable inference of actual control by that shareholder.”  Id. at 332 (emphasis added).

[that] a minority shareholder owns shares eight times greater than any other shareholder, is the sole source of equity financing for a transformative corporate transaction, has a contractual right to prohibit the issuance of shares and the sale of intellectual property necessary for the transaction, and … pledges support for the transaction contingent on terms more favorable to it than to other shareholders.

Id. at 326.  According to the Court of Appeals, these facts showed more than influence—they reasonably implied control.

How would the Supreme Court address this divide between the courts below?  Again, it looked to Delaware.

Delaware law imposes fiduciary duties on minority shareholders who exercise actual control.  But, the requirement to show actual control is a tougher row to hoe than the requirement fashioned below by the Court of Appeals.  In Delaware, actual control exists “only when the allegedly controlling stockholder exercises such formidable voting and managerial power that [it], as a practical matter, [is] no differently situated than if [it] had majority voting control.”  Corwin, 2018 WL 6437701, at *7 (citing In re KKR Fin. Holdings LLC S’holder Litig., 101 A.3d 980, 993 (Del. Ch. 2014) (alterations in original)).  The stockholder’s “power must be so potent that independent directors … cannot freely exercise their judgment, fearing retribution.”  Id. (citing In re KKR, 101 A.3d at 993).

Citing Delaware law, the Supreme Court decided that there must be “well-pleaded facts” of control preventing directors from “freely exercising their judgment in determining whether or not to approve and recommend” a transaction.”  Id. (quoting In re KKR, 101 A.3d at 993).  It determined that, here, even if it applied the “Delaware controlling-stockholder standard,” and imposed fiduciary duties on a minority stockholder who exercises actual control over a board of directors, the complaint did not adequately allege that BAT exercised such actual control.  Corwin, 2018 WL 6437701, at *7.  In fact, it disclosed facts that necessarily defeated the claim.  Id. at *13 (citing Wood v. Guilford C’nty, 355 N.C. 161, 166 (2002)).

Under the Supreme Court’s reasoning, BAT’s contractual rights may have given it favorable terms under the sale, but that alone is insufficient.  Moreover, BAT had contractual handcuffs that actually prevented it from controlling the board.  Id. at *8.  This existence of contractual restrictions on the exercise of control may prevent a finding of the type of control sufficient to impose a fiduciary duty.  Id.

The Supreme Court did not declare a new rule imposing fiduciary duties on a minority shareholder exercising actual control.  It merely held that because the Plaintiff failed to allege facts showing actual control, there could be no fiduciary duty.  Id.

The dissent believed that the complaint satisfied North Carolina’s liberal notice pleading standard, and would have required the Court to decide the ultimate question of whether North Carolina will follow the Delaware approach.

It is curious that the Court had this issue of first impression before it and chose not to craft North Carolina law.  Neither the majority opinion nor the dissent gave much in the way of hints as to how the Court would have come out had it actually decided the issue.  However, as the Court followed Delaware law on the issue of standing, it would not be a stretch to predict that it would have similarly followed Delaware law on the issue that it declined to reach.

Another interesting note to this case is found in footnote 7 of the majority opinion and concerns the Rule 12(b)(6) standard in North Carolina.  The majority admits a possible “lack of doctrinal consistency in our standard of review for Rule 12(b)(6) motions.” Id. at n.7. The Court declined to address that potential inconsistency, however, because it was not one of the issues brought forward in the petition for discretionary review.  That issue was central in Plaintiff’s petition for rehearing, which was denied.  See 822 S.E. 2d 648 (N.C. 2019).

The decision of the N.C. Supreme Court affirmed the Business Court’s original decision in this matter. Judge Gale’s prediction regarding the appellate courts’ treatment of fiduciary duties in this context proved prescient.  There is now a strong presumption that a minority shareholder owes no fiduciary duty to other shareholders absent detailed factual allegations of control that prohibits the free exercise of directors’ judgment.

 

For an additional perspective on this case (and two other Business Court appeals), see the December 20, 2018 post on Fox Rothschild’s North Carolina Appellate Practice Blog.  Supreme Court Gets Down to Business-Business Court Cases, That Is

The Business Court sorted through the drama of an affiliated outsider who wanted to buy a company, settled for half and became an insider, and then allegedly used that perch to benefit himself and his family in W. Avalon Potts v. KEL, LLC, et al, 2019 NCBC 29, 2019 WL 2058599 (N.C. Super. Ct. May 9, 2019). See Order and Opinion. The story has a common backdrop: a nearly 30-year old company (founded by two partners) that wrestles with ownership changes and their impact on the entity’s fortunes. The twist: an original owner goes to the mat to reclaim control and alleges claims that allow the Court to revisit several legal principles that animate disputes over frayed business relationships.

Takeaways:

  • The Business Court, like the North Carolina Supreme Court, declines to hold that a minority shareholder exercising “actual control” could have a fiduciary duty to other shareholders.
  • The Court confirms that the business judgment rule, designed to curb “judicial second guessing,” does not apply “when the officer or director has an interest in the disputed transaction.”
  • Adopting a Third Circuit holding, the Court finds that when “independent third parties are alleged to have joined,” a conspiracy can exist in face of claims that an agent and principal cannot conspire as a matter of law.

Steel Tube, Inc. is a manufacturer of carbon steel and galvanized steel tubing. Plaintiff Potts and Walter Lazenby founded it, divided the stock evenly, and, over time, used the services of Leon Rives, an accountant. Rives offered to buy the company in 2014. Potts resisted the transaction, but Rives bought Lazenby’s shares – in which Lazenby retained a security interest. ¶¶ 5, 6.

With no notice to Potts, Lazenby and Rives promptly executed a management agreement under which Rives and one of his entities would manage Steel Tube. ¶ 7. That shaky start was predictive of what would follow: a series of disputes over Rives’ role in the company that included numerous allegations of self-dealing to benefit Rives and his family. Potts filed a lawsuit seeking dissolution, but recast it a year later in an amended complaint that alleged fiduciary duty breaches, fraud and other individual and derivative counts. Potts changed course after acquiring Lazenby’s security interest in the stock on which Rives ultimately defaulted, and he regained control of Steel Tube. ¶¶ 13-14.

Fiduciary Duty

At summary judgment, the Court considered the fiduciary duty claims within the lens of its general rule that shareholders “do not owe a fiduciary duty to one another.” Id. at ¶ 24. It rejected one exception to that rule – that majority shareholders have a duty to protect minority interests – because Rives and Potts had equal ownership shares. Id. Judge Conrad took a cautious course with regard to a second purported exception: that a minority shareholder exercising “actual control” could have a fiduciary duty to other shareholders. That doctrine had been adopted by the Court of Appeals at the time of the summary judgment hearing, but by the time of the Potts decision the Supreme Court had reversed and found it unnecessary to decide the ultimate issue because the particular plaintiffs had not sufficiently alleged “actual control.” Corwin v. British Am. Tobacco PLC, 251 N.C. App. 45, 51, 796 S.E.2d 324, 330 (2016), rev’d 371 N.C. 605, 821 S.E.2d 729 (2018); see also Blog Post Smoke ’em if You Got ’em (June 2, 2019). So, too, Judge Conrad found it unnecessary to decide what the Supreme Court would not, as the record reflected insufficient evidence of Rives’ “actual control.” The Court added:

Potts points to evidence that Rives was able to misappropriate Steel Tube’s resources without his knowledge, but that is not evidence of control. Rather, if true, it shows the opposite, confirming the Rives was forced to circumvent the board to accomplish his goals.

2019 NCBC 29, at ¶ 26.

Derivative Claims

The Court allowed a variety of derivative claims regarding Rives’ duties to Steel Tube to survive to trial. These included allegations of (i) improper payments to Lazenby, (ii) monthly and lump sum cash withdrawals by Rives, (iii) transferring $120,000 to a company Rives helped form in which his wife was a member, and (iv) entering a services deal with defendant KEL, owned by Rives’ brothers. ¶¶ 8-10. The Court rejected the contention that payments to Rives were contracts fixing compensation for officers allowed under Fulton v. Talbert, 255 N.C. 183, 184, 120 S.E.2d 410, 411 (1961). It found factual disputes about the payments, and that the payments could be challenged under the Court’s recent holding that “`[c]onflict-of-interest transactions between a corporation and its officers or directors have long been subject to special rules,’ including that the transaction must be fair to the corporation.” (citing Ehmann v. Medflow, Inc., 2017 NCBC 86, 2017 WL 4321107 (N.C. Super Ct. Sept. 26, 2017).

Business Judgment Rule

Rives seemed to contend that his transfer of $120,000 to Elite Tube, the company he helped found, was shielded by the business judgment rule. The Court rejected applying the rule, which limits “judicial second guessing,” by noting that those “protections do not apply when the officer or director has an interest in the disputed transaction.” The Court noted sufficient allegations of self-dealing and efforts to conceal the transaction to preclude use of the rule. 2019 NCBC 29, at ¶ 37.

Civil Conspiracy

Rives also contended a civil conspiracy claim that relied on the relationship between himself and one of his companies, Rives & Associates, was barred under the doctrine of intracorporate immunity, because an agent and principal cannot conspire as a matter of law. Id. at ¶ 42. But, showing that family ties take as they give, the Court ruled that inclusion of KEL (owned by Rives’ brothers) preserved a conspiracy claim where “independent third parties are alleged to have joined the conspiracy.” Id. (citing Robison v. Canterbury Vill., Inc., 848 F.2d 424, 431 (3d Cir. 1988)).

Brad Risinger is a partner in the Raleigh office of Fox Rothschild LLP. He maintains a commercial litigation practice that frequently involves business disputes before the North Carolina Business Court, and the state’s federal and state trial courts.

N.C. Business Court Declines to Impose Fiduciary Duties among Sibling Managers of an LLC and Declines to Extend Any “Control Group” Exception to LLCs, but allows Dissolution Claim to Survive, which Creates a Possible Ruling on Meiselman’s application to LLCs.


In Bennett v. Bennett, 2019 NCBC 18 (N.C. Super. Ct. Mar. 15, 2019), Judge Conrad considered a dispute between two groups of six siblings who are current or former members of family-owned real estate company. The case pits Plaintiffs Bert and Terry Bennett against four of their siblings, Defendants Graham, Ann, Jim, and Louise Bennett, for their alleged improper actions concerning Bennett Linville Farm, LLC (“Bennett Farm”), which the parties formed with their parents to facilitate the latter’s estate planning. The Court granted the controlling group’s motions to dismiss certain breach of fiduciary duty claims and constructive fraud claims, but denied the group’s motions to dismiss a claim for judicial dissolution.  See Order and Opinion.

Takeaways:

  • Infringement of an LLC member’s voting rights (including the right to elect managers and the residual right to vote in the absence of proper managers) is a distinct harm and supports a direct claim against fellow members.
  • Dilution of an LLC member’s relative ownership interest is a distinct harm to the member which can confer standing.
  • Judge Conrad held that a group of minority LLC members alleged to exercise control of the company did not owe fiduciary duties to minority members, and he is reluctant to grant such rights when minority members fail to include them in the operating agreement.
  • Judge Conrad did not dismiss an LLC member’s assertion of Meiselman claims in the LLC context because it would be “prudent” (at this juncture) to address the issue after discovery.

Allegations

Plaintiffs allege that  Defendants Graham, Ann, and Jim gained control of the company to the exclusion of the other sibling members and nearly all actions they took were unauthorized.  Plaintiffs assert direct claims against Defendants Graham, Ann, and Jim, alleging they conspired to control the company; that they fraudulently amended the operating agreement to consolidate their control; and that they engaged in unauthorized activity. Defendants Graham, Ann, and Jim moved to dismiss, challenging Plaintiffs’ standing and the merits of their claims. Plaintiffs dismissed their monetary demands against Louise, but kept her in the case as a necessary party.

Operating Agreement

For years, the siblings owned an equal share of Bennett Farm. The Plaintiffs alleged that the limited liability company was designed to be member managed. The original Operating Agreement, however, required management by certain managers listed on its Schedule II, or by others elected by the membership. Plaintiffs allege the Operating Agreement included no Schedule II when executed, and no managers were ever elected. They further allege that Defendants Graham and Ann were later listed on a document labeled as Schedule II, but without membership approval.

Amended Operating Agreement

Plaintiffs allege that in 2010, Defendants Graham, Ann, and Jim amended the Operating Agreement without the knowledge of the other members, and made significant changes. The Amended Operating Agreement:

  • designated Jim as a third manager,
  • authorized the managers to make capital calls without member consent, and
  • permitted Bennett Farm to redeem any member’s interest upon the consent of members owning at least 75% of the company.

While Plaintiffs acknowledged that they executed the signature page for the Amended Operating Agreement, they allege they did so without seeing the document and as a result of brother Graham’s trickery.

Transition

In 2012, the Bennett parents’ ownership interest in Bennett Farms passed to their children, leaving the six siblings in sole ownership. Thereafter, a seventh Bennett sibling (John) granted Bennett Farm a right of first refusal to his 35-acre tract at the request of Defendants Graham, Ann, and Jim. When he requested termination of the right, conflict erupted.

The Conflict

Plaintiffs Bert and Terry (together with Nominal Defendant Louise) claimed they knew nothing of Bennett Farm’s purported acquisition of brother John’s property right, but they would have granted it. Defendants Graham, Ann, and Jim disagreed and, “claiming managerial authority, decided to exercise and enforce the right of first refusal even in the absence of majority approval of the members.” Op. ⁋ 10.

Plaintiffs allege that Defendants Graham, Ann, and Jim used the controversy to force sister Plaintiff Terry out.  Graham allegedly informed Terry that she would have to make a capital contribution of over $100,000, or she could sell her interest to the other siblings. Terry alleges she could afford a capital contribution only with access to a trust fund, for which Defendant Ann served as trustee. Ann allegedly refused to assure Terry that she could dip into the fund for the contribution. Thereafter, Terry sold her interest to the five sibling owners remaining.

Nominal Defendant Louise (allegedly weary from the conflict) sold her ownership interest to the remaining sibling owners in 2018, giving Defendants Graham, Ann, and Jim a combined 80% of the company, and leaving Plaintiff Bert with the remaining 20%.

Analysis

Fiduciary Duty

Plaintiffs Bert and Terry alleged that Defendants Graham, Ann, and Jim breached their fiduciary duties to them as fellow LLC members. Defendants argue Plaintiffs lack standing and the claim lacks merit.

Plaintiffs Alleged Sufficient Distinct Harm to Confer Standing.

The Court held that Plaintiffs Bert and Terry alleged distinct injuries so as to confer standing.

Barger v. McCoy Hillard & Parks, 36 N.C. 650, 658 (1997), provides the rules for shareholder standing for corporations. These rules apply “equally to LLCs.” Op. ⁋ 24. While normally, “shareholders cannot pursue individual causes of action against third parties for wrongs or injuries to the corporation that result in the diminution … of the value of their stock,” Barger’s exceptions allow direct claims when members are owed a special duty, or if the injury is separate and distinct from the harm to other shareholders or to the corporation. Op. ⁋ 24 (citing Barger, 36 N.C. at 659).

Plaintiffs alleged that Defendants deprived them of their voting rights, which include the right to elect managers and the residual right to vote in the absence of proper managers. The Court held that infringement of the voting right is a distinct harm and the subject of a direct claim.

Plaintiffs alleged additional harm to support standing. Plaintiff Terry properly alleged distinct harm caused by Defendant Graham’s alleged wrongful inducement that she sell her ownership interest. Plaintiff Bert properly alleged distinct harm caused by the alleged improper sale of Nominal Defendant Louise’s membership interest, which diluted Bert’s relative share. Op. ⁋ 27 (citing Corwin v. British Am. Tobacco PLC, 821 S.E.2d 729, 735-36 (N.C. 2018) (corporations case)). (See Blog Post Smoke ’em if You Got ’em, dated June 2, 2019).

Plaintiff Alleged Insufficient Facts to Impose a Fiduciary Duty.

While Plaintiffs had standing, their claims based on Defendants’ corporate actions failed on the merits.

Fiduciary Duties Excluded By Operating Agreement

Generally, LLC members do not owe fiduciary duties to each other or to the company. Perhaps because of that rule (and because the original Operating Agreement disclaimed fiduciary duties concerning its members), Plaintiffs based their claim on other factors: the sibling relationship and their disparate business acumen.

The Court had no trouble dispensing with the claim. The Court questioned whether a fiduciary duty could attach in light of the original Operating Agreement’s express language precluding it. But, the Court did not have to decide that issue because the allegations failed to show the requisite control needed. Under North Carolina law, a fiduciary duty can arise only when one party “holds all the cards.” Op. ⁋ 32. As no individual sibling was alleged to wield all the power in the company, no fiduciary duty could attach. Id.

No Control Group Exception for LLCs

You may wonder: could the collective interest of the Defendant siblings form a control group that owes a fiduciary duty to a minority member? When Terry liquidated her membership interest, Defendants Graham, Ann, and Jim together owned more than 50% of the company.  They could use their collective interest against Plaintiff Bert, a minority owner.

The Business Court has recognized the possibility that multiple minority shareholders in a corporation who act in concert to control the corporation may owe a duty to a minority shareholder. See, e.g., Brewster v. Powell Bail Bonding, Inc., 2018 NCBC 74, *19-32 (N.C. Super. Ct. Jul. 26, 2018) (Judge Conrad).

(In Brewster, Judge Conrad cited the Court of Appeals decision in Corwin v. British Am. Tobacco PLC, in which the Court determined that a minority shareholder of a corporation exercising actual control may owe a fiduciary duty to other shareholders. See 796 S.E.2d 324 (N.C. Ct. App. 2016). When the North Carolina Supreme Court considered the issue in the Corwin appeal, it left the matter undecided. (See Blog Post Smoke ’em if You Got ’em, dated June 2, 2019).)

Judge Conrad noted that some recent Business Court cases “have stated that a holder of a majority interest who exercises control over the LLC owes a fiduciary duty to minority interest members.” Op. ⁋ 35 (citing Fiske v. Kieffer, 2016 NCBC 22, ⁋ 35) (N.C. Super. Ct. Mar. 9, 2016) (emphasis added) (Judge McGuire)). But, he also noted that the “scope of the [control group] exception … remains unsettled” and that “[t]his Court has cautioned against a broad application because of the fundamental differences between LLCs and corporations.” Id. Minority members of LLCs have “much greater” ability to negotiate for protections in the operating agreement. Id. Thus, “this Court has routinely refused to extend the control group exception to LLCs.” Id.

Judge Conrad was unwilling to grant such a right here. He determined that Defendants Graham, Ann, and Jim owed no fiduciary duty to Plaintiffs for their actions related to Bennett Farm.

Judicial Dissolution

Plaintiffs also seek judicial dissolution of Bennett Farm. They argue it is not practicable to conduct business in conformance with the operating agreement and governing statutes, and liquidation is necessary to protect their rights and interests. They seek dissolution based on the frustration of their reasonable expectations (rights enjoyed by shareholders of closely held corporations). See Meiselman v. Meiselman, 309 N.C. 279, 299 (1983).

The Court held that Plaintiff Terry lacks standing to seek the remedy because she is no longer a member of Bennett Farm.

But, Plaintiff Bert remains a member. If he develops evidentiary support for his claims, a jury might face “thorny questions” about the company’s ability to bring itself into compliance with its operating agreement after a decade of what would be unlawful management. The Court did not state whether Meiselman’s dissolution standards would apply to LLCs. It decided it would be “prudent” (at this juncture) to address the issue after discovery. Op. ⁋ 70 (citing Pure Body Studios Charlotte, LLC v. Crnalic, 2017 NCBC LEXIS 98 ⁋ 27-8 (N.C. Super. Ct. Oct. 18, 2017) (Judge Robinson)).

This leaves open the possibility that the Court could apply Meiselman in the LLC context.