Opinion
CIVIL ACTION NO:99-3313, SECTION: "G"(2)
April 18, 2001
MEMORANDUM AND ORDER
Background
Plaintiff in the original complaint, Allyson May Sanderson and David Israel, are co-trustees for the Sanderson Children's Trust, created to benefit the four children of Michael Sanderson. Michael Sanderson was named as an additional plaintiff in the first amended and restated complaint.
This action arises out of Michael Sanderson's donation to the trust of stock appreciation rights ("SARs") he had been granted by the defendant, H.I.G. P-XI Holding, Inc. ("P-XI"), as partial consideration for the sale of his interest in a company known as Milliken Michaels', Inc. to P-XI. The name of P-XI was later changed to Co-Source. Plaintiffs claim that when Co-Source was later sold, the trust received less value than the sum to which it was entitled from the proceeds of the sale, for the reason that Co-Source allegedly overpaid defendant, H.I.G. Capital Management, Inc. ("HIG Capital Management" or "Capital Management"), for services rendered in connection with the sale. Specifically, plaintiffs allege that the trust is entitled to an additional amount of $235,896, which represents 9.829% of the $2.4 million fee Co-Source paid to Capital Management.
Defendant, Capital Management, filed a motion to dismiss the plaintiffs' original complaint, arguing that plaintiffs had failed to state a claim against Capital Management under any legal theory. On July 27, 2000, I dismissed all of plaintiffs' claims against Capital Management, except for those claims of breach of contract and breach of the obligation of good faith and fair dealing. I further ordered that these claims would also be dismissed, unless plaintiffs amended their pleadings to sufficiently allege circumstances justifying the piercing of the corporate veil to hold Capital Management liable for breach of contract and breach of the obligation of good faith and fair dealing. Further, I noted that the plaintiffs would not be precluded from alleging in their amended complaint facts that would support an alternative claim against Capital Management for tortious interference with contract.
On October 25, 2000, plaintiffs filed a pleading they entitled "First Amended and Restated Complaint," in which it added four new defendants and one new plaintiff. Plaintiffs did not name P-XI or Co-Source as a defendant in the amended and restated complaint because they had entered into a settlement with P-XI prior to filing the amended complaint.
Defendants filed a motion to dismiss the plaintiffs' amended and restated complaint, which alleged six counts. On January 24, 2001, I dismissed Count II, plaintiffs' claim for securities fraud, and I denied defendants' motion to dismiss Count IV, plaintiffs' claim for tortious interference with contract. Finding that Delaware law was applicable to Counts I, III, V, and VI of the plaintiffs' first amended and restated complaint, I ordered both parties to submit memoranda addressing Delaware law.
Minute Entry of January 24, 2001, at p. 18.
The parties have submitted their memoranda on Delaware law. Accordingly, I now rule on Counts I, III, V, and VI of the plaintiffs' first supplemental and amended complaint.
DISCUSSION
A motion to dismiss under Federal Rule of Civil Procedure 12(b)(6) "is viewed with disfavor and is rarely granted." Kaiser Aluminum Chemical Sales v. Avondale Shipyards, 677 F.2d 1045, 1050 (5th Cir. 1982); Beanal v. Freeport-McMoran, Inc., 197 F.3d 161, 164 (5th Cir. 1999). The standard which governs the dismissal of a complaint under Rule 12(b)(6) is that a complaint should not be dismissed "unless it appears to be a certainty that plaintiff is entitled to no relief under any state of facts which could be proved in support of the claim." 2A Moore's Federal Practice P. 12.08 at 2271 (2d ed. 1975). The Supreme Court has held that when a court reviews the sufficiency of a complaint, its task is a limited one. "The issue is not whether a plaintiff will ultimately prevail but whether the claimant is entitled to offer evidence to support the claims." Scheur v. Rhodes, 416 U.S. 232, 236, 94 S.Ct. 1683, 1686, 40 L.Ed.2d 90 (1974)
In considering this motion to dismiss, I must accept as true not only the allegations of the complaint, but also "any reasonable inferences that may be drawn therefrom." Watts v. Graves, 720 F.2d 1416, 1419 (5th Cir. 1983). However, I need not accept as true "conclusory allegations or unwarranted deductions of fact" contained in the complaint. Tuchman v. DSC Communications Corp., 14 F.3d 1061, 1067 (5th Cir. 1994)
I. Count I: Annulment of the Co-Source Approval to Pay Fee
In Count I, plaintiffs, on their own behalf, allege that Co-Source's approval of the fee paid to HIG Capital Management should be annulled because two out of three Co-Source directors were "interested" directors and were also HIG Capital Management officers at the time the fee was approved. The plaintiffs allege that payment of the fee to HIG Capital Management was unfair because the decision to pay the fee was tainted by the votes of the two "interested" directors. On March 20, 2001, plaintiffs filed an amended second amended complaint asserting that they were also raising this claim on behalf of Co-Source.
On January 4, 2001, Co-Source assigned to plaintiffs all of their "rights, claims, complaints, demands and causes of action" against HIG Capital Management, Inc., H.I.G. Capital, LLC, and H.I.G. Investment Group, L.P., as well as against their respective officers, directors, managers and partners, and the officers and directors of Co-Source. The assignment was for "good and valuable consideration," presumably including the dismissal of Co-Source from the lawsuit.
a. Annulment Claim on Behalf of Plaintiffs
The defendants argue that this claim should be dismissed because the plaintiffs, who are not Co-Source shareholders, do not have standing to seek redress for any alleged unfairness to Co-Source.
Under Delaware law, a derivative action is an action brought by one or more shareholders or members to enforce a right of a corporation or of an unincorporated association. See Delaware State Chancery Court Rule 23.1. If a stockholder complains of an indirect injury sustained as a result of a wrong done to the corporation, such action will be treated as a derivative action. See Elster v. American Airlines, 100 A.2d 219, 222 (Del.Ch. 1953) Any devaluation of stock is shared collectively by all the shareholders, rather than independently by an individual shareholder; therefore, the wrong is entirely derivative in nature. See Kramer v. Western Pac. Indus., Inc., 546 A.2d 348, 353 (Del. 1988)
In Count I, plaintiffs are attempting to redress a wrong done to Co-Source, the devaluation of stock by paying HIG Capital Management a fee of $2.42 million. The plaintiffs specifically alleged that the decision to pay the fee was tainted by the vote of two "interested" directors of Co-Source. Plaintiffs' use of the "interested" directors language implies that they intended that the claim on their own behalf be treated as a derivative action.
In a derivative action, Delaware courts often apply the business judgment rule, a rebuttable presumption that directors do not breach their duty of care. See Aronson v. Lewis, 473 A.2d 805, 812. Only a "disinterested" corporate director can assert the business judgment rule as a defense to a derivative action. See id. A "disinterested" director is a director who has not appeared on both sides of a business transaction and who has not received a personal financial benefit from the transaction. See id.
To bring a derivative action, stockholder status at the time of the transaction being attacked and during the entire litigation is essential. See Jones v. Taylor, 348 A.2d 188, 190 (Del.Ch. 1975). For purposes of a derivative action, an equitable owner is considered a stockholder. See Harff v. Kerkorian, 324 A.2d 215, 218 (Del.Ch. 1974). For example, a plaintiff who entered into an agreement obligating her mother to bequeath one-half of the shares of a company's stock to her was considered an equitable owner. See Jones, 348 A.2d at 191.
On the other hand, debenture holders are not considered stockholders by Delaware courts. See Harff, 324 A.2d at 219. Holders of convertible debentures are creditors of a corporation and do not have standing to maintain a stockholder's derivative action under Delaware law. See id. Similarly, a holder of an option to purchase stock is not considered an equitable owner. See id.
The plaintiffs in this case are holders of stock appreciation rights ("SARs"). The defendants argue that the plaintiffs' rights, as holders of SARs, are specifically defined by contract. In their first motion to dismiss, defendants argued that HIG Capital Management had no fiduciary duty to the plaintiffs under the SAR agreement. Applying New York law, I ruled that the defendants had no contractual fiduciary duty to the plaintiffs and that the SAR agreement did not grant the plaintiffs equity ownership or voting rights in Co-Source. Because Delaware law applies to Count I, I will apply Delaware law and reconsider the plaintiffs' rights as SAR holders.
Minute Entry of July 27, 2000, at pp. 15-16.
A stock appreciation right is a contingent interest; to realize this interest, the common stock of the corporation must be sold. Holders of SARs, unlike debenture holders, may not be solely creditors, but they are creditors. When the common stock of a corporation is sold, the corporation owes and is obligated to pay SAR holders the appreciation value of the stock. Further, unlike stockholders, SAR holders can share in the wealth of a corporation without the same tax liability as a shareholder. See Litle v. Waters, No. CIV.A.12155, 1992 WL 25758, at *2 (Del.Ch. 1992)
I have not found and have not been directed to any Delaware case law that expressly decided whether holders of stock appreciation rights have standing to bring a derivative action. Nevertheless, I find that the plaintiffs do not have standing to bring a derivative action. The plaintiffs do not own stock in Co-Source. The SAR agreement does not require or entitle the plaintiffs to convert their interest into stock to receive the appreciation value. Consequently, the plaintiffs have a contractual contingent interest in Co-Source, but not an ownership or an equitable ownership interest in Co-Source. Although plaintiffs are not solely creditors of Co-Source, their contingent interest in Co-Source stock does not satisfy the ownership requirement to bring a derivative action.
Even if I held that the plaintiffs, as SAR holders, have standing to bring a derivative action, another basis exists for dismissal of this claim against Co-Source. Under Delaware law, the corporation is an adverse party in a stockholders' derivative action. See Elster v. American Airlines, 106 A.2d 202, 203 (Del.Ch. 1954). Although a derivative suit is asserted by a stockholder on behalf of the corporation, it is also a suit by a stockholder to compel the corporation to sue, and the corporation is a nominal defendant. See Harff, 324 A.2d at 218; Lewis D. Solomon Alan R. Palmiter, CORPORATIONS § 18.1.1.
Before the plaintiffs filed their first amended and restated complaint on October 25, 2000, they entered into a settlement with Co-Source, dismissing Co-Source from this action. Therefore, plaintiffs are attempting to assert a derivative action against a corporation that has been dismissed from this suit.
b. Annulment Claim on Behalf of Co-Source
Defendants argue that this claim should be dismissed because the plaintiffs have not alleged that they are appearing pursuant to an assignment of rights from Co-Source. Since defendants filed their brief, however, plaintiffs have amended their complaint to specifically allege this claim on behalf of Co-Source. Accordingly, I will address this claim.
Unfair actions or breaches of corporate duties are usually challenged by shareholders in derivative actions because the directors who abused their positions are unlikely to sue themselves. See Solomon, supra, at § 11.4. Under Delaware law, a corporation can, however, sue its directors for breaches of corporate duties. See MCI Telecommunications Corp. v. Wanzer, Nos. C.A.89C-MR-216, 89C-SE-26, 1990 WL 91100, at *1, 5 (Del.Super.Ct. 1990) (citing Cambridge Fund v. Abella, 501 F. Supp. 598 (S.D.N.Y. 1980); Professional Insurance Co. v. Barry, 303 N.Y.S.2d 556 (N.Y.Sup. 1969)). Co-Source, in its own right, can sue its directors. Plaintiffs' claim on behalf of Co-Source is not dismissed because all of Co-Source's rights against its officers and directors were assigned to the plaintiffs. See supra, n. 1. Therefore, defendants' motion as to Count I is granted as to plaintiffs' claims on their own behalf and denied as to plaintiffs' claims on behalf of Co-Source.
II. Count III: Breaches of Contract, Fiduciary Duty. Good Faith, Fair Dealing Count VI: Individual's Breach of Fiduciary Duty and Duty of Undivided Loyalty
Count III alleges that Co-Source and H.I.G. Investment Group violated their contractually imposed duties of good faith and fair dealing by reducing the fair market value of the proceeds from the sale of Co-Source common stock. Count VI alleges that John Bolduc and Charles J. Hanemann, Co-Source directors, breached their fiduciary duties of loyalty by voting to pay $2.42 million to HIG Capital Management.
On March 7, 2001, I granted summary judgment as to H.I.G. Investment Group, L.P., John Bolduc, and Charles J. Hanemann, dismissing these parties from the suit. In both of these counts, plaintiffs have asserted claims against parties who were dismissed from these proceedings by the summary judgment. Therefore, defendants' motion to dismiss Counts III and VI is granted.
III. Count V: Liability of the Entire H.I.G. Family: Piercing the Corporate Veil
Count V alleges that the H.I.G. Family had complete domination of Co-Source and abused that domination by wrongfully paying $2.42 million dollars to HIG Capital Management. Specifically, plaintiffs argue that the Co-Source corporate veil should be pierced because the H.I.G. Family owned more than 77% of Co-Source stock and controlled two out of three Co-Source directors.
The directors of a Delaware corporation stand in a fiduciary relationship not only to the stockholders but also to the corporations upon whose boards they serve. See Malone v. Brincat, 722 A.2d 5, 10 (Del. 1998) The directors' fiduciary duties have been characterized as a triad: due care, good faith and loyalty. See id.
"Persuading a Delaware court to disregard the corporate entity is a difficult task." Wallace v. Wood, 752 A.2d 1175, 1183 (Del.Ch. 1999) (holding that limited partners did not state a cognizable claim to the veil of their partnership). For a court to pierce the corporate veil, the plaintiffs must allege facts that, if taken as true, demonstrate complete domination or control of a corporation. See id. The degree of control required to pierce the veil is exclusive domination and control to the point that the entity no longer has legal or independent significance of its own. See id.
A court can pierce the corporate veil of an entity where there is fraud or where a subsidiary is in fact an alter ego or mere instrumentality of its owner. See Trustees of Village of Arden v. Unity Constr. Co., No. C.A. 15025, 2000 WL 130627, at *3 (Del.Ch. 2000). Common management of two entities does not, by itself, justify piercing the corporate veil.See id. The corporation must be a sham and exist for no other purpose than as a vehicle for fraud. See Wallace, 752 A.2d at 1184. If two entities, parent and subsidiary, fail to follow legal formalities when contracting with each other, it would be tantamount to declaring that they are indeed one in the same. See Trustees, 2000 WL 130627, at *3
Plaintiffs allege that H.I.G. owned more than 77% of Co-Source stock and controlled two out of three Co-Source directors. Although these facts, once developed, may not rise to the level of exclusive domination and control that would allow piercing of the corporate veil, the issue in a 12(b)(6) motion to dismiss is whether a plaintiff is entitled to offer evidence to support the claim. See Scheur, 416 U.S. at 236. In Pereira v. Cogan, No. 00 CIV.619 (RWS), 2001 WL 243537, at *1-2 (S.D.N.Y. 2001) (applying Delaware law), Cogan was the majority common stockholder and CEO of Trace, chairman of the board, and the beneficiary of voting trusts relating to the stock. The Directors of Trace were all members of the board and attained their positions by virtue of authority exercised by Cogan. Consequently, the directors uncritically supported all of Cogan's decisions, even though Cogan allegedly used corporate funds to make gifts to his family members and to corporate insiders.
Trace became insolvent in 1995, and the Creditors' Committee, with permission of the Bankruptcy Court, initiated an adversary proceeding by filing a complaint against Cogan on behalf of Trace. Subsequently, the Bankruptcy Court appointed Pereira chapter 7 bankruptcy trustee for Trace. Trace directors moved to dismiss the complaint. Pereira filed an amended and a second amended complaint, seeking to pierce the corporate veil and hold Cogan individually liable for Trace's legitimate debts. Specifically, the second amended complaint alleged that Cogan engaged in numerous instances of self-dealing which stripped Trace of its corporate assets, in effect using Trace as his "incorporated pocketbook." Id. at *21. The court denied the directors' motion to dismiss, holding that these allegations satisfied the requirement of pleading an "overall element of injustice or unfairness" and that the veil-piercing claim was adequately pleaded.
In Count V, plaintiffs allege that the H.I.G. Family had complete domination of Co-Source and used that complete domination to wrongfully pay an "excessive and exorbitant fee" to HIG Capital Management. This allegation satisfies the requirement of pleading an overall element of injustice and unfairness, and plaintiffs have adequately pleaded a claim for piercing the corporate veil to reach the H.I.G. entities who have not been dismissed from this litigation. Therefore, defendants' motion to dismiss Count V is denied.
Accordingly,
Considering the foregoing,
IT IS ORDERED that defendants' motion to dismiss Count I of plaintiffs' complaint IS GRANTED as to plaintiffs' claim on their own behalf, and the motion IS DENIED as to plaintiffs' claim on behalf of Co-Source.
IT IS FURTHER ORDERED that defendants' motion to dismiss Counts III and VI of plaintiffs' complaint IS GRANTED.
IT IS FURTHER ORDERED that defendants' motion to dismiss Count V of plaintiffs' complaint IS DENIED.
New Orleans, Louisiana, this day 18th of April, 2001.