Quarterly State Compliance Review

This edition of the Quarterly State Compliance Review looks at some legislation of interest to corporate lawyers that went into effect recently. It also discusses some recent decisions of interest, including one from the Delaware Supreme Court and two from the Delaware Chancery Court.

IN THE STATE LEGISLATURES

The period between Jan. 1 and April 1 tends to be a slow one when it comes to amendments to state business organization statutes. Nevertheless, there were some bills of interest that went into effect during this period. Among them were New Jersey Assembly Bills 2881 and 2883, both effective Jan. 27, 2009. These bills amended the Business Corporation Act to provide that the resignation of a director may be made effective upon the occurrence of an event or events specified in the notice of resignation, that a resignation that is contingent upon a director failing to receive a specified vote for re-election shall be irrevocable, and that the by-laws may set forth a provision that directors shall be elected by other than a plurality of the votes cast at an election.

In Michigan, House Bill 5356, effective Jan. 6, 2009, amended the Business Corporation Act to provide that a domestic corporation may convert into a “business organization” and that a “business organization” may convert into a domestic corporation. “Business organization” is defined as a domestic or foreign LLC, LP, GP, or any other type of domestic or foreign enterprise. The bill also repealed the provisions of the corporation act governing control share acquisitions. Also in Michigan, Senate Bill 1445, effective Jan. 15, 2009, authorized formation of a “low-profit limited liability company.” This is an LLC formed to accomplish certain charitable or educational purposes and that does not have the production of income or appreciation of property as a significant purpose.

In Virginia, Senate Bill 573 and House Bill 780, both effective April 1, 2009, reorganized and revised provisions of the LLC and LP Acts governing the administrative dissolution and cancellation of LLCs and LPs to provide, among other things, that if any LLC or LP fails to pay its annual registration fee on or before Dec. 31 of the year assessed, its existence or foreign registration shall be automatically canceled as of that day.

IN THE STATE COURTS

DE Supreme Court Clarifies Issues of Officer Fiduciary Duty and Shareholder Ratification

Gantler v. Stephens, No. 132, 2008, decided Jan. 27, 2009, involved a corporation whose board of directors put the corporation up for sale. However, instead of selling the company the board decided to reclassify and delist the corporation's stock. A class action was filed alleging breaches of fiduciary duty by the directors and certain officers. The Chancery Court dismissed the claims. However, on appeal, the Delaware Supreme Court reversed.

This decision is significant for two main reasons. One is because of what the court had to say about the duties owed by the corporation's president and vice president. The court stated: “That issue ' whether or not officers owe fiduciary duties identical to those of directors has been characterized as a matter of first impression for this court. In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold.”

The second reason for the case's significance is what the court had to say about shareholder ratification. The Chancery Court dismissed the claim that the board acted disloyally in approving the reclassification, finding that it was ratified by a vote of the shareholders. In reversing, the Supreme Court stated that the common law doctrine of shareholder ratification was unclear and that it was going to restore coherence and clarity to the doctrine. In so doing the court ruled that: 1) the shareholder ratification doctrine is limited to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective; 2) the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve; and 3) the effect of such a ratifying vote in general is to subject the challenged action to the business judgment rule as opposed to extinguishing the claim altogether.

The court then held that the ratification doctrine did not apply here because the reclassification could not become legally effective without a statutorily mandated shareholder vote and because the complaint stated a claim that the proxy was materially misleading, thus precluding a ruling that the vote was fully informed.

DE Chancery Court Dismisses Derivative Claim Alleging Breach of the Duty of Oversight

In re Citigroup Inc. Shareholder Derivative Litigation, C.A. No. 3338, decided Feb. 24, 2009, was a shareholder derivative action alleging, among other claims, that directors of Citigroup breached their fiduciary duties by failing to adequately oversee and manage Citigroup's exposure to the risks of the subprime lending market, even in the face of certain red flags that should have given them notice of the problems brewing. The defendants moved to dismiss on various grounds including a failure to make a demand or adequately plead demand futility. The plaintiffs alleged demand was futile because the directors faced a substantial likelihood of personal liability because of their failure of oversight.

The Delaware Chancery Court disagreed. The court noted that in the typical oversight case the plaintiff argues that the defendants are liable for damages arising from a failure to monitor or oversee employee misconduct or violations of law. Here, however, the claim was based on the defendants' alleged failure to monitor Citigroup's business risks. The court noted that allowing a plaintiff to succeed on such a theory would undermine the well settled policy that a court should not perform hindsight evaluations of business decisions. In addition, because Citigroup had an exculpatory clause in its certificate of incorporation, the complaint had to contain factual evidence of bad faith. However, at most, the evidence showed that the defendants made bad business decisions. There were no allegations of fact evidencing that they acted in bad faith. Thus, the court dismissed the claims based on the alleged breach of the duty of oversight for failure to adequately plead demand futility.

DE Chancery Court Refuses to Consider Evidence of
Members' Intent in Interpreting LLC Agreement

In Spellman v. Katz, C.A. No. 1838, decided Feb. 6, 2009, the plaintiff and defendant each held a 50% ownership interest in a Delaware LLC. The LLC was formed in 1997 to construct a medical office building. The LLC agreement contained a provision stating that the LLC shall be dissolved and its affairs wound up as soon as possible after the construction was completed and certain certificates were issued. The building was completed and the certificates issued in 1999. However, no attempt was made to dissolve or wind up the LLC.

The plaintiff member claimed that the LLC was dissolved by express will of its members pursuant to the dissolution provision of the LLC agreement. He therefore sought an order appointing a liquidating trustee to wind up the LLC. The defendant member opposed the appointment, arguing that the LLC was not dissolved because the provision did not accurately reflect the original intention of the parties. The defendant claimed that neither member knew this provision was in the LLC agreement and that both members intended to operate the LLC for at least as long as mortgage interest obligations and real estate tax benefits remained available to offset profits. He claimed the fact that they had not dissolved the LLC was evidence to support his position.

The plaintiff moved for summary judgment. The Chancery Court noted that summary judgment would be available only if the provision of the LLC agreement in question was unambiguous. And, according to the court, the dissolution provision here was unambiguous. Thus, the court stated it could not consider the fact that no steps had been taken to dissolve the LLC because such evidence was precluded by the parol evidence rule. The court then granted the plaintiff's request for the appointment of a liquidating trustee to wind up the LLC as the parties were unable or unwilling to agree on the winding up process themselves.

CA Appellate Court Allows Dissolved Corporation to Recover Excessive Legal Fees

In Mesa West, Inc. v. LaMoure, G038601 (Cal. App. 4 A.D.), decided Feb. 18, 2009, the plaintiff, a California corporation, entered into a contingency fee agreement with the defendant, its lawyer, but refused to pay what the defendant claimed to be owed. The corporation filed a petition to arbitrate the fee dispute. Several months later, the corporation filed a certificate of dissolution. Over a year later, the corporation filed a complaint for declaratory judgment that the contingency fee agreement was void and for the return of excessive fees paid. The trial court found for the plaintiff. The defendant appealed, asserting that the plaintiff, as a dissolved corporation, lacked standing to void the agreement.

The California Court of Appeal affirmed, concluding that the plaintiff's efforts to recoup money from the defendant was authorized by the California Corporations Code. The court noted that the arbitration was filed before the corporation was dissolved and that the Corporations Code provides that dissolution does not abate a proceeding. In addition, the corporation could file the new action because a dissolved corporation has express statutory authority to collect and distribute assets discovered before the date of dissolution. Here, the corporation discovered its right to the excess fees during the arbitration proceeding.

Sandra Feldman is a publications and research attorney for New York-based CT (www.ctlegalsolutions.com), a Wolters Kluwer business; and a member of this newsletter's Board of Editors.

This edition of the Quarterly State Compliance Review looks at some legislation of interest to corporate lawyers that went into effect recently. It also discusses some recent decisions of interest, including one from the Delaware Supreme Court and two from the Delaware Chancery Court.

IN THE STATE LEGISLATURES

The period between Jan. 1 and April 1 tends to be a slow one when it comes to amendments to state business organization statutes. Nevertheless, there were some bills of interest that went into effect during this period. Among them were New Jersey Assembly Bills 2881 and 2883, both effective Jan. 27, 2009. These bills amended the Business Corporation Act to provide that the resignation of a director may be made effective upon the occurrence of an event or events specified in the notice of resignation, that a resignation that is contingent upon a director failing to receive a specified vote for re-election shall be irrevocable, and that the by-laws may set forth a provision that directors shall be elected by other than a plurality of the votes cast at an election.

In Michigan, House Bill 5356, effective Jan. 6, 2009, amended the Business Corporation Act to provide that a domestic corporation may convert into a “business organization” and that a “business organization” may convert into a domestic corporation. “Business organization” is defined as a domestic or foreign LLC, LP, GP, or any other type of domestic or foreign enterprise. The bill also repealed the provisions of the corporation act governing control share acquisitions. Also in Michigan, Senate Bill 1445, effective Jan. 15, 2009, authorized formation of a “low-profit limited liability company.” This is an LLC formed to accomplish certain charitable or educational purposes and that does not have the production of income or appreciation of property as a significant purpose.

In Virginia, Senate Bill 573 and House Bill 780, both effective April 1, 2009, reorganized and revised provisions of the LLC and LP Acts governing the administrative dissolution and cancellation of LLCs and LPs to provide, among other things, that if any LLC or LP fails to pay its annual registration fee on or before Dec. 31 of the year assessed, its existence or foreign registration shall be automatically canceled as of that day.

IN THE STATE COURTS

DE Supreme Court Clarifies Issues of Officer Fiduciary Duty and Shareholder Ratification

Gantler v. Stephens, No. 132, 2008, decided Jan. 27, 2009, involved a corporation whose board of directors put the corporation up for sale. However, instead of selling the company the board decided to reclassify and delist the corporation's stock. A class action was filed alleging breaches of fiduciary duty by the directors and certain officers. The Chancery Court dismissed the claims. However, on appeal, the Delaware Supreme Court reversed.

This decision is significant for two main reasons. One is because of what the court had to say about the duties owed by the corporation's president and vice president. The court stated: “That issue ' whether or not officers owe fiduciary duties identical to those of directors has been characterized as a matter of first impression for this court. In the past, we have implied that officers of Delaware corporations, like directors, owe fiduciary duties of care and loyalty and that the fiduciary duties of officers are the same as those of directors. We now explicitly so hold.”

The second reason for the case's significance is what the court had to say about shareholder ratification. The Chancery Court dismissed the claim that the board acted disloyally in approving the reclassification, finding that it was ratified by a vote of the shareholders. In reversing, the Supreme Court stated that the common law doctrine of shareholder ratification was unclear and that it was going to restore coherence and clarity to the doctrine. In so doing the court ruled that: 1) the shareholder ratification doctrine is limited to circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective; 2) the only director action or conduct that can be ratified is that which the shareholders are specifically asked to approve; and 3) the effect of such a ratifying vote in general is to subject the challenged action to the business judgment rule as opposed to extinguishing the claim altogether.

The court then held that the ratification doctrine did not apply here because the reclassification could not become legally effective without a statutorily mandated shareholder vote and because the complaint stated a claim that the proxy was materially misleading, thus precluding a ruling that the vote was fully informed.

DE Chancery Court Dismisses Derivative Claim Alleging Breach of the Duty of Oversight

In re Citigroup Inc. Shareholder Derivative Litigation, C.A. No. 3338, decided Feb. 24, 2009, was a shareholder derivative action alleging, among other claims, that directors of Citigroup breached their fiduciary duties by failing to adequately oversee and manage Citigroup's exposure to the risks of the subprime lending market, even in the face of certain red flags that should have given them notice of the problems brewing. The defendants moved to dismiss on various grounds including a failure to make a demand or adequately plead demand futility. The plaintiffs alleged demand was futile because the directors faced a substantial likelihood of personal liability because of their failure of oversight.

The Delaware Chancery Court disagreed. The court noted that in the typical oversight case the plaintiff argues that the defendants are liable for damages arising from a failure to monitor or oversee employee misconduct or violations of law. Here, however, the claim was based on the defendants' alleged failure to monitor Citigroup's business risks. The court noted that allowing a plaintiff to succeed on such a theory would undermine the well settled policy that a court should not perform hindsight evaluations of business decisions. In addition, because Citigroup had an exculpatory clause in its certificate of incorporation, the complaint had to contain factual evidence of bad faith. However, at most, the evidence showed that the defendants made bad business decisions. There were no allegations of fact evidencing that they acted in bad faith. Thus, the court dismissed the claims based on the alleged breach of the duty of oversight for failure to adequately plead demand futility.

DE Chancery Court Refuses to Consider Evidence of
Members' Intent in Interpreting LLC Agreement

In Spellman v. Katz, C.A. No. 1838, decided Feb. 6, 2009, the plaintiff and defendant each held a 50% ownership interest in a Delaware LLC. The LLC was formed in 1997 to construct a medical office building. The LLC agreement contained a provision stating that the LLC shall be dissolved and its affairs wound up as soon as possible after the construction was completed and certain certificates were issued. The building was completed and the certificates issued in 1999. However, no attempt was made to dissolve or wind up the LLC.

The plaintiff member claimed that the LLC was dissolved by express will of its members pursuant to the dissolution provision of the LLC agreement. He therefore sought an order appointing a liquidating trustee to wind up the LLC. The defendant member opposed the appointment, arguing that the LLC was not dissolved because the provision did not accurately reflect the original intention of the parties. The defendant claimed that neither member knew this provision was in the LLC agreement and that both members intended to operate the LLC for at least as long as mortgage interest obligations and real estate tax benefits remained available to offset profits. He claimed the fact that they had not dissolved the LLC was evidence to support his position.

The plaintiff moved for summary judgment. The Chancery Court noted that summary judgment would be available only if the provision of the LLC agreement in question was unambiguous. And, according to the court, the dissolution provision here was unambiguous. Thus, the court stated it could not consider the fact that no steps had been taken to dissolve the LLC because such evidence was precluded by the parol evidence rule. The court then granted the plaintiff's request for the appointment of a liquidating trustee to wind up the LLC as the parties were unable or unwilling to agree on the winding up process themselves.

CA Appellate Court Allows Dissolved Corporation to Recover Excessive Legal Fees

In Mesa West, Inc. v. LaMoure, G038601 (Cal. App. 4 A.D.), decided Feb. 18, 2009, the plaintiff, a California corporation, entered into a contingency fee agreement with the defendant, its lawyer, but refused to pay what the defendant claimed to be owed. The corporation filed a petition to arbitrate the fee dispute. Several months later, the corporation filed a certificate of dissolution. Over a year later, the corporation filed a complaint for declaratory judgment that the contingency fee agreement was void and for the return of excessive fees paid. The trial court found for the plaintiff. The defendant appealed, asserting that the plaintiff, as a dissolved corporation, lacked standing to void the agreement.

The California Court of Appeal affirmed, concluding that the plaintiff's efforts to recoup money from the defendant was authorized by the California Corporations Code. The court noted that the arbitration was filed before the corporation was dissolved and that the Corporations Code provides that dissolution does not abate a proceeding. In addition, the corporation could file the new action because a dissolved corporation has express statutory authority to collect and distribute assets discovered before the date of dissolution. Here, the corporation discovered its right to the excess fees during the arbitration proceeding.

Sandra Feldman is a publications and research attorney for New York-based CT (www.ctlegalsolutions.com), a Wolters Kluwer business; and a member of this newsletter's Board of Editors.