attorneys – Page 3 – Robson and Robson

July 2, 2019November 2, 2020

Closely-Held Company Litigation? Pay Attention to Schedule K-1

July 2, 2019

By Edward S. Robson

In a perfect world, groups of potential business partners would sit down before they started their new ventures to hash out the details of their relationship. They would work in close consultation with one or more attorneys to produce detailed subscription, operating and loan agreements documenting their arrangements and clearly delineating responsibilities. In the real world, the birth of closely-held businesses is sometimes far messier.

Despite their sophistication, entrepreneurs and businesspeople sometimes build and invest in companies without the legal scaffolding necessary to withstand disagreements among the owners. Individuals provide money without having a clear agreement on whether the payments are a loan or were made in exchange for an equity interest. Particularly in the early stages of a business, individuals often provide valuable services for little or below market compensation based on the oral promise of equity, either immediately or vesting in the future. Such arrangements are frequently evidenced only by the vaguest of email exchanges or sometimes “friends” forego any kind of writing.

When disputes involving such businesses boil over into litigation, there is often fierce disagreement on the threshold question of whether someone is an owner at all. The determination of whether someone is an owner, a lender, an employee or simply a “volunteer” who provided services out of family ties or affection is dispositive for many claims common in closely-held company litigation. A putative owner that cannot establish their ownership lacks standing to assert claims for breach of fiduciary duty, waste, dissolution and access to books and records.

There are a variety of ways to prove or disprove that a person is an equity holder in the absence of membership certificates, stock ledgers or written operating agreements. A perennial favorite, however, is using an entity’s tax returns, specifically, the Schedule K-1.

Entities taxed as partnerships or S-corporations must prepare a Schedule K-1 for each of its owners. The Schedule K-1s identify the owners of the business and specify their percentage of equity and profits and losses that will be attributed to each for tax purposes. The entity’s representative signing the tax return certifies under penalties of perjury that the return, including the schedules, are accurate to the best of their knowledge. The Schedule K-1 must be distributed to each owner and filed with the entity’s tax return. Owners then utilize the K-1 when preparing their personal returns to substantiate the profits or losses they are claiming.

Although the IRS generally requires filers to report profits or losses from the business in conformity with the Schedule K-1 they receive from the entity, a filer can object to the contents of the Schedule K-1 by filing a “notice of inconsistent treatment or administrative adjustment request” (Form 8082) with their return. Form 8082 is also used to alert the IRS that an entity has failed to issue a Schedule K-1 to an owner as required by law.

Schedule K-1 would appear to provide clear and unequivocal evidence of an ownership interest in a business. Most courts, however, have taken a more cautious view. Pennsylvania state and federal courts presented with Schedule K-1s generally treat them as probative but not dispositive of an entity’s ownership. The Schedule K-1 is meant to describe, rather than establish as a matter of substantive law, ownership of an entity at a given point in time. It may be subject to error, change and even outright manipulation. Consequently, it is unusual to find cases where a court has held that the contents of a Schedule K-1 is enough to estop a party from asserting that an ownership structure deviates from that reported on the K-1.

Although courts do not usually consider the existence of a Schedule K-1 to be dispositive of the existence or percentage of ownership, the weight afforded a Schedule K-1 often depends on which party is proffering it and for what purpose.

Because the company official signing the business’s return certifies the accuracy of the Schedule K-1 under penalties of perjury, a K-1 tends to be strong evidence of the entity’s position as to who owns it. In the event of litigation, the entity or the owner that controls it may be hard pressed to disavow the contents of the Schedule K-1 it filed. Indeed, the entity or controlling owner likely had exclusive control over the records provided to the accountants preparing the return.

Filing an individual return with a Schedule K-1 attached may also establish the position of a noncontrolling owner with respect to their percentage of ownership. Although an individual owner may not have had any involvement or control over the contents of the Schedule K-1, individual returns (Form 1040) require the filer to certify the accuracy of the return and schedules under penalty of perjury. Presumably this requirement also includes the Schedule K-1. Moreover, the failure of an individual to dispute the Schedule K-1 by filing Form 8082 also suggests that an individual agrees with the information contained in the K-1.

The failure of a putative owner to receive a Schedule K-1 can also be used show that no ownership interest exists. Many individuals provide services to companies without pay or defer salary on the promise of equity from a founder. These individuals often claim to have operated for years under the belief that they were owners, even though the entity never issued a Schedule K-1 to them. The failure of such individuals to file Form 8082 to give notice of the failure to issue the Schedule K-1, as well as the failure to include any profits or losses from the entity in their individual returns, can undermine claims that the individuals reasonably believed that they were owners of the business.

The issuance or failure to issue a Schedule K-1 can also impact the application of the statute of limitations. When defendants assert the statute of limitations, plaintiffs often attempt to rely on the discovery rule or the doctrine of fraudulent concealment to toll the statute. Some courts, notably the U.S. Court of Appeals for the Third Circuit, have held that the failure to receive a Schedule K-1 should provide notice sufficient to start the statute of limitations running. Other courts may take a case by case approach in deciding whether a reasonable person would understand that failure to receive a tax form from an entity that has elected a particular form of taxation equates to the entity denying that they are an owner.

No matter what the posture of the court, it is clear that the Schedule K-1 is an important factor to consider in any litigation that involves an ownership dispute. In the event a client intends to advance an ownership structure that is inconsistent with what was reported on the entity’s Schedule K-1, they should be prepared to present evidence explaining the deviation.

May 20, 2019November 2, 2020

Taxation of Trusts—Guidance Coming From the Supreme Court?

May 20, 2019

By Joseph Frabizzio

The U.S. Supreme Court recently heard oral arguments in a case, North Carolina Department of Revenue v. Kaestner 1992 Family Trust, Docket No. 18-457 (argued on April 16), in which a trust challenged a North Carolina law that taxes resident-beneficiaries on the income earned and retained by a nonresident trust. The trust prevailed at the trial level, appellate level and in the North Carolina Supreme Court, but the U.S. Supreme Court granted the North Carolina Department of Revenue’s petition for a writ of certiorari on the question of whether the due process clause of the Fourteenth Amendment prohibits states from taxing trusts based on trust beneficiaries’ in-state residency. The petitioner asserted that there was a split among the nine states that had considered taxation of trust income based on a beneficiary’s residence and that the split could only be resolved by the Supreme Court. While we await the court’s decision, this case presents an interesting mix of arguments regarding the proper analysis of the minimum contacts inquiry and a public policy appeal by the petitioner to “modernize” trust taxation along the lines of a recent court decision that eliminated the physical-presence requirement in the sales tax context.

General Trust Taxation Rubric

Taxation of income from trusts involves looking at federal law, state law, the language of the applicable trust, and the identity and location of the grantor, trustee, beneficiaries and assets held by the trust. In short, the analysis can be complex. Some states, looking to bring in additional revenue, have passed laws expanding the reach of their power to tax trust beneficiaries. One distinguishing feature of the North Carolina law is that it taxes beneficiaries who have not actually received taxable income from a trust.

There are a few preliminary trust tax issues to understand. Income from a trust is sometimes taxed at the trust level, while at other times it is taxed to beneficiaries. Trusts known as revocable (or living) trusts permit the grantor of a trust to revoke the trust. These trusts are generally ignored for both federal and Pennsylvania trust tax purposes and income is taxed just as if the individual grantor had received it. There are also other types of irrevocable grantor trusts which are taxed to the grantor for federal tax purposes and, in a minority view, to the trust itself for Pennsylvania purposes. These grantor trusts can be utilized by estate planning attorneys to leverage estate and gift tax savings. This leaves the traditional nongrantor irrevocable trust, which is the type of trust at issue before the court.

For these nongrantor trusts, most forms of taxable income actually distributed to a beneficiary or that are required to be distributed to a beneficiary are taxed to that beneficiary. Essentially, the trust takes a deduction for the distributed income, with possible limitations for some forms of income such as capital gains, and distributes a K-1 to the beneficiary. States that impose an income tax would generally require that the individual beneficiaries then report the income on their individual tax return just as they would report any other income received. A trust that retains income and is not required to distribute it, on the other hand, will pay tax at the trust level. For federal income tax purposes, this can have negative consequences since the tax brackets are compressed and trusts reach the highest rate of taxation at just $12,750 in annual income. For a trust with a Pennsylvania grantor, Pennsylvania trustee and Pennsylvania beneficiaries, the state tax consequences are what one would expect: the taxable income, whether paid by the trust or the beneficiary is taxed at Pennsylvania’s flat tax rate of 3.07%.

For Pennsylvania, as well as some other states, a distinction must be made regarding income sourced to a particular state, such as rental income from a property in Pennsylvania or a trust’s income from ownership of a company operating in Pennsylvania, versus nonsource income. Nonsource income would include investment income from ownership of stock of a company not located in Pennsylvania. Current Pennsylvania law provides that it can tax income of a nonresident trust that receives Pennsylvania-sourced income or a nonresident trust beneficiary who receives a distribution from such a trust, but only to the extent that income relates to the Pennsylvania source property. Merely having a beneficiary who resides in Pennsylvania, however, with no other ties to Pennsylvania will not trigger taxation by the state. Of course, Pennsylvania would tax actual distributions of income made to a Pennsylvania resident by a nonresident trust.

North Carolina’s Statute

North Carolina’s law is more expansive. The heart of the dispute presently before the court is whether North Carolina may tax undistributed income of a trust if the only contact with the trust consists of a beneficiary who lives in North Carolina. The Kaestner trust was originally formed in New York and the trustee had no operations or residence in North Carolina. As a constitutional matter, the trust argued that the due process clause should not allow North Carolina to tax the income of the trust since it would be unable to exercise jurisdiction over the trust in a judicial proceeding. Considering the issue in terms of a minimum contacts analysis, the court will likely analyze whether a trust, its trustee and effectively other beneficiaries can be subject to a state’s taxation merely because one of its beneficiaries happens to live in that state.

The law is well-established that a state may tax an actual distribution received by a trust beneficiary in a state in which the trust does not reside. From a practical standpoint, this makes sense. As a beneficiary, one can choose to live in any state. Such beneficiaries have made a choice to subject themselves to the jurisdiction of that state. A beneficiary motivated to save taxes on distributions from a trust might choose to live in Florida, which has no state income tax. The trust, however, cannot exercise control over where its beneficiaries live. Therefore, if the trust’s income is retained by the trust and not distributed, the question is whether a foreign state could then subject any portion of that income to taxation.

A key component of the court’s analysis is likely to be whether serving in a fiduciary relationship to a beneficiary constitutes a sufficient nexus to allow a nonresident trust to be taxed and whether the tax imposed is sufficiently related to values connected to North Carolina. The petitioner argues that there are sufficient minimum contacts because, in what it termed a “fairness-based analysis,” the mere status as beneficiaries of a trust who avail themselves of the benefits of living in North Carolina, such as public roads, police and fire services, is enough to constitute sufficient minimum contacts with the state.

Another component of the court’s focus may be whether the speculative interest of that beneficiary, who had not actually received a distribution, allows North Carolina to impose tax on the trust in this situation. In its brief and at oral arguments, counsel for the trust stressed that the North Carolina beneficiary at issue was a contingent beneficiary of the trust. The trustee had complete discretion whether to make distributions to the beneficiary at issue in this case and there were no distributions made to that beneficiary during the relevant time period. Not only did the trust retain the income, it was conceivable that no trust assets might ever be distributed to that beneficiary. Instead, the trust assets could be distributed to other contingent or remainder beneficiaries who might live in any one of several states at the time they receive the assets.

The petitioner also argues that prohibiting its tax on due process grounds would open up the use of trusts as a tax shelter since individuals could forum shop for a state that does not impose income tax and allow the trust to grow without being taxed. The counter to this position is that states may choose to tax undistributed income in the place where the trust is administered or may impose a throwback tax that would tax the previously untaxed income of a beneficiary in the year that the beneficiary actually receives a distribution.

In sum, this case presents an opportunity to learn how the court will apply due process arguments to trust taxation in light of an increasing focus on income tax planning as the federal estate and generation-skipping transfer taxes impact fewer families.

April 12, 2019November 2, 2020

The Hazards of ‘Weaponizing’ Capital Call and Dilution Provisions

The Hazards of 'Weaponizing' Capital Call and Dilution Provisions

April 12, 2019

By Edward S. Robson

There are many ways that an owner of a closely-held business can use their superior financial resources to gain an advantage over their co-owners in a dispute. One common way is the use of a capital call provision to dilute the interest of minority owners or to create off-setting claims against them. “Weaponizing” capital call and dilution provisions can be an effective sharp elbow tactic in business divorce situations but practitioners should be wary of the risks that come with it.

Weaponized capital calls are typical in situations where there are claims of shareholder oppression and where there is a significant disparity in financial resources between owners. Such a strategy usually is in response to a claim by a minority owner that the majority owner has breached their fiduciary duty to the minority owner, the company or both. Faced with the prospect of litigation from the minority owner, the majority owner causes the company to exercise a right provided in the entity’s governing documents to demand that each of the owners contribute additional capital to the company. In initiating the capital call, it is the expectation of the majority member that the minority member will have insufficient financial resources to make the necessary capital contribution within the time specified in the operative documents. Failure to make a timely contribution could result in dilution of the minority’s interest, trigger a mandatory sale of their interest to the majority or, minimally, create a counterclaim against the minority owner that would act as a setoff against any amounts that might be awarded to the minority owner.

Majority holders considering a capital call in the context of a dispute with a minority owner should exercise caution. Even when expressly permitted by the governing documents, using capital call provisions in bad faith can give rise to claims for breach of fiduciary duty and the implied obligation of good faith and fair dealing.

Improper exercise of capital call provisions may breach the fiduciary duty of loyalty. By setting the terms of the capital call that he or she will have to answer, a majority owner is engaged in self-dealing. Absent a provision in the company’s operative documents to the contrary, courts evaluate self-dealing transactions using an “entire fairness” analysis. Under this approach, the majority owner has the burden to show that the transaction was objectively fair to the company. A majority owner that is unable to meet this high bar will have breached their fiduciary duty to the company.

Weaponizing capital call provisions also risks breaching the implied duty of good faith and fair dealing. Operating agreements, partnership agreements and shareholder agreements are contracts and are subject to the duty of good faith and fair dealing. Just as in any other agreement, courts will not permit a party to a contract to exercise its contractual rights in such a way as to deprive the counterparty of the benefit of its bargain. Contractual provisions that provide an unfettered right to make a capital call invite court scrutiny as to whether the capital call was made in good faith. In evaluating whether a majority owner has complied with its obligations to act in good faith, courts perform a fact-intensive inquiry about the circumstances and the motivations surrounding the exercise of the contractual right and the reasonable expectations of the parties as reflected in the agreement.

There are several strategies for reducing the risks associated with making a capital call. Majority owners can address the risk prospectively by taking the time to create robust operating documents. Fiduciary duties can often be modified or eliminated in operative documents, thereby creating predictability for the majority when engaging in corporate transactions.

Even with the existence of supportive documents, proper exercise of a capital call requires a bona fide business need for capital coupled with a reasonable exercise of the right. Whether a bona fide need exists and whether the capital call was reasonable is a fact-intensive inquiry. Courts will evaluate the timing of the capital call, the capital needs it purports to address, the treatment of past capital calls and the motivations of the majority in making it. Notwithstanding the unpredictability associated with such an inquiry, certain practices can help a majority act with confidence in causing a capital call.

Seeking the assessment of independent directors or managers involved with the company may buttress assertions that the capital call is being made in good faith and may avoid application of the “entire fairness” analysis. If there is no way to avoid the entire fairness standard, the majority owner should be prepared to demonstrate and substantiate a bona fide business purpose that justifies a demand for additional capital. This might require the use of business valuation or accounting experts ready to explain cash flow or other financing issues. At a minimum, the majority should be ready with clear documentation of the need for capital and the amount required. Capital calls for excessive amounts smack of bad faith and suggest that the majority is attempting to exploit the minority owner.

The majority should also be ready to explain why it caused the company to raise money with a capital call rather than other financing sources that would not require additional money from the owners. Well-documented and unsuccessful efforts to obtain bank or other third-party financing before resorting to a capital call can provide helpful justification. Majority owners should be especially wary if the new capital is being used to retire loans or pay debts owed to the majority owners or their affiliates. In such cases, a capital call might only compound claims of self-dealing.

Lastly, majority owners should be prepared for the prospect that a minority owner may, through strategic alliances with other investors or lenders, make a timely contribution, potentially maintaining the status quo ante.

Majority owners do well to remember that no matter how favorable the language of the governing agreements, courts exercising equity powers may not look kindly on capital calls whose purpose is strategic rather than operational.

March 5, 2019November 2, 2020

Pa. Supreme Court Tackles Attorney-Client Privilege Issues in Derivative Cases

March 5, 2019

By Edward S. Robson

This column previously analyzed the Commonwealth Court’s decision in Pittsburgh History and Landmarks Foundation, 161 A.3d 394 (Pa. Commw. Ct. 2017), and its potential impact on the attorney-client privilege in derivative litigation. The Pennsylvania Supreme Court subsequently granted petitions for allowance of appeal in the case, setting the stage for the court’s first decision addressing derivative litigation in more than 20 years. The court’s Jan. 23 decision in Pittsburgh History emphasized the strength of the attorney-client privilege in Pennsylvania but its narrow holding leaves significant questions related the application of the privilege in derivative cases unanswered (see Pittsburgh History & Landmarks Foundation v. Ziegler, No 53 WAP (Pa. Jan. 23, 2019)).

Pittsburgh History arose when a group of former board members of two related nonprofit corporations asserted derivative claims against the president and current board members alleging misconduct. The defendant board members formed a putatively independent investigation committee consisting of themselves to investigate the plaintiffs’ allegations and determine whether the corporations should take action against the defendants. The committee generated an investigative report concluding that the defendants’ actions were proper and that the derivative litigation was not in the best interest of the corporations. Relying on the report, the boards of the two corporations voted to reject the derivative plaintiffs’ demands and filed a motion to dismiss the derivative action. The motion relied on the independent committee’s investigation and report.

While the motion to dismiss was pending, plaintiffs sought to compel production of various communications between the independent committee and its counsel as well as materials generated by the committee. Defendants invoked the attorney-client privilege on behalf of the corporation and refused to produce the requested materials to the derivative plaintiffs.

The court began its analysis by discussing its decision in Cuker v. Mikalauskas, 692 A.2d 1042 (1997), and reaffirming Cuker’s adoption of various sections the “American Law Institute’s, Principles of Corporate Governance: Analysis and Recommendations” (1994) (ALI Principles) related to derivative litigation. The sections of the ALI Principles cited in Cukercontemplate that when faced with a derivative claim against the officers and directors of the corporation, a board may form an independent committee to investigate the allegations and determine whether the corporation should take action against management directly. If the committee determines that the corporation should not take direct action, the board, purporting to act on behalf of the corporation, can file a motion to dismiss the derivative plaintiffs’ claims. Such motions are often supported by opinions of counsel addressing whether the board’s actions complied with its fiduciary obligations to the corporation.

In evaluating the motion to dismiss, a trial court applies the deferential “business judgement rule” to determine whether the board’s decision to terminate the derivative action is in the best interest of the corporation. In an effort to rebut the application of the business judgement rule, derivative plaintiffs will attempt to establish that the board’s decision-making process was infirm, either by showing that directors were conflicted or that the committee failed to consider relevant information in reaching their decision. In making such an argument, access to communications from counsel to the committee members and other ancillary documents can be crucial. For example, a committee action that accepted opinions of its counsel that rejected the merits of a derivative action while rejecting opinions of counsel that supported a derivative action, would be suspect.

Section 7.13 of the ALI Principles describes the procedures to be used by a trial court when reviewing a defendant’s motion to dismiss derivative litigation, including what access a derivative plaintiff has to an investigating committee’s communications with its counsel. Although the court in Cuker adopted Section 7.13 of the ALI Principles in bulk, it did not specifically address how the provisions related to the attorney-client privilege. The Pittsburgh History court addressed this issue directly, considering whether the provisions of Section 7.13(e) of the ALI Principles comported with Pennsylvania’s attorney client privilege jurisprudence.

Section 7.13(e) addresses attorney-client privilege with respect to communications between an independent litigation committee and its counsel. Section 7.13(e) provides a derivative plaintiff with access to certain information that would otherwise be subject to the attorney-client privilege:

“The [derivative] plaintiff’s counsel should be furnished a copy of related legal opinions received by the board or committee if any opinion is tendered to the court. … Subject to that requirement, communications, both oral and written, between the board or committee and its counsel with respect to the subject matter of the action do not forfeit their privileged character, and documents, memoranda, or other material qualifying as attorney’s work product do not become subject to discovery, on the grounds that the action is derivative or that the privilege was waived by the production to the plaintiff or the filing with the court of a report, other written submission, or supporting documents.”

The Pittsburgh History court expressly reaffirmed its adoption of Section 7.13(e). The court reasoned that Section 7.13(e)’s exception to the attorney-client privilege protection is consistent with long standing Pennsylvania attorney-client privilege jurisprudence that prevents a party from relying on an “advice-of-counsel” defense without providing plaintiff with access to that advice. In effect, Section 7.13(e) prevents a litigation committee from submitting a cherry-picked opinion of counsel in support of its motion to dismiss derivative litigation without disclosing unfavorable opinions.

In adopting Section 7.13(e), the court rejected the derivative plaintiffs’ contention that a broader “good cause” exception to the attorney-client privilege should apply. The good cause exception was first articulated by the U.S. Court of Appeals for the Fifth Circuit in Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), and has been adopted by a number of courts throughout the county, including Delaware. In Garner, the Fifth Circuit balanced the interests of derivative plaintiffs and defendant managers where both groups purport to represent the corporation. Garner confirmed that a corporation may still invoke the attorney-client privilege to prevent disclosure of information to derivative plaintiffs but held that a derivative plaintiff is entitled to pierce the privilege upon a showing of “good cause.” The Garner court identified nine factors for evaluating whether good cause exists.

The Pittsburgh History court rejected the Garner analysis as inconsistent with Pennsylvania’s attorney-client privilege. In reaching its conclusion, the court emphasized the need for predictability in the application of the privilege. The court reasoned that “an uncertain privilege, or one which purports to be certain but results in widely varying application by the courts, is little better than no privilege at all.” It held that the Garner test does not provide the predictability that Pennsylvania law requires and leaves managers and the corporation’s attorneys without a “meaningful way of determining whether their otherwise privileged communications would be later divulged in derivative litigation discovery.”

The court’s decision is important but narrow. The court was careful to limit its discussion to the application of the attorney-client privilege with respect to communications between a special litigation committee and its counsel regarding the committee’s decision to file a motion to dismiss derivative litigation. The broader question of whether a derivative plaintiff can pierce the attorney-client privilege with respect to communications outside of a motion to dismiss derivative litigation remains open. Indeed, Garner arose because its derivative plaintiffs sought putatively privileged communications with counsel that occurred in conjunction with defendants’ alleged wrongdoing, not a decision to end derivative litigation. This broader issue affects a much larger group of potential litigants. In practice, most closely-held businesses do not go to the trouble of attempting to dismiss derivative litigation using the procedures employed in Pittsburgh History. Access to communications between a majority management group and the company’s counsel, however, is highly relevant to a minority owner’s claims in the context of a closely-held business dispute.

Although the court did not address whether a derivative plaintiff may access otherwise privileged information outside of a motion to dismiss context, the court’s rationale for rejecting Garner’s analysis provides some insight on how it might view the issue. In rejecting Garner, the court emphasized that its nine-factor analysis injected unacceptable uncertainly into whether the privilege would apply. Since communications between managers and corporate counsel may be wide-ranging, the preference of the Pittsburgh History court for predictability would seem to apply with equal or greater force.

Notwithstanding the court’s apparent preference for certainty over a derivative plaintiffs’ access to information, a rigid application of the privilege in the name of predictability would ignore the representative nature of derivative litigation. Indeed, derivative litigation involves parties that are both purporting to represent the same corporation. When a defendant asserts the attorney client privilege against derivative plaintiffs, it creates an unusual situation of a client asserting privilege against itself. The court has yet to grapple with the issue.

Reprinted with permission from the March 5, 2019 issue of The Legal Intelligencer. © 2019 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

November 30, 2018November 2, 2020

Client Advocacy Isn’t Personal: A Lesson from The National Trial Advocacy Program

November 30, 2018

For those who practice primarily in civil litigation, there are regrettably few opportunities to hone courtroom skills—and even fewer to receive constructive feedback from knowledgeable colleagues. The National Trial Advocacy Program which I recently completed provides both. The three-day program is hosted by the American Inns of Court in conjunction with the Inns of Court College of Advocacy in London. It is conducted by a group of experienced English barristers, the small subset of British attorneys whose practice consists exclusively of litigation.

The program relies on the “Hampel” method, a six-step training methodology widely used in England and Wales. It requires the barrister trainers to provide detailed criticism on specific facets of participants’ mock opening and closing statements, oral arguments and witness examinations. Participants benefit both from receiving criticism of their own performances and those of their peers.

Although the trainers’ comments are meant to address particular issues in a participant’s performance, some comments have broader application that all litigators should consider. One such criticism is to avoid injecting personal opinion into courtroom advocacy. Indeed, since the program, I have noticed that this a common practice for many attorneys. Attorneys that inject their personal opinion and, by extension, themselves into their advocacy create a variety of risks for themselves and their clients.

An attorney injects herself into litigation anytime she does something that invites an evaluation of her personal credibility, skill or judgment. Although there are a variety of situations where this can arise, it commonly arises in oral argument and closing statements. The practice is disfavored in both contexts, albeit for different reasons and with different results.

Injecting personal opinion into oral argument often takes the form of “I think” statements. “I think the prosecution has failed to present a prima facie case.” This rhetorical style makes for unpersuasive and anemic oral advocacy. “I think” or “I believe” invites a court to think – and perhaps opine – “I don’t care what you think Mr. Robson.” Saying “I believe Jones v. Smith requires XYZ” invites a court to question the judgment of the attorney in a way that saying “Jones v. Smith requires XYZ” does not. Moreover, like the passive voice, it suggests a lack of confidence and obscures the source of the information: “I do not think that this is a breach of the agreement” is less informative than “the plain language of Section 1.1 permits the client to terminate the agreement and so there is no breach.”

Vouching for a client or referencing personal experience at trial is another particularly perilous way attorneys can inject themselves into litigation. Vouching for a client by claiming “I would never represent a client that would do XYZ” invites a jury to evaluate the scruples of the attorney in a way that saying “Mr. Jones credibly testified that XYZ” does not. Introducing personal experiences of the attorney converts the attorney from an advocate to a litigant.

Using these techniques can be the basis for reversal of a jury verdict and violates the rules of professional conduct. A number of state and federal courts have reversed jury verdicts after attorneys injected their personal opinions, often in bizarre ways. For example, the Eighth Circuit reversed a jury verdict in a sexual harassment case after plaintiff’s counsel provided the jury with an account of her (counsel’s) experience of being sexual harassed by her law school professor. A Florida appellate court reversed a jury verdict after counsel explained how his client’s “day-in-the-life video” gave him (counsel) nightmares. This type of conduct also violates Rule 3.4(e) of the Model Rules of Professional Conduct which prohibits attorneys from claiming personal knowledge of the facts or stating their personal opinion at trial.

Avoiding personal commentary in court proceedings is more than a trial practice technique, it is the tip of a larger lesson on how to reduce stress in sharp-elbowed litigation. Injecting yourself into litigation can take a subtle toll on the attorney. An attorney who has taken the client’s problems personally enough that they are willing to put their own credibility on the line has likely compromised their ability to give objective advice. It causes the attorney to suffer through litigation in the same way the client does. Every obnoxious move by opposing counsel and every adverse ruling becomes a personal affront that begets stress, anxiety and, possibly, unethical retaliatory behavior. The client, the attorney and the entire litigation process benefit when an attorney cultivates and maintains a professional detachment that allows him or her to evaluate both the strengths and weaknesses of their case and to dispassionately assess the behavior of the adversarial party.

While it is easy to recognize the risks of “getting personal” in litigation, refraining from such actions requires a conscious, conscientious effort. The world has become a less formal place and courtroom advocacy is not immune from the trend. Influenced by unrealistic dramatic portrayals of attorneys in books, films and television, clients expect their attorney to assume the client’s problems as if they were their own. Clients sometimes misconstrue detachment as disinterest and interpret undisciplined passion and ad hominem arguments as effective advocacy.

The British tradition of more detached, but pointed, courtroom advocacy sets a helpful example for American lawyers. Small changes, like avoiding personal opinion in the courtroom, can help counsel maintain the separation that makes for effective advocacy. Excising the “I thinks” and similar statements from courtroom vocabulary can make for more persuasive arguments. Avoiding references to the client as “we” and to the arguments as “ours” can help to create the space necessary to consider the issues, rather than the personalities. If a client’s case depends on the credibility of a witness, counsel should endeavor to have the factfinder evaluate the credibility of the witness, not the attorney. While no panacea exists, such conscious changes remind both litigator and client that we serve our client best when we represent them and not ourselves.

September 27, 2018November 2, 2020

Make Business Divorce Easier—Spell Out Duties in Operating Agreement

September 27, 2018

Closely held companies are like marriages but without the sex or kids to hold things together. And just like some marriages, closely held companies can fall apart. Sometimes these “business divorces” and the painful litigation they generate are inevitable. Business partners have different personalities, expectations regarding finances and strategies for interacting with the world and one another. Some business divorce litigation involving limited liability companies might be resolved more easily or avoided altogether with the operating agreement’s inclusion of thoughtfully drafted provisions that address the owners’ fiduciary and other duties.

Many transactional practitioners devote significant time to drafting and refining complex capitalization structures and distribution waterfalls in their operating agreements. In our experience, nearly all business divorce litigation arises from alleged breaches of fiduciary duties. In such cases, the operating agreements typically are either silent as to what fiduciary or other duties govern the relationships between the parties or give the topic short shrift. These shortcomings may be the result of the mistaken belief among many practitioners that fiduciary duties are neatly defined by statute or caselaw and need not be spelled out in the agreements themselves.

Fiduciary duties generally, and within the context of limited liability companies more specifically, are subject to slippery rules and definitions. For years, Delaware courts have struggled with the concept. Pennsylvania’s jurisprudence, which is not nearly as well developed, has adopted a certain “I know it when I see it” method for identifying such duties. Given the limitless ways a manager can run a business without the requisite care or checks on self-dealing, defining the scope of fiduciary duties is perhaps an inherently fact-intensive exercise that necessitates this ad hoc approach.

Further complicating the landscape is that the duty of good faith and fair dealing is implied in most contracts. This duty is independent of other fiduciary duties. Although it is not clear under the pre-2016 version of the Pennsylvania LLC law whether an operating agreement is subject to the implied duty of good faith and fair dealing, the Pennsylvania Uniform Limited Liability Company Act of 2016 (the act) expressly imposes one (Section 8849.1(d)). The duty is often discussed as a “gap filler” that addresses conduct violating the spirit of a contract. We think of it, less formally, as a “don’t be a jerk” rule.

The transactional practitioner that defers to these foggy standards by not addressing them in the operating agreement is likely to invite litigation between the parties to the operating agreement. Fiduciary standards imposed by court decisions or statutes may conflict with the expectations of business owners. This disconnect between what an owner thinks they can do under the ill-defined terms of the operating agreement and what the court- or statutorily defined fiduciary duties permit is fodder for potential litigation should the parties’ business relationship go awry.

Given that limited liability companies are creatures of contract, there is no reason not to address fiduciary duties in a company’s operating agreement. Pennsylvania, like many states including Delaware, allows operating agreements to modify the traditional corporate fiduciary duties—i.e., the duty of care and duty of loyalty—and the duty of good faith and fair dealing. Modifying these provisions requires thoughtful and precise drafting. For example, while the act permits the alteration of the duty of care, the act ostensibly prohibits the elimination of this duty. In this regard, a generalized disclaimer that “all fiduciary duties are eliminated” or “the parties hereby disclaim the covenant of good faith and fair dealing” is unlikely to be effective. Moreover, modifications can be made only when they are not “manifestly unreasonable.” Thus, the only way to modify, or attempt to eliminate, these duties is to affirmatively and precisely state what they are and define their scope. Should a court ever inquire as to whether a modification is “manifestly unreasonable,” it may also be helpful to provide detailed recitals on the background of the owners’ relationship, the purpose of the company and the reasons for modifying any duties.

Well-drafted duty-of-care provisions should, at a minimum, address the applicable standard of care and the scope of the business judgment rule, exculpation from monetary damages for breach of the duty and the advancement litigation expenses. In crafting these provisions, practitioners should consider the following questions, among others: Is the standard for the duty of care negligence, gross negligence or something else? To what extent can a manger or controlling person rely on information provided by others? Should the managers or controlling members be liable to the company for the monetary damages that result from a breach of the duty of care? Should they receive indemnity or advancement of fees for litigation expenses in the event of an alleged beach?

The duty of loyalty is particularly important in the context of closely held businesses. If controlling owners are going to compete with the company, charge it a fee, cause it to deal with an affiliate or be employed by the business, those issues should all be addressed in the operating agreement. The act encourages this type of specificity by allowing an operating agreement to “identify specific types or categories of activities that do not violate the duty of loyalty.” The agreement should also identify a procedure by which the noncontrolling members can review activities that might otherwise violate a duty of loyalty.

The act allows the parties to prescribe the standards, if not manifestly unreasonable, by which performance of the contractual obligation of good faith and fair dealing is measured. As a practical manner, the obligation is so amorphous that it is difficult to articulate how it should be modified. The obligation, however, cannot contradict the express terms of an agreement. Therefore, careful drafting of the fiduciary duty sections helps to minimize the unexpected invocation of the duty of good faith and fair dealing. Practitioners should nevertheless codify this principal by making clear that whatever duty it creates, such duty cannot supplant the express terms or duties articulated elsewhere in the operating agreement.

Much like including certain provisions in a prenuptial agreement may give rise to awkward conversations between partners before getting married, including these provisions in an operating agreement may provoke uncomfortable discussions between owners at the outset of a new venture. Transactional practitioners should nevertheless encourage those discussions and address owners’ concerns head-on. Resolving these issues up-front will likely avoid punting them to litigators and courts in the back-end and prevent unnecessary or unnecessarily contentious litigation.

Reprinted with permission from the September 20, 2018 issue of The Legal Intelligencer.

June 26, 2018November 2, 2020

Enough With Arbitration Provisions: Litigators Hate Them and GCs Should Too

June 26, 2018

Arbitration provisions are a common feature of commercial transactions for businesses trying to alleviate the burdens of litigation. In-house and transactional attorneys routinely include arbitration provisions in all flavors of commercial agreements. To put it bluntly: please stop. The professed benefits of arbitration in commercial cases are frequently overstated. Proponents of arbitration argue that it is cheaper and faster than litigation with “expert” arbiters rendering final decisions. Careful examination of these claims suggests that they are an unpersuasive justification for a process that should not be incorporated wholesale into every transaction. This article examines four of the most common justifications for arbitration and suggests examination of the knee-jerk impulse to include arbitration provisions in commercial agreements.

Arbitration is Cheaper

The first fallacy of arbitration proponents is the claim that arbitration is cheaper than litigation. Not true. For a nominal filing fee, litigants can access the full infrastructure of the state and federal court systems. The cost of the judges, law clerks, administrative staff and the court house are all subsidized by taxpayers. Arbitrators charge by the hour, the arbitration provider often charges by the size of the claim and the parties may have to pay a room charge. In practice, it is difficult to complete a single arbitrator arbitration of any size for less than $25,000 in costs. Despite the financial realities of arbitration, attorneys routinely include arbitration provisions that require a three-arbitrator panel in contracts even where the amount of the transaction is likely less than the costs associated with paying the arbitrators.

Proponents of arbitration also claim that legal fees are less when compared with the costs associated with a trial. There is nothing to suggest, however, that an attorney preparing to appear before an arbitrator can prepare any less thoroughly than an attorney representing a client at trial. Moreover, the “arbitration-is-cheap” folks also tend to overlook the possibility of significant litigation associated with getting a case into arbitration. Although courts favor arbitration, such preference must yield to the agreement of the parties as expressed in the arbitration provision. It is not uncommon to litigate the scope and validity of an arbitration clause as a prelude to submitting the case to arbitration. The Pennsylvania Rules of Appellate Procedure make an order denying a motion to compel arbitration or granting a stay of arbitration immediately appealable by right. Arguing about whether a claim is subject to arbitration and the terms of such arbitration invites a sideshow that can easily dissipate any cost savings realized by the decision to arbitrate.

You Get a Highly Qualified Subject Matter Expert

A common justification for commercial arbitration is the notion that the arbitrator will be a “subject-matter expert” – one that will clearly do a better job than a judge or jury that has no similar expertise. The ideal “subject-matter expert” is a person experienced in deciding cases who can make intellectually honest, clear and decisive decisions. Most arbitrators are lawyers with little subject matter expertise except in the law. Lawyering skills are not necessarily congruent with judicial skills; claiming that they are overlooks the skills and temperament required of a judge and the time it takes to develop them. Crafting arguments and evaluating arguments are not the same thing.

While the “expertise” of lawyer-arbitrators may raise doubts, there are situations in which a specialized expertise – beyond familiarity with the law – may be warranted. It may be more efficient to resolve a dispute with a securities broker in front of a panel that already understands how securities work. Even if a specialized subject matter arbitrator is warranted, such experts may be difficult to find. Successful industry specific experts are often working in their industries, not serving as arbitrators.

Most commercial litigation, however, does not fall into this category. Commercial litigation comes in a variety of flavors – contracts, fiduciary duties, “business torts” – with widely varying facts that are not easily susceptible to a standardized response. Such cases are commonplace in both the federal courts and Philadelphia’s Commerce Program and judges and juries have resolved them for hundreds of years. Judges and juries can provide a sense of the reasonable expectations or behavior of the parties in similar circumstances. Although there are always (usually well reported) examples of juries doing crazy things, juries get it right most of the time. Commercial disputes can be complicated but the best litigators find the common-sense proposition in complicated fact patterns and convey it in a way that provides context and relevance.

Arbitrators are also subject to certain pressures that judges are not. Professional arbitrators make money by conducting arbitrations. Leaving one party totally defeated at an arbitration reduces the odds of any repeat business from the losing attorney or their friends. It also brands the arbitrator with being plaintiff or defendant friendly, further reducing the odds of future appointments. This is not fair to the arbitrator who has diligently applied the law to the facts but it is the state of the world. As a result, many arbitrators tend to “split the baby” when it should not be split.

Discovery is Less Painful

The next purported benefit of arbitration is that discovery is shorter and more efficient, thereby achieving cost savings and a prompt resolution. There is nothing about arbitration that suggests that the parties will employ “discovery lite.” Many commercial disputes simply require elaborate discovery. There is nothing inherent in the arbitration process that reduces the discovery grind. Discovery can be just as contentious in arbitration as it is in litigation, or perhaps even more so due to the lack of detailed rules of civil procedure.

In litigation, judges have the power to limit the scope of discovery to prevent undue hardship, harassment or delay. Even before the 2015 amendments to FRCP 26, both state and federal judges engaged in a “proportionality” analysis when evaluating discovery requests. Without the benefit of detailed rules of civil procedure, the scope of discovery in arbitration depends in large part on the discretion of the arbitrator. In the event of a dispute between the parties on the scope of discovery, arbitrators may choose to look to the rules of civil procedure, his or her own experience or anything else. There is nothing to prevent an arbitrator from allowing wide-ranging, multi-round discovery, increasing costs for all parties.

Attorneys in the “discovery-is-a-breeze-in-arbitration” group sometimes fail to appreciate the additional annoyance associated with compelling unwilling third-parties to produce information or dealing with an opponent’s unwarranted machinations. Arbitrators lack a court’s power to compel compliance with third-party subpoenas. As a result, extracting information from a third-party often requires the initiation of litigation anyway. Although arbitrators have some ability to punish parties who do not participate in discovery in good faith, many arbitrators are reluctant to do so.

Forward thinking corporate counsel may try to avoid such discovery tsunamis by including parameters for discovery within the provisions authorizing arbitration. But limitations that seem like a good idea when drafting an agreement can backfire if your client is the one that needs the deposition or the e-discovery to advance or defend their case. Given the extremely liberal pleading procedures that the arbitration rules provide, there is often an enhanced need for discovery in arbitration that makes any contractual limitation on the scope problematic.

Arbitration is Final

The finality of arbitration is often touted as one of its benefits. This justification is based on the unsound premise that finality is always desirable. It is only desirable if you are happy with the result or the costs of continued litigation is likely to eclipse the eventual outcome of the litigation. A party that has lost because of an arbitrator’s error has cause for concern about the finality of the proceeding; elimination of a right to appeal merely adds salt to the wound. In recognition of the perceived unfairness of such an outcome, the AAA rules now contemplate that parties may agree to make an arbitration award appealable to another panel of arbitrators.

Even absent an explicit appeal provision, a disappointed party may attempt to set aside an arbitration award by showing arbitrator bias, fraud, obvious miscalculation and other narrow categories of complaints. Although overturning the arbitration decision may have poor odds of success, the appeal may be disruptive and costly to the non-appealing party. If a trial court elects not to set aside the arbitration decision, the disappointed party may seek to appeal from that decision. Thus, a disappointed party in arbitration has two chances to set aside an award – first to the trial court, then to the intermediate appellate court – before it reaches an appellate court with discretionary jurisdiction. Conversely, a party that began its litigation in the court system has typically only one appeal before it reaches a court with discretionary jurisdiction.

The Take Away

Arbitration is not always inappropriate for commercial disputes. Confidentiality, speed and other justifications may make it the preferred method of dispute resolution in certain circumstances. It is equally true, however, that arbitration does not always performed as advertised. It is sometimes more expensive, less efficient and less effective than it might initially be intuited. A thoughtful and deliberate comparison of the costs and benefits of both arbitration and litigation will lead to more efficient dispute resolution that better serves the interests of all parties.

April 24, 2018November 2, 2020

‘Pittsburgh History’: Boring Name, Big Development for Attorney-Client Privilege

'Pittsburgh History': Boring Name, Big Development for Attorney-Client Privilege

April 24, 2018

You represent a privately held corporation considering a restructuring. You believe that the proposed transaction would violate the securities laws and advise the board of directors accordingly. The board, however, disregards your advice and proceeds with the transaction anyway. It violates the securities laws as you advised and several shareholders initiate derivative claims against the board on behalf of the company. The plaintiffs propound discovery seeking your communications with the board related to the transaction. Can the company assert the attorney-client privilege against plaintiffs? Pennsylvania courts have been surprisingly quiet on this common issue until recently.

A company’s assertion of privilege against a derivative plaintiff creates the unusual problem of a client asserting privilege against those purporting to act on the client’s behalf. Moreover, the people invoking the privilege for the corporation are generally the same people whose conduct gave rise to the derivative claim. Allowing defendants to invoke the company’s privilege may deprive derivative plaintiffs of the information they need to vindicate the company’s interests. A rule that allows a derivative plaintiff free access to otherwise privileged communications may impact the corporate client’s willingness to seek legal advice for fear that the request or the advice could later be used against it.

Any discussion of a corporation’s assertion of attorney-client privilege in the context of shareholder litigation begins with Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970). In Garner, a class of shareholders brought a derivative action on behalf of a corporation against various officers, directors and controlling persons. The plaintiffs sought communications between the corporation and its counsel relating to the conduct giving rise to the plaintiffs’ claims. The corporation asserted the attorney-client privilege seeking to prevent disclosure of the communications. Both the corporation and the American Bar Association, as amicus curiae, asserted that the corporation had an absolute right to assert attorney-client privilege in such circumstances. The plaintiffs took the equally extreme position that the privilege simply does not apply in the context of derivative claims.

The U.S. Court of Appeals for the Fifth Circuit rejected both positions and adopted a “goldilocks” approach that affirmed the applicability of the attorney-client privilege for a corporation involved in litigation with its shareholders, but allowed shareholder plaintiffs to pierce the privilege for good cause: The attorney-client privilege still has viability for the corporate client. The corporation is not barred from asserting it merely because those demanding information enjoy the status of stockholders. But where the corporation is in suit against its stockholders on charges of acting inimically to stockholder interests, protection of those interests as well as those of the corporation and of the public require that the availability of the privilege be subject to the right of the stockholders to show cause why it should not be invoked in the particular instance.

The court identified a nonexclusive list of “indicia” used to evaluate whether a derivative plaintiff has good cause for piercing the attorney-client privilege: the number of shareholders and the percentage of stock they represent; the bona fides of the shareholders; the nature of the shareholders’ claim and whether it is obviously colorable; the apparent necessity or desirability of the shareholders having the information and the availability of it from other sources; whether, if the shareholders’ claim is of wrongful action by the corporation, it is of action criminal, or illegal but not criminal, or of doubtful legality; whether the communication related to past or to prospective actions; whether the communication is of advice concerning the litigation itself; the extent to which the communication is identified versus the extent to which the shareholders are blindly fishing; and the risk of revelation of trade secrets or other information in whose confidentiality the corporation has an interest for independent reasons. Both the Restatement (Third) of the Law Governing Lawyers and the American Law Institute’s Principle of Corporate Governance: Analysis and Recommendations also adopted the substance of Garner.

There are two Pennsylvania cases addressing Garner. They reached contrary results and have not settled the law in this area. In Agster v. Barmada, 43 Pa. D. & C.4th 353, 359–60 (Com. Pl. 1999), Judge R. Stanton Wettick addressed a dispute among owners of a closely held business. A minority shareholder of a medical practice sued the majority shareholder for a variety of claims related to the majority’s diversion of business away from the practice. The minority shareholder plaintiff sought communications between the majority shareholder and the corporation’s counsel arguing that the attorney client-privilege does not apply to such communications. The court rejected this argument and prevented disclosure of the communication. Reasoning that the Pennsylvania Supreme Court had never recognized a conditional attorney-client privilege, the court expressly rejected Garner’s “good cause” analysis as inconsistent with Pennsylvania law.

The only Pennsylvania appellate court to address the attorney-client privilege in the context of derivative litigation did so on an unusual fact pattern. In Pittsburgh History & Landmarks Foundation, 161 A.3d 394 (Pa. Commw. Ct. 2017), a group of former board members of two related nonprofit corporations asserted derivative claims against the president and current board members alleging a variety of misconduct. In response to the lawsuit, defendants formed a committee to evaluate whether the derivative action was in the best interest of the nonprofit corporations. The committee determined that the litigation was not in the best interest of the corporations and defendants filed a motion to dismiss the derivative claims on that basis. The plaintiffs sought all the information provided to the investigative committee, including communications with counsel that would otherwise be privileged. The Commonwealth Court explicitly rejected the holding in Agster and adopted Garner’s “good cause” analysis. It emphasized that the possible exception to privilege only applied to communications that were “roughly contemporaneous with the events giving rise to the litigation,” presumably excluding communications that occur after a derivative plaintiff files suit.

The Pennsylvania Supreme Court granted cross-petitions for allowance of appeal from the Commonwealth Court’s decision and heard oral argument on April 11. If upheld, Pittsburgh History has obvious implications for both derivative plaintiffs and corporate counsel. For the derivative plaintiff, the case provides the potential to access a variety of highly relevant communications regarding the conduct that gave rise to their claims. For corporate counsel, the case injects uncertainty as to whether the attorney-client privilege will apply to communications with a corporation in the event of shareholder litigation. Counsel should advise their client of this possibility and, in the context of a closely held company, consider whether a majority owner should obtain personal counsel in circumstances where the majority owner wants to ensure the application of the privilege.

Reprinted with permission from the April 20, 2018 issue of The Legal Intelligencer.

February 28, 2018November 2, 2020

Demystifying Individual and Derivative Claims in Closely-Held Company Disputes

Demystifying Individual and Derivative Claims in Closely Held Corporate Disputes

February 28, 2018

By Edward S. Robson

You represent a minority shareholder of a closely-held corporation and the company is having an off year. The majority shareholder is the sole member of the board and serves in every officer position. She draws significant compensation. Without a business justification, she unilaterally decides to double her salary and have the company pay the mortgage on her vacation home. Your client is the only other shareholder and likely the only person hurt by the majority shareholder’s self-declared raise. Although the minority shareholder suffers a clear injury, characterizing the injury as direct or derivative can have a significant impact on the outcome of the litigation.

Until recently, minority shareholders in closely-held companies could assert claims for breach of fiduciary duty and corporate waste directly against the majority owner. If the claimant was successful, a court could order the majority shareholder to disgorge the spoils of her behavior and pay them to the minority shareholder. This type of direct recovery is no longer permissible. Since 2014, Pennsylvania courts have made clear that claims arising from breach of the duties owed to a corporation, even a closely-held one, belong to the corporation and must be asserted on a derivative basis. This requirement creates procedural and substantive complexities when compared to direct claims. Bringing such claims requires strategic and creative analysis and careful attention to detail.

Without a shareholder’s agreement, minority shareholders are largely at the mercy of the majority shareholder. Minority shareholders have no formal ability to direct how the company spends money, compensates employees or hires vendors. Some majority owners use their power to disadvantage the minority shareholder by excessively compensating themselves or causing the corporation to contract with vendors affiliated with the majority on unfair terms. Although the minority shareholder is the party ultimately damaged by this behavior, the Pennsylvania Business Corporation Law (“BCL”) makes clear that “[t]he duty of the board of directors … is solely to the business corporation … and may not be enforced directly by a shareholder.” To obtain redress for the majority shareholder’s misconduct, the minority shareholder is therefore required to assert their claims on a derivative basis on behalf of the corporation.

Notwithstanding the language of the BCL, Pennsylvania courts previously allowed minority shareholders to directly assert claims arising from a majority owner’s breach of the duties owed to the company and without the need for the formality of a derivative action. The impetus for this flexibility was dicta contained in a footnote in a case not involving a closely-held corporation. In Cuker v. Mikalauskas, 692 A.2d 1042, 1049, n. 5 (Pa. 1997), the Supreme Court relied heavily on the American Law Institute’s Principles of Corporate Governance: Analysis and Recommendations (“ALI Principals”) and offered its resounding endorsement of the publication generally. It emphasized the interlocking character of the provisions of the ALI Principals and invited the lower courts to apply them to the extent consistent with Pennsylvania law.

Pennsylvania trial courts accepted the Court’s invitation in the context of closely-held corporations. Section 7.01(d) of the ALI Principals recognizes that the traditional justifications for requiring derivative claims may be less persuasive in the closely-held company setting and gives courts discretion to relax the requirement in certain circumstances:

In the case of a closely held corporation, the court in its discretion may treat an action raising derivative claims as a direct action, exempt it from those restrictions and defenses applicable only to derivative actions, and order an individual recovery, if it finds that to do so will not (i) unfairly expose the corporation or the defendants to a multiplicity of actions, (ii) materially prejudice the interests of creditors of the corporation, or (iii) interfere with a fair distribution of the recovery among all interested persons.

Trial courts, notably the First Judicial District’s Commerce Program, adopted both the substantive and procedural aspects of Section 7.01(d). They allowed individual recovery to plaintiff shareholders, rather than to the corporation. Adoption of Section 7.01(d) also gave the courts discretion to reduce the procedural hurdles attendant to a derivative suit, such as the requirement that the minority shareholder formally demand that the corporation’s board sue the majority shareholder prior to the minority shareholder filing suit.

In 2014, the Superior Court reversed this trend when it expressly rejected application of the substantive aspects 7.01(d) as inconsistent with Pennsylvania law. Hill v. Ofalt, 85 A.3d 540, 556 (Pa. Super. Ct. 2014). Although the Superior Court left open the possibility that the Supreme Court might adopt the procedural aspects of Section 7.01(d), it rejected the notion that trial courts may “simply ignore the corporate form and … treat an action raising derivative claims as a direct action and order an individual recovery.” Id. (internal quotation and ellipsis omitted).

The post-Hill regime requires attorneys representing minority shareholders to look for opportunities to assert direct claims in lieu of derivative claims. The same facts that support a derivative claim may also be the basis of a direct claim. This is particularly common when the minority shareholder is involved in the operation of the business. For example, claims arising from the wrongful termination of a minority shareholder’s employment may form the basis of a direct claim on behalf of the minority shareholder, as well as a derivative claim against the majority shareholder for the breach of duty of care owed to the company.

Shareholder oppression claims are direct claims and may provide a viable method for a minority shareholder to obtain an individual recovery. Pennsylvania has long recognized that a majority shareholder has a quasi-fiduciary duty not to use their power in such a way as to exclude the minority shareholder from the “benefits accruing from the enterprise.” Carefully structured, a shareholder oppression claim can often address the same conduct that a court might otherwise classify as giving rise to a derivative claim. A claim that a majority shareholder increased their compensation to a level that leaves no profits available to be distributed to shareholders is likely a direct shareholder oppression claim. It may also be a derivative claim if the compensation is excessive by objective measure.

Fraud claims against majority shareholders may also be asserted directly if they arise from a misrepresentation made to the minority shareholder. The misrepresentation, however, must not be related to malfeasance in relation to the company. For example, misrepresenting the financial status of the business to induce a minority shareholder to invest additional capital that is subsequently lost is likely a direct claim. Falsely representing the terms of the majority shareholder’s excessive compensation is likely derivative because it is so closely related to the breach of the majority’s duty owed to the company itself.

When developing claims, keep in mind that counsel’s labeling of claims in pleadings as direct or derivative is not dispositive. Courts look to the substance of the allegations to determine the nature of the wrong.

The distinction between direct and derivative claims presents a variety of challenges in the context of closely-held business disputes. Recognizing the issue at that outset of the litigation and developing theories for asserting direct claims is critical to the successful representation of the minority shareholder.

Edward S. Robson is the managing shareholder of Robson & Robson P.C. and focuses his practice on litigation arising from commercial transactions, disputes among business owners, unfair competition and mergers and acquisitions. He has written and taught on a variety of topics affecting closely-held businesses. Mr. Robson can be reached at 610.825.3009 or [email protected].