Tennessee Business Litigation Law Blog

The Supreme Court of New Jersey ruled that an accounting firm may be liable to shareholders for failing to detect high-level fraud.  In NCP Litigation Trust v. KPMG LLP, a trust representing shareholders of bankrupt corporation Physician Computer Network sued the company's former accounting firm, KPMG. The suit alleged negligence, negligent misrepresentation, breach of contract, and breach of fiduciary duty.  From the case syllabus, among other factual allegations:

According to the Trust, PCN’s 1995 financial records, which KPMG certified, were in such disarray that the successor auditor could not reconstitute them. The Trust also alleged that KPMG failed to verify PCN’s receipt and deposit of a $3.5 million check that was part of a fraudulent asset purchase arranged by Mortell and Wraback. According to the Trust, a simple examination of PCN’s bank records would have revealed that this amount was never deposited. 

The trial court dismissed the lawsuit, concluding that the corporate officers' fraud was imputable to the litigation trust because it was the successor-in-interest to the corporation itself.  The appellate court reversed, and the Supreme Court affirmed with modifications.  The Supreme Court ruled that  when an auditor is negligent within the scope of its engagement, the imputation doctrine does not prevent corporate shareholders who are innocent of corporate wrongdoing from seeking to recover. 

Tenn. R. Civ. P. 23.06 provides that the shareholder must "fairly and adequately represent the interests of the shareholders or members similarly situated." This raises the question of what happens when there are no shareholders similarly situated to the Plaintiff...i.e., where the derivate plaintiff has a unique injury or, as is more often the case, where the plaintiff and defendants are the only shareholders in a close corporation.

This question was answered by the Tennessee Supreme Court in Hall v. Tennessee Dressed Beef Co. 957 S.W.2d 536, 540 (Tenn. 1997)
There, the Court noted that Rule 23.06 refers to "a derivative action brought by one or more shareholders" and that "Rule 23.06 does not require a specific number of similarly situated shareholders." Accordingly, assuming the other requirements of a derivate suit are met, the Court held that a derivative suit may be maintained by a single sharholder despite the fact that there are no other similary situtated individuals.

As pointed out by the Court, one of the more compelling rationales supporting this interpretation is that a contrary rule could effectively bar one shareholder of a closely held corporation from being able to assert the corporation's rights against the other shareholders.

The University of Buffalo School of Engineering Applied Sciences has published a new method for calculating the cost of managerial neglect to a company.

The method, which the UB engineers say can be used with an Excel spreadsheet, finds the net present value of improvements that could be done over a period of time, but are not done. The method factors in the learning rate of a process, which is the rate by which a process would improve naturally, without intervention, through repetition.

I have not seen the published document, the assumptions it relies on, or how peers in the field view its credibility and reliability. Thus, I don't know whether it would (or should) be deemed admissible. Nonetheless, I would expect parties in shareholder derivative suits to attempt to use this method to prove the amount of damages for breach of duty by officers and directors.

As a general rule, a shareholder who initiates a lawsuit derivatively on behalf of a corporation must maintain his ownership in the corporation throughout the life of the litigation. See Denver Area Meat Cutters and Employers Pension Plan ex rel. Clayton Homes, Inc. v. Clayton, 120 S.W.3d 841, 850 (Tenn.Ct.App.,2003) (applying Delaware law). Accordingly, if a derivative plaintiff ceases to own stock in the corportation, his standing to continue pursuing the claim or to appeal the claim on behalf of the corporation usually dissolves.

However, courts have recognized exceptions to the general rule. For example, a merger which terminates stock ownership has been held not to destroy the standing of a derivative plaintiff (1) where the merger itself is the subject of a claim of fraud, or (2) where the merger is in reality a reorganization which does not affect plaintiff's ownership of the business enterprise. Id. (citing Lewis v. Anderson, 477 A.2d 1040, 1046, n. 10 (Del.1982)).

Similarly, in Schilling v. Belcher, 582 F.2d 995, 1003 (5th Cir. 1978), the Fifth Circuit held that former derivative plaintiffs could defend a judgment on appeal supporting an award of attorney’s fees in their favor, but that the plaintiffs, who had ceased to be shareholders, had lost their right to initiate a cross-appeal on behalf of the corporation.

Parties to a derivative action should consult the case law of the relevant jurisdiction to see how those Courts have treated this issue of derivative standing.

There's a post up over at TCS Daily about the business judgment rule. The business judgment rule provides deference to corporate officers' decisions that are made reasonably and in good faith. It is, in essence, a precaution against second guessing with the benefit of hindsight. Instead, courts look to the diligence and competence that directors and officers demonstrated at the time their decisions were made. That said, there's a fine line between deference and ignorance, and the courts need not and can not turn a blind eye when corporate officers carelessly toss away shareholders' money. The Disney shareholder suit over a $140 million severance package paid to Michael Ovitz looks to clarify where that fine line is. (Found via the Modesto Business Law Blog).

Most lawyers are aware that there is a demand requirement attached to shareholder derivative suits. However, the relevent issues in the case will often vary depending on whether or not the demand was "refused" or "excused." Since making a demand prior to filing a derivative suit amounts to a tacit admission that a majority of the board is sufficiently independent and disinterested, the only issues to be examined in a "demand refused" case are the good faith and reasonableness of the board's investigation and response. Lewis on Behalf of Citizens Sav. Bank & Trust Co. v. Boyd, 838 S.W.2d 215, 222 ( Tenn. Ct. App. 1992). By contrast, the focus in a "demand excused" proceeding (i.e. futility) entails a showing that (1) that the board is interested and not independent and (2) that the challenged transaction is not protected by the business judgment rule. Id. A good overview of the factors that should be considered by the court in determining whether these showings have been made in a "demand excused" case can be found in the Lewis case cited above at 224-25.

Like many states, Tennessee allows corporations to include provisions in the corporate charter which limit the personal liability of directors when faced with a shareholder derivative action. [see T.C.A. 48-12-102(b)(3)]. However, this protection only extends to "duty of care" breaches. By statute, corporations cannot insulate directors from liability for "duty of loyalty" breaches, unlawful distributions, or any other act that evidences either bad faith or an intentional or knowing violation of the law. Id.

The much heralded Disney opinion is now online at the Delaware Chancery Court's website. There is little, if any, new law here. It is application of existing law to the facts of a specific case. However, it does succinctly summarize the law on the duties of officers and directors of a corporation in a rather brief section - pages 104 to 125, or 21 pages of a 175 page defense verdict. The Chancellor did analyze whether there is an emerging claim for breach of the duty of good faith by an officer or director of a corporation, concluding that an action might exist in Delaware.

The general consensus on the Disney ruling, based on the summaries of the ruling that have circulated in the last two days, is that it's a big win for the business judgment rule. many people have noted that the Chancellor bashed everyone involved at Disney - Michael Ovitz, Michael Eisner, and the board. Still, the Chancellor let them off with a tongue lashing. Over at the Conglomerate, they've got a bit up about what this means for the business judgment rule.

The shareholder suit against Disney over the $140 million severance package is over (for now). The trial court ruled last night that Disney's board of directors did not violate their fiduciary duties to the company's shareholders when they granted the severance deal to Michael Ovitz. The plaintiffs' lawyers have said they will appeal. A few notes:

• According to most of the news reports, the Chancellor's decision was 175 pages long. When's the last time you received a 175 page decision from a trial judge? Are they counting the transcript of oral argument?
• The L.A. Times has some excerpts from the ruling that chastise Disney's board, its CEO Michael Eisner, Ovitz, and the decisions that each made leading to this case.
• Despite the attention the case has gotten (Google News currently shows 340 reports on the ruling), it is just a trial court's decision applying existing law to the facts of a specific case. It carries slightly more precedential value in a Tennessee dispute than the case in My Cousin Vinny - partly because the prosecutor dismissed that case.