[Shareholder Oppression] Indiana Decision Upholding Dismissal of Derivative C...
Eric Fryar
Long v. Biomet, Inc., 901 N.E.2d 37 (Ind. App. February 13, 2009). [Read Opinion]
This recent case concerns a common tactic employed by majority shareholders or management to defeat shareholder derivative actions. If the majority shareholder or the current management (who can control or persuade a sufficient majority of the stock ownership) is faced with a derivative suit brought by a minority shareholder, one way of seeking to protect the defendants from liability is to engineer a "freeze-out" merger of the corporation, in which the stock of the existing corporation is sold to or merged into an acquiring corporation, and the minority shareholders are cashed out. If the minority shareholder bringing the derivative claim is subject to the cash-out, then that shareholder will lose his share ownership and thus his standing to prosecute the claim. "A plaintiff who ceases to be a shareholder, whether by reason of a merger or for any other reason, loses standing to continue a derivative suit." Lewis v. Anderson, 477 A.2d 1040, 1049 (Del. 1984). Theoretically, the derivative claim, like all assets of the corporation would pass to the surviving entity; however, if the defendants obtain sufficient control of the surviving entity, then they will not prosecute the claim. Even if the surviving entity is owned by a third party (not originally a shareholder), the existing claim will be deemed extinguished because the law presumes that whatever harm the prior owners or managers did to the corporation is accounted for in the purchase price, and thus new corporation will be precluded from suing the former owners or management. Bangor Punta Operations, Inc. v Bangor & A.R.Co., 417 U.S. 710-713 (1974) [Read Opinion]
In the Long case, shareholders of a publicly-held Indiana corporation commenced a derivative suit for back-dating stock options. While that lawsuit was pending, the management arranged for a merger is a third party in which the existing shareholders would be cashed out. After the merger became effective, the trial court dismissed the derivative action because the shareholders had no standing. The court of appeals affirmed.
The decision of the court of appeals turned on two prior Indiana Supreme Court cases: Gabhart v. Gabhart, 370 N.E.2d 345 (Ind. 1977), and Fleming v. International Pizza Supply Corp., 676 N.E.2d 1051 (Ind. 1977). In Gabhart, the plaintiff asserted that his four fellow shareholders in a closely held corporation had misappropriated corporate funds and wrongfully denied him access to corporate records, and he later added the claim that they had effected a "freeze out" merger for the sole purpose of stripping him of his interest in the resulting corporation. As to the latter claim, the Indiana Supreme Court held that "in a bona fide merger proceeding, a dissenting or non-voting shareholder is limited to the means provided by statute for the realization of his equity," specifically, the statutory appraisal process. Id. at 356. However, it held "that a proposed merger which ha[d] no valid purpose" could be challenged "by procedures other than those provided by statute for that purpose." Id. at 356. The Supreme Court cited the "well established" principle that "being a shareholder of the corporation whose cause of action is to be enforced in a derivative suit is a prerequisite for standing to sue," and held that "[w]hen a corporation is merged out of existence, ..., its assets and liabilities are transferred to the surviving corporation by operation of law, ... and the shareholders' interests in the merged corporation come[ ] to an end. … and [the cause of action] passes to the surviving corporation along with the other assets of the merged corporation." Id. at 357. However, there is an "equitable limitation upon a surviving corporation's right to succeed to a merging corporation's cause of action," specifically: when "each" shareholder of the surviving corporation "had participated in the wrong complained of." Id. Accordingly, the court held that "if a merger is effected solely for the purpose of shielding wrongdoers from liability, the merger may be attacked as devoid of a legitimate corporate purpose" by the former shareholder. Id. In such a case, Gabhart concluded, the trial court held equity jurisdiction to grant relief to the former shareholder.
Nine years after the Gabhart decision, the Indiana Legislature amended the Indiana Business Corporation Law, Ind. Code §23-1-44(8)(c). [Read Statute] The amendment basically tracks the Model Corporations Act, except that the Indiana Legislature deleted the language that provided that the appraisal remedy is the exclusive remedy for dissenting shareholders "unless the transaction is unlawful or fraudulent with respect to the shareholder or the corporation." In Fleming v. International Pizza Supply Corp., 676 N.E.2d 1051, 1055 (Ind. 1997), the Indiana Supreme Court held that this amendment was the Legislature's "conscious response" to the Gabhart decision. Therefore, subsequent to the enactment of the BCL, "in a merger or asset sale, the exclusive remedy for the value of the shareholder's shares is the statutory appraisal procedure"—which remedy included "the ability of dissenting shareholders to litigate their breach of fiduciary duty or fraud claims within the appraisal proceeding." Id. at 1056, 1057. In other words, if a merger results in the dismissal of a shareholder's derivative action, then the shareholder's sole remedy is to argue in an appraisal proceeding that the price for his stock should be higher because the merger price did not adequately reflect the value of the derivative claim as a corporate asset.
The shareholders in Long v. Biomet, Inc. received $46 per share for their stock. Apparently, they conceded that this was a fair price, but also wanted to receive their share of hundreds of millions of dollars by which Biomet's management had been unjustly enriched by backdating options. The shareholders argued that their claim for damages should not be transferred to the new corporation and their standing to bring the action should not cease because of the merger; rather, the action should pass to the old shareholders as a group. The plaintiffs relied on a statement in a footnote in Fleming that "the BCL did not intend to restrict any claims of wrongdoing that a corporation or shareholder brings before the corporate action creating dissenters' rights occurs." Id. at 1057 n.9. However, the court of appeals correctly pointed out that, read in context, the Supreme Court's statement clearly meant that the claims of wrongdoing brought prior to the merger must be adjudicated in the context of an appraisal of the dissenting shareholder's stock.
--
Posted By Eric Fryar to Shareholder Oppression at 3/21/2009 09:13:00 AM