[Shareholder Oppression] Two Significant Decisions on Texas Derivative Actions
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Eric Fryar
May 30, 2009, 7:41:39 PM5/30/09
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In Re Schmitz, No. 07-0581, 2009 WL 1427184 (Tex.), 52 Tex. Sup. Ct. J. 772 (Tex. May, 22, 2009) [Download PDF]
Somers v. Crane, No. 01-07-00754-CV, 2009 WL 793751 (Tex. App.--Houston [1st Dist.] March 26, 2009).
Both of these cases involve challenges by shareholders of Texas corporations to proposed cash-out mergers. In Schmitz, the board of directors of Lancer Corp. accepted a buyout offer from Hoshizaki America, Inc. for $22 per share. About a month before the merger was to be submitted to shareholders for approval, a law firm purporting to represent an unnamed shareholder sent a demand to the Board of Directors that the merger be canceled because of the existence of a superior offer of $23 per share. Three days later, a derivative suit was filed seeking an injunction to halt the merger and declaratory relief against the board members. After the merger was approved and closed, and the plaintiff ceased to be a shareholder, the plaintiff amended her petition to seek rescission of the merger and damages against the former directors of Lancer. The defendants moved to dismiss for failure to send a proper pre-suit demand; the trial court denied the motion; the Court of Appeals denied mandamus relief; but the Texas Supreme Court granted a conditional writ of mandamus.
Somers involved a shareholder challenge to a proposed effort by the management of EGL, Inc. to buy the company and take it private. The board of directors approved the merger and also approved onerous "lock up" provisions, including a $30 million termination fee. The plaintiff filed a derivative suit seeking to block the proposed acquisition by management on the grounds that a higher bid had been submitted to the board by a third party buyer. A class action was also filed on behalf of the shareholders seeking essentially the same relief, but asserting breach of fiduciary duty claims directly on behalf of the shareholders rather than derivatively. After the lawsuits were filed, the Board of Directors did agree to the acquisition by the third party, but the management group was paid the termination fee. The lawsuits were then amended to assert claims for damages for payment of the termination fee. The trial court dismissed the derivative suit for failure to comply with the demand requirement in TBCA art. 5.14(c). The derivative plaintiff then sent a formal demand and waited 90 days per the statute. In the meantime, the merger with the third-party buyer was close, and all the shareholders were cashed out. Shortly thereafter, the 90-day waiting period expired, and the derivative plaintiff refiled the case seeking damages for breach of fiduciary duty for paying the termination fee. The trial court dismissed the class-action on the grounds that the shareholders had no standing to assert directly claims for breach of fiduciary duty against the Board of Directors. The trial court also dismissed the new derivative suit on the grounds that the plaintiff was no longer a shareholder and thus no longer had standing to maintain the action.
Adequacy of Presuit Demand
There were two complaints about the pre-suit demand in Schmitz: the demand letter did not identify the shareholder, and the demand letter was not sufficiently "particular" in its description of its complaints. Article 5.14 does not expressly state that a pre-suit demand must state the name the shareholder, but the Texas Supreme Court holds that the plain implication of the statute requires identification of the complaining shareholder. Furthermore, the court noted that a number of public policy reasons would also require that a shareholder demand could not be made anonymously. Among these was the concern that the use of anonymous demands could be abused and that the Board of Directors would need the shareholder's identity in responding to the demand. "In other words, a demand from Warren Buffett may have different implications than one from Jimmy Buffett."
Article 5.14 (c) does require that the demand set forth "with particularity" the matter about which the complaint is made. The Texas Supreme Court held that the Schmitz demand letter was not sufficiently particular in its description of the claim. The demand letter urged the board to stop the merger because it had received a "superior offer" of one dollar more per share. The Supreme Court's problem with the statement of the demand seems to be primarily that the statement was very short -- two sentences -- and that the demand did not state explicitly why one dollar less per share made the offer "inferior." However, the court gives almost no guidance as to how particular the statement must be in order to qualify as a pre-suit demand. "We do not attempt today to explore all the ways in which a demand might or might not meet article 5.14's 'with particularity' requirements. Whether a demand is specific enough will depend on the circumstances of the corporation, the board, and the transaction involved in the complaint. But given the size of this corporation and the nature of this transaction, this demand was clearly inadequate."
The court's holding and analysis raises many more questions than it answers. If the complaint in this case was that there were two offers, and one was more than the other, and that the shareholders would want a higher offer, but that the board took the lower offer, it is difficult to imagine how one could state that complaint with greater "particularity" than was done in this case. The Court acknowledges that "all things being equal" the greater offer would be preferred by the shareholders, but the court notes that in comparing competing offers for a merger, "all things are rarely equal." The court notes a host of reasons why a board might decide that the offer with a lower cash value is actually better for the shareholders. The court stated that a rule requiring the corporation always to accept nominally higher offers would result in harm sometimes to the shareholders and would subvert the business judgment rule in Texas. All of this is true, but all of it is completely irrelevant as to whether the demand stated its complaint with particularity. If a shareholder thinks the board should take the option that gives that shareholder more cash, then in responding to that complaints the board might justifiably decide that the complaint is unfounded for all the reasons and factors cited by the Court, but that does not mean that the board would not know the basis of the shareholders complaint, as the Court suggests. The purpose of a pre-suit demand is to give the board of directors the opportunity to determine whether the complaint is valid and to take corrective action. Inherent in this idea is the assumption that the board may disagree with the shareholder. the language used by the court seems to suggest that all the factors and evidence on which the plaintiff may ultimately base his case must be laid out in the demand letter, almost as if the Board of Directors would have no source of information or basis on which to respond other than the information contained in the demand letter. That is simply unrealistic. The Board of Directors will always have more and better information about a corporate transaction than is available to an individual shareholder. Demand futility is no longer a legal concept in Texas. Therefore, if the shareholder's complaint is that the Board of Directors is acting fraudulently or withholding information, under current Texas law, the shareholders still has to send the demand to the Board of Directors that it shoud sue itself and wait 90 days before filing suit. In that sort of situation, it will almost always be the fact that the shareholder does not have access to information, absent discovery, about the extent of management's wrongdoing.
The requirement of particularity in the demand simply cannot be as onerous as the language in the court's opinion seems to suggest. If, in the course of deciding between competing merger offers, a Board of Directors accepts a lower bid, and fully discloses to the shareholders the reasons for its decision, then clearly a demand merely stating that the board should have taken the higher offer is an adequate because any litigation will ultimately concern whether the board's reasoning was sound or falls within the business judgment rule. If the shareholder has a position as to why the board's evaluation of the offers was incorrect or not disinterested, then merely complaining that the price is lower does conceal the shareholder's true complaint. That may very well have been the situation in this case, but the opinion does not make that clear. However, if the board failed to disclose why it determined the lower offer was better or failed to disclose what about the non-cash provisions of the offers was deemed to be more valuable than difference in cash amounts, then truly all a shareholder can say is "you are not acting in the best interest of the shareholders because your decision gives us less money." If that is the real complaint, it is hard to get more particular.
One standard can be gleaned from the court's analysis. On appeal the plaintiffs had argued that it was proper to challenge the merger because there were personal benefits to the board of directors in the lower offer that may have induced them to violate their duty of loyalty in selecting that offer over the one that gave more benefit to the shareholders. The Supreme Court agrees that a derivative suit would be an important means of preventing a corporate board from enriching themselves at the shareholders' expense, but "the demand letter here said nothing about any of that." It would seem, at a minimum, that the particularity requirement would force a plaintiff to state in the demand letter all the claims, bases, and facts that are in the petition that is ultimately filed. Clearly, the board should be confronted at the demand stage with everything that the plaintiff is prepared to plead 90 days later at the litigation stage, and the plaintiff would have absolutely no legitimate reason to withhold that information. However, since Texas has no requirement that pleadings be stated "with particularity," something more is probably required. The Supreme Court's opinion makes clear that the plaintiff's basis for her complaint about the board's action must be fully disclosed. Hopefully, future courts will not interpret this decision as requiring a plaintiff to submit to the Board a document that could not possibly be created until after discovery in order to have standing to commence the suit and take the discovery.
Pace v. Jordan, 999 S.W.2d 615, 621 (Tex. App.—Houston [1st Dist.] 1999, pet. denied), had previously held that a demand must (1) identify the alleged wrongdoer, (2) describe the factual basis of the claim, (3) describe the corporation's injury, and (4) request remedial action. "A demand is sufficient if the board of directors had a fair opportunity to consider the shareholder's claims." Pace specifically held that the demand need not be as detailed as the plaintiff's pleadings in the lawsuit. The Supreme Court cites Pace on another point but does not even mention the opinion's discussion of this issue. However, Pace was determining the sufficiency of a demand under the version of art. 5.14 prior to the 1997 amendments, which did not have a requirement of particularity. The Supreme Court's ignoring of the Pace decision should probably be taken to mean that Pace is no longer good law on this point.
Procedural Issues in Presuit Demand
The Supreme Court also did address an important procedural issue. If a plaintiff's lawsuit is dismissed because the court determines that the plaintiff failed to give an inadequate pre-suit demand, then the plaintiff has an immediate right to appeal. However, if the trial court fails to enforce that demand requirements of the statute, the lawsuit goes on, and there is no right to an interlocutory appeal. However, the Supreme Court holds that mandamus review is available. The court notes that the availability of mandamus must be decided on a case-by-case basis. The court notes that mandamus might be inappropriate if another shareholder has made a proper demand, or if the lawsuit will go forward regardless on other non-derivative claims, or if recovery of expenses from the shareholder is an adequate remedy. In Somers, the derivative plaintiff's first action was also dismissed on the basis of an inadequate demand. The appellate court's opinion states that the plaintiff alleged that he had made a demand upon the board on January 4, 2007, pursuant to article 5.14, and that the plaintiff filed his lawsuit on April 11, 2007. The defendants filed a motion to dismiss and special exceptions, which the trial court granted. The trial court denied plaintiff's motion for leave to amend and his request for findings of fact and conclusions of law. The appellate opinion makes clear that the plaintiff had pleaded that he had complied with the demand requirements of article 5.14 and that he had made his first demand more than 90 days before the lawsuit was filed. It is a pity that the opinion does not deal with this issue. Given that the court was granting special exceptions, which are challenges to the pleadings, and that the plaintiff was appealing the trial court's refusal to allow him to amend his pleadings, the dismissal may have been based on the plaintiff's failure to comply with pleading requirements of article 5.14 (G) that the petition must allege with particularity facts that establish that the rejection of the demand was not made in accordance with the good faith and disinterestedness requirements of article 5.14 (F) and (H). There is an ambiguity in the statute. Under article 5.14 (C.), a plaintiff is required to wait 90 days after the date that the demand was made, "unless the shareholder has earlier been notified that the demand has been rejected by the Corporation..." It is not clear whether it the pleading requirements of article 5.14(G) apply if the plaintiff has not been informed of a rejection or if the corporation simply ignores the demand and makes no decisions whatsoever. It would seem a terrifically difficult burden on a plaintiff to plead with particularity the defects in the decision-making process when he has heard nothing from the Board of Directors and has no idea what they did. If that situation existed in this case, and the trial court granted special exceptions and dismissed the case on those grounds, it would be interesting indeed to see what an appellate court would have to say about that ruling.
Standing to Pursue Derivative Claim After Cash-out Merger
Somers held that the derivative plaintiff lost his standing to pursue the derivative claims as a result of having his stock cashed out in the merger. The common law rule is well-established that a shareholder loses his standing to maintain a derivative suit if the corporation undergoes a merger and the shareholder's stock is exchanged for cash, unless (1) the merger was fraudulent because its only purpose was to eliminate the defendant's liability in the derivative suit, or (2) the merger was really a reorganization in which the plaintiff retains an ownership interest in the company. See Lewis v. Ward, 852 A.2d 896, 902-04 (Del. 2004). In Zauber v. Murray Sav. Ass'n, 591 S.W.2d 932, 935 (Tex. Civ. App.--Dallas 1979), writ ref'd per curiam, 601 S.W.2d 940 (Tex. 1980), the defendant in a derivative suit argued that the plaintiff lost standing as a result of a reverse stock split that cashed out his resulting fractional shares. The court acknowledged that shareholder does lose standing if he ceases to be a shareholder at anytime during the pendency of the lawsuit, but that there would be an exception if the transaction's purpose was to get rid of the lawsuit. Somers argued that Zauber was construing a prior version of the statute and that the current article 5.14(C) only expressly requires ownership at the commencement of the lawsuit. The appellate court did not see any real difference as a result of the amendment of the TBCA and applied the prior case law. Because Somers did not attack the legitimacy of the merger, he lost his standing.
Somers also argued that TBCA art. 5.03(M) maintained his standing. Section M is part of the merger statute and provides: "To the extent a shareholder of a corporation has standing to institute or maintain derivative litigation on behalf of the corporation immediately before a merger, nothing in this article may be construed to limit or extinguish the shareholder's standing." That is a much tougher argument, and the federal judge in Marron v. Ream, No. CIV H-06-1394, 2006 WL 2734267 (S.D. Tex. May 05, 2006) had previously suggested that this section would preserve the plaintiff's standing in similar circumstances. The court holds that art. 5.03(M) clearly does not create standing, but merely preserves standing. Therefore, in Somers' second lawsuit, filed after he lost his stock, this section does not help. However, with regard to his first lawsuit, which was also on appeal, the court held that the statement that the merger would not "limit or extinguish the shareholders' standing" meant that the plaintiff had to be a shareholder after the merger as well as before, and therefore the provision's sole application was to mergers in which the plaintiff receives shares in the surviving entity. The court dismisses the statement in Marron as dicta. Frankly, that reading of the statute seems a little strained. The provision states that when "a shareholder" has standing immediately prior to the merger, then the law providing for the merger will not limit or extinguish "the shareholder's standing." The term "the shareholder" plainly refers the the person identified in the first part of the sentence. To say that this language imposes an additional condition so that the statute provides nothing more than the traditional common-law exception is a real stretch.
Fiduciary Duties of the Board in a Cash-out Merger
The class-action by shareholders in Somers asserted breach of fiduciary duty claims against the directors directly by the shareholders. The class plaintiffs did not have to worry about the adequacy of demand or any of the other requirements of article 5.14 -- if their theory of liability was correct. The defendants filed special exceptions seeking the dismissal of the claims for failure to state a cause of action recognized under Texas law. This was based on the argument that the fiduciary duties of corporate directors run only to the corporation and not to individual shareholders. The trial court sustained the special exceptions and dismissed the claim because amendment could not cure the defect. Technically, this was incorrect. The duties described by plaintiffs do exist under Texas law, and the cause of action for breach of the students does exist under Texas law. The problem was not that the plaintiffs failed to state a claim recognized by Texas law, it was that the plaintiffs lacked standing to assert that claim individually. Only the corporation or a shareholder suing derivatively on behalf of the corporation could assert that claim. Lack of standing, under Texas law, is a matter of subject matter jurisdiction and should have been challenged through a plea to the jurisdiction, not special exceptions.
The Court of Appeals affirmed, citing a string of Texas cases holding that a director's fiduciary duty runs only to the Corporation, not individual shareholders, except where there is a contract or a confidential relationship or "in certain limited circumstances" in the context of shareholder oppression claims. The class plaintiffs argued that in the context of a cash out merger where the corporation will no longer exist and the shareholders will be dispossessed of their stock, a special duty should arise from the directors to the individual shareholders. In other words, precisely because the law precluded the derivative plaintiffs from maintaining their lawsuit, a special duty should be created to allow the class plaintiffs to do so. The appellate court did not bite.
Actually this issue is much thornier then the appellate court's opinion would suggest. There should be a duty owed by the directors directly to the shareholders in the context of any transaction that involves the acquisition the shareholders' stock -- not because the corporation will cease to exist, but because in considering and negotiating merger and acquisition offers from third parties, the directors of the corporation are not acting on behalf of a corporation but are acting directly as agents for the shareholders. Texas courts have recognized that is, as a general matter, the corporate entity has no interest in its own outstanding stock. Alexander v. Sturkie, 909 S.W.2d 166 (Tex.App.-Hous. (14 Dist.) 1995 writ denied). When a Board of Directors negotiates a stock acquisition or merger, it is negotiating the sale of something that is owned by the shareholders individually, not by the corporation. When the board of directors accepts an offer from a third party, it must present that offer to the shareholders, and the offer is only accepted if approved by the shareholders. If the directors do a poor or dishonest job with respect to the transaction, it is the shareholders who suffer the loss directly, not the corporation. The only reason that the board of directors is involved at all in the sale of the shareholders' property, is that the law provides a mechanism for forcing minority shareholders to sell their property if the majority wants to enter in the transaction. However, the directors in performing those duties are representing the interests of the shareholders directly, not the interests of the corporation. As the agent of the shareholders, logically the board should owe fiduciary duties directly to the shareholders.
Ironically, the Texas Supreme Court in Schmitz, decided almost 2 months to the day after Somers, lends some credence to this argument. In footnote 34, the opinion states that one of the problem with the demand letter sent by the shareholders was that it did not "specify why accepting $22 rather than $23 would harm the corporation." The court cites the Marron opinion for the proposition that it was questionable whether claiming that board should have accepted an offer for $35.50 rather than an offer for $35 per share "was a derivative claim belonging to the corporation." It is almost as if the Supreme Court is hinting in the footnote that the plaintiff had blown it like bringing the action as a derivative claim rather than a direct claim and thus falling under the requirements of article 5.14. Obviously, the Court of Appeals in Somers did not have the Schmidt decision, and this argument was apparently not made to the court. It will be interesting to see whether any Texas courts address this particular issue in the future.
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Posted By Eric Fryar to Shareholder Oppression at 5/30/2009 12:22:00 PM
Somers v. Crane, No. 01-07-00754-CV, 2009 WL 793751 (Tex. App.--Houston [1st Dist.] March 26, 2009).
Both of these cases involve challenges by shareholders of Texas corporations to proposed cash-out mergers. In Schmitz, the board of directors of Lancer Corp. accepted a buyout offer from Hoshizaki America, Inc. for $22 per share. About a month before the merger was to be submitted to shareholders for approval, a law firm purporting to represent an unnamed shareholder sent a demand to the Board of Directors that the merger be canceled because of the existence of a superior offer of $23 per share. Three days later, a derivative suit was filed seeking an injunction to halt the merger and declaratory relief against the board members. After the merger was approved and closed, and the plaintiff ceased to be a shareholder, the plaintiff amended her petition to seek rescission of the merger and damages against the former directors of Lancer. The defendants moved to dismiss for failure to send a proper pre-suit demand; the trial court denied the motion; the Court of Appeals denied mandamus relief; but the Texas Supreme Court granted a conditional writ of mandamus.
Somers involved a shareholder challenge to a proposed effort by the management of EGL, Inc. to buy the company and take it private. The board of directors approved the merger and also approved onerous "lock up" provisions, including a $30 million termination fee. The plaintiff filed a derivative suit seeking to block the proposed acquisition by management on the grounds that a higher bid had been submitted to the board by a third party buyer. A class action was also filed on behalf of the shareholders seeking essentially the same relief, but asserting breach of fiduciary duty claims directly on behalf of the shareholders rather than derivatively. After the lawsuits were filed, the Board of Directors did agree to the acquisition by the third party, but the management group was paid the termination fee. The lawsuits were then amended to assert claims for damages for payment of the termination fee. The trial court dismissed the derivative suit for failure to comply with the demand requirement in TBCA art. 5.14(c). The derivative plaintiff then sent a formal demand and waited 90 days per the statute. In the meantime, the merger with the third-party buyer was close, and all the shareholders were cashed out. Shortly thereafter, the 90-day waiting period expired, and the derivative plaintiff refiled the case seeking damages for breach of fiduciary duty for paying the termination fee. The trial court dismissed the class-action on the grounds that the shareholders had no standing to assert directly claims for breach of fiduciary duty against the Board of Directors. The trial court also dismissed the new derivative suit on the grounds that the plaintiff was no longer a shareholder and thus no longer had standing to maintain the action.
Adequacy of Presuit Demand
There were two complaints about the pre-suit demand in Schmitz: the demand letter did not identify the shareholder, and the demand letter was not sufficiently "particular" in its description of its complaints. Article 5.14 does not expressly state that a pre-suit demand must state the name the shareholder, but the Texas Supreme Court holds that the plain implication of the statute requires identification of the complaining shareholder. Furthermore, the court noted that a number of public policy reasons would also require that a shareholder demand could not be made anonymously. Among these was the concern that the use of anonymous demands could be abused and that the Board of Directors would need the shareholder's identity in responding to the demand. "In other words, a demand from Warren Buffett may have different implications than one from Jimmy Buffett."
Article 5.14 (c) does require that the demand set forth "with particularity" the matter about which the complaint is made. The Texas Supreme Court held that the Schmitz demand letter was not sufficiently particular in its description of the claim. The demand letter urged the board to stop the merger because it had received a "superior offer" of one dollar more per share. The Supreme Court's problem with the statement of the demand seems to be primarily that the statement was very short -- two sentences -- and that the demand did not state explicitly why one dollar less per share made the offer "inferior." However, the court gives almost no guidance as to how particular the statement must be in order to qualify as a pre-suit demand. "We do not attempt today to explore all the ways in which a demand might or might not meet article 5.14's 'with particularity' requirements. Whether a demand is specific enough will depend on the circumstances of the corporation, the board, and the transaction involved in the complaint. But given the size of this corporation and the nature of this transaction, this demand was clearly inadequate."
The court's holding and analysis raises many more questions than it answers. If the complaint in this case was that there were two offers, and one was more than the other, and that the shareholders would want a higher offer, but that the board took the lower offer, it is difficult to imagine how one could state that complaint with greater "particularity" than was done in this case. The Court acknowledges that "all things being equal" the greater offer would be preferred by the shareholders, but the court notes that in comparing competing offers for a merger, "all things are rarely equal." The court notes a host of reasons why a board might decide that the offer with a lower cash value is actually better for the shareholders. The court stated that a rule requiring the corporation always to accept nominally higher offers would result in harm sometimes to the shareholders and would subvert the business judgment rule in Texas. All of this is true, but all of it is completely irrelevant as to whether the demand stated its complaint with particularity. If a shareholder thinks the board should take the option that gives that shareholder more cash, then in responding to that complaints the board might justifiably decide that the complaint is unfounded for all the reasons and factors cited by the Court, but that does not mean that the board would not know the basis of the shareholders complaint, as the Court suggests. The purpose of a pre-suit demand is to give the board of directors the opportunity to determine whether the complaint is valid and to take corrective action. Inherent in this idea is the assumption that the board may disagree with the shareholder. the language used by the court seems to suggest that all the factors and evidence on which the plaintiff may ultimately base his case must be laid out in the demand letter, almost as if the Board of Directors would have no source of information or basis on which to respond other than the information contained in the demand letter. That is simply unrealistic. The Board of Directors will always have more and better information about a corporate transaction than is available to an individual shareholder. Demand futility is no longer a legal concept in Texas. Therefore, if the shareholder's complaint is that the Board of Directors is acting fraudulently or withholding information, under current Texas law, the shareholders still has to send the demand to the Board of Directors that it shoud sue itself and wait 90 days before filing suit. In that sort of situation, it will almost always be the fact that the shareholder does not have access to information, absent discovery, about the extent of management's wrongdoing.
The requirement of particularity in the demand simply cannot be as onerous as the language in the court's opinion seems to suggest. If, in the course of deciding between competing merger offers, a Board of Directors accepts a lower bid, and fully discloses to the shareholders the reasons for its decision, then clearly a demand merely stating that the board should have taken the higher offer is an adequate because any litigation will ultimately concern whether the board's reasoning was sound or falls within the business judgment rule. If the shareholder has a position as to why the board's evaluation of the offers was incorrect or not disinterested, then merely complaining that the price is lower does conceal the shareholder's true complaint. That may very well have been the situation in this case, but the opinion does not make that clear. However, if the board failed to disclose why it determined the lower offer was better or failed to disclose what about the non-cash provisions of the offers was deemed to be more valuable than difference in cash amounts, then truly all a shareholder can say is "you are not acting in the best interest of the shareholders because your decision gives us less money." If that is the real complaint, it is hard to get more particular.
One standard can be gleaned from the court's analysis. On appeal the plaintiffs had argued that it was proper to challenge the merger because there were personal benefits to the board of directors in the lower offer that may have induced them to violate their duty of loyalty in selecting that offer over the one that gave more benefit to the shareholders. The Supreme Court agrees that a derivative suit would be an important means of preventing a corporate board from enriching themselves at the shareholders' expense, but "the demand letter here said nothing about any of that." It would seem, at a minimum, that the particularity requirement would force a plaintiff to state in the demand letter all the claims, bases, and facts that are in the petition that is ultimately filed. Clearly, the board should be confronted at the demand stage with everything that the plaintiff is prepared to plead 90 days later at the litigation stage, and the plaintiff would have absolutely no legitimate reason to withhold that information. However, since Texas has no requirement that pleadings be stated "with particularity," something more is probably required. The Supreme Court's opinion makes clear that the plaintiff's basis for her complaint about the board's action must be fully disclosed. Hopefully, future courts will not interpret this decision as requiring a plaintiff to submit to the Board a document that could not possibly be created until after discovery in order to have standing to commence the suit and take the discovery.
Pace v. Jordan, 999 S.W.2d 615, 621 (Tex. App.—Houston [1st Dist.] 1999, pet. denied), had previously held that a demand must (1) identify the alleged wrongdoer, (2) describe the factual basis of the claim, (3) describe the corporation's injury, and (4) request remedial action. "A demand is sufficient if the board of directors had a fair opportunity to consider the shareholder's claims." Pace specifically held that the demand need not be as detailed as the plaintiff's pleadings in the lawsuit. The Supreme Court cites Pace on another point but does not even mention the opinion's discussion of this issue. However, Pace was determining the sufficiency of a demand under the version of art. 5.14 prior to the 1997 amendments, which did not have a requirement of particularity. The Supreme Court's ignoring of the Pace decision should probably be taken to mean that Pace is no longer good law on this point.
Procedural Issues in Presuit Demand
The Supreme Court also did address an important procedural issue. If a plaintiff's lawsuit is dismissed because the court determines that the plaintiff failed to give an inadequate pre-suit demand, then the plaintiff has an immediate right to appeal. However, if the trial court fails to enforce that demand requirements of the statute, the lawsuit goes on, and there is no right to an interlocutory appeal. However, the Supreme Court holds that mandamus review is available. The court notes that the availability of mandamus must be decided on a case-by-case basis. The court notes that mandamus might be inappropriate if another shareholder has made a proper demand, or if the lawsuit will go forward regardless on other non-derivative claims, or if recovery of expenses from the shareholder is an adequate remedy. In Somers, the derivative plaintiff's first action was also dismissed on the basis of an inadequate demand. The appellate court's opinion states that the plaintiff alleged that he had made a demand upon the board on January 4, 2007, pursuant to article 5.14, and that the plaintiff filed his lawsuit on April 11, 2007. The defendants filed a motion to dismiss and special exceptions, which the trial court granted. The trial court denied plaintiff's motion for leave to amend and his request for findings of fact and conclusions of law. The appellate opinion makes clear that the plaintiff had pleaded that he had complied with the demand requirements of article 5.14 and that he had made his first demand more than 90 days before the lawsuit was filed. It is a pity that the opinion does not deal with this issue. Given that the court was granting special exceptions, which are challenges to the pleadings, and that the plaintiff was appealing the trial court's refusal to allow him to amend his pleadings, the dismissal may have been based on the plaintiff's failure to comply with pleading requirements of article 5.14 (G) that the petition must allege with particularity facts that establish that the rejection of the demand was not made in accordance with the good faith and disinterestedness requirements of article 5.14 (F) and (H). There is an ambiguity in the statute. Under article 5.14 (C.), a plaintiff is required to wait 90 days after the date that the demand was made, "unless the shareholder has earlier been notified that the demand has been rejected by the Corporation..." It is not clear whether it the pleading requirements of article 5.14(G) apply if the plaintiff has not been informed of a rejection or if the corporation simply ignores the demand and makes no decisions whatsoever. It would seem a terrifically difficult burden on a plaintiff to plead with particularity the defects in the decision-making process when he has heard nothing from the Board of Directors and has no idea what they did. If that situation existed in this case, and the trial court granted special exceptions and dismissed the case on those grounds, it would be interesting indeed to see what an appellate court would have to say about that ruling.
Standing to Pursue Derivative Claim After Cash-out Merger
Somers held that the derivative plaintiff lost his standing to pursue the derivative claims as a result of having his stock cashed out in the merger. The common law rule is well-established that a shareholder loses his standing to maintain a derivative suit if the corporation undergoes a merger and the shareholder's stock is exchanged for cash, unless (1) the merger was fraudulent because its only purpose was to eliminate the defendant's liability in the derivative suit, or (2) the merger was really a reorganization in which the plaintiff retains an ownership interest in the company. See Lewis v. Ward, 852 A.2d 896, 902-04 (Del. 2004). In Zauber v. Murray Sav. Ass'n, 591 S.W.2d 932, 935 (Tex. Civ. App.--Dallas 1979), writ ref'd per curiam, 601 S.W.2d 940 (Tex. 1980), the defendant in a derivative suit argued that the plaintiff lost standing as a result of a reverse stock split that cashed out his resulting fractional shares. The court acknowledged that shareholder does lose standing if he ceases to be a shareholder at anytime during the pendency of the lawsuit, but that there would be an exception if the transaction's purpose was to get rid of the lawsuit. Somers argued that Zauber was construing a prior version of the statute and that the current article 5.14(C) only expressly requires ownership at the commencement of the lawsuit. The appellate court did not see any real difference as a result of the amendment of the TBCA and applied the prior case law. Because Somers did not attack the legitimacy of the merger, he lost his standing.
Somers also argued that TBCA art. 5.03(M) maintained his standing. Section M is part of the merger statute and provides: "To the extent a shareholder of a corporation has standing to institute or maintain derivative litigation on behalf of the corporation immediately before a merger, nothing in this article may be construed to limit or extinguish the shareholder's standing." That is a much tougher argument, and the federal judge in Marron v. Ream, No. CIV H-06-1394, 2006 WL 2734267 (S.D. Tex. May 05, 2006) had previously suggested that this section would preserve the plaintiff's standing in similar circumstances. The court holds that art. 5.03(M) clearly does not create standing, but merely preserves standing. Therefore, in Somers' second lawsuit, filed after he lost his stock, this section does not help. However, with regard to his first lawsuit, which was also on appeal, the court held that the statement that the merger would not "limit or extinguish the shareholders' standing" meant that the plaintiff had to be a shareholder after the merger as well as before, and therefore the provision's sole application was to mergers in which the plaintiff receives shares in the surviving entity. The court dismisses the statement in Marron as dicta. Frankly, that reading of the statute seems a little strained. The provision states that when "a shareholder" has standing immediately prior to the merger, then the law providing for the merger will not limit or extinguish "the shareholder's standing." The term "the shareholder" plainly refers the the person identified in the first part of the sentence. To say that this language imposes an additional condition so that the statute provides nothing more than the traditional common-law exception is a real stretch.
Fiduciary Duties of the Board in a Cash-out Merger
The class-action by shareholders in Somers asserted breach of fiduciary duty claims against the directors directly by the shareholders. The class plaintiffs did not have to worry about the adequacy of demand or any of the other requirements of article 5.14 -- if their theory of liability was correct. The defendants filed special exceptions seeking the dismissal of the claims for failure to state a cause of action recognized under Texas law. This was based on the argument that the fiduciary duties of corporate directors run only to the corporation and not to individual shareholders. The trial court sustained the special exceptions and dismissed the claim because amendment could not cure the defect. Technically, this was incorrect. The duties described by plaintiffs do exist under Texas law, and the cause of action for breach of the students does exist under Texas law. The problem was not that the plaintiffs failed to state a claim recognized by Texas law, it was that the plaintiffs lacked standing to assert that claim individually. Only the corporation or a shareholder suing derivatively on behalf of the corporation could assert that claim. Lack of standing, under Texas law, is a matter of subject matter jurisdiction and should have been challenged through a plea to the jurisdiction, not special exceptions.
The Court of Appeals affirmed, citing a string of Texas cases holding that a director's fiduciary duty runs only to the Corporation, not individual shareholders, except where there is a contract or a confidential relationship or "in certain limited circumstances" in the context of shareholder oppression claims. The class plaintiffs argued that in the context of a cash out merger where the corporation will no longer exist and the shareholders will be dispossessed of their stock, a special duty should arise from the directors to the individual shareholders. In other words, precisely because the law precluded the derivative plaintiffs from maintaining their lawsuit, a special duty should be created to allow the class plaintiffs to do so. The appellate court did not bite.
Actually this issue is much thornier then the appellate court's opinion would suggest. There should be a duty owed by the directors directly to the shareholders in the context of any transaction that involves the acquisition the shareholders' stock -- not because the corporation will cease to exist, but because in considering and negotiating merger and acquisition offers from third parties, the directors of the corporation are not acting on behalf of a corporation but are acting directly as agents for the shareholders. Texas courts have recognized that is, as a general matter, the corporate entity has no interest in its own outstanding stock. Alexander v. Sturkie, 909 S.W.2d 166 (Tex.App.-Hous. (14 Dist.) 1995 writ denied). When a Board of Directors negotiates a stock acquisition or merger, it is negotiating the sale of something that is owned by the shareholders individually, not by the corporation. When the board of directors accepts an offer from a third party, it must present that offer to the shareholders, and the offer is only accepted if approved by the shareholders. If the directors do a poor or dishonest job with respect to the transaction, it is the shareholders who suffer the loss directly, not the corporation. The only reason that the board of directors is involved at all in the sale of the shareholders' property, is that the law provides a mechanism for forcing minority shareholders to sell their property if the majority wants to enter in the transaction. However, the directors in performing those duties are representing the interests of the shareholders directly, not the interests of the corporation. As the agent of the shareholders, logically the board should owe fiduciary duties directly to the shareholders.
Ironically, the Texas Supreme Court in Schmitz, decided almost 2 months to the day after Somers, lends some credence to this argument. In footnote 34, the opinion states that one of the problem with the demand letter sent by the shareholders was that it did not "specify why accepting $22 rather than $23 would harm the corporation." The court cites the Marron opinion for the proposition that it was questionable whether claiming that board should have accepted an offer for $35.50 rather than an offer for $35 per share "was a derivative claim belonging to the corporation." It is almost as if the Supreme Court is hinting in the footnote that the plaintiff had blown it like bringing the action as a derivative claim rather than a direct claim and thus falling under the requirements of article 5.14. Obviously, the Court of Appeals in Somers did not have the Schmidt decision, and this argument was apparently not made to the court. It will be interesting to see whether any Texas courts address this particular issue in the future.
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Posted By Eric Fryar to Shareholder Oppression at 5/30/2009 12:22:00 PM
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