Wednesday, November 02, 2005


Lifting the Yoke of Oppression

I look at a lot of judicial opinions. I comment on some of them. Rarely, however, do I have the opportunity to review and comment on an opinion that is as signficant for business practitioners as the opinion of the Court of Special Appeals in Edenbaum v. Schwarcz-Osztreicherne, handed down last Friday. I will discuss the opinion in three postings, one this evening and one tomorrow, both describing the case and the holdings and briefly analysing the Court's conclusions. In a subsequent posting, I will discuss the holdings at greater depth and address the broader policy implicatons of the opinion.

The case arose from a shareholders' dispute. The two parties owned all of the stock in Liberty Assisted Living, Inc., which owns and operates a small, eight-bed assisted living facility in Montgomery County.

Between December 2000 and early January 2001, the parties, Edenbaum and Schwarcz, agreed that they would operate Liberty's business on a "50/50 basis," although Edenbaum held a 51% interest in Liberty, and Schwarcz a 49% interest. The parties entered into a "sparse, one-page" shareholders' agreement that was summarized by the Court as follows:
The . . . agreement provided that both parties would be directors of the corporation; that Edenbaum would be President, Secretary, Treasurer, and Chief Executive Officer; and that Schwarcz would be Vice President and Director of Operations. It further stated that Edenbaum's vote would be "controlling in any business decisions and/or disputes between the parties either as shareholders or directors" and that Edenbaum would "have the final say in all business and corporate decisions."

The agreement also spelled out the parties' duties and responsibilities. While Edenbaum was responsible for paying "all bills," "generat[ing] resident bills," "hiring of consultants," "[m]arketing of the facility," making all "business management decisions," "oversee[ing] all paperwork of resident files," "giving tours to prospective clients and their families," and "keeping [the] house in compliance with state and county regulations," Schwarcz was responsible for the "[c]ooking and cleaning of the home, patient care, grocery shopping, transportation for residents, laundry and daily house maintenance." The two shared responsibility for "[r]esident activities, hiring staff ... accepting residents" and "family interactions. And finally, the agreement provided that Edenbaum and Schwarcz would receive "equal salaries" and share equally in the company's profits.
In late September, 2001, after a lenghty period of strife, Edenbaum discharged Schwarcz from her position as Director of Operations and discontinued payment of her salary.

The resulting lawsuit was brought by Schwarcz. Initially, she alleged breach of contract. Later, she added a request that Liberty be dissolved because of Edenbaum's "illegal, oppressive and/or fraudulent" conduct. The trial was marked by allegations by Edenbaum that Schwarcz had acted improperly with respect to her assigned tasks and denials of those allegations by Schwarcz.

The trial court ruled that, under the terms of the shareholders' agreement, Edenbaum had the right to relieve Schwarcz of her responsibilities at Liberty. But it declined to find that the shareholders' agreement constituted an employment contract. However, the trial court awarded Schwarcz $89,880 for lost profits and post-termination salary, entering judgment against Edenbaum and Liberty jointly and severally. Finally, the trial court refused to order the dissolution of Liberty because it found that Edenbaum's conduct was not "oppressive."

The Court of Special Appeals reversed both the judgment for damages and the denial of Schwarcz's request for dissolution. I will discuss the reversal of the denial of the request for dissolution tonight because that action will likely have a greater impact on business disputes.

Corps. & Ass'ns § 3-413(b)(2) permits "[a]ny stockholder entitled to vote in the election of directors of a corporation" to petition a court to dissolve the corporation on the ground that the "acts of the directors or those in control of the corporation are illegal, oppressive, or fraudulent." Critically, the Court distinquished "oppressive" conduct from conduct that is illegal or fraudulent, stating that:
"Oppressive" conduct is not defined by the statute. But, as it is singled out as a separate category of conduct justifying corporate dissolution by Corps. & Ass'ns § 3-413(b)(2), we surmise that it does not necessarily involve "fraudulent: or "illegal" conduct. "Oppressive" conduct has been described by other jurisdictions as:
burdensome, harsh and wrongful conduct; a lack of probity and fair dealing in the affairs of a company to the prejudice of some of its members; or a visual departure from the standards of fair dealing, and a violation of fair play on which every shareholder who entrusts his money to a company is entitled to rely.
(Citations omitted.)

The Court went on to state that:
"Oppression," however, has also been defined by one Maryland commentator as "conduct that substantially defeats the reasonable expectations of a stockholder." James J. Hanks, Jr., Maryland Corporation Law § 11.7(b)(1990, 2004 Supp.). Or, in the more precise terminology of one of our sister states, "conduct that substantially defeats the 'reasonable expectations' held by minority shareholders in committing their capital to the particular enterprise."
(Citation of judicial authority omitted.)

The Court ultimately looked to the reality of the parties' relationship, not merely the artifices of legal form:
[I]t is generally understood that, in addition to supplying capital and labor to a contemplated enterprise and expecting a fair return, parties comprising the ownership of a [closely held] corporation expect to be actively involved in its management and operation. Unlike the typical shareholder in a publicly held corporation, who may simply be an investor or a speculator and does not desire to assume the responsibilities of management, the shareholder in a [closely held] corporation considers himself or herself as a co-owner of the business and wants the privileges and powers that go with ownership. Employment by the corporation is one such privilege and often is the shareholder’s main source of income. Moreover, "providing for employment may have been the principal reason why the shareholder participated in organizing the corporation."

But the very nature of a closely held corporation makes it possible for a majority shareholder to "freeze out" a minority shareholder, that is, deprive a minority shareholder of her interest in the business or a fair return on her investment. The limited market for stock in a [closely held] corporation and the natural reluctance of potential investors to purchase a noncontrolling interest in a [closely held] corporation that has been marked by dissension can result in a minority shareholder's interest being held "hostage" by the controlling interest, and can lead to situations where the majority "freeze out" minority shareholders by the use of oppressive tactics.

Because of the "predicament" a minority shareholder is in when a freeze out occurs, courts have looked at a majority shareholder's alleged "oppressive" conduct, in terms of the "reasonable expectations" held by minority shareholders in committing their capital to the particular enterprise. The "reasonable expectations" view of oppressive conduct "[r]ecogniz[es] that a minority shareholder who reasonably expects that ownership in the corporation would entitle him to a job, a share of the corporate earnings, and a place in corporate management would be 'oppressed' in a very real sense [sic] when the majority seeks to defeat those expectations and there exists no effective means of salvaging the investment." But, we caution, "oppression should be deemed to arise only when the majority conduct substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the petitioner's decision to join the venture. It "should not be deemed oppressive simply because the petitioner's subjective hopes and desires in joining the venture are not fulfilled." That is to say, "[d]isappointment alone should not necessarily be equated with oppression."
(Citations and most internal quotation marks omitted.)

Applying its analysis to the case before it, the Court found that Schwarcz had a reasonable expectation that she would be "employed by the corporation, share in corporate earnings, and have a place in corporate management." "Her termination [by Edenbaum] substantially defeated her reasonable expectations that she would be employed by the corporation, receive a salary, and take part in its management." Thus, the Court reversed the trial court's finding that Edenbaum had not engaged in oppressive conduct.

However, the Court's analysis did not stop there. It went on to discuss the remedy that Schwarcz might be entitled to. Specifically, the Court made it clear that her remedy was (i) not limited to judicial dissolution of the corporation and (ii) that judicial dissolution might actually be inappropriate because it represents fairly drastic action. Instead, the Court invited the trial court to "allow alternative equitable remedies not specifically stated in the statute." Specifically, the Court suggested numerous possible alternative remedies:
(a) The entry of an order requiring dissolution of the corporation at a specified future date, to become effective only in the event that the stockholders fail to resolve their differences prior to that date;

(b) The appointment of a receiver, not for the purposes of dissolution, but to continue the operation of the corporation for the benefit of all the stockholders, both majority and minority, until differences are resolved or 'oppressive' conduct ceases;

(c) The appointment of a 'special fiscal agent' to report to the court relating to the continued operation of the corporation, as a protection to its minority stockholders, and the retention of jurisdiction of the case by the court for that purpose;

(d) The retention of jurisdiction of the case by the court for the protection of the minority stockholders without appointment of a receiver or 'special fiscal agent';

(e) The ordering of an accounting by the majority in control of the corporation for funds alleged to have been misappropriated;

(f) The issuance of an injunction to prohibit continuing acts of 'oppressive' conduct and which may include the reduction of salaries or bonus payments found to be unjustified or excessive;

(g) The ordering of affirmative relief by the required declaration of a dividend or a reduction and distribution of capital;

(h) The ordering of affirmative relief by the entry of an order requiring the corporation or a majority of its stockholders to purchase the stock of the minority stockholders at a price to be determined according to a specified formula or at a price determined by the court to be a fair and reasonable price;

(i) The ordering of affirmative relief by the entry of an order permitting minority stockholders to purchase additional stock under conditions specified by the court;

(j) An award of damages to minority stockholders as compensation for any injury suffered by them as the result of 'oppressive' conduct by the majority in control of the corporation.
The portion of the opinion that deals with Schwarcz's claims is truly breathtaking. It extends the concept of "oppression" as used in Corps. & Ass'ns § 3-413(b)(2) further than most Maryland practitioners believed was the case. Just as importantly, the opinion opens the way for trial courts to resolve shareholder disputes with a well-designed scalpel rather than a meat ax.

1 comment:

Daryl J. Sidle said...

Stuart:

Nice summary of this important case.

Hopefully, we can generate some disucssion once you have completed your analysis and more people have read the case in its entirety.

Any chance tht the Court of Appeals will review this?