A recent Chancery Court case, Carlson v. Hallinan, covered many corporate issues of import in a 74-page opinion. The length of the ruling is not unusual in Chancery Court, but the smorgasbord of issues discussed in the court’s decision is notable. Thus, this summary will be longer than normal due to the many issues addressed, such as: Excessive compensation; indemnification; dissolution or appointment of receiver of solvent closely-held entity; fees awarded for Section 220 demand; accounting of funds by fiduciary; entire fairness standard instead of BJR; independent committees and minority shareholder ratification by those disinterested; attorneys’ fees in derivative claim for company with 3 shareholders, and ultra vires.
The case of Carlson v. Hallinan, download file , involved direct and derivative claims by a minority shareholder against the two other shareholders and directors of closely-held and affiliated entities.
The court found that the controlling shareholder and the two interested directors failed to satisfy their burden of entire fairness, including fair dealing and fair price, in paying themselves excessive compensation. The court noted that only when disinterested shareholders, even if they are a minority of shareholders, ratify an interested transaction will the burden shift to establish the entire fairness of an interested transaction. The same reasoning was applied to hold that the payment of a management fee to an affiliated entity was a breach of their fiduciary duty. The problems of the defendants were compounded by their failure to follow corporate formalities. The court noted that the use of an independent committee of directors or the hiring of outside compensation experts and related experts is not a prerequisite to a finding that a transaction was the result of a fair process (i.e., fair dealing and fair price), but the court observed that the defendants in this case did not use either of those procedures even though the courts have favored them. Supplemental to the foregoing breach of fiduciary duties, claims were made regarding expenses that were paid to affiliated entities of the controlling shareholders. The court noted that fiduciaries have the burden of showing that they “dealt properly with corporate funds and other assets entrusted to their care” and when the exercise of their power over those funds is challenged “the fiduciaries have a duty to account for the disposition of those funds” (see footnote 205). The court concluded that an accounting was necessary because the controlling shareholder and directors admitted that they did not even keep track of expenses incurred by one entity on behalf of related entities.
The court determined that the payment by the corporation of the legal fees in the defense of the instant action was ultra vires because they failed to follow the formality of making an undertaking, pursuant to Section 145, to repay such amount if it was ultimately determined that they were not entitled to indemnification. The court noted that although it would be a best practice to obtain a written undertaking, it is not required by Delaware law. Nonetheless, the business judgment rule did not protect their decision, as they incorrectly and unsuccessfully argued that because they would be submitting the undertaking to themselves, it was unnecessary. It appears that if the controlling shareholder and the two directors constituting a majority of interested directors followed the formality of submitting a formal written undertaking pursuant to Section 145 to repay the corporation if they were found not to be entitled to indemnification, they might have been authorized to allow the corporation to pay their legal fees in this case. The court also found that the two interested directors aided and abedded each other’s breach of fiduciary duties.
The plaintiffs also sought the dissolution of the corporation and the appointment of a custodian.
The court noted that it had the power to dissolve a solvent company and appoint a custodian or a receiver only in extreme circumstances of gross mismanagement, positive misconduct or a breach of trust that would show imminent danger of great loss which could not otherwise be prevented, but the court also emphasized that:
“mere dissension among corporate stockholders seldom, if ever, justifies the appointment of a receiver for a solvent corporation. The minority’s remedy is to withdraw from the corporate enterprise by the sale of its stock” (citing Hall v. John S. Isaacs & Sons Farms, Inc., 163 A.2d 288 293 (Del. Ch. 1960)).
The court found here however that the facts and circumstances constituted the very rare case where the appointment of a receiver and the dissolution of a solvent corporation were necessary due to the abuses and multiple breaches of fiduciary duty. The court also reasoned that the minority shareholder was the only party that did not have unclean hands, and was powerless as a minority to prevent continuing abuses.
The court also addressed a demand for attorneys’ fees incurred in prosecuting a Section 220 action, pursuant to the bad faith exception to the American Rule. The bad faith exception allowing for the award of attorneys’ fees carries the prerequisite that the “defendant’s conduct forced the plaintiff to file suit to secure a clearly defined and established right.” (See footnote 264.) The court found that the plaintiff made the requisite showing that the defendant directors acted in subjective bad faith in refusing the inspection demand and that there was a clearly established right to inspect the books and records.
The court cited cases at footnote 266 for the rule that “a director who has a proper purpose is entitled to virtually unfettered access to the books and records of the corporation.” Defendants did not dispute the proper purpose which was stated at the time as whether the directors “had breached their fiduciary duties” and “to fulfill his own obligations as a director.” The court also found that the effort to remove him as a director two days after his inspection demand was evidence of bad faith. The court however, did not allow “fees on fees” because it did not find that the opposition to the request for attorneys’ fees was egregious. The court also allowed for attorneys’ fees based on the derivative claims in light of the well established common fund doctrine, however, because there are only a total of three shareholders and the court did not want the two culpable shareholders to benefit without contributing to the costs incurred by the plaintiff, the court allowed 30% of the recovered money damages to go directly to the plaintiff.