Shareholder Oppression

In Staiger v. Holohan, 100 A.3d 622 (Pa. Super. 2014), a Pennsylvania appellate court found that a trial court could order the dissolution of a profitable Pennsylvania Limited Liability Company (“LLC”).

The facts of the case are simple and fairly straightforward. Plaintiff Michael Staiger (“Staiger”) and Defendant Kevin Holohan (“Holohan”) formed two Pennsylvania LLCs: 200 East Airy, LLC (“200 East Airy”) and Green and Airy Laundromat, LLC (“Laundromat”). Stainger lent 200 East Airy $165,000, to be used as start-up capital. The members agreed in writing that Stainger would be repaid the start-up money within five years. Both men owned 50% of both 200 East Airy and Laundromat. Both 200 East Airy’s and Laundromat’s operating agreements contained identical language which set forth that the members (Holohan & Stainger) have the authority to make business decisions and the decisions of a majority are controlling. Shortly after forming Laundromat, the members executed an agreement which provided that another unnamed LLC of Holman’s was to manage Laundromat for a fee for an initial term of five years, then continue for two additional five-year periods.

Continue Reading Pennsylvania Appellate Court Affirms Dissolution of Profitable Limited Liability Companies Based Finding of Deadlock

In Adler v. Tauberg, 881 A.2d 1267 (Pa. Super. 2005), a Pennsylvania Appellate Court upheld an Order of the Court of Common Pleas of Allegheny County appointing Lawrence N. Adler, M.D., (“Adler”), a fifty percent shareholder, director and president of a closely-held Pennsylvania corporation, as custodian to manage the business affairs of the corporation after finding that the defendants oppressed him.

At trial, Adler sought appointment of a custodian on the basis of the defendant’s alleged illegal, oppressive and fraudulent conduct, causing the assets of the closely-held Pennsylvania Corporation to be misapplied and wasted. During the course of the trial, Adler further alleged the defendants wrongly attempted to issue stock and change the rules of governance of the corporation to Adler’s detriment. In granting Adler’s motion for appointment of a custodian, the trial court concluded, inter alia, appellants "had unjustly exercised authority and power over [Adler] with respect to the corporate affairs of [the closely held Pennsylvania Corporation]." Id. at 1267-1268.

In their appeal, the Defendants argued the trial court record did not support the need for the appointment of a custodian, given that the evidence presented was insufficient to sustain a finding they had acted illegally, oppressively or fraudulently within the meaning of the statute. Id. at 1268 (citing 15 Pa.C.S.A. § 1767).

During the course of the trial, the Court heard testimony and came to the following factual conclusions:

  1. The three other directors were attempting to issue stock and change the rules of governance for the corporation to the detriment of the corporation and Adler, who was a director and president of the corporation.
  2. Beginning in October of 2002, the Defendants began to request that Adler retire from the practice and his position as president.
  3. The Defendants initially demanded that Adler’s salary be reduced by one-third, then demanded that his contractually guaranteed salary be revoked and his compensation be tied to his production.
  4. The other members of corporation attempted to divert patients from the care and treatment of Adler.
  5. On November 5, 2003, the other shareholder [appellants] attempted to issue corporate shares to Dr. Tauberg. When the corporation’s counsel advised that a previous written agreement restricting the transfer of corporate shares may have precluded the issuance of these shares, the vote was tabled. On November 18, 2003, defendants Dr. Chandra and Dr. Madhavan (each owning 25% of the shares), voted to increase the number of board members from 3 to 4 and fill the new board seat with Dr. Tauberg. The Defendants then voted to make themselves officers and pay each of them an additional $ 50,000 for serving as officers. This had the effect of reducing Adler’s compensation by $ 37,500.
  6. The Defendants then fired the corporations’ long-time legal counsel and replaced him with their attorney.
  7. The Defendants approved a resolution that paid their attorney’s fees with corporate funds.
  8. The Defendants effectively removed Adler’s power to write checks on the corporation’s bank accounts. The Defendants wrote corporate checks for items with which Adler did not agree.

As a result of considering the evidence, the Trial Court concluded that the ongoing disagreements between the parties negatively affected the functioning of the corporation and could have endangered patient care. Id.

In deciding the appeal, the Superior Court of Pennsylvania Appellate Court held that under 15 Pa.C.S. § 1767, a trial court may appoint a custodian for a corporation upon application of a shareholder when: "[i]n the case of a closely held corporation, the directors or those in control of the corporation have acted illegally, oppressively or fraudulently toward one or more holders or owners of 5 percent or more of the outstanding shares of any class of the corporation in their capacities as shareholders, directors, officers or employees." Id. (quoting 15 Pa.C.S. § 1767(a)(2)).

The Adler Court then held that “Oppressive conduct in the context of a close corporation ‘often takes the form of freezing-out a minority shareholder by removing him from his various offices or by substantially diminishing his power or compensation,’ although no further description is given.” Id. (citing, 15 Pa.C.S. § 1767).

The Superior Court found that there was not a lot of law in Pennsylvania defining oppressive conduct. Rather, the Adler Court recognized that there are three different definitions of “oppressive” conduct utilized by Courts throughout the country. They are:

  1. Oppression as ‘burdensome, harsh and wrongful conduct, a visible 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;
  2. Oppression is linked to the term directly to breach of the fiduciary duty of good faith and fair dealing majority shareholders owe minority shareholders, a duty that many courts recognize as enhanced in a close corporation setting; and
  3. A third view ties oppression to frustration of the reasonable expectations of the shareholders.

The Adler Court found that Pennsylvania employs the “reasonable expectations of the shareholders” test. That would be the same test used by New York and New Jersey Courts. In finding the same, the Superior Court upheld the trial court’s findings that Adler was oppressed. As such, it affirmed the trial court’s appointment of a custodian to manage the day-to-day affairs of the corporation.

The Adler v. Tauberg decision is important for three reasons. First, the Court found that a 50% owner was found to be an oppressed minority shareholder despite the fact that he controlled half of the company. The Court recognized that although Adler held half of the stock he was being controlled by the other two shareholders who collectively owned the remaining 50% of the corporation’s shares. Second, a custodial receiver may be appointed pursuant to Pennsylvania law if oppression or deadlock is found. Third, the Superior Court used the “reasonable expectations of the shareholder” test when determining shareholder oppression.

On February 5, 2014, a Superior Court of Pennsylvania issued an interesting and important decision explaining when claims must be brought derivatively as opposed to individually in the name of a shareholder. Hill v. Ofalt, 85 A.3d 540 (Pa. Super. Ct. 2014).

A “derivative” claim is a lawsuit brought by a shareholder on behalf of the corporation against a third-party. The central issue in Hill v. Ofalt, was whether or not Thomas Hill (“Hill”) a 50% shareholder of a closely held Pennsylvania corporation called Millstone Restaurant Company, Inc. (“Millstone”) could assert direct claims alleging breach of contract, breach of fiduciary duty, unjust enrichment, and conversion and seeking declaratory relief all against the other 50% shareholder, Defendant Ronald Ofalt (“Ofalt”). After considering the nature of those claims, the Superior Court of Pennsylvania held that Hill could not assert those claims directly. In other words, the Pennsylvania Appellate Court agreed with the Trial Court that those claims belonged to the corporation and therefore had to be asserted derivatively. Nevertheless, the Hill Court reversed the Trial Court’s denial of Hill’s motion to amend the complaint, so as to assert derivative claims.

The decision is important and interesting because it provides a good explanation as to when claims must be brought derivatively as opposed to individually in Pennsylvania. In summary, the analysis hinges on who suffered the complained damages as alleged in the complaint. In this case, the Plaintiff alleged that Ofalt was stealing from the corporation. Moreover, Hill alleged that Ofalt stole trustee taxes from the company. Furthermore, Hill alleged as a result of Ofalt’s unlawful activities the corporation eventually went out of business exposing Hill to personal financial peril because he personally guaranteed the corporation’s mortgage.

The Superior Court of Pennsylvania analyzed each of the claims raised in the complaint. The Hill Court held, “under established Pennsylvania law, a shareholder does not have standing to institute a direct suit for "a harm [that is] peculiar to the corporation and that is only indirectly injurious to the shareholder." Hill v. Ofalt, 85 A.3d at 548 (quoting, Reifsnyder v. Pgh. Outdoor Adver. Co., 405 Pa. 142, 173 A.2d 319, 321 (Pa. 1961)).” Rather, such a claim belongs to, and is an asset of, the corporation. Id. “To have standing to sue individually, the shareholder must allege a direct, personal injury – that is independent of any injury to the corporation – and the shareholder must be entitled to receive the benefit of any recovery.” Hill v. Ofalt, 85 A.3d at 549. Because the Court concluded the primary injuries suffered as a result of the alleged unlawful activities were borne by the corporation the Court held the claims must be brought derivatively.

The decision in dicta (a part of the opinion which went beyond the facts of the case) discussed whether or not a Pennsylvania shareholder could individually assert minority oppression claims under Pennsylvania law. Id. at 550. The Court relied upon previously decided cases and said that an oppressed minority shareholder could assert direct claims against the majority shareholder. Id. (considering, Feber v. Am. Lamp. Corp., 469 A.2d 1046, 1050 (Pa. 1983); Viener v. Jacobs, 834 A.2d 546, 556 (Pa. Super. 2003). Because Hill did not assert oppression claim against Ofalt, the Court did not reverse.

One of the unique things about litigating in Pennsylvania is “preliminary objections.” Pennsylvania requires litigants to plead with specificity (as opposed to most states which are merely notice pleading states). If the case is not plead with specificity it is subject to dismissal by way of preliminary objections. Hence, when asserting minority oppression claims in a Pennsylvania action it is extremely important to set forth specific ways the minority shareholder was injured (as opposed to the corporation).

Finally, when drafting or responding to a complaint filed in Pennsylvania state court, it is imperative that the claim be properly asserted derivatively or individually. The Hill decision provides guidance on this issue.