Sale-to-a-Looter Breach of Fiduciary Duty Claim
What if the majority shareholder sells out to a crook who subsequently loots the company? The minority shareholders may have a breach of fiduciary duty claim. An example of a claim that is brought under the duty of care is liability for selling control of a corporation to a looter.
No such cases have been decided in Texas, but the claim is well established in Delaware. Controlling shareholders and directors of a Delaware corporation owe fiduciary duties of care and loyalty to non-controlling shareholders. These fiduciary duties include an obligation to investigate the bona fides of a potential purchaser of their controlling interest under certain circumstances. Specifically, the controlling shareholders must investigate the buyer when the controlling shareholders are aware of facts that the buyer intends to or is likely to plan any depredations to the corporation. The standard of care is whether the controlling seller is aware of facts that would give rise to suspicion by a reasonably prudent person.
Assume a situation in which a majority shareholder (with control of the board of directors) owns a controlling interest in a corporation. For whatever reason, the majority shareholder wishes to divest its ownership of the corporation and arranges for the sale of majority control to a third party. However, the third party turns out to be a crook and proceeds to loot the corporation once it has gained control. Obviously, the remaining minority shareholders could bring a derivative claim against the crook for misappropriation in violation of the duty of loyalty—but the crook may have vanished or be unable to pay the judgment. Therefore, the minority shareholders sue the former majority shareholder on the grounds that the sale to the looter had been negligent and a violation of its duty of care because the actions of the looter were reasonably foreseeable.
In Harris v. Carter, the Delaware Court of Chancery addressed the sale of controlling interest in Atlas Energy Corporation to a purported looter. The plaintiff (a non-controlling shareholder of a Delaware corporation) alleged that the prospective purchaser made fictitious representations to the controlling shareholders both in the sale agreement and in the draft financials circulated prior to closing. The CFO of the corporation raised several questions regarding the accuracy of the financial statements, but the controlling shareholders ignored these concerns and sold their interest without investigating the buyer. As part of the sale, the sellers agreed to resign as directors of the corporation and allow the purchasers to fill the director positions with their designees. Following the sale, the purchasers pursued a series of self-dealing transactions to the detriment of the corporation.
Focusing on the fact that the controlling shareholders ensured that the buyers would assume control over the corporation, Chancellor Allen held that the plaintiff had stated a claim for breach of fiduciary duty. Specifically, the Court found that the controlling shareholders placed others at risk of foreseeable injury, and that there was no privilege that would allow controlling shareholders to exempt themselves from this general principle:
It is established American legal doctrine that, unless privileged, each person owes a duty to those who may foreseeably be harmed by her action to take such steps as a reasonably prudent person would take in similar circumstances to avoid such harm to others. While this principle arises from the law of torts and not the law of corporations or of fiduciary duties, that distinction is not, I think, significant unless the law of corporations or of fiduciary duties somehow privileges a selling shareholder by exempting her from the reach of this principle. The principle itself is one of great generality and, if not negated by privilege, would apply to a controlling shareholder who negligently places others foreseeably in the path of injury.
The touchstone of the Court’s inquiry is foreseeability.
Entering into an arrangement with a potential buyer is certainly a transaction involving the exercise of business judgment. Assuming that the sale was “negligent, unwise, inexpedient, or imprudent,” why doesn’t the business judgment rule protect the selling shareholder? Many of the exceptions potentially apply to this factual scenario. First, because there is a transaction between the defendant and the looter in which the defendant receives a benefit, the self-dealing exception may bar the protection of the business judgment rule—particularly if it could be demonstrated that the majority shareholder was paid a premium for control. Second, the majority shareholder may have been so eager to sell that it never even considered the issue of whether the sale was good for the corporation. Information may have been reasonably available as to the background and nature of the looter, which the selling shareholder didn’t even investigate. In that situation, the abdication of duty and lack of information exceptions would apply. Alternatively, the selling shareholder may have been so desperate to sell that he ignored negative information about the buyer and was consciously indifferent to the risk that the looter would subsequently harm the corporation. In that situation, the jury might find that the selling shareholder had acted with gross negligence and thus was not protected by the business judgment rule. Finally, the business judgment rule might not apply because the sale to a looter involved a transaction not in the ordinary course of business.
This post is taken from HCWD, PLLC recently published White Paper, The Duty of Loyalty and the Business Judgment Rule in Texas. Download the White Paper today and get access to the complete legal analysis and case citations.