Stock Redemption by Fraud

Inducement of Stock Redemption by Fraud

Minority shareholder squeeze-outs often end in a redemption of shares by the corporation. The claim for fraud in the inducement.

Corporations rarely enter into transactions with existing shareholders in their capacity as shareholders, as opposed to officer, director, employee, lender, lessor, vendor, etc., other than in the repurchase or redemption of the shareholder’s stock. Redemption or repurchase of the minority shareholder’s stock by the corporation is very common in successful squeeze-outs, and the corporation’s fiduciary duties as trustee permit the shareholder to sue for fraud in the inducement or breach of fiduciary duties if information is withheld or the transaction is otherwise tainted by misrepresentation or unfair consideration.

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Corporation's Duty to Minority Shareholders

In In re Fawcett, the widow of a shareholder in a closely held corporation entered into an agreement with the corporation providing for the corporation to repurchase her shares.  She later sued the corporation for fraud in the inducement and breach of fiduciary duties because the corporation and the other shareholders failed to disclose the existence of a significant business opportunity that the corporation commenced within days after signing the agreement, and which would have greatly increased the value of her shares. The court of appeals held that there was a fact issue as to the existence of fiduciary duties owed to the individual shareholder under the circumstances.  “An officer or director of a closely held corporation, as well as the corporation itself, may become fiduciaries to a shareholder when the corporation, officer, or director repurchases the shareholder’s stock.”  Subsequent cases have cited In re Fawcett for the proposition that fiduciary relationships may be created by contract, through the repurchase of a shareholder’s stock in a closely held corporation.  However, it is clear from the opinion that the contract itself did not create fiduciary duties; rather it was the occasion of entering into the contract that resulted in the application of fiduciary duties that already existed in the relationship between the corporation and its shareholder.

This duty has more frequently been imposed upon majority shareholders involved in defrauding minority shareholders, but the fiduciary duty both in corporate redemptions and purchases by majority shareholders stems from the corporation's legal duty to the shareholder and is imposed upon the majority shareholder or director by virtue of his inside knowledge gained through control over the corporation.

A corporation may be sued for fraudulent inducement where is makes a misrepresentation to a shareholder in order to induce that shareholder to sell his shares back to the corporation at a certain price. The more common scenario is that the corporation fails to disclose important information, such as an upcoming contract, that would affect the shareholder's decision to sell or significantly affect the value of the shares, Under Texas law, fraud in the inducement of a transaction may be committed by nondisclosure, but only where there is a duty to speak. In most arm's-length transactions there is no affirmative duty. However, the corporation's position as trustee to its shareholders does impose affirmative duties on the corporation with respect to share ownership, those duties include fairness and disclosure. In a stock redemption or repurchase, the corporation has a duty of full disclosure, and the corporation's non-disclosure of material information can result in liability for fraud in the inducement.

It is important to note that the legal duty and liability for breach of that duty in such fraud in the inducement cases arises in the context of a shareholder selling his stock to the corporation or those in control and is based on the fiduciary relationship between corporation and not on general tort law concepts in securities fraud. If the fiduciary duty is removed, the result is different. In Ward v. Succession of Freeman, the Fifth Circuit reversed a securities fraud judgment in favor of former minority shareholders of a Louisiana Coke-bottling corporation. A group of shareholders who together controlled twenty percent of the outstanding shares and who had control of the corporation’s management, caused the corporation to make a series of tender offers to repurchase minority shares after attending a 1979 convention at which they learned that the Coca-Cola Corporation intended to initiate a restructuring program whereby it would “actively participate” in changes to the ownership of the affiliated bottling companies. In 1980, 1982, and 1983, the corporation made nonbinding offers to redeem minority shares at prices ranging from $321 per share to $850 per share. The plaintiffs sold their shares in the 1982 tender offer. In the 1982 tender offer document, the defendants mentioned to the possibility of a future reverse stock split (which would cash out a minority shareholder positions) but also represented at the company had no current plans for such a reverse split. As a result of the various tender offers, the defendants increase their share position from 20% to 80%. In 1984, the defendants sold the bottling company to Big Coke for $148 million. Thereafter, the plaintiffs sued, claiming that the series of tender offers were fraudulent and constituted part of the defendants’ plans to “squeeze out” and “freeze out” the minority shareholders. The case was tried to a jury, and the plaintiffs received a favorable judgment for fraud in the inducement under federal securities laws.

With respect to the securities fraud claim, the Court held that there must be a misrepresentation or omission of a material fact. The Court held that the plaintiffs’ contention that the defendants had failed to disclose their “secret plan” or “true purpose” to “squeeze out or freeze out” the minority shareholders in order to sell to Big Coke did not state a claim for securities fraud. Federal securities laws do not provide a cause of action for breach of fiduciary duties unless there is an element of deception or fraudulent manipulation. Therefore, the defendants’ good faith or subjective motivation in entering into the transaction is not a “material fact.”  The mere possibility of a future sale to Big Coke also did not need to be disclosed because there was no offer, and negotiations did not begin until more than a year after the tender offer. The breach of fiduciary duties claim was brought under Louisiana law. The Court held that the jury charge had applied the incorrect standard because the tender offers were not self-dealing transactions under Louisiana law because the benefit to the defendant shareholders from those transactions was no different from the benefit that devolved upon the corporation or all shareholders generally. However, under the duties recognized in Yeaman v. Galveston City Co., it would seem that the result would be different under Texas Law.

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Constructive Fraud Cause of Action

The corporation’s fiduciary duties to its shareholders include the duty to not to impair his ownership interests, to “to observe its trust for their benefit” and to preserve both the stock and its “fruits.” A transaction in which the corporation purchases an existing shareholder’s stock and renders him no longer an owner falls squarely within the scope of this fiduciary duty. Liability for common-law fraud in the inducement, where there is a duty to disclose and failure to do so, applies “even in an ordinary arms-length transaction in which no “fiduciary duties” exist and only the ethics of the marketplace apply.” However, the cause of action asserted in the context of a fiduciary relationship is for constructive fraud, which “is the breach of a legal or equitable duty that the law declares fraudulent because it violates a fiduciary relationship.” Common-law fraud includes both “actual” fraud in the inducement and “constructive fraud.” “Breach of a fiduciary relationship can constitute fraud because the fiduciary relationship imputes higher duties, such as duties of good faith, candor, and full disclosure.” The elements of a breach of a fiduciary duty claim are (1) a fiduciary relationship between the plaintiff and defendant, (2) a breach by the defendant of her fiduciary duty to the plaintiff, and (3) an injury to the plaintiff or benefit to the defendant as a result of the defendant's breach. In a fiduciary relationship, constructive fraud “does not require an intent to defraud.” Nor is reliance an element. In Miller v. Miller, the purchase of a minority shareholder’s stock by the majority owner was held invalid, notwithstanding jury findings that the defendant had acted in good faith, that his failure to disclose was not done with the intent to induce reliance, and that the plaintiff had not relied on the nondisclosure.

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The Texas cases have not fully examined the fiduciary duties that the trustee relationship imposes on a corporation in a transaction whereby it purchases the stock of an existing shareholder. However, in the context of a partnership, those duties are well-settled. The “law imputes to the relationship additional and higher duties and their breach may constitute a fraud as well.” These heightened duties, include the duty of “full disclosure respecting matters affecting the principal’s interests and a general prohibition against the fiduciary’s using the relationship to benefit his personal interest, except with the full knowledge and consent of the principal.” In Johnson v. Peckham, the Texas Supreme Court has held: “[I]n a sale by one partner to another of his interest in the partnership, an absolute duty of full disclosure of all material facts and information to the buying partner is imposed upon the selling partner; such a sale, when challenged, will be sustained only when it is made in good faith, for a fair consideration and on a full and complete disclosure of all information as to value.” Strained relations between the parties do not lessen the duty.  While the fiduciary duties that partners owe each other are admittedly broader than the duties that the corporation owes each shareholder, there is no reasoned basis that the fiduciary duties involved in the purchase of an ownership interest would be any different. In Miller v. Miller, the Dallas Court of Appeals cited Johnson v. Peckham as the “leading Texas case” on a fiduciary duties in the context of the purchase of an ownership interest and applied the holding of that case to a purchase of minority shares.

Furthermore, the burden of proving that the purchase of the minority shares was “made in good faith, for a fair consideration and on a full and complete disclosure of all information as to value” is squarely on the purchaser. “All transactions between the fiduciary and his principal are presumptively fraudulent and void, which is merely to say that the burden lies on the fiduciary to establish the validity of any particular transaction in which he is involved.”   Although the purchasing corporation must prove that it acted in good faith to sustain the transaction, good faith itself does not satisfy the defendant’s burden of proof. The fiduciary must also show that the transaction was “fair, honest, and equitable.”

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Remedy for Fraud in the Inducement and Constructive Fraud

The defrauded shareholder may elect to rescind the sale. In Miller v. Miller, the court of appeals held that the existence of a fiduciary duty along with the defendant’s failure to prove that the transaction was fair to the minority shareholder entitled the plaintiff to rescission as a matter of law, and reversed the trial court’s judgment in favor of the defendant and rendered judgment for the plaintiff.

Actual damages are recoverable for both actual fraud in the inducement and constructive fraud.  The plaintiff may recover the his out-of-pocket damages, the difference between the value of what the defrauded party parted with and the value it actually received, or benefit-of-the-bargain damages, the difference between the value as represented and the value as received.  As most cases would involve the failure to disclose information indicating a higher value of the shares being sold or payment on unfairly low consideration, the out-of-pocket measure would be the usual theory of damages. A difficulty arises when the undisclosed information is an opportunity that does not materialize for a period of time.

In Allen v. Devon Energy Holdings, L.L.C., the company redeemed the minority owner’s interest for an agreed price but failed to disclose recent technological advances that made the company potentially much more valuable. One and a half years after the redemption, the majority (now sole) owner sold the company for twenty times the valuation used in the redemption. The defendants argued on appeal that the plaintiff had no actual damages as a matter of law because the price eventually received for the stock could not constitute actual damages, as the amount was not knowable at the time of the fraudulent transaction and such an award would be based on speculation.  The defendants relied on the Texas Supreme Court’s decision in Miga v. Jensen, in which the Court reversed an award of damages for breach of an option contract to sell shares based on the increased value of the shares at the time of trial: “But the rule in Texas has long been that contract damages are measured at the time of breach, and not by the bargained-for goods’ market gain as of the time of trial.” The court of appeals rejected this authority as inapplicable in a fraud case, noting that “[u]nlike a contract case, the law favors granting the benefit of the delay to the victim of the fraud.” Because Allen was an appeal of a summary judgment in favor of the defendants, the plaintiff had not yet made his damages record. The court of appeals conceded that there might very well be issues with speculative damages evidence, but concluded that the defendants had not established that there were no damages as a matter of law.

Significantly, however, the Allen court held that, even if the full benefit received by the defendants as a
result of the fraud could not be recovered as actual damages, that amount certainly could be recovered through the equitable remedy of disgorgement. Additionally, the equitable doctrines of unjust enrichment and quasi-contract “allow for recovery of damages to prevent a party from obtaining a benefit from another by fraud, duress, unjust enrichment, or because of an undue advantage.”