Limits of this defensive tactic
Effect of a freeze out merger in on-going derivative litigation. Limits of this defensive tactic.
Defeating a Derivative Claim With a Freeze Out Merger
The 2009 Houston Court of Appeals decision in Somers v. Crane involved a shareholder challenge to a proposed effort by the management of EGL, Inc. to buy the company and take it private. The board of directors approved the merger and also approved onerous "lock up" provisions, including a $30 million termination fee. The plaintiff filed a derivative suit seeking to block the proposed acquisition by management on the grounds that a higher bid had been submitted to the board by a third party buyer. A class action was also filed on behalf of the shareholders seeking essentially the same relief, but asserting breach of fiduciary duty claims directly on behalf of the shareholders rather than derivatively. After the lawsuits were filed, the Board of Directors did agree to the acquisition by the third party, but the management group was paid the termination fee. The lawsuits were then amended to assert claims for damages for payment of the termination fee. The trial court dismissed the derivative suit for failure to comply with the demand requirement in TBCA art. 5.14(c) (BOC § 21.552). The derivative plaintiff then sent a formal demand and waited 90 days per the statute. In the meantime, the merger with the third-party buyer was close, and all the shareholders were cashed out. Shortly thereafter, the 90-day waiting period expired, and the derivative plaintiff refiled the case seeking damages for breach of fiduciary duty for paying the termination fee. The trial court dismissed the class-action on the grounds that the shareholders had no standing to assert directly claims for breach of fiduciary duty against the Board of Directors. The trial court also dismissed the new derivative suit on the grounds that the plaintiff was no longer a shareholder and thus no longer had standing to maintain the action.
Important Note: There are special rules governing derivative actions in closely-held corporations. It is unlikely that a freeze-out merger would have any effect on derivative litigation involving closely-held corporations.
Standing to Pursue Derivative Claim After Freeze-Out Merger
Somers held that the derivative plaintiff lost his standing to pursue the derivative claims as a result of having his stock cashed out in the merger. The common law rule is well-established that a shareholder loses his standing to maintain a derivative suit if the corporation undergoes a freeze out merger and the shareholder's stock is exchanged for cash, unless (1) the merger was fraudulent because its only purpose was to eliminate the defendant's liability in the derivative suit, or (2) the merger was really a reorganization in which the plaintiff retains an ownership interest in the company. In Zauber v. Murray Sav. Ass'n, the defendant in a derivative suit argued that the plaintiff lost standing as a result of a reverse stock split that cashed out his resulting fractional shares. The court acknowledged that shareholder does lose standing if he ceases to be a shareholder at anytime during the pendency of the lawsuit, but that there would be an exception if the transaction's purpose was to get rid of the lawsuit. Somers argued that Zauber was construing a prior version of the statute and that the current article 5.14(C) only expressly requires ownership at the commencement of the lawsuit. The appellate court did not see any real difference as a result of the amendment of the TBCA and applied the prior case law. Because Somers did not attack the legitimacy of the merger, he lost his standing.
Somers also argued that TBCA art. 5.03(M) maintained his standing. Section M is part of the merger statute and provides: "To the extent a shareholder of a corporation has standing to institute or maintain derivative litigation on behalf of the corporation immediately before a merger, nothing in this article may be construed to limit or extinguish the shareholder's standing." That is a much tougher argument, and the federal judge in Marron v. Ream, had previously suggested that this section would preserve the plaintiff's standing in similar circumstances. The court holds that art. 5.03(M) clearly does not create standing, but merely preserves standing. Therefore, in Somers' second lawsuit, filed after he lost his stock, this section does not help. However, with regard to his first lawsuit, which was also on appeal, the court held that the statement that the merger would not "limit or extinguish the shareholders' standing" meant that the plaintiff had to be a shareholder after the merger as well as before, and therefore the provision's sole application was to mergers in which the plaintiff receives shares in the surviving entity. The court dismisses the statement in Marron as dicta. Frankly, that reading of the statute seems a little strained. The provision states that when "a shareholder" has standing immediately prior to the merger, then the law providing for the merger will not limit or extinguish "the shareholder's standing." The term "the shareholder" plainly refers the person identified in the first part of the sentence. To say that this language imposes an additional condition so that the statute provides nothing more than the traditional common-law exception is a real stretch.
Fiduciary Duties of the Board in a Freeze Out Merger
The class-action by shareholders in Somers asserted breach of fiduciary duty claims against the directors directly by the shareholders. The class plaintiffs did not have to worry about the adequacy of demand or any of the other requirements of article 5.14 -- if their theory of liability was correct. The defendants filed special exceptions seeking the dismissal of the claims for failure to state a cause of action recognized under Texas law. This was based on the argument that the fiduciary duties of corporate directors run only to the corporation and not to individual shareholders. The trial court sustained the special exceptions and dismissed the claim because amendment could not cure the defect. Technically, this was incorrect. The duties described by plaintiffs do exist under Texas law, and the cause of action for breach of the students does exist under Texas law. The problem was not that the plaintiffs failed to state a claim recognized by Texas law, it was that the plaintiffs lacked standing to assert that claim individually. Only the corporation or a shareholder suing derivatively on behalf of the corporation could assert that claim. Lack of standing, under Texas law, is a matter of subject matter jurisdiction and should have been challenged through a plea to the jurisdiction, not special exceptions.
The Court of Appeals affirmed, citing a string of Texas cases holding that a director's fiduciary duty runs only to the Corporation, not individual shareholders, except where there is a contract or a confidential relationship or "in certain limited circumstances" in the context of shareholder oppression claims. The class plaintiffs argued that in the context of a cash out merger where the corporation will no longer exist and the shareholders will be dispossessed of their stock, a special duty should arise from the directors to the individual shareholders. In other words, precisely because the law precluded the derivative plaintiffs from maintaining their lawsuit, a special duty should be created to allow the class plaintiffs to do so. The appellate court did not bite.
Actually this issue is much thornier then the appellate court's opinion would suggest. There should be a duty owed by the directors directly to the shareholders in the context of any transaction that involves the acquisition the shareholders' stock -- not because the corporation will cease to exist, but because in considering and negotiating merger and acquisition offers from third parties, the directors of the corporation are not acting on behalf of a corporation but are acting directly as agents for the shareholders. Texas courts have recognized that is, as a general matter, the corporate entity has no interest in its own outstanding stock. When a Board of Directors negotiates a stock acquisition or merger, it is negotiating the sale of something that is owned by the shareholders individually, not by the corporation. When the board of directors accepts an offer from a third party, it must present that offer to the shareholders, and the offer is only accepted if approved by the shareholders. If the directors do a poor or dishonest job with respect to the transaction, it is the shareholders who suffer the loss directly, not the corporation. The only reason that the board of directors is involved at all in the sale of the shareholders' property, is that the law provides a mechanism for forcing minority shareholders to sell their property if the majority wants to enter in the transaction. However, the directors in performing those duties are representing the interests of the shareholders directly, not the interests of the corporation. As the agent of the shareholders, logically the board should owe fiduciary duties directly to the shareholders.
Ironically, the Texas Supreme Court in In re Schmitz, decided almost 2 months to the day after Somers, lends some credence to this argument. In footnote 34, the opinion states that one of the problem with the demand letter sent by the shareholders was that it did not "specify why accepting $22 rather than $23 would harm the corporation." The court cites the Marron opinion for the proposition that it was questionable whether claiming that
board should have accepted an offer for $35.50 rather than an offer for $35 per share "was a derivative claim belonging to the corporation." It is almost as if the Supreme Court is hinting in the footnote that the plaintiff had blown it like bringing the action as a derivative claim rather than a direct claim and thus falling under the requirements of article 5.14. Obviously, the Court of Appeals in Somers did not have the Schmidt decision, and this argument was apparently not made to the court. It will be interesting to see whether any Texas courts address this particular issue in the future.