defense of fairness
The affirmative defense of fairness
The corporation's reverse burden of proof in a shareholder claim for breach of trust--the affirmative defense of fairness.
Affirmative Defense of Fairness
Reversing the Burden of Proof Through an Affirmative Defense of Fairness
The breach of trust cause of action, as we believe it will develop, would require the plaintiff to prove that corporate action was taken (1) with an intent to harm the plaintiff, (2) with the effect of impairing the plaintiff's rights or interests as a shareholder, and (3) that the plaintiff has no adequate alternative remedy. The intent element, we believe, will require that the corporation act with the purpose impairing the interests of the plaintiff or favoring the interests of another shareholder to the relative disadvantage of the plaintiff or acting with reckless disregard of the interests of the plaintiff as a motivating factor in deciding to take the corporate action.
Even if the plaintiff can prove a prima facia case, there will still probably be factual situations in which the corporation was faced with no good alternative and made the best decision that it could under the circumstances, notwithstanding the injury to the plaintiff. We believe that courts will deal with this eventuality in a manner similar to how the law deals with self-interested transactions by corporate directors and with transactions involving trust beneficiaries and other fiduciary relationships: the law reverses the burden of proof, requiring the party owing the fiduciary duty to prove fairness.
Reverse Burden of Proof
The Common-Law Reverse Burden of Proof
The Texas Supreme Court has held: “It should be emphasized that the imposition by equity of a fiduciary relationship in such circumstances does no more than cast upon the profiting fiduciary the burden of showing the fairness of the transactions.” Texas courts apply a presumption of unfairness to transactions between a fiduciary and a party to whom he owes a duty, thus reversing the ordinary burden of proof on the plaintiff. In the trust context, courts have held: “[T]he burden of proving the propriety of acts set forth in the account, if they are objected to, should rest on the trustee . . . .” Section 21.418 permits a director involved in a self-dealing transaction with the corporation to escape liability, even if the transaction was no approved by a disinterested majority of the directors or shareholders, by proving the fairness of the transaction.
The case law is sometimes unclear as to whether this reverse burden of proof is placed on one of the elements of the plaintiff's case or is an affirmative defense. In practice, the reverse burden of proof almost always operates like an affirmative defense. The plaintiff must prove that the corporate director received a personal benefit at the corporation's expense; then the defendant must prove the entire fairness of the transaction. The plaintiff must prove that the corporate director usurped an opportunity and how much revenue he received; the defendant must prove how much of that revenue constituted net profit over which the corporation possesses a constructive trust.
Fairness to Breach of Trust
Affirmative Defense of Fairness to Breach of Trust
Applying the law of reverse burden of proof governing trustee and interested director situations to potential fact patterns that would give rise to a claim for breach of trust, we believe that the defendant corporation's burden would be to prove the following:
(1) That the corporate act in question was a lawful and legitimate exercise of corporate authority.
The question of fairness, honesty, and good faith are only relevant where the corporation had the lawful right and power to take the action. Acting to prevent a shareholder from voting or failing to count his votes simply cannot be defended based on the best interests of the corporation. A pure heart will not excuse a violation of statutory duties to shareholders or a clear violation of common-law rights. Therefore, the defendant corporation must first establish that the act in question is an action that the corporation would otherwise have the right to take if done for the proper purpose.
(2) That the decision was taken in good faith and for a reasonable business purpose.
The corporation must prove that it acted in good faith and for a reasonable business purpose. The plaintiff has already proven that a motivating factor was an improper purpose; however, the defendant should be able to prove that the primary purpose was an honest, reasonable, and based on the business needs of the corporation.
(3) That the corporation dealt fairly with the plaintiff in light of all the circumstances.
If the corporation was faced with a situation in which there were no good alternatives, but acted fairly toward the interests of all shareholders, notwithstanding the harmful impact on the plaintiff, then the corporation would be in the same position as a trustee whose action will harm one beneficiary or another no matter what. In those situations, where a trustee acts with due regard for the various interests of the beneficiaries and treats all beneficiaries fairly and with impartiality, the trustee faces no liability. The same standard should apply to corporate trustees as to the interests of their minority shareholders; however, the burden of proving such a situation is reversed. The corporate trustee must prove the fairness of the transaction to escape liability.
Take the fact situation of Patton v. Nicholas. The majority shareholder suppressed dividends for the malicious purpose of harming the minority shareholders. The jury found the malicious intent, and the Supreme Court held that the evidence was more than adequate based on statement made by the majority shareholder to employees. If the facts were slightly different, the affirmative defense of fairness might have been available. Assume that the plaintiff made their prima facia case by proving (1) a motivating factor in the decision not to declare dividends was personal animus toward them, (2) the failure to declare dividend impaired their right to proportionally share in the profits of the corporation, and (3) they had no other adequate remedy other than equitable relief against the corporation to compel payment of dividends or buy-out the plaintiffs. The defendant corporation might concede that the decision not to declare dividends was made by someone who did not like the plaintiffs and shed no tears at their inability to extract money from the company.
Nevertheless, there would be no breach of trust if the corporation proved (1) the decision to retain profits in the corporation rather than declare dividends was a lawful and legitimate exercise of corporate authority (it clearly is); (2) the decision was made in good faith primarily for the purpose of preparing for an anticipated shortfall in cashflow, which is a reasonable business purpose; and (3) the plaintiffs were dealt with fairly, because the corporation had not paid out the profits to the majority shareholder, directly or indirectly, and the money would be available for distribution once the crisis had passed.