Direct and Derivative Shareholder Claims into the 21st Century

The first few years of the 21st century did not see any major shareholder decisions by the Alabama appellate courts. However, from 2004-2006 there was a flurry of reported cases.

In 2004, the Alabama Supreme Court heard the first appeal in the case of Robbins v. Sanders. See Robbins v. Sanders, 890 So. 2d 998 (Ala. 2004) (per curiam) (“Robbins I”). In Robbins I, the Court affirmed that a breach of fiduciary duty was a tort claim; held that a shareholder derivative claim is equitable in nature (and, therefore, may survive the death of a shareholder); and reiterated that an individual shareholder cannot recover damages in a shareholder-derivative action. Robbins I, 890 So. 2d at 1011, 1013-14.

Next, in 2005, the Supreme Court issued its opinion in the case of Hensley v. Poole, 910 So. 2d 96 (Ala. 2005). In Hensley, the Court again opined that a breach of fiduciary duty was a tort claim, but also clarified that this tort was subject to a two year statute of limitations under Alabama Code § 6-2-38(l), citing Norman v. Occupational Safety Assoc. of Alabama Workmen’s Compensation Fund, 811 So. 2d 492, 497 (Ala. 2001) and System Dynamics Int’l, Inc. v. Boykin, 683 So. 2d 419, 419 (Ala. 1996) in support of this proposition.

One of Hensley’s defenses in the case was that the actions of the business in paying rent to Hensley were shielded by the business-judgment rule:

Alabama’s business-judgment rule is stated best in Michaud v. Morris, 603 So. 2d 886 (Ala. 1992):

“If in the course of management, directors arrive at a decision, within the corporation’s powers ..., for which there is a reasonable basis, and they act in good faith, as the result of their independent discretion and judgment, and uninfluenced by any consideration other than what they honestly believe to be the best interest of the corporation, a court will not interfere with internal management and substitute its judgment for that of the directors to enjoin or set aside the transaction or to surcharge the directors for any resulting loss.”

603 So. 2d at 888 (quoting Roberts v. Alabama Power Co., 404 So. 2d 629, 631 (Ala. 1981), quoting in turn H. Henn, Law of Corporations § 242 (2d ed. 1970)).

Unless a court finds the existence of either bad faith or the absence of a “reasonable basis,” a court is “loath to interfere” in the decisions of a business. Smith v. Dunlap, 269 Ala. 97, 102, 111 So.2d 1, 4 (1959). However, a court need only conclude that one of those two conditions exists for it to disallow the defense and to assess the conduct of the business.

"In evaluating compensation under the business-judgment rule, our inquiry is “whether the compensation is so excessive that it bears no reasonable relation to the value of services rendered.” Dunlap, 269 Ala. at 101, 111 So. 2d at 4.

“To come within the rule of reason the compensation must be in proportion to the executive’s ability, services and time devoted to the company, difficulties involved, responsibilities assumed, success achieved, amounts under jurisdiction, corporate earnings, profits and prosperity, increase in volume or quality of business or both and all other relevant facts and circumstances.”

Dunlap, 269 Ala. at 101, 111 So. 2d at 4 (quoting Gallin v. National City Bank of N.Y., 152 Misc. 679, 273 N.Y.S. 87, 114 (N.Y.Sup.Ct. 1934)).

Hensley, 910 So. 2d at 104. In Hensley, the Supreme Court chose to affirm the trial court’s ruling based upon the ore tenus evidentiary presumption.

In regard to Hensley’s counterclaims against Poole for breach of fiduciary duty, the Supreme Court held that “a necessary element to be proven in an action alleging breach of duty is damages.” Hensley, 910 So. 2d at 106. Because Hensley did not provide any evidence of damage as a result of Poole’s purported fiduciary breach, her claim failed.

In Baldwin Elec. Membership Corp. v. Catrett, 942 So. 2d 337 (Ala. 2006), a case involving a corporation organized to provide electrical service, we begin to see the Court recognize the contractual relationships between owners of a corporation. In Catrett the Supreme Court determined that “the constitution, bylaws, rules and regulations of a voluntary association constitute a contract between an association’s members, which is binding upon each member so long as the bylaws, etc., remain in effect.” 942 So. 2d at 345. Therefore, a member may seek to redress the infringement of a member’s right to vote as a direct cause of action “because they are enforcing an individual right—the right to vote—rather than a right of the corporation.” Id. at 346. Although this case does not directly involve a closely-held corporation, but a special purpose “cooperative,” it may be instructive as to the Court’s more recent view of non-natural entity governance.

Although not argued in state court, Davis v. Dorsey, 495 F.Supp. 2d 1162 (M.D. Ala. 2007) (Thompson, J.) is a detailed and well-reasoned opinion as to squeeze-out from Judge Myron Thompson of the United States District Court for the Middle District of Alabama. In Davis, Judge Thompson held that “Alabama courts recognize oppression and squeeze-out as a distinctly individual and direct cause of action,” but rejected the plaintiff’s claim of squeeze-out because, in that case, there were no corporate gains for the majority to withhold from the plaintiff. Id. at 1168-69.

Regarding the claim of a breach of fiduciary duty owed by the majority shareholder to the minority, Judge Thompson held:

This court is unaware of any fiduciary duty owed to shareholders individually, as distinct from the fiduciary duty owed to the corporation itself, other than the fiduciary duty to shareholders recognized in the cause of action for oppression and squeeze-out.

Id. at 1170. In other words, according to Judge Thompson, a corporate officer and director owes a fiduciary duty to the corporation, and the breach of that obligation would be a derivative claim on behalf of the corporation that was owed the duty. The only duty owed by the corporate officer and/or director to an individual shareholder, would arise from the position of the corporate officer and/or director as the majority shareholder. This is the duty not to “oppress” or “squeeze-out” the minority shareholder.

Judge Thompson also gave an excellent overview of the duties of a director or officer to the corporation:

Generally speaking, a director or officer owes both a duty of care and a duty of loyalty to the corporation. Richard A. Thigpen, Alabama Corporation Law § 10:2 (3d ed. 2003); see also Massey v. Disc Mfg., Inc., 601 So. 2d 449, 456 (Ala. 1992). Because Davis’s next claim is for negligence, the court will treat count 3 as a claim for a violation of the duty of loyalty and count 4 as a claim for a violation of the duty of care. See Thigpen, supra, § 10:2 (“duty of care is essentially a negligence cause of action”).

The duty of loyalty is the “duty to act honestly for the corporation’s best interest and to avoid acts of self-dealing.” Id. § 10:12. “[A]n officer-director of a corporation owes a duty of managing the corporate affairs honestly and impartially and he may not achieve personal advantage, profit, or gain from his position.” Jefferson County Truck Growers Ass’n v. Tanner, 341 So. 2d 485, 487 (Ala. 1977).

Two types of claims frequently arise under the duty of loyalty: the conflicting-interest transaction and the corporate-opportunity doctrine. A conflicting-interest transaction occurs when a director (or a close relation to a director or an entity in which the director has a financial interest) is a party to a transaction effected by the corporation. 1975 Ala. Code § 10–2B-8.60 [no Ala. Code § 10A-2-8.60]; see Jones v. Ellis, 551 So. 2d 396, 403–04 (Ala. 1989); see also 19 C.J.S. Corporations § 596 (2007); Thigpen, supra, § 10:12. The corporate-opportunity doctrine is invoked when a director or officer appropriates for personal benefit a business opportunity that belongs to or should have been offered to the corporation. Banks v. Bryant, 497 So. 2d 460, 463–65 (Ala. 1986); Morad v. Coupounas, 361 So. 2d 6, 8–9 (Ala. 1978); see also 19 C.J.S. Corporations § 604; Thigpen, supra, § 10:17. In other words, the conflicting-interest transaction calls into question the director or officer’s loyalty regarding a transaction that the corporation did make but possibly should not have made; whereas the corporate-opportunity doctrine calls into question the director or officer’s loyalty regarding a transaction that the corporation did not make but possibly should have made.

Id. at 1170-71. Judge Thompson notes that the inability of the corporation to finance a proposed transaction may not be a good defense to a claim that a director or officer violated the corporate-opportunity doctrine, id. at 1172-73, and that, in a conflicting-interest transaction, “the burden of proof in demonstrating fairness to the corporation … rests with the director or officer defending the conflicting-interest transaction.” Id. at 1175.

Judge Thompson further addresses the implications of the business-judgment rule in regard to derivative claims for negligence (or a violation of the director/officer’s duty of care):

The Alabama legislature has designated the duty of care owed by directors and officers to the corporation: they must exercise their duties in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner they believe to be in the best interests of the corporation. 1975 Ala. Code §§ 10–2B–8.30, –8.42 [now Ala. Code §§ 10A-2-8.30, -8.42]. When shareholders allege a violation of the duty of care, defendant directors and officers are protected by the so-called business-judgment rule: “If in the course of management, directors arrive at a decision, within the corporation’s powers, for which there is a reasonable basis, and they act in good faith, as the result of their independent discretion and judgment, and uninfluenced by any consideration other than what they honestly believe to be the best interests of the corporation, a court will not interfere with internal management and substitute its judgment for that of the directors to enjoin or set aside the transaction or to surcharge the directors for any resulting loss.” Roberts v. Alabama Power Co., 404 So. 2d 629, 631 (Ala. 1981), quoted with approval in Hensley v. Poole, 910 So. 2d 96, 104 (Ala. 2005), and Michaud v. Morris, 603 So. 2d 886, 888 (Ala. 1992).

The business-judgment rule, however, does not operate to protect self-dealing by directors and officers. 3A Fletcher, supra, § 1040; Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 360–61 (Del. 1993); see also Jones v. Ellis, 551 So. 2d 396, 400–01 (Ala. 1989); Ingalls Iron Works Co. v. Ingalls Found., 266 Ala. 656, 98 So. 2d 30, 39 (1957). In other words, if the defendant has engaged the corporation in a conflicting-interest transaction or has usurped a corporate opportunity, the business-judgment rule will not bar a claim based on the duty of care.

The Supreme Court of Delaware has described the business-judgment rule as part-procedural and part-substantive. Cede, 634 A.2d at 360. Substantively, the rule prohibits courts from second-guessing the good-faith business judgments of corporate management. Id. Procedurally, the rule creates a burden-shifting mechanism: a corporate decision carries a presumption of due care; but if the plaintiff demonstrates fraud, bad faith, or self-dealing by management, the presumption is rebutted and the burden shifts to the defendant to show that the challenged decision was fair to the corporation.

Id. at 1176.

In Altrust Financial Services, Inc. v. Adams, 76 So. 3d 228 (Ala. 2011), certain minority shareholders sought to bring direct claims against the directors and officers of the corporation for the breach of “duties of care owed in the management and administration of Altrust’s affairs.” Id. at 237. In Altrust, the Alabama Supreme Court provided a detailed summary of the history in Alabama of direct vs. derivative claims. Altrust also overruled the holding of Boykin v. Arthur Andersen & Co., 639 So. 2d 504 (Ala. 1994) relating to the ability of shareholders to bring direct claims without evidence or allegations of damages specific to the minority shareholders. Id. at 241-45.

In the case of Jackson v. Wicks, 139 So. 3d 813 (Ala. Civ. App. 2013), the Court of Civil Appeals affirmed that a claim for conversion of corporate assets may only be raised by a shareholder as a derivative claim on behalf of the corporation, and not as a direct claim by the shareholder.

Alabama federal courts also addressed shareholder litigation-related issues in the past few years. In re Dalton, 2009 WL 4667116 (Bankr. N.D. Ala. 2009) (Mitchell, J.) was heard in the Bankruptcy Court for the Northern District of Alabama. In that case, Judge Mitchell noted that derivative actions are only necessary where a shareholder cannot get the corporation to act. Accordingly, if the corporation can bring a claim directly on its own behalf (such as when the shareholder attempting to assert the derivative claim is in control of the corporation), then “there can be no derivative shareholder claim.” Id. at *6.

The case of In re Dixie Pellets, LLC, 2010 WL 2367326 (Bankr. N.D. Ala. 2010) (Mitchell, J.) was also decided by Judge Mitchell in the Bankruptcy Court for the Northern District of Alabama. In that case, Judge Mitchell set out the law as to direct squeeze-out or oppression claims, and determined that the allegations of actions by the majority to enrich itself to the detriment of the minority shareholders “drained off Dixie Pellets’ income through this conduct for the benefit of the [majority shareholder] and, consequently, prevented or restricted the availability of dividends for the [minority shareholders].” Id. at *5. Accordingly, the plaintiffs’ direct claims survived the motion to dismiss.

In Mobile Attic, Inc. v. Cash, 2012 WL 2149889 (M.D. Ala. 2012) (Coody, M.J.), Magistrate Judge Coody of the Middle District of Alabama reaffirmed that waste of corporate assets is a derivative claim that belongs to the corporation, and not an individual claim of the minority shareholder. Id. at *11-12. Judge Coody rejected the minority shareholder’s argument that the claim was one for squeeze-out or oppression, stating: “To establish the tort of oppression, [the minority shareholder] must demonstrate, not only that the [majority shareholder] took control of [the corporation], but as that the [majority shareholder], ‘acting through the board and corporate officers, which they control, deprived [the minority shareholder] of its just share of corporate gains.’” Id. at *13 (quoting Burt v. Burt Boiler Works, Inc., 360 So. 2d 327, 332 (Ala. 1978)).