Minority Interest Discount for Breach of Corporate Fiduciary Duties

The issue this week concerns the appropriate remedy when controlling shareholder(s) breach the fiduciary duties they owe to the other shareholders.  An article by attorney William S. Monnin-Browder discusses whether courts should apply a minority interest discount in a forced sale.

Background

As explained in many published opinions, “stockholders in the close corporation owe one another substantially the same fiduciary duty in the operation of the enterprise that partners owe to one another . . . They may not act out of avarice, expediency or self-interest in derogation of their duty of loyalty to the other stockholders and to the corporation.”  Donahue v. Rodd Electrotype Co., 328 N.E.2d 505, 515 (Mass. 1975)

Wrongful Conduct by the Controlling Shareholder

Mr. Monnin-Browder explains that, “There are a number of ways that majority shareholders can usurp the interest of the minority.  For instance, the terms ‘freeze-out’ and ‘squeezeout’ are often used, synonymously, to describe a situation where the majority uses its controlling position to exclude a minority shareholder from participation in the business.”

By the wrongful acts of the majority, “minority shareholders can be prevented from gaining a return if they are fired, which a majority-controlled board can freely do . . . One common form of the squeeze-out occurs when a majority shareholder prevents a minority from receiving a return on her investment, and then attempts to buy the minority’s shares when the value of the stock is compromised . . . The lack of a ready market for shares in a close corporation prevents a minority shareholder from selling shares as a means of escape.”

The Remedy

“Once a court determines that majority shareholders have breached their fiduciary duty, the court is forced to find an appropriate remedy.  Remedies for breach of fiduciary duty are equitable in nature . . . Common remedies for breach of fiduciary duty in a close corporation include dissolution, reversal of an offending decision, or buyout of the minority shareholder’s shares by the corporation.”

However, “the most common remedy employed by courts today [ ] is buyout . . . Courts view buyout as a less harsh remedy than dissolution because it compensates the aggrieved shareholder, while allowing the corporate entity to survive.  It is also often the most practical remedy.  A court order to rehire or return the shares sold, for example, may not be a viable option.”

Marketability Discount

But to do so, the court must establish the value of the victim’s interest in the entity.  “Valuing a share in a close corporation usually begins with an analysis of the value of the corporation as a whole.  To do this, courts often look to three major approaches: market value, net asset value, and earnings value.  These factors are weighed differently, according to the specific factual circumstances.”

Two general forms of discount are commonly applied in valuing interests in a closely-held corporation.  The first is a marketability discount.  As explained, “The marketability discount compensates for the absence of a market for shares of a close corporation.  Investors will pay less for these shares, compared to more liquid shares, because they prefer shares that are easily sold and/or transferred.  Marketability discounts can be substantial, averaging from approximately 35 to 50% of the value of the stock. “

Minority Interest Discount

The second principal discount is the minority interest discount.  “The minority discount compensates for the fact that the shares constitute a minority interest in the corporation that is not controlling, so long as there is no shareholder agreement to the contrary.  Investors prefer stock that has the accompanying voting power to influence the operations of the corporation.  Therefore, investors will pay less for those shares than shares in the majority interest.  Like marketability discounts, minority discounts can have a substantial impact on the value of the shares, reducing the price as much as 33%.”

Thus, the combined discount based on minority interest and lack of marketability can exceed 50% of the value of the stock.  Such discounts are commonly used in the estate planning context.

Should a Court Apply the Discount?

The judicial trend is not to apply the discount in the context of a forced buyout of a minority interest.  “Some courts state that the context and purpose of the legislation suggest that no discount should apply.  In Swope v. Siegel Robert, Inc., for example, the Eighth Circuit Court of Appeals applied Missouri law to reject the application of both a marketability and minority discount.”

In this way, “The typical freeze-out situation arises when a minority shareholder has no other choice but to sell their shares to the majority shareholder at less than their fair value.  From a policy standpoint, it would be illogical to discount the value of the shares because doing so would reward an oppressive majority shareholder and injure the party who is relatively blameless.”

That analysis is sound, because the “buyout does not occur on an open market.  Therefore, courts argue that they should not apply discounts that account for irrelevant market conditions.  As Professor Moll writes, ‘the forced-sale nature of buyout proceeding and the identity of the purchasers involved weigh heavily against the application of discounts.’”

An Extreme Result

One court went the opposite direction.  “Rather than force the oppressor shareholder to purchase the oppressed shareholder’s stock, the trial court chose a different remedy, holding that the oppressed shareholder was entitled to buyout the shares of the oppressor.  The court [then] applied discounts.”  Balsamides v. Protameen Chemicals, Inc., 734 A.2d 721, 734 (N.J. 1999).

We could certainly ask – Isn’t sauce for the goose also sauce for the gander?  The court put a real hurt to the wrongdoer by forcing a sale and also applying  a judicially-created discount.

A Point of Dispute

Mr. Monnin-Browder posits that “a heightened fiduciary duty exists among shareholders of a close corporation,” explaining that, “In the wake of the Massachusetts ruling, courts in many other states adopted the fiduciary duty rationale of Donahue, thereby recognizing heightened fiduciary duties among shareholders in close corporations and creating a common-law cause of action.”

That is not a careful use of terms.  Fiduciary duties are, by definition, “heightened duties,” filling gaps in the relationship between the parties.  It does not make a great deal of sense to speak in terms of a “heightened fiduciary duty.”

William S. Monnin-Browder, Are Discounts Appropriate?: Valuing Shares in Close Corporations for the Purpose of Remedying Breach of Fiduciary Duty under Massachusetts Law, in 40 Suffolk Univ. Law Review, Vol. 3 (2007) page 723.

A Comparative Fault Defense in Contract Law – Part 2

This posting continues the question of whether fault should be considered in evaluating a claim for breach of contract, specifically, whether the courts should weigh the “fault” of the non-breaching party.

When would such “fault” by the non-breaching party arise?  It would seem that three time frames could be considered:

  • Before (i.e., during the formation of contract)
  • During performance
  • After breach

The bigger question is, Are we better off as a society if we disregard all fault by the non-breaching party when we assess liability for breach of contract?

Here are several hypotheticals from Prof. Porat, and my comments regarding them.

Before performance:

“Ann, a contractor, and Bob, the owner of a certain piece of land, enter a contract for the performance of construction work.  Due to geological difficulties, there is a delay in performance that causes Bob substantial losses.  It becomes evident, however, that Bob knew about these obstacles at an early stage (although not prior to entering into the contract with Ann).  Had he revealed this to Ann in due time, the delay could have been prevented.”

Response:  This is a thorny issue for contract purists, who would insist that Ann had the obligation to review the situation fully before entering into the contract.  Yet, Bob had the power to prevent some of the losses, and, indeed, could probably help reduce the overall cost of performance.  The law should impose a duty on Bob to cooperate and assist in the performance of the contract.

During performance:

“In the course of a construction project, Charles makes demand for an installment payment.  In fact, Charles is not entitled to any payment, because she failed to meet an additional condition stipulated by the contract.  Charles is not aware of this additional condition because of an oversight on her part.  Debbie refuses to pay, stating that he is not obliged to do so under the contract, but Debbie provides no other explanation.  Charles then stops her work, causing loss to Debbie.  Only after a month, during which Debbie stubbornly refuses to meet with Charles, does Debbie explain to Charles why he was not entitled to payment.”

Response:  The law should encourage efficiency.  Debbie should not be rewarded for her failure to act in a commercially reasonable manner, and the damages should be reduced accordingly.

During performance:

“Edward undertakes to construct a building for Fay.  During the last stage of performance, Fay gives Edward’s employees confusing instructions on the construction work required.  In the end, there is a delay in the completion of performance; moreover, some of the construction work is found to be defective.  Had Fay refrained from instructing Edward’s employees, the contract would have been adequately performed.”

Response:  In this hypothetical, the contributing fault of Fay, the non-breaching party, should be considered to reduce liability.  Fay caused part of the harm, and Edward should not bear all of the losses.

Comment:  The hypothetical is not complete, as we need to know the nature of the losses suffered by Fay.

During performance:

“In a home remodeling contract, both George and Harold are aware that there could be delays in completion.  Even though Harold is well aware of this risk, he enters into a contract with a contractor to refurnish the house starting on the day set for delivery.  He also incurs expenses advertising the house for rent.  In the end, George breaches due to late delivery, and Harold suffers losses due to forfeiting the contractor’s deposit and his advertising expenses.  These losses would have been prevented had Harold waited to see whether the contract would be adequately performed.”

Response: It would seem that Harold assumed the risk of loss.  However, assumption of the risk is not a traditional contract defense.  This is an uncomfortable fit for the law, as Harold caused some of his own losses, yet it appears that George is liable for late delivery.

After breach:

“Ike, a carrier, undertakes to ship a crank shaft from Jane’s mill for repair and to bring it back in one week’s time.  Ike instead brings the shaft back after two weeks, which results in high consequential losses to Jane, who could not find a substitute shaft.  At the time of contracting, the parties were aware of a small risk that a substitute shaft would not be available.  One week later it became clear to Jane, but not to Ike, that this risk had materialized.  Had Jane conveyed this information to Ike on time, Ike would have taken costly precautions to ensure that he would return the shaft on time, thus preventing the breach.”

Response:  Historically, the law has favored common carriers, in the sense that the public does not want to pay exorbitant rates for carriage.  It seems that the carrier could have take precautions to avoid the loss.  However, I want know whether the rate structure reflected the potential loss.

In other words, Did the price for shipping reflect a one-week delivery time?  Ike could have shopped for someone who would have guaranteed delivery.  Further, the additional loss was not due to any acts or omissions on the part of Ike, in that Jane simply could not locate the replacement part in a timely manner.

(Ariel Porat, A Comparative Fault Defense in Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1397.)

A Comparative Fault Defense in Contract Law – Part 1

This week’s posting considers whether culpability should be considered in a claim for breach of contract.  The traditional answer in the U.S. (traditional at least since 1900) is No.

As discussed in a recent symposium, “In terms of the Restatement of Contracts conception, then, contract law is strict liability without a contributory negligence defense . . . The core of contract law as applied in the courts is a no-fault regime.”

“Among the many debates about fault in contract law, one principle remains unchallenged: a promisor is strictly liable for defective performance or nonperformance despite her exercise of due care.”

“Even the most fervent adherents of fault in contract law concede that the law always applies this rule strictly.  Thus, the promisee does not have to prove that the promisor failed to take cost-effective precautions against breach.  Nor, for that matter, can the promisor escape liability by showing that the breach was caused by exogenous factors beyond her control.”

(Robert E. Scott, In (Partial) Defense of Strict Liability in Contract, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1381.)

Which means that contract law is applied as a binary system – either you perform the contract or you do not.  If you do not perform (i.e., if you breach), then you are liable for damages.

This system is effectively 180 degrees different from tort liability, in which culpability is always an issue.  Another commentator notes that,

“The main puzzle that emerges from the discussion is why contract law puts the burden on the wrongdoer to show that he was not at fault in order to avoid paying damages, while tort law puts the burden on the victim to show that the wrongdoer was at fault in order to obtain damages.”

(Eric A. Posner, Fault in Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1431.)

Thus, one of the issues is whether society is better when contract law is treated as a binary system of liability, without consideration of fault by either party.  A third commentator considers whether the non-breaching party contributed to the loss.  Prof. Ariel Porat proposes that “the comparative fault defense should be available to a breaching party against an aggrieved party when the latter’s fault has contributed to his own losses.”

In this scenario, “the promisee should be considered ‘at fault,’ and should shoulder part of the loss, when he fails to meet a legal burden to reduce his potential losses by cooperating with the promisor or avoiding overreliance.”

Next week’s posting further examines comparative fault as a defense to a breach of contract claim.

(Ariel Porat, A Comparative Fault Defense in Contract Law, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1397.)

The Enforcement of Trusts in the Medieval Legal System

Trusts have been employed in the English legal system for hundreds of years.  In 1979, Prof. R.H. Hehnholz reviewed court records to examine the early history of trusts.

Prof. Hehnholz started by noting, “As a means of avoiding feudal incidents and of evading the common law rule prohibiting devises of freehold land, the feoffment to uses, ancestor of the modem trust, enjoyed a popularity at least from the reign of Edward I (1327-1377).”

The question is, How were they enforced?  “Enforcement of the feoffor’s directions, however, long posed a problem.  What of the feoffee who refused to carry out those directions after the feoffor’s death?”

“How can so important and so widespread an institution have existed without legal sanction?  Can its effectiveness really have rested solely on the conscience and good sense of the feoffees prior to the time the Chancellor began to intervene? This seems implausible.”

Jurisdiction over decedent’s estates was, in the early years, an ecclesiastical matter.  “As is well known, the English Church exercised probate jurisdiction throughout the Middle Ages, and even afterwards.  One of the responsibilities attendant upon that jurisdiction, in the eyes of the men who exercised it, was the duty to secure a person’s final wishes.”

“In an age when the grant of land need not have been by deed, and in which the Church courts would enforce the wishes of a dying man with no requirement of a testamentary writing, there was inevitably much room for uncertainty and disagreement.”

Prof. Hehnholz finds that the historical record reflects the long-standing enforcement of the use.  “In fact, good evidence to support the suggestion does exist: the court records from the ecclesiastical courts of the dioceses of Canterbury and Rochester contain many cases involving feoffments to uses.  The records are in manuscript.  They are hard to read, and often difficult to interpret.”

Humorous aside: G.R. Elton has described these early court records as “among the more strikingly repulsive of all the relics of the past.”  G. ELTON, ENGLAND, 1200-1600, at 105 (1969).

Prof. Hehnholz explains that “the records furnish the best test of the actual scope of the Church’s jurisdiction, and although they do not allow for absolutely confident generalization, they tend to prove that some English Church courts regularly enforced feoffments to uses.”

“For example, in a suit brought at Canterbury in 1416, the Act book records that ‘the aforesaid Henry was ordered to restore the three virgates of woodland’ . . . The records unfortunately supply no evidence on what remedies the Church courts offered in more complicated cases, if indeed any was available . . . Nor is there any sign of the recovery of money damages from defaulting feoffees.  So far as the records reveal, an order for specific performance was the sole remedy available.”

Violation of the church order meant that “they were excommunicated.  What action they had to take to have the sentence lifted, and whether or not they took it, unfortunately does not appear in the surviving records.”

However, the evidence is limited.  “The fact that all the evidence comes from the two English dioceses that lay within the county of Kent is undeniably troublesome.  The pre-eminent influence there of the archbishop of Canterbury, not only England’s most powerful churchman but also a powerful secular landlord within the county, suggests at least the possibility of a special place for the Church courts in his diocese.  Not every man would question the rights of an archbishop who happened also to be his lord.”

As time passed, the enforcement of the use/trust shifted to courts administered by the crown (as opposed to courts administered by the church).  “Cases involving feoffnents to uses cease to appear in the court records after the middle third of the fifteenth century.  The last unambiguous example found comes from 1465 . . . By that date, of course, the jurisdiction of Chancery over uses had been established.”

And, of course, there were lobbyists 500 years ago.  “The Statute of Uses (1536), was passed specifically to put an end to these evasions of the common law.  The ability to devise lands was quickly restored, because of pressure from the land-owning classes, in the Statute of Wills (1540).”

R. H. Hehnholz, The Early Enforcement of Uses, in 79 Columbia Law Review 1503 (1979)

Change of Property Ownership Triggers Big Tax Bill

The California Supreme Court recently considered when a transfer of ownership occurs in the context of an estate planning trust.  The dispute arose in under Proposition 13, which sets the rules for property tax reassessment.

According to the court, “When Helfrick died, the residence’s assessed value for tax purposes was $96,638, with total taxes due of $1,105.  Upon her death, defendant County of Los Angeles reassessed the residence and increased its valuation for tax purposes to $499,000.  For the next three tax years, the County sent property tax bills of, respectively, $5,492, $5,764, and $6,245.”

That’s the dispute – do the property taxes increase by 500% upon the owner’s death?  Stated the court, “The starting point for our conclusion lies in the fact that, during her lifetime, Helfrick transferred the residence to a trust of which she was the sole present beneficiary and as to which she held the power to revoke.”

The court explained that “under general principles of trust law, trust beneficiaries . . . are regarded as the real owners of that property . . . Moreover, property transferred to, or held in, a revocable inter vivos trust is deemed the property of the settlor.”

The court cited to a legislative task force, which had explained that:  “Revocable living trusts are merely a substitute for a will.  The gifts over to persons other than the trustor are contingent; the trust can be revoked or those beneficiaries may predecease the trustor.”

According to the court, “although transferring legal title to the residence to herself as trustee, Helfrick, as sole trust beneficiary and holder of the revocation power, continued to hold the entire equitable estate personally and effectively retained full ownership of the residence.”

It’s a relief to see such a clear statement from the California Supreme Court.  A living trust is established for estate planning purposes as a will substitute.  Such a trust can be amended or revoked by the trustor (i.e., the property owner) during the his or her lifetime, just like a will.  In the court’s explanation, “Any interest that beneficiaries of a revocable trust have in trust property is ‘merely potential’ and can evaporate in a moment at the whim of the settlor.”

What happens to the property after death?  At this point, the trust cannot be modified.  “Upon Helfrick’s death, the trust became irrevocable and the entire equitable estate in the residence, which Helfrick had personally held during her lifetime, transferred from Helfrick to Steinhart and her siblings (or their issue) as beneficiaries of the irrevocable trust.”

The same thing with a will – the instrument becomes permanent at death, and the property passes to the persons named as the beneficiaries.  Here’s the point at which the court had to make a slight leap.

With a will, Probate Code section 7000 states that, “title to a decedent’s property passes on the decedent’s death to the person to whom it is devised in the decedent’s last will.”  However, there is no statutory counterpart in California’s trust laws.  Hence, the court filled the gap by holding that, “upon [the] settlor’s death, [the] trust became irrevocable and the full beneficial interests in the property transferred to the residual beneficiaries of the trust.”

Thus, during her lifetime, “Helfrick personally held the entire equitable estate in the residence and was regarded as the residence’s real owner.  Under the terms of the trust, upon her death, Helfrick transferred not just a life estate, but the entire fee interest – i.e., the full bundle of rights – to, collectively, Steinhart and her siblings (or their issue) . . . Helfrick, who was the sole beneficial owner of the residence before her death, retained no interest in the residence after her death.”

In the case before the court, the decedent left a life estate to one heir, with the remainder interest passing to certain siblings.  The life estate tenant claimed that the property was not subject to reappraisal until her death.  The court disagreed:  “That circumstance does not alter the fact that, upon Helfrick’s death, the entire equitable estate in the residence was transferred from Helfrick to, collectively, Steinhart and her siblings (or their issue) as beneficiaries of the irrevocable trust . . . This transfer constituted a ‘change in ownership’ within the [meaning of Proposition 13].”

The holding is not surprising but again reflects the legal tensions that arise from the use of a trust agreement as a substitute for a will.

Steinhart v. County of Los Angeles, 2010 DJDAR 1913 (Feb. 5, 2010)

Agent Not Liable for Breach of Fidicuary Duty Without Proof of Damages

In the recent case of Sharabianlou v. Karp, 2010 DJDAR 2039 (Feb. 8, 2010), the court considered the following facts.

“Faced with uncertainty about the scope of the contamination and the cost of its cleanup, and unable to agree on who should pay for the remediation, the parties failed to close escrow.  After further efforts to resuscitate the transaction were unsuccessful, the [buyer] sued the [seller] and the [real estate agent].”

“The second amended complaint also included claims against the [real estate agent] for breach of fiduciary duty . . . The [buyer] contends that [the real estate agent] breached his fiduciary duty by failing to disclose to their lender’s appraiser that environmental contamination had been discovered on the property.”

So far, that’s a traditional basis for a breach of fiduciary claim.  The agent is required to disclose all material facts concerning the subject of the agency.

Thus, the buyer “asserts that [the real estate eagent] knew he was relying on the appraisal to determine whether to exercise a contractual right to walk away from the contract.  [The buyer] claims that had the contamination been disclosed to the appraiser, the property could have appraised for less than $1.7 million, and he would have exercised his right under Addendum 4 to cancel the Agreement.”

That’s the background for the court’s review – did the real estate agent “fail to disclose the existence of the Piers environmental reports to US Bank’s appraiser?” In its analysis, the court held that,

“A claim for breach of fiduciary duty by a real estate agent has three elements; a plaintiff must demonstrate the existence of a fiduciary relationship, its breach, and damages proximately caused by that breach. The trial court found no breach of fiduciary duty because the evidence showed the [buyer] and US Bank already knew that the toxic hazard and potential remediation cost was undefined and unknown.”

This finding that will not be disturbed on appeal unless it is unsupported by evidence, and would undermine any claim for relief.

The buyer made a peculiar concession to the appellate court. “On appeal, the [buyer] does not contest any of these findings. Instead, [the buyer] claims that as a matter of law, ‘[the real estate agent] owed a duty to disclose the existence of environmental contamination on the property when he must have known that his failure to do so would affect his principals’ substantive rights.’”

The appellate review could have ended at this point, because there was no finding of a failure to disclose. Instead, the court held held “appellants cannot show any prejudicial error because they failed to present evidence of damages proximately caused by [the real estate agent’s failure to disclose.”

The court explained that “there simply is no evidence that the property would have appraised for less than $1.7 million, and thus any claim that the [buyer] would have been entitled to cancel the Agreement on that basis is entirely speculative. Without such evidence, the [buyer] cannot show that [he was] damaged by the alleged breach of fiduciary duty.”

That’s a bit of a strange turn. The concession that there was no failure to disclose should have ended the inquiry.

Sharabianlou v. Karp, 2010 DJDAR 2039 (Feb. 8, 2010)

Judge Posner Writes on Blameworthiness in Contract Theory

Continuing his recent discussion of fault in contract law, Judge Posner explains that,

“The idea of ‘good faith’ is an example.  We generally want people to be honest and aboveboard in their dealings with others.  But there is no general duty of good faith in contract law.  If you offer a low price for some good to its owner, you are not obliged to tell him that you think the good is underpriced – that he does not realize its market value and you do.

“You are not required to be an altruist, to be candid, to be a good guy.  You are permitted to profit from asymmetry of information.  If you could not do that, the incentive to discover information about true values would be blunted.  It is an example of the traditional economic paradox that private vice can be public virtue.”

True, and eloquently stated.  The principle of capitalism is that a person should be able to profit from skill and knowledge.  Continuing his analysis, Judge Posner explains his view the duty of god faith in contract law, stating that,

“There is a legally enforceable contract duty of ‘good faith,’ but it is just a duty to avoid exploiting the temporary monopoly position that a contracting party will sometimes obtain during the course of performance.”

OK.  Good faith in contract law concerns good faith in performance, not to good faith in contract formation (although he recognizes that some standard of decency is necessary to police unreasonably sharp deals).

Thus, “More often than not the parties to a contract do not perform their contractual duties simultaneously, and so one party may unavoidably deliver himself into the power of the other party for a time during the performance of the contract.  [Take this example.]  A may agree to build a swimming pool for B, and B may agree to pay A upon completion.  Suppose that when A has finished, B refuses to pay the agreed-upon price because he knows that A is desperately short of cash and will agree to a reduction in the contract price, having no possible source of cash other than B.  A’s cash shortage, coupled with his having completed performance before B has begun and his having no alternative source of cash, gives B a monopoly position as A’s financier; monopoly is inefficient and so a modification of the contract to lower its price will not be enforced.”

Yes, but, isn’t this conduct bad faith in performance?  If so, should the law award extra-contractual damages for violation?  Judge Posner continues, citing from his opinion in Market Street Associates v. Frey, 941 F.2d 588 (7th Cir. 1991):

“In all these examples the duty of ‘good faith’ arises after the contract has been formed; that is why it is properly called the duty of good faith in performing a contract.  If I may be permitted to quote again from my opinion in the Frey case:

“Before the contract is signed, the parties confront each other with a natural wariness.  Neither expects the other to be particularly forthcoming, and therefore there is no deception when one is not.

“Afterwards the situation is different.  The parties are now in a cooperative relationship the costs of which will be considerably reduced by a measure of trust.  So each lowers his guard a bit, and now silence is more apt to be deceptive . . .

“As performance unfolds, circumstances change, often unforeseeably; die explicit terms of the contract become progressively less apt to the governance of the parties’ relationship; and the role of implied conditions and with it the scope and bite of the good-faith doctrine grows.”

We see the analysis heading toward the territory of the fiduciary, in which neither party may take action to deprive the other of the benefit of the bargain.  The question is, If the action by the contract-breaker is intentional, after the other party has become vulnerable, should the law respond more harshly?  Judge Posner says no – but on a societal level, why should this be the rule?

Richard A. Posner, “Let Us Never Blame a Contract Breaker,” in Michigan Law Review (June 2009), Vol. 107, No. 8, page 1349.

Judge Posner Considers the Distinction between Liability for Contract and Liability for Fraud

Judge Richard A. Posner of the Seventh Circuit Court of Appeals contributed his thoughts at a symposium on the rationale for liability for breach of contract.  One of his points is a sound analytic distinction between tort liability and contract liability, a concept which is sadly muddled in California cases.

Writes Judge Posner, “Here is a simplified version.  A and B make a written contract.  Later A sues B claiming that during the negotiations B deliberately misrepresented the benefits that A would derive from the contract.  But A does not sue for breach of contract.  He can’t; the parol evidence rule would bar a claim that promises made during the negotiations but not repeated in the contract should be deemed contractually binding.”

That’s clear legal thinking.  There is no claim for breach of contract because the law of evidence excludes evidence of terms that contradict the terms of the contract.

Judge Posner continues.  “So A sues B in tort, charging fraud.  The parol evidence rule is not a rule of tort law.”

Right again.  Parol evidence knocks out the contract claim, but not the tort claim.

“B has a defense [to the fraud claim]: the written contract had included a clause stating that neither party was relying on any representations not embodied in the written contract.”

According to Judge Posner, “The ‘no reliance’ clause scotches A’s fraud suit because you cannot obtain damages for fraud unless you relied on the fraudulent representations, and A has disclaimed such reliance.  So although B is assumed to have acted wrongfully, A has no remedy either in contract or in tort.”

Well, maybe not so fast.  Isn’t the whole point of the fraud claim that the wrongdoer deceived the victim?  Conceptually, I don’t see how the bad guy gets to hide behind his contract, when the injured part was induced, by false promises, to enter into the contract.  The false promises should negate the terms of the contract, at least insofar as such terms act to exculpate the bad guy.

Now, here’s an even deeper way to look at the issue, which takes us into philosophical terms.  Judge Posner posits that, “There is, however, a limited duty of good faith at the contract-formation stage as well.”

Now we’re getting to the point.  Are we focusing on a wrong arising out of the contract, or a wrong that preceded the contract?

“It is one thing to say that you can exploit your superior knowledge of the market for if you cannot, you will not be able to recoup the investment you made in obtaining that knowledge or that you are not required to spend money bailing out a contract partner who has gotten into trouble. Just in case a bail out is necessary, bail bonds from a bondsman are a great way for those immediate cases. It is another thing to say that you can take deliberate advantage of an oversight by your contract partner concerning his rights under the contract.”

This runs straight to a utilitarian moral theory, which is not easy to square with cold-blooded contract analysis.  Yet Judge Posner continues on.  “Such taking advantage is not the exploitation of superior knowledge or the avoidance of unbargained-for expense . . . Like theft, it has no social product, and also like theft it induces costly defensive expenditures, in the form of overelaborate disclaimers or investigations into the trustworthiness of a prospective contract partner, just as the prospect of theft induces expenditures on locks.”

Richard A. Posner, “Let Us Never Blame a Contract Breaker,” in Michigan Law Review (June 2009), Vol. 107, No. 8, page 1349

Differentiating The Duties Owed by Agents

Prof. Deborah A. DeMott from Duke University School of Law has written a thoughtful article in which she differentiates among the fiduciary duties owed by agents.  Prof. Demott begins as follows:

“Legal theorists differ on how best to characterize fiduciary duty; to some, it’s best understood as a consequence of contract – as a set of default terms to which parties would agree, had they the benefit of unlimited resources.”

[On this topic, see my prior article regarding Le vs. Pham, in which I posit that the court got it wrong by creating additional duties where the contract already established the relationship between the parties.]

Prof. DeMott continues.  “It’s conventional to distinguish among an agent’s duties.  Restatement (Third) of Agency uses the terminology of duties of performance and duties of loyalty.

Hooray – someone who breaks down the different duties owed by a fiduciary.  As to agents, she says it’s a duty of loyalty and a duty of performance.

The duty of performance is seemingly self-evident.  “An agent’s duties of performance include the duty:

  • To act only as authorized by the principal;
  • To fulfill any obligations to the principal defined by contract;
  • To act with the competence, care, and diligence normally exercised by agents in similar circumstances; and
  • To use reasonable effort to provide the principal with facts material to the agent’s duties to the principal.

“An agent’s duties of performance are often defined by agreement between principal and agent.”

The obligations arising the duty of loyalty are more subtle.  “An agent’s duties of loyalty stem from the agent’s basic obligation to act loyally for the principal’s benefit in matters connected with the agency relationship.  An agent’s more specific duties of loyalty include:

  • A duty not to acquire a material benefit from a third party in connection with transactions or other actions taken on behalf of the principal or otherwise through the agent’s use of position;
  • A duty not to deal with the principal as or on behalf of an adverse party;
  • A duty not to compete with the principal or assist the principal’s competitors during the duration of the agency relationship; and
  • A duty not to use property of the principal, and not to use or communicate confidential information of the principal, for the agent’s own purposes or those of a third party.”

The author then tracks the effects of the legal analysis to the remedies available to the principal.  Explains Prof. DeMott, “The remedies available to a principal do not map neatly onto the contours of either contract law or tort law principles and remedies.

“For example, remedies that have the consequence of stripping profit or benefit from the agent do not necessarily approximate the amount of harm that a principal either has suffered or would be able to prove or the benefit that the principal expected to realize through the transaction conducted by the agent.”

From “DISLOYAL AGENTS” by Deborah A. DeMott, Professor of Law, Duke University School of Law.  Prof. Demott served as the Reporter for the Restatement (Third) of Agency.

Alabama Law Review (2007) Vol. 58:5:1049

Le vs. Pham – Careless Reasoning in Sale of a Pharmacy

The Fourth District Court of Appeal held in Le vs. Pham,  2010 DJDAR 297 (January 6, 2010) “that where the bylaws of a pharmacy corporation provide that one stockholder must give another a right of first refusal on the sale of any stock, it is a breach of fiduciary duty for the selling stockholder to attempt to sell to a third party in violation of the right of first refusal.”

The problem is that the court fails to adequately explain which fiduciary duty was breached, instead conflating breach of contract with breach of fiduciary duty.

To be sure, the Les did wrong by Pham, their fellow shareholder.  “Le and his wife owned 50 percent of the corporate shares of Newland Pharmacy, while Pham owned the other 50 percent. They also had a department dedicated solely to handing out prescription discounts to patients. Corporate bylaws obligated the Les to give Pham written notice of any intent to sell or transfer.  The bylaws also gave Pham a right of first refusal on any sale based on that notice of intent.”

The Les wanted to sell their stock and “gave written notice to Pham (by certified mail) of their intent to sell their 50 percent share to Paul and Kimngang Hoang for a total of $70,000, cash at transfer.”  The Phams replied by stating that they needed 30 days to review the proposal.

The Les did not wait but instead sold their stock, however, neither at the price nor on the terms set forth in the notice.  Instead, “the Les sold their shares [for]$24,000, considerably less than the $70,000 offered to Pham.  Nor was it a cash sale.  The Hoangs [buyers] were allowed to make installment payments on the $24,000.”

OK.  Breach of contract through and through.  Further, the sale caused problems with the Board of Pharmacy, as “Hoang [the buyer] did not file a change of ownership form with the California Board of Pharmacy, an omission which prompted a ‘cease and desist’ order from the board that closed the pharmacy down for about three months beginning in March 2007.”

Not content with this set of problems, “the seller and the buyer sued the other shareholder [Pham], contending that the transfer was valid in accordance with Newland Pharmacy’s bylaws.”

Pham prevailed on the complaint at trial.  “The court, in its statement of decision, ruled that the Les’ attempted transfer of shares to the Hoangs was null and void because it did not comply with the corporate bylaws.  It was obvious, after all, that the Les had attempted to sell the shares to the Hoangs for a better price ($24,000 as distinct from $70,000) and on better terms (installments rather than cash) than had been offered Pham in the notice of intent to sell.”

Pham, the other shareholder, countered with cross-complaint for breach of fiduciary duty, which is where it gets interesting.  According to the court, “as a matter of common law, we divine a public policy in favor of the strict enforcement of the corporate bylaws of pharmacy corporations restricting transfers of shares in such corporations. . . The statutes and regulations just mentioned reflect a public policy, ala Snyder’s Drug Stores, seeking a reasonably snug fit between the ownership of pharmacies and their control by licensed pharmacists.”

“Having ascertained a public policy in favor of control of pharmacies by licensed pharmacists, we apply California corporate common law involving protection of vulnerable stockholders from other stockholders who have the power, by the choice of to whom shares will be sold, to affect the actual conduct of the corporation.”

Why take this step?  The contract already protects the remaining shareholder.  There is no need to search for new law.

Here’s where the court takes a leap.  “The common law has involved fiduciary duties imposed on majority or controlling shareholders.  In this case, however, it is not the quantum of shares owned by the Les that made Pham as vulnerable as any minority shareholder in a close corporation, but the fact that, by circumventing the bylaws, the Les could adversely affect, as Justice Traynor put it in Ahmanson, the ‘proper conduct of the corporation’s interest.’”

OK, so which duty was violated?  The duty not to take advantage of a corporate opportunity?  The duty of loyalty? (Remember that “the primary duty of the fiduciary is to receive the res and manage it for the benefit of the cestui.  This is the fiduciary’s duty of management.”) The court does not say, instead painting broadly (and carelessly) with a generic “fiduciary duty.”

Thus, the court reasoned that, “it is clear that a fiduciary duty was violated by that attempted transfer, based on mutual vulnerability in which the stockholders found themselves.  By unilaterally [ ] selling to the Hoangs and effectively excluding Pham from the process, the Les jeopardized the ‘proper conduct’ of the business and unilaterally deprived Pham of an important right given her by the corporate bylaws:  the right to control who were her ‘partners’ in a regulated professional corporation.”

That’s sloppy legal reasoning.  Fiduciary duties are gap fillers, applied to regulate dealings between persons in a close relationship.  The sellers breached the contract, and the remedies for breach of contract were adequate to make the other shareholder whole.  The court did not need to reach for a “fiduciary duty” based on a “duty of good faith and fairness.”  This result leads only to ambiguity and imprecise analysis.

Le vs. Pham, 2010 DJDAR 297 (January 6, 2010)