Opinion
A113049
12-11-2006
LINDA L. ARNOLD, Plaintiff and Appellant, v. ALBERT J. SCOMA et al., Defendants and Respondents.
Appellant Linda Arnold (Arnold) is a minority (25%) shareholder in a subchapter "S" corporation which has two other shareholders, one owning 50% of the shares, the other the remaining 25%. Arnold filed a complaint against the 50% shareholder and two other officers and directors, essentially alleging breach of fiduciary duty in the refusal to distribute Arnolds share of net income, asserting among other things that the refusal was (a) "in repudiation of their Agreement that the income would be distributed" and (b) to "oppress [Arnold] and to pressure her to relinquish her interest in the corporation."
The trial court sustained a demurrer to the first amended complaint without leave to amend. We hold that Arnold stated a cause of action, and that the trial courts ruling was wrong. We thus reverse.
I. The Pleadings And The Proceedings Below
On May 25, 2005, Arnold filed a complaint for damages, naming as defendants Albert J. Scoma (Albert), Thomas Creedon (Creedon), and Mariann Costello (Costello) (when referred to collectively, Respondents.) The essential allegations included that Scomas Restaurant, Incorporated (Scomas or the restaurant) was a subchapter "S" corporation; that Arnold owned 25% of the shares of Scomas, Albert owned 50%, and Ann Scoma owned the remaining 25%; and that Albert, Creedon, and Costello were officers and directors of Scomas and had complete financial control of it, including as to the payment of Arnolds distributive share of income. With that as background, Arnolds complaint alleged six causes of action: (1) breach of fiduciary duty; (2) conversion; (3) constructive trust; (4) unfair business practices; (5) infliction of emotional distress; and (6) accounting. These causes of action, particularly the breach of fiduciary duty claim, included more specific allegations as discussed below.
The register of actions reveals that a demurrer was filed to the complaint, which was sustained, essentially with leave to amend, the only exception being as to the cause of action for unfair business practices, which Arnold withdrew and the demurrer to which was thus sustained without leave to amend.
On September 20, 2005, Arnold filed a first amended complaint alleging seven causes of action: (1) book account; (2) breach of fiduciary duty; (3) conversion; (4) constructive trust; (5) infliction of emotional distress; (6) accounting-audit; and (7) declaratory relief. While there are seven causes of action alleged, the heart of Arnolds claim, incorporated into all subsequent causes of action, is the second cause of action for breach of fiduciary duty. It begins at paragraph 12, and alleges that Respondents as directors and/or officers of Scomas had a fiduciary duty to deal with Arnold, a minority shareholder, with good faith and inherent fairness; that Respondents violated this fiduciary duty by, among other things, refusing, and continuing to refuse, to have the corporation pay Arnold money which was hers, namely $20,855.81 of her distributive share of the net income for the fiscal year ending September 30, 2003, and/or $30,476.75 of her distributive share of the net income for the fiscal year ending September 30, 2004; and that the corporation had more than sufficient cash available to pay the shareholders respective distributive shares for these fiscal years.
Then, and particularly significant here, the first amended complaint alleges as follows:
"13. The defendants . . . further violated their fiduciary duty to [Arnold] by, amongst other things, giving her false and misleading information regarding the fiscal status of the corporation, and/or of the income that had been distributed to the shareholders for the fiscal years ending September 30, 2003 and/or September 30, 2004.
"14. The defendants . . . are further violating their fiduciary duty to [Arnold] by, amongst other things, refusing, for more than six (6) months and continuing, to have the corporation pay her monthly pro-rata share of the income of the corporation for the fiscal year commencing October 1, 2004, in repudiation of their agreement that the income of the corporation would be distributed by pro-rata payments each month during the fiscal year.
"15. The defendants . . . have and are further violating their fiduciary duty to [Arnold] by, amongst other things, refusing, and still refusing, to discuss with Linda why they are not paying her full distributive share of the net income of the corporation.
"16. The defendants, and each of them, have and are further violating their fiduciary duty to [Arnold] by, amongst other things, intentionally and maliciously doing the things alleged in paragraphs 9, 10, 11, and 12 [sic: 12, 13, 14, and 15] in order to oppress Linda and to pressure her to relinquish her interest in the corporation."
On October 24, 2005, Respondents jointly filed a general demurrer to each cause of action in the first amended complaint. The demurrer made no efforts to distinguish between or among Respondents, no argument premised on the significance, if any, of the different roles occupied by them (for example, that Albert was a 50% shareholder, while Creedon and Costello owned no shares.)
While the demurrer did appropriately address each cause of action separately, the thrust of the demurrer was the fundamental premise capsulized as follows: Respondents have "no duty to distribute profits to all shareholders or preferentially to a single shareholder to the exclusion of others. It is well recognized that corporate officers and directors have great discretion with respect to disposition of the corporations surplus funds. Sole Energy Co. v. Petrominerals Corp. (2005) 128 Cal.App.4th 212, 229 [(Sole Energy)]."
On November 30, 2005, Arnold filed a brief 6-page opposition to the demurrer. It begins by asserting that "[t]his lawsuit raises a question of first impression," as it involves a subchapter "S" corporation. Then, after a brief description of a subchapter "S" corporation and a brief distillation of the allegations in the first amended complaint, Arnold provided three pages of argument, asserting three points: (1) Respondents are acting in bad faith; (2) Respondents cited case does not support its position; and (3) Arnold has a right to her share of the net profits.
On December 7, 2005, Respondents filed a reply memorandum in support of their motion for sanctions, though apparently no reply on their demurrer.
Defendants had apparently filed a motion for sanctions, though it is not in the record and there is no reference to it in the register of actions.
The demurrer came on for hearing on December 14, 2005, prior to which the court had issued a tentative ruling sustaining the demurrer without leave to amend. The court heard brief argument, at the conclusion of which the court stated as follows:
"THE COURT: In just looking back at my notes of the demurrer, of the first demurrer, my notes indicate that paragraph 10—and I havent done this work today, Im just looking back at my notes—alleged a fraud, and when I read the fraud allegations, there were no allegations as to who said it or what the misrepresentation was, and I denied [sic] the demurrer with leave to amend.[]
Respondents devoted several pages of their argument below, as they do here, contending that "any allegations sounding in fraud fail to state a cause of action for breach of fiduciary duty." From there Respondents argued that Arnold failed to allege fraud with the requisite specificity, an argument that was obviously referred to the trial court and which apparently contributed to its ruling below. Such contention is a red herring, as Arnold did not even attempt to plead to a cause of action for fraud. Thus the cases addressing the issue of specificity are inapposite.
"So just historically, thats how we go to today. And so when I looked at this demurrer and the complaint, I dont find that those missing elements are there.
"A closely held corporation had disadvantages if youre in the minority. Obviously, the board of directors make decisions about your money. It might be what otherwise would be your money if you invested it in something else. But thats the nature of a closely-held corporation.
"The argument that since youre taxed on it, it has to be distributed to you, its an argument. I find no authority one way or the other on it. I could see the Internal Revenue saying, `Were going to tax you on a lot of things. Now, whether you get them or not might be a contract issue and so forth.
"So I cant find that because youre taxed on them, youre entitled to it. So Ill adopt the tentative ruling, and as you say, some court may have to make that decision."
On that same day a minute order was filed, providing as follows:
"Nature of proceedings: 1) hearing on demurrer . . . 2) motion for sanctions ([Code of Civil Procedure section] 128.7) . . . .
"RULING
"Defendants demurrer to the first amended complaint is sustained without leave to amend. Plaintiff has not alleged evidentiary facts to support her claim of entitlement to a distribution of the subchapter "S" corporations profits in any amount.
"Defendants motion for sanctions pursuant to Code Civ. Proc. § 128.7 is denied. The court finds the first amended complaint is not presented for an improper purpose.
"The tentative ruling is heard, argued and adopted."
On December 20, 2005, the court filed an order sustaining defendants demurrer and motion to strike first amended complaint. That order, prepared by Respondents counsel, was three paragraphs long, the first two of which were recitals. The dispositive third paragraph reads in its entirety as follows: "It is hereby ordered that the Courts Tentative Ruling, a copy of which is attached hereto, shall become and is the final Order of the Court. Thus, Defendants Demurrer is sustained without leave to amend as to all causes of action alleged in the First Amended Complaint, and Defendants Motion for Sanctions is denied."
Notice of entry of order was served on December 29, 2005. On January 23, 2006, Arnold filed a notice of appeal from that order "and the Tentative Ruling on which the above Order is based, which ruling was made, adopted and entered on December 14, 2005." On July 14, 2006, a judgment of dismissal was filed, and on July 25, 2006, an amended notice of appeal from that judgment.
This late filed judgment of dismissal assists us in connection with an issue not raised by either party: the absence of any judgment or appealable order at the time the appeal was filed. As noted, Arnolds original appeal was from the order sustaining the demurrer without leave to amend, which order is non-appealable. (see generally 9 Witkin, Cal. Procedure (4th ed. 1997) Appeal § 113, pp. 178-179.) Despite this, it has been recognized that Courts of Appeal have the discretion to "save" an inappropriate or otherwise premature appeal from a non-appealable order in the "interests of judicial economy" and the "orderly administration of justice." (See, for example, Vibert v. Berger (1966) 64 Cal.2d 65, 67-68, noting that this "saving" power is usually invoked in the situation, like here, where the appeal is from a non-appealable order but where there is in fact an existing judgment or order of dismissal. Thus, we need not reach further to "save" the appeal by deeming the order sustaining the demurrer without leave to amend to include a judgment of dismissal and treat the appeal as applying to the dismissal. (See Smith v. Hopland Band of Pomo Indians (2002) 95 Cal.App.4th 1, 2; Coast Plaza Doctors Hospital v. UHP Healthcare (2002) 105 Cal.App.4th 693, 699.)
II. The First Amended Complaint States A Claim For Breach Of Fiduciary
A. The Rules on Review
"It is well established that a demurrer tests the legal sufficiency of the complaint. [Citations.] On appeal from a dismissal entered after an order sustaining a demurrer, we review the order de novo, exercising our independent judgment about whether the complaint states a cause of action as a matter of law. [Citations.] We give the [complaint] a reasonable interpretation, reading it as a whole and viewing its parts in context. [Citations.] We deem to be true all material facts that were properly pled. [Citation.] We must also accept as true those facts that may be implied or inferred from those expressly alleged. [Citation.] We may also consider matters that may be judicially noticed, but do not accept contentions, deductions or conclusions of fact or law. [Citation.]." (City of Morgan Hill v. Bay Area Air Quality Management Dist. (2004) 118 Cal.App.4th 861, 869-870; Blank v. Kirwan (1985) 39 Cal.3d 311, 318.)
Applying those rules, we conclude that the first amended complaint states a claim for breach of fiduciary duty.
B. The Parties Positions
Respondents accurately state the elements necessary to allege a claim for breach of fiduciary duty, that "a plaintiff must allege: (a) the existence of a fiduciary duty owed by the defendant to the plaintiff; (b) a breach of that duty; and (c) damages proximately caused by the breach. See Pierce v. Lyman, (1991) 1 Cal.App.4th 1093, 1101."
The focus of both sides here is properly on the second element: breach. Arnold alleges a breach of duty against Respondents by not distributing income, relying heavily on the fact that Scomas is a subchapter "S" corporation, and the resulting effect that Arnold must pay income tax on Scomas income, yet Respondents refuse to distribute that income to pay the tax. Respondents, by contrast, urge that Scomas status as a subchapter "S" corporation is of no moment, and summarize their argument this way: "According to Appellant, this case presents a question of first impression centered on the obligation of the officers and directors of an "S" corporation to distribute profits to shareholders who demand payment. [Citation.] Appellant is wrong; her argument is nothing other than a desperate attempt to evade the well-settled legal principle that shareholders have no "right" to a distribution of corporate profits. There is absolutely nothing here that presents a question of first impression. [¶] Appellants claim for breach of fiduciary duty is fatally deficient because no legal duty exists that requires a corporations board to distribute profits to shareholders regardless of whether a corporation is classified as an "S" corporation or a "C" corporation."
Respondents summary of argument goes on to assert that Arnolds "claim also is not pled with the specificity required of claims sounding in fraud or bad faith. Moreover, because appellants legally insufficient allegations vis-à-vis breach of fiduciary duty are essential to each of the other causes of action, all must fail. And, even assuming arguendo that the defective breach of fiduciary duty allegations do not undercut all the other causes of action, independent grounds exist to sustain Respondents demurrer in its entirety."
Footnote 2, ante, deals with the first sentence quoted above; and the last sentence is of no significance because the court did not address each cause of action separately.
Respondents may be correct that there is no duty that requires a corporate board to distribute profits, at least in the abstract. But that is not the thrust of Arnolds position here, which is that the refusal to distribute profits in the circumstances here breaches the fiduciary duty owed to her. We agree with Arnold, and conclude that the subchapter "S" nature of the corporation has significance, at least in the circumstances here.
C. Analysis
Heller v. Franchise Tax Bd. (1994) 21 Cal.App.4th 1730, 1733, describes the significance of an S Corporation: "For federal income tax purposes, there are two kinds of corporations: `C Corporations (so named because their governing provisions are found in subch. C, ch. 1, subtit. A of the Int. Rev. Code) and `S corporations (governed by subch. S of the same chapter). A C corporation is a separate entity which pays corporate income taxes `according to or measured by its net income. (Rev. & Tax. Code, § 23151, subd. (a).) [¶] In contrast, an S corporation generally does not pay income taxes as an entity. (26 C.F.R. § 1.1363-1 (1993).) Rather, the S corporation files only an informational return reporting for the taxable year its gross income (or loss) and deductions, its shareholders, and the shareholders pro rata shares of each item. (26 U.S.C. § 6037(a).) The items are then `passed through on a pro rata basis to the shareholders, who report them on their personal income tax returns. (Beard v. United States (11th Cir. 1993) 992 F.2d 1516, 1518; [citation].) `The S Corporation is, in effect, a Code-created hybrid combining traits of both corporations and partnerships. (Beard v. United States, supra, 992 F.2d at p. 1518.)"
And particularly significant to Arnolds claim here, S corporation shareholders are taxed on their share of the S corporations income regardless of whether the corporation makes any distributions. (Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders (5th ed. 1987) § 6.08, p. 6-25.)
Here, as noted, Arnold alleged that Respondents breached their fiduciary duty to her in four particulars: (1) by giving her false and misleading information regarding the fiscal status of Scomas and/or the income that had been distributed in fiscal years 2003 and 2004 (First Amended Complaint, ¶ 13); (2) by refusing to distribute income in repudiation of their agreement that the income of the corporation would be distributed by pro-rata payments each month during the fiscal year (¶ 14); (3) by refusing to discuss with Arnold why they were not paying her full distributive share (¶ 15); and (4) by oppressing Arnold "and to pressure her to relinquish her interest in the corporation" (¶ 16).
A leading treatise on close corporations states that "[m]ajority shareholders in a close corporation sometimes deliberately try to squeeze out a minority member by withholding dividends, the majority hoping ultimately to buy out the minority interest at a price considerably less than its actual value." (ONeill and Thompsons Close Corporations and LLCs, Law and Practice (Rev. Third ed. 2004) § 9.20, p. 9-113.) The subject setting is a fortiori, in that Arnold would be taxed on the corporate income and yet not have the corporate distribution to pay the taxes. The enhanced opportunity for squeeze out in such circumstances is not difficult to discern.
The first amended complaint does not allege that Scomas is a "close corporation" in the statutory sense, that is, one "whose articles contain, in addition to the provisions required by Section 202, a provision that all of the corporations issued shares of all classes shall be held of record by not more than a specified number of persons, not exceeding 35, and a statement, `This corporation is a close corporation. "(Corp. Code, § 158a.) Nevertheless, Arnolds argument below focused on Scomas being a "closely held corporation (three shareholders)," going on to argue that a "director, officer, controlling stockholder, or group of stockholders are fiduciaries. Their powers are powers of trust. These fiduciary obligations are neither to specific statutory duties nor avoidance of fraudulent practices. The defendants are bound by the comprehensive rule of good faith and inherent fairness to [Arnold]. The purpose of this rule is to provide protection to minority shareholders, especially those in closely held corporations, such as ours, whose disadvantageous and often precarious position renders them vulnerable to abuse. (Jones v. H. F. Ahmanson & Co. (1969) 1 Cal.3d 93, at pp. 107-112.)"
Indeed, application of the law as distilled in Respondents own brief dictates that the demurrer should have been overruled. For example, Respondents assert that the law is that "[u]nless there is a prior agreement between a corporation and a shareholder to distribute profits in a particular manner—something that does not exist here—the corporation is `at liberty to exercise a very large discretion in that respect. (Mulcahy v. Hibernia S. & L. Soc. (1904) 144 Cal. 219, 223 [(Mulcahy)]. In other words, provided that a corporation `act[s] in the exercise of an honest judgment, with honest motives, and for honest ends, [its] . . . power over such funds is absolute. Id."
Contrary to the unsupported clause between the dashes, Arnold did allege that Respondents refusal to pay her monthly pro rata share of income was "in repudiation of their Agreement." Likewise does Arnolds pleading easily read that Respondents were not acting with "honest judgment . . . honest motives . . . honest ends."
The very next paragraph in Respondents brief asserts the following rule: "Absent evidence of bad faith, fraud, illegality, or gross overreaching, courts are not at liberty to interfere with the exercise of business judgment by corporate directors. Barnes v. State Farm Mut. Auto Ins. Co. [(1993)] 16 Cal.App.4th [365,] 378-379 [(Barnes)]; see also Cal. Corp. Code § 309. Thus, courts will not interfere with a corporate decision to withhold dividends in the absence of a showing of fraud, oppression, corruption or conflict of interest by the directors. [Barnes,]supra, 16 Cal.App.4th at pp. 378-379. `[T]here must be a showing of facts that would set forth, and not just in a conclusory way, that there has been fraud or oppression on the part of the Board of Directors or a lack of merit in the manner in which their work is performed, or that their work has resulted in a breach of law or mistake or other wrongful [act]. Id. at p. 379-380, fn. 14 (emphasis added)."
While Barnes is a demurrer case, and thus applicable on that score, it is not applicable factually, as it does not involve a closely held corporation, let alone a subchapter "S one. All Barnes held is that the class action by a State Farm policyholder which alleged two causes of action, one of which was to compel State Farm to distribute "excess" surplus funds, did not state a claim, as a policyholder has no right to require a particular distribution from surplus. (Barnes, supra, 16 Cal.App.4th at pp. 378-379.) No, the court held, because Barnes "failed to allege facts showing that the directors decision regarding the accumulation of State Farms surplus was not made in good faith or in what the directors believed to be the best interests of the corporation. He has alleged no facts demonstrating fraud, oppression, corruption or conflict of interest by the directors. Indeed, he appears to rest his claim upon the singular proposition that State Farms surplus and dividend policy differs significantly from an industry average. This is clearly insufficient to permit a court to interfere in the management of an apparently successful corporate enterprise." (16 Cal.App.4th at p. 379, fn. omitted.)
Here by contrast, Arnold has alleged oppression (however conclusorily) and conflict of interest, not to mention that Respondents are attempting to "pressure her to relinquish her interest in the corporation."
Respondents also cite the century-old case of Mulcahy, supra, 144 Cal. 219, 223, for the proposition that a corporation is "at liberty to exercise a very large discretion" in distributing profits, providing that the corporation ". . . act[s] in the exercise of an honest judgment, with honest motives and for honest ends, [its] . . . power over such funds is absolute." Two pages further in Mulcahy, however, the court notes that "[t]his discretion, it is true, is not an arbitrary one. It must be exercised fairly and honestly, and where it appears that the proceedings of the corporation are unfair, that its officers are acting wantonly and in bad faith, or in disregard of the rights of the members of the corporation relative to such reserve fund, the courts will intervene." (144 Cal. at p. 225.) Respondents can find no solace in Mulcahy.
Finally, Respondents rely heavily on Sole Energy, supra, 128 Cal.App.4th 212, a case they cite four times. It does not avail them. In Sole Energy putative shareholders in a corporation that had never issued stock sued the corporation (and others) seeking lost future profits. The jury ruled for plaintiffs, but the trial court granted judgment notwithstanding the verdict. And the Court of Appeal affirmed, holding that the putative shareholders could not individually recover proportionate shares of the corporations future lost profits as damages because a shareholder did not have an ownership interest in corporate profits. Rather, the gravamen of the injury asserted, lost profits, was derivative and could not be recovered individually. (128 Cal.App.4th at p. 232.) Sole Energy has nothing to do with the setting here.
In sum, the essence of Respondents position is that the business judgment rule pertains, the effect of which is that Arnolds claim must fail. While it may be true that Respondents can rely on the business judgment rule, this does not mean that sustaining the demurrer was proper, as it is well recognized that whether the business judgment rule appears is generally a question of fact. As a recognized California treatise describes it, "The application of the business judgment rule to judicial review of a directors actions raises various issues of fact, such as whether the director acted as an ordinarily prudent person under similar circumstances and in the corporations best interests, and whether the director made a reasonable inquiry as indicated by the circumstances. These questions generally should be left to a trier of fact, but may properly be resolved on a motion for summary judgment when the evidence establishes that there is no controverted material fact." (2 Ballantine & Sterling, Cal. Corporations Laws (4th ed. 2006) § 292.06, p. 14-36-14-37.) And if the facts are not uncontroverted, grant of summary judgment is error. (See Everest Investors 8 v. McNeil Partners (2003) 114 Cal.App.4th 411, 430 [summary judgment based on business judgment rule improper where triable issues of fact existed as to defendants motives and conflict of interest].) In any event, we here address Arnolds allegations in a first amended complaint in the context of a demurrer—a long way from any uncontroverted facts.
III. Disposition
As is apparent from the order quoted above, the trial court did not address the first amended complaint on a cause-of-action by cause-of-action basis. Thus, there has been no determination whether any of the causes of action fail to state claims for reasons unrelated to the fundamental defect the trial court concluded was present here. In light of this, it is not our task to determine these issues in the first instance. "[O]ur inquiry ends and reversal is required once we determine a complaint has stated a cause of action under any legal theory." (Genesis Environmental Services v. San Joaquin Valley Unified Air Pollution Control Dist. (2003) 113 Cal.App.4th 597, 603.)
Having said that, we are skeptical that some of the causes of action may in fact not survive pleading attacks on them, which attacks we neither invite nor discourage. We simply reverse the order of December 20, 2005, and remand the matter to the superior court with directions to vacate that order sustaining the general demurrer without leave to amend and to enter an order overruling it. Arnold shall recover her costs on appeal.
We concur:
KLINE, P.J.
LAMBDEN, J.