Opinion
No. X10-UWYCV-065001410S
March 30, 2007
MEMORANDUM OF DECISION
Before the court is a motion to dismiss counts one and two of plaintiffs Jonathan May and Carolyn May's ("May") complaint filed by the defendants William Coffey et al. Count one of the complaint alleges breach of fiduciary duty. Count two of the complaint alleges unjust enrichment. The defendants assert that the court does not have subject matter jurisdiction over the complaint. They claim May lacks standing because the injury he has alleged is not a direct injury but an injury to the corporation, Latex Foam International Holdings, LLC. ("LFIH"). For the reasons set forth herein, the defendants' motion to dismiss is granted on both counts.
The other defendants are Richard Merril, Richard Merril as trustee of the John M. Coffey Family Grantor Trust, Richard Merril as trustee of the John M. Coffey Spray Trust, Robert Jenkins, Stephen Russo, Maureen Coffey as custodian for Caroline A. Coffey UGTMA, William Basset, Val Stalowir, Pouschine Cook Capital Partners, L.P., John Pouschine, Richard Merril as trustee of the Richard J. Coffey Family Grantor Trust, Richard Merril as trustee of the Richard J. Coffey Family Spray Trust, Richard Merril as trustee of the Maureen A. Coffey Family Grantor Trust, Richard Merril as trustee of the Maureen A. Coffey Family Spray Trust, Mary Coffey, John Coffey, John Coffey as custodian for Brenda H. Coffey UGTMA, John Coffey as custodian for the Michael J. Coffey UGTMA, Nancy Coffey, Richard Coffey as custodian for the Kathleen E. Coffey UGTMA, Richard Coffey as custodian for Patricia M. Coffey UGTMA, and Maureen Coffey.
The following facts are not in dispute. LFIH is a closely held corporation that manufactures latex foam products. Its headquarters and manufacturing facility is located in Shelton, Connecticut.
Prior to relocating in Shelton, CT LFIH was based in Ansonia, CT.
Jonathan May was LFIH's Executive Vice President and Chief Operating Office from January 1, 1993 to January of 2001 when his employment was terminated. During his employment with LFIH he purchased stock in the corporation. Jonathan May had an agreement with the corporation whereby the corporation lent him the money needed to purchase the stock. The agreement provided that if he were to leave LFIH, the corporation had the right to demand repayment of the borrowed money. If payment was not forthcoming LFIH could repossess the requisite number of shares to retire the debt with the value of each share based upon an independent appraisal.
When May's employment was terminated, LFIH refused to pay severance and benefits due under his employment contract. May sued to compel payment and the parties agreed to submit their dispute to binding arbitration. The arbitrator panel found in favor of May and ordered payment of severance and benefits due. LFIH filed an action in Superior Court to vacate the award. The court found in May's favor and May ultimately received payment on November 4, 2003 after initiating property execution proceedings.
Meanwhile on June 4, 1999 the defendant Pouschine Cook Capital Partners, LP ("PCCP") entered into an agreement with LFIH whereby LFIH received $5,000,000 in exchange for 48,000 shares of LFIH and a $3,500,000 senior subordinated note. The note was due in June 2005; LFIH paid it off early in 2002.
On May 14, 2001 a fire destroyed LFIH's manufacturing plant and damaged its corporate offices. Insurance proceeds were received in December 2001 and the board of directors decided to rebuild the manufacturing facility rather than liquidate the company. The new manufacturing facility was opened in Shelton, Connecticut on the first anniversary of the fire.
In the midst of the dispute between LFIH and May over his severance and benefits, LFIH decided to repurchase May's shares and to pay off the loan balance of approximately $900,000 effective July 31, 2002. An independent appraisal valued the stock at $57.30 per share before applying a 35% discount for lack of marketability and a 23.1% discount for being a minority shareholder. The ultimate price per share set by the appraiser for purposes of the repossession was $26.50. The appraisal was performed by an appraiser chosen by LFIH unilaterally. May claims the governing agreement specified that the appraiser was to be selected by both the shareholders and the corporation and that there was to be no discount for illiquidity or for being a minority shareholder.
In October of 2002, the board of directors determined that LFIH was in need of capital to continue its operations. In December of 2002, six months after repossessing the shares from May, LFIH undertook a multi-phase stock offering to raise $3,500,000. The plaintiff contends the amount being raised was the same amount as the note which was repaid to PCCP earlier in 2002. The LFIH shareholders approved the corporation's increase in outstanding shares on December 13, 2002. Under the stock offering existing shareholders were offered one share of stock for each share they currently held. Shares not purchased during the initial offering were subsequently offered to the shareholders who had purchased shares in the offering. The offering price was $8.95 per share. The defendants represented that the offering price was based upon a valuation performed in September 2002.
According to plaintiffs' exhibit #12, 427,222 shares were issued in the offering. At the offering price of $8.95 per share the total amount raised by the offering would be $3,823,636.90.
For purposes of this motion only the parties have stipulated that the share offering price of $8.95 was unreasonably low, and, that it was not unreasonable for the plaintiffs to decline to participate in the stock offering. The stock purchases under this two-phase offering resulted in a change in the proportion of ownership among the shareholders. The most notable result was that PCCP became the majority shareholder; the Coffey family members and the trusts held for their benefit were no longer the majority shareholders. The Mays chose not to participate in the offering. As a result their percentage ownership of the outstanding stock was reduced. This lawsuit then ensued. It has been brought by the Mays as a direct action only against the defendants William Coffey et al. The defendants have filed the pending motion to dismiss challenging May's standing to bring this action.
The May family, the Coffey Family and one other shareholder had previously entered in to a voting trust where by the members of the trust would vote among themselves and then vote their collective shares as a block. The voting trust held a majority of the outstanding shares in the fall of 2002. After the offering the Coffey/May voting trust held less than 50% of the shares outstanding.
Prior to the offering the Coffey family owned 54.5% of the shares, Pouschine Cook Capital Partners owned 22.35% of the shares, the May family owned 1.79% of the shares, the Kordiak family owned 14.21%, former employees owned 7% and current employees owned .1% After the offering the Mays held 0.6% of the shares.
"It is commonly understood that [a] shareholder — even the sole shareholder — does not have standing to assert claims alleging wrongs to the corporation." (Citations omitted; internal quotation marks omitted.) Smith v. Snyder, 267 Conn. 456, 461, 839 A.2d 589 (2004). "If a party is found to lack standing, the court is without subject matter jurisdiction to determine the cause . . . A determination regarding a trial court's subject matter jurisdiction is a question of law." (Citations omitted; internal quotation marks omitted.) Carruba v. Moskowitz, 274 Conn. 533, 550, 877 A.2d 773 (2005). "The motion to dismiss shall be used to assert (1) lack of jurisdiction over the subject matter . . ." P.B. § 10-31.
With respect to the issue of standing, we previously have noted that, [w]hen standing is put in issue, the question is whether the person whose standing is challenged is a proper party to request an adjudication of the issue . . . standing is the legal right to set judicial machinery in motion; and implicates this court's subject matter jurisdiction. A party cannot rightfully invoke the jurisdiction of the court unless he [or she] has, in an individual or representative capacity, some real interest in the cause of action, or a legal or equitable right, title or interest in the subject matter of the controversy. The burden rests with the party who seeks the exercise of jurisdiction in his favor . . . clearly to allege facts demonstrating that he is a proper party to invoke judicial resolution of the dispute. (Citations omitted; internal quotation marks omitted.)
Goodyear v. Discala, 269 Conn. 507, 511, 849 A.2d 791 (2004).
"It is well established that [i]n ruling upon whether a complaint survives a motion to dismiss, a court must state the facts to be those alleged in the complaint, including those facts necessarily implied from the allegations, construing them in a manner most favorable to the pleader." (Citations omitted; internal quotation marks omitted.) Lawrence Brunoli, Inc. v. Town of Branford, 247 Conn. 407, 410-11, 722 A.2d 271 (1999).
The defendants challenge the plaintiffs' standing on several bases. First, they contend that the complaint has not alleged an injury caused by the defendants and therefore the plaintiffs are not legally grieved. They note that the money raised was to continue the operations of LFIH and that the Mays had the opportunity to purchase shares. Second, to the extent the Mays have suffered an injury, defendants assert that the injury is not separate or distinct from any other shareholder or the corporation, therefore not supporting a suit by an individual shareholder. Additionally, defendants argue that under Connecticut law, to the extent anyone has standing, it would be only in the context of a shareholder derivate claim inasmuch as a reduction in percentage ownership interest caused by a secondary stock offering does not provide the basis for an individual claim of damages.
The plaintiffs allege that the defendants caused LFIH to undertake the stock offering, that the offering price was "artificially low" and that the defendants acted in concert to harm the minority shareholders, including the Mays. They contend that, subsequent to the offering, the defendants improperly obtained options for more shares and/or additional shares at prices set artificially low. This resulted in the defendants improperly diluting the Mays' percentage of the outstanding stock of LFIH while improperly increasing the defendants' percentage share of the outstanding stock of LFIH which in turn impacted not only percentage of equity but also the percentage voting rights. Citing Yanow v. Teal Industries, Inc., 178 Conn. 262, 422 A.2d 311 (1979), plaintiffs assert that the conduct of the defendants resulted in breach of the defendants' fiduciary duties to the plaintiffs and that the defendants have unjustly enriched themselves. They contend that under both Connecticut law and Delaware law the claim is for an individual injury.
Theoretically, May would not have suffered a cash value dilution of his equity interest if the offering price was fair even though he would have suffered a percentage dilution.
Plaintiffs and defendants both cite Connecticut and Delaware case law as supporting their positions. "Reading Connecticut Supreme Court cases on the distinctions between direct and derivative actions can be an unsettling experience as the decisions are few in number, somewhat sporadic in issuance, and deal with different fact scenarios." Puri v. Norwalk Anesthesiologists, Superior Court, complex litigation docket at Stamford, Docket No. X08 CV 05 4003801 S (Jul. 19, 2006, Adams, J.). In Connecticut "[i]t is . . . well settled that if the injury is one to the plaintiff as a stockholder, and to him individually, and not to the corporation, as where an alleged fraud perpetrated by the corporation has affected the plaintiff directly, the cause of action is personal and individual."(Citations omitted.) Yanow, supra at 282-83. "In such a case, the plaintiff-shareholder sustains a loss separate and distinct from that of the corporation, or from that of other shareholders, and thus has the right to seek redress in a personal capacity for a wrong done to him individually." (Citations omitted.) (Emphasis added.) Id., 282.
Plaintiffs also cite the New York case of Katzowitz v. Sidler, 24 N.Y.2d 512 (1969).
In Yanow, the minority shareholder was the sole minority shareholder since there were only two shareholders of the corporation. Conceptually, by the standard set forth in Yanow any injury that befalls the minority shareholder and not the majority shareholder will be distinct and separate from any other shareholder but not necessarily from the corporation.
In Yanow, the sole minority shareholder in Mallard Corp. sought damages arising out of a merger and for transactions prior to the merger between Teal Industries and Mallard Corp. The plaintiff alleged that the defendants had looted Mallard Corp. through these transactions; that the transactions were not disclosed; and that they were unfair to him as the minority shareholder.
The rule of corporation law and of equity invoked is well-settled: the majority has the right to control, but when it does so, it occupies a fiduciary relationship toward the minority, as much as the corporation itself or its officers and directors. As pleaded, these causes of action are based upon alleged unlawful acts relating solely to the stock owned by the plaintiff, in violation of the fiduciary duty owed the plaintiff by the defendants, and they thus state individual, and not derivative, claims. (Citations omitted.)
Yanow, supra at 283-84.
In Fink v. Golenbock, 238 Conn. 183, 680 A.2d 1243 (1996), a 50% minority shareholder brought a derivative action on behalf of the corporation for breach of the statutory duty of care by the defendants. The Connecticut Supreme Court, seeing no need to decide if the plaintiff could have brought an individual action, rejected defendant's argument that in a closely held corporation, with only two owners, any injury suffered would have to be an individual injury. The court noted that "[i]f we were to accept this argument, shareholders of a closely held corporation would rarely, if ever, be able to sue on behalf of the corporation when the other shareholders acted in a manner detrimental to the corporation." Fink, supra, at 202. The court did acknowledge ". . . that there may be some instances in which the facts of a case give rise either to a direct action or to a derivative action — such as when an act affects both the relationship of the particular shareholder to the corporation and the structure of the corporation itself . . ." Id., 202.
In Smith v. Snyder, 267 Conn. 456, 839 A.2d 589 (2004) the court refined and explicated the standard of inquiry for when a separate shareholder action would lie. In that case the plaintiff shareholders alleged that the defendants breached a fiduciary duty to the corporation through a pattern of self-dealing designed to diminish the value of the corporation. The court, accepting the allegations in the complaint as true, found that the harm suffered was to the corporation. The court found that the trial court properly dismissed the claims of the two individual shareholders for lack of standing noting ". . . that no specific shareholder sustained an injury separate and distinct from that suffered by any other shareholder or by the corporation." (Emphasis added.) Id., 462.
Delaware, which recognizes that a derivative and individual claim can co-exist, rejected the separate and distinct standard applied by Connecticut in Tooley v. Donaldson, Lufkin Jenrette, 845 A.2d 103] (Del. 2004). Prior to Tooley "[i]n order to bring a direct claim, a plaintiff must have experienced some "special injury." A special injury is a wrong that "is separate and distinct from that suffered by other shareholders, . . . or a wrong involving a contractual right of a shareholder, such as the right to vote, or to assert majority control, which exists independently of any right of the corporation." (Citations omitted.) Tooley, supra at 1035. Deciding that the "special injury" was not the best standard the Delaware court stated "[t]he analysis must be based solely on the following questions: Who suffered the alleged harm — the corporation or the suing stockholder individually — and who would receive the benefit of the recovery or other remedy?" Tooley, supra at 1035. "That is, a court should look to the nature of the wrong and to whom the relief should go. The stockholder's claimed direct injury must be independent of any alleged injury to the corporation. The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation." (Emphasis added.) Tooley, supra at 1039.
In Fink although the court reaffirms the holding of Yanow, the court also seems to suggest a standard not unlike that in Tooley. "In contrast, in order for a shareholder to bring a direct or personal action against the corporation or other shareholders, that shareholder must show an injury that is separate and distinct from that suffered by any other shareholder or by the corporation." Yanow v. Teal Industries, Inc., supra, 178 Conn. 282; see also In re Ionosphere Clubs, Inc., 17 F.3d 600, 605 (2d Cir. 1994) ("[t]he distinction between derivative and direct claims turns primarily on whether the breach of duty is to the corporation or to the shareholder[s] and whether it is the corporation or to the shareholder[s] that should appropriately receive relief"). (Emphasis Added.) Fink, supra at 201.
In Gentile v. Rosette, 906 A.2d. 91 (Del 2006) the minority shareholders of Singlepoint sought redress for breach of fiduciary duty from the former directors and controlling shareholder of Singlepoint, arising out of asset for stock exchange. The plaintiffs asserted that they suffered a reduction in both a cash value and voting rights of their stock. Defendants, relying on In re Tri-Star Pictures, Inc. Litig., 634 A.2d 319 (Del. 1993), argued that the reduction in voting power was not material, i.e. transforming the majority shareholders into the minority, and therefore no harm was suffered. Addressing the narrow issue of whether the reduction in voting power had to be material, the court held that the claim was not exclusively derivative, noting
[t]here is, however, at least one transactional paradigm — a species of corporate overpayment claim — that Delaware case law recognizes as being both derivative and direct in character. A breach of fiduciary duty claim having this dual character arises where: (1) a stockholder having majority or effective control causes the corporation to issue "excessive" shares of its stock in exchange for assets of the controlling stockholder that have a lesser value; and (2) the exchange causes an increase in the percentage of the outstanding shares owned by the controlling stockholder, and a corresponding decrease in the share percentage owned by the public (minority) shareholders. Because the means used to achieve that result is an overpayment (or "over-issuance") of shares to the controlling stockholder, the corporation is harmed and has a claim to compel the restoration of the value of the overpayment. That claim, by definition, is derivative. But, the public (or minority) stockholders also have a separate, and direct, claim arising out of that same transaction. Because the shares representing the "overpayment' embody both economic value and voting power, the end result of this type of transaction is an improper transfer — or expropriation — of economic value and voting power from the public shareholders to the majority or controlling stockholder.
Gentile, supra at 99-100.
The dilution of May's equity interests is an injury that is shared with the corporation and other minority shareholders. The artificially low price harmed the corporation by virtue of the corporation receiving inadequate consideration for the newly issued shares and the other minority shareholders who did not purchase shares in the offering suffered an injury identical to May.
Generally, individual stockholders cannot sue the officers at law for damages on the theory that they are entitled to damages because mismanagement has rendered their stock of less value, since the injury is generally not to the shareholder individually, but to the corporation — to the shareholders collectively. In this regard, it is axiomatic that a claim of injury, the basis of which is a wrong to the corporation, must be brought in a derivative suit, with the plaintiff proceeding "secondarily," deriving his, rights from the corporation which is alleged to have been wronged. (Citations omitted.)
Yanow, supra at 281.
If the offering price was inadequate, all nonpurchasing shareholders who held stock prior to the offering would suffer a dilution in value of their shares. Inasmuch as the offering injured the corporation financially and it potentially affected all nonpurchasing shareholders proportionately, the court concludes that the injury that May suffered was ancillary to the offering and a breach of fiduciary duty to the corporation. This was not a transaction or an asset exchange that was available to one or a select group of shareholders that could manipulate the terms for their sole benefit at the expense of the minority or other shareholders as in Gentile. In other words, it was not the choice of a shareholder whether to purchase additional shares that the court finds relevant, but rather the fact that the choice did exist so that the alleged actions of the defendants could not guarantee injury to any specific shareholder or shareholders but did secure harm to the corporation for the purchase price being too low.
If the intention of the defendants was to dilute away the interests of the Mays then this could have been achieved when the company repossessed shares to pay back May's debt. All the company had to do was set the per share price low enough to repossess all the shares owned by the Mays.
Even if the defendants' aim was to alter who the majority shareholder is, to achieve this by means of a stock offering at an artificially low price open to all shareholders is not a breach of duty to the minority shareholders. As stated in his brief the plaintiff agrees with the general proposition that a stock offering undertaken for a proper purpose and at a fair price generally does not result in a cognizable injury, i.e. a claim based upon share dilution. Ergo, if the purpose and price were proper and fair then the defendants would not have breached any duty. The breach of fiduciary duty owed to the corporation occurs because the price is artificially low and the injury to the minority shareholders is incidental, that is, not distinct from that breach. The reduction of percentage voting power is also an injury that is not a separate or distinct injury from that of the other shareholders. Out of the 45 shareholders prior to the offering, only 16 shareholders opted to acquire more shares and 25 shareholders declined to purchase more shares. Every one of those 25 shareholders has seen their voting rights diminished. As one superior court judge noted
[t]he possible inconsistencies that can be read into the few Connecticut appellate decisions on the subject have engendered the widely disparate readings . . . The interpretation more accommodative of direct actions which can be drawn from Yanow and Fink as distinguished from Smith may be reconciled by limiting the interpretation to fact scenarios involving very small numbers of shareholders. The plaintiff in Yanow was described as the "sole minority stockholder"; 178 Conn. 283 and n. 9; and in Fink v. Golenbock, supra, there were only two stockholders.
Puri v. Norwalk Anesthesiologists, supra.
Nor is the reduction of percentage voting power an injury separate and distinct from that of the corporation. Voting power cannot be altered without some change in the number of shares outstanding, or reclassification of the outstanding shares that would alter voting rights. A change in the number of shares outstanding can only occur by an action of the corporation. If the price of a secondary offering is fair, then any change in voting power that would result must be presumed to be fair since it is an unavoidable result of issuing new shares. In the present case, if the issuance of the shares at an unfairly low price created an injury to the corporation, then the shareholders' injury is not distinct from the injury to corporation, it is subsequent to it.
Accordingly, since this action should be a shareholder derivative suit, May lacks standing and the motion to dismiss is granted as to the breach of fiduciary duty.
Both defendants and plaintiffs have urged the court to adopt Delaware case law analyses, each arguing that it supports their position. After examining the cited cases the court concludes that application of Delaware law to the facts before the court would likely produce the same result. Unlike the present case, Gentile, and the similar In re Tri-Star Pictures, Inc. Litig., 634 A.2d 319 (Del. 1993), involved asset exchanges for stock orchestrated by the controlling shareholder solely for the benefit of the controlling shareholder at the expense of the other shareholders. Although the instant case would seemingly hold to this pattern, it is, in fact, factually distinct since the "asset exchange" was a secondary stock offering available to all shareholders. Unlike Gentile and Tri-Star, where the majority shareholder determined who benefited and who did not benefit, in this case the majority shareholder could not dictate to whom the benefits flowed. At most, the majority caused the need for the issuance of new shares since the note it held was paid back early, which surely contributed to the depletion of cash at LFIH. As previously explained, the offering itself did not constitute a breach of the majority's fiduciary duties to May since the outcome, in terms of benefits and harms, of the offering was indeterminate, whereas the asset exchange in Gentile and Tri-Star was designed to provide a specific benefit to a specific shareholder at the expense of the minority shareholders.
Following Tooley and looking at the nature of the wrong, it is evident that the wrong was to LFIH by pricing the shares too low. Injury, in the form of percentage reductions in equity and voting power, to the minority shareholders was inextricably tied to the harm to the corporation and not independent of the injury to the corporation when the shares were priced below fair value. Inasmuch as Tooley requires the shareholder's injury to be independent of any injury to the corporation, the court finds the plaintiffs have not satisfied this requirement, since without the issuance of the additional shares at an artificially low price May would not be aggrieved.
The second prong of Tooley, who would be the recipient of the remedy, is also determinative. Because the harm suffered by the minority shareholders is incidental to the harm suffered by the corporation, the corporation is the party who should receive relief. Rectifying the injury to the corporation would also relieve the shareholders of their injury since it was subsequent to the injury to the corporation. The best remedy would be to require payment at full price for the new shares or to cancel the new shares which were issued for inadequate consideration thereby rectifying the breach to the corporation and restoring everyone to the positions they would be in if the shares were never offered. Such action would remedy the minority shareholders as well as the corporation. A direct remedy of compensation to May would leave the0 corporation and other minority shareholders harmed and a direct remedy to all the injured shareholders would leave the corporation harmed. Applying this prong to Gentile it cannot be ignored that in Gentile, as well as Tri-Star and Yanow, the corporation no longer existed. "[T]he result reached here fits comfortably within the analytical framework mandated by Tooley . . . [I]n this specific case the sole relief that is presently available would benefit only the minority stockholders. Because SinglePoint no longer exists, there are no `overpayment' shares that a court of equity could cancel, and there is no corporate entity to which a recovery of the fair value of those shares could be paid." Gentile, supra at 102-03.
The motion to dismiss is also granted as to the unjust enrichment claim. "Unjust enrichment is, consistent with the principles of equity, a broad and flexible remedy . . . Plaintiffs seeking recovery for unjust enrichment must prove (1) that the defendants were benefited, (2) that the defendants unjustly did not pay the plaintiffs for the benefits, and (3) that the failure of payment was to the plaintiffs' detriment." (Citations omitted; internal quotation marks omitted.) Vertex, Inc. v. Waterbury, 278 Conn. 557, 573, 898 A.2d 178 (2006). If the defendants were unjustly enriched it was at the expense of the corporation. Like the court's analysis of the claim based upon an individual injury, the injury to the plaintiffs resulted from the injury to the corporation. It was the corporation that did not receive payment, or in this case adequate consideration, and that was to the detriment of the corporation.
The defendants' motion to dismiss is granted.