Minority Shareholders can “Follow the Money” Linked To Alleged Diversions by Majority for Phantom Salaries and Benefits

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The minority shareholders of a podiatry practice felt like they had been kicked around by the alleged financial misadventures of two colleagues who together controlled an 80 percent interest. A four-way split of practice expenses was particularly galling to the minority, based on their allegations that practice “expenses” included robust salaries and benefits afforded to family members of the majority shareholders who didn’t work for the practice, and Carolina Hurricanes season tickets reserved for personal use. In Kelly v. Nolan, 2022 NCBC 37, the Business Court took a close look at plaintiffs’ complaint to figure out whether it contained counts that would support pursuit of the alleged diversions.

Plaintiffs Joel Kelly and Elizabeth Bass Daughtry each held ten percent interests in Piedmont Foot Clinic, P.A., and defendants Jason Nolan and Richard Hauser each held 40 percent shares. Piedmont was sold in 2020 to a group of entities that operate a multi-state business under the banner of Foot and Ankle Specialists of the Mid-Atlantic, LLC, where each of the parties are noted as still practicing. The financial disputes center around payment for equipment Daughtry brought to Piedmont that was later sold in the 2020 transaction; issues regarding disposition of proceeds from the sale of Piedmont; and the alleged diversion of assets to the majority shareholders and their families. Id. ¶¶ 4-6. Plaintiffs alleged, for instance, that in 2019 Nolan’s spouse received a $245,000 salary plus benefits and Hauser’s spouse got $160,000 plus benefits, each without doing any work for the practice. Id. ¶ 13.

While the Court acknowledged the general rule that shareholders don’t owe a fiduciary duty to one another, Judge Davis found that Nolan and Hauser owed the minority shareholders a “special duty” that North Carolina requires majority shareholders in a close corporation to afford to minority holders. Thus, even where a derivative action was an available course, “minority shareholders . . . may maintain their individual actions against the majority shareholders . . . including the allegation of diversion of corporate assets and opportunities. ¶¶ 26-28 (quoting Norman v. Nash Johnson & Sons’ Farms, Inc., 140 N.C. App. 390, 407 (2000)).

The Court noted that North Carolina law also allows minority shareholders to pursue asset diversion claims in settings, like here, where more than one shareholder is alleged to have acted together to exercise control to the detriment of minority interests. Id. ¶ 29 (citing Brewster v. Powell Bail Bonding, Inc, 2018 WL 3603023 (N.C. Super. Ct. July 26, 2018); Flynn v. Pierce, 2020 WL 7635489 (N.C. Super. Ct. Dec. 22, 2020)).

Civil Conspiracy: Nolan and Hauser argued plaintiffs’ conspiracy claim should fall because it didn’t adequately plead an agreement between the two of them to disadvantage the minority shareholders. Judge Davis differed, holding that state law permits a party to prove up a civil conspiracy claim through circumstantial evidence. The Court held that plaintiffs sufficiently alleged that defendants developed a “plan or scheme” in meetings and other conversations for the purpose of denying the minority shareholders of Piedmont “a fair share of profits and income.” Kelly, ¶ 65.

The Court acknowledged that a civil conspiracy claim cannot stand alone, but “must be based on an adequately pled underlying claim.” Judge Davis observed that the Business Court frequently has allowed such conspiracy claims to survive a motion to dismiss when premised on an adequately pled breach of fiduciary duty claim. Id. ¶¶ 63, 66.

Breach of Contract: The Court agreed with Nolan and Hauser that the minority shareholders had not made out an adequate claim for breach of contract. Plaintiffs had relied on a “recital” from Piedmont’s Shareholder Agreement that stated the shareholders “desire and intend . . . to encourage the harmonious and successful management and control of the Corporation and to prevent the interference with the orderly conduct of the business[.]” Id. ¶ 35. The Court found the language largely hortatory, and an insufficient hook for recovery (Id. ¶ 38):

“The fatal defect in Plaintiffs’ argument is that Section C does not contain any actual contractual obligations sufficient to form the basis for a breach of contract claim. Instead, it is merely a recital as to the overall purpose of the Shareholder Agreement.”

Takeaways

  • The “special duty” that majority shareholders owe to minority shareholders can allow “minority shareholders to bring individual claims . . . even where a derivative action would otherwise have been appropriate.” Id. ¶ 28.
  • The Court offered a practice tip that defeating a breach of contract claim automatically squelches a “good faith and fair dealing” claim where its grounds are “identical to the basis for [the] breach of contract claim.” Cordaro v. Harrington Bank, FSB, 260 N.C. App. 26, 38-39 (2018).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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