Judge: shareholders owe no fiduciary duty

Massachusetts Superior Court judge has determined that minority shareholders of Demoulas Super Markets Inc. can sell their stock to third parties even if doing so causes the corporation to lose its favorable tax status.

The Tewksbury, Mass., supermarket chain had asked the court to declare that the shareholders would breach their fiduciary duties if they sold their shares in a manner that would result in the corporation forfeiting its Subchapter S status. A Subchapter S corporation pays only one layer of tax.

Demoulas argued that a shareholders’ agreement to elect Subchapter S status also constituted an agreement to not alter the corporation’s tax status. The corporation’s articles of organization allow shareholders to sell their stock however they see fit once the board declines to buy the stock. But Demoulas contended that fiduciary law compliments contract law.

Judge S. Jane Haggerty disagreed, ruling that the shareholders were not bound by fiduciary duty to Demoulas on the Subchapter S issue. Haggerty did add a caveat to the order, requiring the shareholders to follow the covenant of good faith and fair dealing implied in Demoulas’ articles of organization.

“To the extent that DSM [Demoulas] might argue that the [shareholders’] sale of shares in a manner destructive to DSM’s interests would breach the covenant of good faith and fair dealing implied in the Articles of Organization, this court notes simply that the implied covenant ensures that parties ‘remain faithful to the intended and agreed expectations of the contract,’” she said.

The 19-page decision is Merriam, et al. v. Demoulas Super Markets, Inc, et al.

Conflicting authority

Demoulas argued that the shareholders could not defend a breach of fiduciary duty by claiming that their plan to sell stock complied with the articles of organization. They urged the court to consider the shareholders’ implied understanding of their rights and obligations to Demoulas, rather than their contractual duties as defined by the articles of organization.

Meanwhile, the shareholders asserted that their sale of stock should be governed not by implied fiduciary duties but by the language in the articles, specifically a stock transfer provision in Article 5 that did not contain a Subchapter S restriction.

The shareholders cited the Massachusetts Supreme Judicial Court’s 2007 decision in Chokel v. Genzyme Corp. to bolster their position, while Demoulas pointed to the 1st U.S. Circuit Court of Appeal’s 1997 decision in A.W. Chesterton Co. v. Chesterton.

In Chesterton, the court upheld a permanent injunction against a shareholder defendant after he transferred his interest to a pair of shell corporations he owned as part of a scheme to dissolve the company’s Subchapter S status. The 1st Circuit found that the shareholder’s actions lacked a legitimate business purpose and constituted a breach of fiduciary duty.

The Chokel decision affirmed the dismissal of a plaintiff shareholder’s claim against a defendant director accused of breaching his fiduciary duty based on the timing of a stock exchange. The SJC found that the transaction complied with the corporation’s articles of organization.

The shareholders’ attorney, Thomas S. Fitzpatrick of the Boston firm Davis, Malm & D’Agostine, declined comment through a spokeswoman. Demoulas’ attorney, Thomas O. Bean of McDermott, Will & Emery in Boston, did not return e-mails and phone messages seeking comment.

In a motion for reconsideration, Bean argued that the court erroneously considered material outside of the pleadings and failed to give the parties a chance to provide a complete factual record, and that the decision contradicts applicable tax law.

“If a minority can sell shares to a transferee non-qualified shareholder and thereby destroy Subchapter S status, that minority can do, indirectly, what it cannot do directly,” he wrote.

An attorney familiar with the case but not involved in the matter, Christopher Weld Jr. of Boston’s Todd & Weld, said Haggerty’s decision leaves open the issue of whether the shareholders would be in violation of the covenant of good faith and fair dealing if they cause Demoulas to lose Subchapter S status.

“Where she’s taken the fiduciary duties out of the case, the issue of interpreting the covenant is front and center now,” he said. “By the way she’s drafted this, it’s almost like she’s inviting the SJC to give us some more direction.”

No deal

The plaintiff shareholders gave written notice to defendant Demoulas and its board of directors of their intent to sell their stock. The notice included a stock purchase proposal and, as an alternative, named an arbitrator that the board could use to determine the value of the stock.

After initially claiming that the notice was invalid, the board’s four members acknowledged and then rejected the plaintiffs’ offer. They brought in a second arbitrator to appraise the stock while they reserved their right to contest the validity of the plaintiff’s original written notice.

The plaintiffs filed suit last July, seeking a declaration that the written notice they provided to the board was valid under Demoulas’ articles of organization. They also said the board should be barred from challenging the validity of the notice because it had already started arbitration.

In its counterclaims, Demoulas argued that the plaintiffs owed fiduciary duties to the corporation that prevented them from selling their stock in a way that would cause the business to lose its Subchapter S status. Demoulas also claimed that if the plaintiffs lowered the sales price of the stock they would be required to re-offer the stock to the corporation before approaching any third parties.

‘Shenanigans’

In determining that the plaintiffs owed no fiduciary duty to Demoulas, the court looked to the “broad language” in Chokel and found that the decision “unambiguously provides that parties may displace their fiduciary obligations via contract.”

As for the Chesterton decision, Haggerty determined that the case did not appear to help Demoulas’ argument because it involved a spiteful shareholder intent on harming a company that could not buy the shareholder’s stock even if it so desired.

Haggerty found no evidence that the plaintiffs’ sole intent in selling their stock was to destroy Demoulas’ favorable tax status. She also considered the fact that the corporation had the opportunity to purchase the plaintiffs’ shares but declined.

Still, Haggerty noted: “It may well be that, given the opportunity, the Supreme Judicial Court would reject an expansive interpretation of Chokel and adopt the Chesterton view that fiduciary principles attach to the sale of stock pursuant to a contractual provision.”

Haggerty was more confident in dismissing Demoulas’ assertion that it was entitled to a perpetual right of first refusal whenever the plaintiffs changed the terms or price of the stock sale. She said Demoulas’ argument was “flatly inconsistent with the plain language of Article 5” and, unlike its Subchapter S claim, unsupported by the caselaw before the court.

If the court were to give the defendants an endless right of first refusal, the plaintiffs and other shareholders could be forced to repeat the arbitration process every time they offered the stocks to a third party at a slightly different price, Haggerty said.

“Given the animosity between these parties, it is easy to imagine the shenanigans that would ensue if this were the case,” she said. “This court will not countenance an artificial stock transfer restriction that empowers DSM to add new obstacles to the plaintiffs’ divestment of their shares.”