Brief Fact Summary. Defendant, Western Bank and Trust Company (Bank), sold its controlling majority shares in Alfred S. Johnson Incorporated (Corporation) to Raymond J. Mattison, without conducting adequate investigation into the public records. Consequently, Mattison looted Corporation.
Synopsis of Rule of Law. A controlling majority shareholder must exercise good faith and fairness in selling its controlling shares in a company, which includes the duty to reasonably investigate whether a potential buyer is a looter.
Points of Law - Legal Principles in this Case for Law Students.
A fiduciary's dealings with the corporation are subjected to rigorous scrutiny and where any of their contracts or engagements with the corporation is challenged the burden is on the director or stockholder not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein.
Facts. Corporation was incorporated by Alfred S. Johnson in 1955 to process color photographs to be reproduced in printed form. The 100 shares in Corporation were owed as follows: Johnson owned 70 shares; Respondent, James DeBaun, Corporation’s primary salesman, owned 20 shares; and Respondent, Walter Stephens, its production manager, owned 10 shares.
After Johnson’s death on January 15, 1965, Bank became the trustee of Johnson’s trust, which included the 70 shares of Corporation. Respondents retained managerial control.
On October 27, 1996, Bank decided to sell its 70 shares in Corporation without notifying DeBaun and Stephens. When Respondents found out, they refused to sell their interest in Corporation. DeBaun submitted an offer for Bank’s 70 shares, but Bank rejected the offer as inadequate.
On May 15 and 20, 1968, Mattison, acting in the name of S.O.F. Fund, made an offer that Bank rejected. Expecting a third offer to be made, Bank ordered a Dun & Bradstreet report on Mattison and the fund. On May 24, 1968, the report indicated that Mattison had pending litigations, bankruptcies, tax liens, and suggested S.O.F. Fund no longer existed. On May 27, 1968, Mattison made a third offer.
Bank counter-offered. The terms are as follows: the S.O.F. Fund would pay $250,000 for the shares, $50,000 in marketable securities as a down payment with the balance payable over five-years, Corporation would pay no dividends out of pre-sale retailed earnings. On June 4, 1968, McCarrol, Mattison’s lawyer, proposed that Corporation use its assets to secure the $200,000 unpaid balance of the purchase price rather than Mattison supplying the security in the form of marketable securities and suggested the elimination of the restriction against dividends from pre-sale retained earnings.
On June 27, Bank met with Mattison and McCarrol, so that Mattison could explain the poor Dun report. Bank also requested a written report on the status of Mattison’s pending litigations. McCarrol suggested Bank look into the public records for this information. However, Bank did not pursue its investigation into the public record of Los Angeles County because a superior at Bank knew McCarrol as a former trust officer of Bank’s predecessor in interest and because McCarrol received a warm welcome at the Jonathan Club.
As of July 1, 1968, the Los Angeles county public records had on record 38 unsatisfied judgments against Mattison totaling $330,886.27, 54, pending actions claiming $373,588.67, 22 recorded abstracts of judgments against Mattison totaling $285,704.11, and 18 tax liens aggregating $20,327.97.
Bank accepted the McCarrol modification despite the fact that it knew or should have known that Corporation could not meet the $200,000 balance as scheduled in the McCarrol proposal and that Mattison could make those payments only by resorting to distribution of pre-sale retained earnings and assets of Corporation.
A new board of directors was elected, in which Mattison had control and DeBaun and Stephens remained as directors. Bank informed Respondents that a security agreement was in place to protect Corporation in the event of Mattison’s death or default and that in such an event, Bank would foreclose on the stock. Bank did not tell them that the corporate assets were security for Mattison’s debt to Bank. Relying on these misrepresentations, they voted to approve the security agreement.
At the time of Bank’s sale to Mattison, Corporation was doing well. Mattison, however, immediately implemented a scheme to loot Corporation’s assets. He diverted $73,144 in corporate cash to himself and MICO, a shell company owned by him; he had Corporation assign to MICO all of Corporation’s asset in exchange for a fictitious agreement for management services; he diverted Corporation’s mail to a post office box in his control in order to extract all Corporate’s checks; he ceased paying trade creditors promptly or at all; he delayed shipments on new orders; he removed the corporate books and records; he collected employee payments on insurance premiums for a cancelled voluntary employee insurance plan; he issued payroll checks without sufficient funds; and did not supply Bank with the required financial reports.
In September 1968, DeBaun left Corporation and in December 1968, Stephens left Corporation. Bank was aware of Mattison’s misconduct, but took no action until April 25, 1969, when it filed an action in the superior court seeking the appointment of a receiver. On June 20, 1969, Bank shut down Corporation’s operations when Corporation was completely insolvent.
Bank sold Corporation on July 10, 1969 for $60,000, paid $25,000 to release the federal tax lien on Corporation, and retained $25,000. Corporation still owed $218,426 to creditors.
Respondents filed a claim for damages and a stockholders derivative suit against Bank. Bank demurred to both complaints, contending that Respondents, as shareholders, lacked capacity to pursue the first claim, and Bank was not liable for Corporation in the derivative action. The trial court sustained the first demurrer without leave to amend, and overruled second demurrer. The trial court held for Respondents, finding that Bank breached duties it owed as a majority controlling shareholder to Corporation and awarding $473,836 in monetary damages, attorneys’ fees, and denied punitive damages. Bank appealed.
Whether Bank as the controlling majority shareholder had a duty to the Corporation and minority shareholders to act as a reasonably prudent person in selling its controlling shares?
If so, did Bank breach its duty?
If Bank breached its duty, whether the trial court properly awarded damages?
Held. Affirmed. Remanded to determine additional amount payable to Respondents for Counsel fees due as a result of the appeal.
Yes. Bank owed a duty to Corporation and its minority shareholders to act as a reasonably prudent person with respect to its sale of its controlling shares of stock to ensure that a potential buyer is in the best interests of the corporation, i.e., not a looter.
Yes. Bank breached its duty because it failed to act as a reasonably prudent person when it failed to act reasonably in selling its controlling shares to Mattison because it failed to investigate Mattison.
Yes. The trial court properly determined total damage to Corporation as the sum “necessary to restore the negative net worth, plus the value of its tangible assets, plus its going business value determined with reference to its future profits reasonably estimated.”
Bank became directly aware of facts that would alert a prudent person that Mattison was likely to loot the corporation. Such factors included: Bank knew from the Dun & Bradstreet report of Mattison’s poor financial history; it knew of Mattison’s past fraudulent conduct; and it knew that Mattison’s only method of paying for Corporation’s shares was in Corporation’s assets. Consequently, Bank had a duty to Corporation and its minority shareholders to act as a reasonably prudent person to further investigate Mattison.