legal spotlight rma files brief · held corporation owe fiduciary duties to a solvent corpora-tion...

5
December 2007–January 2008 The RMA Journal 44 IN SEPTEMBER 2007, The Risk Management Association filed an Amicus Curiae (friend of the court) brief in Polsky v. Virnich and Moores, a case now pending before the Wis- consin Court of Appeals. This was a significant event in RMA’s 93-year history because it marked the first time that the Association had ever filed such a brief. RMA was interested in this case because it involved one of its community bank members, American Trust & Sav- ings Bank, headquartered in Dubuque, Iowa. The bank was the largest secured creditor of Communications Prod- ucts Corporation (CPC), a manufacturer of loudspeaker components. The case concerned misuse of the corpora- tion to defraud creditors of CPC and render it insolvent. CPC was in default on an operating line of credit ex- tended by American Trust & Savings Bank. Accordingly, the bank applied to have a receiver appointed, and Michael S. Polsky was appointed the receiver of CPC in 2003. At the time of Polsky’s appointment, CPC was the larg- est employer in Grant County, Wisconsin. From 1986 through 2003, Daniel Virnich and Jack Moores, the direc- tors of CPC and also its indirect sole shareholders, ex- BY EDWARD J. DEMARCO JR. in Support of Wisconsin Community Bank RMA Files Brief This past fall, RMA filed a “friend of the court” brief in support of a court-appointed receiver in a case involving American Trust & Savings Bank, an RMA community bank member. Now pending before an appeals court, the case could have serious implications for lending institutions doing business with companies having operations in Wisconsin. At issue is whether directors of a closely held corporation owe fiduciary duties to that corporation when they are also its sole shareholders. tracted approximately $10 million from the corporation through a variety of mechanisms, including management fees, administrative salaries, bonuses, dividends, and equipment leases, rendering CPC insolvent. Consequently, the receiver brought suit against Vir- nich and Moores, alleging that through their actions they breached their fiduciary duties to CPC. Following a five-day trial, the jury returned a verdict of $6.5 million in favor of the receiver. The defendants ap- pealed the verdict, arguing that as the sole directors and indirect shareholders of CPC, they had the power to oper- ate CPC for their sole benefit and did not owe fiduciary duties to the corporation. RMA filed its brief in support of Polsky. The Facts of the Case Daniel Virnich and Jack Moores purchased CPC in 1986 through a leveraged buyout. Over the next 18 years, they were the sole directors of the corporation and indirectly controlled all of its issued and outstanding stock through two other corporations, Basic Products Corporation and Legal Spotlight

Upload: others

Post on 03-Aug-2020

3 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: Legal Spotlight RMA Files Brief · held corporation owe fiduciary duties to a solvent corpora-tion when those directors are also the sole shareholders. RMA’s Brief in Support of

December 2007–January 2008 The RMA Journal44

In September 2007, The Risk Management Association filed an Amicus Curiae (friend of the court) brief in Polsky v. Virnich and Moores, a case now pending before the Wis-consin Court of Appeals. This was a significant event in RMA’s 93-year history because it marked the first time that the Association had ever filed such a brief.

RMA was interested in this case because it involved one of its community bank members, American Trust & Sav-ings Bank, headquartered in Dubuque, Iowa. The bank was the largest secured creditor of Communications Prod-ucts Corporation (CPC), a manufacturer of loudspeaker components. The case concerned misuse of the corpora-tion to defraud creditors of CPC and render it insolvent.

CPC was in default on an operating line of credit ex-tended by American Trust & Savings Bank. Accordingly, the bank applied to have a receiver appointed, and Michael S. Polsky was appointed the receiver of CPC in 2003.

At the time of Polsky’s appointment, CPC was the larg-est employer in Grant County, Wisconsin. From 1986 through 2003, Daniel Virnich and Jack Moores, the direc-tors of CPC and also its indirect sole shareholders, ex-

by Edward J. dEMarco Jr.

in Support of Wisconsin Community Bank

RMA Files Brief

This past fall, RMA filed a “friend of the court” brief in support of a court-appointed receiver in a case involving American Trust & Savings Bank, an RMA community bank member. Now pending before an appeals court, the case could have serious implications for lending institutions doing business with companies having operations in Wisconsin. At issue is whether directors of a closely held corporation owe fiduciary duties to that corporation when they are also its sole shareholders.

tracted approximately $10 million from the corporation through a variety of mechanisms, including management fees, administrative salaries, bonuses, dividends, and equipment leases, rendering CPC insolvent.

Consequently, the receiver brought suit against Vir-nich and Moores, alleging that through their actions they breached their fiduciary duties to CPC.

Following a five-day trial, the jury returned a verdict of $6.5 million in favor of the receiver. The defendants ap-pealed the verdict, arguing that as the sole directors and indirect shareholders of CPC, they had the power to oper-ate CPC for their sole benefit and did not owe fiduciary duties to the corporation. RMA filed its brief in support of Polsky.

The Facts of the CaseDaniel Virnich and Jack Moores purchased CPC in 1986 through a leveraged buyout. Over the next 18 years, they were the sole directors of the corporation and indirectly controlled all of its issued and outstanding stock through two other corporations, Basic Products Corporation and

Legal Spotlight

Page 2: Legal Spotlight RMA Files Brief · held corporation owe fiduciary duties to a solvent corpora-tion when those directors are also the sole shareholders. RMA’s Brief in Support of

The RMA Journal December 2007–January 2008 45

in SOX and

IT Risk Assessments

CePro Incorporated. In short, CPC was a subsidiary of Basic Products, which in turn was a subsidiary of CePro. CePro was owned jointly by Moores and by companies owned by Virnich. At various times since 1986, Virnich and Moores served as officers and directors of CPC.

In July 1999, American Trust & Savings Bank entered into a commercial lending and deposit relationship with CPC, which included a $1 million line of credit and equipment term financing. The bank extended CPC’s line of credit several times with a maturity date of October 1, 2003. Significantly, Virnich and Moores did not sign personal guarantees.

Virnich and Moores allegedly arranged for CPC to pay them 3% of the net sales of CPC and also allegedly es-tablished an intercompany receivable account that paid dividends from CPC to Basic Products over and above the capital contributions from Basic Products. The intercom-pany receivable was recorded as an asset on CPC’s bal-ance sheet even though Virnich and Moores allegedly did not have any intention of repaying the amounts disbursed to Basic Products.

In 2002, the intercompany receivable account paid ap-proximately $485,000 to Basic Products, reducing CPC’s assets by $500,000. Virnich and Moores were also alleged to have established leasing trusts that leased equipment to CPC at rates substantially in excess of market value. CPC paid these trusts approximately $2.75 million for equipment allegedly valued at only $695,000.

In June 2003, CPC had difficulty meeting its obliga-tions to the bank, and the bank filed suit to ask that a re-ceiver be appointed. In June 2003, Polsky was appointed the receiver of CPC.

In September 2003, the court approved the sale of CPC’s assets to a local buyout group. At the time of clos-ing, CPC’s assets were insufficient to cover its debts. In fact, the value of the assets was at least $1 million less than the company’s value as a going concern. The receiver filed a motion with the court, asking that special coun-sel be appointed, and subsequently brought suit against Virnich and Moores, alleging breach of the fiduciary du-ties of loyalty, care, and good faith, waste of corporate as-sets, and other claims. After a trial on the merits, the jury

in Support of Wisconsin Community Bank

Page 3: Legal Spotlight RMA Files Brief · held corporation owe fiduciary duties to a solvent corpora-tion when those directors are also the sole shareholders. RMA’s Brief in Support of

December 2007–January 2008 The RMA Journal46

awarded $6.5 million, including $2.7 million based on a finding that the defendants conspired to harm CPC. This was the largest verdict awarded in Wisconsin in 2006. Virnich and Moores subsequently appealed the verdict to the Wisconsin Court of Appeals.

Virnich and Moores raised several issues on appeal, the most important of which is whether directors of a closely held corporation owe fiduciary duties to a solvent corpora-tion when those directors are also the sole shareholders.

RMA’s Brief in Support of the ReceiverAfter reviewing the pleadings in the case and the brief filed by the defendants, RMA determined that it was in the best interests of its membership—particularly the community bank members—to address the important corporate gov-ernance issues raised in this case.

RMA maintained that closely held corporations must adhere to proper standards of corporate governance be-cause the absence of such standards and the means to en-force them could unintentionally compromise the finan-cial health of the institutions that lend to them, restricting the flow of funds from lender to borrower. In its brief, RMA argued that receivers and trustees must be able to enforce the fiduciary duties that directors owe to corpora-tions on whose boards they serve. This position is consis-tent with the U.S. Supreme Court decision Pepper v. Litton, where the court stated:

While normally that fiduciary obligation is enforceable directly by the corporation, or through a stockholder’s derivative action, it is, in the event of bankruptcy of the corporation, enforceable by the trustee. For that standard of fiduciary obligation is designed for the protection of the entire community of interests in the corporation—creditors as well as stockholders.In its brief, RMA advanced three principal arguments. RMA’s first argument was that directors of a corpora-

tion owe their fiduciary duties to the corporation and its shareholders. These duties, which are typically expressed as care, loyalty, and good faith, cannot be waived by shareholders because a corporation is a per-son separate and apart from its owners. It is precisely because a director’s fiduciary duties run to the benefit of the corporation, as well as the stockholders, that the law strictly differentiates between claims brought by shareholders directly or derivatively on behalf of the corporation.1

Virnich and Moores opposed this traditional view, ar-guing that as officers, directors, and indirect sole share-holders of CPC, they did not breach their fiduciary duties by authorizing distributions to related entities because CPC was solvent, a going concern, and all sharehold-ers consented to the distributions. However, one of the fundamental principles of corporate law is that directors of a corporation owe fiduciary duties of care and loyalty to the corporation and to its shareholders. Virnich and Moores ignored the fact that, as directors, they owed a fiduciary duty to CPC as a matter of law, not shareholder prerogative.

Under Wisconsin law, a director owes a fiduciary re-sponsibility to the corporation and its shareholders to act with care, with loyalty, and in good faith. Moreover, the role of directors is to advance the interests of the cor-poration, consistent with their fiduciary duties. Once a corporation has complied with all the legal obligations owed to its creditors, the directors are generally free to take economic risk on behalf of the shareholders, pro-vided that the directors comply with their fiduciary du-ties to the corporation “by selecting and pursuing with fidelity and prudence a plausible strategy to maximize the firm’s value.”2

RMA noted that Virnich and Moores failed to recognize that the shareholders of a corporation often have interests that diverge from the corporation’s.

Quoting a decision from the Court of Appeals for the Second Circuit, RMA noted, “The sole shareholder of a corporation is differently situated legally from the corporation, whose interests frequently overlap but are not identical in all respects.”3 Simply put, a corporation may have an interest in reinvesting earnings to grow its business, while the shareholders may have an interest in withdrawing those earnings for personal use or to diver-sify their holdings. It is for this very reason that direc-tors owe fiduciary duties to both the corporation and the shareholders. RMA stressed that Virnich and Moores’ po-sition is tantamount to stating that CPC was their alter ego, which is illogical given that the principal purpose of forming a corporation or other limited liability entity is to insulate its owners from personal liability. RMA noted that this argument particularly defies credibility given that Virnich and Moores caused not one but two holding companies to be embedded between them and CPC.

In arguing that the distributions CPC paid to them were proper, Virnich and Moores requested that the Court of Appeals ignore the long-held principle that a corporation is a person separate and distinct from its owners. The thrust of their argument was that manipulating the cor-poration for their own benefit, even to the detriment of CPC, was acceptable as long as they, as shareholders, had consented to the transaction. RMA argued that under that reasoning, any transaction involving a closely held cor-poration would be a proper corporate action if approved

RMA noted that Virnich and Moores

failed to recognize that the shareholders

of a corporation often have interests

that diverge from the corporation’s.

Page 4: Legal Spotlight RMA Files Brief · held corporation owe fiduciary duties to a solvent corpora-tion when those directors are also the sole shareholders. RMA’s Brief in Support of

The RMA Journal December 2007–January 2008 47

will refuse to review the decision-making process of a cor-poration’s board of directors unless there is an allegation that the board failed to act on an informed basis, in good faith, or in the honest belief that the action taken was in the company’s best interests. To take advantage of the busi-ness judgment rule, the directors cannot personally ben-efit from the proposed transaction, and prior to making a business decision, they have a duty to familiarize them-selves with all material information reasonably available to them. However, in such cases, if the directors’ conduct involved insider self-dealing, the business judgment rule is not applied because self-dealing generally results in a detriment to the corporation. Consequently, in reviewing directors’ decisions, the courts look for fairness to the cor-poration itself as opposed to fairness to the shareholders.

The Wisconsin Supreme Court held in Beloit Liquidating Trust v. Grade that officers and directors of a corporation do not have a fiduciary duty to creditors unless the cor-poration is both insolvent and no longer a going concern. Under Beloit, lenders and other creditors will not be able to assert claims of breach of fiduciary duty against the direc-tors and officers of a corporation based in Wisconsin unless the breach of duty occurred after the corporation was both insolvent and no longer a going concern. This means that

Lenders and other third parties who deal

with Wisconsin corporations would be put

on notice that the shareholders of these

corporations would have the power to

ratify, confirm, or approve fraudulent or

illegal transactions.

by the shareholders. Wisconsin has long recognized the widespread harm threatened by such an argument:

These general principles sufficiently establish the doc-trine that the owner of all the capital stock of a corpo-ration does not therefore own its property, or any of it, and does not himself become the corporation, as a natural person, to own its property and do its business in his own name. While the corporation exists he is a mere stockholder of it, and nothing else. The conse-quences of a violation of these principles would be that the stockholders would be the private and joint owners of the corporate property, and they could assume the powers of the corporation, and supersede its functions in its use and disposition for their own benefit without personal liability, and thus destroy the corporation, ter-minate its business, and defraud its creditors.4

RMA also noted that should the court adopt the ap-pellants’ argument, a corporation could properly engage in fraudulent or illegal transactions as long as the share-holders approved the transactions. This outcome would be counter to black letter corporate law and all reason. Wisconsin law is clear that directors owe a fiduciary duty to the corporation and its shareholders and that those directors cannot act in self-interest to the corporation’s detriment. Lenders and other third parties who deal with Wisconsin corporations would be put on notice that the shareholders of these corporations would have the power to ratify, confirm, or approve fraudulent or illegal trans-actions. Accordingly, lenders would likely evaluate the credit risk associated with lending to these corporations in an unfavorable light, resulting in increased underwrit-ing standards and higher transaction costs for Wisconsin corporations.

Were the Court of Appeals to adopt Virnich and Moores’ argument, noted RMA, shareholders would be empowered to eliminate a board’s fiduciary duties to the corporation, since they would have the ability to act on their personal motivations at any given moment. It is for this very reason that the law imposes fiduciary duties on directors—duties to both shareholders and corporations, without any exceptions, because both are separated from control of their own destinies. The directors’ duty to the corporation is even more important than their duty to shareholders because shareholders often do have the abil-ity to exert control.

RMA’s second argument was that directors of a cor-poration are required to consider the effect that their actions may have on their constituents other than the shareholders—including employees, creditors, and their local community—when they are acting for the benefit of insiders. In making this argument, RMA illustrated why the “business judgment rule” does not apply to Virnich and Moores’ conduct. The business judgment rule pro-tects directors from being second-guessed in the courts. A corporate governance principle, it maintains that courts

Page 5: Legal Spotlight RMA Files Brief · held corporation owe fiduciary duties to a solvent corpora-tion when those directors are also the sole shareholders. RMA’s Brief in Support of

December 2007–January 2008 The RMA Journal48

the corporation’s directors and officers will have the op-portunity to unjustly enrich themselves at the expense of the lenders and other creditors prior to either insolvency or the corporation ceasing to be a going concern.

RMA argued that Wisconsin Statute section 180.0827 expressly provides that, in discharging duties to the corpo-ration, a director, in addition to considering the effects of any action on shareholders, may also consider the effects on employees, suppliers, and customers. RMA’s reasoning was that if lenders are defrauded or dealt with unfairly due to insider self-dealing, the insiders will be manifestly harming the interests of the corporation. And as a matter of public policy, this would result in lenders prematurely calling loans and/or increasing the cost of capital to Wis-consin corporations.

To better protect the rights of a Wisconsin corporation when it is insolvent or in danger of becoming so, RMA suggested that directors are required to consider the ef-fects of corporate action on the corporation if it has the ef-fect of conferring a benefit on insiders. This consideration is consistent with Wisconsin Statute section 180.0826, which provides that, in performing his or her duties, a director is entitled to rely in good faith on information, opinions, reports, or statements (including financial state-ments and other financial data) prepared or presented by officers, employees, legal counsel, and certified public ac-countants. RMA stated that if directors were not required to consider the interests of other constituencies, Section 180.0826 would be rendered superfluous and irrelevant, which cannot have been the legislature’s intention.

The final argument raised by RMA was that application of fiduciary duties—regardless of shared ownership—is vital to the expectations of lenders and the promotion of commerce. Virnich and Moores argued for additional ambiguity in corporate law by claiming a special excep-tion for directors and officers who are the only sharehold-ers. RMA reasoned that such a concept is undesirable as a matter of public policy and is unworkable in practice. In short, Virnich and Moores suggested that Wisconsin common law should be reinterpreted to allow sharehold-ers to take and dispose of corporate assets at any time and in any circumstance. If shareholders did so, it would undercut loan agreements, leaving the lender without any recourse.

RMA also noted that Virnich and Moores’ theory does not provide any workable manner for determining which restrictions will apply at any given time. For instance, if a corporation’s equity ownership becomes consolidated after corporate loans are made, applicable self-dealing restrictions and corresponding risk become dramatically altered, despite not being a consideration of the initial agreement. Adopting a policy of unconstrained risk to lenders will force lenders to impose prohibitive lending rates and terms on any corporation incorporated or domi-ciled in Wisconsin.

At its most basic level, eliminating legal restrictions on the conduct of corporate management would exact a destructive toll on lenders, and it would harm com-merce—in Wisconsin and elsewhere—by increasing the costs of both debt and equity while imposing high trans-action costs. Commentators have recognized that proper standards of corporate governance are vital to both debt and equity allocation because “creditors and sharehold-ers negotiate the terms of loans and capital contributions against a backdrop of legal rules that provide a baseline risk allocation.”5 RMA reminded the court that whether corporate insiders have a legal duty to protect the cor-porate enterprise is an important facet of risk determina-tion and consequent contractual terms with the corpo-rate entity, which in turn provides important commercial benefits. Other commentators have noted that fiduciary duties are implicit standard terms that create commercial efficiencies in corporate contracts. That being the case, fiduciary duties imposed by state law are therefore inher-ent in corporate loan terms and are essential to lenders’ expectation. For example, the Second Circuit Court of Appeals has stated that “lenders’ expectations are cen-tral to the calculation of interest rates and other terms of loans, and fulfilling those expectations is therefore impor-tant to the efficiency of credit markets.”6

ConclusionAt the time of this writing, Polsky v. Virnich and Moores is pending before the Wisconsin Court of Appeals. RMA will continue to monitor developments in this case and provide an update on the Court of Appeals decision, which could have serious implications for our members if the court were to adopt the argument of Virnich and Moores. v

Edward J. DeMarco Jr. is general counsel at RMA. Contact him by e-mail at [email protected].

Notes 1. A derivative action is one brought on behalf of a corporation by a shareholder or receiver where the management of a corporation has misused its authority.

2. Prod. Res. Group, LLC v. NCT Group, Inc., 863 A.2d at 790.

3. Grace v. Bank Leumi Trust Co., 443 F. 3d 180, 192 (2d Cir. 2006).

4. Button v. Hoffman, 61 Wis. 20, 23, 20 N.W. 667, 669 (1884).

5. Christopher W. Frost, Organizational Form, Misappropriation Risk, and the Substantive Consolidation of Corporate Groups, 44 Hastings L.J.

449, 451 (1993).

6. In re Augie/Restivo Baking Co., 860 F.2d 515, 519 (2nd Cir. 1988).