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You Must be a Shareholder to Sue for Breach of Corporate Fiduciary Duty
An interesting case out of the US District Court for the Southern District of California reminds us that, in order to sue officers and directors for breach of fiduciary duties, one must actually BE a shareholder. The case is also interesting as a unique example of the legal distinction between natural persons and the corporate entities owned and controlled by them. The case is Melcher v. Fried, Case No. 16-cv-02440-BAS(BGS) (US Dist., SD California May 29, 2018).
San Diego Corporate Law: Facts of Melcher v. Fried
As described by the Court, the facts of Melcher v. Fried are these: The case involved a small closely-held corporation called Face It Corp., which was a “social engagement and mobile customer care solution provider.” Defendant Fried was at all times the CEO and Chairman of the Board. A certain Carl Melcher was the founder and one of the limited partners of Plaintiff Melcher Family Limited Partnership (“MFLP”). MFLP is a California limited partnership that Melcher formed as a vehicle for making various investments.
In 2011, MFLP purchased 30.875% of Face It’s stock for $3 million. Thereafter, Melcher became a board member of Face It. MFLP was the sole outside investor in Face It.
Two years later, Face It was having financial troubles. Fried asked Melcher for an additional investment through MFLP, but Melcher refused without proof that Face It could generate more sales or revenue.
Having failed to obtain additional financing from Melcher, in late 2013, Fried contacted Five9, a company interested in utilizing Face It’s technology. Fried and Five9 discussed a potential sale of Face It for a sales price of about $10 million. Then, without disclosing these negotiations with Five9, Fried proposed to Melcher that Face It repurchase all of the shares in the company held by MFLP. In mid-September, MFLP agreed and sold its shares for half of the amount it originally paid. The repurchase was effectuated through an agreement between Face It and MFLP. Melcher signed the agreement as the President of the “Melcher Family Corporation,” which was identified in the paperwork as the “General Partner of Melcher Family Limited Partnership.”
The next day, Face It signed a term sheet with Five9 and then finalized its sale to Five9 in mid-October 2013. In 2016, Melcher discovered the sale to Five9. Thereafter, Melcher and MFLP sued alleging various causes of action including fraud and breach of fiduciary for Fried’s failure to disclose the negotiations with Five9 prior to buying back the stock in Face It from MFLP.
San Diego Corporate Law: Motion to Dismiss Melcher
In responding to the lawsuit, Fried filed a motion to dismiss against Melcher individually, arguing that he was not allowed to sue for breach of fiduciary duty because at no point was he an actual shareholder of Face It Corp. Fried also argued that Melcher was not a party to the repurchase agreement; that agreement was between Face It and MFLP.
The District Court agreed and held that Melcher was not a proper party to bring the lawsuit. In addition to the above two facts, the court also noted the method in which the repurchase agreement was signed. Melcher did not sign individually, but as President of the general partner of MFLP (which the Melcher Family Corporation). For these reasons, the court held that Melcher could not bring any claims for breach of fiduciary duty in his individual capacity.
San Diego Corporate Law: Legal Lessons
As noted above, the case provides a real-world example of how the legal system distinguishes and treats individuals as distinct and separate from the corporate entities owned and controlled by them. Usually, a corporate entity is formed to shield personal assets; here the corporate form was weaponized to prevent the individual owner from suing in his individual capacity. As a practical matter, however, preventing Melcher from suing in his individual capacity did not end the case. MFLP was not dismissed and its various claims against Fried remain viable and pending.
Another interesting real-world aspect of the case is the fact that Mr. Melcher had TWO layers of corporate entities between himself personally and his investments. Mr. Melcher used a corporation to create MFLP (a limited partnership) which, then in turn, was the purchaser of the Face It stock. In general, two corporate entities can provide a double shield if done correctly and if the corporate formalities are maintained.
Contact San Diego Corporate Law
For further information, please contact Michael Leonard, Esq. of San Diego Corporate Law. Mr. Leonard has the experience to help you form your corporation, keep your corporation in good standing, create and review buy-sell agreements, create and assist in executing business contracts, and assist with any business-related matter. Contact Mr. Leonard by email or by calling (858) 483-9200.
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