Owner of Closely Held Corporation Must Use Derivative Action to Sue Director
An individual owner of a closely held corporation may not directly sue a director over alleged breach of duty to the company, the state Superior Court has ruled, holding that under Pennsylvania law such an action should be pursued as a derivative action on behalf of the corporate entity.
In Hill v. Ofalt, the frontline appeals court rejected a provision of the American Law Institute's corporate governance principles that say a court may treat those derivative claims as a direct action.
The panel, upholding a trial judge's decision to throw out the direct action, said the ALI principles are inconsistent with Pennsylvania law and would likely not be adopted by the state Supreme Court.
Superior Court Judge Judith Ference Olson wrote for the majority that the ALI's rule conflicted with the state's Business Corporation Law Section 1717, which limits standing.
"We conclude that our Supreme Court would not simply ignore the corporate form and allow courts to 'treat an action raising derivative claims as a direct action ... and order an individual recovery,'" Olson said, quoting Section 7.01(d). "At the outset, it would appear that, in the vast majority of cases, the substantive aspects of Section 7.01(d) expressly conflict with Pennsylvania statutory law."
Olson, however, ultimately held that the trial court erred by failing to preclude the plaintiff from amending the pleadings. She noted that recent amendments to Rule 1033 of the Pennsylvania Rules of Civil Procedure explicitly allow the plaintiff to add the corporation as a party to the suit. She remanded the case. Judges Sallie Updyke Mundy and Eugene B. Strassburger joined the opinion.
Attorney Paul J. LaBelle, who represented the defendant, said he agreed with the court's decision and maintained that the alleged injuries were only sustained by the corporation and not by the plaintiff individually.
"With this decision, the sanctity of shareholder derivative suits is being preserved by the Pennsylvania courts," LaBelle said. "If we don't preserve the derivative action scenario, then we're going to have shareholders suing shareholders all over the place if they don't like what was done."
According to Olson's opinion, plaintiff Thomas Hill and defendant Ronald J. Ofalt Jr. formed Milestone Restaurant Co. to create a bar and restaurant. The two agreed to have an equal stake in the corporation and agreed Hill would provide start-up capital, expertise and good credit to establish the restaurant. Months after incorporating, the two procured a $250,000 bank loan and a $50,000 small business association loan.
Hill worked to set up the restaurant for four months and then Ofalt took over heading the company, as per the agreement.
However, Hill alleged that once Ofalt assumed control, he began using the business as a "cash cow," Olson said. Hill alleged that Ofalt gave free drinks to family and friends, voided transactions to conceal the free food and drinks, pocketed money, diverted funds and deducted money from employees' paychecks, portraying them as requiring tax withholding.
The restaurant closed, and the business fell into arrears to taxing authorities. The state Department of Revenue imposed a $79,000 lien against Hill and the restaurant. The company also defaulted on the loans that Hill and Ofalt had personally guaranteed. According to Olson, Hill and the company were exposed to debts in excess of $500,000.
Hill then filed a complaint alleging breach of contract, breach of fiduciary duty, unjust enrichment and conversion, Olson said.
Ofalt filed preliminary objections arguing that the complaint was legally insufficient because the injuries were suffered by the corporation and the suit was filed as an individual action instead of a shareholder derivative action. Ofalt further argued that he did not owe Hill any fiduciary duty.
The trial court sustained the preliminary objections and held that Hill did not have standing to institute a direct action for individual damages. The action, the court said, was more appropriate as a shareholder derivative suit.
Before the Superior Court, Hill argued he had standing to institute a direct action against Ofalt because, within the complaint, he alleged that he was individually harmed by Ofalt's actions. Hill also argued that, pursuant to Section 7.01(d) of the ALI's Principles of Corporate Governance: Analysis and Recommendations, he is entitled to bring an action as a member of a closely held corporation.
Hill cited the 1997 Supreme Court's decision in Cuker v. Mikalauskas, in which the court adopted sections of the ALI's Principles of Corporate Governance and authorized the court to consider and use other parts of the principles if they were found to be helpful and consistent with state law.
Olson, however, found that while the Supreme Court might adopt the procedural aspects of Section 7.01(d), such as excusing the demand requirement for derivative actions filed on behalf of closely held corporations, the high court would not adopt the substantive aspects of the principle because it conflicted with state law.
The court further noted that the section grants courts the option to ignore the corporate form of a closely held corporation and to treat the corporation as an "incorporated partnership." Olson, however, agreed with the U.S. Court of Appeals for the Seventh Circuit's 1990 decision in Bagdon v. Bridgestone/Firestone, which said corporations are not partnerships.
"Although we believe that our Supreme Court might adopt some portions of Section 7.01(d), we conclude that our high court would not allow individuals such as appellant to sue directly—and individually recover—for injuries that were sustained by the closely held corporation," Olson said.
Hill's attorney, Kevin Quinn of Hourigan, Kluger & Quinn in Kingston, Pa., said he was pleased with the decision to allow the plaintiff to amend the complaint.
"We respectfully continue to maintain that Hill, the only person being pursued for a defaulted [small business association] loan, has continued to suffer personal harms and we do believe that entitles him to pursue claims personally," Quinn said. "We live to fight another day and we're pleased the Superior Court has given us that opportunity."