Caseflicks

Court of Appeals for the Second Circuit • 1980

Lewis v. S. L. & E., Inc.

629 F.2d 764

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Takeaway

In short, this case holds that directors who deal with an affiliated company they control must prove the transaction was fair to the corporation; they cannot use the business-judgment rule to shift that burden to a minority shareholder.

Background

S.L. & E., Inc. (SLE) owned a Rochester property that was its sole significant asset. Its affiliated company, Lewis General Tires, Inc. (LGT), operated a tire business on the property. After a 1956 lease expired in 1966, LGT remained in possession and continued paying the old rent of $14,400 annually. SLE remained responsible for real-estate taxes, which rose sharply during this period.

Donald Lewis owned SLE stock but no LGT stock. His brothers Richard, Alan, and Leon, Jr., were SLE directors and were also directors, officers, or shareholders of LGT. They treated SLE largely as a vehicle to support LGT: they did not consider a new lease, seek an appraisal, explore other tenants, or discuss raising the rent after the lease expired.

Under a family shareholders' agreement, Donald was required to sell his SLE shares to LGT in 1972 at their June 1, 1972 book value. Believing that SLE's value had been depressed by inadequate rent, Donald refused to sell and brought a derivative action alleging that his brothers had wasted SLE's assets. LGT intervened and sought specific performance of Donald's obligation to sell.

After a bench trial, the district court held that Donald had failed to prove that the rent was unreasonably low, ordered specific performance of the stock-sale agreement, and awarded attorneys' fees to SLE and the defendant directors. Donald appealed.

Issues

Issue #1

Whether Donald, rather than the interested SLE directors, bore the burden of proving that the continued $14,400 annual rent paid by LGT was unfair to SLE.

Holding

No. Because the SLE directors had overlapping directorships and financial interests in LGT, they bore the burden of affirmatively proving that the SLE-LGT rental arrangement was fair and reasonable to SLE.

Reasoning

The ordinary business-judgment rule ordinarily shields directors' good-faith decisions about corporate contracts and adequate consideration. But that rule assumes that the directors are disinterested. Where directors stand on both sides of a transaction or have a substantial financial interest in the counterparty, courts must scrutinize the transaction's merits rather than defer to business judgment.

New York Business Corporation Law § 713 preserved the common-law rule for interested-director transactions. Under the current statute, and under its predecessor, a transaction lacking the prescribed disinterested approval or disclosure could be avoided unless its proponents established that it was fair and reasonable to the corporation. Thus, the burden rested on the interested directors, not on the shareholder challenging the transaction.

During the entire relevant period, Richard, Alan, and Leon, Jr., served as directors of both SLE and LGT. They also had direct financial stakes in LGT. There were no SLE directors independent of LGT, so the continued rental arrangement was an interested-director transaction subject to the fairness burden.

Issue #2

Whether the defendant directors proved that LGT's continued payment of $14,400 annually from 1966 through June 1, 1972 was fair and reasonable to SLE.

Holding

No. The defendants failed to establish that the fixed rent was fair and reasonable, and the evidence instead suggested that SLE may have been substantially undercompensated.

Reasoning

The directors made no contemporaneous effort to determine a fair rent. They did not obtain appraisals, seek another tenant, attempt to lease the property on market terms, or even discuss a rent increase after the 1956 lease expired. Their own testimony showed that they viewed SLE as a shell existing for LGT's benefit, despite the fact that some SLE shareholders, including Donald, held no LGT shares.

The defendants' evidence concerning rents paid on other East Avenue properties did not establish the property's fair rental value during 1966 through 1972. One comparison concerned rents in 1973 and 1974, while another involved a lease entered in 1961. Because rental value could vary from year to year, these remote comparisons did not prove the fairness of maintaining the same rent throughout the relevant period.

Evidence of the neighborhood's economic decline also did not carry the directors' burden. A general decline in property values provides no meaningful answer without a reliable starting point establishing what fair rent was in 1966 or in each subsequent year.

Several pieces of the defendants' own evidence indicated that the property could have commanded far more than $14,400. A 1972 appraisal valued the property at $220,000; another director offered $200,000 to buy it; and defense experts suggested that a fair return, or a rent with taxes included, would yield an annual figure near $33,000 in 1972. The directors also conceded that the property was worth at least as much in 1966 as in 1972.

The claim that LGT could not afford higher rent was unpersuasive. The district court improperly relied on losses from 1963 and 1973, outside the relevant period. During 1966 through 1972, LGT was unprofitable only once and earned aggregate after-tax profits exceeding $100,000. Further, its reported profitability could have been reduced by family-member salaries and other benefits, including substantial salary increases that followed the brothers' acquisition of additional LGT stock.

Even if LGT itself could not have paid market rent, the directors did not prove that SLE could not have rented the property to a financially stronger tenant. They made no effort during the relevant period to find another tenant. The court therefore directed entry of judgment for SLE against the defendant directors, jointly and severally, for the difference between fair annual rent and $14,400, with a later accounting to revise the June 1, 1972 book value of Donald's shares before ordering specific performance.

Issue #3

Whether Donald was a proper party to bring the action and whether the claim for inadequate rent was properly asserted derivatively.

Holding

Yes. Donald, as an SLE shareholder, could bring the derivative action, and a claim that directors wasted corporate assets had to be asserted derivatively rather than as an individual claim.

Reasoning

A shareholder may bring a derivative action on behalf of the corporation regardless of the number of shares held or whether other shareholders want the claim pursued. The defendants could not challenge Donald's ownership of the shares on appeal because they had admitted his ownership below and did not raise the contrary argument in the district court.

The alleged injury was to SLE itself: its directors supposedly caused the corporation to accept inadequate rent for its principal asset. Any recovery therefore belonged to SLE, making the derivative form not merely permissible but the appropriate vehicle for the claim.

Issue #4

Whether the district court could award attorneys' fees to SLE and the defendant directors against Donald.

Holding

No. New York law did not authorize fee awards to the defendants or SLE on this record, and the merits reversal eliminated any possible bad-faith basis for the awards.

Reasoning

In a diversity action, state law governs the availability of attorneys' fees. Under New York law, a litigant may recover attorneys' fees only when a statute authorizes the award, absent a valid alternative basis such as a sustainable bad-faith finding.

The defendants identified no statute authorizing fees against Donald. New York's derivative-action security-for-expenses provision did not apply because Donald owned more than five percent of SLE's shares. The appellate court also concluded that its reversal on the merits removed any basis for treating Donald's suit as one brought in bad faith.

New York law does permit a successful derivative plaintiff's attorney to receive fees from the corporation's recovery. Because Donald succeeded on the merits, the court indicated that a renewed motion in the district court for such an award would be appropriate.