New York High Court Addresses Shareholder's Right to Challenge Transaction Without First Voting "No"

On February 17, 2000, in Pinnacle Consultants, Ltd. v. Leucadia National Corp. 94 N.Y.2d 426, 706 N.Y.S.2d 46 (N.Y. Feb 17, 2000), the New York Court of Appeals, in a unanimous decision by Chief Judge Judith S. Kaye, put an end to a five-year long litigation that managed to make its way through no less than five courts in the federal and state systems. The Court addressed (although did not decide) an issue of first impression which could significantly affect the interaction between shareholders and corporations in New York and elsewhere: whether a shareholder who fails to vote against a proposed corporate transaction may subsequently challenge the transaction once it has been executed. The Court of Appeals (in the first case argued in the Court in the twenty-first century) expressed a view contrary to that of the Appellate Division, First Department, and arguably contrary to those of various trial courts throughout the state as well, and suggested - but did not decide - that a shareholder of a widely-held corporation who fails to vote against a proposed transaction should not be estopped from later challenging that same transaction.

The suit was brought as a purported shareholder derivative action against nominal defendant Leucadia National Corporation ("Leucadia") and two of Leucadia's directors and executive officers, Ian M. Cumming and Joseph S. Steinberg. The plaintiff shareholder alleged that: (1) the issuance of stock warrants in 1985, 1991 and 1992 by Leucadia to Cumming and Steinberg violated New York Business Corporations Law ("BCL") ' 505 because Leucadia allegedly did not receive adequate consideration, and (2) the 1990 merger of Marks Investing Corporation ("MIC") into Leucadia violated BC L ' 612(b) because a proxy statement, seeking shareholder approval of the merger, allegedly misled shareholders by disclosing that TLC, a partnership which owned a majority of Leucadia's outstanding shares, would vote such shares in favor of the merger. Plaintiff's theory was that BCL ' 612(b), which prohibits a subsidiary "corporation" from voting shares held by the parent corporation, prohibited TLC (a partnership) from voting its Leucadia shares. The plaintiff asserted causes of action for fraud, conversion, corporate waste and breach of fiduciary duty.

Notably, this action was a reprise of a prior, unsuccessful action brought by the same plaintiff in federal court attacking the issuance of the warrants and the merger. In May 1994, plaintiff filed a complaint in the United States District Court for the Southern District of New York (the "District Court") alleging that the issuance of the warrants and the merger violated the federal securities laws and also constituted unlawful "predicate acts" under the federal Racketeer Influenced and Corrupt Organizations Act ("RICO"). After dismissing the federal securities claims as time-barred, the District Court dismissed the federal RICO claim on the merits because plaintiff's alleged predicate acts (expressly premised on violations of BCL ' 505 and 612(b)) failed as a matter of law: the Court concluded that (1) the warrants issued to defendants Cumming and Steinberg had compensated them for extraordinary service to Leucadia and were therefore issued in full compliance with BCL ' 505; and (2) BCL ' 612(b), prohibiting a company from voting its own shares held by a subsidiary corporation, "applies only to corporations, and specifically to relationships between parent and subsidiary corporations." Pinnacle Consultants, Ltd. v. Leucadia Nat'l Corp., 923 F. Supp. 439, 445-446 (S.D.N.Y. 1995) (emphasis added).

The United States Court of Appeals for the Second Circuit affirmed on the merits the District Court's dismissal of the RICO claim, finding that plaintiff had failed to allege any predicate act of mail and wire fraud in connection with the issuance of the warrants and merger. See Pinnacle Consultants, Ltd. v. Leucadia Nat'l Corp., 101 F.3d 900 (2d Cir. 1996). Specifically, the Second Circuit affirmed the District Court's conclusion that the issuance of the warrants did not violate BCL ' 505 because the warrants had been issued to defendants Cumming and Steinberg for valid consideration. The Second Circuit concluded that "[b]ecause there has been no fraud shown in the issuance of the warrants, we hold that the [d]irectors' business judgment is conclusive that valid consideration was received for the warrants." Id. at 905. Having affirmed the dismissal of the federal RICO claim, the Second Circuit declined to rule on the pendent state law claims.

Despite the rejection of its core claims in federal court, plaintiff subsequently commenced an action in New York State Supreme Court, attacking the same warrant transactions and merger as had been at issue in the federal court.

In the state action, defendants argued that, as a threshold matter, the plaintiff was estopped from maintaining this purported derivative action on behalf of Leucadia because the plaintiff admitted that it did not cast its proxy against the challenged transactions. The rule - preventing a stockholder from challenging transactions to which the stockholder has consented or failed to object - repeatedly has been applied to bar actions by stockholders complaining that excessive compensation has been paid to the directors and officers of closely-held corporations. Cases illustrating this principle include Winter v. Bernstein, 177 A.D.2d 452, 453, 576 N.Y.S.2d 549, 550 (1st Dep't 1991) (shareholder/director could not maintain action challenging allegedly excessive compensation paid to corporation's executives where plaintiff "never challenged these salaries"), Jacobson v. VanRhyn, 127 A.D.2d 743, 744, 512 N.Y.S.2d 135, 136 (2d Dep't 1987) (shareholder/director "waived any right he may have had to challenge the adoption of a certain incentive compensation plan which he abstained from voting upon initially"), and Kranich v. Bach, 209 A.D. 52, 54, 204 N.Y.S. 320, 322 (1st Dep't 1924) (it was "too late for these plaintiffs [stockholders] to question the salaries" paid to company officers where plaintiffs either voted for or abstained from voting on the salaries).

The trial court (Justice Herman Cahn of the Supreme Court, New York County) held that this established rule should not apply to shareholders of publicly-traded corporations such as Leucadia and, therefore, concluded that the plaintiff should not be estopped from maintaining its suit merely because it did not vote its shares against the subject transactions. The trial court determined that cases involving closely-held corporations were distinguishable because in a closely-held corporation the complaining shareholders have a significantly greater ability to influence policy than shareholders in a large, publicly-held corporation such as Leucadia. The trial court also determined that plaintiff was collaterally estopped as a matter of law from relitigating in state court the exact same challenge to the warrants which had been rejected by the Second Circuit in its ruling on the RICO claim and therefore dismissed the claim that the warrants had been improperly issued. The trial court further held that BCL ' 612 had not been violated because on its face it did not prohibit a partnership, as opposed to a subsidiary corporation, from voting shares it owned of the subject corporation. The court, however, held that the plaintiff had stated a claim for breach of fiduciary duty and corporate waste.

The Appellate Division, First Department, disagreed with the trial court on the question of shareholder estoppel and concluded that the plaintiff was estopped from maintaining its suit because it had "acquiesced" in the challenged transactions (citing Diamond v. Diamond, 307 N.Y. 263, 266, 120 N.E.2d 819, 820 (1954) and Winter v. Bernstein, 149 Misc. 2d 1017, 1020, 566 N.Y.S.2d 1012, 1014 (Sup. Ct. N.Y. Co.), aff'd in relevant part, 177 A.D.2d 452, 576 N.Y.S.2d 549 (1st Dep't 1991). In Winter, the court held that a "shareholder is estopped to challenge a corporate policy which he or she affirmatively approved, or of which the shareholder had knowledge but to which no objection was interposed." Winter, 149 Misc. 2d at 1020, 566 N.Y.S.2d at 1014. The Appellate Division also found that (1) BCL ' 612 did not prohibit TLC, a partnership, from voting its shares in favor of the merger because that section does not apply to partnerships, and (2) defendants' compliance with BCL ' 505 precluded the plaintiff's claims that defendants had committed conversion and corporate waste in issuing the warrants. On these bases, the Appellate Division modified the Supreme Court's judgment and dismissed the entire complaint.

The New York Court of Appeals granted leave to appeal and, in an opinion by Chief Judge Kaye, unanimously affirmed the order of the Appellate Division. The Court of Appeals held that the plaintiff's claims concerning the warrants were barred by collateral estoppel. The Court reasoned that since the Second Circuit's dismissal of the RICO claim necessarily determined the same issues raised by the corporate waste and breach of fiduciary duty claims (i.e., that the directors properly exercised their business judgment in authorizing the warrants), the state law claims were barred by collateral estoppel.

Although the Court did not resolve the question of whether shareholder estoppel applies to a shareholder who failed to vote against a challenged transaction, the Court discussed the issue at length. The Court acknowledged the defendants' contention that the plaintiff lacked standing and was estopped from challenging the merger agreement because the plaintiff failed to vote its shares against the merger. The defendants argued that irrespective of whether the company at issue is a widely-held public company or a privately-held company, a disgruntled shareholder should not be permitted to challenge a past corporate transaction where the shareholder had notice (and full disclosure) concerning the transaction and chose not to vote against it. Effectively agreeing with the trial court and disagreeing with the defendants, however, the Court of Appeals distinguished cases in which New York lower courts found estoppel because shareholders in closely-held corporations did not oppose the challenged actions, including Kranich, 209 A.D. at 54, 204 N.Y.S. at 322, and Winter, 149 Misc. 2d at 1020, 566 N.Y.S.2d at 1014. The Court reasoned that "[w]hile it might be reasonable to expect a shareholder in a close corporation to object affirmatively to an action before bringing suit, the dynamics are quite different in a publicly-traded corporation."

The Court also distinguished between the situation in which the shareholder voted in favor of the challenged transaction and the situation, as in this case, in which the shareholder abstained from the vote altogether. The Court noted that while "a shareholder in a publicly-held corporation who votes in favor of a merger - and thus participates in the challenged activity - might be deemed to have acquiesced to it (see Vierling v. West Chem. Prods., 143 A.D.2d 829, 830 [plaintiff who voted his shares in favor of merger estopped from bringing suit]; Kahn v. Household Acquisition Corp., 591 A.2d 166, 176-177 (Del. 1991) [same])," "that does not also mean that the shareholder who abstains from voting must be estopped from later bringing suit." The Court further stated that "[t]his is especially true where, as here, a predetermined number of affirmative votes are required to approve the merger, thus making abstention the equivalent of a negative vote (see, Pavlidis v. New England Patriots Football Club, 675 F. Supp. 696, 698-700 [D Mass] [shareholders who abstained not deemed to have acquiesced to merger where 'merger approval required the affirmative vote of a majority of each class entitled to vote'])."

Despite the fact that the Court did not finally decide the issue, New York's highest court seemingly has endorsed the distinction between closely-held corporations and publicly-held corporations where a shareholder is aware of, but does not vote against, a corporate transaction, and subsequently brings an action challenging the transaction. The Court, however, did not address the defendants' proposition that if a shareholder has notice of a corporate transaction, with full disclosure, and still chooses not to vote against it, that shareholder should be estopped from later challenging the transaction in court, regardless of whether the corporation was widely or closely-held. Compare Skeen v. Jo-Ann Stores, Inc., 1999 Del. Ch. LEXIS 193, at *10, 1999 WL 803974, at *3 (Del. Ch. Sept. 27, 1999) (in Delaware the rule is that "[o]nly fully informed shareholders waive their right to challenger a merger by tendering their shares and accepting the merger consideration"). Indeed, if the rationale for estoppel in the closely-held corporation context is that the shareholder has greater power to influence events, then why should not the rule apply to a shareholder of a publicly-held corporation who owns a significant percentage of the outstanding shares? The Court's opinion leaves this question unanswered.

Nonetheless, despite this lengthy analysis of the shareholder acquiescence issue, the Court did not definitely rule on the issue, finding that the merger was properly executed given that BCL ' 612(b) applies only to corporations and therefore the statute did not prevent TLC from tendering its shares in favor of the merger.

While the Court's views on shareholder estoppel will likely provide guidance to the lower courts of New York State and perhaps courts nationwide, the Court's decision will not end the debate over this important issue. Furthermore, the Court's decision to leave the issue unresolved leaves conflicting lower court decisions intact. Therefore, the future of shareholder ratification remains unknown and only time will tell whether the publicly-held/closely held corporation distinction will prevail as the guiding principle.