Last month the Virginia Supreme Court issued two significant opinions relating to the judicial dissolution of partnerships and closely held corporations. Both cases addressed issues of first impression. The opinion addressing the corporate issues also considered the propriety of a shareholder not only seeking a judicial dissolution but also pursuing a derivative suit under Va. Code
§ 13.1-672.1 at the same time.
Russell Realty Associates v. C. Edward Russell, Jr.
involved the standard for judicial dissolution of general partnerships under § 50-73.117(5) of the Virginia Uniform Partnership Act. Here are the facts. In 1978, Charles E. Russell, Sr. created an irrevocable trust dividing his estate into two separate trust shares, one for the benefit of his son, Eddie, and the other for the benefit of his daughter, Nina, and her children. The partnership was created to fund the trust. Its purpose was to acquire, hold, invest in, lease and sell investment properties. As Charles Russell withdrew from the partnership his son took over its active management. After Charles’ death the management of the partnership and the trust became acrimonious, specifically as to the future of the partnership and trust distributions. Those disagreements prevented the sale of certain partnership assets. The two partners and their counsel unsuccessfully tried to resolve the issues for years. Over that period, Nina began to insert herself in the management and operations of the partnership to a significant degree.
Ultimately, Eddie filed suit seeking a judicial dissolution of the partnership. He alleged (1) serious and irreconcilable conflicts with his sister and her son; and (2) that those conflicts had frustrated the partnership’s economic purpose and made management of its assets and affairs not reasonably practicable. Nina responded seeking an accounting and alleging that Eddie had violated his fiduciary duties. She also sought aid, guidance and a declaration regarding her son’s rights to distributions from the trust as well as Eddie’s removal as co-trustee. After trial, the Court found in Eddie’s favor and granted dissolution of the partnership. Nina appealed.
The sole issue on appeal was whether Eddie met the strict standards for judicial dissolution of a partnership under the Virginia Code
. The Code
provides, inter alia, that a court may dissolve a partnership where “(a) the economic purpose of the partnership is likely to be unreasonably frustrated; (b) another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business and partnership with that partner; or (c) it is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement.” Va. Code
§ 50-73.117(5). A court may dissolve a partnership where it finds that any of those three conditions have been satisfied.
the trial court granted dissolution based upon (a) and (c) above, the economic purpose and business operations tests, respectively. Because the Supreme Court had never addressed the legal standard for dissolution in the partnership context, it adopted the test applicable to dissolution actions that involve limited liability companies. See The Dunbar Group, LLC v. Tignor
, 267 Va. 361, 593 S.E.2d 216 (2004).
On appeal, Nina argued that dissolution under the economic purpose prong of the statute required a showing of “truly poor financial performance” and that the trial court’s conclusion that the partnership was not run as a “model of business efficiency” was insufficient justification for dissolution of a profitable business. The Court rejected Nina’s argument noting: “[T]he purpose of the change [in the Revised Uniform Partnership Act] was to allow continuation of a partnership that was not financially profitable based on an inquiry into the partners’ expectations in determining the economic purpose of the partnership.” It concluded that a partnership need not be a financial failure to support a judicial dissolution under the economic purpose prong of the statute.
the Supreme Court found evidence in the record that: (1) the relationship between the siblings frustrated the ability of the partnership to take advantage of economically favorable offers to sell certain properties; (2) the “disruptive relationship between the partners had resulted in the partnership incurring substantial added costs” including the need for attorney intervention to facilitate communications and decision making; and (3) despite the provisions of the Partnership Agreement that vested decision-making authority in Eddie, the parties’ relationship imposed unnecessary economic costs “preventing the partnership from taking advantage of and conducting its business in a timely and efficient manner.” According to the Supreme Court those facts were sufficient to satisfy the economic purpose test and warrant the judicial dissolution ordered by the trial court.
The second suit, Cattano v. Bragg
, involved a tempest between the only two partners/shareholders in a law firm structured as a corporation. Among other complaints, after discovering that checks had been written on the firm’s escrow/trust account to Cattano’s wife and children, Bragg sought inspection of all corporate records. Cattano responded by firing Bragg and attempting to remove her as director at a special meeting of the shareholders.
Bragg filed suit seeking a judicial dissolution and an accounting and division of assets. She later amended the Complaint adding derivative claims against Cattano for breach of fiduciary duty and conversion.
The Circuit Court appointed a Receiver and directed that the Receiver perform a complete accounting of the books and records of the firm.
At trial, the jury found in Bragg’s favor on the derivative conversion count and awarded the firm $234,412.18. It also awarded Bragg monetary damages for breach of contract and judicial dissolution. It did not find in Bragg’s favor, however, on the claim for breach of fiduciary duty. In a separate trial the Circuit Court awarded Bragg $269,813.00 in attorneys’ fees, plus costs and expenses of $19,415.71, finding that the conversion claim had “yielded a substantial benefit to the corporation.”
Cattano appealed raising a number of corporate issues.
First, Cattano objected that Bragg did not have standing under Va. Code § 13.1-672.1(A) to bring the derivative claim on the basis that she did not “fairly and adequately represent the interests of the corporation in enforcing the right of the corporation.” Noting that in Virginia there is no exception to the rule that actions for injuries to a corporation must be brought derivatively rather than directly by a shareholder, the court found that a single shareholder could pursue a derivative claim on behalf of the corporation. Because it had never addressed the standard to apply in determining whether a plaintiff fairly and adequately represented the interests of the corporation in a corporate derivative claim, the Court adopted the factors it had used in Jennings v. Kay Jennings Family Limited Partnership, 275 Va. 594, 659 S.E.2d 283 (2008) which it borrowed from Davis v. Co-Med, Inc., 619 F.2d 588, 593-94 (6th Cir. 1980). Those factors are:
“ (1) economic antagonisms between the representative and members of the class;
(2) the remedy sought by the plaintiff in the derivative action;
(3) indications that the named plaintiff is not the driving force behind the litigation;
(4) plaintiff’s unfamiliarity with the litigation;
(5) other litigation pending between the plaintiff and defendant;
(6) the relative magnitude of plaintiff’s personal interests as compared to his interests in the derivative action itself;
(7) plaintiff’s vindictiveness toward the defendant; and
(8) the degree of support plaintiff is receiving from the shareholders he purports to represent.”
, 659 S.E.2d at 288
The Court noted that these factors “are not exclusive and must be considered in the totality of circumstances found in each case.” (quoting Jennings
, 659 S.E.2d at 288.)
Significantly, the Cattano
"While the present case contains economic antagonism as well as apparent animosity between the firm’s only two shareholders, we do not find this to be a determinative factor when evaluating a closely held corporation; nor do we find it determinative that the sole other shareholder does not support the derivative suit. To so hold would be to enact a de facto bar on derivative suits in two shareholder corporations. . . . In closely held corporations, we must look beyond the mere presence of economic and emotional conflict, placing more emphasis on whether the totality of the circumstances suggest that the plaintiff will vigorously pursue the suit and that the remedy sought is in the interest of the corporation."
Applying the appropriate factors, the Supreme Court held that Bragg fairly represented the interests of the corporation in that she sought a return of funds that had been misappropriated by an officer. Such a claim was highly appropriate for a derivative action. Given that she would be entitled a portion of the funds returned to the corporation suggested that her interests were aligned with the corporation and she would vigorously pursue the claim.
Second, Cattano argued that Bragg was pursuing her own interest given the possibility of an award of attorneys’ fees and costs, whereas with pure judicial dissolution no such fee shifting mechanism was available. The Court rejected the argument finding that, because the fee shifting mechanism in the context of a derivative claim was a deliberate policy choice on the part of the General Assembly, the claim should not be barred.
Third, Cattano asserted that Bragg could not act in the firm’s interest in pursing a derivative claim at the same time she was seeking to dissolve the corporation. That argument, too, was unpersuasive. Instead, the Court held that, not only was it in the interest of the corporation to have the misappropriated funds returned, but “judicial dissolution is a remedial mechanism that exists in addition to, rather than as a substitute for, shareholder’s rights.” It is not a per se bar to a derivative claim.
Finally, the court examined the appropriateness of awarding attorneys’ fees to Bragg as a result of her prevailing on the derivative claim. Va. Code § 13.1-672.5(1) provides that: on termination of a derivative proceeding, the court shall: (1) order the corporation to pay the plaintiff’s reasonable expenses (including counsel fees) incurred in the proceeding if it finds that the proceeding has resulted in a substantial benefit to the corporation. . .” Prior to this opinion, no Virginia court had interpreted that provision of the Code. Because there was no Virginia precedent as to the standard to be applied, the Court borrowed from the United State Supreme Court’s decision in Mills v. Electric Auto-Lite Company
, 396 U.S. 375 (1970) where that Court held:
"[A] substantial benefit must be something more than technical in its consequence and be one that accomplishes a result which corrects or prevents an abuse which would be prejudicial to the rights and interests of the corporation or affect the enjoyment or protection of an essential right to the stockholder’s interest."
, 396 U.S. at 396. In Cattano
, the Court found, as did the Circuit Court, that the recovery of over $234,000 of misappropriated funds was a substantial benefit to the firm.
These opinions are welcomed additions to the limited case law in Virginia addressing judicial dissolution and derivative actions. In particular, they suggest that both partners and 50% shareholders in closely held corporations have significant remedies they can use to protect against abuses by other owners. They should serve as cautionary tales.
A noncompete entered into as part of a settlement agreement to end litigation between an employer and former employee receives more latitude than a traditional noncompete signed before or during the employment period.
In a recent case
, Plaintiff McClain & Co. Inc. sued a former employee for breach of an agreement not to compete that was included in a post-employment settlement and release contract to which the two parties agreed.
McClain accused the former employee of misappropriating $285,793 of McClain’s funds while he was an employee by submitting false payroll records for employee services that the employees did not actually perform. The parties then entered into a Settlement Release and Agreement a few months after the former employee was no longer employed by McClain where McClain released him from claims relating to his supposed misconduct in exchange for a payment of $250,000, and his compliance with a noncompete restrictive covenant, among other things.
The covenant provides:
The former employee agrees that for a period of thirty (30) months immediately following the Termination Date . . . , he shall not provide perform or undertake any Competing Services anywhere in the territory . . . (ii) instruct, hire, engage, or contract with any other person or entity to provide, perform, or undertake any Competing Services anywhere in the Territory; and (iii) own . . . , serve as director, officer or manager of, or control . . . any entity or business that provides, performs or undertake Competing Services anywhere in the Territory.
McClain accused the former employee of establishing a competing business, MPT, just six days after signing the settlement agreement. As a result, McClain sued for breach of contract against the former employee for violation of the non-competition covenant in the contract as well as conversion and tortious interference with contract.
The former employee moved to dismiss on the ground of failure to state a claim for which relief can be granted because the noncompete is unenforceable as a matter of law. His motion was denied as to the breach of contract and conversion counts.
The court decided that McClain’s allegation that the former employee established a business on a certain date that competed with McClain’s business is sufficiently specific and factual in nature to pass muster under Federal Rule of Civil Procedure 8. The court also held that the phrase “upon information and belief” can be used when the factual basis supporting a pleading is only available to the defendant at the time of the pleading.
The former employee’s other attack on the breach of contract is a claim that the non-competition clause is unenforceable. “In considering the enforceability of restraints on trade, Virginia courts focus on the reasonableness of the restraint because the law looks with favor upon the making of contracts between competent parties upon valid consideration and for lawful purposes and therefore courts are averse to holding contracts unenforceable on the ground of public policy.” Opinion at 7 (internal citations omitted).
The court held that agreements not to compete in the employer/employee context as part of an employment contract are subject to more careful scrutiny. The test is whether the contract is narrowly drawn to protect the employer’s legitimate business interest, and is not unduly burdensome on the employee’s ability to earn a living, and is not against public policy. Id., quoting Omniplex World Servs. Corp. v. U.S. Investigations Servs., 270 Va. 246, 249 (2005).
The court noted that a noncompete like the one in this case which is part of a post-employment agreement has yet to be reviewed in Virginia. The court stated that greater latitude is allowed in determining a convenant’s reasonableness when it’s a covenant not to compete between a vendor and buyer than when it’s related to an employment contract.
Restraints are given more leeway for being acceptable when the noncompete is between a buyer and seller than between an employer and employee because “employees often have comparatively little bargaining power and less leverage for negotiating a fair deal, while the sale of a business more typically involves sophisticated parties coming to an agreement after an arms-length negotiation process.” Op. at 9, citing Centennial Broad., LLC v. Burns, 2006 U.S. Dist. LEXIS 70974, at *27-29 (W.D. Va. Sept. 29, 2006). “Restrictions on an employee’s means of procuring a livelihood for himself and his family” are more likely to threaten public policy interests than restrictions on a seller . . . .” Op. at 9, citing Centennial Broad., 2006 U.S. Dist. LEXIS 70974, at *28-29. The court noted that this same reasoning applies with the noncompete is between partners in a professional firm. Op. at 9.
In the instant case, the court held refused to hold the noncompete to the more restrictive standard applicable in employment cases because the former employee was not an employee when it was made and it was negotiated at arm’s length while the former employee was represented by counsel. There was consideration for both parties and it was not a “take it or leave it” situation where the former employee was concerned with securing a job. The court concluded that bargaining power was more equally distributed and reasonable in general. Therefore the noncompete was sufficiently circumscribed to survive the former employee’s facial attack on a motion to dismiss.
As we begin to see more categorization of noncompete agreements, Virginia courts are giving wider discretion to noncompetes in business sales and settlement agreements than to traditional noncompetes in employer/employment agreements. This raises the question whether a different standard may be applied to even more potential categories of noncompetition agreements.