We would like to introduce Mack Sperling, a NC business litigation lawyer, who will appear here regularly as a guest blogger on NC startup litigation issues.

The owners of a new business start out with the highest of expectations and the best of intentions.  They divide ownership, allocate responsibilities, and strive shoulder to shoulder for success.  But the road is littered with companies that deteriorated into discord and dissent.

Those situations often land in litigation, like the case of Vernon v. Cuomo, decided by the North Carolina Business Court on March 17th.  The shareholders in Vernon had split into warring camps.  The majority fired the minority, stripped them of their positions as members of the Board of Directors, and then took steps to dilute their ownership interest in the Company.

Although the ousted shareholders didn’t get their jobs back, they did win a significant legal victory: the reinstatement of their ownership positions and the right to be bought out at fair value.

The Company And The Dispute

The case involved TriboFilm Research, Inc., a research and development startup.  The Court described the Company as “the prototypical research and development company in which the owners contributed their time and individual expertise in the hope of producing a breakthrough commercial technology that could be licensed or sold for a large profit.”   TriboFilm, formed by researchers associated with North Carolina State University, was working on the development of technology aimed at the elimination of silicone as a lubricant in syringes.

Things went well after the formation of the company in 1997.  It obtained significant research grants, including several from the National Institutes of Health, obtained two patents, had licensing prospects for its technology, and things looked promising.

But in 2005, in-fighting began.  The shareholders split into two camps.  The eventual Plaintiffs, Vernon and Williams, held about 40% of the stock. The Defendants were five other stockholders controlling the remaining 60%: Cuomo, Sakhrani, Tomasino, Chiklis, and Mineo.

Things got vicious.  Williams accused Sakhrani of taking confidential documents from Williams’ briefcase.  Sakhrani refused to return the documents, and Williams sued him in a separate lawsuit.  Vernon and Sakhrani had a separate spat about Sakhrani’s compensation.  Vernon and Williams refused to sign non-compete agreements which other shareholders signed. Vernon blasted Sakhrani in a performance evaluation.  Vernon went to the university where Cuomo had gotten his doctorate and accused him of plagiarizing his thesis and took other action which the Court called unjustifiable and spiteful. Williams tried to obtain the Company’s trademarks in his own name.  The Court summed up the situation as “intolerable.”

The Majority Fires The Minority Shareholders And Dilutes Their Ownership

The Defendants called a meeting of the Company’s Board of Directors and fired Vernon and Williams.  Then the Defendants held a shareholder vote and removed Vernon and Williams as directors, effectively eliminating any entire connection to TriboFilm other than their stock ownership.  The Defendants then offered to buy the Plaintiffs’ shares, for a penny apiece.  The Plaintiffs refused.

Wanting the Plaintiffs completely disassociated from the Company, the Defendants then took steps to nearly eliminate the Plaintiffs’ ownership interest.  The Defendants voted themselves big salaries (which the Company couldn’t afford to pay), agreed to defer the salaries, and then arranged to exchange the deferred salaries for additional stock in the Company.  The end result was that the Plaintiffs ownership interest was diluted down from 20.2% each to an anemic 2.4%

Vernon and Williams sued, claiming that they had been wrongfully terminated and that their ownership interests had been improperly diluted.  They asserted that their “reasonable expectations” as shareholders included the right to continued employment and the right to continued ownership of the same percentage of stock.  (North Carolina law prevents majority shareholders from depriving minority shareholders of their “reasonable expectations” in the corporation under a North Carolina Supreme Court decision known as Meiselman).

The Court’s Ruling

Did the Plaintiffs have a reasonable expectation of continued employment?  The Court said no.  It determined that their forced departure was appropriate, given “the dysfunctional status of the Company.”  It held:

While shareholders may hold reasonable expectations as a result of their ownership of a small, closely held company, those expectations may be subverted to the overall business interest of the company or may become unsustainable under certain circumstances. . . . [T]he relationships among the shareholders became dysfunctional.  . . .The Company could not operate and fulfill its function. There was no communication or cooperation among the small group of researchers who were required to work closely together. A company is not required to fulfill once-reasonable expectations of continued employment where that employment may be detrimental to the ongoing survival of the business. Something had to be done to keep the Company alive and functioning.

The reasonable expectations of the Plaintiffs regarding their continued stock ownership were different.   The Court observed that while startup companies “often have to issue new stock to angel investors,” Vernon and Williams “had reasonable expectations that their ownership percentage in TriboFilm in relation to the Individual Defendants’ ownership percentage would not be changed without their consent,” at least not “purely to benefit other shareholders.”

The Court ordered Vernon and Williams to be restored to their original ownership position.  It also ordered that the Company should be dissolved, giving the Company the opportunity to buy out the Plaintiffs at “fair value.”  The Company took that option, which will involve a process by which the shares of the Plaintiffs are valued.

Although the considerations of “reasonable expectations” may be unique to North Carolina, most states recognize a claim by a minority shareholder for oppression by the majority.

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About Mack Sperling

Mack Sperling is a business litigation lawyer with Brooks Pierce LLP, an 80 lawyer firm with offices in Greensboro and Raleigh, North Carolina.  Mack frequently litigates cases involving disputes among members of closely held business, and he writes about business litigation issues on his blog, the North Carolina Business Litigation Report.

A different version of this post is also available on Mack’s blog, the North Carolina Business Litigation Report.