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COSA Clarifies Shenker Exception

In its 2009 decision in Shenker v. Laureate Educ., Inc., 411 Md. 317, the Court of Appeals of Maryland inserted a caveat in the premise that shareholder lawsuits against corporate directors must be pursued as a derivative action on behalf of the corporation itself. By declaring that a corporation’s impending sale gave rise to common-law duties by directors that could be enforced directly by shareholders, the high court outlined an exception that risked swallowing the rule. Last month, however, the Court of Special Appeals gave a more thorough explanation about when Shenker applies – and, as to be expected, it’s not as broad as disgruntled shareholders might hope.

In Sutton v. FedFirst Fin. Corp., Ct. of Spec. App., Sept. Term 2014 (Oct. 29, 2015), the planned stock-for-stock merger of FedFirst Financial Corporation and CB Financial Services, Inc., upset FedFirst shareholder Larry Sutton, who brought direct claims against the company’s individual directors alleging that, in effecting the merger, they breached their fiduciary duties to the shareholders by undervaluing the company and giving themselves exclusive benefits. (He also sued the two companies for allegedly aiding and abetting the directors’ breach of those duties.) The defendants moved to dismiss the lawsuit, arguing, among other things, that Sutton was barred from bringing a direct action against FedFirst. Sutton responded by invoking the Shenker exception, but the trial court wasn’t convinced and tossed the case out.

Reviewing the dismissal, the Court of Special Appeals started with the baseline premise that, because directors’ fiduciary duties are to the company and not the shareholders, lawsuits by shareholders alleging mismanagement generally have to be brought as derivative actions on behalf of the company, even if that mismanagement has the effect of decreasing the value of stock. A lawsuit by an individual stockholder is appropriate, however, when a duty owed directly to him is violated and he suffers a distinct personal injury independent of harm to the company itself. As the Court also recognized, in the six years since Shenker, there’s been another category of permissible stockholder lawsuits.

In Shenker, a corporation was directly sued by individual shareholders after it was purchased in a cash-out merger (that is, when a merger is structured so that one company pays cash for the other’s stock). The Court of Appeals rejected the corporation’s argument that the lawsuit was barred as an improper direct action, holding that directors have certain common-law duties to shareholders – including candor and maximization of stock value – that “may be triggered by the occurrence of appropriate events,” such as the impending sale of the company. The question for the Court of Special Appeals in Sutton, therefore, was whether the merger at issue was one of those “appropriate events.”

The Court first rejected the argument that Shenker only applied to cash-out mergers, finding that “the principles set forth were not limited to that specific scenario” and interpreting the case to pertain to an impending sale or “change of control” of a company. FedFirst wasn’t being sold, the Court noted, so the only way the Shenker exception would be relevant was if control of the company was changing. Unfortunately, Shenker did not explain what constitutes a “change of control” that would enable direct shareholder lawsuits, so the Court did what most courts would do and looked to Delaware law.

In Delaware, corporate directors effecting stock-for-stock mergers have duties to shareholders when the stock they receive would be subject to control by a colluding or individually owned majority; in those circumstances, Delaware courts have held, there are “real consequences to the financial value” of the stock and “[t]he law offers some protection to such shares[.]” Fiduciary duties to the shareholders do not attach, however, when control of the merged entity remains “in a large, fluid, public market” and is owned by a “fluid aggregation of unaffiliated voters.” In such a case, the Court of Special Appeals was persuaded, there is no change of control. As such, because Sutton involved a stock-for-stock transaction in which the combined corporation “continued to remain in a large, fluid, public market” and FedFirst’s shareholders had a continuing interest and participation in the company, the Court of Special Appeals found no change of control and upheld the dismissal.

After Sutton, direct shareholder lawsuits against corporate directors are authorized in Maryland in three circumstances: (1) when the shareholder has individual, particular rights that have been violated leading to distinct, personal injury; (2) when fiduciary duties to the shareholders have been violated after initiation of the sale of the company; or (3) when fiduciary duties to the shareholders have been violated in a merger that will subject their stock to control by an individually owned or colluding majority. Otherwise, a derivative action is the shareholder’s only litigation option. It’s a sensible compromise that recognizes that the directors’ duties are typically to the company itself – but reasons that, when the company is going to be sold or taken over, those duties should revert to the existing shareholders.

At Silverman Thompson Slutkin & White, LLC, we have defended and prosecuted shareholder matters in Maryland and elsewhere. To discuss the matters in this article, please contact the chair of the Firm’s business litigation group, Bill Sinclair, at, or the author of this article, Chris Mincher, at, or call us at (410) 385-2225.

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