Fraud & Fundamental Unfairness: A Lesson for Majority Shareholders
As a majority shareholder and/or a corporate fiduciary, you have the responsibility to ensure that all transactions undertaken by your company are completed with the company’s best interests in mind, which includes the company as an entity as well as its shareholders. When it came time to execute sound judgment on behalf of their company, FLOORgraphics, Inc., the majority shareholders failed to act in the company’s best interests and engaged in a corporate takeover, which resulted in self-dealing and numerous breaches of their fiduciary duties.
Until mid-2009, FLOORgraphics, Inc. (“FGI”) was an advertising and marketing company that specialized in floor advertisements in supermarkets and other shopping areas. By 2001, FGI’s revenues rose to roughly $50 million per year, peaking in 2004 at $70 million. At about the same time, News America Marketing In-Store Services, Inc. (“News America”) became a fierce competitor of FGI by luring away FGI customer accounts as well as FGI personnel. Through various efforts, it became clear that News America would undertake any and all measures to destroy FGI’s business. In 2004, FGI initiated litigation against News America for various business torts (“FGI Litigation”).
The FGI Litigation carried on for the better part of five years before FGI initiated discussions with News America in the effort to settle the case. A trial date was set for March 9, 2009 but on March 6, 2009, a price of $29.5 million was agreed upon as a settlement offer, which News American would pay to essential buy-out FGI.
Richard Rebh (“Rebh”) the CEO of FGI as well as a majority shareholder testified that he accepted the settlement offer as being in the best interests of the shareholders. Further, Rebh believed FGI’s chances of success at trial were very low.
Fred Potok (“Plaintiff”), the founder of FGI and a minority shareholder at the time of settlement instituted a derivative claim against Rebh and the other majority shareholders alleging breaches of numerous business torts for the acceptance of News America’s settlement offer.
The Plaintiff argued that the transaction between FGI and News America was fundamentally unfair, thereby placing the transaction beyond the limited bounds of Pennsylvania’s Business Corporation Law (“BCL”). Pennsylvania has recognized that where “fraud or fundamental unfairness” exists, the exclusivity of the remedy available under the BCL is waived. The Plaintiff argued that the transaction was fundamentally unfair because although the $29.5 million price tag was agreeable, only $13 million was assigned to FGI retailer contracts while the remaining $16.5 million was allocated to Rebh and the other defendants for signing non-compete agreements and for their “personal goodwill.”
The court found that the evidence clearly established that there was fundamental unfairness in the transaction as “each of the defendants was personally interested in the negotiation, structure, and approval of the transaction in which a majority of the allocated funds would be paid to them personally.”
The court further found that Rebh and the other defendants’ decision to allocate $16.5 million of the transaction funds to themselves personally was agreed to and accepted by News America who had “absolutely no ‘mission’ to protect minority shareholders.”
Furthermore, the court found that the “Notice of Adoption of Plan” (“Shareholder Notice”), which was sent to shareholders upon the agreement between FGI and News America omitted numerous materials facts, which made the information disclosed misleading and the transaction as a whole fundamentally unfair.
Finally, the court dealt with the fiduciary duties of the majority shareholders, directors, and officers. The court stated that majority shareholders hold the fiduciary duty of fair dealing, which requires the majority shareholders not to use their power “in such a way as to exclude the minority from their proper share of the benefits accruing from the enterprise.” This does not mean majority shareholders cannot act in their own interest as long as acting in their own interest is also in the best interest of all shareholders as well as the corporate entity itself.
The court also stated that the fiduciary duties of care and loyalty are imposed upon officers and directors of corporate entities, which included Rebh and the other defendants here. In order to determine whether these fiduciary duties were carried out by the defendants, the court applied the “entire fairness test,” which is used in self-dealing transactions to determine whether the controlling shareholders were entirely fair to the minority shareholders.
The entire fairness test has two parts: fair dealing and fair price. Fair dealing looks to the timing of the transaction, how it was initiated, structured, negotiated, etc. while fair price relates to the economic and financial considerations of the transaction. The court concluded that the transaction failed the entire fairness test because: (1) the settlement occurred during high-pressured litigation where the court refused to suspend the trial while the parties attempted to settle (lack of fair dealing); and (2) that the price of the transaction, $29.5 million, although reasonable at first glance, was fundamentally unfair as $16.5 million of it was allocated to the defendants personally (lack of fair price).
As a result, a verdict for the Plaintiff was entered in the amount of $12 million.
 Potok v. Rebh, 2014 Phila. Ct. Com. Pl. LEXIS 318 (Pa. C.P. 2014).
 Id. at 12.
 Id. at 20.
 15 Pa.C.S.A. § 1105.
 Potok v. Rebh, 2014 Phila. Ct. Com. Pl. LEXIS at 43.
 Id. at 45.
 Id. at 49.
 Id. at 50. The Plaintiff argued that the Shareholder Notice did not: (1) disclose that the case between FGI and News America was settled; (2) provide a copy of the Mutual Release agreed upon; (3) include copies of the goodwill and non-compete agreements; and (4) disclose the basis upon which the defendants claimed entitled to payments based upon personal goodwill.
 Id. at 53 citing Ferber v. Am. Lamp Corp., 503 Pa. 489 (Pa. 1983).
 Id. at 54.
 Id. at 56.
 Id. at 56-57 citing Americas Mining Corp. v. Theriault, 51 A.3d 1213, 1239 (Del. 2012).