Opinion
Civil Action No. 97-3139 (NHP).
January 26, 1999
Thomas H. Bruinooge, Esq., BRUINOOGE ASSOCIATES, Rutherford, N.J., Attorneys for Plaintiff.
Michael B. Himmel, Esq., Christopher S. Porrino, Esq., GREENBAUM, ROWE, SMITH, RAVIN, DAVIS HIMMEL, LLP, Woodbridge, N.J., Attorneys for Defendant, Sills, Cummis, Zuckerman, Radin, Tischman, Epstein Gross, P.C.
Robert J. Fettweis, Esq., ROTH FETTWEIS, LLC, Newark, N.J., Attorneys for Defendants, Rita Jean Kiefer, Estate of Kurt L. Kiefer.
LETTER OPINION ORIGINAL ON FILE WITH CLERK OF THE COURT
Dear Counsel:
This matter comes before the Court on three separate motions, namely: (1) defendant Sills Cummis Zuckerman Radin Tischman Epstein Gross' motion for summary judgment; (2) defendants Rita Jean Kiefer and the Estate of Kurt L. Kiefer's motion for summary judgment dismissing the First Amended Complaint; and (3) plaintiff Walter F. Kiefer's motion to stay all proceedings pending arbitration and to compel arbitration. This Court heard oral argument on October 13, 1998. For the reasons set forth more particularly herein, defendant Sills Cummis Zuckerman Radin Tischman Epstein Gross' motion for summary judgment is GRANTED. Furthermore, defendants Rita Jean Kiefer and the Estate of Kurt L. Kiefer's motion for summary judgment dismissing the First Amended Complaint is GRANTED. Finally, plaintiff Walter F. Kiefer's motion to stay all proceedings pending arbitration and to compel arbitration is DENIED. Accordingly, plaintiff Walter F. Kiefer's Complaint is DISMISSED WITH PREJUDICE.
STATEMENT OF FACTS
Plaintiff Walter F. Kiefer ("Walter") and defendant, Kurt Kiefer ("Kurt") (now deceased), were brothers and equal co-owners of Smith Equipment Company, Inc. ("Smith"), a subchapter "S" corporation. See Affidavit of Michael B. Himmel, Exhibit A, Amended Complaint at ¶¶ 7, 8. Defendant Rita Jean Kiefer ("Rita"), Smith's bookkeeper, was married to Kurt Kiefer. See id. at ¶ 9; see also Plaintiff's Statement of Uncontested Material Facts, ¶ 4.
In 1993, Walter and Kurt were charged with three counts of income tax evasion. Defendant Sills Cummis Zuckerman Radin Tischman Epstein Gross ("Sills") was the law firm retained to represent both Walter and Kurt, individually, in connection with the IRS proceeding. See id. at ¶ 18. Subsequently, both Walter and Kurt pled guilty to Count Three of the indictment and were sentenced to a two-year term of probation. See id., Exhibit B at ¶ 3.
As a result of that plea, the Internal Revenue Service ("IRS") assessed each officer 50% of the disallowed tax deduction since each man was a 50% shareholder in the corporation, pursuant to the Internal Revenue Code. The disallowed deductions arose from actions taken between 1988 and 1990. See Affidavit of Michael B. Himmel, Exhibit A, Amended Complaint at ¶ 24.
Upon conclusion of the criminal action, Walter filed the within action naming as defendants Kurt Kiefer, Rita Jean Kiefer, Sills Cummis Zuckerman Radin Tischman Epstein Gross, and the company's accountants, Broza Block Rubino. In Counts One through Six of plaintiff's Amended Complaint, plaintiff alleges that: (1) Sills violated its professional duty to avoid a conflict of interest in its representation of Walter; (2) Sills breached that duty by committing legal malpractice; (3) Sills violated the Rules of Professional Conduct; (4) Sills' representation constituted negligent misrepresentation; (5) Sills' conduct constituted a breach of an oral, express or implied contract as well as a breach of the implied covenant of good faith and fair dealing; and (6) Sills' negligently and/or wilfully concealed corporate records.
In Count Eight, plaintiff alleges that, during the years 1988, 1990, 1991, 1992, 1993 and 1994, Kurt breached the Shareholders Agreement and various contemporaneous oral agreements with Walter by paying himself "Excess Income" and intentionally concealing from Walter such payments and the documents which would have revealed same.
In Counts Nine through Twelve, plaintiff alleges that both Rita, in her capacity as bookkeeper, and Kurt breached a fiduciary duty when they wrongfully converted monies into personal use and made false representations with regard to the financial records of Smith.
In December 1997, this Court granted defendant Broza Block Rubino's Motion to Dismiss the Amended Complaint based upon § 1366 of the Internal Revenue Code. See December 17, 1997 Letter Opinion.
DISCUSSION
I. Standard for Summary Judgment
The standard governing a summary judgment motion is set forth in Fed.R.Civ.P. 56(c), which provides, in pertinent part, that:
[t]he judgment sought shall be rendered forthwith if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law.
Fed.R.Civ.P. 56(c). A fact is material if it might affect the outcome of the suit under the governing substantive law. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 255 (1986).
Procedurally, the movant has the initial burden of identifying evidence that it believes shows an absence of genuine issues of material fact.Celotex Corp. v. Catrett, 477 U.S. 317, 324 (1986). When the movant will bear the burden of proof at trial, the movant's burden can be discharged by showing that there is an absence of evidence to support the non-movant's case. Id. at 325. If the movant establishes the absence of a genuine issue of material fact, the burden shifts to the non-movant to do more than "simply show that there is some metaphysical doubt as to material facts." Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 586 (1986).
In this matter, there are no genuine issues of material fact and therefore, summary judgment is appropriate.
II. Direct v. Derivative Recovery
A derivative action is one brought on behalf of the shareholders of a corporation to enforce a corporate cause of action against officers, directors or third parties. Papilsky v. Berndt, 466 F.2d 251, 255 (2d Cir. 1972). It is the responsibility of the corporate directors to determine whether or not to pursue different causes of action available to the corporation. Galef v. Alexander, 615 F.2d 51, 57 (2d Cir. 1980). A direct action is one brought by an individual shareholder of a corporation seeking to recover damages resulting from personal wrongs.Glenn v. Hoteltron Systems, Inc., et al., 74 N.Y.2d 386, 392, 547 N.E.2d 71, 74, 547 N.Y.S.2d 816, 819 (1989). In order to determine whether a plaintiff's Complaint states a direct or a derivative cause of action, courts examine "the nature of the wrongs alleged in the body of the complaint, not the plaintiff's designation or stated intention."Strasenburgh v. Straubmuller, 146 N.J. 527 (1996).
New York law provides that a shareholder generally has no individual cause of action for wrongs committed against a corporation even though a shareholder loses value in his or her investment or, worse, incurs personal liability in an effort to maintain the solvency of a corporation. Abrams v. Donati, 66 N.Y.2d 951, 953 489 N.E.2d 751, 498 N.Y.S.2d 782, 783 (1985). Accord Davis v. Magavern, II, 237 A.D.2d 902, 654 N.Y.S.2d 517 (1997); Elenson v. Wax, 215 A.D.2d 429, 626 N.Y.S.2d 531 (1995). This rule of law applies with equal force to an individual person closely affiliated with a corporation (i.e., a sole shareholder, a principal shareholder, or even a 50% shareholder) who has been incidentally damaged by an injury to the corporation. New Castle Siding Company, Inc. v. Wolfson, 97 A.D.2d 501, 502, 468 N.Y.S.2d 20, 21 (1983), aff'd, 63 N.Y.2d 782, 470 N.E.2d 868, 481 N.Y.S.2d 70 (1984);see also Schaeffer v. Lipton, 243 A.D. 969, 970, 663 N.Y.S.2d 392, 393 (1997) (holding that a 95% shareholder of closely held subchapter "S" corporation lacked standing to bring an individual/direct action for legal malpractice); Jones v. Niagara Frontier Transportation Authority, 836 F.2d 731, 736 (2d Cir. 1987), cert. denied, 488 U.S. 825 (1988) (opining that even a sole shareholder does not have standing to assert claims alleging wrongs to a corporation); Outen v. Mical, 118 N.C. App. 263, 267, 454 S.E.2d 883, 886 (1995) (holding that damages awarded in favor of plaintiff, a 50% shareholder of a subchapter "S" corporation for misappropriation of funds was error; damages should have been awarded in favor of corporation).
In addition to the fact that Smith is a New York corporation, the relevant shareholder agreement provides a New York choice of law provision. See Affidavit of Walter F. Kiefer at Exhibit B, ¶ 17. Thus, this Court will conduct the analysis pursuant to New York case law.
New Jersey courts are also in accord with this rule of law. See egs . , Strasenburgh v. Strabmuller, III , 146 N.J. 527, 550 (1996); Pepe v. General Motors Acceptance Corp . , 254 N.J. Super. 662, 666 (N.J.Super.Ct. App. Div.), certif . denied , 130 N.J. 11 (1992); 68th Street Apts., Inc. v. Lauricella , 142 N.J. Super. 546, 557 (N.J.Super.Ct. Law Div. 1976), aff'd , 150 N.J. Super. 47 (N.J.Super.Ct. App. Div. 1977); Kauffman v. Dreyfus Fund, Inc . , 434 F.2d 727, 732 (3d Cir. 1970), cert . denied , 401 U.S. 974 (1971); Pullman-Peabody Co. v. Joy Mfg. Co . , 662 F. Supp. 32, 35 (D.N.J. 1986).
See also Kaplan v. First Options of Chicago, Inc ., 143 F.3d 807, 812 (3d Cir. 1998).
An exception to the well-recognized rule that a shareholder must bring a derivative action against the wrongdoer, as opposed to a direct action, is where evidence has been produced that the wrongdoer has breached a duty owed to the shareholder "independent" of any duty owing to the corporation. Abrams, 66 N.Y.2d at 951, 953 N.E.2d at 752, 498 N.Y.S.2d at 783 (1985) (emphasis added); see also Elenson v. Wax, 215 A.D.2d 429, 626 N.Y.S.2d 531, 532 (1995). For example, a direct action has been permitted in a situation where corporate directors caused the corporation to offer a shareholder an inadequate price for his share of stock and when the shareholder refused to sell, the corporate directors redistributed his shares among the directors without compensating the shareholder. See Tornick v. Dinex Furniture Industries, Inc., 148 A.D.2d 602, 603, 539 N.Y.S.2d 68, 69 (1989).
Mere allegations of mismanagement or diversion of corporate assets by officers or directors "to their own enrichment," without more, does not warrant a shareholder bringing an individual action. Abrams , 66 N.Y.2d at 951, 953 N.E.2d at 752, 498 N.Y.S.2d at 783 (1985).
Delaware courts, which are often faced with these issues, have attempted to explain this exception more clearly. See In re Ionsphere Clubs, Inc. v. Sobchack, et al . , 17 F.3d 600, 605 (2d Cir. 1994) (articulating that "[t]he distinction between derivative and direct claims turns primarily on whether the breach of duty is to the corporation or to the shareholder(s) and whether it is the corporation or the shareholder(s) that should appropriately receive relief.").
However, "[t]he fruits of a diverted corporate opportunity are [considered] . . . a corporate asset. Awarding that asset directly to a shareholder could impair the rights of creditors whose claims may be superior to that of the innocent shareholder." Glenn v. Hoteltron Systems, Inc., et al., 74 N.Y.2d 386, 547 N.E.2d 71, 547 N.Y.S.2d 816 (1989). Accord Paradiso DiMenna, 232 A.D.2d 257, 258, 649 N.Y.S.2d 126, 127 (1996) (articulating that the conversion of funds from a corporate account results in a corporate injury and not an individual because it deprived the corporation the use of those funds); Bingham v. Zolt, 66 F.3d 553, 561 (2d Cir. 1995), cert. denied, 517 U.S. 1134 (1996); Maki v. Estate of Ziehm, 55 A.D.2d 454, 455, 391 N.Y.S.2d 705, 706 (1977);Kleban v. S.Y.S. Restaurant Management, Inc., 929 F. Supp. 294, 304 (N.D.Ill. 1996) (citing Borgsmiller v. Burroughs, 187 Ill. App.3d 1, 134 Ill. Dec. 774, 779, 542 N.E.2d 1281, 1286 (5th Dist. 1989)); Pickett v. Paine, 230 Ga. 786, 790, 199 S.E.2d 223, 227 (1973).
In Glenn, a case factually similar to the matter at bar, a fifty-percent shareholder of a closely held corporation brought suit against the other fifty-percent shareholder alleging diversion of corporate assets for personal profit. Glenn, 74 N Y2d at 392, 547 N.E.2d at 74, 547 N.Y.S.2d at 819. The New York Court of Appeals reasoned that the innocent shareholder was injured "only to the extent that he was entitled to share in those profits. His injury was real, but it was derivative, not direct." Id. Accordingly, the Glenn Court held that the diversion of corporate assets by a shareholder for his own personal profit results in a corporate injury to shareholders rather than an individual injury. Glenn v. Hoteltron Systems, Inc., 74 N.Y.2d 386, 547 N.Y.S.2d 816, 547 N.E.2d 71 (1989).
It is worth noting that the Glenn case, while distinguishable, is not as strong as the present matter in that, unlike the plaintiff shareholder in Glenn who was an innocent victim, Walter Kiefer was also convicted in connection with the diversion of corporate assets in the underlying criminal action.
In this matter, Walter first claims that he is entitled to initiate this direct action against the various defendants and recover for the diversion of "Excess Income" by Kurt because he and Kurt entered into a shareholders' agreement which is, in Walter's opinion, "extrinsic" and "independent" of the corporation.
Walter defines the term "Excess Income" as "income and/or compensation and/or perquisites from Smith and Megapak [received by Kurt which was] substantially in excess of the income, compensation or perquisites received from Smith and Megapak by Walter." See Affidavit of Michael B. Himmel, Exhibit A, ¶ 11.
The fact that the arrangement between Walter and Kurt is pursuant to a shareholders' agreement, however, is inapposite and does not transform Walter's claim for diversion of corporate funds into a "personal" one. The express terms of the shareholders' agreement simply do not give Walter any rights independent or extrinsic to the corporation. When this Court looks to the nature of the wrongs alleged in the body of the complaint and the relevant case law providing that the Excess Income alleged to have been siphoned by Kurt is a corporate asset rather than a "personal" asset, it is clear that Walter's cause of action against Kurt is clearly derivative. Accordingly, any claims which Walter may have had against Kurt and his estate for the diversion of corporate funds should have been brought in a derivative action.
Walter alternatively argues that even if his claims are indeed derivative in nature, the Sills firm's liability to Walter for negligence is not "cut-off" because "Sills never informed Walter of its conflict in the case, and has irretrievably prejudiced Walter's ability to recover his loss derivatively from Kurt." See Plaintiff's Brief in Opposition to Motion for Summary Judgment. Walter further buttresses this argument by contending that "[h]ad Walter acted upon that advice, he would have had the opportunity to bring a derivative claim before he sided with Kurt in pleading guilty to avoiding taxes for income he never actually received."
This Court rejects these arguments. First, it is highly unlikely that Walter, as a 50% shareholder in Smith, would have brought a derivative action simply because Walter has admitted, by virtue of his guilty plea in the underlying criminal action, to siphoning money out of the corporation. Thus, Walter would have had to name himself, as well as Kurt, as a defendant in that action since he too was taking money out of the corporation. This is truly an unlikely scenario given the fact that the IRS was conducting an investigation at the point in time in which the Sills firm became involved and allegedly dispensed "negligent" advise. Any actions taken by Walter at that time could have proven more fatal to Walter's situation. Moreover, assuming that the claim was brought derivatively and damages were awarded, the damages would have been awarded to the corporation and not directly to Walter as discussedsupra. Second, since Walter, as a 50% shareholder in Smith, was clearly subject to the terms of the Internal Revenue Code which provided that he was liable for 50% of the tax liability, Sills' advise would not have affected the end result: Walter's responsibility for 50% of the liability for the same activity. Accordingly, Walter's belief that he would have been given the opportunity to accept less than his allocated amount of tax liability is wholly misplaced. Thus, the Sills firm could not be held negligent.
See Ono v. Itoyama , 884 F. Supp. 892, 899 (D.N.J. 1995), aff'd , 79 F.3d 1138 (3d Cir. 1996).
Ironically, Walter argues that "[f]raud may also ground individual liability against a corporate wrongdoer under New York's `reason to expect standard.'" See Plaintiff's Opposition Brief, page 16; see also Powers v. Ostreicher, 824 F. Supp. 372, 378 (S.D.N.Y. 1993). However, Walter's reliance upon the Powers case is not entirely accurate. InPowers, the Court expressly opined that "an existing corporate shareholder does not have standing to bring an individual fraud action" for the diminution in value of the stock or for the loss of the shareholder's investment in the company. Id. at 378. Since Walter seeks to recoup the value of his investment by claiming that he is entitled to recover the value of the "Excess Income" taken by Kurt, the Powers case is not applicable. More significantly, this Court will not entertain Walter's equitable argument and allow Walter to recoup the "ill gotten gains" of his brother when, in fact, Walter was convicted for the same activity.
Accordingly, Walter's claims against Sills, Rita, and Kurt's estate should be dismissed.
III. The Effect of Internal Revenue Code § 1366
Even assuming arguendo that Walter could bring this direct action, Walter's claim against Sills is further barred by the statutory terms of the Internal Revenue Code.
The Internal Revenue Code provides that shareholders of a subchapter "S" corporation are responsible for their pro rata share, based upon a percentage of ownership, of the corporation's tax liability. Specifically,
(a) Determination of shareholder's tax liability —
(1) In general — In determining the tax under this chapter of a shareholder for the shareholder's taxable year in which the taxable year of the S corporation ends (or for the final taxable year of a shareholder who dies, or of a trust or estate which terminates, before the end of the corporation's taxable year), there shall be taken into account the shareholder's pro rata share of the corporation's —
(A) items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and . . .
(c) Gross income of a shareholder —
In any case where it is necessary to determine the gross income of a shareholder for purposes of this title, such gross income shall include the shareholder's pro rata share of the gross income of the corporation.
In this matter, Walter contends that the Sills firm "sacrificed its objectivity and breached ethics when it undertook the representation of both Kurt and Walter, whose interests were clearly adverse at the time the representation began." However, Smith was an "S" corporation and, therefore, each brother was responsible for 50% of the tax liability, as determined by the Internal Revenue Code. Sills, as legal counsel for Walter and Kurt, could not change the allocation of responsibility for the improper deductions made by each brother. Since the Internal Revenue Code clearly provides that each brother is 50% responsible for the monies owed, both brothers were required by law to each accept 50% of the responsibility. As this Court has opined in the past, "[w]hether Walter or Kurt siphoned more is irrelevant." See December 19, 1997 Letter Opinion.
III. Arbitration
Relying upon a contractual provision in the shareholders' agreement, Walter contends that the entire matter should be submitted to arbitration. The relevant provision of the most recent shareholders' agreement provides:
16. Any dispute arising out of or relating to this agreement or breach thereof, shall be settled by arbitration in the City of New York in accordance with the rules then obtaining of the American Bar Association, and judgment upon award rendered by the arbitrator may be entered by any party, in any Court having jurisdiction thereof.See Affidavit of Walter F. Kiefer, Exhibit B, ¶ 16.
Despite the judiciary's policy of favoring arbitration, it is a basic proposition of law that a party cannot be compelled to arbitrate a dispute when that party has not agreed, either by express words or conduct, to arbitrate a dispute. First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938, 944-45 (1995). In this matter, neither Sills nor Rita Kiefer agreed either by express terms of a contract or by conduct to arbitrate any dispute between the parties. The shareholders' agreement, upon which Walter relies, is an agreement only between Kurt and Walter. Since neither Rita nor Sills is willing to arbitrate this matter, and there is no agreement indicating otherwise, this Court will not require Sills and Rita to attend arbitration.
This is, of course, assuming arguendo that Walter's claims are arbitrable under the shareholders' agreement.
Moreover, it is also a well-settled principle of law that a party who files a Complaint, and pursues litigation thereafter, in lieu of attempting to arbitrate a matter is assumed to have waived whatever right there was to arbitration. See De Sapio v. Kohlmeyer, 35 N.Y.2d 402, 405, 321 N.E.2d 770, 772, 362 N.Y.S.2d 843, 846 (1974). In determining whether there has been a waiver, there are certain factors to be considered by the court such as the amount of litigation (typically the exchange of pleadings and discovery), the time elapsed from the commencement of the litigation to the request for arbitration, and the proof of prejudice. Advest, Inc. v. Wachtel, 677 N.Y.S.2d 549, 551 (1998); Leadertex, Inc. v. Morganton Dyeing Finishing Corp., 67 F.3d 20, 25 (2d Cir. 1995).
In this matter, Walter filed the Original Complaint on June 20, 1997. The present motions were filed on August 3, 1998. Throughout that period of time, Walter did not attempt to arbitrate this matter. Walter sat idly by and continued to participate in the discovery process while Magistrate Judge Hedges entered several pretrial orders. In fact, the joint discovery plan entered into between the parties on November 18, 1997 provided:
12. Matter [is] not appropriate for arbitration because (1) plaintiff seeks money damages substantially in excess of $100,000; (2) plaintiff seeks equitable relief (constructive trust); and (3) plaintiff wants a jury trial of al issues so triable. Parties have not agreed to arbitrate.See Affidavit of Michael B. Himmel in Opposition to Plaintiff's Motion to Arbitrate, Exhibit D, ¶ 12.
The record also indicates that Sills, Rita and Kurt's estate have expended substantial resources in defending this action. See e.g., Declaration of Rita Jean Kiefer, ¶ 3. It is this Court's opinion that Walter has had a significant period of time in which to indicate to the parties that he wanted to go to arbitration instead of pursuing this action in federal court. At this point, all parties would be sufficiently prejudiced by the amount of time which has passed if this Court were to order that the parties must proceed in arbitration.
CONCLUSION
For the foregoing reasons, defendant Sills Cummis Zuckerman Radin Tischman Epstein Gross' motion for summary judgment is GRANTED. Furthermore, defendants Rita Jean Kiefer and the Estate of Kurt L. Kiefer's motion for summary judgment dismissing the First Amended Complaint is GRANTED. Finally, plaintiff Walter F. Kiefer's motion to stay all proceedings pending arbitration and to compel arbitration is DENIED. Accordingly, plaintiff Walter F. Kiefer's Complaint is DISMISSED WITH PREJUDICE.
An appropriate Order accompanies this Letter Opinion.