Legal Briefs: A Periodic Summary of Judicial Decisions Affecting Accounting and Financial Services Professionals
Amendments to New Jersey Statute Limit Shareholder Derivative Suits
On April 1, 2013, New Jersey’s provisions governing shareholder derivative proceedings were significantly revised in an effort to make the state more "business-friendly." The changes to the Business Corporation Act were made because the prior law placed few restrictions on shareholder derivative suits and offered little protection to corporations. For example, under the prior law shareholders at the time of an alleged wrong and their successors in interest could initiate an action without prior notice to the board of directors and without having any current share ownership. Thus, corporations and directors were at risk of being named in shareholder derivative suits without any real ability to evaluate the claims in advance and being exposed to suits from those with no real interest in the action. The new legislation has rectified this problem and established new requirements that should offer greater protections for corporations.
First, in order to have standing a derivative plaintiff must now satisfy three strict criteria: the plaintiff must have been a shareholder at the time of the alleged wrong; the plaintiff must remain a shareholder throughout the derivative action; and the plaintiff must fairly and adequately represent the interests of the corporation in enforcing the right of the corporation. The new amendments thus ensure that the plaintiff will have a direct interest in the proceeding at all relevant times and will be subject to potential exclusion in the event he or she is not deemed to be a fair and adequate representative.
Second, as a prerequisite to any derivative proceeding, a shareholder must make a written demand on the corporation to take action. Following the demand, a prospective plaintiff must then wait 90 days before filing a lawsuit unless the corporation rejects the demand sooner, or "unless irreparable injury to the corporation would result" by waiting. In the event that a corporation rejects a demand, a shareholder’s complaint must "allege with particularity facts establishing that a majority of the board of directors" that rejected the demand were not "independent directors." In order to surmount that hurdle, it should no longer be enough to allege generally that the board cannot reach a truly independent, objective decision. Instead, a shareholder must plead that specific directors have a material economic interest or a close relationship with a specific director or officer who, in turn, has a material interest in the outcome.
Third, if the board determines after considering the demand that the action is not in the best interests of the corporation, a court mustgrant a motion to dismiss the lawsuit. The board’s determination can be made by one of four groups: (1) a majority of independent directors, where such directors constitute a quorum; (2) a majority vote of independent directors or a single independent director, where such directors do not constitute a quorum; (3) a majority vote of the shareholders, not including shareholders with a material interest or under improper influence; or (4) a court appointed panel. In the event that such determination is made by less than a quorum of independent directors, the corporation will bear the burden of proving the derivative action is not in the corporation’s best interests. In any other case, the plaintiff will have the burden of rebutting the board’s determination. An added benefit to defendants is the presumption that all discovery is stayed pending the filing of a motion to dismiss. While such a motion is pending, a plaintiff may only take limited discovery if, after a motion and hearing, the court finds that there is evidence of lack of independence or good faith on the part of the person or group that made the determination.
Finally, the new amendments empower the court to award any defendant – whether the corporation, a director or officer – litigation costs and attorneys’ fees if the plaintiff is found to have commenced or maintained the action without exercising reasonable diligence, without reasonable cause, or for an improper purpose. In connection with that provision, a corporation may demand that a plaintiff post a bond to cover the corporation’s costs and attorneys’ fees unless the plaintiff (or group of plaintiffs) holds more than 5 percent of the outstanding shares, or the market value of such shares exceeds $250,000. This is a significant increase from the prior law (unchanged since 1968), which only required the value to be $25,000.
In sum, these revisions to the New Jersey Business Corporation Act should be a positive development for corporations in New Jersey. The new provisions create a number of safeguards against frivolous or improper derivative actions and empower the courts to short-circuit lawsuits deemed not to be in the best interests of a corporation with a minimum of time and expense.
Two District Courts Deny IRS Access To Taxpayer Documents Protected By Attorney-Client Privilege and Attorney Work Product Doctrine
Federal district courts in Minnesota and New Jersey recently sided with taxpayers who objected to disclosing sensitive documents to the IRS. The Minnesota decision dealt with tax accrual workpapers and the scope of the work product doctrine. Wells Fargo v. U.S., Civil No. 10-mc-57 (D. Minn., June 4, 2013). The New Jersey case involved attorney-client communications and work product relating to allegedly improper tax shelters. Kearney Partners Fund v. U.S., Civil Action No. 11-4075, April 22, 2013).
In Wells Fargo the IRS had issued summonses to the bank and its outside auditor, KPMG, for documents relating to the bank’s tax accrual workpapers (TAW). The TAWs incorporated documents discussing the uncertain tax positions (UTPs) that Well Fargo had identified in determining its required reserve for tax benefits that risked being disallowed by the IRS. Under FASB Interpretation Number 48 (FIN 48) that determination involved a two-step process — first, analyzing whether it was more likely than not that the claimed tax benefit would be sustained ("recognition") and, second, determining the appropriate reserve based on an evaluation of the potential settlement outcomes ("measurement"). Wells Fargo contended that the TAWs by their very nature included assessments about potential litigation and, hence, were shielded as attorney work product doctrine.
The district court took a middle position—compelling production of a narrow set of documents relating to the UTPs but denying the broader request for all TAWs. The court reasoned that the UTPs and related factual information was created in the ordinary course of business and not in anticipation of litigation. The court found that the UTPs had to be identified whenever the bank formulated transactions aimed at producing tax benefits. Moreover, Wells Fargo’s witnesses testified that the bank would not enter into any transaction unless it had a 70 percent or greater certainty that the tax benefits would be upheld. Thus, even if its attorneys were involved in these determinations, the UTPs were unlikely to meet the "in anticipation of litigation" requirement for work product. While at some point the bank’s evaluation of the UTPs shifted from ordinary business to "in anticipation of litigation," the court held that Wells Fargo had not met its burden of proof on that issue. The court also rejected the bank’s broader claim that every time Wells Fargo considered entering into a potentially controversial transaction, it could be deemed to have anticipated tax litigation.
Unlike the UTPs, the court expressed no doubt that the other TAWs were protected as work product. The "measurement" analysis required under FIN 48 reflected the legal analysis of Wells Fargo’s attorneys in preparation of litigation. The court also held that the disclosure of the TAWs to KPMG, the bank’s auditor, did not waive the protections because the bank had by agreement bound KPMG to honor the confidentially of those documents and because KPMG and the bank were not adverse parties. The court also found that eight other documents between the bank (including draft TAWs) constituted protected attorney-client communications.
In the Kearney Partners Fund case, the district court in New Jersey upheld a Magistrate Judge’s holding that 63 documents sought by the IRS were privileged as attorney-client communications and also protected as attorney work product. The IRS had sought the communications between the Rabner Allcorn law firm and its client, Sarma, to support the Service’s pending Florida lawsuit involving $77 million in capital losses that were alleged to have been generated from an abusive tax shelter called FOCus. Rabner Allcorn advised Sarma in connection with the investments at issue. In response to the IRS subpoena, the law firm produced thousands of documents but withheld 63 documents as privileged or protected by work product.
The Magistrate Judge conducted an in camera review and found that the attorney-client privilege applied because Rabner Allcorn was providing legal advice to Sarma about the transactions and the potential for litigation. He rejected the IRS’s claim that the privilege had been waived because Sarma had placed the advice of counsel at issue in the lawsuit because Sarma and his companies had certified they would not be relying on Rabner Allcorn’s advice in the Florida litigation. He also held that the government had not argued that the application of the privilege would deprive it of information vital to the tax shelter case and there was also no basis to rely on the crime-fraud exception to vitiate the privilege. Separately, the Magistrate Judge held that the documents were protected as work product because they were prepared in part to advise Sarma about the potential for litigation over the proposed investments, given their aggressive nature.
On appeal to the district judge, the IRS only challenged the ruling on the attorney-client privilege. That gave the district judge an easy way to resolve the case because, even if he accepted the government’s argument, the documents would still be protected under the work product rule. "Simply put, the Government has failed to even disagree with Judge Shipp’s work product ruling, let alone show that it was clearly erroneous or contrary to law."
The holdings of Wells Fargo and Kearney Partners show that courts are willing to protect taxpayer documents under the work product doctrine, even if those documents incorporate some level of business advice, as long as the dominant purpose of the documents was to discuss potential legal exposures.
Appraisal Performed Under LLC Operating Agreement Can Be Reviewed By Court for Factual and Procedural Flaws.
The New Jersey Appellate Division has recently held that a court may review the appraisal performed under an LLC operating agreement to determine the value of a departing member’s interest. Leach v. Princeton Surgiplex, LLC (June 6, 2013).
The unpublished decision overturned the trial court’s grant of summary judgment to the defendants. The lower court had reasoned that, because the operating agreement specified that an appraisal would determine the payment to a departing member, the court had no power to look behind the appraisal’s bottom line result. The rationale of Leach would appear to require courts to scrutinize similar appraisal results whenever disappointed members, shareholders or partners can assert that the appraiser did not follow proper methodology or failed to consider relevant information.
Leach was a member of Surgiplex who gave notice of withdrawal effective December 31, 2008. Under the LLC’s operating agreement, Surgiplex was regularly appraised by Physicians Business Advisors (PBA). Prior PBA appraisals determined Surgiplex’s fair market value to be $3,600,000 as of December 31, 2004 and $5,900,000 as of June 30, 2006. Pursuant to the operating agreement, to determine the value of Leach’s interest, a new appraisal had to be performed by PBA or another appraiser who shall be "a member of the American Society of Appraisers" with a designation of ‘Accredited Senior appraiser’ or have "national" or other acceptable experience "in appraising or valuing ambulatory surgery centers." Surgiplex retained 7/49 Solutions, LLC and its principal, David J. Shuffler, who had been affiliated with PBA and had done the prior two appraisals. Shuffler determined the fair market value of Surgiplex to be $2,325,000 as of June 30, 2008. Leach then filed a lawsuit against Surgiplex, two individual members, 7/49 and Shuffler alleging breach of contract, breach of fiduciary duty, breach of the covenant of good faith and fair dealing, fraud, conspiracy and negligent representation.
Leach contended that Shuffler had departed from the methodology he had employed in the two prior appraisals. Specifically, Shuffler had changed the way he computed EBITDA, using only the actual revenues for the last 12 months ending on December 31, 2007, rather than annualizing Surgiplex’s revenues from January 1, 2008 through September 30, 2008. Shuffler had also used a higher debt service coverage ratio (DSCR) without offering any explanation, even though the facts suggested that the DSCR figure should have been consistent with or lower than the one used in the prior appraisal. Nevertheless, the trial court granted summary judgment to the defense on the ground that the value of Leach’s interest was set by the appraisal required under the operating agreement, and the result could not be reviewed by the court.
The Appellate Division reversed and remanded, holding that the operating agreement appraisal provisions did not preclude judicial review of the appraisal. The appeals court reasoned that, "[i]t cannot be seriously argued that the appraiser is entitled to determine fair market value by spinning a wheel or flipping a coin, or that the appraiser may consider less than all relevant evidence, or that no party could question a mathematical error in the appraiser’s calculations." Slip op. at 7. The court found that the operating agreement contained an implicit requirement that the appraiser would utilize accepted standards and norms. Moreover, Leach had a legitimate expectation that the appraisal would be conducted in a manner consistent with the prior appraisals. The court thus concluded that it would be a breach of the covenant of good faith and fair dealing if the defendants had altered the methodology in an effort to produce a lower value. The appeals court found that, unlike an arbitration provision, in which judicial review was narrowly limited to bias, fraud or similar wrongdoing, the appraisal provision in the operating agreement could be reviewed for mistakes of law or fact. The Appellate Division remanded the case to the trial court for further development of the record on those issues.
Leach portends greater scrutiny by courts of appraisals rendered under agreements governing the rights of LLC members, shareholders and partners. It also suggests that more comprehensive and careful drafting of appraisal provisions may limit the scope of such review.
Madoff’s Victim’s Estate Not Entitled to Tax Refund on Alleged Worthless Asset
New Jersey’s Appellate Division has overturned a Tax Court decision and held that the estate of a Madoff victim who died in 2006 may not claim a tax refund for an alleged worthless IRA investment that came to light after Madoff’s Ponzi scheme was revealed in December 2008. Estate of Theodore Warshaw v. Director, Division of Taxation (A-884-12 (June 10, 2013).
In 2007, the Estate had paid $88,677 in estate taxes on the total estate, including the IRA, but it sought a refund of that amount after Madoff’s fraud came to light. After the State Division of Taxation denied the refund, the Estate filed a complaint in Tax Court, alleging that the purportedly worthless IRA reduced the value of the Estate below the New Jersey estate tax exemption threshold. The Tax Court considered the post-date of death circumstances relevant to the value of the IRA on the date of death and found that the Estate was entitled to a refund based on a mistake of fact about the investment assets.
The appeals court reversed, finding that the Tax Court judge had misapplied the law and made unsupported factual determinations. The Appellate Division held that there was no basis to question the date of death value of the IRA, concluding that there was no evidence to suggest that anyone had knowledge of Madoff’s Ponzi scheme in May 2006. Furthermore, the decedent had received over $600,000 in distributions from the IRA prior to his death and his wife had received over $275,000 in distributions in the 2007 and 2008 tax years. Thus, the factual record showed that the IRA had substantial value as of the date of death.
The Warshaw case is strong confirmation of the principle that an estate is to be valued at the death of the decedent based on only those facts that could reasonably have been known or were foreseeable at that time.