California Court of Appeals, First District, Fifth Division
ANN M. MORRICAL, Individually and as Trustee, etc., Plaintiff and Respondent,
JESSE ROGERS et al., Defendants and Appellants.
Superior Court of the County of San Mateo, No. CIV 513558, Barbara J. Mallach, Judge.
Ropes & Gray, Rocky Chiu-Feng Tsai, Michelle L. Visser, Howard S. Glazer, Douglas H. Hallward-Driemeier, Robert G. Jones; Gibson, Dunn & Crutcher, Daniel M. Kolkey, Thad A. Davis, Michael Li-Ming Wong, Enrique A. Monagas, Kyle A. Withers and Jenna Musselman Yott for Defendants and Appellants.
Reed Smith, Paul D. Fogel, Raymond A. Cardozo, Dennis P. Maio; Long & Levit, Joseph P. McMonigle, John B. Sullivan, Glen R. Olson; Cohen & Jacobson, Lawrence A. Jacobson and Sean M. Jacobson for Plaintiff and Respondent.
Siblings Michael (Mike) McGraw, John McGraw and Ann Morrical are co-equal shareholders of a group of family corporations. Disputes between the siblings over the management of these corporations led to conflicts and litigation. Mike and John (collectively the Brothers) then entered into a series of transactions with an outside management company and, over the objection of their sister, voted to restructure the corporate boards of directors, granting effective corporate control to the management company. Ann filed suit to challenge the election of new directors pursuant to Corporations Code section 709,  arguing that the Brothers had a material financial interest in the transactions between the corporations and management company, and that the transactions were unfair to the family corporations and to her as a minority shareholder. The trial court agreed, setting aside the election of new directors and invalidating several of the underlying corporate transactions.
The primary issue presented in this appeal is whether an action brought under section 709, which allows the court to determine the validity of an election of corporate directors, may be based on an alleged breach of fiduciary duty or more specifically a violation of section 310, which governs corporate transactions with companies in which one or more corporate directors have a material financial interest. After reviewing the plain text of the statute, its statutory context, its legislative history, and the case law interpreting the statute, we conclude that section 709 permits a corporate electoral challenge on such grounds.
We also conclude, however, that the trial court erred in failing to require that the Brothers be joined in this action as indispensable parties. We therefore do not address the merits of the judgment entered, but reverse and remand for further proceedings.
From the 1970’s to the early 1990’s, Jack McGraw, the father of Mike, John and Ann, built the McGraw Group of Affiliated Companies (McGraw Group), companies that originally specialized in the sale of motorcycle and watercraft insurance and later expanded to other lines of insurance. The McGraw Group is comprised of three principal companies: McGraw Company (McGraw), which is the managing agent that sells the insurance and retains a share of premiums; Western Service Contract Corporation (Western), which sells service contracts (essentially extended warranties) to the insureds; and Pacific Specialty Insurance Company (Pacific), the actual insurer and a wholly owned subsidiary of Western. We refer to two entities, McGraw and Western, collectively as the Companies.
Jack and his wife, Joan, eventually transferred ownership in the Companies to their three children, Ann, John and Mike (collectively the Siblings). The Siblings were the sole and equal shareholders of the Companies. Under a “Buy and Sell Agreement, ” each of the Siblings had a right of first refusal to purchase any other Sibling’s Western shares at a discounted price before the shares could be sold to any third party. Section 7 of the agreement gave Jack and Joan a preemptive right to buy all of the Siblings’ Western shares at an even greater discount before the Siblings could sell all of their Western shares to a third party.
The Companies apparently have been successful. Between 1993 and 2011, each sibling received approximately $53.8 million in dividends and distributions from the Companies and, since about 2005, each sibling’s monthly distribution has been approximately $385, 000. Nevertheless, the Siblings have been in conflict for many years over management of the Companies.
A. 2009 Removal of Mike as Chief Executive Officer and Adoption of Phantom Stock Plans
In the mid-1990’s, Mike took over as chief executive officer of the Companies. In about 2005, Mike moved to Southern California and became less involved in daily operations, which were left to the Companies’ long-term management team: Tim Summers, Brian McSweeney, David Sacks, and six others. Sacks (then chief financial officer) resigned in 2009, complaining that Mike was misusing corporate funds for personal expenses. At the request of Ann and John, an audit was conducted, which in Ann’s view showed there was substantial abuse of corporate funds by Mike for personal use. Jack and Joan attempted to negotiate a resolution of the Siblings’ dispute and threatened to assign or sell their preemptive rights under section 7 of the Buy and Sell Agreement in order to pressure the Siblings to come to an agreement.
In November 2009, Ann and John voted to remove Mike as president and chief executive officer of the Companies, and to remove Jack and two other directors from the Pacific board. Subsequently, McSweeney was appointed president of McGraw and Western, Summers was appointed president of Pacific, and Sacks was rehired as vice president of corporate risk and finance.
In February 2010, McGraw adopted phantom stock plans (PSP’s) for nine of the Companies’ managers (including McSweeney, Summers and Sacks),  which gave the managers immediately-vesting equity interests in the Companies payable upon a change in control, and which were designed as a retention and incentive tool. In the meantime, Jack and Joan sold Mike their preemptive rights under section 7 of the Buy and Sell Agreement for $400, 000 (Section 7 Assignment). Litigation ensued.
B. The Altamont Transactions
Defendant Altamont Capital Management, LLP (Altamont Management) is affiliated with Altamont Capital Partners, which is represented to be a private equity firm with $500 million in capital that focuses on investing in middle-market businesses that have not reached their full potential. Defendants Jesse Rogers and Keoni Schwartz were cofounders and managing directors of Altamont Capital Partners, and defendant Gene Becker was an operating partner. Rogers had personal connections with Mike. Becker had personal connections to Mike and Jack, and had served as a Pacific director until he was removed along with Jack in November 2009.
In August 2011, Altamont Management proposed an investment relationship with the Companies that would involve the purchase of one or more of the Siblings’ shares in the Companies. At about the same time, Altamont Capital Partners proposed a purchase of Mike’s shares with investment funds it managed. In December, the Brothers discussed a sale of Mike’s shares in the Companies to John that would be financed by Mike and an Altamont entity, with that entity receiving an interest in the appreciation of certain stock. All of these deals fell through.
On February 28, 2012, the Brothers noticed a joint special board meeting for McGraw and Western to consider amendments to the Companies’ articles of incorporation and bylaws, adoption of management and director indemnification agreements, appointment of officers, and (as to Western only) purchase of Mike’s Section 7 Assignment rights. John sent Ann copies of the proposed board actions, as well as copies of agreements between the Brothers and affiliated Altamont entities (collectively the Altamount Transactions). The Altamont Transactions, consist more specifically of the following:
1. Expansion of the Companies’ Boards
a. Amendments to Bylaws and Articles of Incorporation
The Brothers agreed to amend the bylaws and articles of incorporation of the Companies to increase the size of each board to eight directors and to adopt certain “shareholder protections.” The protections required approval by holders of a majority of a Companies’ stock before the Companies or its subsidiary could take certain actions, such as issuing new stock, incurring indebtedness greater than $25 million, or authorizing a merger or a sale of 40 percent or more of company assets outside of the McGraw Group.
b. Voting Agreement
Under a voting agreement, the Brothers agreed to vote their shares “to ensure that Altamont [Management] shall be entitled to designate five candidates to be elected as members of the Board of Directors of [the Companies]” and to maintain the size of each board at eight directors.
c. Indemnification Agreements
Indemnification agreements would be adopted for all directors.
2. Management Agreement
Under a management agreement, Altamont Management would provide McGraw, Western, and Pacific with management, consulting, financial and other advisory services for a fee of $500, 000 a year. Altamont Management promised to “devote such time and efforts to the performance of services contemplated hereby as [Altamont Management] deems necessary or appropriate.” The agreement allowed Altamont Management and its affiliates to directly or indirectly engage in competing businesses and to withhold potential business opportunities from the McGraw Group and pursue those opportunities for its own or for other companies’ benefit.
3. Payments to and by the Brothers
a. Loans by Altamont California
Altamont California Investment LLC (Altamont California) would loan $4 million and $2 million to Mike and John respectively. The Brothers would sign nonrecourse promissory notes promising to repay these amounts with interest by March 13, 2019, and would pledge McGraw stock as collateral for the notes.
b. Cash Settled Stock Option Agreements (CSSOA’s)
Mike and John would give Altamont California cash-settled stock option rights in exchange for payments of almost $2 million and $1 million respectively. Under these agreements, Altamont California would recover a percentage of the difference between the fair market value and the stated “exercise price” for certain shares of Western and McGraw owned by the Brothers. The exercise price was based on a valuation in excess of $300 million for the companies. The option rights ...