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October 29, 2018

Cooler Heads Often Prevail in Shareholder Disputes

Shareholder disputes in closely-held corporations can be fast-moving and they often escalate quickly. Because people’s livelihoods can be at stake in such disputes – and because family dynamics can play a part, figuratively if not literally – parties sometimes act on emotion or fall victim to their temper. As much as possible, they should strive to act in a way that is reasonable and level-headed should the matter proceed to trial, where a judge will be looking back at the parties’ actions with the benefit of hindsight.

These principles were on display in the case of Palumbo v Quercia, 2018 ONSC 5034, a recent decision of Justice Dunphy of the Ontario Superior Court of Justice, Commercial List. The case centred on a business known as Boothworks Inc., a trade show and event management company.

The Background

Boothworks was founded in 2008 by three partners: Mr. Palumbo, the applicant, and Mr. Quercia and Mr. Imhoff, the respondents. The partners agreed that their interests would be equal: each was made a director and officer of the company, each was an equal shareholder, each drew an equal salary and each made equal capital contributions to the company.

Over time, Boothworks’ revenue became overly dependent on just one of its clients, Spin Master, a company that became a client because of a previous business relationship between Mr. Palumbo and its principal. Spin Master grew to represent more than half of Boothworks’ revenue.  Despite this, the partners continued to take equal salaries from Boothworks.

A dispute eventually arose between the partners. There was conflicting evidence before the application judge as to what happened and who was to blame, but the court accepted that there was a deterioration of the relationship between the partners, caused (at least in part) by a combination of Mr. Palumbo’s frustration that his partners were not taking a bigger role in servicing Spin Master, and his partners’ concern that Mr. Palumbo was plotting to steal Spin Master and open a competing business.

The Respondents Execute a “Pre-Emptive Strike”

The dispute culminated with a confrontation between the partners. Mr. Quercia and Mr. Imhoff alleged that they had received an anonymous phone call informing them that Mr. Palumbo was planning to resign from Boothworks and take Spin Master’s business to a new, competing business. Mr. Palumbo says that he denied the accusation.

With the parties’ frustrations out in the open, the respondents decided to execute a “pre-emptive strike”. They convened the first-ever shareholders’ meeting of Boothworks (after nine years of operation), gave Mr. Palumbo one day’s notice of the meeting, and at the meeting purported to vote to remove Mr. Palumbo as a director, remove him as an officer, and impose terms of his future “employment” with Boothworks as an “Account Manager”.

Within five months, Mr. Palumbo was no longer employed at Boothworks. He opened his own corporation, and Spin Master chose to terminate its relationship with Boothworks and start doing its business with Mr. Palumbo’s new company.

The Court Finds that Mr. Palumbo had been Oppressed

There were duelling applications before Justice Dunphy. Mr. Palumbo sought an order requiring the respondents to purchase his shares in the corporation. His former partners sought damages, alleging that Mr. Palumbo had breached his fiduciary duty to Boothworks by stealing Spin Master’s business.

To say that Justice Dunphy was unsympathetic to Mr. Quercia and Mr. Imhoff would be an understatement. After summarizing the actions that led to kicking Mr. Palumbo out of the company and losing Spin Master’s business, Justice Dunphy wrote:

As a result of these events, more than 50% of Boothworks historic revenue and its dominant rain-maker were gone in the space of a few short weeks. A better example of catching more flies with honey than with vinegar would be hard to conceive of.

Justice Dunphy dismissed the application by Mr. Quercia and Mr. Imhoff and refused the invitation to find that Mr. Palumbo had breached his fiduciary obligations to Boothworks. He also granted Mr. Palumbo’s application, declaring that Mr. Quercia and Mr. Imhoff had acted in a manner that oppressed, unfairly prejudiced and unfairly disregarded Mr. Palumbo’s interests in Boothworks, and ordered them to purchase Mr. Palumbo’s shares in Boothworks at fair market value.

Some Key Findings are Applicable to Many Cases

In coming to his conclusion, Justice Dunphy made a number of findings that are relevant to other shareholder disputes:

  1. A Client Relationship is not an Asset of the Company

    Mr. Quercia and Mr. Imhoff argued that Spin Master was an asset of Boothworks that they were entitled to “defend”.

    Justice Dunphy found that Spin Master’s business was based on a relationship, and that that relationship was personal to Mr. Palumbo. He placed reliance on the fact that it stemmed from a business contact that Mr. Palumbo had cultivated before Boothworks had been founded. He also noted that Boothworks never took steps to develop the internal capacity to replace that relationship should Mr. Palumbo leave. He summarized his thinking in the following paragraphs:

    Spin Master was not an asset of Boothworks that could be lost. It was an opportunity that had to be earned every day on a project-by-project basis. Boothworks lost the capacity to earn further business when it forced out the key person in whom Spin Master had confidence without a back-up plan. Mr. Palumbo was not the property of Boothworks and it was Mr. Palumbo that Boothworks lost, not Spin Master. Absent Mr. Palumbo, Boothworks simply could not credibly compete for Spin Master’s business and it lacked the skills to earn Spin Master’s business.

    The loss of the relationship with Spin Master following Mr. Palumbo’s departure was always an inevitability and fully understood as such by the respondents, a fact that renders their actions to hasten that event instead of seeking to avoid it all the more baffling.

    This reasoning is persuasive. It is also aided greatly by the measured and responsible approach that Mr. Palumbo took to the deterioration of his business. Mr. Palumbo did not tell Spin Master to take its business away from Boothworks or solicit its business to his new company. In fact, he did not even tell Spin Master that he was being forced out of Boothworks – it was Mr. Quercia and Mr. Imhoff who ultimately broke that news to their biggest client. Mr. Palumbo was professional to the end, ensuring that Spin Master’s requirements were met, staying on at Boothworks even after being forced out as a director, to finish the projects for Spin Master that Boothworks had outstanding.

    If Mr. Palumbo had taken a different approach, and had tried to sabotage the relationship between Boothworks and Spin Master, or tried to actively solicit its work away from Boothworks, the result may have been very different.

  2. Former Directors Can Compete with the Corporation in Certain Circumstances

    The respondents argued that Mr. Palumbo had breached his fiduciary duties to Boothworks by taking the business of Spin Master for his new corporation. Justice Dunphy acknowledged that a fiduciary’s duties to the corporation continue following his departure and that soliciting business from former clients may constitute a breach of a fiduciary duty. However, in the circumstances of the case before him, he found that no such breach existed.

    Justice Dunphy noted that absent a non-competition agreement or similar restriction, a fiduciary may use his or her own skills and experience and compete with the corporation post-departure, providing it is not done unfairly. He also found that the restrictions on soliciting clients of the corporation vary with the circumstances of each case. In this case, because of Mr. Palumbo’s ouster from the corporation and his previous relationship with Spin Master, Justice Dunphy found that no breach of fiduciary obligation had occurred.

  3. Compliance with By-Laws does not End the Analysis of Reasonable Expectations

The test for oppression is grounded in establishing that the applicant’s reasonable expectations have been frustrated by the respondents. In this case, the respondents argued that they called a shareholder meeting and voted to remove Mr. Palumbo as a director and officer in accordance with Boothworks’ by-laws, and they therefore could not have violated Mr. Palumbo’s reasonable expectations.

Justice Dunphy was not persuaded by that argument. He noted that past practice of the company displayed little knowledge of or compliance with the by-laws of the corporation, and that there had never been a formal shareholder meeting called over the previous nine years. While acknowledging that this state of affairs is not unusual for small, closely-held corporations, Justice Dunphy reasoned that the directors’ past practice established the parties’ reasonable expectations, notwithstanding the wording of the corporation’s by-laws, and that by that standard, Mr. Palumbo’s reasonable expectations had been frustrated.

The Aggressive Approach was the Wrong Approach

The litigation can be fairly characterized as an unmitigated disaster for the respondents. They lost over half of their business and their rainmaker partner, were ordered to buy their partner’s shares, and (assumedly) paid substantial legal fees, with exposure to an adverse costs award in their near-future.

While their legal strategy is open to criticism, perhaps it is also helpful to consider what they could have done differently before litigation was commenced. It is not surprising that they were concerned that their business was becoming overly dependent upon just one client, who happened to have a strong relationship with their partner.

The situation calls for a delicate touch. Negotiating or renegotiating a unanimous shareholders agreement may be appropriate in certain circumstances. Frank discussions about the direction of the company or relative contributions from partners are never easy conversations, but companies are often better off for having them.

In cases where litigation seems probable – or perhaps inevitable – it is often a good strategy to play nice, or to put it in Justice Dunphy’s vernacular, to set traps of honey rather than vinegar. If nothing else, a shareholder can set him or herself up to be the reasonable one in the judge’s eyes, which is more than half the battle in any oppression remedy application.

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