Shareholders in close corporations often overlook or ignore the importance of creating formal governing documents and maintaining accurate corporate records. The recent New Jersey decision in Liu v. Liu, (App. Div. Dec. 23, 2009), a dispute over which parties controlled a close corporation, shows why shareholders should pay attention to those requirements.
The parties in Liu were shareholders of Star Pacific Corporation, a New Jersey close corporation that imported and exported rugs, carpets and sundries. Frank Liu and Chang Liu formed the corporation in 2001, and as the corporation grew, Frank and Chang brought in two additional shareholders and expanded Star Pacific’s operations to Florida and California. The corporation issued stock certificates but never adopted a shareholder agreement or formally recorded stock transfers, shareholder interests or the identity of the corporation’s officers.
In late 2005, Frank left Chang in control while he travelled to China to visit Star Pacific’s suppliers. Frank intended to return from China after a few weeks but was detained when a supplier filed suit against the corporation. Cash flow problems prevented Star Pacific from satisfying the debt and Frank was forced to stay in China for nearly 10 months before his wife raised sufficient funds to pay the claim. Chang called a special shareholders’ meeting while Frank was still in China, but the meeting was delayed until October 18, 2006, until Frank could attend. At the meeting, Chang introduced a new investor who, on the strength of a forged stock certificate, was represented to be an original shareholder of the corporation. Over the objections of Frank and the other shareholders, Chang and his new “shareholder” seized majority control of the corporation. The next day, Chang presented Star Pacific’s banks with a “Certificate of Resolution” that purported to remove Frank as an officer of the corporation. On the basis of that document, the banks removed Frank as a signatory on the corporation’s accounts.
Frank and the other two shareholders promptly filed suit against Chang for violations of his fiduciary duties and the wrongful takeover of the corporation. Despite the lawsuit, Chang continued to take actions on behalf of the corporation and, among other things, attempted to exert control over the California warehouse, disposed of the entire New Jersey inventory valued at $700,000, incorporated a competing enterprise and used Star Pacific assets to fund that new enterprise.
After sorting out the conflicting testimony from the shareholders as to the validity and size of their interests, the court determined that Chang had staged a “coup of the company” that was “propped up with forged documents” for his personal financial gain. In a scathing opinion, the trial court permanently removed Chang as an officer of Star Pacific and awarded plaintiffs compensatory and punitive damages. On appeal, Chang argued that he could not be personally liable for punitive damages and disputed the compensatory damages award. The Appellate Division affirmed in part but sent the case back to the trial court because the record of the ownership interests was so unclear.
he Appellate Division had no problem with the trial court’s finding of liability against Chang, reasoning that the principle of shareholder immunity for the liabilities of the corporation did not apply when corporate principals engage in fraud. The appeals court agreed that Chang had breached his fiduciary duties by fabricating documents and the existence of a new shareholder, then fraudulently assuming control of the corporation and diverting corporate resources for his personal use.
But the Appellate Division had to remand the compensatory damages award back to the trial court because the corporate documents did not support the award. Because the shareholders never had a shareholder agreement and did not maintain adequate books and records, the trial court could only award damages based on the testimony. The absence of formal documentation in the corporation’s books and records contributed to the trial court’s misstatement of the amount of Frank’s initial investment and its failure to account for the fact that one of the original shareholders had transferred half of her interest in a divorce proceeding. In addition, no clear documentation existed to support the inclusion in the damage award of an amount to compensate Frank for a loan he had made to the corporation.
lthough the aggrieved shareholders prevailed, their failure to adhere to corporate formalities allowed a rogue shareholder to assume control of the corporation and its assets. The lack of documentation also made it more difficult to prove their shareholder status, which then depended on the court’s assessment of the credibility of the testimony of witnesses at trial. Shareholders in any corporation, closely held or otherwise, are best advised to insist on compliance with corporate formalities and detailed and updated records, particularly of stock transfers and shareholder interests.