The Appellate Division’s recent decision in Liss v. Federal Insurance Co. (February 3, 2009) highlights some of the important consequences that flow from a court’s decision whether to characterize a minority shareholder’s claim as a breach of contract or a breach of fiduciary duty by the majority shareholder.

The case arose from plaintiff John Liss’s employment at Grace Technologies, in which Anthony Ilutzi was controlling shareholder and served as president. In November 1998, Liss was hired as vice president of a newly formed Ilutzi company, Gracetech, Inc. As part of his employment agreement with Gracetech, Liss agreed to waive $800,000 in commissions he was owed by Grace Technologies and received a 9.8 percent interest in Gracetech. While Gracetech did not have any assets at the time, Ilutzi promised Liss that the assets of Grace Technologies and another Ilutzi company, Grace Consulting, would be transferred to Gracetech. In January 1999, Liss resigned from Gracetech and sought to redeem his shares. Meanwhile, Ilutzi learned that Liss had begun working for a competitor and not only refused to redeem Liss’s shares but instituted suit on behalf of his companies against Liss for breach of the employment agreement. Liss counterclaimed to compel the redemption of his shares.

During the litigation, Liss discovered that Ilutzi had never transferred the assets of Grace Technologies and Grace Consulting to Gracetech, as promised. Instead, several months after Liss’s resignation, Ilutzi transferred those assets to a new company, Grace Holdings, in which Liss held no ownership. Liss amended his counterclaim and sued Ilutzi for fraud, breach of contract and breach of fiduciary duty, claiming that Ilutzi’s actions rendered Liss’s shares of Gracetech worthless.

Ilutzi sought coverage for Liss’s claims under the executive liability and indemnification policy issued by Federal Insurance Company. Liss, Ilutzi and the Grace companies reached a settlement in which Ilutzi agreed to pay $1.45 million, representing the value of Liss’s shares in Gracetech, including interest. Liss agreed not to seek recovery against Ilutzi’s personal assets but to limit any recovery to the proceeds of the Federal policy. Ilutzi then assigned to Liss his rights under the insurance policy.

In Liss’s action against Federal, the trial court granted Federal’s motion for summary judgment. The appeals court reversed and ordered a trial, noting that Federal’s policy provided no coverage for the breach of contract claim, so Liss could only succeed by proving a breach of fiduciary duty. At trial, the court found that Ilutzi had in fact breached his fiduciary duty. Federal appealed, arguing that Liss’s claim was for breach of contract and not covered by the policy. Federal also argued that Ilutzi merely decided to restructure his companies because he wished to improve their ability to obtain venture capital, and that his actions breached no tort duty to Liss. Federal also contended that requiring insurers to indemnify corporate directors or officers for breaches of corporate contractual obligations would encourage corporate officials to renege on contracts whenever they thought it would benefit the corporation (and perhaps, the directors and officers directly) – an especially high risk in the case of closely held corporations in which the director or officer often is the corporation.

The Appellate Division disagreed, though it did not specifically address the policy argument. The court found that Ilutzi, as the majority shareholder, owed a fiduciary duty to Liss, the minority shareholder. The court found that Liss was entitled to receive the fair value of his shares and that Ilutzi’s conduct in transferring the assets meant for Gracetech to another entity defeated that right. The court cited the trial court’s findings that Ilutzi’s actions “left Gracetech as a shell corporation with no assets, which rendered Liss’s shares of stock worthless, [thus] prevent[ing] Liss from redeeming his shares.” The Appellate Division stopped short of holding that any breach of contract by corporate officers or directors would constitute a breach of fiduciary duty. Rather, it emphasized Ilutzi’s sole responsibility for the breaching actions: “Ilutzi testified that it was his decision as CEO and majority shareholder in each company not to redeem Liss’s stock, to leave Gracetech a shell company, and to create Grace Holdings and to make it, rather than Gracetech, the parent and sole owner of the Grace companies. No one else had the authority to make that decision or to overrule the actions taken by Ilutzi.”

The court’s reasoning raises the question of whether the result would have been different if the company’s actions had been taken or ratified by the board of directors or by corporate officers who did not constitute a majority of the shareholders. Under those circumstances, the court might have viewed the actions as merely a breach of contract rather than a breach of fiduciary duty.