Texas Business Dispute Blog

Tuesday, January 20, 2015

Case Update: The Fifth Circuit Affirms Shareholder Oppression Claim and Highlights Importance of Derivative Claims for Compensatory Damages

By James Sheppard

The Fifth Circuit Court of Appeals recently issued an opinion in In re Mandel, 578 Fed. App’x 376 (5th Cir. 2014) arising out of a long-running dispute among former business partners of a company they formed in efforts to develop an internet search engine they hoped would rival Google.  The decision in Mandel follows a lengthy trial in the bankruptcy court and subsequent appeals to the federal district court and the Fifth Circuit.  From a legal perspective, Mandel is interesting because it was the first decision to consider – and then affirm – a shareholder oppression claim after the Texas Supreme Court’s ruling in Ritchie v. Rupe.   From a factual perspective, Mandel reflects the aftermath of the conflict that began as an optimistic joint venture between a patent attorney and an eager Entrepreneur, but which led to years of litigation over their company, White Nile. 

The full opinion from the Fifth Circuit in Mandel is available here.

FACTS OF THE CASE

The problems for White Nile started almost immediately and were due, in large part, to fraudulent representations made by the entrepreneur who promised: (1) to pay $300,000 in start-up costs (he never did); (2) that a design team in the Philippines would design the search engine (that never happened); and (3) that an investor would invest $1 million in the company (the opposite was true – the investor wanted to be paid to develop the website).  When these fraudulent statements came to light, the relationship between the Patent Attorney and Entrepreneur quickly disintegrated.  The Entrepreneur and several of his colleagues also formed a competing business by actively using White Nile’s patents.  The Entrepreneur even drafted a business plan “virtually identical” to the one that had been created for White Nile and which referred to the new company as “just a name change” from White Nile.  The Bankruptcy Court commented that the Entrepreneur’s conduct “transformed White Nile into little more than an empty shell.”

The lawsuit began in early 2006 and the state trial court appointed a receiver for the company in May 2009.  When the Entrepreneur refused to pay his portion of the receiver fees, he filed a chapter 11 bankruptcy petition. This led the Patent Attorney and others to file state law claims – both individual and derivative claims on behalf of White Nile – against the Entrepreneur.  After a bench trial, the bankruptcy court found the Entrepreneur liable for (1) theft or misappropriation of trade secrets; (2) breach of contract; (3) breach of fiduciary duty; (4) fraud and fraudulent inducement; (5) oppression of shareholder rights; and (6) conspiracy.  The bankruptcy court awarded $1 million in damages to the Patent Attorney; $300,000 to the company; and $400,000 to a contract employee for White Nile.  The Fifth Circuit affirmed these findings in Mandel, but vacated the damages award and remanded it to the bankruptcy court. 

CASE HOLDINGS

The Fifth Circuit’s decision in Mandel is important for three reasons:

Shareholder OppressionMandel considered a shareholder oppression claim under the new standard announced in Ritchie v. Rupe, but even under this heightened standard (discussed in previous Blog posts here and here), the Fifth Circuit concluded that the Patent Attorney (minority shareholder) demonstrated a statutory claim for shareholder oppression based on the following actions by the Entrepreneur:  (1) usurping the company’s business opportunities; (2) failing to prosecute the company’s intellectual property; (3) using litigation to prevent the Patent Attorney from reclaiming their intellectual property; and (4) creating a new company to develop substantially similar intellectual property.  As noted, this was a victory in name only for the Patent Attorney (minority shareholder) because his sole remedy after Ritchie was to appoint a receiver, but the state court had previously appointed a receiver for White Nile in May 2009 months before the Patent Attorney filed his oppression claim.  The appointment of a receiver would likely have been futile because, as the bankruptcy court noted, the Entrepreneur’s conduct “transformed White Nile into little more than an empty shell.”  

In short, the Patent Attorney prevailed on his oppression claim, but his exclusive remedy (a receiver) was already in place.  In conclusion, the Fifth Circuit in Mandel held that, on remand to determine damages, the bankruptcy court could not consider the oppression claim in awarding compensatory damages to the Patent Attorney.  This is one of the changes ushered in by the Ritchie case which removes the ability of a shareholder from using the oppression claim to recover monetary damages.

Derivative Claims: Ritchie makes it more difficult for minority shareholders to obtain relief when they are subject to oppression.  As a result, shareholder plaintiffs who bring derivative claims will likely be required to show harm suffered by the company rather than for harm they suffered individually.  In Mandel, for example, the minority shareholder pursued a derivative claim on behalf of White Nile, asserting that the majority shareholder breached his fiduciary duty as an officer, which hurt the company.  Interestingly, many of the same facts that supported the shareholder oppression claim in Mandel also served as the basis for the derivative breach of fiduciary duty claim against the majority shareholder.  Our prior blog post discusses the importance of derivative claims for plaintiffs after the Ritchie case – especially in the context of closely-held businesses.

Theft of Trade Secrets: Based on the pattern of the majority shareholder’s improper use of the company’s intellectual property, the minority shareholder successfully pursued a claim under the Texas Theft Liability Act (“TTLA”).  See in Texas Penal Code § 31.05, which was recently superseded by the Texas Uniform Trade Secrets Act (“TUTSA”) in Texas Civil Practice & Remedies Code § 134A.001-004.  The Fifth Circuit affirmed the bankruptcy court’s ruling that the majority shareholder violated the TTLA through his theft of trade secrets and also awarded attorney’s fees permitted by the statute.  Even under the recently-enacted TUTSA, Texas trial courts have discretion to award attorney’s fees to the prevailing party where (a) willful and malicious prosecution is shown; or (b) for misappropriation claims made in bad faith.  This is an important claim for plaintiffs to consider in the context of disputes like in Mandel in which claims are alleged for theft of the company’s intellectual property or other confidential information.

The dispute in Mandel is not an unfamiliar set of facts for partnerships torn apart by greed and dishonesty.  The case is an important guide for plaintiffs to make certain that their claims – brought in a derivative or individual capacity – are the proper vehicle to recover actual damages.  In addition, Mandel vacated the damages award (well over $1 million) and remanded back to the bankruptcy court to clarify the actual damage awards.  It is therefore crucial for a plaintiff harmed by a breach of fiduciary duty or similar acts (other than for oppression) to ensure it can demonstrate how it calculated the amount of its actual damages.  Clarifying a plaintiff’s damages is important because, as in Mandel, prevailing on an oppression claim (and the appointment of a receiver) provides little value to a minority shareholder after the Entrepreneur has already destroyed the business or looted the company’s assets.  


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