Appeal from a judgment of the United States District Court for the Western District of New York, Harold P. Burke, Judge, entered for defendant directors after a bench trial in a shareholder's derivative action. Reversed and remanded.
Before Timbers and Kearse, Circuit Judges, and Lasker, District Judge.*fn*
This case arises out of an intra-family dispute over the management of two closely-held affiliated corporations. Plaintiff Donald E. Lewis ("Donald"), a shareholder of S.L. & E., Inc. ("SLE"), appeals from judgments entered against him in the United States District Court for the Western District of New York, Harold P. Burke, Judge, after a bench trial of his derivative claim against directors of SLE, and of a claim asserted against him by the other corporation, Lewis General Tires, Inc. ("LGT"), which intervened in the suit. The defendants Alan E. Lewis ("Alan"), Leon E. Lewis, Jr. ("Leon, Jr."), and Richard E. Lewis ("Richard"), are the brothers of Donald; they were, at pertinent times herein, directors of SLE and officers, directors and shareholders of LGT. Donald charged that his brothers had wasted the assets of SLE by causing SLE to lease business premises to LGT from 1966 to 1972 at an unreasonably low rental. LGT was permitted to intervene in the action, and filed a complaint seeking specific performance of an agreement by Donald to sell his SLE stock to LGT in 1972. The district court held that Donald had failed to prove waste by the defendant directors, and entered judgment in their favor. The court also awarded attorneys' fees to the defendant directors and to SLE, and granted LGT specific performance of Donald's agreement to sell his SLE stock.
On appeal, Donald argues that the district court improperly allocated to him the burden of proving his claims of waste, and that since defendants failed to prove that the transactions in question were fair and reasonable, he was entitled to judgment. Donald also argues that the awards of attorneys' fees were improper. We agree with each of these contentions, and therefore reverse and remand.
For many years Leon Lewis, Sr., the father of Donald and the defendant directors, was the principal shareholder of SLE and LGT. LGT, formed in 1933, operated a tire dealership in Rochester, New York. SLE, formed in 1943, owned the land and complex of buildings at 260 East Avenue in Rochester. This property was SLE's only significant asset. Prior to 1956 LGT occupied SLE's premises without benefit of a lease; the rent paid was initially $200 per month, and had increased over the years to $800 per month by 1956, when additional parcels were added. On February 28, 1956, SLE granted LGT a 10-year lease on the newly expanded property ("the Property"), for a rent of $1200 per month, or $14,400 per year. Under the terms of the lease, SLE was responsible for payment of real estate taxes on the Property, while all other current expenses were to be borne by the tenant, LGT.*fn1
In 1962, Leon Lewis, Sr., transferred his SLE stock, 90 shares in all, to his six children (defendants Richard, Alan and Leon, Jr., plaintiff Donald, and two daughters, Margaret and Carol), giving 15 shares to each.*fn2 At that time Richard, Alan and Leon, Jr., were already shareholders, officers and directors of LGT. Contemporaneously with their receipt of SLE stock, all six of the children entered into a "shareholders' agreement" with LGT, under which each child who was not a shareholder of LGT on June 1, 1972 would be required to sell his or her SLE shares to LGT, within 30 days of that date, at a price equal to the book value of the SLE stock as of June 1, 1972.*fn3
LGT's lease on the SLE property expired on February 28, 1966. At that time the directors of SLE were Richard, Alan, Leon, Jr., Leon, Sr., and Henry Etsberger; these five were also the directors of LGT. In 1966 Alan owned 44% of LGT, Richard owned 30%, Leon, Jr., owned 19%, and Leon, Sr., owned 7%. From 1967 to 1972 Richard owned 61% of LGT and Leon, Jr., owned the remaining 39%. When the lease expired in 1966, no new lease was entered into. LGT nonetheless continued to occupy the property and to pay SLE at the old rate, $14,400 per year. According to the defendants' testimony at trial, there was never any thought or discussion among the SLE directors of entering into a new lease or of increasing the rent. Richard testified: "We never gave consideration to a new lease." From all that appears, the defendant directors viewed SLE as existing purely for the benefit of LGT. Richard testified, for example, that although real estate taxes rose sharply during the period 1966-1971, from approximately $7,800 to more than $11,000, to be paid by SLE out of its constant $14,400 rental income, raising the rent was never mentioned. He testified that SLE was "only a shell to protect the operating company (LGT)." When this suit was commenced there had not been a formal meeting of either the shareholders or the directors of SLE since 1962. Richard, Alan and Leon, Jr., had largely ignored SLE's separate corporate existence*fn4 and disregarded the fact that SLE had shareholders who were not shareholders of LGT and who therefore could not profit from actions that used SLE solely for the benefit of LGT.
Neither Donald nor his sisters ever owned LGT stock. As the June 1972 date approached for the required sale of their SLE stock to LGT, Donald apparently came to believe that SLE's book value was lower than it should have been. He sought SLE financial information from Richard, who had been president of SLE since 1967.*fn5 Richard refused to provide information. Donald therefore refused to sell his SLE shares in 1972,*fn6 and commenced this shareholders' derivative action in the district court in August 1973, basing jurisdiction on diversity of citizenship.*fn7 The sole claim raised in the complaint was that the defendant directors*fn8 had wasted the assets of SLE by "grossly undercharging" LGT for the latter's occupancy and use of the Property. Although the complaint charged such mismanagement for the period 1962 to 1973, plaintiff subsequently limited this claim to the period between February 28, 1966, the date on which the lease expired,*fn9 and June 1, 1972, the date contractually set for valuation of the SLE shares which plaintiff had agreed to sell to LGT. LGT intervened and demanded specific performance of Donald's agreement to sell his SLE stock. Donald did not contest his ultimate obligation to sell, but took the position that since the book value of the shares would be increased if he prevailed on his derivative claim, specific performance should be granted only after adjudication of that claim.
There ensued an eight-day bench trial, at which plaintiff sought to prove, by the testimony of several expert witnesses, that the fair rental value of the Property was greater than the $14,400 per year that SLE had been paid by LGT. Defendants sought to show that the rental paid was reasonable, by offering evidence concerning the financial straits of LGT, the cost to LGT of operating the Property, the general economic decline of the East Avenue neighborhood, and rentals paid on two other properties in that neighborhood. LGT presented expert testimony that the value of plaintiff's stock as of June 1972, assuming a successful defense of the derivative claims, was $15,650.
The district court subsequently filed lengthy and detailed findings of fact and conclusions of law. Many of the court's findings went to the validity and probative value of the testimony given by plaintiff's expert witnesses, and the court ultimately declined to credit that testimony. On this basis, the court held that Donald had failed to establish the rental value of the Property during the period at issue, and that defendants were therefore entitled to judgment on the derivative claims. Implicit in the district court's ruling, granting judgment for defendants upon plaintiff's failure to prove waste, was a determination that plaintiff bore the burden of proof on that issue. The court also ruled that LGT was entitled to specific performance of Donald's agreement to sell his SLE stock, and that Donald was not entitled to recover attorneys' fees from SLE, but that SLE and the individual defendants were entitled to attorneys' fees from Donald.*fn10 This appeal followed.
Turning first to the question of burden of proof, we conclude that the district court erred in placing upon plaintiff the burden of proving waste. Because the directors of SLE were also officers, directors and/or shareholders of LGT, the burden was on the defendant directors to demonstrate that the transactions between SLE and LGT were fair and reasonable. New York Business Corporation Law ("BCL") § 713(b) (McKinney Supp.1979) (eff. September 1, 1971); BCL § 713(a)(3) (McKinney 1963) (repealed as of September 1, 1971); see Cohen v. Ayers, 596 F.2d 733, 739-40 (7th Cir. 1979) (construing current BCL § 713); Remillard Brick Co. v. Remillard-Dandini Co., 109 Cal.App.2d 405, 241 P.2d 66, 75 (1952) (construing California Corporations Code § 820, upon which the prior BCL § 713 was patterned).
Under normal circumstances the directors of a corporation may determine, in the exercise of their business judgment, what contracts the corporation will enter into and what consideration is adequate, without review of the merits of their decisions by the courts. The business judgment rule places a heavy burden on shareholders who would attack corporate transactions. Galef v. Alexander, 615 F.2d 51, 57-58 (2d Cir. 1980); Auerbach v. Bennett, 47 N.Y.2d 619, 629, 419 N.Y.S.2d 920, 926, 393 N.E.2d 994, 1000 (1979); 3A Fletcher, Cyclopedia of the Law of Private Corporations § 1039 (perm. ed. 1975). But the business judgment rule presupposes that the directors have no conflict of interest. When a shareholder attacks a transaction in which the directors have an interest other than as directors of the corporation, the directors may not escape review of the merits of the transaction. At common law such a transaction was voidable unless shown by its proponent to be fair, and reasonable to the corporation.*fn11 BCL § 713, in both its ...