Lerner v. Lerner Corp.

MARVIN H. SMITH, Judge (Retired, Specially Assigned). In this case, a “brotherly” dispute, involving two appeals from the same suit in the Circuit Court for Montgomery County plus a cross appeal, we shall affirm the grant of summary judgment in each instance by the trial judge (Ferretti, J.). Lawrence E. Lerner (Lawrence) was the plaintiff below and is the appellant and cross-appellee here. His brother, Theodore N. Lerner (Theodore), and Lerner Corporation (Lerner Corp. or the Corporation) were the defendants and are the appellees and cross-appellants here.

Lerner Corp. is a Sub-chapter S corporation formed in 1965 by Theodore. 1 The ⁴ Internal Revenue Code provisions relative to Subchapter S corporations have significance in this litigation, as we shall later develop. Since 1965 Theodore and Lawrence have been Lerner Corp.’s only stockholders. From 1965 to late 1995, Theodore owned 70 shares or 73.6% of the common stock. Lawrence owned 25 shares or 26.4% of the common stock.

Theodore was the Corporation’s president and one of its three directors. Prior to 1983, Lawrence was the secretary and a director. The brothers reached the parting of the ways. In 1985, Lawrence sued Theodore alleging a breach of fiduciary duties and sought dissolution of the Corporation.

Theodore then attempted to freeze out Lawrence by way. of a reverse stock split that would have required Lerner Corp. to buy out Lawrence’s shares at fair value. Lawrence filed a second suit seeking to enjoin the freezeout. This resulted in the first of three trips to the appellate courts of this State by the brothers and Lerner Corp. when Lawrence sought and obtained an interlocutory injunction forbidding the Corporation from carrying out the reverse stock split. In Lerner v. Lerner, 306 Md. 771 , 511 A.2d 501 (1986), the Court of Appeals affirmed, as Judge Rodowsky put it for the Court, “for reasons having more to do with the law of preliminary injunctions than with the law of minority freezeouts.” Id. at 772 , 511 A.2d at 501 , 2 ⁵ A settlement between the parties was reached on October 16, 1987.

Under it Theodore would continue with his then current activities while Lawrence would remain only as a minority stockholder; Theodore was permitted to use Lerner Corp.’s personnel and resources for development opportunities; and Lerner Corp. was not to issue additional shares of common stock without first offering Lawrence the right to purchase his proportionate share at the same price and terms offered to any other party. Integral to the litigation here is that portion of the agreement which stated: A payment shall be made by Lerner Corp. to [Lawrence] after the end of each calendar year, beginning with calendar year 1988, equal to [his] proportionate share, based on the percentage of stock ownership, of the difference between the total amount of Lerner Corp.’s management income for such calendar year and the total amount of Lerner Corp.’s business expenses for such calendar year which relate to management activities as distinguished from development activities. [Emphasis added.] Unfortunately, this settlement did not end the acrimony between the parties. As a result, in 1991 Lawrence filed yet another suit against Theodore, Lerner Corp., and some other entities controlled by Theodore. This suit is known by the parties as “the enforcement suit.” It reached this Court in Lerner v. Lerner, 101 Md.App. 728 , No.1914, 1993 Term, per curiam, filed Sept. 30,1994, known as “Lerner II. ” Pursuant to the decision of this Court in Lerner II, a substantial sum of money was paid to Lawrence with interest.

Lerner Corp. then borrowed money to make a proportionate payment to Theodore plus an amount equal to interest on this sum. Thereafter, in December 1995, a stock sale was effected to liquidate this indebtedness. Lawrence filed this suit on April 28, 1994, while Lerner II was pending in this Court. We are here concerned with ⁶ certain portions of the fourth amended complaint.

The fourth amended complaint was filed on April 4, 1996. In Count IV Lawrence claimed Theodore was not entitled to any interest on any distribution made to him by the Corporation. Count V sought an injunction prohibiting the distribution of interest to Theodore. On December 4, 1996, summary judgment was granted in favor of Lawrence.

An injunction was denied as to payment of interest to Theodore. The declaratory judgment entered declared that in computing the payment to be made each year by the Lerner Corporation to Lawrence E. Lerner pursuant to the terms of Paragraph No. 10 of the Settlement Agreement of Litigation and Contemporaneous Releases dated October 17, 1987, any interest paid to Theodore N. Lerner with respect to the distributions to him for the years 1988 through 1992 shall not be considered as a management expense of Lerner Corporation and shall not be subtracted from management income when calculating the payment to be made to Lawrence E. Lerner. The trial court certified under Maryland Rule 3-602(b) that there was no just reason for delay and that this order should be a final judgment. 3 Count VIII of the fourth amended complaint sought a declaratory judgment that the Corporation was not required to make a distribution to Theodore, that the distribution to Theodore violated Maryland Code (1975, 1985 Repl.Vol., 1992 Supp.), section 2-311 of the Corporations & Associations Article, and that the Corporation could not raise money to fund the distribution by way of issuance of stock. Count XII (sometimes referred to as the “recoupment claim”) sought restoration of Lawrence’s stock ownership interest in Lerner ⁷ Corp. following the December 1995 stock sale.

The court entered an order on March 26, 1997, granting Theodore’s and Lerner Corp.’s motion for summary judgment on Count VIII. It declared: 1. ... 2. The Court grants defendants’ motion for summary judgment on count VIII and declares: (a) Lerner Corporation was not precluded from selling stock on the ground that the sale was intended to raise capital to fund an illegal distribution; (b) Lerner Corporation was not precluded from selling stock on the ground that the valuation was flawed or inadequate or on the ground that the stock could not adequately be valued; (c) Lerner Corporation was not required to re-value the stock in order to sell the stock; (d) that in accordance with this Court’s prior ruling on counts IV and V of the fourth amended complaint, plaintiff is entitled to payment by the Corporation equal to his proportionate share of the net profits (as defined in paragraph 10 of the Settlement Agreement), but that the amount of interest paid to Theodore N. Lerner on the distributions for the period 1987 through 1996 cannot be treated as an expense item to reduce the net profits as defined in the Settlement Agreement. The trial judge entered summary judgment in favor of Theodore and Lerner Corp. on Count XII.

He stated from the bench: Count 12: On Count 12, which [seeks] restoration of the stock ownership and interest of Lawrence E. Lerner, I am going to grant summary judgment to the defendants. I grant summary judgment on the basis that there is no material issue of fact in this case. There is a presumption that the stock issued is properly valued by the board of directors, which is supported by evidence and by the exhibits attached. There are no counter exhibits.

There is no evidence of gross disparity or fraud suggested. ⁸ This is a business decision. They had to — they issued the stock and it was not inappropriate to issue the stock. I don’t know any facts. I can’t imagine any facts that aren’t already in this record that can be brought to bear in a trial to modify that presumption.

The orders as to Counts VIII and XII were likewise certified as final judgments. Both sides appealed. Lawrence sees the issues as: 1. Did the Circuit Court err in holding that the Corporation could pay interest to [Theodore] pro rata to the interest paid to [Lawrence] pursuant to the judgment in the Enforcement Case, where [Lawrence’s] judgment was based upon an express contractual obligation of the Corporation to make annual distributions to [Lawrence], and where interest was paid to [Lawrence] because the Corporation (a) failed to adhere to the plain and specific terms of the Agreement and (b) failed to pay the resulting judgment until it was affirmed by this Court? 2.

Did the Circuit Court err in refusing to set aside the stock sale and restore [Lawrence’s] full ownership interest in the Corporation, in light of: (a) evidence that [the] sale was not conducted for a lawful purpose, but rather was intended to raise capital to fund an illegal distribution; (b) the Circuit Court error in holding that it could not set aside the stock sale in the absence of fraud or gross disparity, or even if that test was applicable, it was satisfied; and (c) the Corporation’s admission that restoration of [Lawrence’s] stock interest is practicable? 3. Did the Circuit Court err in refusing to order recoupment from [Theodore] of $3 million of the $3.5 million pro-rata payment to [Theodore] in light of: (a) the lack of any legal or contractual basis for the payment of interest to [Theodore]; and ⁹ (b) the fact that the Corporation had to incur debt to fund $3 million of the $3.5 million distribution? Theodore and Lerner Corp. put the matter more succinctly: APPEAL 1. Was the circuit court legally correct in declaring that the Corporation was not prohibited from paying interest to [Theodore]? 2.

Was the circuit court legally correct in granting summary judgment on [Lawrence’s] claim to have the 1995 stock sale set aside? 3. Was the circuit court legally correct in granting summary judgment to the appellees on [Lawrence’s] claim to have [Theodore] return the distribution he received in 1995 to the Corporation? CROSS APPEAL 4. Did the circuit court err in declaring that the interest payments to [Lawrence] could not be treated as business expenses and reduced from the Corporation’s gross income for purposes of determining the net income to be distributed to shareholders?

We are of the view that the issues before the court are: 1. Was it legally permissible for Lerner Corp. to pay to Theodore a sum which equaled interest on the distribution to him? 2. Was Lerner Corp.’s stock sale proper? All other issues are subsumed into these.

As indicated earlier, these appeals are from grants of summary judgment. In this instance, unlike many appeals from grants of summary judgment, we are not required to determine whether there was a material dispute as to a material fact that would preclude the grant of summary judgment because here there is no factual dispute. The disputes relate entirely to the application of law to the facts before the court. Integral to the decision below and to our decision here is the situation relative to a Subchapter S corporation.

Theodore and the other directors of Lerner Corp. had before them the ¹⁰ advice of their own certified public accountant plus the advice of a national accounting firm and that of a prominent District of Columbia law firm. All were in agreement. The national accounting firm advised: [W]e have analyzed the tax consequences of the proposed distribution of funds to Lawrence E. Lerner. It is our understanding that the potential distribution calls for a payment to Lawrence E. Lerner of $926,449, which represents two components: Lawrence’s share of the S corporation’s accumulated but undistributed earnings as of 12/31/92 $805,325 An interest factor to account for the lack of use of the undistributed earnings 121,124 Total $926,449 Since Lerner Corporation is a Subchapter S corporation, it is required under the Internal Revenue Code (“IRC”) to have only one class of stock.

According to the IRC, if an S corporation does not make prorata distributions, a second class of stock could exist with respect to distribution rights. Should two classes of stock exist, IRC regulations require the corporation’s S corporation status be terminated and be converted to a Subchapter C corporation. As a C corporation the entity would now be subject to taxation both at the corporate level and at the shareholder level. This would severely impact the value of the shareholder’s interest in the corporation since there would be less cash flow available to the shareholder’s [sic] due to the fact that the corporation would now be paying income taxes.

As a result, we would recommend that if Lerner Corporation must distribute $926,449 to Lawrence E. Lerner, it should also distribute $2,582,828 to Theodore N. Lerner in order to protect its S corporation status. This would require a total distribution of $3,509,277 to the shareholders. The law firm said: You have requested our opinion whether, when the Company makes the distribution to Lawrence E. Lerner mandated by the Court’s decision, it has a concomitant obli ¹¹ gation to make a proportionate distribution to its other stockholder, Theodore N. Lerner. You have also requested our opinion whether, if the Company fails to make a proportionate distribution to its other stockholder, such failure would adversely affect the Company’s continued ability to be taxed as a Subchapter S corporation for federal and Maryland income tax purposes. ...

If Paragraph 10 of the Settlement Agreement is interpreted as creating a priority distribution in favor of Lawrence E. Lerner, it is our opinion that the Company will not satisfy the “1 class of stock” requirement of Section 1361(b)(1)(D) and, therefore, will cease to qualify as an S corporation, with the resulting loss to the Company and its shareholders of the federal and Maryland income tax benefits conferred by its status as an S corporation. There was presented to the circuit court judge the deposition of Sheldon S. Cohen, an attorney who was an expert in the field of taxation and happened also to be a former Commissioner of Internal Revenue. He concurred in these views. Lawrence has presented nothing to the contrary.

INTEREST It is important to understand that although the parties have referred to the payment to Theodore as “interest,” it in fact was not interest. Pursuant to the agreement Lawrence was paid a specified sum. Then, he was paid interest on that sum. In the case of Theodore he, as a Subchapter S stockholder, was paid from the Corporation a sum of money which in proportion to stock holdings was equal to the sum paid Lawrence.

Then, also, because of Subchapter S tax status, the payment that has been referred to as “interest” was paid to him. It likewise was in mathematical proportion to the sum paid Lawrence as interest. Lawrence makes three arguments that the distribution of what he calls “interest” to Theodore was improper. First, he asserts Theodore was not entitled to interest because he, ¹² unlike Lawrence, had no contractual right to receive interest.

Second, Lawrence argues the payment of interest was not a dividend but a gift. Finally, he asserts the payment was not fair or equitable to the Corporation and constituted an unlawful self-interested transaction. Lawrence is correct in asserting Theodore had no contractual right to receive the interest payment. The payment of interest to Lawrence was because of the final judgment rendered by the circuit court in Lemer II.

The payment of “interest” to Theodore was premised on the need of the Corporation to maintain its Subchapter S tax status. 4 Accordingly, it is immaterial whether Theodore had a contractual right to the interest payment. The issue is whether such payment was unlawful. Likewise, Lawrence’s characterization of the distribution as a gift is unavailing. The issue is whether the directors of the Corporation could authorize such a payment.

This distribution of interest to Theodore does not impinge upon Lawrence and what he is to receive from the Corporation. The agreement between the parties provides for him to receive a designated portion “of the- difference between the total amount of Lerner Corp.’s management income for such calendar year in the total