CORPORATIONS; SHAREHOLDERS; SALARIES—When one or more shareholders in a close corporation assert that another shareholder’s salary is too high, a court can decide on an appropriate salary.
Two men were the sole shareholders in three closely affiliated companies. They then sold their majority interest in them to a third party who became the president of a new company that resulted from the merger of the three companies. The original partners retained a twenty-four and one-half percent interest in the new company and were paid ten percent of the $300,000 annual salary of the president. After twelve years, the original shareholders sued, claiming that they were owed more money based on payments received by the president over and above his $300,000 salary. They also alleged the president had changed the beneficiary of his life insurance policy from the corporation, as required by a shareholder agreement, to a trust for his son, using company money to pay the premiums. The three shareholders claimed that this constituted a waste of corporate assets and a breach of the president’s fiduciary duty to the corporation.
Just before trial, the president died, and his wife inherited his interest in the company. She promoted the executive vice-president and chief operating officer to become the new president, increasing his salary from $160,000 to $200,000. Also, she became a full-time employee of the company with a $300,000 salary. At the same time, the president notified the original shareholders that their ten percent share would increase from $30,000 to $50,000. In response, the three original shareholders then added a new count to their suit, alleging that the wife’s salary was excessive and was a sham intended to effectuate a distribution to her without incurring an obligation to them. They also alleged that it constituted a breach of the agreements between the parties, and that it constituted a gross waste of corporate assets.
The lower court held that the wife had failed to justify her large salary. It ordered that her salary be reduced to $45,000 and that the difference should be returned to the company. It noted that the new president was receiving $200,000 per year, and that the company’s vice-presidents, who actively ran the corporation, made only $100,000 per year. The wife’s duties and responsibilities were much less than those earning a great deal less than her chosen salary.
The Appellate Division agreed. It stated that it was the wife’s burden to establish the monetary worth of her services and that she failed to do so. On appeal, the wife had claimed that her annual salary should only have been reduced to $200,000, the same as that of the new president. The Court disagreed, finding that she had neither the president’s background nor experience. Furthermore, it was the new president, not the wife, who replaced her husband as the president of the company.
The lower court also held that the company was not entitled to the insurance policy and that it rightfully belonged to the trust for the original president’s son. At the time he purchased his fifty-one percent interest in the company, the former president paid the original shareholders $3,500,000. Of this amount, the president used $500,000 of his personal funds; the remainder was borrowed by the company from a lender. Under the lending agreement, the president was required to obtain a four million dollar life insurance policy for the benefit of the company. Later, the life insurance requirement was reduced to three million dollars when the loan was refinanced. After that, the president maintained two life insurance policies: a one million dollar policy and a three million dollar policy, both for the benefit of the company. However, since the president’s insurance obligation was reduced to three million dollars, changed the beneficiary of the one million dollar policy from the company to a trust for his son.
The Court concluded that the initial reason for the policy, and apparently the only reason, was for the president to obtain the money necessary to purchase his fifty-one percent interest of the company from the original owners. In addition, the president and his wife had the power to cancel the entire policy. They apparently exercised this power, leaving $3 million in insurance for the corporation’s benefit and transferring $1 million of it to the son as beneficiary. Finally, the record indicated that the partners knew about the $1 million life insurance policy benefitting the son for approximately a decade, yet did not complain until even after they filed their initial complaint. The Court found that this indicated that they believed that the president had the right to both reduce the policy amount and to transfer the $1 million policy to his son.
Specifically, the original owners claimed that the insurance transfer by the president and his wife, as the sole members of the company’s board of directors, violated the business judgment rule, and constituted a breach of the governing shareholders’ agreement. They contended that the president and his wife had a right to cancel the policy and to purchase it for its cash surrender value, personally paying the premiums. However, they argued that the policy was not canceled, but instead was maintained at the corporation’s expense for the personal advantage of the son, without any payment to the corporation. They further argued that the purchase of key-man insurance by the corporation and the payment of premiums by the corporation created a constructive trust in the corporation’s favor. Finally, the partners alleged that if the “cancellation” were contractually authorized, the president and his wife still violated their duty of good faith and fair dealing by making the transfer.
In response, the wife argued that the insurance was not key-man insurance because the three shareholders never had a vested interest in the policy proceeds. Rather, the insurance was intended to benefit the original lender by providing added collateral for its loan. When the loan was refinanced, there was no longer any need for the insurance, and the president had the right to terminate all of the insurance. Instead, he left $3 million dollars of coverage in place, and transferred $1 million for the benefit of his son. She further emphasized the three shareholders’ long-term failure to challenge the beneficiary designation, despite their knowledge of it. She raised these arguments as a defense to the charge she had violated the business judgment rule. Finally, she contended that the three shareholders’ conduct in failing to seek the return of the policy at any time prior to the submission of briefs for the trial, and after payment of the policy proceeds, constituted a “classic laches case.”
The Appellate Division held that the laches defense was applicable to the insurance dispute. Factors considered in determining whether to apply a laches defense include the length of the delay, the reasons for delay, and the existence of any change in position by either or both parties during the delay. The record indicated that the three shareholders were aware of the change in the beneficiary of the insurance policy two years before the president’s death, and gave no excuse for their failure to act. Therefore, the Court held that it would have been inequitable to require the return of the insurance proceeds to the company.
Finally, the three shareholders claimed that bonuses paid to the president and the insurance premium payments paid on his behalf constituted compensation that increased the base upon which their ten percent annual compensation should have been calculated. Evidence at the trial established that the president had received various bonuses throughout the years, and paid expensive premiums on the life insurance policy, but the lower court barred the shareholders’ claim on the grounds of laches and equitable estoppel. On appeal, the Appellate Division held that only certain years were barred. Specifically, the Court found that approximately seven years earlier, the three shareholders learned of the accrual of liability for a bonus to the president, as well as the company’s payment of life insurance premiums. As a result of that discovery, the three of them demanded that the company increase their compensation. In light of this demand letter, the Court found no grounds for applying the laches defense with respect to obligations incurred at the time of, and following, the demand letter.
In sum, the Appellate Division affirmed the lower court’s conclusion that the wife’s salary was excessive; affirmed its determination not to require a “return” to the company of one million dollars in policy proceeds from the life insurance policy; and reversed the lower court’s decision to bar the three shareholders’ claims for additional compensation after their demand letter.
Copyright ©2004. Meislik & Meislik. All rights reserved.