The Appellate Division of the Supreme Court of NY, first department recently heard an appeal in the case of Zyskind v. FaceCake Marketing Technologies. This breach of contract case involved corporate maneuvering, with allegations of impropriety and certain failures to disclose. As a teaching tool, this case illustrates how a great many of the legal considerations involved both running a corporation and suing other corporations are contractual in nature. In many ways, a corporation is a contractual creature: it is created by filing articles of incorporation with the state, shares are issued via written documents, and many other aspects implicate contractual matters.
Lawsuits against and between corporations are interesting because many times the shareholder’s main legal theory is that the corporation or its officers or directors breached their own bylaws, articles of incorporation, stock purchase agreement, etc. An interesting legal principle known as the business judgment rule (BJR) basically operates to grant the officers and directors of a corporation a great deal of deference in how they actually run their corporation, when allegations are made they acted in a way that, e.g., stupidly or negligently harmed the corporation.
Background of the Case and Appeal
The plaintiff sought to invest in the defendant corporation (FaceCake). There were many claims and counterclaims back and forth between the parties throughout the history of their litigation before the courts of New York. In essence, one area of contention was the allegation that plaintiff had paid for certain shares that defendant then cancelled. Plaintiff alleged that this was a violation of what was known as an antidilution agreement between them.
Someone seeking to buy a sizeable stake in a corporation is usually seeking some form of control. Every situation is of course different, but generally this is true. Control might come in the form of being able to appoint an officer or director, or may be even more direct, such as acquiring a majority stake and effecting a ‘hostile takeover.’ Corporations have, of course, evolved elegant tricks in these kinds of dealings. One of those is dilution. Assume P Corp. is trying to take over T Corp. by buying up 51% of its shares. Assume there are 100 shares outstanding, meaning that P Corp. simply needs to buy 51 shares. Now, assume P Corp. already owns 46 shares, and approaches T Corp. wanting to buy 5 shares. T Corp. says ‘sure, that’ll be $1 Million.’ Although that might seem exorbitant, P decides it is worth it for control of this valuable company. P shells out $1 Million for 5 shares. Well, T, not wanting to surrender control, immediately issues 1000 new shares right before it sells the 5 shares to P. P now owns 51 out of 1100 shares, slightly less than 5% instead of the 51% it hoped to get. This is how dilution works in theory – issue so many new shares that P corp’s ‘controlling’ share becomes greatly diminished or diluted, and effectively worthless.
One way around this, is, as in this case, for the P Corp., or in this case the plaintiff, to get the T Corp. (defendant) to sign a contract saying it will not dilute its pool of stock. A related concept is cancellation: the T Corp. may simply cancel the shares it issued to P. Plaintiff alleges that defendant violated the antidilution agreement via cancellation of shares plaintiff had already paid for.
The defendant claimed it had not breached the agreement, because the plaintiff had breached their own side of the deal – failure to make certain payments. However plaintiff claims that defendant’s own breach, the failure to provide certain financial documents, served as an excuse. This is a common legal situation, where one party’s breach, if material, may excuse another party’s subsequent breach. The court, refusing to cut the Gordian knot via summary judgment, stated that the case must proceed to a full trial to determine the materiality of each side’s potential breaches of contract.
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