AHLERS v. ECOVATION, INC

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Docket Number

No. CA 09-02438.

Attorney(S)

HODGSON RUSS LLP, BUFFALO (KEVIN M. KEARNEY OF COUNSEL), FOR DEFENDANTS-APPELLANTS W. JEROME FRAUTSCHI, W. JEROME FRAUTSCHI LIVING TRUST, PLEASANT T. ROWLAND, PLEASANT T. ROWLAND REVOCABLE TRUST, PLEASANT T. ROWLAND FOUNDATION, INC., AND OVERTURE FOUNDATION, INC. PEPPER HAMILTON LLP, PHILADELPHIA, PENNSYLVANIA (M. DUNCAN GRANT, OF THE PENNSYLVANIA AND DELAWARE BARS, ADMITTED PRO HAC VICE, OF COUNSEL), AND THE WOLFORD LAW FIRM LLP, ROCHESTER, FOR DEFENDANTS-APPELLANTS DIANE C. CREEL, GEORGE SLOCUM, DAVID CALL, DAVID PATCHEN, CREIGHTON K. (KIM) EARLY, RICHARD KOLLAUF, RITA OBERLE, ROBERT SHEH, AND PHILIP STRAWBRIDGE. SONNENSCHEIN NATH ROSENTHAL LLP, NEW YORK CITY (JONATHAN D. FORSTOT OF COUNSEL), AND WOODS OVIATT GILMAN LLP, ROCHESTER, FOR PLAINTIFFS-RESPONDENTS.

Judges

Nancy E. Smith
Eugene M. Fahey
Edward D. Carni
Rose H. Sconiers

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Smart Summary

Factual and Procedural Background

Plaintiffs, former minority shareholders of defendant Ecovation, Inc. (Ecovation), initiated this lawsuit alleging, among other claims, breach of fiduciary duty and unjust enrichment. These claims arose from defendants' alleged misconduct during a series of transactions culminating in a merger agreement between Ecovation and defendant Ecolab, Inc. The defendants include former directors of Ecovation, two former controlling shareholders, and several entities controlled by them. The defendants moved to dismiss certain causes of action in the second amended complaint. The Supreme Court, Ontario County, denied in part the motions to dismiss the second through fourth and ninth causes of action, and the defendants appealed that order.

Legal Issues Presented

Whether plaintiffs, as former minority shareholders, have standing to assert the second through fourth and ninth causes of action after the merger of Ecovation with Ecolab.
Whether the ninth cause of action for unjust enrichment is barred by the existence of a valid merger agreement.
Whether the second amended complaint sufficiently alleges defendants' control over the transactions underlying the claims.

Arguments of the Parties

The opinion does not contain a detailed account of the parties' legal arguments.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Sweeney, Cohn, Stahl Vaccaro v Kane, 6 AD3d 72, 75	Delaware law governs standing issues for corporations incorporated in Delaware.	Applied Delaware law to determine plaintiffs' standing post-merger.
Feldman v Cutaia, 951 A2d 727, 731 (Del 2008)	A corporate merger generally extinguishes derivative claims because they belong to the corporation, which merges into the acquiring company.	Used to explain why derivative claims typically do not survive a merger.
Gentile v Rossette, 906 A2d 91, 99-100 (Del 2006)	Direct shareholder actions survive a merger because relief flows to shareholders, not the corporation.	Supported the court’s conclusion that certain claims were direct and survived the merger.
Parnos v Bally Entertainment Corp., 722 A2d 1243, 1245 (Del 1999)	Validity of a merger can be challenged by shareholders alleging breaches of fiduciary duty and unfair dealing.	Used to establish that plaintiffs' challenge to the merger's validity allows direct claims to survive.
IIG Capital LLC v Archipelago, L.L.C., 36 AD3d 401, 405	An unjust enrichment claim may proceed if the contract alleged to govern the parties is invalid.	Supported plaintiffs' assertion that unjust enrichment claim was not barred by the merger agreement.
Marc Contr., Inc. v 39 Winfteld Assoc., LLC, 63 AD3d 693, 695	Nonparties to a contract may assert claims despite the existence of that contract.	Supported the court's finding that plaintiffs, not parties to the merger agreement, could pursue unjust enrichment claims.
Gatz v Ponsoldt, 925 A2d 1265, 1275 (Del 2007)	Standards for alleging control by defendants over transactions relevant to fiduciary duty claims.	Used to assess sufficiency of allegations regarding defendants’ control over the challenged transactions.
Rhodes v Silkroad Equity, LLC, 2007 WL 2058736, 4-5, 2007 Del CH LEXIS 96, 13-20 (2007)	Further guidance on pleading control and fiduciary breaches in Delaware corporate law.	Supported the court’s conclusion that plaintiffs sufficiently alleged defendants’ control.

Court's Reasoning and Analysis

The court applied Delaware law to determine standing because Ecovation is incorporated in Delaware. Under Delaware law, derivative claims typically do not survive a merger because such claims belong to the corporation, which merges into the acquiring company. However, direct claims survive because the relief sought flows directly to the shareholders rather than the corporation. The court found that the second through fourth causes of action were both derivative and direct, as plaintiffs alleged that controlling shareholders caused Ecovation to issue excessive shares in exchange for undervalued assets, diluting minority shareholders’ interests. Additionally, the ninth cause of action for unjust enrichment was not barred by the merger agreement because plaintiffs alleged the merger agreement was invalid and were not parties to it. Finally, the court concluded that the second amended complaint sufficiently alleged defendants’ control over the transactions forming the basis of the claims, referencing Delaware precedents on pleading control and fiduciary breaches.

Holding and Implications

The court unanimously affirmed the order of the Supreme Court, Ontario County, which denied in part the defendants-appellants’ motions to dismiss the second through fourth and ninth causes of action.

The decision directly affects the parties by allowing the plaintiffs’ claims to proceed, confirming that plaintiffs have standing to pursue both direct and derivative claims post-merger and that the unjust enrichment claim is viable despite the merger agreement. The opinion does not establish new precedent but applies existing Delaware law to affirm the sufficiency of the plaintiffs’ allegations and their standing.

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DAVID M. AHLERS et al., Respondents, v. ECOVATION, INC., et al., Defendants, and W. JEROME FRAUTSCHI et al., Appellants.

Memorandum:

Plaintiffs, former minority shareholders of defendant Ecovation, Inc. (Ecovation), commenced this action for, inter alia, breach of fiduciary duty and unjust enrichment as a result of defendants' alleged misconduct during a series of transactions culminating in a merger agreement between Ecovation and defendant Ecolab, Inc. Two groups of defendants, i.e., the former directors of Ecovation, as well as two former controlling shareholders of Ecovation and several entities controlled by them (collectively, defendants), appeal from an order that, inter alia, denied those parts of their respective motions to dismiss the second through fourth and ninth causes of action against them.

Contrary to defendants' contention, plaintiffs have standing to assert the second through fourth and ninth causes of action. Under Delaware law, which we must apply to the issue of standing inasmuch as Delaware is the state of incorporation ( see generally Sweeney, Cohn, Stahl Vaccaro v Kane, 6 AD3d 72, 75, lv dismissed 3 NY3d 751), "a corporate merger generally extinguishes a plaintiffs standing to maintain a derivative [action] . . . [because] a derivative claim is a property right owned by the nominal corporate defendant [and] that right flows to the acquiring corporation by operation of a merger" ( Feldman v Cutaia, 951 A2d 727, 731 [Del 2008]). A direct action, however, survives a corporate merger because the relief flows directly to the stockholders rather than to the corporation ( see generally Gentile v Rossette, 906 A2d 91, 99-100 [Del 2006]; Parnos v Bally Entertainment Corp., 722 A2d 1243, 1245 [Del 1999]). Here, the second through fourth causes of action are both derivative and direct in nature because plaintiffs allege that "(1) . . . stockholder[] having . . . effective control cause[d Ecovation] to issue `excessive' shares of its stock in exchange for assets of the controlling stockholder[s] that have a lesser value; and (2) the exchange cause[d] an increase in the percentage of the outstanding shares owned by the controlling stockholder[s], and a corresponding decrease in the share percentage owned by the . . . (minority) shareholders" ( Gentile, 906 A2d at 100).

Further, the second through fourth causes of action, as well as the ninth cause of action, are direct in nature because plaintiffs have "challenged] the validity of the merger itself, . . . by charging [defendants] with breaches of fiduciary duty resulting in unfair dealing" ( Parnes, 722 A2d at 1245). Specifically, plaintiffs allege that the merger agreement was the product of unfair dealing inasmuch as it was knowingly designed to enrich two of the controlling shareholders at the expense of the common shareholders ( see id.).

Contrary to defendants' further contention, the ninth cause of action, for unjust enrichment, is not barred by the existence of a valid contract, i.e., the merger agreement. Plaintiffs have alleged that the merger agreement was invalid ( see generally IIG Capital LLC v Archipelago, L.L.C., 36 AD3d 401, 405) and, in any event, plaintiffs are not parties to the merger agreement ( see Marc Contr., Inc. v 39 Winfteld Assoc., LLC, 63 AD3d 693, 695).

Finally, when viewed as a whole, the second amended complaint alleges sufficient control by defendants over the series of transactions that plaintiffs allege as the basis for their claims ( see generally Gatz v Ponsoldt, 925 A2d 1265, 1275 [Del 2007]; Rhodes v Silkroad Equity, LLC, 2007 WL 2058736, *4-5, 2007 Del CH LEXIS 96, *13-20 [2007]).