Court Protects Shareholder from Liability When It Terminates Payments to Former Executive

Date: 7/6/2012
 Business Group Update 7-6-2012

One of the benefits to a corporate form of entity is the protection of shareholders from liability for obligations of the corporation. Of course, as we all know, there are still legal claims which could impose liability on a corporate shareholder for obligations of the corporation. In a recent case, a former executive of a corporation tried to assert a tortious interference claim against a majority shareholder, when it terminated severance payments that were owed to the executive. (Nation v. American Capital, Ltd., 7th Circuit Court of Appeals, Case No. 11-2102 decided June 4, 2011)

James Nation served as CEO of The Spring Air Company, owner and licenser of the "Spring Air" mattress brand name. American Capital financed HIG Capital's investment in Spring Air in 2007, making HIG Capital a minority shareholder. Shortly after HIG Capital invested in Spring Air, Nation was replaced as president and CEO. However, he received a generous severance entitling him to a series of payments totaling $1,243,140 in exchange for his agreement not to compete with Spring Air through December 31, 2008.

But the investment in Spring Air did not go well. In January 2008, American Capital and HIG Capital each invested an additional $11 million in Spring Air. As a result of this investment, American Capital increased its representation on Spring Air's board of directors. Later in 2008, American Capital invested an additional $15 million in Spring Air. This additional investment made American Capital a majority shareholder with four of the seven board seats.

In August, 2008 Spring Air's CEO and CFO decided to suspend all of Nation's severance payments, as well as the severance payments of three other former executives of Spring Air. On September 15, 2008, Nation began working for Serta, a Spring Air competitor, which the court characterized as a violation of Nation's severance agreement with Spring Air. In May, 2009 Spring Air filed for Chapter 7 (liquidation) bankruptcy. By that time, Nation had received approximately 2/3 of the promised severance payments from Spring Air.

Because of its bankruptcy, Nation could not recover from Spring Air. So, in October 2009, he changed his legal theories and defendants and brought a claim against American Capital alleging that American Capital, as majority shareholder, tortiously interfered with his severance contract by causing Spring Air to stop payments to him.

The district court did not give Nation's claim much credence, granting American Capital's motion for summary judgment, without even the necessity of a trial. Nation appealed, which resulted in the 7th Circuit's decision.

To succeed on his claim, Nation had to show that 1) he had a valid and enforceable contract with Spring Air; 2) American Capital was aware of the contractual relationship; 3) American Capital intentionally and without justification induced Spring Air to breach the contract; 4) the breach was caused by American Capital; and 5) Nation suffered damages as a result. Nation's claim failed on the third prong, justification.

The court noted that Illinois recognizes a "conditional privilege" covering the acts of corporate officers, directors and shareholders undertaken on behalf of the corporation. The basis for the privilege is the business judgment rule, which permits those running a corporation to use their good faith "business judgment" to act on behalf of a corporation without the second guessing and oversight of courts. Said the court, "Because the interests of corporate officers, directors, and shareholders are sufficiently aligned with those of the company, they generally cannot be liable in tort when they interfere with the company's contracts for the benefit of the company."

Nation tried to rebut the privilege by an argument similar to a corporate veil piercing theory. Since American Capital was so "enmeshed" in Spring Air's affairs, American Capital was, in effect, Spring Air. But the court turned this argument on its head, noting that, even if this was true, American Capital would be further protected because a party cannot tortiously interfere with its own contract, only an outside third party can do so. So, because of its conditional privilege as a controlling shareholder of Spring Air, American Capital had no liability to Nation for interfering with Nation's contract with Spring Air.

The court also mentioned another theory which could protect American Capital, its role as a creditor. In dicta, the court said that American's Capital's action may also be privileged based on its status as a creditor of Spring Air. It cited Illinois case law holding that "conflicting contractual rights stand on an equal plane." It quoted from an earlier Illinois case:

"[W]hen A has a valid contract with C, and C enters into a contract with B, and the enforcement of A's contract depends on the non-enforcement of B's contract, A is privileged to use any reasonable means to bring about a breach of B's contract with C to protect his own interest."

This means that a creditor can compete for payments with other creditors without liability for interfering with the debtor's contract with the other creditors. Applied to this situation, American Capital, as a creditor of Spring Air, was privileged to act in a way that protected its interest, even to the detriment of Nation, Spring Air's former CEO. But the court acknowledged the "sparse" case law on this "creditor privilege" principle and rested its holding on American Capital's status of Spring Air's majority shareholder.

In the end, the court said the application of the privilege in this case was "straightforward." The court made the correct decision in protecting the shareholder. While a shareholder does not, and should not, enjoy absolute immunity in all situations, this was a case where the shareholder made business decisions, as a shareholder and as a creditor, that should be protected.

For more information about this or any other corporate law topic, please contact Stephen Proctor, Chair of the Business Group, at 847.734.8811 or via e-mail at sproctor@masudafunai.com.