Judge: Mark H. Epstein, Case: 23SMCV03744, Date: 2024-01-18 Tentative Ruling

Case Number: 23SMCV03744    Hearing Date: January 18, 2024    Dept: I

This is a demurrer by defendants Hudson and Millennium Dance Studios (Millennium).  The complaint seeks declaratory relief and damages for breach of fiduciary duty.  The demurrer is to the breach of fiduciary duty cause of action only.  The major theory of the demurrer is that this is really a derivative case and no demand was made on the entity (which ought to be a nominal defendant only).  Plaintiff contends that the cause of action is direct, not derivative.  Hudson also alleges that she has no fiduciary duty to plaintiff.  She is not Millennium’s manager and as a 50% owner, she owes no duties to other owners.  Plaintiff opposes.

A derivative claim is one belonging to the entity; an individual claim is one belonging directly to the shareholder.  (There is a whole body of law on this that the court is woefully abbreviating here.)  Thus, for example, paying too high a bonus is derivative in nature; the argument is that the corporate treasury was depleted by the defendants’ bad act and the money ought to be given back to the entity.  The individual shareholder has no right to the money directly.  In contrast, a cause of action that the board wrongfully refused to declare a dividend is a direct claim.  The dividend would go directly to the shareholder, and the wrongful failure to declare one deprived the shareholder of the money; the corporation was not harmed at all.  The general rule of thumb is whether, if the cause of action succeeds, will the money go to the shareholder directly or will it go to the entity and benefit the shareholder only indirectly through the shareholder’s ownership interest.  The former is direct; the latter is derivative.

Usually, the entity’s governing body owes (whether a group or an individual) a fiduciary duty to the entity, not to each individual shareholder.  The entity comes first.  Indeed, individual shareholders might have competing interests.  There can be exceptions; there are some duties that are owed directly to shareholders, including some limited fiduciary ones.  But not all.  Further, unless the governing documents require the distribution of profits, there is no fiduciary duty to the members to distribute profits as opposed to using them in some other way (such as to expand the business or keep in reasonable reserve).  Whether it is best to hold the profits in the entity or distribute them is left to the board’s discretion.  However, where the governing documents require a distribution, then a duty can arise.  Where there is a right to a distribution, the cause of action to force the distribution is direct, not derivative.  (Using the above rule of thumb, the proceeds from the distribution would not go to the entity; they would go to the shareholder or shareholders.)

In the instant case, originally the parties owned the studio 50/50.  But in 2016, plaintiff signed a stock redemption agreement, which is not attached to the complaint or any of the moving or opposing papers.  As such, the court does not know its terms other than as are alleged in the complaint.  Further, Millennium’s governing documents—such as the Operating Agreement—are not in the papers.  Without that information, it becomes hard to resolve this motion.

The problem the court has is that the complaint as drafted does not say enough.  For example, the complaint alleges that plaintiff has no stock in the company because he sold it.  If he is claiming that the redemption contract is no good, then he needs to be specific about the ground for revoking it and what flows from that.  If he is claiming that notwithstanding the redemption agreement he still owns half of the company, then he needs to be specific about that because it is hardly intuitively obvious that, having redeemed his stock, he still owns half of the company.

If plaintiff is alleging that the redemption contract provides an entitlement to money that he has not received, then the cause of action would seem to sound in breach of contract, not in tort or by way of breach of fiduciary duty.  Two contracting parties do not generally owe each other fiduciary duties, although they might depending on the contract.  The complaint alleges that in the agreement, plaintiff “purported” to “divest” his “ownership interest in [Millennium] in return for the payment of $13,250/month and 50% of the entity’s profits.  (Compl., par. 26.)  But what the means here is simply unknown.

And it gets more complicated.  In 2019, plaintiff sued the entity for breach of contract.  The Millennium and Hudson cross-complained for defamation and other causes of action.  Plaintiff contends that his poor lawyer led to his complaint being stricken and a default judgment entered against him on the cross-complaint.  (Id., par. 28-29.)  That might give rise to res judicata or collateral estoppel problems, or not.  The court cannot tell because no one attached enough papers.  (Demurring parties attached the docket as well as a motion, but not any substantive court orders.  Plaintiff attached the actual judgment, but again no ruling that explains what specific issues were adjudicated or why.)

The problem here is that the court cannot tell whether plaintiff even has an ownership interest in the entity.  He might, but then again, if he redeemed his stock, he might not.  If he is not an owner, then he might well have a contractual right, and that right might well require that the defendants act in good faith consistent with the covenant of good faith and fair dealing.  But it would not be a fiduciary right.  On the other hand, the Redemption Agreement might still give plaintiff an ownership interest.  As an owner, plaintiff does have rights.  However, to determine whether what he seeks in the second cause of action is a right he personally has or is the entity’s right requires the allegation of more facts. 

If the cause of action is derivative, then plaintiff has not made a demand upon the entity’s managers for relief, as is required by the Corporations Code, nor has he alleged that doing so would be futile (although it takes no great leap of imagination to assume that he could at least attempt to allege futility).  As to Hudson’s liability, the court agrees that there are instances in which a controlling shareholder owes duties to the non-controlling shareholders, that will be fact specific and will be determined by whether the controlling shareholder was exercising control as a shareholder or in some other capacity.  One cannot tell from this complaint.

The long and short of it is that more needs to be alleged.  Plaintiff will be given 30 days’ leave.  In the amended complaint, plaintiff ought to attach the Redemption Agreement, attach the judgment from the 2019 case, and state specifically what he claims his relationship to the entity is now—is it contractual, ownership, or something else.  Plaintiff will also need to allege with some particularity exactly what he claims was done and by whom that was in violation of whatever rights he is alleging.  The court had considered overruling the demurrer and dealing with this at summary judgment.  But it is not right to allow plaintiff to escape demurrer by eliding the facts in a pleading.

When a proper complaint is filed, the court ought to be able to sort out whether the complaint is derivative or direct and whether anyone owes him a fiduciary duty as opposed to a contractual one.  The court also ought to be able to determine whether all or some of the complaint is foreclosed by the earlier suit.

Therefore, the demurrer is SUSTAINED WITH 30 DAYS’ LEAVE TO AMEND.  The motion to strike is MOOT.