Harris v. Carter
1990 Del. Ch. LEXIS 65, 582 A. 2d 222, 1990 WL 168373 (1990)
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Rule of Law:
A controlling shareholder has a duty to exercise reasonable care when transferring corporate control. When circumstances surrounding a proposed sale of control would awaken suspicion in a prudent person, the seller has a duty to conduct a reasonably adequate investigation to ensure the buyer does not intend to defraud or loot the corporation.
Facts:
- The Carter group, who collectively owned a controlling 52% of Atlas Energy Corporation stock, served as the company's directors.
- The Carter group entered into a Stock Exchange Agreement to sell their controlling interest to Frederic Mascolo.
- In exchange for their Atlas stock, the Carter group received shares in a company called Insuranshares of America ('ISA'), which Mascolo falsely represented was engaged in the insurance business through subsidiaries.
- During negotiations, Mascolo provided a suspicious draft financial statement for ISA, which Atlas's own CFO questioned, but the Carter group failed to investigate these red flags.
- The Stock Exchange Agreement required the Carter group to resign their director positions seriatim to ensure Mascolo and his designees would be appointed as their replacements.
- After gaining control, Mascolo and his new board caused Atlas to acquire the worthless ISA for 3,000,000 of newly issued Atlas shares.
- The Mascolo-controlled board also engaged in other self-dealing transactions that allegedly looted Atlas's assets, including paying a $100,000 commission to the broker who found Mascolo for the Carter group.
Procedural Posture:
- Harris, a minority shareholder of Atlas, filed an initial class action lawsuit in the Delaware Court of Chancery against the Carter group and the Mascolo group.
- After the transaction Harris sought to enjoin was abandoned, Harris filed an Amended and Supplemental Complaint, asserting claims derivatively on behalf of Atlas for the first time.
- The Carter defendants and defendant Mascolo filed separate motions to dismiss the amended complaint.
- The defendants argued for dismissal based on: failure to state a claim, failure to make a pre-suit demand upon the board as required by Rule 23.1, and lack of personal jurisdiction over the Carter defendants.
- The Delaware Court of Chancery is now ruling on these motions to dismiss.
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Issue:
Does a controlling shareholder who sells their stock and transfers corporate control have a duty to conduct a reasonable investigation into the buyer when circumstances exist that would awaken suspicion in a prudent person?
Opinions:
Majority - Allen, Chancellor
Yes. A controlling shareholder has a duty not to transfer control to outsiders if the circumstances surrounding the proposed transfer would awaken suspicion and put a prudent person on guard, unless a reasonably adequate investigation reveals that no fraud is intended or likely to result. The court explicitly adopts the majority view articulated in Insuranshares Corporation and rejects the minority view requiring actual knowledge of a buyer's intent to loot, as that would place a 'premium on the head in the sand approach.' While a shareholder generally has a right to sell their stock, the sale of a controlling interest coupled with an agreement to orchestrate the transfer of board control implicates corporate mechanisms and fiduciary duties. The general common law principle that a person owes a duty of care to those foreseeably harmed by their actions applies, and no corporate privilege exempts a controlling shareholder from this duty when red flags are present. The allegations that the Carter group ignored suspicious financial statements and other warning signs about Mascolo are sufficient to state a claim that they breached this duty of care owed to the corporation.
Analysis:
This opinion establishes for Delaware law the important principle that a selling controlling shareholder can be held liable for negligence if they fail to investigate a suspicious buyer who subsequently loots the company. It imports a tort-like duty of reasonable care into the corporate context of transferring control, moving beyond a standard that would require proof of the seller's actual knowledge of the buyer's malicious intent. The decision puts future sellers of control on notice that they cannot ignore red flags regarding a potential buyer's integrity without risking liability for the buyer's subsequent misdeeds, thereby extending a duty of care to the corporation and its minority shareholders in such transactions.
