Sinclair Oil Corp. v. Levien 478

SINCLAIR OIL CORPORATION, Defendant Below, Appellant, 478

v. 478

Francis S. LEVIEN, Plaintiff Below, Appellee 478

Supreme Court of Delaware 478

June 18, 1971. 478

WOLCOTT, Chief Justice. 478

This is an appeal by the defendant, Sinclair Oil Corporation (hereafter Sinclair), from an order of the Court of Chancery, 261 A.2d 911 in a derivative action requiring Sinclair to account for damages sustained by its subsidiary, Sinclair Venezuelan Oil Company (hereafter Sinven), organized by Sinclair for the purpose of operating in Venezuela, as a result of dividends paid by Sinven, the denial to Sinven of industrial development, and a breach of contract between Sinclair's wholly-owned subsidiary, Sinclair International Oil Company, and Sinven 478

Sinclair, operating primarily as a holding company, is in the business of exploring for oil and of producing and marketing crude oil and oil products. At all times relevant to this litigation, it owned about 97% Of Sinven's stock. The plaintiff owns about 3000 of 120,000 publicly held shares of Sinven. Sinven, incorporated in 1922, has been engaged in petroleum operations primarily in Venezuela and since 1959 has operated exclusively in Venezuela 478

Sinclair nominates all members of Sinven's board of directors. The Chancellor found as a fact that the directors were not independent of Sinclair. Almost without exception, they were officers, directors, or employees of corporations in the Sinclair complex. By reason of Sinclair's domination, it is clear that Sinclair owed Sinven a fiduciary duty. Getty Oil Company v. Skelly Oil Co., 267 A.2d 883 (Del.Supr.1970); Cottrell v. Pawcatuck Co., 35 Del.Ch. 309, 116 A.2d 787 (1955). Sinclair concedes this 479

The Chancellor held that because of Sinclair's fiduciary duty and its control over Sinven, its relationship with Sinven must meet the test of intrinsic fairness. The *720 standard of intrinsic fairness involves both a high degree of fairness and a shift in the burden of proof. Under this standard the burden is on Sinclair to prove, subject to careful judicial scrutiny, that its transactions with Sinven were objectively fair. Guth v. Loft, Inc., 23 Del.Ch. 255, 5 A.2d 503 (1939); Sterling v. Mayflower Hotel Corp., 33 Del.Ch. 293, 93 A.2d 107, 38 A.L.R.2d 425 (Del.Supr.1952); Getty Oil Co. v. Skelly Oil Co., supra 479

Sinclair argues that the transactions between it and Sinven should be tested, not by the test of intrinsic fairness with the accompanying shift of the burden of proof, but by the business judgment rule under which a court will not interfere with the judgment of a board of directors unless there is a showing of gross and palpable overreaching. Meyerson v. El Paso Natural Gas Co., 246 A.2d 789 (Del.Ch.1967). A board of directors enjoys a presumption of sound business judgment, and its decisions will not be disturbed if they can be attributed to any rational business purpose. A court under such circumstances will not substitute its own notions of what is or is not sound business judgment 479

We think, however, that Sinclair's argument in this respect is misconceived. When the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing the terms, the test of intrinsic fairness, with its resulting shifting of the burden of proof, is applied. Sterling v. Mayflower Hotel Corp., supra; David J. Greene & Co. v. Dunhill International, Inc., 249 A.2d 427 (Del.Ch.1968); Bastian v. Bourns, Inc., 256 A.2d 680 (Del.Ch.1969) aff'd. Per Curiam (unreported) (Del.Supr.1970). The basic situation for the application of the rule is the one in which the parent has received a benefit to the exclusion and at the expense of the subsidiary 479

Recently, this court dealt with the question of fairness in parent-subsidiary dealings in Getty Oil Co. v. Skelly Oil Co., supra. In that case, both parent and subsidiary were in the business of refining and marketing crude oil and crude oil products. The Oil Import Board ruled that the subsidiary, because it was controlled by the parent, was no longer entitled to a separate allocation of imported crude oil. The subsidiary then contended that it had a right to share the quota of crude oil allotted to the parent. We ruled that the business judgment standard should be applied to determine this contention. Although the subsidiary suffered a loss through the administration of the oil import quotas, the parent gained nothing. The parent's quota was derived solely from its own past use. The past use of the subsidiary did not cause an increase in the parent's quota. Nor did the parent usurp a quota of the subsidiary. Since the parent received nothing from the subsidiary to the exclusion of the minority stockholders of the subsidiary, there was no self-dealing. Therefore, the business judgment standard was properly applied 479

A parent does indeed owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealings. However, this alone will not evoke the intrinsic fairness standard. This standard will be applied only when the fiduciary duty is accompanied by self-dealing--the situation when a parent is on both sides of a transaction with its subsidiary. Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary 480

We turn now to the facts. The plaintiff argues that, from 1960 through 1966, Sinclair caused Sinven to pay out such excessive dividends that the industrial development of Sinven was effectively prevented, and it became in reality a corporation in dissolution 480

From 1960 through 1966, Sinven paid out $108,000,000 in dividends ($38,000,000 *721 in excess of Sinven's earnings during the same period). The Chancellor held that Sinclair caused these dividends to be paid during a period when it had a need for large amounts of cash. Although the dividends paid exceeded earnings, the plaintiff concedes that the payments were made in compliance with 8 Del.C. s 170, authorizing payment of dividends out of surplus or net profits. However, the plaintiff attacks these dividends on the ground that they resulted from an improper motive--Sinclair's need for cash. The Chancellor, applying the intrinsic fairness standard, held that Sinclair did not sustain its burden of proving that these dividends were intrinsically fair to the minority stockholders of Sinven 480

Since it is admitted that the dividends were paid in strict compliance with 8 Del.C. s 170, the alleged excessiveness of the payments alone would not state a cause of action. Nevertheless, compliance with the applicable statute may not, under all circumstances, justify all dividend payments. If a plaintiff can meet his burden of proving that a dividend cannot be grounded on any reasonable business objective, then the courts can and will interfere with the board's decision to pay the dividend 480

Sinclair contends that it is improper to apply the intrinsic fairness standard to dividend payments even when the board which voted for the dividends is completely dominated. In support of this contention, Sinclair relies heavily on American District Telegraph Co. (ADT) v. Grinnell Corp., (N.Y.Sup.Ct.1969) aff'd. 33 A.D.2d 769, 306 N.Y.S.2d 209 (1969). Plaintiffs were minority stockholders of ADT, a subsidiary of Grinnell. The plaintiffs alleged that Grinnell, realizing that it would soon have to sell its ADT stock because of a pending anti-trust action, caused ADT to pay excessive dividends. Because the dividend payments conformed with applicable statutory law, and the plaintiffs could not prove an abuse of discretion, the court ruled that the complaint did not state a cause of action. Other decisions seem to support Sinclair's contention. In Metropolitan Casualty Ins. Co. v. First State Bank of Temple, 54 S.W.2d 358 (Tex.Civ.App.1932), rev'd. on other grounds, 79 S.W.2d 835 (Sup.Ct.1935), the court held that a majority of interested directors does not void a declaration of dividends because all directors, by necessity, are interested in and benefited by a dividend declaration. See, also, Schwartz v. Kahn, 183 Misc. 252, 50 N.Y.S.2d 931 (1944); Weinberger v. Quinn, 264 A.D. 405, 35 N.Y.S.2d 567 (1942) 480

We do not accept the argument that the intrinsic fairness test can never be applied to a dividend declaration by a dominated board, although a dividend declaration by a dominated board will not inevitably demand the application of the intrinsic fairness standard. Moskowitz v. Bantrell, 41 Del.Ch. 177, 190 A.2d 749 (Del.Supr.1963). If such a dividend is in essence self-dealing by the parent, then the intrinsic fairness standard is the proper standard. For example, suppose a parent dominates a subsidiary and its board of directors. The subsidiary has outstanding two classes of stock, X and Y. Class X is owned by the parent and Class Y is owned by minority stockholders of the subsidiary. If the subsidiary, at the direction of the parent, declares a dividend on its Class X stock only, this might well be self-dealing by the parent. It would be receiving something from the subsidiary to the exclusion of and detrimental to its minority stockholders. This self-dealing, coupled with the parent's fiduciary duty, would make intrinsic fairness the proper standard by which to evaluate the dividend payments 480

Consequently it must be determined whether the dividend payments by Sinven were, in essence, self-dealing by Sinclair. The dividends resulted in great sums of money being transferred from Sinven to Sinclair. However, a proportionate share of this money was received by the minority shareholders of Sinven. Sinclair received nothing from Sinven to the exclusion of its *722 minority stockholders. As such, these dividends were not self-dealing. We hold therefore that the Chancellor erred in applying the intrinsic fairness test as to these dividend payments. The business judgment standard should have been applied 481

We conclude that the facts demonstrate that the dividend payments complied with the business judgment standard and with 8 Del.C. s 170. The motives for causing the declaration of dividends are immaterial unless the plaintiff can show that the dividend payments resulted from improper motives and amounted to waste. The plaintiff contends only that the dividend payments drained Sinven of cash to such an extent that it was prevented from expanding 481

The plaintiff proved no business opportunities which came to Sinven independently and which Sinclair either took to itself or denied to Sinven. As a matter of fact, with two minor exceptions which resulted in losses, all of Sinven's operations have been conducted in Venezuela, and Sinclair had a policy of exploiting its oil properties located in different countries by subsidiaries located in the particular countries 481

From 1960 to 1966 Sinclair purchased or developed oil fields in Alaska, Canada, Paraguay, and other places around the world. The plaintiff contends that these were all opportunities which could have been taken by Sinven. The Chancellor concluded that Sinclair had not proved that its denial of expansion opportunities to Sinven was intrinsically fair. He based this conclusion on the following findings of fact. Sinclair made no real effort to expand Sinven. The excessive dividends paid by Sinven resulted in so great a cash drain as to effectively deny to Sinven any ability to expand. During this same period Sinclair actively pursued a company-wide policy of developing through its subsidiaries new sources of revenue, but Sinven was not permitted to participate and was confined in its activities to Venezuela 481

However, the plaintiff could point to no opportunities which came to Sinven. Therefore, Sinclair usurped no business opportunity belonging to Sinven. Since Sinclair received nothing from Sinven to the exclusion of and detriment to Sinven's minority stockholders, there was no self-dealing. Therefore, business judgment is the proper standard by which to evaluate Sinclair's expansion policies 481

Since there is no proof of self-dealing on the part of Sinclair, it follows that the expansion policy of Sinclair and the methods used to achieve the desired result must, as far as Sinclair's treatment of Sinven is concerned, be tested by the standards of the business judgment rule. Accordingly, Sinclair's decision, absent fraud or gross overreaching, to achieve expansion through the medium of its subsidiaries, other than Sinven, must be upheld 482

Even if Sinclair was wrong in developing these opportunities as it did, the question arises, with which subsidiaries should these opportunities have been shared? No evidence indicates a unique need or ability of Sinven to develop these opportunities. The decision of which subsidiaries would be used to implement Sinclair's expansion policy was one of business judgment with which a court will not interfere absent a showing of gross and palpable overreaching. Meyerson v. El Paso Natural Gas Co., 246 A.2d 789 (Del.Ch.1967). No such showing has been made here 482

Next, Sinclair argues that the Chancellor committed error when he held it liable to Sinven for breach of contract 482

In 1961 Sinclair created Sinclair International Oil Company (hereafter International), a wholly owned subsidiary used for the purpose of coordinating all of Sinclair's foreign operations. All crude purchases by Sinclair were made thereafter through International 482

On September 28, 1961, Sinclair caused Sinven to contract with International whereby Sinven agreed to sell all of its *723 crude oil and refined products to International at specified prices. The contract provided for minimum and maximum quantities and prices. The plaintiff contends that Sinclair caused this contract to be breached in two respects. Although the contract called for payment on receipt, International's payments lagged as much as 30 days after receipt. Also, the contract required International to purchase at least a fixed minimum amount of crude and refined products from Sinven. International did not comply with this requirement 482

Clearly, Sinclair's act of contracting with its dominated subsidiary was self- dealing. Under the contract Sinclair received the products produced by Sinven, and of course the minority shareholders of Sinven were not able to share in the receipt of these products. If the contract was breached, then Sinclair received these products to the detriment of Sinven's minority shareholders. We agree with the Chancellor's finding that the contract was breached by Sinclair, both as to the time of payments and the amounts purchased 482

Although a parent need not bind itself by a contract with its dominated subsidiary, Sinclair chose to operate in this manner. As Sinclair has received the benefits of this contract, so must it comply with the contractual duties 482

Under the intrinsic fairness standard, Sinclair must prove that its causing Sinven not to enforce the contract was intrinsically fair to the minority shareholders of Sinven. Sinclair has failed to meet this burden. Late payments were clearly breaches for which Sinven should have sought and received adequate damages. As to the quantities purchased, Sinclair argues that it purchased all the products produced by Sinven. This, however, does not satisfy the standard of intrinsic fairness. Sinclair has failed to prove that Sinven could not possibly have produced or someway have obtained the contract minimums. As such, Sinclair must account on this claim 482

Finally, Sinclair argues that the Chancellor committed error in refusing to allow it a credit or setoff of all benefits provided by it to Sinven with respect to all the alleged damages. The Chancellor held that setoff should be allowed on specific transactions, e.g., benefits to Sinven under the contract with International, but denied an over all setoff against all damages claimed. We agree with the Chancellor, although the point may well be moot in view of our holding that Sinclair is not required to account for the alleged excessiveness of the dividend payments 482

We will therefore reverse that part of the Chancellor's order that requires Sinclair to account to Sinven for damages sustained as a result of dividends paid between 1960 and 1966, and by reason of the denial to Sinven of expansion during that period. We will affirm the remaining portion of that order and remand the cause for further proceedings. 483

Lewis v. S. L. & E., Inc. 484

Donald E. LEWIS, Plaintiff-Appellant, 484

v. 484

S. L. & E., INC., Alan E. Lewis, Leon E. Lewis, Jr., and Richard E. Lewis, 484

Defendants-Appellees. 484

LEWIS GENERAL TIRES, INC., Plaintiff-Intervenor-Appellee, 484

v. 484

Donald E. LEWIS, Defendant-Appellant 484

No. 893, Docket 79-7767 484

United States Court of Appeals, 484

Second Circuit 484

Argued March 20, 1979 484

Decided July 22, 1980. 484

KEARSE, Circuit Judge: 484

This case arises out of an intra-family dispute over the management of two closely-held affiliated corporations. Plaintiff Donald E. Lewis ("Donald"), a shareholder of S.L. & E., Inc. ("SLE"), appeals from judgments entered against him in the United States District Court for the Western *766 District of New York, Harold P. Burke, Judge, after a bench trial of his derivative claim against directors of SLE, and of a claim asserted against him by the other corporation, Lewis General Tires, Inc. ("LGT"), which intervened in the suit. The defendants Alan E. Lewis ("Alan"), Leon E. Lewis, Jr. ("Leon, Jr."), and Richard E. Lewis ("Richard"), are the brothers of Donald; they were, at pertinent times herein, directors of SLE and officers, directors and shareholders of LGT. Donald charged that his brothers had wasted the assets of SLE by causing SLE to lease business premises to LGT from 1966 to 1972 at an unreasonably low rental. LGT was permitted to intervene in the action, and filed a complaint seeking specific performance of an agreement by Donald to sell his SLE stock to LGT in 1972. The district court held that Donald had failed to prove waste by the defendant directors, and entered judgment in their favor. The court also awarded attorneys' fees to the defendant directors and to SLE, and granted LGT specific performance of Donald's agreement to sell his SLE stock 484

On appeal, Donald argues that the district court improperly allocated to him the burden of proving his claims of waste, and that since defendants failed to prove that the transactions in question were fair and reasonable, he was entitled to judgment. Donald also argues that the awards of attorneys' fees were improper. We agree with each of these contentions, and therefore reverse and remand 484

I 485

For many years Leon Lewis, Sr., the father of Donald and the defendant directors, was the principal shareholder of SLE and LGT. LGT, formed in 1933, operated a tire dealership in Rochester, New York. SLE, formed in 1943, owned the land and complex of buildings at 260 East Avenue in Rochester. This property was SLE's only significant asset. Prior to 1956 LGT occupied SLE's premises without benefit of a lease; the rent paid was initially $200 per month, and had increased over the years to $800 per month by 1956, when additional parcels were added. On February 28, 1956, SLE granted LGT a 10-year lease on the newly expanded property ("the Property"), for a rent of $1200 per month, or $14,400 per year. Under the terms of the lease, SLE was responsible for payment of real estate taxes on the Property, while all other current expenses were to be borne by the tenant, LGT.[FN1] 485

FN1. It appears that SLE was also responsible for payments due on a mortgage on the Property. In addition, LGT charged SLE for the costs of certain capital improvements, such as the major structural repairs to the principal building's facade, carried out in 1969. 485

In 1962, Leon Lewis, Sr., transferred his SLE stock, 90 shares in all, to his six children (defendants Richard, Alan and Leon, Jr., plaintiff Donald, and two daughters, Margaret and Carol), giving 15 shares to each.[FN2] At that time Richard, Alan and Leon, Jr., were already shareholders, officers and directors of LGT. Contemporaneously with their receipt of SLE stock, all six of the children entered into a "shareholders' agreement" with LGT, under which each child who was not a shareholder of LGT on June 1, 1972 would be required to sell his or her SLE shares to LGT, within 30 days of that date, at a price equal to the book value of the SLE stock as of June 1, 1972.[FN3] 485

FN2. SLE had 150 shares outstanding, and each child thus received a ten percent interest. At the same time LGT purchased the remaining 60 outstanding shares from the elder Lewis's business partner, Henry Etsberger. 485

FN3. The agreement specified procedures by which the book value, and hence the price of the shares, would be determined. 485

LGT's lease on the SLE property expired on February 28, 1966. At that time the directors of SLE were Richard, Alan, Leon, Jr., Leon, Sr., and Henry Etsberger; these five were also the directors of LGT. In 1966 Alan owned 44% of LGT, Richard owned 30%, Leon, Jr., owned 19%, and Leon, Sr., owned 7%. From 1967 to 1972 Richard owned 61% of LGT and Leon, Jr., owned the remaining 39%. When the lease expired *767 in 1966, no new lease was entered into. LGT nonetheless continued to occupy the property and to pay SLE at the old rate, $14,400 per year. According to the defendants' testimony at trial, there was never any thought or discussion among the SLE directors of entering into a new lease or of increasing the rent. Richard testified: "We never gave consideration to a new lease." From all that appears, the defendant directors viewed SLE as existing purely for the benefit of LGT. Richard testified, for example, that although real estate taxes rose sharply during the period 1966- 1971, from approximately $7,800 to more than $11,000, to be paid by SLE out of its constant $14,400 rental income, raising the rent was never mentioned. He testified that SLE was "only a shell to protect the operating company (LGT)." When this suit was commenced there had not been a formal meeting of either the shareholders or the directors of SLE since 1962. Richard, Alan and Leon, Jr., had largely ignored SLE's separate corporate existence [FN4] and disregarded the fact that SLE had shareholders who were not shareholders of LGT and who therefore could not profit from actions that used SLE solely for the benefit of LGT. 485

FN4. For example, Richard's testimony includes the following statements: 486

Q Mr. Lewis, you have always looked at these two corporations as being one and the same, haven't you, Lewis General Tires and S.L. & E.? 486

A Yes. 486

I never really got into S.L. & E. at all. (Tr. 6/21/78, at 972-73.) 486

I don't think I ever looked at an operating statement of S.L. & E. seriously. (Id. at 991.) 486

I had very little to do with S.L. & E. (Tr. 7/28/78, at 80.) 486

Alan testified that at no time after 1964 did he participate in any discussions of any increase in rent for SLE. (Id. at 160, 164.) 486

And Leon, Jr., testified, "I didn't have anything to do with running S.L. & E. . . . ." (Id. at 230.) 486

Neither Donald nor his sisters ever owned LGT stock. As the June 1972 date approached for the required sale of their SLE stock to LGT, Donald apparently came to believe that SLE's book value was lower than it should have been. He sought SLE financial information from Richard, who had been president of SLE since 1967.[FN5] Richard refused to provide information. Donald therefore refused to sell his SLE shares in 1972,[FN6] and commenced this shareholders' derivative action in the district court in August 1973, basing jurisdiction on diversity of citizenship.[FN7] The sole claim raised in the complaint was that the defendant directors [FN8] had wasted the assets of SLE by "grossly undercharging" LGT for the latter's occupancy and use of the Property. Although the complaint charged such mismanagement for the period 1962 to 1973, plaintiff subsequently limited this claim to the period between February 28, 1966, the date on which the lease expired,[FN9] and June 1, 1972, the date contractually set for valuation of the SLE shares which plaintiff had agreed to sell to LGT. LGT intervened and demanded specific performance of Donald's agreement to sell his SLE stock. Donald did not contest his ultimate obligation to sell, but took the position that since the book value of the shares would be increased *768 if he prevailed on his derivative claim, specific performance should be granted only after adjudication of that claim. 486

FN5. It does not appear that SLE paid salaries to any of its officers or directors. 486

FN6. Donald's sisters Carol and Margaret sold their SLE shares to LGT in 1972 and 1973 respectively. Alan, who had sold his LGT stock in 1967, sold his SLE stock to LGT in 1972. 486

FN7. When suit was commenced, plaintiff was a citizen of Ohio, Alan was a citizen of Florida and all of the other individual defendants were citizens of New York. SLE is a New York corporation and has its principal place of business in New York. 486

FN8. Leon E. Lewis, Sr., also was originally named as a defendant in this action. When he died in 1975 his executor was substituted as a defendant; subsequently the parties stipulated to dismissal of the executor. Etsberger died in about 1969, and his estate was not named as a defendant. 486

FN9. Donald was not a shareholder of SLE in 1956 when the lease was entered into and hence had no standing to challenge its terms. BCL s 626(b); Bernstein v. Polo Fashions, Inc., 55 A.D.2d 530, 389 N.Y.S.2d 368 (1st Dep't 1976). 486

There ensued an eight-day bench trial, at which plaintiff sought to prove, by the testimony of several expert witnesses, that the fair rental value of the Property was greater than the $14,400 per year that SLE had been paid by LGT. Defendants sought to show that the rental paid was reasonable, by offering evidence concerning the financial straits of LGT, the cost to LGT of operating the Property, the general economic decline of the East Avenue neighborhood, and rentals paid on two other properties in that neighborhood. LGT presented expert testimony that the value of plaintiff's stock as of June 1972, assuming a successful defense of the derivative claims, was $15,650 486

The district court subsequently filed lengthy and detailed findings of fact and conclusions of law. Many of the court's findings went to the validity and probative value of the testimony given by plaintiff's expert witnesses, and the court ultimately declined to credit that testimony. On this basis, the court held that Donald had failed to establish the rental value of the Property during the period at issue, and that defendants were therefore entitled to judgment on the derivative claims. Implicit in the district court's ruling, granting judgment for defendants upon plaintiff's failure to prove waste, was a determination that plaintiff bore the burden of proof on that issue. The court also ruled that LGT was entitled to specific performance of Donald's agreement to sell his SLE stock, and that Donald was not entitled to recover attorneys' fees from SLE, but that SLE and the individual defendants were entitled to attorneys' fees from Donald.[FN10] This appeal followed. 487

FN10. The district court also held that plaintiff was not a proper party to bring this action, and that the claim of waste was not properly asserted derivatively. Both of these conclusions were incorrect. 487

As to the first point, plaintiff asserts that he has been, at all relevant times, a shareholder of SLE. As such, he would be a proper party to assert claims on behalf of the corporation in a derivative action, regardless of the number of shares he owns, and whether or not any other shareholder wishes that the claims be pursued. N.Y.Bus.Corp.Law s 626(a) (McKinney 1963); Greenberg v. Acme Folding Box Co., 84 Misc.2d 181, 374 N.Y.S.2d 997 (Sup.Ct.1975). In this Court, defendants argue that Donald no longer owns SLE shares in his own right, having transferred his shares in 1971 to himself as custodian for his three children, pursuant to the Ohio Uniform Gifts to Minors Act. Defendants did not raise this point below; indeed, defendants admitted Donald's stock ownership in their answer, and defendants' counsel repeated the concession at trial. They may not raise the issue now. 487

On the second point, it is clear that plaintiff's claim of corporate waste is properly asserted by way of a derivative action. N.Y.Bus.Corp.Law s 626(a); Bernstein v. Polo Fashions, Inc., supra. Indeed, such a claim of waste must be brought derivatively, and cannot be asserted in a direct action. Empleton v. D'Elia Gemstones Corp., 46 A.D.2d 751, 360 N.Y.S.2d 683 (1st Dep't 1974). 487

II 487

Turning first to the question of burden of proof, we conclude that the district court erred in placing upon plaintiff the burden of proving waste. Because the directors of SLE were also officers, directors and/or shareholders of LGT, the burden was on the defendant directors to demonstrate that the transactions between SLE and LGT were fair and reasonable. New York Business Corporation Law ("BCL") s 713(b) (McKinney Supp.1979) (eff. September 1, 1971); BCL s 713(a)(3) (McKinney 1963) (repealed as of September 1, 1971); see Cohen v. Ayers, 596 F.2d 733, 739-40 (7th Cir. 1979) (construing current BCL s 713); Remillard Brick Co. v. Remillard-Dandini Co., 109 Cal.App.2d 405, 241 P.2d 66, 75 (1952) (construing California Corporations Code s 820, upon which the prior BCL s 713 was patterned) 487

Under normal circumstances the directors of a corporation may determine, in the exercise of their business judgment, what contracts the corporation will enter into and what consideration is adequate, without review of the merits of their decisions by the courts. The business judgment rule places a heavy burden on shareholders *769 who would attack corporate transactions. Galef v. Alexander, 615 F.2d 51, 57-58 (2d Cir. 1980); Auerbach v. Bennett, 47 N.Y.2d 619, 629, 419 N.Y.S.2d 920, 926, 393 N.E.2d 994, 1000 (1979); 3A Fletcher, Cyclopedia of the Law of Private Corporations s 1039 (perm. ed. 1975). But the business judgment rule presupposes that the directors have no conflict of interest. When a shareholder attacks a transaction in which the directors have an interest other than as directors of the corporation, the directors may not escape review of the merits of the transaction. At common law such a transaction was voidable unless shown by its proponent to be fair, and reasonable to the corporation.[FN11] BCL s 713, in both its current and its prior versions, carries forward this common law principle, and provides special rules for scrutiny of a transaction between the corporation and an entity in which its directors are directors or officers or have a substantial financial interest. 487

FN11. E. g., Geddes v. Anaconda Copper Co., 254 U.S. 590, 599 (1921); Sage v. Culver, 147 N.Y. 241, 41 N.E. 513 (1895); Kaminsky v. Kahn, 23 App.Div.2d 231, 240, 259 N.Y.S.2d 716, 725 (1st Dep't 1965); Tomarkin v. Vitron Research Corp., 12 App.Div.2d 496, 206 N.Y.S.2d 869 (2d Dep't 1960). See also 3 Fletcher, supra s 921. 488

The current version of s 713,[FN12] which became effective on September 1, 1971, and governs at least so much of the dealing between SLE and LGT as occurred after that date, expressly provides that a contract between a corporation and an entity in which its directors are interested may be set aside unless the proponent of the contract "shall establish affirmatively that the contract or transaction was fair and reasonable as to the corporation at the time it was approved by the board . . . ." s 713(b). Thus when the transaction is challenged in a derivative action against the interested directors, they have the burden of proving that the transaction was fair and reasonable to the corporation. Cohen v. Ayers, supra. 488

FN12. BCL s 713 (McKinney Supp.1979) provides in pertinent part: 488

(a) No contract or other transaction between a corporation and one or more of its directors, or between a corporation and any other corporation, firm, association or other entity in which one or more of its directors are directors or officers, or have a substantial financial interest, shall be either void or voidable for this reason alone or by reason alone that such director or directors are present at the meeting of the board, or of a committee thereof, which approves such contract or transaction, or that his or their votes are counted for such purpose: 488

(1) If the material facts as to such director's interest in such contract or transaction and as to any such common directorship, officership or financial interest are disclosed in good faith or known to the board or committee, and the board or committee approves such contract or transaction by a vote sufficient for such purpose without counting the vote of such interested director or, if the votes of the disinterested directors are insufficient to constitute an act of the board as defined in section 708 (Action by the board), by unanimous vote of the disinterested directors; or 488

(2) If the material facts as to such director's interest in such contract or transaction and as to any such common directorship, officership or financial interest are disclosed in good faith or known to the shareholders entitled to vote thereon, and such contract or transaction is approved by vote of such shareholders. 488

(b) If such good faith disclosure of the material facts as to the director's interest in the contract or transaction and as to any such common directorship, officership or financial interest is made to the directors or shareholders, or known to the board or committee or shareholders approving such contract or transaction, as provided in paragraph (a), the contract or transaction may not be avoided by the corporation for the reasons set forth in paragraph (a). If there was no such disclosure or knowledge, or if the vote of such interested director was necessary for the approval of such contract or transaction at a meeting of the board or committee at which it was approved, the corporation may avoid the contract or transaction unless the party or parties thereto shall establish affirmatively that the contract or transaction was fair and reasonable as to the corporation at the time it was approved by the board, a committee or the shareholders. 488

The same was true under the predecessor to s 713(b), former s 713(a)(3), which was in effect prior to September 1, 1971.[FN13] Section 713(a)(3) was not explicit as to the burden *770 of proof, but simply stated that a transaction with interested directors would not be voidable "If the contract or transaction is fair and reasonable as to the corporation at the time it is approved by the board . . . ." The consensus among the commentators was that s 713(a)(3) carried forward the common law rule, which placed the burden of proof as to fairness on the interested directors. E. g., Hoffman, The Status of Shareholders and Directors Under New York's Business Corporation Law: A Comparative View, 11 Buff.L.Rev. 496, 566 (1962); Note, "Interested Director's" Contracts Section 713 of the New York Business Corporation Law and the "Fairness" Test, 41 Fordham L.Rev. 639, 648-49 (1973); see also Note, The Status of the Fairness Test Under Section 713 of the New York Business Corporation Law, 76 Colum.L.Rev. 1156, 1167-74 (1976) (discussing legislative history). We agree with this construction. Cf. Remillard Brick Co. v. Remillard-Dandini Co., supra (burden of proof allocated to interested directors under California Corporations Code s 820, upon which s 713(a)(3) was modeled). 489

FN13. BCL s 713 (McKinney 1963) (repealed) provided in pertinent part: 489

(a) No contract or other transaction between a corporation and one or more of its directors, or between a corporation and any other corporation, firm, association or other entity in which one or more of its directors are directors or officers, or are financially interested, shall be either void or voidable for this reason alone or by reason alone that such director or directors are present at the meeting of the board, or of a committee thereof, which approves such contract or transaction, or that his or their votes are counted for such purpose: 489

(1) If the fact of such common directorship, officership or financial interest is disclosed or known to the board or committee, and the board or committee approves such contract or transaction by a vote sufficient for such purpose without counting the vote or votes of such interested director or directors; 489

(2) If such common directorship, officership or financial interest is disclosed or known to the shareholders entitled to vote thereon, and such contract or transaction is approved by vote of the shareholders; or 489

(3) If the contract or transaction is fair and reasonable as to the corporation at the time it is approved by the board, a committee or the shareholders. 489

During the entire period 1966-1972, Richard, Alan and Leon, Jr., were directors of both SLE and LGT; [FN14] there were no SLE directors who were not also directors of LGT. Richard, Alan and Leon, Jr., were all shareholders of LGT in 1966, and from 1967 to 1972 Richard and Leon, Jr., were the sole shareholders of LGT. Under BCL s 713, therefore, Richard, Alan and Leon, Jr., had the burden of proving that $14,400 was a fair and reasonable annual rent for the SLE property for the period February 28, 1966 through June 1, 1972. 489

FN14. Alan ceased to be a director in November 1972; Leon, Jr., ceased to be a director in 1977. Richard remains a director. 489

Our review of the record convinces us that defendants failed to carry their burden. At trial, there was no direct testimony as to what would have been a fair rental during the relevant period, i. e., 1966 to 1972, and the evidence that was introduced fell far short of establishing that $14,400 was a fair annual rental value for those years 489

Quite clearly Richard, Alan and Leon, Jr., had made no effort to determine contemporaneously what rental would be fair during the years 1966-1972. Their view was that the rent should simply cover expenses and that SLE existed for the benefit of LGT.[FN15] During this period no appraisals were made; no attempts were made to sell or rent the Property; no thought whatever was given to whether $14,400 was a fair and reasonable rent even when real estate taxes had risen to consume nearly all of that amount 490

FN15. See footnote 4 supra, and accompanying text. 490

Defendants offered instead evidence of rents paid on other properties. Among their best evidence was the expert testimony of Harvey Rosenbloom, a real estate appraiser. Rosenbloom testified that two other East Avenue buildings, which the district court found to be comparable to the 260 East Avenue premises, were leased at lower per-square-foot rentals than was paid by LGT to SLE. However, as to one of these properties, Rosenbloom testified only *771 to rent paid in 1973 and 1974, and did not consider the 1966-1972 period. As to the other property, Rosenbloom described a fifteen year lease that was entered into in 1961. This testimony, while perhaps not wholly irrelevant to the issues in this suit, fell far short of demonstrating what rental the Property could have fetched in 1966, or in any other of the relevant years. Indeed, Rosenbloom himself testified that rental value could well be different for each year of the period. Thus, rentals that Rosenbloom testified were agreed to in 1961 or 1973 might well have been unfair in 1966 or 1967. This evidence thus could not support a finding that defendants acted fairly in maintaining an annual rental of $14,400 during the years from 1966 to 1972. [FN16] 490

FN16. Defendant Richard E. Lewis testified that defendants tried, without success, to sell the Property in 1975, listing it with a realtor for $200,000. In addition he testified that an effort was made to rent the Property in 1973, and that only one offer, for $700 per month, was forthcoming. Since these efforts were made in 1973 and 1975, this evidence, like the evidence as to rentals of other property, was too remote in time to establish a fair rental value, especially as to the earlier years of the 1966-1972 period. 490

Defendants also produced considerable evidence that over the relevant period, the East End neighborhood had been on an economic decline; that businesses had been leaving the area; that urban renewal projects and increased crime had depressed property values there; and that the area had, in general, become a less desirable place to do business. There was also evidence of specific developments that had an adverse effect on the Property: for example, the street running along one side of the Property was made a one-way street, thus limiting customers' access to LGT's premises. The district court credited all of this testimony, and it is fair to say that defendants proved that there was a general downward trend in the value of the Property. However, as noted above, defendants did not establish what was a fair rental value for the Property in 1966. Absent such a point of reference, a general downward trend in value is of no assistance in determining whether the rental actually paid was fair and reasonable during the ensuing years 490

Moreover, working in reverse, some of defendants' own evidence as to the value of the Property at the end of the relevant period suggested that $14,400 was less than a fair rental in 1966, and that the figure of $38,099, estimated by plaintiff's expert, was perhaps not far off the mark.[FN17] First, there was a variety of evidence suggesting that in 1972 the Property was worth more than $200,000. An appraisal by defense witness Harold Grunert in 1972 set the fair market value of the Property as of June 30, 1972, at $220,000. In 1972 Leon, Jr., had offered personally to buy the Property for $200,000, an offer which Richard had rejected.[FN18] And in 1971, Richard had informed Donald that evaluations by another appraiser, Harold Galloway, had set the value of the Property at $200,000 and $236,000. Second, defendants' expert witness Rosenbloom, asked what he would consider a fair rent for the property, given Grunert's 1972 valuation of $220,000, stated that ten percent of the value would be inadequate and that fifteen to seventeen percent would be closer to adequate. Fifteen percent of $220,000 would have yielded a rent of $33,000 on the basis of the 1972 valuation. Grunert's own expert testimony was entirely consistent with this. While he had made no estimate as to the fair rental value of the property for 1966-1972, he opined that a fair rental as of June 30, 1972, would be $20-21,000 with the tenant paying all expenses including real estate taxes. According to Richard, SLE's real estate taxes in 1972 were about $12,000. Thus Grunert's testimony, too, suggests about $33,000 as the fair rental value in 1972. Finally, consistent with their view of the general downward economic trend, Richard and Alan conceded that, whatever the Property was worth in *772 1972, it was worth more in 1966.[FN19] Thus the evidence presented by defendants, far from carrying their burden of showing that $14,400 was a fair and reasonable annual rental in 1966-1972, suggested that the fair rental value of the Property throughout that period exceeded $33,000 per year. 490

FN17. Plaintiff's expert made his evaluation as of February 1973. He did not make any evaluation for the period 1966-1972. 491

FN18. Leon, Jr., had just been fired from LGT by Richard. 491

FN19. Leon, Jr., did not know whether the value had decreased from 1966 to 1972, but did not believe it had risen. 491

The defendants argued, however, that LGT could not have afforded to pay SLE rent higher than $14,400. They produced evidence designed to show that LGT had made little profit; that this low profitability was due to the expenses of maintenance and upkeep of the 260 East Avenue property; and that LGT therefore would not have been able to pay a higher rent to SLE. The district court credited this evidence, finding that LGT had "experienced a number of years of very severe losses," that during the period from 1962-1973, LGT's overall profit was only $53,876, and that payment of rent at the rate of $39,099 per year during this period could have led to the "demise" of LGT. These findings have only a distorted relationship to this lawsuit 491

The period in issue here is 1966-1972. The only "severe" losses shown, totaling nearly $83,000, occurred in 1963 and 1973. Their inclusion in the computation of what LGT could afford to pay in 1966-1972 was patently unfair. In fact LGT's only unprofitable year during the period in issue was 1969 when its loss was small: $1,168. LGT's after-tax profits in 1966-1972 in fact totaled $102,963, or an average of $14,709 per year. Thus, even on paper, LGT could have "afforded" to double its rent payments to SLE during the period in question 491

Moreover, the proposition that LGT could not afford to pay as rent more than what its own books showed as profits ignores the fact that LGT was owned and managed by members of the Lewis family, some of whom were also employees of that corporation. It is entirely possible that these family members granted to themselves unusually high salaries or other perquisites, thus reducing LGT's paper profits. For example, in 1966 Richard's salary was approximately $21,000; Leon, Jr.'s compensation was $3,000 salary plus commissions. In 1967, LGT acquired all of Alan's LGT stock; and Richard and Leon, Jr., acquired all of the LGT stock of their father, agreeing to pay the purchase price over a ten-year period. Richard and Leon, Jr., thus became LGT's only shareholders, and their LGT salaries were immediately increased by a total of $23,000 per year (Richard's salary went from $21,000 to $36,000; Leon, Jr.'s went from $3,000 to $11,000), to cover the cost of the LGT stock they had just acquired. [FN20] Defendants bore the burden of proof on the question of a fair and reasonable rental; if they would rely on the proposition that LGT was unable to pay more, it was incumbent on them to demonstrate the fairness of the management and the reasonableness of the conduct of LGT's affairs. It does not appear that they made any effort to do so 491

FN20. Richard had no doubt he could have paid for his newly acquired shares without the increase in his LGT salary. Leon, Jr., apparently lacked other resources from which to pay for the LGT stock (at least after he was fired from LGT in 1972). 492

Finally, even if we were to assume that LGT's financial records provided a fair basis for evaluating the SLE-LGT transactions, defendants would not have carried their burden of proof. Defendants did not demonstrate that SLE could not have found some other tenant, stronger financially than LGT, which would have been willing and able to pay a higher rental. Even given the general downward trend of the East Avenue neighborhood, it is entirely possible that at least during the early years of the 1966-1972 period, such a tenant might have been secured. No effort was made during that period to rent to anyone other than LGT 492

We conclude, therefore, that defendants failed to prove that the rental paid by LGT to SLE for the years 1966-1972 was fair and reasonable. Thus, Donald is not required to sell his SLE shares to LGT without such upward adjustment in the June 1, 1972, book value of SLE as may be *773 necessary to reflect the amount by which the fair rental value of the Property exceeded $14,400 in any of the years 1966-1972. 492

III 492

The district court also erred in entering awards of attorneys' fees in favor of the defendant directors and SLE. Under New York law,[FN21] such awards are improper absent statutory authorization. City of Buffalo v. J. W. Clement Co., 28 N.Y.2d 241, 262-63, 321 N.Y.S.2d 345, 364, 269 N.E.2d 895, 908 (1971). Defendants have not pointed to any statute that would allow an award of attorneys' fees to them in this case, and our research has disclosed none. [FN22] Insofar as the district court may have premised these awards on an implicit finding that plaintiff brought this action in bad faith, our reversal on the merits removes the basis for such a determination. Accordingly, we reverse the awards of attorneys' fees to the defendants and SLE. 492

FN21. In this diversity action, state law governs the question of availability of attorneys fees'. Alyeska Pipeline Serv. Co. v. Wilderness Soc'y, 421 U.S. 240, 259 n.31, 95 S.Ct. 1612, 1622-1623, 44 L.Ed.2d 141 (1975); 6 Moore's Federal Practice P 54.77(2) at 1712-13 (2d ed. 1976). 492

FN22. N.Y.Bus.Corp.Law s 627 (McKinney Supp.1979), under which a shareholder bringing a derivative action may be required to give security for costs and attorneys' fees, does not apply to this case because plaintiff owns more than 5% of the shares of SLE. In those derivative actions where s 627 does not apply, there is no statutory basis for awarding attorneys' fees against a plaintiff shareholder. See Schielcrawt v. Moffett, 294 N.Y. 180, 187, 61 N.E.2d 435, 438 (1945) and Isensee v. Long Island Motion Picture Co., 184 Misc. 625, 54 N.Y.S.2d 566 (Sup.Ct.1945) (construing the predecessor section to s 627, General Corporation Law s 61-b). 492

Finally, we note that plaintiff sought unsuccessfully in the district court to recover his own attorneys' fees from the defendants. New York law permits the award of attorneys' fees to the attorney for a successful derivative plaintiff, out of the corporation's recovery from the defendants. BCL s 626(e); Ripley v. International Railways, 16 App.Div.2d 260, 227 N.Y.S.2d 64 (1st Dep't), aff'd, 12 N.Y.2d 814, 236 N.Y.S.2d 64, 187 N.E.2d 131 (1962); Jones v. Uris Sales Corp., 373 F.2d 644 (2d Cir. 1967). We suggest that, in light of our decision, a new motion in the district court for such an award would not be inappropriate 492

We remand to the district court (a) for the entry of judgment in favor of SLE against Richard, Alan and Leon, Jr., jointly and severally, in such amount as the district court shall determine to be equal to the amounts by which the annual fair rental value of the Property exceeded $14,400 in the period February 28, 1966-June 1, 1972, (b) for an accounting as to the value of Donald's SLE shares as of June 1, 1972, in light of such judgment, (c) for an order, following such accounting, of specific performance of the shareholders' agreement, and (d) for such other proceedings as are not inconsistent with this opinion. 493