DeSantis, Conrad J.

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Volume 9 Issue 2 Article 11 1964 Corporations - Contract between Corporation and Its Controlled Affiliate to Allocate More than Proportionate Share of Tax Saving to Dominant Corporation Violates Its Fiduciary Duty to Minority Shareholders of Affiliate Conrad J. DeSantis Follow this and additional works at: https://digitalcommons.law.villanova.edu/vlr  Part of the Business Organizations Law Commons Recommended Citation Conrad J. DeSantis, Corporations - Contract between Corporation and Its Controlled Affiliate to Allocate More than Proportionate Share of Tax Saving to Dominant Corporation Violates Its Fiduciary Duty to Minority Shareholders of Affiliate, 9 Vill. L. Rev. 326 (1964). Available at: https://digitalcommons.law.villanova.edu/vlr/vol9/iss2/11 This Note is brought to you for free and open access by Villanova University Charles Widger School of Law Digital Repository. It has been accepted for inclusion in Villanova Law Review by an authorized editor of Villanova University Charles Widger School of Law Digital Repository. VILLANOVA LAW REVIEWCORPORATIONS-CONTRACT BETWEEN CORPORATION AND ITS CON-TROLLED AFFILIATE To ALLOCATE MORE THAN PROPORTIONATE SHAREOF TAX SAVING TO DOMINANT CORPORATION VIOLATES ITS FIDUCIARYDUTY TO MINORITY SHAREHOLDERS OF AFFILIATE.Case v. New York Cent. R.R. (N.Y. 1963)The defendant, New York Central Railroad Company (hereinaftercalled Central), owned a majority of the stock in the Mahoning Coal Rail-road Company (hereinafter called Mahoning). In 1957, Central increasedits holdings in Mahoning to eighty per cent in order to qualify undercurrent tax law' to file a consolidated return with Mahoning. Then, byreason of its control, it caused Mahoning to enter a contract with it bywhich any tax savings accruing to Mahoning as a result of the consolidatedreturn would be allocated in the proportion of ninety three per cent toCentral and seven per cent to Mahoning.2 The minority stockholders ofMahoning brought suit claiming a violation of the fiduciary duties owedthem by Central as majority stockholder.The relief sought by the plaintiffs was rescission of the allocationagreement and an accounting of all moneys received by Central fromMahoning pursuant to the contract for the tax years 1957-60. TheAppellate Division with two judges dissenting, reversed the lower courtand held the allocation agreement unfair and unenforceable against theminority stockholders. It further directed the defendant to account for allmoneys received under the agreement. Case v. New York Cent. R.R ...........App. Div ........... 243 N.Y.S.2d 620 (1963).The court, in holding this agreement invalid, found that there wasa fiduciary relationship between Central, as majority stockholder inMahoning, and the plaintiffs as minority stockholders, which requiredfairness in dealings between the affiliates. It cited scant precedent in the1. INT. Rxv. Cooz or 1954, §§ 1501-04.2. Since 1884, Central had owned a majority of the stock of Mahoning and hadbeen the lessee of Mahoning's railroad under an agreement by which Central paid allmaintenance and operating expenses of the railroad and, in addition, paid to Mahoning40% of gross earnings. In 1957, Central acquired additional stock of Mahoning inorder to qualify Mahoning as an "affiliate" under the 1954 revision of the InternalRevenue Code (Ibid.) and allow it to file a consolidated return, thus permittingMahoning's net profits to be setoff against Central's net losses.Had Mahoning filed separate returns for the years in question, 1957-1960, itstotal tax liability would have been $3,825,717.43. The filing of consolidated returnscaused Mahoning's net profits to be totally offset by Central's losses and effected asaving of the entire tax liability. The agreement in dispute here, provided for dis-tribution of this tax saving, and by its terms, the sum of $3,556,992.15, or approxi-inately 93%, was allocated to Central. The balance of the tax saving, $268,725.28, or7%, was the net saving to Mahoning. This saving then, in theory, became apotential dividend to the stockholders of Mahoning which gave the 20% minoritystockholders a dividend expectancy of $53,751.05, or approximately 1.5%, of theoriginal tax saving, and gave to Central, as 80% stockholders, $3,771,966.38, or 98.5%of the total tax savings. It is because of this disproportionate distribution ofMahoning's tax saving that the minority stockholders allege a breach of fiduciaryduty by Central as controlling majority stockholders.[VOL. 91DeSantis: Corporations - Contract between Corporation and Its Controlled AfPublished by Villanova University Charles Widger School of Law Digital Repository, 1964RECENT DEVELOPMENTS.particular field of allocation of tax savings. Western Pac. R.R. v. WesternPac. R.R. 3 had settled the proposition that, in the absence of agreement, thetax saving would fall where it may. That case, however, did not involveany agreement and could not answer the problem presented here. Theonly case cited which did involve an agreement to allocate tax savings toone other than the one benefited by it was Alleigro v. Pan American Bank.4That case also involved a parent and subsidiary corporation. The courtthere held the agreement invalid, but on the theory that the allocationrepresented a preferential dividend which was not ratified by the stock-holders. The court in the instant case did not reach that question andstated that it was unnecessary to do so. The avoidance of that problemseems to be correct. The basic question is whether such an agreementbetween affiliates is fair. Although a finding that any money transferredunder such an agreement is in fact a preferential dividend would a fortiorirequire a finding that the agreement was unfair, if it is found unfair onthe more general ground of fiduciary duty, as it was here, it is logicallyunnecessary to proceed further.The basic problem of fairness is best highlighted by the dissentingopinion. It argues that since Mahoning would have paid all the money tothe federal government as tax liability, the savings, "whatever percent-age, . . .represents income that Mahoning's minority stockholders wouldnever have realized had there been no agreement." 5 The point the opinionmakes is simply, if there is no injury, but in fact benefit to Mahoning,how can the contract be unfair? To understand why the simplicity of thisargument may entrap the unwary, it is necessary to examine first how thefiduciary duty is created and the burdens it imposes.Generally, a fiduciary relationship arises in those cases in. which oneholds a position of superiority and influence over the interest of anotherso that the latter is forced to rely upon the good faith and fair dealings ofthe former.6 The law gives the majority shareholders the right to control,but requires that those who have this control act with the utmost goodfaith.7 Thus where the majority control causes the corporation to enter aprofitable transaction, the minority may not be excluded from a fair partici-pation in the fruits of the deal.83. 197 F.2d 994 (9th Cir. 1951).4. 149 So. 2d 45 (Fla. 1963).5. Case v. New York Cent. R.R., 243 N.Y.S.2d 620, 626 (App. Div. 1963).6. Schweickhardt v. Chessen, 329 Ill. 637, 161 N.E. 118 (1928) ; Small v. Nelson,137 Me. 178, 16 A.2d 473 (1940).7. In Allied Chem. & Dye Corp. v. Steel & Tube Co., 14 DOI. Ch. 1, 120 Atl. 486(1923), the court said:The same considerations of fundamental justice which impose a fiduciarycharacter upon the relationship of the directors to the stockholders will alsoimpose ...a like character upon the relationship which the majority of thestockholders bear to the minority. . . .Unless the majority in such case are tobe regarded as owing a duty to the minority such as is owed by the directorsto all, then the minority are in a situation that exposes them to the grossestfrauds and subjects them to most outrageous wrongs.Id. at 12-13, 120 Ati. at 491.8. Southern Pac. Co. v. Bogert, 250 U.S. 483, 488, 39 S.Ct. 533, 535 (1918).WINTER 1964]2Villanova Law Review, Vol. 9, Iss. 2 [1964], Art. 11https://digitalcommons.law.villanova.edu/vlr/vol9/iss2/11VILLANOVA LAW REVIEWIn Case, Central, as majority stockholder of Mahoning, had nominatedall directors, of whom five were officials of Central and one an official ofone of its other subsidiaries. Where one corporation controls another byholding a majority of the stock, and elects its own employees to controlthe board of directors, contracts between the two corporations must beregarded as if between a corporation and its directors, and should begoverned by the same principles.9 The general rule seems to be that suchtransactions are subject to the careful and close scrutiny of the courts,10and according to the weight of authority such contracts will be set asideunless they are fair and reasonable."The dissent recognizes the nature of the relation when it says "thatthe agreement was one made by Central with itself,' 2 but it fails to applythe standard demanded. The traditional bargaining mechanism of themarket place which determines values to be received in the normal agree-ment is obviously not present in dealings between a dominant and a domi-nated corporation. The courts attempt to compensate for the balanceacquired in the free market by inserting the fairness test. Although thistest affords the fiduciary more latitude than the strict duties of the trusteewhich prohibits any self-dealing 3 it still provides a constant reminder todirectors, officers and majority stockholders that the minority interestswill be protected when equity requires.The essence of the test of fairness is whether or not, under all thecircumstances, the transaction carries the earmarks of an arm's lengthbargain.' 4 Thus, while all contracts between a dominant and a dominatedcorporation are not void, the element of fairness must be present. Themajority in Case recognizes that "there cannot be effective independentbargaining among affiliates,"' and applied the proper test when it held thatCentral, as majority stockholder, owed a duty of fairness in its dealingswith Mahoning.The defendant argues that it was only through Central's independentdecision to make increased investment in additional stock and its consentto file a consolidated return that a tax saving was realized. The apparentthrust of this argument was that the contract was based on adequateconsideration and thus should be enforceable. Even assuming this issueto be arguable in spite of the fairness required, the majority adequately andlogically answers this argument by saying that "this was not an act of9. Ripley v. International Rys., 8 N.Y.2d 430, 436, 209 N.Y.S.2d 289, 292 (1960) ;Kavanaugh v. Kavanaugh Knitting Co., 226 N.Y. 185, 195-96, 123 N.E. 148, 151-52(1919) ; Farmers' Loan & Trust Co. v. New York & No. R.R., 150 N.Y. 410, 429-30,44 N.E. 1043, 1048-49 (1896).10. Pepper v. Litton, 308 U.S. 295, 60 S.Ct. 238 (1939); Twin-Lick Oil Co. v.Marbury, 91 U.S. 328 (1875).11. Montgomery Traction Co. v. Harmon, 140 Ala. 505, 37 So. 371 (1904).12. Case v. New York Cent. R.R., 243 N.Y.S.2d 620, 626 (App. Div. 1963).13. RESTATVMVNT (StcoND), TRUSTS § 170, comment b; § 206 (1959).14. Pepper v. Litton, 308 U.S. 295, 306-07, 60 S.Ct. 238, 245 (1939).15. Case v. New York Cent. R.R., 243 N.Y.S.2d 620, 623 (App. Div. 1963).[VOL. 93DeSantis: Corporations - Contract between Corporation and Its Controlled AfPublished by Villanova University Charles Widger School of Law Digital Repository, 1964RECENT DEVELOPMENTSCentral that was a matter of free choice."' 16 They express the view that,in the light of the obvious saving to the affiliated corporations, Central hada "duty" to qualify Mahoning by increasing its investment in stock up toeighty per cent.17 The majority thus relies on the well-recognized principlethat a pre-existing duty will not support a new promise and, therefore, thecontract is void for lack of consideration. However, even if the court hadreached the opposite conclusion on this issue, the most important anddeterminative issue here was whether the contract was fair.Case was a unique situation which was the product of the InternalRevenue Code provisions "permitting" affiliated corporations to file con-solidated returns.'8 These provisions recognize the realities of big businessand allow a large corporate complex to file income tax returns as oneunit. The Code provisions contain an inherent ambiguity in requiring the"consent" of each corporation in an affiliated group,' 9 and on the other hand,in specifying eighty per cent ownership of the subsidiary by the parent.2 0The requirement of consent by both parties gives some weight to Cen-tral's position that the contract was fair, and to Mr. Justice Jackson's argu-ment in his dissenting opinion in Western Pac. R.R. v. Western Pac. R.R.21Jackson argued that the loss corporation had a right to ask for compensa-tion for the use of its loss privilege and said "indeed, it is probable thatthe intention of the statute ...was to provide salvage for the loser, notprofit for one which sustained no loss."'22 The argument can then be madethat the consent requirement would have permitted Central to refuse toallow Mahoning the benefit of its tax loss.However, there is an intrinsic fallacy in the argument as usedhere. The Code clearly calls for eighty per cent ownership.23 This factorplus the realities of corporate organization make it clear that the decisionas to Mahoning's consent was made only by the dominant corporation, andthe subsidiary's "consent" was automatic. Central's consent was compelledby its duty to the affiliate. Thus, while automatic consent may be sufficientto meet the standard of the tax provision, it has no bearing on collateralallocation agreements. Given the fiduciary duty of Central, the courtsimply determined that the contract was unfair and void.There is an apparent dearth of authority concerning the effects ofconsolidated returns on the rights of the stockholder. The federal taxprovisions involved clearly provide no answer since they merely allowcertain advantages if a corporate complex so organizes itself to meet the16. Id. at 624.17. The additional investment of $1,000,000 is hardly significant in proportion tothe tax saving of $3,825,717.43 over the period 1957-1960.18. INT. RXv. CODe OF 1954, §§ 1501-04.19. INT. Rev. CODS oP 1954, § 1501.20. INT. Rzv. CODS OF 1954, § 1504(a) (1).21. 345 U.S. 247, 73 S.Ct. 656 (1953). The majority opinion in this case wasinvolved only with procedural aspects. It did not disturb the holding of the lowercourt on the merits. Western Pac. R.R. v. Western Pac. R.R., 197 F.2d 994 (9thCir. 1951).22. Id. at 277, 73 S.Ct. at 671.23. INT. Rrv. CODt OF 1954, § 1504(a) (1).WINTER 1964]4Villanova Law Review, Vol. 9, Iss. 2 [1964], Art. 11https://digitalcommons.law.villanova.edu/vlr/vol9/iss2/11

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Corporations - Contract between Corporation and Its Controlled Affiliate to Allocate More than Proportionate Share of Tax Saving to Dominant Corporation Violates Its Fiduciary Duty to Minority Shareholders of Affiliate

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Corporations - Contract between Corporation and Its Controlled Affiliate to Allocate More than Proportionate Share of Tax Saving to Dominant Corporation Violates Its Fiduciary Duty to Minority Shareholders of Affiliate

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