APPELLATE COURT TO SMALL BUSINESS OWNER: “READ YOUR CORPORATE DOCUMENTS”

The Sixth Circuit Court of Appeals recently affirmed the dismissal of a cosmetologist’s lawsuit in which she alleged that her business partner committed securities fraud in swindling her out of her rights in their two-owner company.  The factual essence of the plaintiff’s case was that she wanted to show that she trusted her co-owner, the defendant-shareholder, by not reading the corporate organizational documents prepared by the defendant-shareholder to memorialize their oral discussions about their relative rights and responsibilities in the ownership and governance of their company. She signed whatever she was handed. The plaintiff’s trust was misplaced it turns out, and she learned the hard way that courts enforce written agreements.

The basic corporate organizational documents prepared by the defendant-shareholder for the plaintiff’s signature appear to be similar to the basic forms included in a standard corporate kit. The documents that the plaintiff blindly signed included:

• the articles of incorporation, which provided for two-classes of stock, and which were filed with the state to incorporate the company,
• a Written Consent in Lieu of the First Meeting of the Board of Directors, which appointed plaintiff as president and defendant-shareholder as corporate secretary and treasurer and noted that defendant-shareholder had subscribed to 50 Class A shares and plaintiff to 50 Class B shares;
• an Action of Shareholders appointing defendant-shareholder and plaintiff as the Directors;
• a Subscription to Shares noting that defendant-shareholder subscribed for 50 Class A shares and plaintiff subscribed for 50 Class B shares; and
• a stock certificate showing plaintiff’s ownership of 50 shares of the company’s Class B Nonvoting Stock.

Of the documents plaintiff signed, only the stock certificate indicated that her stock was nonvoting, but all of the documents relating to stock ownership made clear that plaintiff’s stock was not the same class as defendant-shareholder’s. Plaintiff did not read the documents she signed, instead relied on defendant-shareholder’s husband to read and explain them.

Approximately one and one-half years later, defendant-shareholder’s husband asked plaintiff to sign more documents. In this second round of signings, plaintiff unwittingly sold her ownership interest in the company to defendant-shareholder for $1.00.

An attempted third opportunity by the defendant-shareholder to get plaintiff to sign documents failed, as plaintiff consulted legal counsel and ultimately filed suit.

The court’s opinion is a startling reminder that there is no legal justification for signing corporate documents that one does not read. In both circumstances, the purchase of stock in the company and the later sale of that stock were situations in which plaintiff was presented with corporate documents, and no attempt was made by the defendants to prevent plaintiff from reading them. Had plaintiff read the documents, she would have easily learned what was happening. Thus, the court held that plaintiff’s ignorance of the contents of the documents and her alleged reliance on the defendants’ oral representations was not justified. The court also held that during the organizational stage of the company the defendants did not have a fiduciary duty to plaintiff, nor did the plaintiff have a claim against the defendant-shareholder’s husband, who is the only person plaintiff spoke to about selling her stock, because the defendant’s husband had no official position in the company. Plaintiff had been the company’s president for over a year, was inexperienced in financial and investment matters but was a successful business woman and was somewhat familiar with contracts. The court said:

“[a] reasonable small business owner entering into a partnership of this nature would seek to understand exactly what rights and responsibilities she would have in the new company. [The parties] had previously discussed what each individual’s role would be in the company, and it would have been prudent to attempt to check that the paperwork confirmed, rather than contradicted, [plaintiff’s] interpretation of the partners’ common understanding. [Plaintiff] was thus reckless in relying on the [Defendant’s] alleged misrepresentations regarding her control of [the company], and so her reliance on those representations in acquiring shares of [the company] was not justifiable.”

There are many morals to this story: the obvious one, of course, in business you must take basic steps to protect yourself like reading the organizational documents of the company that you are president of and the contracts that you are asked to sign. There is also the moral that it is important for small business owners to document their organizational systems, processes, rights, and responsibilities and to maintain the company’s internal controls over these matters for the protection of the company and its investors.

Bender v. Logan, 2015 U.S. App. LEXIS 7212 (6^th Cir. 2015).