Schmidt v. Magnetic Head Corp.

• Citation: 476 N.Y.S.2d 151,101 A.D.2d 268
• Parties: Herbert J. SCHMIDT, Jr., Appellant-Respondent, v. MAGNETIC HEAD CORPORATION, et al., Respondents-Appellants; Edward W. Gleason, Respondent.
• Decision Date: 30 April 1984
• Court: New York Supreme Court Appellate Division

Page 151

476 N.Y.S.2d 151

101 A.D.2d 268

Herbert J. SCHMIDT, Jr., Appellant-Respondent, v. MAGNETIC HEAD CORPORATION, et al., Respondents-Appellants Edward W. Gleason, Respondent.

Supreme Court, Appellate Division Second Department.

April 30, 1984.

Berg & Duffy, Lake Success (James P. Duffy, III, Lake Success, pro se, Walter J. Gumersell and Elaine B. Zapfel, Lake Success, of counsel), for appellant-respondent.

Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C., Mineola (William V. Alesi, Mineola, of counsel), respondent-appellant pro se and for the other respondents-appellants.

Before TITONE, J.P., and O'CONNOR, WEINSTEIN and RUBIN, JJ.

PER CURIAM.

These appeals are closely related to other appeals (Schmidt v. Magnetic Head Corp., 97 A.D.2d 151, 468 N.Y.S.2d 649 and Matter of Schmidt 97 A.D.2d 244, 468 N.Y.S.2d 663 ), both decided by this court on November 14, 1983. A summary of that litigation will provide an enlightening factual basis for review of the instant appeals.

On April 30, 1978, Herbert J. Schmidt, Jr. and his wife Barbara Schmidt, principal stockholders of MCP Corporation (hereinafter MCP), a Delaware corporation, entered into an agreement with defendant Magnetic Head Corporation (hereinafter Magnetic Head) a publicly traded New York corporation, whereby the latter acquired MCP by exchanging 47.5% of its issued stock for all of the MCP shares. As a result of this transaction, the Schmidts became the owners of 45.8% of Magnetic Head stock, the largest stockholder interest.

A shareholders' agreement was entered into on April 30, 1978, the acquisition date. Disagreements subsequently arose between the Schmidts and other members of the board of directors with respect to this agreement, particularly as to the right, if any, of the Schmidts to name a successor director in place of their prior designee who had resigned. The other members of the board refused to elect James P. Duffy, the Schmidts' new designee, and instead chose one Edward Gleason to fill the vacancy.

The Schmidts commenced an action (Index No. 4823/81) against Magnetic Head and the other members of its board, requesting, among other things, specific performance, construction and reformation of the shareholders' agreement and also to compel Duffy's acceptance as a director. Alternately, they sought rescission of the agreement. The Schmidts cross-moved within the action to disqualify the law firm of Farrell, Fritz, Cleary, Barnosky and Armentano, P.C. (hereinafter Farrell, Fritz) from representing both Magnetic Head and the defendant directors.

This court, in its opinion (Schmidt I, supra ), held that the causes of action for reformation and rescission would survive a motion to dismiss. In addition, the order of Special Term (WAGER, J.), entered July 14, 1981, which denied that part of the Schmidts' cross motion which was to disqualify the law firm was affirmed.

Prior to the holding of Magnetic Head's annual meeting in October, 1981, both the board of directors, under the control of a majority led by defendant Rockwell, and the Schmidts solicited proxies. The measures proposed by the Rockwell group easily passed at the meeting; among those were the election of a slate of directors, including the board's nominee to replace the director who had resigned.

Herbert Schmidt thereafter commenced an action to annul the tabulation of the votes at the shareholders' meeting and initiated a proceeding purportedly pursuant to section 619 of the Business Corporation Law, to set aside the election of the board of directors and to vacate the passage of amendments to the articles of incorporation authorizing the issuance of new shares. This court affirmed the order of Special Term which dismissed the complaint in the action but reversed the judgment of Special Term which had dismissed the proceeding brought pursuant to section 619 (Schmidt II, supra ). That aspect of the proceeding as pertained to the authorization of new shares was converted into an action to determine the validity of the authorizations.

Subsequent to the October, 1981, annual meeting, the parties became involved in additional litigation, of which motions with respect thereto resulted in orders which are the subject of the instant appeals.

An action was brought (Index No. 7036/82) as a purported shareholders' derivative action by Herbert Schmidt against Magnetic Head, MCP and the directors of each corporation, with the exception of his wife Barbara Schmidt. The first cause of action alleges that director Gleason was guilty of a conflict of interest and failure to exercise his business judgment in connection with a secret relationship that he had with one William Sommerfield and Perth-Am Service Corp. (hereinafter Perth-Am). It alleges that Sommerfield received over $250,000 of commissions, which included commissions for business MCP conducted with Perth-Am, that the business relationship of Gleason and Sommerfield was unknown to and not consented to by Magnetic Head and MCP, and that Gleason, as the highest and final approving authority for the awarding of commissions to MCP sales agents, had a duty to avoid undue expense to MCP. An accounting was sought of Gleason for any benefits he may have derived from the secret business relationship. The second cause of action alleges that as a result of the secret relationship and business dealings, Gleason has wasted assets of Magnetic Head and MCP. The third cause of action claims that Gleason had used the services of MCP's employees and its equipment to perform Perth-Am's obligations to others without compensating MCP and requests an accounting for this waste. The fourth cause of action alleges that by acting as a principal in Perth-Am, Gleason competed with MCP, thus violating his duty of undivided loyalty to MCP. The fifth cause of action alleges that Gleason had engaged in self dealing and profited personally at MCP's expense from his secret business dealings and seeks an accounting. Each of the first five causes of action asserts that, although requested to do so, the board of directors of Magnetic Head failed to take any action to compel Gleason to account for his conduct. The sixth cause of action alleges that by their refusal to investigate and take appropriate action, the boards of directors of Magnetic Head and MCP had been derelict and negligent in their duties and had failed to act in the best interests of the corporations.

Defendants Rockwell, McKinley, Oakley, M. Sprague and R. Sprague served a joint answer on behalf of themselves, Magnetic Head, and MCP. A counterclaim was also asserted by the individual defendants on behalf of the corporations, alleging that Herbert Schmidt had violated his fiduciary duties to the corporations by failing and refusing to provide the defendant directors with documentation to support his accusations, by acting solely for his personal benefit and motives, and by delegating his duties to participate in the management of the corporations' affairs.

Gleason's answer essentially follows that of the other defendants, denying the allegations that he had engaged in secret business dealings or had committed a breach of fiduciary duties and waste of corporate assets. He admits that he was one of the principals of Perth-Am from January, 1978 through April 6, 1978, but denies that he received any compensation from Perth-Am or that it had engaged in the business referred to in the complaint.

By notice of motion dated June 9, 1982, defendants moved, in the Index No. 7036/82 action, for an order disqualifying the firm of Berg and Duffy, and James Duffy, individually, from representing Schmidt, individually, and on behalf of all other shareholders of Magnetic Head, claiming that Duffy had acquired a personal and proprietary interest in the subject litigation by accepting plaintiff's nomination for Magnetic Head's board of directors. The notice of motion also demanded that plaintiff produce all memoranda, correspondence and agreements relating to any understanding between plaintiff and Duffy regarding his designation and/or nomination as a director of Magnetic Head and/or his designation as a proxy holder. While a decision on this motion was pending, plaintiff moved for an order disqualifying Farrell, Fritz from representing both the defendant corporations and the defendant directors in the same action on the ground that the corporations and directors were active participants in the litigation with conflicting interests.

Both motions were decided on September 27, 1982. Special Term (MORRISON, J.) ruled that a hearing was necessary to determine whether Duffy had violated the Code of Professional Responsibility and granted plaintiff's motion to the extent of disqualifying Farrell, Fritz from representing the corporate defendants, holding that the assertion by Magnetic Head of a counterclaim made active participants of those defendants.

By notice of motion dated October 15, 1982, plaintiff moved in the Index No. 4823/81 action for an order disqualifying Farrell, Fritz from representing both the corporate defendant and the defendant directors on the same grounds advanced in his motion for this relief in the shareholders' derivative action. In an affidavit in opposition, defendants noted, among other things, that the relief requested had previously been denied by Justice WAGER and that plaintiff's appeal of that order was still pending.

During the pendency of this motion and still prior to a hearing being held on defendants' motion to disqualify Duffy and his firm in the shareholders' derivative (Index No. 7036/82) action, four more motions were brought by the litigants. By notice of motion dated October 21, 1982, plaintiff moved for an order disqualifying Farrell, Fritz from representing the noncorporate defendants in the derivative action on the ground that the firm had been disqualified from representing the corporate defendants. Plaintiff further alleged that in connection...