Smith v. Tele-Communication, Inc.

• Decision Date: 27 July 1982
• Docket Number: TELE-COMMUNICATIO,INC
• Citation: 134 Cal.App.3d 338,184 Cal.Rptr. 571
• Court: California Court of Appeals Court of Appeals
• Parties: John SMITH, Plaintiff and Appellant, v., et al., Defendants and Respondents. Civ. 51291.

Page 571

184 Cal.Rptr. 571

134 Cal.App.3d 338

John SMITH, Plaintiff and Appellant, v. TELE-COMMUNICATION, INC., et al., Defendants and Respondents.

Civ. 51291.

Court of Appeal, First District, Division 3, California.

July 27, 1982.

Hearing Denied Oct. 28, 1982.

Law Offices of Charles Stuhr, Eugene P. McAuliffe, San Francisco, for plaintiff and appellant.

Farrow, Schildhause & Wilson, Lynne M. Armstrong, Oakland, for defendants and respondents.

FEINBERG, Associate Justice.

This is an appeal from a judgment of dismissal entered after the court sustained without leave to amend the demurrer of the parent corporation defendant Tele-Communication, Inc. (TCI), and the directors of the subsidiary, Crystal Brite Television, Inc. (Crystal Brite) (the individual defendants). The fifth amended complaint filed by plaintiff John Smith, the minority shareholder of the subsidiary, alleged fraud, breach of fiduciary duties, and sought an accounting. For the reasons set forth below, we reverse.

The novel question is whether, without the consent of the minority shareholder, the parent was entitled to appropriate all of the tax savings produced as a result of consolidated tax returns filed with the subsidiary.

Accepting, as we must in the procedural posture of the case, the truth of the factual allegations of the fifth amended complaint, the following appears: TCI is a Colorado corporation doing business in California; Crystal Brite is a California corporation. Since July 1, 1970, Smith has been the owner and holder of 20% of the outstanding stock of Crystal Brite; between July 1, 1970, and October 30, 1975, TCI acquired the remaining 80% of the stock of Crystal Brite. Thereafter, the individual defendants, who were agents or employees of TCI, were elected as directors of Crystal Brite (directors).

Around October 31, 1975, the directors entered into a contract to sell all of the assets of Crystal Brite to State Video Cable, Inc., a California corporation. The contract price was $712,639.08; $600,139.08 in cash, and the balance of $112,500 by a five-year promissory note with interest at 10% per annum.

The effect of the sale was not communicated to Smith until after October 31, 1975. Smith was provided with work papers that indicated that the $562,092 gain on the sale of Crystal Brite would generate a tax liability of around $202,000. In reliance on these representations, Smith executed the necessary sale documents. Crystal Brite had no assets other than the proceeds of the sale.

Between March 1, 1976, and November 15, 1976, TCI and the directors represented that as a result of the sale, Crystal Brite had accrued a combined federal and state income tax liability of $279,013.85. Between July 1, 1976, and November 15, 1976, Smith was orally advised that the taxes would in fact not be paid because of the consolidated return filed by TCI. Smith relied on the prior written representation that a tax liability existed as a result of the sale of Crystal Brite's assets and would, in fact, be paid.

In May 1977, Smith received $19,152.61, his distributive share in the proceeds of the sale and the interest on the promissory note; thereafter he continued to receive his proportionate share of the payments received from the purchaser. No taxes were paid and $279,013.85 was paid directly to TCI on the theory that if Crystal Brite had filed separate income tax returns, this amount would have been paid to the federal and state governments.

As a result of the consolidated return, no tax liability was or would be incurred by Crystal Brite and TCI. If the $279,013.85 had not been paid to TCI, Smith's initial distributive share would have been increased by 20% or $55,802.77. Smith was therefore deprived of a portion of his distributive share of Crystal Brite. The acts and conduct of TCI and the directors in paying the entire tax savings to TCI were willful, fraudulent and malicious and in violation of their fiduciary duties.

We are faced at the outset with the contention that even if any causes of action are stated, they are derivative in nature and cannot be asserted by Smith in his individual capacity. The criteria for derivative and individual actions were summarized by our Supreme Court in Jones v. H. F. Ahmanson & Co. (1969) 1 Cal.3d 93, 106-107, 460 P.2d 464. The action is in the corporate right, if the gravamen of the complaint is injury to the corporation, or to the whole body of its stock and property without any severance or distribution among individual holders. A derivative suit is brought to enforce a cause of action which the corporation itself possesses against some third party, a suit to recompense the corporation for injuries which it has suffered as a result of the acts of third parties. The management owes to the stockholders a duty to take proper steps to enforce all claims which the corporation may have. When it fails to perform this duty, the stockholders have a right to do so. The corporation nevertheless is the real plaintiff and it alone benefits from the decree; the stockholders derive no benefit therefrom except the indirect benefit resulting from a realization upon the corporation's assets. A stockholder's individual suit, on the other hand, is a suit to enforce a right against the corporation which the stockholder possesses as an individual.

Here, it is clear that Smith does not seek to recover on behalf of Crystal Brite. He does not contend that the diminishment in his share of the assets reflects an injury to Crystal Brite and a resultant depreciation in the value of its stock. As in Ahmanson, supra, the gravamen of the causes of action is injury to Smith as the only minority shareholder. Smith suffered sufficient injury to bring this action in his individual capacity. (Cf. Crain v. Electronic Memories & Magnetics Corp. (1975) 50 Cal.App.3d 509, 522-523, 123 Cal.Rptr. 419.) In any event, the cause of action based on the fraud is individual and not representative in character. (Sheppard v. Wilcox (1962) 210 Cal.App.2d 53, 64, 26 Cal.Rptr. 412; Campbell v. Clark (1958) 159 Cal.App.2d 439, 443, 324 P.2d 55.)

The main question arises because the tax laws permit parent and subsidiary corporations to file consolidated returns. (Int.Rev.Code of 1954, § 1501 et seq.) The consolidated return allows the taxable income of one corporate entity to be offset by the losses of the other, and thus reduces the tax liability of the profitable entity. (Int.Rev.Code of 1954, § 172.)

However, the Internal Revenue Code does not address which entity ultimately is entitled to the benefit of a consolidated tax return. While the Internal Revenue Service (IRS) regulations provide that the parent corporation is the agent for the subsidiary, this agency relationship is for the convenience and protection of the IRS only and does not extend further. ¹ In the absence of controlling federal law, state law governs the rights and responsibilities between a parent corporation and its subsidiaries. (See Jump v. Manchester Life & Cas. Management Corp. (8th Cir. 1978) 579 F.2d 449, 452; In re Bob Richards Chrysler-Plymouth Corp. (9th Cir. 1973) 473 F.2d 262, 265, cert. den., sub nom., Western Dealer Management, Inc. v. England (1973) 412 U.S. 919, 93 S.Ct. 2735, 37 L.Ed.2d 145.)

In this state, majority shareholders have fiduciary duties toward the minority shareholders as well as the corporation. As set forth in Jones v. H. F. Ahmanson & Co., supra, 1 Cal.3d 93, 108, 460 P.2d 464:

"Majority shareholders may not use their power to control corporate activities to benefit themselves alone or in a manner detrimental to the minority. Any use to which they put the corporation or their power to control the corporation must benefit all shareholders proportionately .... [T]he burden is on the director or stockholder not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation .... The essence of the test is whether or not under all the circumstances the transaction carries the earmarks of an arm's length bargain. If it does not, equity will set it aside." (Emphasis added.)

Here, Smith alleged that by means of the consolidated tax procedure, the taxable gain resulting from the sale of the subsidiary was offset against the losses of the parent, with the result that the subsidiary incurred no federal or state income tax. The subsidiary then transferred to the parent the entire tax...