O'Shea, Patrick F. v. Frain, Michael F. ( 2000 )

In the
United States Court of Appeals
For the Seventh Circuit
No. 00-1162
In re Michael Frain,
Debtor-Appellee,
Appeal of Patrick F. O’Shea and
Roger L. Schoenfeld
Appeal from the United States District Court
for the Northern District of Illinois, Eastern
Division.
No. 98 C 5651--David H. Coar, Judge.
Argued September 22, 2000--Decided October 30,
2000
Before Posner, Manion, and Evans, Circuit
Judges.
Manion, Circuit Judge. Michael Frain
filed for Chapter 7 bankruptcy.
Appellants Patrick O’Shea and Roger
Schoenfeld filed a complaint under the
Bankruptcy Code, 11 U.S.C. sec.
523(a)(4), seeking nondischargeability of
debts owed to them from a business
relationship they had with Frain. The
bankruptcy court held that the asserted
debts were dischargeable, and the
district court affirmed. O’Shea and
Schoenfeld appeal. We reverse and remand
for further proceedings.
I.
In May 1989, Michael Frain, Patrick
O’Shea, and Roger Schoenfeld formed a
closely held corporation called the
Preferred Land Title Insurance Company.
Under the shareholder agreement, Frain
was Chief Operating Officer and possessed
50% of the shares of the corporation.
O’Shea and Schoenfeld were both directors
and each held 25% of the shares. Frain
was authorized to make day-to-day
business decisions and all decisions
affecting the normal operations of the
corporation. The shareholder agreement
further provided that major decisions
required consent by 75% of the shares of
the corporation, although certain
decisions required a unanimous vote.
Anything requiring a majority vote was
required to have the approval of Frain
and either O’Shea or Schoenfeld.
The shareholder agreement set a specific
salary formula for Frain during the first
three years of the corporation. He was to
receive $70,000 the first year with
annual increases based on the Consumer
Price Index (CPI). The salary provision
expired in 1992. Frain continued in his
position as Chief Operating Officer after
the end of the three-year term, and
increased his salary annually well above
the CPI formula set by the initial salary
provision. The shareholder agreement,
however, also provided that "[n]o
salaries, bonuses, or other compensation
shall be paid to a shareholder . . .
unless set forth herein or approved by a
unanimous vote of the Board of
Directors." O’Shea and Schoenfeld were
aware that Frain was still receiving a
salary, but at the time did not know of
the salary increase.
The shareholder agreement also
prioritized distributions of corporate
cash flow. Because it was a so-called
"subchapter S corporation" (see 26 U.S.C.
sec. 1361), income and taxes were passed
through directly to the shareholders. The
agreement designated the distributions in
the following order: first, payments to
the shareholders for payment of federal
and state income taxes in proportion to
ownership of shares of the corporation;
second, payments of any outstanding
shareholder loans; and third, payments of
the balance to the shareholders also in
proportion to their ownership of shares.
Frain made shareholder distributions--the
third priority--before repaying
shareholder loans. O’Shea and Schoenfeld
protested but accepted and deposited
their shareholder distributions.
The corporation ceased operation in
December, 1995. Frain subsequently filed
for relief under Chapter 7 of the
Bankruptcy Code. O’Shea and Schoenfeld
filed a Dischargeability Complaint in the
bankruptcy court. See In re Frain, 222
B.R. 835 (Bankr. N.D. Ill. 1998).
Apparently outstanding loans were owed to
one or both of the plaintiffs. They
argued that these debts were not
dischargeable pursuant to the Bankruptcy
Code, sec. 523(a)(4), which provides that
an individual debtor is not discharged
from any debt "for fraud or defalcation
while acting in a fiduciary capacity."
The bankruptcy court held that there was
no fiduciary relationship for purposes of
sec. 523(a)(4), and accordingly that the
alleged debts were dischargeable. The
district court affirmed on the same
basis. O’Shea and Schoenfeld appeal,
alleging that the district court erred in
its determination that no fiduciary
relationship existed.
II.
Section 523(a)(4) of the Bankruptcy Code
provides that "[a] discharge under
section 727, 1141, 1228(a), 1228(b), or
1328(b) of this title does not discharge
an individual debtor from any debt . . .
for fraud or defalcation while acting in
a fiduciary capacity."
The bankruptcy court and the district
court held that there was no fiduciary
relationship between Frain and appellants
because the terms of the shareholder’s
agreement did not create a fiduciary
relationship under this circuit’s case
law. We review the bankruptcy and
district court’s legal findings and
contract interpretations de novo. See In
re Scott, 172 F.3d 959, 966 (7th Cir.
1999); GNB Battery Technologies, Inc. v.
Gould, Inc., 65 F.3d 615, 621 (7th Cir.
1995). Findings of fact, however, are
reviewed for clear error. See Scott, 172
F.3d at 966. In this appeal, the
relevant facts are not disputed. The
dispute is over the lower courts’
interpretation of the shareholder
agreement and whether those courts
correctly applied the law to the facts.
Accordingly, we apply de novo review.
This court has defined a fiduciary
relationship under sec. 523(a)(4) as "a
difference in knowledge or power between
fiduciary and principal which . . . gives
the former a position of ascendancy over
the latter." In re Marchiando, 13 F.3d
1111, 1116 (7th Cir. 1994). See also
Woldman v. Johnson, 92 F.3d 546, 547
("section 523(a)(4) reaches only those
fiduciary obligations in which there is
substantial inequality in power or
knowledge in favor of the debtor seeking
the discharge and against the creditor
resisting discharge.").
A "fiduciary duty" under this test
covers circumstances which, although not
comprising a literal "trust," do "call
for the imposition of the same high
standard." See Marchiando, 13 F.3d at1115 (citing Restatement (Second) of
Trusts sec. 2, comment b (1959)). For
example, a lawyer-client relation, a
director-shareholder relation, or a
managing partner-limited partner relation
all call for the principal to "repose a
special confidence in the fiduciary." See
id., 13 F.3d at 1116.
The existence of a "fiduciary
relationship" is a matter of federal law.
It bears emphasis that not all fiduciary
relationships qualify under the
Bankruptcy Code. See Woldman, 92 F.3d at
547 (7th Cir. 1996) ("[O]nly a subset of
fiduciary obligations is encompassed by
the word ’fiduciary’ in section
523(a)(4)."). A fiduciary relation only
qualifies under sec. 523(a)(4) if it
"imposes real duties in advance of the
breach." See Marchiando, 13 F.3d at 1116.
In Marchiando, we recognized the well-
established principle that, for purposes
of sec. 523(a)(4), the fiduciary’s
obligation must exist prior to the
alleged wrong. A constructive trust, for
example, will not qualify for purposes of
sec. 523(a)(4), since the obligations do
not exist until the wrong is committed.
See Marchiando, 13 F.3d at 1115 (citing
Davis v. Aetna Acceptance Co., 293 U.S.
328, 333 (1934); In re Bennett, 989 F.2d
779, 784 (5th Cir. 1993); In re Tiechman,
774 F.2d 1395 (9th Cir. 1985)).
As this court has noted, there is a
"broad spectrum of fiduciary obligations
from the case in which a trustee defrauds
a child beneficiary or a lawyer defrauds
a client or a general partner defrauds a
limited partner." Woldman, 92 F.3d at 547(7th Cir. 1996). For example, a joint
venture between equals will not qualify
as a fiduciary relationship. See id. The
relationship in this case, however, falls
on the fiduciary end of the spectrum.
A difference in knowledge or power can
create a fiduciary relationship, see
Marchiando, 13 F.3d at 1116. Frain was
responsible for the day-to-day business
decisions of the corporation, giving him
a natural advantage over the other two
shareholders in terms of knowledge of the
corporation’s finances. But it does not
necessarily follow that this knowledge
was unavailable to appellants. Indeed, it
was no secret that Frain was drawing a
salary after the initial three-year
period, and the appellants themselves
received and accepted shareholder
distributions from Frain even though they
were disgruntled because their loans were
not repaid first. Frain’s superior
knowledge of day-to-day operations was
not sufficient in itself to establish a
position of ascendancy.
While the parties’ access to knowledge
and information may have been reasonably
similar, the concentration of power was
substantially one-sided. The
shareholder’s agreement was structured to
give Frain ultimate power over both his
own employment and the direction of the
corporation. Frain’s control over the
day-to-day business of the corporation
and ownership of 50% of the shares gave
him significant freedom to run the
corporation as he saw fit, including
oversight of such items as salary and
distributions of corporate cash flow. The
only real limit to his power was the
chance of deadlock; that is, if he voted
his 50% one way and O’Shea and Schoenfeld
voted their combined 50% the other,
nothing would happen. A further reading
of the thirty-plus-page contract
discloses that "major decisions shall
require the consent of the holders of
seventy-five percent (75%) of the voting
common shares" (with some decisions
requiring 100%). The contract defined
"major decisions" to include "all
decisions affecting the Corporation which
are not in the ordinary course of
business of the Corporation." So no major
decisions can be made unless Frain
agrees. The district court, while noting
that O’Shea and Schoenfeld had 50% of the
shares and had a balance of power in many
areas, emphasized the provision that they
could "purchase Frain’s interest for
$1.00 in the event [he] . . . committed
any material breach . . . ." O’Shea v.
Frain, 1999 WL 1269352, *3 (N.D. Ill.
Dec. 22, 1999).
But the contract requires a majority
vote to determine whether to continue
Frain’s employment. Unless Frain
voluntarily terminates his employment,
the $1.00 purchase option kicks in only
if he is terminated for cause. Obviously
that is a major decision requiring 75% of
the voting shares; he can’t be fired
unless he votes in favor of it. Thus the
$1.00 purchase option cannot be exercised
without Frain’s approval.
Both lower courts relied on the $1.00
purchase provision in reaching their
decision, on the theory that the power to
buy Frain out limited his position of
power in the corporation. Theoretically,
they were correct. The termination
provision did limit Frain’s position of
ascendancy under the shareholder’s
agreement, but in practice this power was
hollow. Not only is for-cause termination
a "major decision" requiring consent of
holders of 75% of voting shares, but also
the contract specifically provides that
in order to terminate Frain for cause, a
majority vote was required. And as noted,
a majority vote was defined as a vote by
75% of the shares. Since Frain held 50%
of the shares, he could be removed by
appellants only if he wanted to be
removed. Thus, the power for O’Shea and
Schoenfeld to independently remove Frain
and purchase the corporation for $1.00
did not exist.
III.
A Chief Operating Officer with 50% of
the shares who cannot be removed for
cause without his consent possesses a
position of considerable ascendancy over
the other shareholders. All of the
decisions made in the ordinary course of
business were Frain’s to make. All of
the major decisions required Frain’s
agreement. If Frain abused this power,
termination for cause was a tantalizing,
but unavailable fiction. This
shareholder’s agreement was not a system
of checks and balances. Frain had more
knowledge, and substantially more power,
than appellants.
In this case, a fiduciary relationship
was created by the structure of the
corporation under the shareholder
agreement, which had given Frain a
position of ascendancy under our case
law. Frain argues that violations of a
contract entered into by equals are not
covered by sec. 523(a)(4). However, Frain
had a pre-existing fiduciary obligation
to O’Shea and Schoenfeld independent of
any breach of contract. This is not a
case where a fiduciary relationship was
implied from a contract. See Bennett, 989
F.2d at 784 (sec. 523 (a)(4) does not
cover fiduciary duty implied from
contract). A contract was necessary to
the existence of a fiduciary
relationship, but the obligations of the
contract were not the source of the
fiduciary relationship. The source of the
fiduciary relationship was Frain’s
substantial ascendancy over O’Shea and
Schoenfeld. Whether any alleged breach of
contract was a defalcation is an issue
for the bankruptcy court.
We conclude, therefore, that based on
the contract Frain possessed an ascendant
position in relation to appellants. There
was accordingly a fiduciary relationship
for purposes of sec. 523(a)(4). The
bankruptcy court must now decide whether
Frain actually committed any defalcation
under sec. 523(a)(4).
REVERSED and REMANDED.