Schmidt v. Magnetic Head Corp.

OPINION OF THE COURT

Titone, J.

These appeals involve the interpretation and construction of a corporate shareholders’ agreement. Our primary concern is with the question of whether plaintiffs are entitled to designate a successor director in the place of their prior designee who has resigned. We are also called upon to determine whether the defendant directors are entitled to indemnification for legal expenses incurred in defending this action and whether the attorneys represent- . ing those directors should be disqualified on the basis of an alleged conflict of interest. As we shall explain, the plaintiffs have no right to designate a successor under the unambiguous terms of the agreement, the defendants may be indemnified, and disqualification is inappropriate. In addition, we reject the appealing defendants’ challenge to the causes of action seeking reformation, rescission and return of moneys paid for indemnification.

On April 30, 1978, defendant Magnetic Head Corporation acquired MCP Corporation by exchanging 47.5% of its shares for all the shares of MCP. As a result of this transaction, plaintiffs Herbert and Barbara Schmidt, shareholders of MCP, became the owners of 45.8% of Magnetic Head stock, which was the largest shareholder interest in that corporation.

Nonetheless, the Schmidts did not obtain a controlling interest in the new corporate structure. In accordance with the terms of the shareholders’ agreement more fully discussed below, the Schmidts and the other shareholders designated James North, the Schmidts*’ attorney, Charles Rockwell, Magnetic Head’s chairman of the board of directors, and Royce McKinley, president of Santa Anita Consolidated, Magnetic Head’s largest preacquisition shareholder, as the holders of irrevocable proxies. The proxy holders elected North and the Schmidts to the board of directors as required by this agreement.

On April 30,1981, North resigned both as a proxy holder and director and Herbert Schmidt thereupon attempted to designate one James P. Duffy as his successor. Those having a controlling interest in Magnetic Head claimed that Schmidt had no such right, and the remaining seven members of the board of directors refused to elect Duffy to the board. Instead, they chose one Edward Gleason to fill the vacancy.

The shareholders’ agreement limits the number of members of the board of directors to nine so long as the Schmidts own at least 30% of Magnetic Head’s common stock. The sections of the agreement governing voting rights and successors read as follows:

“3. Voting Rights. On the date hereof, each shareholder shall sign an Irrevocable Proxy in the form annexed hereto as Exhibit Z, granting to the Proxy Holders the exclusive right to vote all Shares subject to the provisions of this Shareholders Agreement, or to give written consents in lieu of voting thereon, at their discretion for whatsoever purposes and in any and all proceedings, whether at meetings of the shareholders of the Company or otherwise, wherein the vote or written consent of shareholders of the Company may be required or authorized by law. It is expressly provided that during any period in which Herbert J. Schmidt, Jr. and Barbara B. Schmidt, and their associates are the holders of 30% or more of the common shares of the Company the Proxy Holders shall vote the Shares for the election of Herbert J. Schmidt, Jr., Barbara B. Schmidt and James North for election as directors and for determining the number of directors at not more than nine (9). During any period in which there are three Proxy Holders any action of the Proxy Holders may be exercised by a majority of the Proxy Holders. During any period in which there are only two Proxy Holders any action of the Proxy Holders shall be exercised jointly.”

“4. Successors to the Proxy Holders. In the event of the resignation, incapacity or death of James North, one of the Proxy Holders, his successor shall be designated by Herbert J. Schmidt, Jr. by an instrument in writing duly acknowledged. In the event of the resignation, incapacity or death of Royce McKinley, one of the Proxy Holders, his successor shall be designated by Santa Anita Consolidated, Inc. by an instrument in writing duly acknowledged. In the event of the resignation, incapacity or death of Charles S. Rockwell, one of the Proxy Holders, his successor shall be designated by Magnetic Head Corporation by an instrument in writing duly acknowledged. Upon the designation of any successor Proxy Holders, the Shareholders shall sign and deliver to the Proxy Holders a new Irrevocable Proxy appointing the Proxy Holders then qualified to act, including the newly designated Proxy Holder. The rights, powers and privileges of each Proxy Holder shall be possessed by each successor Proxy Holder. In the event any successor named herein fails to accept the position of Proxy Holder or in the absence of the appointment of a successor, the Proxy Holders then acting shall possess all of the right, title and powers of the original Proxy Holders.

“In witness Whereof, the undersigned Shareholders have executed the Agreement and the Proxy Holders, to evidence their respective acceptance of the functions and duties of the Proxy Holders, have executed this Agreement, all as of the date and year first above written.”

The other pertinent provisions of the agreement may be more briefly summarized. Section 2 vests the proxy holders with the right to exercise the voting power acquired by the shareholders of Magnetic Head under the acquisition agreement. Section 6 specifies that the agreement’s duration is to be at least 5 years but no longer than 10 years. Section 7 authorizes the proxy holders to incur reasonable expenses and employ professional counsel in performance of their duties, which may be charged pro rata to the shareholders. Section 8 provides that each proxy holder is not disqualified from voting for himself to serve as an officer or director of Magnetic Head or any of its subsidiaries. Section 9 sets forth the mode and sufficiency of notice to proxy holders. Finally, section 10 requires that all certificates of stock subject to the shareholders’ agreement shall contain a legend indicating that the voting rights of the shareholder represented by the certificates can be exercised only by the holders of the irrevocable proxies appointed under such agreement.¹

The Schmidts commenced this action shortly before Gleason was selected to fill North’s vacancy on the board. Their complaint, resting upon numerous theories, sought, among other things, to compel Duffy’s acceptance as a director.

On a motion to dismiss pursuant to CPLR 3211 (subd [a]), Special Term sustained the causes of action seeking reformation, rescission and return of moneys paid to the defendants for indemnification,² but dismissed those for specific performance, construction and breach of the shareholders’ agreement. The court perceived no ambiguity in the agreement and, except for the prospect of reformation and rescission, regarded the relief sought to be precluded by the absence of an express provision for the appointment of a successor director. All the litigants but North and his law partners have appealed.

We begin with the causes of action for specific performance, construction of the shareholders’ agreement, and a declaration that the agreement has been breached. It is evident that they must stand or fall together inasmuch as they all derive from plaintiffs’ claim that the agreement entitled them to select directors. Basically, it is plaintiffs’ position that extrinsic evidence should be received because the failure of the agreement to delineate the succession of directors renders it ambiguous, particularly since they claim that they would not have limited their voting rights for up to 10 years without the right to replace North or themselves on the board.

The threshold question of whether a writing is ambiguous “is the exclusive province of the court” (Sutton v East Riv. Sav. Bank, 55 NY2d 550, 554). Our reading of the shareholders’ agreement compels us to conclude that there is simply no ambiguity with respect to the selection of a director in the event of a vacancy on the board (cf. Hartford Acc. & Ind. Co. v Wesolowski, 33 NY2d 169, 172). Completely absent is any allusion to the procedure to be employed in the filling of such vacancy. An omission or mistake in a contract does not constitute an ambiguity (see Gearns v Commercial Cable Co., 293 NY 105, 109; Matter of Rivas’ Trust, 100 NYS2d 357, 365; 4 Williston, Contracts [3d ed], § 619, pp 742-743) and, as Justice Lazer observes in his concurring opinion, the question of whether an ambiguity exists must be ascertained from the face of the agreement without regard to extrinsic evidence (Breed v Insurance Co. of North Amer., 46 NY2d 351, 355; Facet Inds. v Wright, 95 AD2d 262, 266).

It is fundamental that courts enforce contracts and do not rewrite them (Grace v Nappa, 46 NY2d 560, 565; Rodolitz v Neptune Paper Prods., 22 NY2d 383, 386). “The courts may not by construction add or excise terms, nor distort the meaning of those used and thereby ‘make a new contract for the parties under the guise of interpreting the writing’ ” (Morlee Sales Corp. v Manufacturers Trust Co., 9 NY2d 16, 19). As commentators caution, “An obligation undertaken by one of the parties that is intended as a promise or agreement should be expressed as such, and not left to implication” (Handel, Preparation of Commercial Agreements [1978 ed], pp 12-13).

In construing the provisions of a contract, ascertainment of the intention of the parties is paramount (see, e.g:, Brown Bros. Elec. Contrs. v Beam Constr. Corp., 41 NY2d 397, 400) and due consideration must be given to the purpose of the parties in entering into the contract (Matter of Cromwell Towers Redevelopment Co. v City of Yonkers, 41 NY2d 1, 6). Although to carry out that intention, words may be transplanted, supplied, or rejected to make its meaning more clear (Castellano v State of New York, 43 NY2d 909, 911), where the intention of the parties is clearly and unambiguously set forth in the agreement itself effect must be given to the intent as indicated by the language used without regard to extrinsic evidence (Mallad Constr. Corp. v County Fed. Sav. & Loan Assn., 32 NY2d 285). The express “provisions establish the rights of the parties and prevail over conclusory allegations of the complaint” (805 Third Ave. Co. v M. W. Realty Assoc., 58 NY2d 447, 451) and the subjective intent is irrelevant (Handel, op. cit., p 12).

The acquisition agreement³ is essentially a contract between the Schmidts and other individuals on the one hand and Magnetic Head on the other, which provides for the purchase of all of the shares of MCP by Magnetic Head in exchange for 47.5% of Magnetic Head stock. It contains sections pertaining to the aggregate purchase price for the shares of MCP, representations and warranties of the parties, the conduct of business prior to closing, the survival of representations, warranties and covenants, and a “catch all” section of additional provisions. Included in the latter is subsection (h) which reads as follows: “(h) At the closing the sellers shall sign and deliver a Shareholders Agreement by and among themselves, the Buyer and James North, Royce McKinley and Charles S. Rockwell as Proxy Holders, in the form annexed hereto as Exhibit N, and each Seller shall have signed and delivered an Irrevocable Proxy in the form annexed to the Shareholders Agreement as an exhibit hereto.”

We conclude that it cannot be inferred from a reading of the two agreements together that the Schmidts were to be afforded the right to select at least one third of the board of directors during the life of the shareholders’ agreement. Rather, we believe that the raison d’etre for the shareholders’ agreement was to create and implement a proxy system of voting shares of Magnetic Head during the life of that agreement and to vest concomitant powers and duties in the proxy holders to accomplish that purpose.

Further, when the board of directors selected Gleason to fill the vacancy, the action was not interdicted by any language contained in the shareholders’ agreement but, more important, was consistent with the authority vested in the remaining directors by statute (see Business Corporation Law, § 705; see, also, Business Corporation Law, § 602, subd [b]). In sum, we decline to fashion a new clause to be placed in the shareholders’ agreement which the plaintiffs believe to be more equitable (cf. Laba v Carey, 29 NY2d 302, 308).

The determination sustaining the causes of action for reformation and rescission should also be upheld. True, as defendants correctly assert, absent fraud, unilateral mistake is not a ground for reformation (Backer Mgt. Corp. v Acme Quilting Co., 46 NY2d 211, 219; Nash v Kornblum, 12 NY2d 42, 46) and an instrument may not be reformed to include a provision that one party suggested and the other rejected (Mason v Mason, 41 AD2d 607). But such defenses revolve around disputed factual questions appropriately left for resolution at trial and do not warrant dismissal of the complaint as a matter of law (see Hotel Credit Card Corp. v American Express Co., 13 AD2d 189, 193). Liberally read, as it must be at the pleading stage (CPLR 3026; Guggenheimer v Ginzburg, 43 NY2d 268, 275; National Compactor & Technology Systems v Kohleriter & Spandorf, 38 NY2d 933; Foley v D'Agostino, 21 AD2d 60, 64-65), the complaint alleges a mutual mistake of the parties (see 13 Williston, Contracts [3d ed], §§ 1548, 1549).

As for rescission, the complaint states that the ability to designate a successor was a material element of the agreement, and without such a provision, the parties failed to achieve a meeting of the minds. We similarly construe this cause of action as alleging mutual mistake which, if proven, would entitle plaintiffs to rescission (Coffin v City of Brooklyn, 116 NY 159; Brauer v Central Trust Co., 77 AD2d 239, 243; Sheridan Drive-In v State of New York, 16 AD2d 400, 405).

We now turn to plaintiffs’ appeal from the denial of the portion of their cross motion which sought to enjoin Magnetic Head primarily from indemnifying the defendant directors for the legal expenses they have incurred in defending this action. Defendants’ position is straightforward: indemnification is proper pursuant to section 724 (subd [b], par [2], cl [A]) of the Business Corporation Law. That section provides that litigation expenses of directors may be paid by the corporation when authorized “[b]y the board upon the opinion in writing of independent legal counsel that indemnification is proper”.

The payment to the directors was made on the basis of an opinion letter issued by William Downey on behalf of a law firm known as Lovejoy, Wasson & Ashton, P. C. The letter states that the standard for indemnification, i.e., that the directors acted in “good faith, for a purpose which [they] reasonably believed * * * in * * * the best interests of the corporation” (Business Corporation Law, § 723, subd [a]), had been met.

Plaintiffs challenge the independence of Downey’s firm. They observe that Downey was retained by a partner in the firm which represented the corporation and the defendant directors. Yet, Downey owned no stock in Magnetic Head, had not previously represented the corporation, and had no past relationship with any of the company’s officers or directors. There is no evidence concerning any other member of the firm. Special Term concluded that “there was no showing of any lack of independence”. Based upon the statutory provisions and their history, we agree.

At common law, no right of indemnification accrued to directors in an unsuccessful defense of an action- brought against them by shareholders, though a possible exception existed where the corporation was substantially benefited (see, e.g., Warnecke v Forty Wall St. Bldg., 16 Misc 2d 467, 468-469, affd sub nom. Marine Midland Trust Co. v Forty Wall St. Corp., 13 AD2d 630; Comment, Indemnification of Management for Litigation Expenses, 52 Mich L Rev 1023).⁴ On the other hand, when the defense proved successful, authorities divided on the question of whether a common-law right of indemnification existed (Henn & Alexander, Law of Corporations [3d ed], § 379, p 1117). New York followed the view that there was no such right (see, e.g., New York Dock Co. v McCollum, 173 Misc 106 [Crouch, Off Ref]).

In order to rectify the perceived inequity, New York took the lead in 1941 by enacting the first indemnification statute (L 1941, chs 209, 350; see 1945 Report of NY Law Rev Comm, NY Legis Doc, 1945, No. 65 [E], pp 131-175; 1957 Report of NY Law Rev Comm, NY Legis Doc, 1957, No. 65 [J], pp 315-345). Other States quickly joined (see, e.g., Cheek, Control of Corporate Indemnification: A Proposed Statute, 22 Vand L Rev 255; Sebring, Recent Legislative Changes in The Law of Indemnification of Directors, Officers and Others, 23 Bus Law 95). Several different approaches have been taken. Some statutory schemes simply grant the corporation a power to indemnify. Others make it a matter of right, while still others combine the two approaches (Henn & Alexander, op. cit., § 380, p 1121). All were enacted “to induce capable and responsible businessmen to accept positions in corporate management” (Merritt-Chapman & Scott Co. v Wolfson, 264 A2d 358, 360 [Del]) by protecting them against personal risk (see 3A Fletcher’s Cyclopedia Corporations [perm ed], § 1344; 13 Fletcher’s Cyclopedia Corporations [perm ed], § 6045.1).

The present New York statutory provisions, which are exclusive (Business Corporation Law, § 721), provide that a director, acting “in good faith, for a purpose which he reasonably believed to be in * * * the best interests of the corporation” (Business Corporation Law, § 723, subd [a]), may be indemnified by the corporation he serves for judgments, settlement payments and litigation expenses. Indemnification is a matter of right if the director is wholly successful (Business Corporation Law, § 724, subd [a]). If the director is not wholly successful or if indemnification is sought during the pendency of the action, indemnification may be made by the corporation if the “good faith” standard of section 723 is met. The finding of “good faith” may be made by a quorum of the board who are not parties to the action, by the shareholders, or “[b]y the board upon the opinion in writing of independent legal counsel” (Business Corporation Law, § 724, subd [b], par [2], cl [A]; subd [c]).

The term “independent legal counsel” is not statutorily defined and we have found no New York case construing it (see 3 White, New York Corporations [13th ed], par 724.02). Nonetheless, we are not without guideposts. The Model Business Corporation Act (1980, § 5, subd [e]) contains an analogous provision requiring the determination to be made by “special legal counsel”. Many of the members of the advisory committee believed that such counsel should have “no prior professional relationship with the corporation or those seeking indemnification * * * and should not be either inside counsel or regular outside counsel” (Changes in the Model Business Corporation Act Affecting Indemnification of Corporate Personnel, Report of the Committee on Corporate Laws, 36 Bus Law 99,114). Eschewed was a proposal to disqualify an attorney simply because he previously performed services for a person to be indemnified.

We note that commentators, as well, emphasize that “independent” counsel should not have an on-going relationship with the corporation (see Bishop, Sitting Ducks and Decoy Ducks: New Trends in the Indemnification of Corporate Directors and Officers, 77 Yale LJ 1078; Symposium, Officers’ and Directors’ Responsibilities and Liabilities, 27 Bus Law [Feb., 1972] 109-164; McAdams, A Proposal to Amend the Indemnification Section [§ 5] of the Model Business Corporation Act, 31 Bus Law [No. 4] 2123) and that “[s]ome attorneys or retired judges might well specialize in this kind of practice” (Henn & Alexander, op cit., § 380, p 1127, n 21).

In the end, the concern is basically to guard against counsel passing judgment upon his own acts (cf. Securities & Exch. Comm. v North Amer. Fin. Co., 214 F Supp 197, 200 [independent certified public accountant]). We thus hold that “independent legal counsel” under section 724 of the Business Corporation Law is an attorney who is free from past connections with the corporation or the persons to be indemnified. We decline any invitation to establish a system by which the judiciary will select independent counsel, supervise the selection process (see Hoffman, The Status of Shareholders and Directors under New York’s Business Corporation Law: A Comparative View, 11 Buf L Rev 496, 581; cf. Matter of Siegel [Lewis], 40 NY2d 687) or otherwise correct purported defects in the legislation.

Under the standard we have enunciated the independent counsel requirement has been met. Neither Downey nor, from what we are able to discern from the record, any member of the firm had a present or past relationship with Magnetic Head or its directors. While we are aware that one lawyer retained by another may well feel a sense of responsibility for his retainer, we are content to rely upon counsel’s fiduciary obligation to the corporation and the strictures set forth in the Code of Professional Responsibility (EC 5-21, 5-22; DR 5-107).

We must also reject plaintiffs’ claim that Downey’s investigation was a sham as a matter of law because he did not interview the parties to the litigation. Downey testified at the hearing on the cross motion to enjoin indemnification payments that he had examined the pleadings and certain affidavits and exhibits but had not interviewed plaintiffs, their counsel or the defendant directors. Aside from the complaint, which does not directly impugn Downey’s good faith, these documents are not contained in the record on appeal. Since the motives of the directors and their loyalty to the corporation are the focus of the “good faith” standard (3 White, New York Corporations [13th ed], par 723.01), we believe it best to leave the ultimate determination as to whether the defendant directors should have been indemnified to the trier of fact (Business Corporation Law, § 726, subd [a]).

The final question is whether Farrell, Fritz, Caemmerer & Cleary, P. C., should be disqualified from representing both Magnetic Head and the defendant directors. We conclude that denial of this aspect of the cross motion was also proper.

Unlike a derivative suit, where an adverse interest generally exists between a corporation and its directors (see, e.g., Patton, Disqualification of Corporate Counsel in Derivative Actions: Jacuzzi and the Inadequacy of Dual Representation, 31 Hast LJ 347; Note, Independent Representation for Corporate Defendants in Derivative Suits, 74 Yale LJ 524), Magnetic Head’s current posture is that of a passive litigant in an action involving the rights of competing stockholder factions to select a corporate director (cf. Garlen v Green Mansions, 9 AD2d 760). There is no allegation that Magnetic Head will benefit or suffer from the outcome of this lawsuit and matters of corporate policy are not in issue.

We recognize that disqualification motions are often used for tactical purposes (see, e.g., Matter of Schumer v Holtzman, 60 NY2d 46, 55; Allegaert v Perot, 565 F2d 246, 251) and, in the absence of a demonstrated conflict of interest (compare Evans v Artek Systems Corp., 715 F2d 788, and Greene v Greene, 47 NY2d 447, with Martin v Donghia Assoc., 73 AD2d 898; see Code of Professional Responsibility, DR 5-105), a party’s selection of counsel should not lightly be interfered with (Board of Educ. v Nyquist, 590 F2d 1241, 1246; Grant Co. v Haines, 531 F2d 671, 677; cf. People v Gomberg, 38 NY2d 307, 312).

For the reasons stated, the orders appealed from should be affirmed.

1 . The remaining sections of the shareholders’ agreement, i.e., sections 11 (“Construction”), 12 (“Counterparts”), 13 (“Headings”), 14 (“Amendment”), and 15 (“Binding Effect”) have no bearing on the issues before this court.

2 . A malpractice claim against North and his law partners was also sustained. Because those defendants have not appealed that question is not now before us.

We also note that the issue before us is properly resolved by motion under CPLR 3211 (subd [a], par 7) (see 805 Third Ave. Co. v M. W. Realty Assoc., 58 NY2d 447) and, in any event, by failing to object, the parties are deemed to have acquiesced in this procedure (Stevenson v News Syndicate Co., 302 NY 81, 87; Ballentine & Sons v Boston Celtics Basketball Club, 36 AD2d 914).

3 . Although the acquisition agreement is not part of the record on appeal, we have taken judicial notice of it because it is contained in the record on appeal in another case now pending in this court (Matter of Ordway, 196 NY 95; Rossbach v Rosenblum, 260 App Div 206, affd 284 NY 745; Richardson, Evidence [Prince, 10th ed], § 30).

4 . Officers and employees, as distinguished from directors, might qualify as agents of the corporation and thus might obtain indemnification under agency principles (Restatement, Agency 2d, § 439 et seq.; Cohn v Lionel Corp., 21 NY2d 559).