A Corporate Logjam Ends Badly: Lessons to Learn from the Kentucky Court of Appeals’ Decision in Gross v. Adcomm, Inc.

February 8, 2016Articles

As featured in Law 360 Expert Analysis

“Who is entitled to assert and litigate the rights of an aggrieved corporation when, as here, the party who allegedly injured the corporation is a 50% shareholder, controls half of the corporation’s board of directors, and does not want the corporation to pursue litigation?” The Kentucky Court of Appeals framed a recent dispute before it with this question. The answer, as set forth in Gross v. Adcomm, Inc. has significance for many closely-held Kentucky corporations and their shareholders.i

Sam Gross and Christopher Pearson incorporated Adcomm, Inc. together. They each took half of Adcomm’s stock. They served as its only directors. They voted themselves in as the company’s sole officers. And then they had a falling out.

As an officer and director of Adcomm, Pearson hired a lawyer and caused Adcomm to file a complaint against Gross for “converting corporate assets and breaching various fiduciary duties.” Gross responded that Adcomm could not sue him because its board of directors (of which he was one of the only two members) had not voted to approve the company hiring a lawyer and suing him. The trial court rejected Gross’s argument, and eventually entered a judgment compelling Gross to repay funds to Adcomm.

Gross appealed the judgment to the Kentucky Court of Appeals. He again argued that Adcomm simply could not sue him because a majority of its board of directors never authorized it. The appellate court agreed.

First, the appellate court noted that Adcomm owned the claims asserted against Gross because “corporate assets are the property of the corporation, not the shareholders.” Going further, the appellate court stated that any fiduciary duty that Gross owed as an officer or director of Adcomm flowed only to Adcomm, and not to its shareholders, because “if corporate assets are misappropriated, or if a corporate officer or director otherwise breaches a fiduciary duty, it is an injury to the corporation, not a shareholder.”

Significantly, the appellate court did not cite a published opinion from a Kentucky court to support its declaration that “[o]fficers and directors owe fiduciary duties to the corporation, not the shareholders.” Instead, the appellate court attributed this broad and unqualified statement to two sources: (i) state statutes codifying standards of conduct for officers and directors – even though the Kentucky Supreme Court stated in 2013 that the director-related statute “does not abrogate common law fiduciary duty claims against directors in Kentucky,”ii and (ii) a legal encyclopedia. Its reliance on this encyclopedia entry also is curious. The appellate court has cited this encyclopediaiii entry in three prior opinions, including another 2015 opinion that now is before the Kentucky Supreme Court on a motion for discretionary review. But no published and binding prior opinion from the Kentucky Court of Appeals or Kentucky Supreme Court relies on this encyclopedia entry for this broad statement, and the Kentucky Supreme Court has never cited it. Next, the appellate court did not mention that the encyclopedia entry it cited offers exceptions to the broad rule: “Specifically, a fiduciary relationship with individual shareholders will be imposed on officers and directors where some contract or special relationship exists between them in addition to the corporate relationship.” Unlike the encyclopedia, the appellate court did not qualify its statement that directors and officers owe no fiduciary duties to shareholders in Kentucky. And perhaps most notably, it appears that this encyclopedia entry has been superseded by one in a new volumeiv. The entry in the new volume does not state that officers and directors owe no fiduciary duties to shareholders. As the appellate court opted to “publish” the Gross decision, however, it intends its unqualified and broad statement that “[o]fficers and directors owe fiduciary duties to the corporation, not the shareholders” to be the law of Kentucky.

In taking this position, the appellate court aligned Kentucky law with that in several other states that also follow the Model Business Corporation Act (“MBCA”), such as Texasv. However, Kentucky courts routinely follow Delaware case law on corporate matters, even though Delaware law is not based on the MBCA. Delaware court opinions do not state that directors owe no fiduciary duties to shareholders under Delaware law. For example, the Supreme Court of Delaware has held that “[t]he directors of Delaware corporations stand in a fiduciary relationship not only to the stockholders but also to the corporations upon whose boards they serve” such that “directors who knowingly disseminate false information that results in corporate injury or damage to an individual stockholder violate their fiduciary duty, and may be held accountable in a manner appropriate to the circumstances.”vi The Supreme Court of Delaware also has allowed an individual shareholder to pursue a direct breach of fiduciary duty claim based on stock dilution against an entity’s directors.vii

Returning to the Gross opinion, the appellate court also explained that, while corporations ordinarily enforce their own rights in litigation, they only can sue if a majority of its board of directors approves. Here, a majority of the board did not vote to cause Adcomm to sue Gross. As a result, Adcomm could not proceed with its suit, even though Pearson – an officer, director, and 50% shareholder of the corporation – wanted to pursue the lawsuit and Gross, the only other board member, had a clear conflict of interest in voting on whether Adcomm should sue him.

Next, the appellate court distinguished between a direct lawsuit brought by a corporation and a derivative lawsuit brought on a corporation’s behalf by a shareholder. Here, Adcomm directly sued Gross even though its board had not voted to approve the lawsuit, which rendered the lawsuit unauthorized. On the other hand, a derivative suit “is a statutory remedy available to disappointed shareholders when a corporation’s board of directors ignores or wrongfully refuses to enforce the corporation’s right to redress a corporate injury and has effectively blocked the corporation from taking any direct action.” Derivative suits may be appropriate “when, by asking the board to cause the corporation to enforce its rights, a shareholder would be effectively asking a majority of the board of directors to cause the corporation to sue themselves.” (Emphasis in original)

By causing Adcomm to file a complaint in its own name against Gross, Pearson chose the wrong mechanism for a lawsuit. Because of this, the lawsuit, which started in August 2005, ended in December 2015 with the ultimate conclusion being that it never should have been filed.

What significance does Gross have for Kentucky closely-held corporations? First, it speaks to the scope of fiduciary duties owed by officers and directors in Kentucky, which in turn may bear on decisions regarding the state in which an entity’s owners may want to incorporate. While the harm alleged in Gross appears to have been to Adcomm and not to its individual shareholders, slightly different facts may cause a case to be decided differently now under Kentucky law than it would under Delaware law. Second, Gross reflects that two equal owners can create a logjam for their closely-held corporation if a once-solid relationship falls apart. Third, it confirms that derivative actions may provide a solution to a logjam in certain circumstances. And fourth, it provides further support for the principle that people entering into closely-held businesses should pick their partners carefully and make full use of corporate formation documents to address potential problems on the front end in an effort to avoid a messy corporate divorce.


iGross v. Adcomm, Inc., No. 2014-CA-131-MR, 2015 Ky. App. LEXIS 170 (Dec. 11, 2015) (To Be Published)
iiBaptist Physicians Lexington, Inc. v. New Lexington Clinic, P.S.C., 436 S.W.3d 189, 191 (Ky. 2013).
iii18B Am. Jur. 2d Corporations § 1462 (2011).
iv46 Am. Jur. 2d. Corporations § 1462 (2015).
vE.g., Somers ex rel. EGL, Inc. v. Crane, 295 S.W.3d 5, 11 (Tex. App.-Houston (1st Dist.) 2009, pet. denied) (“A director’s fiduciary duty runs only to the corporation, not to individual shareholders or even to a majority of the shareholders.” (citations omitted)).
viMalone v. Brincat, 722 A.2d 5, 9, 10 (Del. 1998).
viiGentile v. Rossette, 906 A.2d 91 (Del. 2005).