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In re PHC, Inc. Shareholder Litigation

United States Court of Appeals, First Circuit

July 2, 2018

BRUCE A. SHEAR, Defendant, Appellant/Cross-Appellee. MAZ PARTNERS LP, on behalf of itself and all others similarly situated, Plaintiff, Appellee/Cross-Appellant,


          James H. Hulme, with whom Matthew Wright, Nadia A. Patel, Arent Fox LLP, Richard M. Zielinski, Leonard H. Freiman, and Goulston & Storrs, were on brief, for defendant.

          Chet B. Waldman, with whom Jeffrey W. Chambers, Patricia I. Avery, Adam J. Blander, Wolf Popper LLP, Norman Berman, Nathaniel L. Orenstein, and Berman Tabacco were on brief, for plaintiff.

          Before Torruella, Selya and Lynch, Circuit Judges.


         The briefs in this case read like a law school examination covering a curriculum that ranges from corporate law to the law of equitable remedies. The questions presented are intricate, entangled, and in some instances novel. The most important of them implicate Massachusetts law and include whether a non-majority shareholder who also serves as a director can, under certain circumstances, be deemed a controlling shareholder; what effect, if any, shareholder ratification may have with respect to a self-interested transaction; and whether - in the absence of economic loss - equitable disgorgement can be ordered as a remedy for a breach of fiduciary duty. Concluding, as we do, that the able district judge handled the profusion of issues appropriately, we leave the parties where we found them, affirming both the district court's multi-million-dollar disgorgement order in favor of the plaintiff class and the jury's take-nothing verdict in the favor of the defendant. The tale follows.

         I. BACKGROUND

         We limn the facts and travel of the case, reserving some details for our subsequent discussions of specific issues. For efficiency's sake, we assume the reader's familiarity with our opinion regarding an earlier phase of this litigation. See In re PHC, Inc. S'holder Litig. (MAZ I), 762 F.3d 138 (1st Cir. 2014).

         Until the fall of 2011, PHC, Inc. (PHC) functioned as a publicly traded corporation focusing on behavioral healthcare. Defendant Bruce A. Shear was a co-founder of PHC, serving as its board chairman and chief executive officer. The company was organized under the laws of Massachusetts, and its capital structure featured two classes of stock: Class A shares and Class B shares. Class A shares were publicly traded and were entitled to one vote per share. Those shares, collectively, had the right to elect two out of six board members. Class B shares were not publicly traded and were entitled to five votes per share. Those shares, collectively, had the right to elect the remaining four board members. At the times relevant hereto, Shear held approximately 8% of the Class A shares and approximately 93% of the Class B shares. Given the proportion of Class B shares owned by Shear, he had the power, practically speaking, to name a majority of the board of directors (four out of six board members).

         After PHC's stock price remained relatively flat for a protracted period of time, the PHC board grew restless and began to mull a variety of strategic transactions designed to enhance shareholder equity. To this end, Shear initiated discussions about a possible merger with Acadia Healthcare, Inc. (Acadia) in early 2011. Based on conversations with Shear - who was acting as the de facto lead negotiator on behalf of PHC - Acadia's chief executive officer transmitted a letter of intent, dated March 22, 2011, to the PHC board. The letter delineated the material terms of a proposed merger.

         The merger proposal contemplated that Acadia would be the surviving company. PHC shareholders would own 22.5% of the merged entity and Acadia shareholders would own the remainder. To achieve this ratio, holders of both Class A and Class B shares of PHC would receive one-quarter share of the stock of the merged entity in exchange for each PHC share, and the difference between the two classes of PHC stock would evaporate. In order to compensate Class B shareholders for relinquishing their enhanced voting rights, they would receive an additional $5, 000, 000 as a premium. Shear's ownership of approximately 93% of the Class B shares put him in line to receive most of this premium - roughly $4, 700, 000.

         The letter of intent spelled out a variety of other salient features of the proposed transaction (including Acadia's plan to pay a special dividend to its own shareholders so as to achieve the desired equity split). Under another provision of the letter of intent, Shear would get to select two directors of the merged entity - and those two directors would be the PHC shareholders' sole designees to the new Acadia board. Finally, the letter of intent contained a prohibition against shopping Acadia's offer to other potential merger partners and specified that a termination fee would be payable if PHC backed out of the merger.

         Following receipt of Acadia's letter of intent, Shear asked William Grieco (a PHC director) to serve as the PHC shareholders' principal merger negotiator. Despite naming Grieco as the point man, Shear continued to play a leading role in negotiations. Shear's choice of Grieco was not mere happenstance. The two men had enjoyed a lengthy professional relationship, and Shear had previously named Grieco to the PHC board. Moreover, Shear had arranged that, once the merger was consummated, he and Grieco would be the two PHC designees on the new Acadia board.

         As part of his new role as principal negotiator, Grieco assumed responsibility for selecting a financial advisor to analyze the merger and to handle stockholder communications. To that end, the PHC board retained Stout Risius Ross, Inc. (SRR) - a firm that proceeded to evaluate the proposed merger and provide a fairness opinion. SRR reported that the aggregate consideration offered to Class A and Class B shareholders, as a combined group, was fair. Separately, it concluded that the consideration offered to the Class A shareholders was fair. SRR was not asked to analyze (and did not analyze) whether the $5, 000, 000 Class B premium was fair to the Class A shareholders. The PHC board considered the transaction in light of SRR's truncated fairness opinion and voted - with Shear abstaining - to recommend the proposed merger to PHC's shareholders. None of the five directors who voted for this recommendation owned any Class B shares.

         On May 23, 2011, Acadia and PHC signed a merger agreement, contingent upon shareholder approval. In anticipation of a shareholder vote, PHC disseminated a proxy statement chronicling the details of the anticipated merger. Among other things, the proxy statement disclosed the $5, 000, 000 premium to be paid to the Class B shareholders, noting that Shear would receive the bulk of that payment. It also disclosed that the PHC board had opted not to form an independent committee to evaluate the merger proposal. Finally, it disclosed that Shear and Grieco would serve as directors of Acadia following the merger. SRR's fairness opinion was distributed to the shareholders along with the proxy statement.

         For the merger to be approved, at least a two-thirds majority of Class A shares, a two-thirds majority of Class B shares, and a two-thirds majority of Class A and Class B shares combined had to vote in favor. On October 26, 2011, PHC shareholders approved the merger: 88.7% of the Class A shares and 99.9% of the Class B shares voted in the affirmative. MAZ Partners LP (MAZ), the owner of over 100, 000 Class A shares, voted its shares against the proposed merger. On November 1, the merger was consummated, resulting in the conversion of all PHC stock into Acadia stock. The market reacted favorably to the merger: Acadia stock began a long upward climb. The per-share price of Acadia stock rose from $8 at the time of the merger to over $80 in less than four years. MAZ did not stay aboard but, rather, sold all of its Acadia stock in January of 2012 (at a profit).

         Well before the merger took effect, MAZ repaired to a Massachusetts state court and sued the PHC directors, seeking to block the merger. Invoking diversity jurisdiction, the defendants removed the action to the federal district court. See 28 U.S.C. §§ 1332(a), 1441(b). MAZ was unsuccessful in attempting to halt the transaction: the district court refused to enjoin the merger. Nevertheless, MAZ continued to press its breach-of-fiduciary-duty claims, seeking both a remedy at law (money damages) and equitable relief.

         In due course, the district court (O'Toole, J.) granted summary judgment in favor of the defendants. MAZ appealed and succeeded in snatching a partial victory from the jaws of defeat: it persuaded a panel of this court to vacate the summary judgment. See MAZ I, 762 F.3d at 145. On remand, the case was reassigned to Chief Judge Saris. See D. Mass. R. 40.1(k). After some further skirmishing, the district court certified a class of former Class A shareholders who had voted against the merger, abstained from voting, or failed to vote. MAZ was designated as the class representative and alleged that the PHC directors, jointly and severally, had breached their fiduciary duties by orchestrating the merger transaction through an unfair process and, of particular pertinence here, by facilitating the payment of the (allegedly inflated) $5, 000, 000 premium to the Class B shareholders.

         The legal claims were tried to a jury (the parties reserving the resolution of the equitable claims). During the course of the trial, the Massachusetts Supreme Judicial Court (SJC) decided International Brotherhood of Electrical Workers Local No. 129 Benefit Fund v. Tucci, 70 N.E.3d 918 (Mass. 2017). Premised on their reading of this decision, the defendants moved for judgment as a matter of law, see Fed.R.Civ.P. 50(a), arguing, inter alia, that MAZ should have brought its claims derivatively. The district court granted this motion in part and entered judgment in favor of all the directors save Shear. As to the latter, the court refused to enter judgment as a matter of law, ruling that there was a jury question as to whether Shear was a controlling shareholder and, thus, came within one of the Tucci exceptions. Accordingly, the court submitted the case to the jury on the legal claims asserted against Shear.

         The jury made a series of special findings. See Fed.R.Civ.P. 49. It found, inter alia, that Shear controlled the board's decision to enter into the merger and that the process undertaken to negotiate the merger was not entirely fair to the Class A shareholders. The jury went on to find, though, that the proof was insufficient to establish that the Class A shareholders had suffered any economic loss. Predicated on this finding, the jury determined that the plaintiff class was not entitled to money damages and returned a take-nothing verdict.

         After the jury returned its verdict, MAZ (on behalf of the plaintiff class) moved for equitable relief. Specifically, MAZ sought disgorgement of the Class B premium based largely on the jury's findings that Shear was not only a director but also a controlling shareholder, that he therefore owed the shareholders a fiduciary duty, and that he had breached that duty by arranging the merger through a process that was not entirely fair to the Class A shareholders. Following a hearing, the district court agreed with MAZ, adopted the relevant jury findings, ruled that Shear had breached his fiduciary duty, and determined that the class was entitled to equitable relief. See MAZ Partners LP v. Shear (MAZ II), 265 F.Supp.3d 109, 118-21 (D. Mass. 2017).

         Concluding that disgorgement was an available and appropriate equitable remedy, the court proceeded to make a series of calculations. First, it determined that $1, 820, 000 of the $5, 000, 000 Class B premium represented fair compensation for the enhanced voting rights carried by the Class B shares. See id. at 119. The remainder of the Class B premium ($3, 180, 000), the court stated, was unjustified. See id. Next, the court determined that - based on Shear's percentage ownership of the Class B shares - "Shear's pro rata portion of the unjustified portion of the Class B premium" was "93.22% of $3.18 million, or $2, 964, 396." Id. at 120. Finally, the court ordered that Shear disgorge this amount, and it awarded those funds to the plaintiff class, together with interest. See id.

         On a parallel track, MAZ challenged the jury verdict and moved for a new trial with respect to the class's legal claims. In support, MAZ contended that the district court had permitted the introduction of unduly prejudicial evidence during the trial. The district court denied this motion. See id. at 121-22. These timely appeals ensued: Shear appeals the disgorgement order, and MAZ appeals the denial of its motion for a new trial.


         Shear attacks the disgorgement order on several fronts. His threshold argument is that MAZ's suit is infirm because it should have been brought derivatively, not directly. Next, he argues that the district court applied the wrong standards in adjudicating MAZ's claim. Finally, he argues that the disgorgement order was beyond the district court's authority and, even if it was not, comprised an abuse of discretion. We deal with these arguments sequentially.[1]

         A. Direct and Derivative Actions.

         The first skirmish centers on Shear's asseveration that this suit should have been brought derivatively, not directly. The distinction is critically important: shareholders can bring a direct claim for their own benefit, but a derivative claim belongs to the corporation. See Tucci, 70 N.E.3d at 923. This distinction holds even though the law "permits an individual shareholder to bring 'suit to enforce a corporate cause of action against officers, directors, and third parties'" in the form of a derivative action. Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 95 (1991) (emphasis omitted) (quoting Ross v. Bernhard, 396 U.S. 531, 534 (1970)). Derivative suits are subject to special procedural guardrails designed to balance the legitimate exercise of business judgment by corporate decisionmakers, on the one hand, with the oversight function of corporate shareholders, on the other hand. A claim that is brought directly when it should have been brought derivatively is not a claim at all and, hence, is subject to dismissal. See Tucci, 70 N.E.3d at 927.

         In diversity jurisdiction, state law supplies the substantive rules of decision. See Erie R.R. Co. v. Tompkins, 304 U.S. 64, 78 (1938). Questions of corporate law - including whether a claim is properly classified as derivative or direct - are generally substantive and, thus, governed by state law. See Gasperini v. Ctr. for Humanities, 518 U.S. 415, 427 (1996); Kamen, 500 U.S. at 99. Consistent with PHC's status as a Massachusetts corporation, the parties agree that Massachusetts law controls in this case.

         The starting point for our inquiry is, of course, Tucci. There, the SJC clearly articulated, for the first time, the framework for determining which causes of action must be brought derivatively and which can be brought directly.[2] The crux of the inquiry is "whether the harm [that shareholders] claim to have suffered resulted from a breach of duty owed directly to them, or whether the harm claimed was derivative of a breach of duty owed to the corporation." Tucci, 70 N.E.3d at 923. Because a director's fiduciary duties are generally owed only to the corporation, any suit to enforce those duties ordinarily must be brought as a derivative action. See id. at 925-27.

         We say "ordinarily" because the Tucci court identified at least two situations in which a director's fiduciary duties are owed to shareholders and can be enforced directly, rather than derivatively. The first of these exceptions involves close corporations, see id. at 926, and is plainly inapposite (PHC stock, after all, was publicly traded, and PHC can by no stretch of even the most lively imagination be considered a close corporation).

          The second exception hits closer to home: it involves situations in which a "controlling shareholder who also is a director proposes and implements a self-interested transaction that is to the detriment of minority shareholders." Id. The case at hand requires us to explore the parameters of this exception and decide whether Shear fits within it.

         To begin, Shear does not contest the self-interested nature of the corporate transaction that gave rise to the Class B premium. Nor can he gainsay that the jury made a special finding of detriment: the merger was not entirely fair to the Class A shareholders. The question, then, reduces to whether the district court supportably determined that Shear possessed a sufficient degree of control to be considered a controlling shareholder.[3]

         Answering this question requires us to delve into matters of first impression: Tucci did not elaborate on the attributes that are necessary to distinguish a controlling shareholder from a non-controlling shareholder. Faced with terra incognito, we must "endeavor to predict how [the state's highest] court would likely decide the question." Butler v. Balolia, 736 F.3d 609, 612-13 (1st Cir. 2013). We are mindful that, when making such an informed prophecy, "[a] federal court should consult the types of sources that the state's highest court would be apt to consult, including analogous opinions of that court, decisions of lower courts in the state, precedents and trends in other jurisdictions, learned treatises, and considerations of sound public policy." Id. at 613.

         At the outset, we reject out of hand Shear's insistence upon a bright-line rule that only majority shareholders can be controlling shareholders under Massachusetts law. He offers little to support such a proposition. And while Shear is correct that the SJC sometimes uses terminology reminiscent of the majority shareholder/minority shareholder dichotomy, it has done so only in the abstract or in cases in which those terms accurately describe the relationship between the relevant parties. See, e.g., Tucci, 70 N.E.3d at 923-27; Coggins v. New England Patriots Football Club, Inc., 492 N.E.2d 1112, 1119 (Mass. 1986). The SJC has given no meaningful indication that the employment of such language was meant to be a guiding principle for determining "controller" status in the mine-run of future cases.

         A contrary hypothesis is more compelling. The SJC's use of the adjective "controlling" to modify "shareholder" strongly suggests a desire to encompass a category of shareholders broader than majority shareholders. If "controlling shareholder" meant no more than "majority shareholder," there would be no reason at all for the SJC to resort to the "controlling shareholder" parlance. Cf. United States v. Thomas, 429 F.3d 282, 286 (D.C. Cir. 2005) (explaining that a court's obvious choice to use one phrase over ...

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