Opinion ID: 6498322
Heading Depth: 2
Heading Rank: 3

Heading: Grounds for Appointing a Custodian5

Text: Section 1767(a)(3) of title 15 of the Pennsylvania Consolidated Statutes permits a court to appoint a custodian “of and for any business corporation when it is made to appear that … the conditions specified in section 1981(a)(1), (2)[,] or to decline supplemental jurisdiction); see also Valencia ex rel. Franco v. Lee, 316 F.3d 299, 305 (2d Cir. 2003) (“[W]e review the district court’s decision to exercise such jurisdiction under an abuse-of-discretion standard.”). In this instance, however, we need not delve deeply into that exercise of discretion, as the parties have not addressed the issue and any complaint about it has been forfeited. It is sufficient to observe that we do not perceive an abuse of discretion. 5 We review the District Court’s decision to appoint a custodian for abuse of discretion. Maxwell v. Enter. Wall Paper Mfg. Co., 131 F.2d 400, 403 (3d Cir. 1942). A court abuses its discretion if its “decision rests upon a clearly erroneous finding of fact, an errant conclusion of law[,] or an improper application of law to fact.” EEOC v. City of Long Branch, 866 F.3d 93, 97-98 (3d Cir. 2017) (citation omitted). The interpretation of bylaws is subject to our plenary review. Peters Creek United Presbyterian Church v. Wash. Presbytery of Pa., 90 A.3d 95, 104 (Pa. Commw. Ct. 2014). “When we interpret corporate bylaws, we must use the same rules applicable to the interpretation of statutes.” M4 Holdings, LLC v. Lake Harmony Ests. Prop. Owners’ Ass’n, 237 A.3d 1208, 1218 (Pa. Commw. Ct. 2020) (citation and internal quotation marks omitted). 20 (3) … exist with respect to the corporation.” There are five conditions specified in section 1981: (1) The acts of the directors are illegal, (2) The acts of the directors are oppressive, (3) The acts of the directors are fraudulent, (4) The corporate assets are being misapplied or wasted, or (5) The directors are deadlocked, the shareholders are unable to break the deadlock, and the corporation is suffering or being threatened to suffer irreparable injury. See 15 Pa. Cons. Stat. § 1981(a). The District Court found that each of those five grounds individually justified the appointment of the Custodian in this case. The Court’s conclusions, however, are based on a faulty interpretation of the Bylaws and on unsupported findings of facts. Accordingly, they cannot stand.
The District Court found that the Madonna Directors acted illegally and oppressively and that the Republic First Board was deadlocked. Each of those conclusions was based on the Court’s interpretation of the Bylaws as requiring at least five of the Board’s full complement of eight directors to be present to form a quorum and conduct any business, including filling any Board vacancy. Based on that interpretation, the Court held that the four Madonna Directors violated the Bylaws by their actions at the May 13 special board meeting and by intending to fill the Board’s vacancy at the May 17 21 special board meeting.6 Similarly, it held that the Madonna Directors’ attempt to “wrest immediate control of Republic First” was oppressive, as those actions likely violated the Bylaws and “are thus ultra vires or unjust.” (App. at 18.) Finally, it concluded that the Board was deadlocked because neither faction could muster enough directors to form a fiveperson quorum. Each of those conclusions, however, is based on an unsupportable interpretation of the Bylaws. Article II, Section 7 of the Bylaws addresses the process for filling vacancies on the Board. Its first two sentences state: Any vacancies in the Board of Directors, whether arising from death, resignation, removal or any other cause except an increase in the number of directors, shall be filled by a vote of the majority of the Board of Directors then in office even though that majority is less than a quorum. A majority of the entire Board may fill a vacancy that results from an increase in the number of directors. (App. at 45 (emphasis added).) That language is unambiguous. If a vacancy on the Board arises from the death of a director, the majority of the remaining directors must fill that vacancy, regardless of 6 The District Court held that violating the Bylaws was illegal under title 15, section 1505 of the Pennsylvania Consolidated Statutes, which states that the directors of a corporation are bound by its bylaws. 22 whether they form a quorum. Based on that clear language, the four Madonna Directors, who constituted a majority of the seven remaining directors, had the power and in fact the obligation to fill the vacancy left by Flocco. Contrary to the District Court’s holding, the clarity of Section 7 is not “obscured” by its third sentence. (App. at 16.) That sentence reads: In the event that at any time a vacancy exists in any office of a director that may not be filled by the remaining directors, a special meeting of the shareholders shall be held as promptly as possible and in any event within sixty (60) days, for the purpose of filling the vacancy or vacancies. (App. at 45.) The District Court construed “may not be filled” to mean “shall not be filled,” and then expressed confusion at why Section 7 would, in the first two sentences, address situations where the remaining directors shall fill a vacancy and then, in the third sentence, imply that there are situations where they shall not fill a vacancy. Based on that perceived inconsistency, the Court concluded that Section 7 did not permit the remaining directors to fill a vacancy.7 7 The District Court also reasoned that Republic First’s articles of incorporation “seem to contemplate the filling of Directorships only by shareholder election.” (App. at 17.) The articles of incorporation indeed provide that shareholders will elect directors to three-year terms at each annual shareholders’ meeting, but they do not exclude the availability of interim, temporary appointments to the Board. Section 7 of the Bylaws 23 But Section 7’s third sentence does not generate ambiguity. Combined with the first two sentences, it leads to a consistent and logical understanding of the Bylaw: The remaining directors must fill a vacancy with a majority vote; if the remaining directors are unable to fill the vacancy – such as when the vacancy leaves the Board with an even number of directors who are deadlocked – then the shareholders must fill that vacancy. That clear construction gives effect to every sentence of Section 7, and it makes sense. The District Court needlessly stretched its reading of “may not be filled” to create an inconsistency, making no discernable effort to harmonize the provisions before tossing out that crucial Bylaw. See Keystone Fabric Laminates, Inc. v. Fed. Ins. Co., 407 F.2d 1353, 1356 (3d Cir. 1969) (“It is axiomatic in contract law that two provisions of a contract should be read so as not to be in conflict with each other if it is reasonably possible.”). That was error. The Hill Directors do not defend the District Court’s analysis. Rather, their main argument is that a quorum is still required for the remaining Board members to fill a vacancy, and Section 7’s contrary language – “the majority of the Board of Directors then in office even though that majority is less than a quorum” – only comes into play if there are not enough directors remaining to mathematically form a quorum. They provides that “[a]ny director elected or appointed to fill a vacancy shall hold office for the balance of the term then remaining and until a successor has been chosen[.]” (App. at 45.) That does not conflict in any way with the articles of incorporation. 24 are correct that, “[a]s a general rule[,] the directors of a corporation may bind a corporation only when they act at a legal meeting of the board.” Stone v. Am. Lacquer Solvents Co., 345 A.2d 174, 176 (Pa. 1975). And a legal meeting requires a quorum, unless the bylaws provide otherwise. 15 Pa. Cons. Stat. § 1727(a). Their argument fails here, however, because the Bylaws plainly do provide otherwise. Moreover, Section 7 of the Bylaws tracks Pennsylvania’s default rule for filling vacancies on the boards of corporations: “Except as otherwise provided in the bylaws[,] [v]acancies in the board of directors … may be filled by a majority vote of the remaining members of the board though less than a quorum, or by a sole remaining director[.]” Id. § 1725(b)(1)(i). Pennsylvania courts have not addressed whether the phrase “though less than a quorum” overrides the general quorum requirement even when a quorum is possible, but Delaware courts have provided helpful guidance in applying their substantively identical statute, 8 Del. C. § 223(a)(1). Ninety years ago, the Delaware Court of Chancery flatly stated that a bylaw implementing section 223(a)(1) meant that “a majority of the remaining directors may [fill a vacancy] regardless of whether a quorum of the board is left in office or not.” In re Chelsea Exch. Corp., 159 A. 432, 434 (Del. Ch. 1932). That interpretation has not been abrogated by any later decision. Nevertheless, the Hill Directors cite two cases they believe signal that Chelsea Exchange is no longer good law. The first is Applied Energetics, Inc. v. Farley, 239 A.3d 409 (Del. Ch. 2020). But Applied Energetics was not about filling board vacancies. Rather, it was about whether a single director could transact business even though he alone did not constitute 25 a quorum under his company’s bylaws. The Court of Chancery held that he could not, but it pointed to section 223(a)(1) as one of the very few instances in which a board can act without a quorum. Id. at 426-47. The Applied Energetics decision did not cite Chelsea Exchange. The second case is Tomlinson v. Loew’s Inc., 134 A.2d 518 (Del. Ch.), aff’d, 135 A.2d 136 (Del. 1957). In Tomlinson, the company had a bylaw that expressly granted to the board the power to fill vacancies. Id. at 523. The company also had a second bylaw allowing for vacancies to be filled by a majority of the remaining directors even if not a quorum, similar to the bylaw in Chelsea Exchange (and here). Id. at 524. The Court of Chancery acknowledged the holding from Chelsea Exchange, but it held that the existence of the first bylaw made Chelsea Exchange distinguishable. The court said that the two bylaws worked together to create a tiered framework: If there were enough directors to form a quorum, the first bylaw required board action at a meeting with a quorum; if there were not enough directors to form a quorum, the second bylaw permitted the remaining directors to fill vacancies with a majority vote, regardless of any quorum requirement. Id. at 525-28. In our case, however, there is no separate Bylaw that specifically grants the Board the power to fill vacancies. The Hill Directors’ request to have us adopt the same framework as in Tomlinson is therefore without any foundation in the governing documents of Republic First.8 8 The Hill Directors further claim that the Madonna Directors cannot fill a Board vacancy without first allowing the Board’s Nominating Committee to recommend a candidate. The responsibilities of the Nominating Committee, as listed in its charter, include “[i]dentify[ing] individuals qualified to 26 The Bylaws here unambiguously permit – in fact, require – the remaining directors in office to fill the vacancy with a majority vote, regardless of whether those voting to fill the vacancy constitute a quorum. The Madonna Directors constitute four of the seven remaining directors, so they have sufficient numbers to fill the vacancy. Because the Bylaws give the Madonna Directors the power and obligation to fill the vacancy, their efforts to do so were not illegal or oppressive, and there is no deadlock on the Board.9 The District Court’s become Board members” and, “[i]n the case of a vacancy in the office of a director, … recommend[ing] to the Board an individual to fill such vacancy though appointment by the Board[.]” (App. at 344.) But nowhere in the Nominating Committee’s charter (or any other constitutive document) is there a requirement that the Board wait for a recommendation from the Nominating Committee before filling a vacancy. The Bylaws state that a vacancy arising from death “shall be filled by a vote of the Majority of the Board of Directors then in office[.]” (App. at 45.) The Board organized a committee to assist in that process, but the Board did not abdicate its appointment power or delegate it to the Nominating Committee. 9 If the Madonna Directors appoint an ally, then they will also have sufficient numbers (five out of eight) to ratify past acts, including acts taken at the May 13 special board meeting. See Stone v. Am. Lacquer Solvents Co., 345 A.2d 174, 177 (Pa. 1975) (noting that ratification can remedy acts taken at an illegal board meeting). The Madonna Directors’ ability to fill the vacancy with an allied fifth director likely renders irrelevant the parties’ 27 interpretation of Section 7 is erroneous, and hence its findings of illegality, oppression, and deadlock – all of which depended on that interpretation – were abuses of discretion. None of those grounds justified appointing a custodian for Republic First.
Independent of the District Court’s declaration that the Madonna Directors were acting ultra vires under the Bylaws, the Court also found that fraud and waste justified the appointment of a custodian. A review of the Court’s decision, however, reveals that there was no evidence to justify the drastic remedy of appointing a custodian. With respect to fraud, the District Court merely opined that the accusations between the two Board factions “suggest widespread self-dealing and dishonesty among the Directors.” (App. at 18.) It conceded that it did not actually know “if either accusation is true.” (App. at 18.) And that is a serious problem. Mere speculation of fraud will not justify appointing a custodian, particularly when that speculation is based on dispute over the Bylaws’ quorum requirement. Article II, Section 15 of the Bylaws defines a quorum as “[a] majority of the members or the entire Board of Directors[.]” (App. at 46.) The Madonna Directors interpret that to mean a majority of the directors then in office; the Hill Directors say that it contains a typo and should instead read “a majority of the members of the entire Board.” We need not offer an interpretation of that phrase, but Republic First would do well to amend Section 15 to clarify that language. 28 nothing more than the plaintiff’s unsupported allegations. See, e.g., Tyler v. O’Neill, 1998 WL 695991, at  (E.D. Pa. Oct. 6, 1998) (declining to appoint a custodian where there were “no substantiated allegations of present waste, mismanagement, fraud, or dissipation”), aff’d, 189 F.3d 465 (3d Cir. 1999). With respect to waste, the District Court expressed its concern that the infighting on the Board would “injure both public confidence in the institution and the institution itself.” (App. at 18-19.) But it acknowledged that it could not quantify that harm, and it cited no other evidence or even allegation of waste. Potential reputational damage stemming from infighting directors does not come close to the type of waste that justifies appointing a custodian. See Principles of Corp. Governance: Analysis & Recommendations § 1.42 (Am. Law Inst. 1994) (defining corporate waste as “an expenditure of corporate funds or a disposition of corporate assets” in exchange for little or no consideration and with no rational business purpose); In re Tower Air, Inc., 416 F.3d 229, 238 (3d Cir. 2005) (explaining that, to constitute corporate waste under Delaware law, “the decision must go so far beyond the bounds of reasonable business judgment that its only explanation is bad faith”). A contrary ruling would invite every dissenting director of a Pennsylvania corporation to request a custodian to supplant the governance rules of the company. The District Court’s terse reasoning and the lack of any well-developed evidentiary record expose the insufficient factual basis for the findings of fraud and waste. Appointing a custodian based on those reasons, on the current record, was an abuse of discretion. 29