Last week, the Manhattan-based Appellate Division, First Department, handed down one of the more intriguing decisions by a New York court I’ve seen in a long time involving a dispute between LLC members.

The central issue in the case, brought by an investor in a Delaware LLC against the LLC’s controller, is whether an oral agreement between two sophisticated entrepreneurs, in which the controller allegedly induced the investment by guaranteeing to cash out the plaintiff’s position under either of two scenarios, is barred by the generic merger clause in a subsequent amended operating agreement that the investor never signed.

The lower court granted the defendant’s pre-answer dismissal motion following which the plaintiff appealed. The Appellate Division last week in Behler v Tao (read here) affirmed the order below in a 3-2 decision featuring a majority opinion authored by Presiding Justice Sallie Manzanet-Daniels, applying what she labels “explicitly contractarian” Delaware LLC law “sometimes leading to harsh results,” and a dissenting opinion authored by Justice Ellen Gesmer exalting “basic principles of contract law and fundamental fairness.”

Background

The case was decided on a pre-answer dismissal motion, hence most of the facts you’ll read in the court’s decision and here are the plaintiff Behler’s version of the events as laid out in his complaint which you can read here.

Continue Reading New York Appellate Court’s Split Decision Involving Delaware LLC Pits “Harsh” Contractarianism Against “Fundamental Fairness”

Jury trials in business divorce litigation are uncommon. Bifurcated business divorce jury trials are all but nonexistent.

But in Aronov v Khavinson (81 Misc3d 1242(A) [Sup Ct, Kings County Feb. 9, 2024]), we encounter the elusive specimen in the wild: a successful jury verdict on liability on a slew of business tort, quasi-contract, and equitable claims in the first phase of a bifurcated jury trial by an LLC owner against the entity’s three managers, including a lawyer.

Basic Principles of Bifurcation

For those not familiar, “bifurcation” refers to the practice of trying a case in two parts: a liability phase, followed, if the jury renders a plaintiff’s verdict on liability, by a separate damages phase.

Our readers who happen to be lawyers may associate trial bifurcation generally with the Appellate Division – Second Department, and with bodily injury or death claims specifically, not business divorce cases (see e.g. Castro v Malia Realty, LLC, 177 AD3d 58 [2d Dept 2019] [“For decades, trial courts in the Second Judicial Department have, as a general rule, conducted trials in personal injury actions in a bifurcated manner”]). In cases for “personal injury,” judges are “encouraged” to “direct a bifurcated trial of the issues of liability and damages” (Marisova v Collins-Brewster, 223 AD3d 891 [2d Dept 2024]).

One of the theories of bifurcation is that the jury should not reach the question of damages without first finding a viable case for liability. If a plaintiff’s damages case is strong, but liability weak, a unified trial of both liability and damages may unfairly incline a jury to sympathize with the plaintiff, disfavor the defendant, or otherwise permit its view of damages to influence its perception of liability. Or so the thinking goes. Hence, the bifurcated trial, where a plaintiff must prove liability in one trial before the jury may reach the question of damages in another.

But sometimes damages overlap with liability to such a degree that bifurcation may be impractical or unfair to the plaintiff. Where damages have “an important bearing upon the question of the liability,” a unified trial is warranted (Matthew H. v County of Nassau, 131 AD3d 135 [2d Dept 2015]).

In the end, bifurcation is “not an absolute given,” but a matter of discretion: it is the “responsibility of the trial judge to exercise discretion in determining whether bifurcation is appropriate in light of all relevant facts and circumstances presented by the individual case” (Rueda v Elmhurst Woodside, LLC, 187 AD3d 955 [2d Dept 2020]).

How did the trial judge – Kings County Supreme Court Justice Patria Frias-Colon – arrive at that exercise of discretion in Aronov? Let’s take a look.

Continue Reading Rare as a Dodo: Bifurcation in Business Divorce Trials

“Under any standard of value, the true economic value of a business enterprise will equal the company’s accounting book value only by coincidence . . .” says the late business valuation expert and author Shannon Pratt.  So why do so many shareholder buy-sell agreements require that the shares be purchased for book value? 

While I can think of a few likely answers to that question (e.g., ease of calculation, agreements modeled on BCL 1510, and the likelihood that for operating businesses fair value will exceed book value), the near certainty of a disparity between book value and fair value increases the odds for litigation.  Inevitably, one party to a book value buy-sell agreement is getting a bad deal. 

As a result, New York caselaw is filled with cases covering all sorts of attempts to evade the sometimes economically harsh consequences of a book value buyout, to varying degrees of success.  Neville, Rodie and Shaw, Inc. v LeGard, 3:23-CV-266 (D Conn Feb. 16, 2024) is the latest.

Continue Reading And the Award for Most Creative Attempt to Evade a Book Value Buy-Sell Provision Goes To . . .

In my business divorce practice I deal with many closely held corporations that have only a few or perhaps just two shareholders, each of whom is actively involved in running the business. Within that category are many companies whose owners essentially ignore some if not all the corporate formalities mandated by New York’s Business Corporation Law.

Foremost among the neglected formalities is a functioning board of directors as required by BCL 701 (“the business of a corporation shall be managed under the direction of its board of directors”), the members of which “shall be elected” at “each annual meeting of shareholders” as required by BCL 703. At least while relations among the owners are copacetic, I’m sure I’d be met with incredulous looks if I were to recommend annual board elections and regular board meetings complete with meeting minutes to a small group of operating owners who are in regular if not daily contact with one another.

Relations among co-owners can sour for many reasons. One of the more common reasons for dissension is a co-owner’s self-interested transaction with the company. Apart from whether the transaction breaches a common-law fiduciary duty, when the actor is a director — even if only nominally so — enter the “Interested Directors” statute, BCL 713, which imposes a series of guardrails on the ability of a director to engage the corporation in a contract or other transaction with any other entity in which the director has a substantial financial interest.

Continue Reading Enforcing the Guardrails on Transactions Involving Interested Directors of Close Corporations

Sections 706 (d) and 716 (c) of the Business Corporation Law (the “BCL”) both contain a “for cause” standard for judicial removal of corporate directors and officers. Complaints with claims for judicial corporate director and officer removal are common. Decisions actually ordering removal are rare. Very rare. Over the past two decades, there have been less than a dozen appeals court decisions to even cite BCL 706 or 716, and not one involved actual removal on the merits of an officer or director.

The closest to reach the merits of a removal claim, Colucci v Canastra (130 AD3d 1268 [3d Dept 2015]), ruled that four shareholders of a corporation that owned and operated a golf course “submitted prima facie evidence” warranting a trial whether “there was cause for defendant’s removal due to his use of Hillcrest’s profits to pay for clubhouse operations that only benefitted him.”

Last month, in Gam v Dvir (___ AD3d ___, 2024 NY Slip Op 00181 [2d Dept Jan. 17, 2024]), a Brooklyn-based appeals court became the first in a generation to consider the merits of a lower court’s decision ordering judicial removal of a corporate officer or director.

Continue Reading The Flexible “For Cause” Standard for Director and Officer Removal

More often than not, the centerpiece of an intra-owner business dispute is a claim that those in control of the business breached their fiduciary duties to the company or the minority owners.  While often easy to assert, the breach of fiduciary duty claim is subject to incredibly nuanced legal theories, including those surrounding agreed-upon conduct, safe harbors, conflicts of interest, business judgment, reasonable means, and different standards of review.  Litigants often agree that a majority shareholder or director owes fiduciary duties to the company, then sharply disagree on what those duties are and how their conduct should be adjudged.  

This week’s post takes us to the halls of Delaware Chancery Court, where a recent decision from Vice Chancellor Laster, In re Sears Hometown and Outlet Stores, Inc. Stockholder Litig., 2019-0798-JTL [Del Ch Jan. 24, 2024], offers a first-of-its-kind roadmap for assessing the fiduciary duties owed by a majority shareholder.

Continue Reading The First State Defines the Scope of Majority Shareholder Fiduciary Duties

Capital contributions by business owners are the lifeblood of any newly formed business entity. Typically the lifeblood consists of cash, but not always. In many instances the contribution may consist of tangible (e.g., real property) or intangible (e.g., intellectual property rights) assets. In other instances it may consist of services provided by an equity owner.

As in most if not all states, New York’s statutes governing business entities sensibly permit various forms of capital contributions as consideration for equity interests. With minor variations each of Section 504 of the Business Corporation Law, Section 121-501 of the Revised Limited Partnership Act, and Sections 102(f) and 501 of the Limited Liability Company Law provide that capital contributions may take the form of cash, property, services rendered, or promises to provide any of the foregoing.

LLCs and Indeterminate Membership Interests

The default rules under New York’s LLC Law are modeled on what I call indeterminate or variable membership interests. The measure of a member’s voting power (LLCL 402[a]), profit and loss share (LLCL 503), share of distributions (LLCL 504), and share of net assets distributed upon dissolution (LLCL 704[c]) all are based on the proportionate “value” of each member’s “contributions” which in theory may vary over time.

Most of the LLCs I encounter in my practice have operating agreements that depart from the default rules by granting the members fixed voting and economic rights based on static membership percentages which may be based on actual contributions or an arbitrary incentive-based allocation such as equal shares for all members. To the extent such operating agreements leave room for post-formation adjustments to member percentages and allocations, it’s usually captured by a provision contemplating possible additional cash contributions down the road.

The risk of member disputes over contributions is greater for LLCs either with no written operating agreement, and therefore governed by the statutory default rules, or with operating agreements that replicate the default rules. The latter often appear when LLCs use off-the-shelf operating agreements offered by various vendors such as LegalZoom. For those LLCs, when member relations sour and a power struggle ensues, there’s a strong incentive to challenge the value of member contributions where the facts warrant it.

This can take the form of claims that a managing member falsified the LLC’s accounting records and tax filings to record values for cash contributions that were never made or for services that never were disclosed or the subject of an agreed valuation among the members. The accusation invariably is tied to a claim for a greater share of voting rights, profit and loss allocations, or distributions.

Continue Reading The Perils of Indeterminate LLC Membership Interests, Redux

There are many paths to a fair value appraisal proceeding. A road less traveled begins at Section 910 of the Business Corporation Law (the “BCL”).

BCL § 909 (a) requires board and shareholder approval for a “sale, lease, exchange or other disposition of all or substantially all the assets of a corporation, if not made in the usual or regular course of the business” of the corporation.

BCL § 910 (a), in turn, provides that a shareholder who timely dissents from a corporation’s sale, lease, exchange or other disposition of “all or substantially all” assets shall “have the right to receive payment of the fair value of his shares” in an amount for the parties to litigate and the court to decide in a fair value appraisal proceeding under BCL § 623.

Cases involving a shareholder’s right to fair value appraisal of his or her stock resulting from an “all or substantially all” sales transaction are rare.

More than a dozen years ago, Peter Mahler wrote about one such case, Barasch v Williams Real Estate Co. (33 Misc 3d 1219[A] [Sup Ct, NY County 2011]).

In Barasch, former Commercial Manhattan Division Justice Bernard Fried held that a complex, multi-step reorganization ultimately resulting in the acquisition of 65% of the corporation’s former interests by a new investor triggered a shareholder’s right to dissent and cash out in an appraisal proceeding.

The Appellate Division – First Department later affirmed Justice Fried’s Barasch decision, but on other grounds, ruling that the entity was “estopped” from denying the transaction was an “all or substantially all” transaction because it sent a notice of shareholders meeting stating that it was exactly that: a “disposition of substantially all of the assets” of the company (100 AD3d 562 [1st Dept 2012]).

In his piece on Barasch, Peter Mahler wrote that the case fell in a “grey area” between, on the one hand, a clear right to appraisal from a sale or disposition that “terminates the corporation’s existence or operation,” and, on the other hand, a clear absence of right to appraisal where a corporation “merely transfers some of its assets to subsidiaries.”

Earlier this month, in Haruvi v Hungerford (81 Misc 3d 1229[A] [Sup Ct, NY County Jan. 16, 2024]), Manhattan Commercial Division Justice Andrew Borrok decided another “grey area” BCL § 909 case. In some ways, Haruvi’s facts, especially the complexity of the deal, resemble those of Barasch. But the legal outcome could not have been more different.

Continue Reading Direct to Beneficial: Change of Corporate Ownership Structure Yields No Right to Dissent and Seek Appraisal

When a closely-held business is profitable, self-interested owners naturally want a bigger slice of the pie, especially where the personal relationships among the owners are frayed.  Perhaps that’s why we often discuss the value of freeze-out mergers as a mechanism for those in control of a closely-held corporation or limited liability company to squeeze a minority owner out of the business’ future profits. 

Equity dilution is another common method by which those in control of a corporation or LLC attempt to squeeze out a minority owner.  For one, stock dilution impairs the minority owner’s ability to influence company action by voting his shares, and it lessens the owner’s right to participate pari passu in the distributions or dividends of the company.  Perhaps more importantly, a minority owner can see his or her ownership interest diluted below certain critical thresholds—for instance, the 20% ownership required to petition for dissolution under BCL 1104-a.

Despite the potentially drastic consequences of stock dilution, many closely-held businesses we encounter fail to adequately address the issue of dilution in their governing documents.  And New York caselaw on the issue leaves plenty to be desired.  Let’s interpret those factors as an invitation to review the basics, key caselaw, and the current status of the improper dilution claim.

Continue Reading Let’s Talk About Dilution

Welcome to this year’s Winter Case Notes where, amidst the arctic blast currently sweeping most of the nation, I offer shortish takes on several court decisions in recent business divorce cases.

This year’s edition features notable decisions by New York courts stemming from cases with, shall we say, not your typical fact patterns:

  • Affirming the lower court’s post-trial verdict rejecting a shareholder’s claim to enforce an alleged agreement requiring the defendant shareholder, following the plaintiff’s acquittal on murder charges, to transfer back to the plaintiff shares he sold to the plaintiff in the course of the plaintiff’s lengthy criminal proceedings;
  • Without deciding whether the death — accidental in this case — of an LLC member qualifies as a withdrawal for purposes of LLC Law § 509’s buyout provision, ordering the surviving member to turn over books and records to the estate representative but only through the date of death; and
  • Denying interim injunctive relief restoring a minority shareholder to his former management position in a group of auto dealerships upon the court’s finding that the plaintiff failed to establish a likelihood of success on his claims of minority shareholder oppression and that the governing agreements were never effective.
Continue Reading Winter Case Notes: Murder, Forgery, Accidental Death, Oppression, Oh My!