Following Delaware Precedent, New York Appeals Court Rules that Indemnification of LLC Managers for Successful Defense in First Action Need Not Await Resolution of Second, Related Litigation
A little over a year ago, in the Ficus Investments case, the Manhattan-based Appellate Division, First Department, looked to Delaware case law for guidance in holding that an LLC manager named as defendant in an action brought by a member alleging conversion and fiduciary breach was entitled to advancement of his legal defense costs notwithstanding preliminary injunction rulings against him. (Read my prior post on Ficus here.)
Last month, in 546-552 West 146th Street LLC v. Arfa, 2010 NY Slip Op 01416 (1st Dept Feb. 18, 2010), the First Department again looked to Delaware precedent in another ruling of apparent first impression involving indemnification rights in the LLC internal warfare context. The issue this time: Is the defendant LLC manager entitled to indemnification for winning the non-merits dismissal of Action No. 1 prior to the adjudication on the merits of Action No. 2 asserting the same or similar claims? The Delaware Chancery Court answered "yes", and now so too does the First Department.
The Arfa litigation saga begins in 2006, when several real estate holding LLCs sued their former managers for failing to make certain disclosures to the LLC members when they were being solicited to invest in the LLCs. In February 2007, Manhattan Commercial Division Justice Charles E. Ramos dismissed the case on the ground that the LLCs lacked standing to pursue the claims, which properly belonged to their members. In September 2008, the First Department rejected the LLCs' appeal in a decision reported at 54 AD3d 543 (1st Dept 2008).
Meanwhile, even before the appeal was decided, the law firm that initiated the first suit on behalf of the LLCs started a second lawsuit on behalf of the members asserting the same claims against the managers. The second case remains pending.
Continue Reading..."Unusual Actions Breed Unusual Outcomes": Delaware Court Dismisses Non-Voting Trust's Action to Dissolve LLC Born of Estate Plan
A bench ruling and supplemental letter opinion last month in an unusual case called The Homer C. Gutchess 1998 Irrevocable Trust v. Gutchess Companies, LLC, C.A. No. 4916-VCN, adds another chapter to the growing book of Delaware Court of Chancery decisions addressing judicial dissolution of limited liability companies under §18-802 of the Delaware LLC Act. In Gutchess's dismissal of a dissolution petition, we see once again the Delaware court's elevation of the private ordering of LLC affairs, as expressed in the operating agreement, over challenges to the LLC's ongoing existence based on "equitable" factors. The transcript of counsel's argument and the bench ruling on February 16, 2010, can be read here. The supplemental letter opinion dated February 22, 2010, can be read here.
What makes Gutchess particularly interesting is the subject LLC's origin as an estate planning device and its design featuring an almost complete division of the economic interest, held by an inter vivos trust, and the voting control and management exercised originally by the grantor and subsequently by his wife and son.
The story begins in 1904, when George Gutchess founded a small lumber mill called Gutchess Lumber in upstate New York. His grandson and successor, Homer C. Gutchess, greatly expanded the company's operations, turning it into a leading supplier of hardwood lumber in the Northeast U.S. In 2002, around the same time the company transitioned to employee ownership, Homer and his estate planning advisors formed Gutchess Companies, LLC to hold Homer's shares in the operating company. The LLC's operating agreement reflects an almost complete split of the voting interest from the equity interest, with Homer retaining 100% of the voting interest but only 1% of the equity, his wife, Martha, holding another 1% equity, and the rest of the equity (98%) being held by The Homer C. Gutchess 1998 Irrevocable Trust. Later, on the advice of counsel, Homer transferred the voting interest to Martha. Homer died in 2006, after which Martha designated their son, Gary, as the LLC's sole manager.
Continue Reading...Fair Value in Stock Valuation Proceedings: Podcast Interview of Peter Mahler by Business Appraiser Mark Gottlieb
.jpg)
Forensic accounting and business valuation specialist Mark S. Gottlieb (on the left; that's me on the right) has a spanking new website featuring podcast audio interviews of professionals addressing topics of interest to business appraisers and lawyers whose practices involve business valuation and other modes of economic analysis.
Mark recently invited me to speak with him on the subject of fair value and discounts in stock valuation proceedings. During the interview I answer Mark's questions about the elusive definition of fair value; the differences between fair value and fair market value, particularly as regards treatment of discounts; the varying quality of expert testimony in these proceedings; and the impact of shareholder agreement buy-sell provisions on judicial determination of fair value.
You can listen to the podcast by clicking here. The play button is at the bottom of the linked page. The interview lasts about 16 minutes.
The Perils of For-Cause Expulsion Provisions in LLC Agreements
A number of valuable lessons can be learned from a recent decision by Manhattan Commercial Division Justice Melvin L. Schweitzer (pictured) in Jain v. Rasteh, Decision and Order, Index No. 109920-09 (Sup Ct NY County Feb. 1, 2010), where the court summarily dismissed a complaint by a minority member of a limited liability company who was expelled from the LLC for breach of its operating agreement.
The last time I wrote on the subject (read here) I noted that, unlike some other states, New York's LLC Law has no express provision authorizing or prohibiting member expulsion, although LLCL Section 701(b) mentions member expulsion in the context of various events (death, retirement, bankruptcy, etc.) not requiring the LLC's dissolution. Jain involved an LLC formed under Delaware's LLC Act, which, unlike New York's law, expressly authorizes the LLC agreement to provide for the elimination or forfeiture of a member's interest for failure to comply with the LLC agreement, or under any other circumstances specified in the LLC agreement (see Delaware LLC Act Section 18-306 and Section 18-502(c)).
The subject of Jain is a New York based, two-member company formed in Delaware in 2008 to provide investment management and advisory services for a hedge fund. The defendant Majority Member contributed most of the firm's capital and held an 83% profit interest. The plaintiff Minority Member held the balance. Section 5 of the LLC agreement designated the two as co-managers, however it also gave the Majority Member the final say in case of disagreement on any issue with specified exceptions such as dissolution and admission of new members.
Section 12 of the LLC agreement, entitled "Withdrawal of a Managing Member," included a subsection (a)(ii) governing involuntary withdrawal by the Minority member, authorizing the Majority Member to "require" him to withdraw at any time for "Cause" as defined. The definition included conviction for felony or violation of securities laws, fraud, or "a material breach of this Agreement." Section 13 of the LLC agreement entitled the Minority Member to be paid specified percentages of the firm's net profit over the three years following any such involuntary withdrawal, depending on the number of years of service. For termination after less than two years -- which is what happened -- the Minority Member's share of net profit goes from 4.25% in the first year down to about 1.4% in the third year. Under Section 17 of the LLC agreement, following his termination for any reason the Minority Member is prohibited for six months from competing with the company or soliciting any of its clients or employees.
Continue Reading...It Only Took 16 Years: New York Appellate Court Defines Standard for Judicial Dissolution of Limited Liability Companies
No more complaining about the absence of appellate guidance on the standard for judicial dissolution of limited liability companies under §702 of the LLC Law. Finally, almost 16 years after the cryptically-worded statute became law, the Appellate Division, Second Department, in Matter of 1545 Ocean Avenue, LLC, 2010 NY Slip Op 00688 (2d Dept Jan. 26, 2010), offers a carefully considered explanation of what §702 means -- and what it doesn't mean -- in a decision also notable for a two-judge dissent from the majority's disposition of the case without an evidentiary hearing.
As discussed below, the 1545 Ocean opinion's motif is fidelity to the LLC's operating agreement. This contract-centric approach sharply distinguishes LLC dissolution from partnership and close corporation dissolution cases in which implied fiduciary duties and untethered notions of fairness permeate the courts' analysis. It also brings New York LLC jurisprudence closer in line with Delaware's approach to LLC dissolution fueled by the admonition contained in §1101(b) of the Delaware LLC Act, to give "maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements."
It's no surprise that the signed opinion's author is Associate Justice Leonard B. Austin (pictured) who was appointed to the appellate bench in 2009 after serving ten years as trial judge in the Commercial Division of the Nassau County Supreme Court. Justice Austin's Commercial Division caseload, among other types of business disputes, included a steady influx of judicial dissolution proceedings involving closely held corporations and LLCs. That experience undoubtedly gave him a first-hand feel for the analytical and practical difficulties posed by these cases and an appreciation of the legal and business community's need for greater certainty in applying the broad and undefined terms of the dissolution statutes.
There's another reason I'm not surprised by Justice Austin's authorship. In June 2002, I wrote an article for the New York State Bar Association Journal on LLC dissolution (read it here) in which I observed that most of the few cases decided to that point freely borrowed from corporate dissolution norms applicable in cases involving oppressed minority shareholders and internal dissension. I did, however, cite a trial court decision in a case called Matter of Quinn, NYLJ Apr. 20, 2000, p. 32, col. 6 (Sup. Ct. Nassau County), as the sole example I'd found of a court, consistent with §702's language, focusing on whether the complained-of grounds for dissolution conformed to the members' operating agreement. The judge who decided Quinn? Justice Austin.
Now let's examine the 1545 Ocean decision.
Continue Reading...Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part II
|
.jpg)
Last week's post presented an interview with John Cunningham who, along with co-author Vernon Proctor, recently published the pictured practice manual called Drafting Delaware LLC Agreements. John, whose practice focuses on entity formation, addressed some important issues involving Delaware LLCs from the perspective of the drafter of the LLC agreement. In this Part II of the interview, we get Vern's perspective on Delaware LLCs as a seasoned litigator. As John explained last week, "Vern is the guy who makes sure that the book’s analysis of Delaware law is correct. Vern has an amazing knowledge of Delaware statutory and common law."
It's no surprise that John teamed up with Vern as his Delaware law expert. Vern is a founding partner of Proctor Heyman LLP in Wilmington, Delaware, where he has a diverse corporate litigation and counseling practice relating to Delaware business entities, primarily in the Delaware Court of Chancery. Vernon has lectured widely on subjects of Delaware corporate and limited partnership law, and he has served on the editorial boards of leading Delaware law publications. For ten years, he was a member of the Corporation Law Council of the Delaware State Bar Association, a group of attorneys that considers and recommends proposed changes to the Delaware General Corporation Law. He is currently a member of the Alternate Entities Committee of the Delaware State Bar Association, which serves the same function with respect to Delaware statutes governing general partnerships, limited partnerships, and limited liability companies.
In the following interview, Vern answers questions that I suspect are on the minds of many Delaware and non-Delaware lawyers, particularly litigators, whose practices deal with the evolving LLC form.
Mahler: There's a vast body of Delaware case law that lawyers should be aware of in forming Delaware LLCs. If you had to mention just the three or four most important cases, which would they be?
Proctor: As we say in the book, the most important (and, until recently, the only) Delaware Supreme Court opinion construing the Delaware Limited Liability Company Act is Elf Atochem N.A. v. Jaffari, 727 A.2d 286 (Del. 1999). There, the Court provided a comprehensive overview of the structure of the statute, highlighting freedom-of-contract principles and the manner of ascertaining mandatory, default and permissive provisions of the Act. Last month, the Supreme Court decided Olson v. Halvorsen, 2009 WL 4846616 (Del. Dec. 15, 2009), in which it affirmed a Chancery Court holding that the statute of frauds applies to Delaware LLC agreements, notwithstanding the Act’s express allowance of oral and implied LLC agreements. One of the most significant recent trial court decisions in the LLC area is Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. Apr. 20, 2009), where the Court of Chancery examined the efficacy of certain contractual attempts to restrict or eliminate common law fiduciary duties and applied the USACafes doctrine (directors of corporate general partners may owe fiduciary duties to the limited partners of the limited partnership, not just to the corporate general partner and its owners) in the LLC context. Finally, in R&R Capital, LLC v. Buck & Doe Run Valley farms, LLC, CA # 3803-CC (Del. Ch. Aug. 19, 2008), the Court of Chancery held as a matter of first impression that an LLC member could contractually waive its statutory right to seek judicial dissolution of a Delaware LLC, despite the absence from the statute of the phrase “unless otherwise provided in the LLC agreement.” As always in Delaware, check the unreported decisions!
Continue Reading...Interview with Delaware LLC Experts and Practice Manual Co-Authors John Cunningham and Vernon Proctor: Part I
In almost all states, the limited liability company in recent years has become the business organization form of choice for closely held entities. By far the most popular LLC Act for use in forming sophisticated LLCs is the Delaware Act. There are presently something like 7 million U.S. LLCs of which approximately 600,000 are Delaware LLCs.
As a New York practitioner who handles all types of messy disputes between business co-owners, I know first hand the outsized claim of Delaware law on jurisdictional choice of entity as well as the powerful influence of Delaware decisional law even in disputes involving non-Delaware entities. I also know -- because it's written right into the Delaware LLC Act -- that freedom of contract is the cornerstone of Delaware LLC jurisprudence, and therefore nothing contributes more to the long-term health and welfare of a Delaware LLC -- or any LLC, for that matter -- than having a carefully planned, comprehensive, forward-looking, well-drafted operating agreement.
In 2009, Wolters Kluwer Law & Business published what quickly has become the preeminent formbook and practice manual on forming Delaware LLCs entitled Drafting Delaware LLC Agreements. The co-authors are John M. Cunningham and Vernon R. Proctor. I am very pleased to present this first of a two-part interview of the authors of this extremely well-written and user-friendly manual, which also includes a CD containing over two dozen sample Delaware operating agreements.
In this first part of the interview I talk with John Cunningham (pictured left), a member of the New Hampshire and Massachusetts bars whose practice focuses on forming LLCs for business start-ups and on restructuring existing businesses. Among his many achievements John was a principal drafter of the New Hampshire LLC Act. He is not only the co-author of Drafting Delaware LLC Agreements but also is the sole author of Drafting Limited Liability Company Operating Agreements, the leading U.S. general (i.e., non-state specific) LLC formbook and practice manual. I hope you find the interview, which begins after the jump, as interesting and useful as I did.
Continue Reading...Do Advancement and Indemnification Rights Include Defense Costs of Litigation Misconduct After Officer Leaves Company?
If there's a more litigious partnership falling-out than that of the closely-held mortgage company, Private Capital Group (PCG), I don't know about it. The case, entitled Ficus Investments, Inc. v. Private Capital Management, LLC, has racked up 87 motions since it was filed in Manhattan Supreme Court in March 2007, including several contempt applications. The court's docket lists over 2,300 separate documents filed, and the case isn't even close to being tried. There have been three interlocutory appeals decided thus far, with several others awaiting decision. Did I mention the parties have filed at least five other, related cases?
PCG was a New York-based Florida limited liability company formed to buy, manage and sell non-performing mortgages. Ficus Investments, Inc. (Ficus), the 80% member and sole manager of PCG, put up $300 million debt financing. Private Capital Management (PCM), the 20% member, operated PCG's mortgage business by PCM's two beneficial owners, Thomas Donovan and Lawrence Cline. The conflagration started a little over a year after operations began, in March 2007, when Ficus ousted Donovan and Cline and brought suit accusing them of misappropriating over $20 million.
The complex, high stakes litigation not surprisingly has generated millions in legal bills, which in turn has spawned a litigation within the litigation over the issue of the defendants' entitlement to advancement and indemnification of legal expenses under the provisions of PCG's operating agreement.
A year ago I wrote about a January 2009 appellate decision in Ficus in which the court held that the primary defendant, Thomas Donovan, as a former officer of PCG was entitled to seek advancement of his legal defense costs under the operating agreement. The primary issue there was whether the trial court's issuance of preliminary injunctions against Donovan defeated his advancement rights. Manhattan Commercial Division Justice Bernard Fried ruled (read here), and the Appellate Division affirmed (read here), that the ultimate determination of Donovan's indemnification rights had no impact on his interim advancement rights under the operating agreement's terms. The rulings resulted in reimbursement to Donovan of approximately $1.5 million in legal fees incurred through the end of 2007, which was upheld by yet another appellate court ruling in June 2009 (read here).
As it turned out, 2007 was just a warm-up for the next year, in which Donovan incurred another $3.8 million in legal defense costs for which he also sought advancement. Ficus opposed the bulk of the request, arguing that Donovan was not entitled to advancement for fees incurred opposing Ficus's applications for discovery and contempt sanctions concerning Donovan's alleged misconduct after he was terminated as an officer, during the course of litigation. Donovan's alleged misconduct included the "hacking" of former co-defendant Cline's e-mail account -- early in the case Cline and Ficus entered into settlement and cooperation agreements -- and failing to turn over company books and records in violation of court order.
The arguments raised in this second go-round, and the court's recent decision in favor of Ficus, raise novel legal issues with important ramifications for advancement and indemnification litigation in this and other cases.
Continue Reading...Winding Up an Acrimonious Partnership Following Death of a Partner
According to a summary on the website of the Uniform Law Commissioners, thirty-four states have adopted the Revised Uniform Partnership Act of 1994 (RUPA) which, among other significant changes to the original Uniform Partnership Act of 1914 (UPA), no longer provides for automatic dissolution of a general partnership upon the ordinary dissociation of a partner, including upon the death of a partner. Under the default rules of RUPA §§601 and 801, the partnership continues after the death of a partner subject to the partnership's obligation under §701 to purchase the deceased partner's interest for a buyout price equal to the greater of liquidation or going-concern value. (Read here a summary of RUPA's major revisions. Read here the text of RUPA.)
New York is in the minority of states that has not adopted RUPA. Thus under §62(4) of New York's UPA-based Partnership Law enacted in 1919, absent contrary agreement the death of a partner automatically triggers dissolution of an at-will general partnership. While Partnership Law §73 permits continuation of the partnership accompanied by a buyout of a deceased member's interest under certain, narrowly-defined circumstances (e.g., see my previous piece on the Vick v. Albert case), otherwise the partnership must be dissolved and its business wound up.
Such was the case in Matter of Franzese (Franzese Realty Associates), 2009 NY Slip Op 33139(U) (Sup Ct Nassau County Dec. 16, 2009), in which Nassau County Commercial Division Justice Timothy S. Driscoll was tasked with cleaning up a messy dispute between the surviving siblings of a family-owned real estate partnership. Franzese does not involve any novel legal issues, but it nonetheless merits attention as an example of how courts deal with some of the typical problems that arise during the winding up of the partnership, and particularly the question of receivership.
Continue Reading...Court Invalidates Control-Shifting Stock Transfer Made in Violation of Corporation's Right of First Refusal
The right of first refusal (RFR) is a type of stock transfer restriction found in shareholder agreements of closely held corporations. Under the most common form of RFR, the shareholder seeking to transfer his or her shares to another person is required to submit sequentially to the corporation and, if the corporation declines, to the other shareholders the opportunity to purchase the shares on the same terms as are being offered by the proposed purchaser. The courts routinely enforce RFRs in recognition of the special partnership-like character of close corporations.
A recent decision by the Appellate Division, First Department, in Giaimo v. EGA Associates Inc., 2009 NY Slip Op 09277 (1st Dept Dec. 15, 2009), illustrates the mischief that can occur when the RFR is not properly spelled out in a shareholders' agreement but, instead, is set forth in abbreviated and incomplete form on the back of the share certificates. Giaimo also illustrates the paramount importance New York courts place on the fiduciary duties owed by majority shareholders and directors of close corporations to minority shareholders, arguably to the point of preempting the statutory scheme governing director's self-interested transactions.
EGA Associates Inc. (EGA) is a closely held New York corporation formed in 1961 to own and operate real estate. According to the complaint filed by Robert Giaimo (read here), the stock of EGA was held one-third each by Robert and his siblings, Edward and Janet. Edward died after a long illness in March 2007. Edward's will bequeathed his EGA shares in equal parts to Robert and Janet, which would have left them as equal 50% shareholders. Two weeks before his death, however, Edward sold one of his shares to Janet for $80,000, thereby giving her majority ownership upon Edward's death. Some months later, Janet gave notice of meetings of the shareholders and directors at which she obtained voting control of the board by electing herself and her lawyer as two of the three directors.
Continue Reading...