A Manhattan appellate panel’s two-page decision in Gartner v Cardio Ventures, LLC, 2014 NY Slip Op 07423 [1st Dept Oct. 30, 2014], offers a dry account of a disputed transfer of an LLC membership interest, in which the court held that the terms of an LLC subscription agreement did not bar the transfer otherwise permitted under the LLC Law’s default rules.
But the story behind the decision is anything but dry. As revealed in papers filed in the lower court proceedings, the suit was brought by the ex-husband of the transferee in an attempt to frustrate a Florida court’s final judgment of divorce, requiring him to transfer to his wife one half of his membership interest in a company that operates physical therapy offices at multiple New York locations. The judgment further provided that if the transfer couldn’t be done, the wife would receive the net economic benefits of the half-interest.
Soon after the divorce judgment was entered, the husband signed a court-approved transfer document instructing the LLC to transfer half his 4% interest to his wife. The other LLC members promptly executed a consent to the transfer, admitting the wife as a 2% member.
The now ex-husband, who had fiercely resisted the transfer in the Florida divorce proceedings and had signed the transfer directive under the court’s threat of contempt, subsequently filed suit in Manhattan Supreme Court against the LLC, its managers, and his ex-wife, claiming that the transfer was “unauthorized” and “illegal,” and should be rescinded, because of language in his LLC Subscription Agreement purportedly barring the transfer of membership interests. Continue Reading
Think of it this way: At every negotiation of a shareholder buyout involving an S corporation or other passthrough entity, there are three parties at the table — the seller, the buyer, and the IRS.
Why the IRS? The commonly understood answer, even to those lacking tax expertise, is the seller’s liability for capital gains tax on buyout proceeds in excess of the seller’s basis in the shares.
Less appreciated, especially to those without tax expertise, but potentially of equal or even greater financial impact, is the seller’s liability for ordinary income taxes on undistributed a/k/a phantom income that may be reported on his or her Form K-1 issued by the passthrough entity after the buy-out closes for a tax period that preceded the buyout. For this type of tax liability, think of the IRS as a tax allocator which, at the direction of the remaining shareholders who control the company’s tax reporting, will reduce some portion of their personal income tax liability by allocating undistributed net income to the selling shareholder who will be forced to pay ordinary income taxes on phantom income. While this also should reduce the seller’s capital gain on the sale by increasing basis in the shares, overall the seller loses because of the significantly higher tax rates on ordinary income versus capital gains.
This is a topic I’ve written about several times before, featuring cases in which the seller’s release barred a post-buyout suit seeking reimbursement for taxes on phantom income (read here) or where the seller relied unsuccessfully on tax provisions in the buyout agreement that didn’t support indemnification of taxes on phantom income (read here and here). Add to this collection a case decided last month by the Appellate Division, First Department, which handed the selling shareholder a double defeat by finding that his release barred his claim to recover taxes on phantom income and also ordering him to pay attorneys’ fees incurred by the corporation and its majority shareholder defending the seller’s suit under the buyout agreement’s indemnification provision. Sina Drug Corp. v Mohyuddin, 2014 NY Slip Op 07757 [1st Dept Nov. 13, 2014]. Continue Reading
Are books-and-records proceedings on a roll?
Last September I wrote about an important appellate ruling that month in a books-and-records proceeding against the McGraw-Hill publishing company, in which the court held that the petitioning shareholder’s allegations of mismanagement and breach of fiduciary duty by board members constituted a proper purpose for the inspection demand, regardless whether the inspection ultimately establishes that no wrongdoing occurred. I referred to the ruling as a boost for New York’s under-utilized books-and-records proceeding under Section 624 of the Business Corporation Law, especially for minority shareholders of closely held corporations who, unlike shareholders in public companies with reporting duties, are sometimes shut out completely from any information concerning the company’s business dealings and financial affairs.
Sure enough, less than two months after the McGraw-Hill decision, Brooklyn Commercial Division Presiding Justice Carolyn E. Demarest cited it as precedent for her ruling in Novikov v Oceana Holdings Corp., 2014 NY Slip Op 24332 [Sup Ct, Kings County Nov. 3, 2014], granting a close corporation minority shareholder’s petition to inspect an array of financial and corporate records to investigate possible wrongdoing by the controlling shareholders. Continue Reading
There’s a wrinkle in New York’s LLC Law still being ironed out by the courts when it comes to the necessity for member meetings to approve certain actions such as mergers.
On the one hand, under LLC Law § 407(a)’s default rule, whenever LLC members “are required or permitted to take any action by vote,” such action may be taken ”without a meeting, without prior notice, and without a vote” so long as signed written consents are obtained from members holding the number of votes required to approve the action had there been ”a meeting at which all of the members entitled to vote therein were present and voted.” When consents in lieu of meeting are used, § 407(c) requires “prompt notice” thereafter be given to any members who did not execute consents. In other words, any excluded, non-consenting member is presented with a fait accompli.
On the other hand, LLC Law § 1002(c) provides that any proposed agreement of merger or consolidation “shall be submitted” to the members for a vote “at a meeting called on twenty days’ notice or such greater notice as the operating agreement may provide.” In addition, § 1002(e) echoes the meeting requirement by providing that any member entitled to vote on the proposed transaction ”may, prior to that time of the meeting at which such merger or consolidation is to be voted on, file . . . written notice of dissent from the proposed merger or consolidation.”
The question is, does § 407(a)’s written consent trump § 1002(c)’s meeting mandate, or the other way around? Continue Reading
Over 100 years ago, in Lord v Hull, 178 NY 9 , the New York Court of Appeals — the state’s highest court — drew upon English common law to establish what has become a bedrock principle of American partnership law, that courts generally will not entertain lawsuits between partners except in the setting of a dissolution or final accounting. As the court wrote:
If the members of a firm cannot agree as to the method of conducting their business, the courts will not attempt to conduct it for them. Aside from the inconvenience of constant interference, as litigation is apt to breed hard feelings, easy appeals to the courts to settle the differences of a going concern would tend to do away with mutual forbearance, foment discord and lead to dissolution. It is to the interest of the law of partnership that frequent resort to the courts by copartners should not be encouraged and they should realize that, as a rule, they must settle their own differences or go out of business. [Emphasis added.]
Many decades later, in another partnership case called Gramercy Equities Corp. v Dumont, 72 NY2d 560 , the same court expressed the same sentiment thusly:
[C]ourts are generally loath to intercede in squabbles between partners that result in piecemeal adjudications, preferring that partners either settle their own differences amicably or dissolve and finally conclude their affairs by a full accounting.
In the modern era, partnerships have been eclipsed by other forms of business associations including close corporations and, more recently, limited liability companies. Each form has fundamentally different characteristics and is governed by a fundamentally different statutory scheme. Yet, if we focus on the internal dynamics and turmoil that can afflict shareholders of a close corporation or members of an LLC – especially the smaller, owner-operated firms — the above-quoted partnership rationale, expressed so long ago in Lord v Hull and more recently in Gramercy Equities, seems equally apropos of these modern forms.
One judge who both has made that connection and put it into practice is Nassau County Commercial Division Justice Stephen A. Bucaria (pictured). Over the years this blog has featured many decisions by Justice Bucaria demonstrating, as described here, his willingness to think outside the box when it comes to devising practical and sometimes novel solutions to intractable problems in business divorce cases. Continue Reading
When not tightly drafted, expulsion provisions in shareholder or LLC operating agreements can cause a lot more trouble than they’re worth. Case in point: Harker v Guyther, 2014 NY Slip Op 07403 [3d Dept Oct. 30, 2014], decided last month by the Appellate Division, Third Department, in which the court resorted to dictionary definitions of the term “misappropriation” in denying summary judgment to a 50% LLC member who sought to expel the other 50% member in a fight ostensibly over health insurance coverage, of all things.
The case involves a Delaware limited liability company known as 3H Corporate Services, LLC based in Saratoga Springs, New York. The company, formed in 2003, bills itself as specializing in the provision of corporate and insurance licensing services to the insurance community. 3H’s two members, each holding a 50% interest, are Gary Harker and Joan Guyther.
In 2008, Harker and Guyther agreed to have 3H pay for their health insurance as an employment benefit. They later disagreed over various business issues, including Guyther’s contention that she deserved extra compensation for the disparity between the higher cost of Harker’s family health insurance plan and her individual coverage. The lid blew off after Guyther withdrew over $3,000 from the company’s operating account to true up the discrepant insurance premiums over the prior six months, and announced to Harker her intention to continue doing so. Continue Reading
The under-reporting of cash receipts a/k/a skimming by restaurant owners and other cash-intensive businesses costs many billions of dollars in lost tax revenues each year and, when detected by audit, can lead to stiff penalties and even criminal prosecution. When the business has multiple owners, not all of whom are in on the skimming, it also can constitute grounds for judicial dissolution, as illustrated in a fascinating post-trial decision last week by Brooklyn Commercial Division Presiding Justice Carolyn E. Demarest in Cortes v 3A N. Park Ave. Rest Corp., 2014 NY Slip Op 24329 [Sup Ct, Kings County Oct. 28, 2014].
Any publicly aired business divorce involving allegations of looting can be a nasty affair. Throw into the litigation mix the specter of under-reported taxes and it becomes positively toxic, which is the flavor I got from reading Justice Demarest’s detailed findings of fact and conclusions of law in her 24-page ruling which, ultimately, found that the controlling shareholders skimmed about $3.7 million and conditionally ordered dissolution of the corporation, contingent upon the controllers’ buy-out of the plaintiff’s shares for over $1.2 million.
The Cortes case involves a 150-table Mexican restaurant, bar, and nightclub called Cabo, located in Rockville Center on Long Island. In 2003, the plaintiff, Porfirio Cortes, acquired for $50,000 a 16.67% stock interest in the restaurant’s operating company, in which the remaining shares were owned equally by defendants Angelo Ramunni and Domenick DeSimone. The purchase agreement gave the corporation the right to repurchase Cortes’s shares in the event he resigned his designated position as managing partner though, oddly, it did not specify a price or a pricing mechanism. Continue Reading
The first and last time I wrote about the AriZona Iced Tea dissolution case — likely the biggest ever of its kind in New York – was four years ago, when 50% owner and co-founder John Ferolito filed his petition under Section 1104-a of the Business Corporation Law for judicial dissolution of the collection of companies that produce beverages and food products under the popular AriZona Iced Tea brand.
Since then, there’s been a multitude of trial and appellate decisions in that and several related lawsuits between Ferolito and the other co-founder and 50% shareholder, Domenick Vultaggio, all of which eventually were consolidated for trial starting last May before Nassau County Commercial Division Justice Timothy S. Driscoll, to whom the task fell of determining the fair value of the Ferolito shares pursuant to AriZona’s BCL Section 1118 buyout.
As you might expect, this was no ordinary valuation trial. Ferolito valued AriZona at $3.2 billion versus Vultaggio’s $426 million. For over a month, Justice Driscoll heard the testimony of 34 lay and expert witnesses, many of whom supplemented their in-court testimony with affidavits totaling about 1,000 pages, in addition to tens of thousands of pages of exhibits introduced into evidence. The parties filed post-trial memoranda last August, followed by oral summations in September, followed by more post-trial memoranda.
The wait is over. In a 42-page decision dated October 14, 2014 (2014 NY Slip Op 32830(U)), relying solely on the Discounted Cash Flow method, Justice Driscoll valued the entire enterprise somewhere around $1.4 to $1.5 billion after applying a 25% marketability discount. The number’s fuzziness reflects post-decision adjustments that will have to be calculated based on certain findings made by Justice Driscoll that departed from some of the assumptions made by the parties’ experts. According to Justice Driscoll’s self-described “back-of-the-envelope” calculations, the value of Ferolito’s 50% stock interest currently “approaches” $1 billion when pre-judgment interest is added at the rate of 9%. Justice Driscoll also left to future proceedings the critical question of AriZona’s ability to pay the fair value award, and its impact on the terms and conditions of any payout. Continue Reading
Last week’s post gave the factual and procedural background of the Zelouf case, summarized Justice Kornreich’s decision awarding the 25% dissenting minority shareholder $2.2 million for the fair value of her shares and another $2.2 million damages for her “quasi-derivative” claims, and then focused on the court’s rejection of a discount for lack of marketability. If you haven’t already read last week’s post, I recommend you do so before continuing with this one.
In this Part Two, I’ll highlight a number of other, interesting issues addressed in Zelouf of importance both to business divorce lawyers and business appraisers.
Court Adopts ”No-Burden” Approach
Justice Kornreich’s decision at pages 6-9 offers a useful summary of the legal standard for determining fair value in a dissenting shareholder appraisal proceeding under Section 623 (h) of the Business Corporation Law, including a brief discussion of burden of proof. Noting that New York’s highest court never has addressed the issue, the court adopted the “no-burden” approach proposed by the parties and supported by former Justice Stephen Crane’s analysis in Matter of Cohen, 168 Misc 2d 91 [Sup Ct, NY County 1995], aff’d, 240 AD2d 225 [1st Dept 1997], under which, as Justice Kornreich put it, “the court will consider the parties’ expert testimony as persuasive evidence of fair value, but, at the end of the day, and even if the court finds neither expert to be persuasive, it is the court’s burden to make a fair value determination.” As to the quasi-derivative claims for corporate looting and waste, however, Justice Kornreich stated that the dissenting shareholder, Nahal, “still has the burden of proof . . . but the impact of such claims on the value of the company, if proven, will be decided by the court under the no-burden approach.” Continue Reading
A year ago I wrote about a novel ruling by Manhattan Commercial Division Justice Shirley Werner Kornreich permitting the majority owners of a family-owned textile business to proceed with a freeze-out merger on the eve of trial of a 25% shareholder’s derivative lawsuit, where the avowed purpose of the merger was to strip the minority shareholder of standing to pursue her derivative claims. Key to the ruling were (1) the parties’ stipulation that, in any subsequent dissenting shareholder appraisal proceeding, the minority shareholder’s multi-million dollar claims of corporate waste and self-dealing by the controlling shareholders could be factored into the court’s appraisal, and (2) the inclusion in such appraisal of the minority shareholder’s legal fees in the terminated derivative action, assuming she prevailed in establishing her claims of waste and self-dealing.
The contemplated appraisal proceeding materialized after the minority shareholder rejected the corporation’s offer of $1.5 million for the statutory “fair value” of her 25% stake. A bench trial was held before Justice Kornreich over 11 days between March and July 2014. Last week, Justice Kornreich released her 32-page decision in Zelouf International Corp. v Zelouf, 2014 NY Slip Op 51462(U) [Sup Ct, NY County Oct. 6, 2014], fixing the fair value of the 25% stock interest at $2.2 million and awarding additional “damages” of another $2.2 million on the “quasi-derivative” claims for waste and self-dealing. The court also awarded the former minority shareholder her attorney’s and expert’s fees in both the appraisal proceeding and the prior derivative action, the calculation of which Justice Kornreich referred to a Special Referee to hear and report. The anticipated fee award plus pre-judgment interest likely will add millions more to the ultimate judgment against the company.
Zelouf tells a fascinating if not atypical tale of a highly profitable family-owned business run by second-generation owners whose internecine warfare and financial abuses led to years of bitter litigation. It also raises a number of interesting issues surrounding appraisal proceedings, including burden of proof, tax affecting, the discount for lack of marketability (DLOM), control premiums, and the inclusion of “quasi-derivative claims.” In this post, I’ll give the factual and procedural background of the case, followed by discussion of the opinion’s headline-grabbing issue, namely, Justice Kornreich’s rejection of any DLOM. Next week I’ll highlight the remaining issues of interest. Continue Reading