LLC Dissolution and Receivers
New York’s statutory scheme for dissolution of closely held business entities sometimes looks like a crazy quilt. For instance, for reasons that defy all logic, a petition for dissolution of a business corporation based on shareholder oppression triggers an absolute right on the part of the other shareholders to avoid dissolution by purchasing the petitioner’s shares for fair value, but if the petition is based on director or shareholder deadlock, there’s no buyout right. A petition for dissolution of a business corporation requires service upon the state tax commission and publication notice of the order to show cause in advance of the hearing, but no such service or publication is required in a proceeding for judicial dissolution of a limited liability company (LLC).
Here’s another. The statute governing judicial dissolution of LLCs, contained in Section 702 of the LLC Law (LLCL), has no provision for appointment of a temporary receiver to protect the company’s assets pending the dissolution proceeding. In contrast, Section 1113 of the Business Corporation Law (BCL) expressly authorizes a court to appoint a temporary receiver for that purpose in a dissolution proceeding.
The divergence on this point between the BCL and the LLCL is highlighted in a recently decided case called At the Airport, LLC v. Isata, LLC, 15 Misc 3d 1145(A) (Sup Ct Nassau County June 6, 2007). The case was brought by a 20% member of an LLC seeking its dissolution based on income diversion, financial mismanagement, and denial of access to company records. In a decision by Nassau County Supreme Court Justice Leonard B. Austin, the court notes that the only provision of the LLCL authorizing appointment of a receiver or liquidating trustee, found in LLCL Section 703(a), by its terms applies after the company has been dissolved. Said the court, "[petitioner] is putting the cart before the horse since there must first be a finding of the right to judicial dissolution before a receiver can be appointed."
The petitioner in that case was forced to seek appointment of a temporary receiver under the more formidable standards for receivership found in Article 64 of the Civil Practice Law and Rules. The court held that he failed to make the requisite clear showing that the company’s property was in imminent danger of being materially injured or destroyed, and therefore denied the application for appointment of a receiver.
The petitioner in the same case fared no better on a subsequent application for reconsideration based on newly discovered evidence (read opinion here). If anything, the court's second ruling makes the point more emphatically, that compared to applications involving corporations under the BCL, the courts have strictly limited authority to appoint a temporary receiver for an LLC prior to an order of dissolution.
Lawyers Suing Lawyers
A decision last week by New York’s highest court may have registered an uptick on the public’s schadenfreude meter, at least among the portion of the public who hold the legal profession in low esteem and who therefore might enjoy the sight of internecine warfare among splitting partners of a law firm.
In Ederer v. Gursky, Lawyer A joined and became a 30% shareholder along with Lawyer B (who then held 70%) of a small law firm organized as a professional corporation (PC). Several years later they re-organized the firm as a registered limited liability partnership (LLP) and took in three new partners who collectively held a 15% partnership interest, leaving Lawyer A with 30% and Lawyer B with 55%. Two years later, Lawyer A decided to leave the firm – according to him, because of a falling out with Lawyer B over a firm client; according to Lawyer B, because the firm was in financial dire straits for which Lawyer A was partially responsible – following which he entered into a written withdrawal agreement with the LLP setting forth various financial and case-sharing arrangements. Six months later, Lawyer A sued the LLP and each of its four remaining partners claiming breach of the withdrawal agreement and seeking an accounting and certain profit shares.
Garden variety financial disputes among former business or law partners do not usually garner the attention of New York’s Court of Appeals. This one did, however, because of the defendant partners’ reliance on a provision in the statute governing LLPs that, in general terms, shields partners of LLPs from vicarious liability for obligations of the LLP or for the negligence of their law partners. The case thus raised a novel question of statutory construction whether Section 26(b) of the Partnership Law (go to "PTR", Article 3) was meant to protect only against partner liability asserted by third parties or whether, as the defendants argued, it also encompasses liabilities among the partners.
The Court’s decision traces the highly interesting history of partnership liability laws, including the nationwide surge of LLP formations in the aftermath of the savings and loan crisis of the 1980s when regulators went after deep-pocketed law firms to recover massive bank losses. In a 5-2 majority decision, the Court handed victory to Lawyer A by concluding that Section 26(b) only addresses a partner’s vicarious liability for partnership obligations to third parties and does not extend to claims among the partners of the LLP.
The dissenting judges note that Lawyer A’s withdrawal caused the firm’s finances to deteriorate and thereby rendered the firm unable to satisfy its obligations under the withdrawal agreement. They raise two provocative questions: Under these circumstances why should a former law partner be able to collect the firm’s debt from the “innocent” individual partners where a third-party creditor could not, and why should partners of an LLP be saddled with an obligation from which they would be shielded had the firm remained organized as a PC? The majority’s decision, laying emphasis on statutory construction rather than policy, means it will be up to the legislature to amend the law if it sees the same anomaly as do the dissenters.
Update (May 2, 2008): In Kuslansky v. Kuslansky, Robbins, Stechel & Cunningham, LLP, 2008 NY Slip Op 04061 (Apr. 29, 2008), the Appellate Division, Second Department, under the authority of the Court of Appeals' Ederer decision, reversed a lower court's decision dismissing an action brought by a former law firm partner for breach of contract based on the alleged failure of the defendants to pay him the value of his interest in the subject partnership as provided for in the parties' partnership agreement upon a partner's withdrawal from the partnership.
Fair Value vs. Fair Market Value
New York’s statutes governing buyouts in dissolution and dissenting shareholder cases use the term “fair value” (FV) as the standard used to determine purchase price. The statutes do not define FV.
In contrast, “fair market value” (FMV) is a widely recognized standard of value used in the business world, in tax assessment proceedings and elsewhere. The International Glossary of Business Valuation Terms defines FMV as “the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.”
Are FV and FMV the same?
Not by a long shot. As succinctly stated in one of the more prominent valuation treatises, “the term fair value is usually a legally created standard of value that applies to certain specific transactions”. S. Pratt, R. Reilly & R. Schweihs, Valuing a Business, p. 32 (4th ed. 2000). My even more succinct translation: FV means whatever the courts say it means.
In New York case law, the main difference between FMV and FV concerns application of a minority discount in valuing the shares of a dissolution petitioner or dissenting shareholder. A minority discount, also referred to as a discount for lack of control (“DLOC”), reflects the lower price a hypothetical buyer would pay for shares in a corporation that do not give their owner control of the board of directors, company management, distributions, changes to the articles of incorporation, etc. For over 20 years New York courts consistently have ruled that, unlike in proceedings applying the FMV standard of value, the FV standard excludes DLOC. In many other states that also use the FV standard in statutory buyout proceedings, unlike New York, the courts also exclude the discount for lack of marketability (“DLOM”) applicable to non-publicly listed shares that cannot be sold quickly and at low cost. Bottom line: in New York statutory valuation proceedings applying the FV standard, the selling shareholder gets a significantly higher price compared to the FMV standard.
For those who want to learn more on the subject, I recommend reading a recent appellate decision out of Arkansas in which the court explains the difference between FMV and FV in the context of a dispute over the valuation of the interests of withdrawing partners in a family limited partnership.
Dissolution and the 50% Shareholder
In the judicial dissolution arena, one of the trickiest decisions faced by counsel representing a 50% shareholder of a closely held New York corporation is whether to ask for dissolution based on deadlock under Section 1104 of the Business Corporation Law (BCL), or based on allegations that the other 50% shareholder is guilty of illegal, fraudulent or oppressive conduct or has looted, wasted or diverted corporate assets under BCL Section 1104-a, or under both statutes.
The choice can have a dramatic effect on the outcome of the proceedings, not just because of the different proofs required, but because only one of the statutes – BCL Section 1104-a – triggers the other shareholder’s right to avoid dissolution by electing to purchase for “fair value” the shares of the petitioning shareholder. (See previous post on the subject.)
In many business divorce cases involving two 50% shareholders there nonetheless is one natural buyer and one natural seller. Sometimes it’s because one of the two controls more of the client relationships. Sometimes it’s because one of the two personally or through a separate company owns the realty leased by the co-owned company. Sometimes it’s because one of the two has far deeper pockets. In these situations, the 50% shareholder who wants out and his or her counsel must think long and hard about whether they gain or lose bargaining leverage by handing the opposing shareholder the right to force a buyout. In my experience, a deadlock petition under BCL Section 1104 usually packs a bigger wallop than an 1104-a petition by denying the automatic buyout and thereby putting added pressure on the shareholder who may be more motivated to keep the company as a going concern.
Here’s a recent case where things took a different and unhappier direction for the petitioning 50% Shareholder A who sought dissolution under BCL Section 1104-a alleging that he was frozen out by 50% Shareholder B. The case involved a real estate holding company that leased the property to a separate business solely owned by Shareholder B. The troubles started when Shareholder A’s employment with the tenant business terminated. The court denied Shareholder A’s application to dissolve upon finding no evidence of oppression, looting or other misconduct by Shareholder B.
Would Shareholder A have done better seeking deadlock dissolution under Section 1104? It’s hard to say without knowing more facts. Establishing deadlock in a relatively passive real estate holding company can pose a challenge. The fact that he did proceed under Section 1104-a suggests that he made a losing bet that Shareholder B would elect to purchase his shares. One also can speculate that the lease held by Shareholder B’s separate company was of the sweetheart variety, thereby taking away some measure of Shareholder B’s incentive to opt for a buyout.
The case, Matter of Livolsi (111 Glen Street Corp.), 2007 NY Slip Op 32911 (U) (Sup Ct Nassau County Sept. 13, 2007), was decided by Justice Stephen A. Bucaria of the Nassau County Supreme Court, Commercial Division.
Voluntary Dissolution vs. Judicial Dissolution
Dissolution of a closely held New York corporation can be accomplished either voluntarily, by vote of the shareholders, or involuntarily by way of a petition for judicial dissolution. The two methods are fundamentally different and should never be confused.
Article 10 of the Business Corporation Law (BCL) governs voluntary or “non-judicial” dissolution. For corporations formed after February 22, 1998, when the law was amended, a simple majority vote of the shareholders may authorize the filing of a certificate of dissolution. For corporations formed before that date, a two-thirds vote is required unless an amended certificate is filed authorizing dissolution approved by a simple majority. For older or newer corporations, the certificate need not contain any provision on the subject, and frequently the issue instead is dealt with in the shareholders agreement, which often prohibits voluntary dissolution absent unanimous consent of the shareholders.
BCL Article 11 governs judicial dissolution. Section 1104 authorizes a 50% shareholder to seek a court order dissolving the corporation based on director deadlock, shareholder deadlock and “internal dissension”. Section 1104-a authorizes a 20% or greater shareholder to seek judicial dissolution where those in control have engaged in illegal, fraudulent or oppressive conduct or have looted, wasted or diverted corporate assets.
In Matter of General Trading Co., Index No. 106157 (Sup Ct NY County July 28, 2006), a 50% shareholder and creditor of the corporation brought a petition for judicial dissolution even though he had already gained control of all the corporation’s shares under a pledge agreement and had replaced its board of directors with his own single designee. The court dismissed the case on the ground that, since the petitioner held all the shares and controlled the one director, there was no deadlock under BCL Section 1104 and no need for judicial dissolution under Section 1104-a when the petitioner could achieve the same result by filing a certificate of voluntary dissolution under Article 10. The case was decided by Justice Leland DeGrasse of the New York County Supreme Court.
Judicial Dissolution and Buyouts
New York has a peculiar statutory scheme when it comes to dissolution proceedings and buyouts.
There are two basic statutes governing dissolution of closely held business corporations. The older statute, codified as Section 1104 of the Business Corporation Law (BCL), permits a 50% shareholder to seek dissolution in cases of deadlock. When one 50% shareholder petitions for judicial dissolution under this statute, the other has no right to elect to purchase the petitioner’s shares. More often than not, if the business has going concern value, the parties eventually will reach a settlement involving a buyout, but the point is, neither party can force a buyout. Essentially it becomes a game of chicken as both sides maneuver in and out of court to gain negotiating leverage as the company approaches the dissolution precipice.
The other, newer statute, BCL Section 1104-a, permits a shareholder holding at least 20% of the voting shares of a closely held corporation to seek judicial dissolution where those in control have engaged in illegal, fraudulent or oppressive conduct or have looted, wasted or diverted corporate assets. Here, unlike deadlock dissolution, the legislature enacted a companion statute, BCL Section 1118, which gives the respondent majority shareholders (that is, the shareholders who did not bring the dissolution petition) the absolute right to avoid dissolution by electing to purchase the petitioner’s shares. If the parties cannot agree on price and terms, the court will determine the “fair value” of the petitioner’s shares.
This distinction between buyout rights based on the different grounds for dissolution is ignored by many (arguably wiser) states whose statutes authorize compelled buyouts in all cases seeking judicial dissolution of closely held corporations.
Future posts will address the interesting tactical decisions faced by 50% shareholders who may have the option to seek judicial dissolution under both BCL Sections 1104 and 1104-a simultaneously. For now, if you’re considering bringing a dissolution petition as an oppressed minority shareholder under Section 1104-a, be aware that the controlling shareholders will have the right to buy you out, but not if you’re a 50% shareholder seeking dissolution based on deadlock under Section 1104.
The Case of the One-Dollar Buyout
Under New York’s statute governing corporate dissolution petitions by oppressed minority shareholders, the remaining shareholders may avoid dissolution by electing to purchase the petitioner’s shares for fair value. (View the buyout statute, Section 1118 of the Business Corporation Law). I recently got a call from someone deciding whether to make the election, asking if it’s possible for a court to assign a zero value to the petitioner’s shares. The practical side of my brain responded, If the business has no value, why are both sides spending legal fees fighting over a corpse?
In law as in life, however, the practical answer does not always carry the day. It is not unusual for one business owner (i.e., the purchaser) to see a sow’s ear where the other owner (i.e., the seller) sees a silk purse. There is nothing in the buyout statute or case precedent that precludes a court from deciding that the petitioner’s shares are worthless. In one recent decision in a valuation proceeding, the court ordered the petitioner to deliver his shares to the purchasing shareholder for a symbolic $1.00 payment. The court credited the opinion of the purchaser’s expert appraiser, who testified that the shares had no positive value based on the company’s debt, its continuing losses and the short remaining term of its lease. The petitioner appears to have sealed his own fate by failing to offer his own appraiser. Worse yet, the court also denied the petitioner’s application to remove his surname from the company’s name. A very painful dollar to accept, indeed.
The case, Matter of Giraud, 2007 NY Slip Op 32473 (U) (Sup Ct NY County Aug. 3, 2007), was decided by Justice Lewis Bart Stone of the New York County Supreme Court.
For Want of a Nail, the Case Was Lost
A recent court decision reminds us how the simple, easily avoidable mistakes made by counsel at the outset of a dissolution case can end in a misfire -- and likely an angry client.
In Matter of Cohen (Last Choice Real Estate Corp.), Index No. 5940/07 (Sup Ct Nassau County July 18, 2007), Justice Stephen A. Bucaria of the Nassau County Supreme Court, Commercial Division, dismissed a deadlock dissolution petition brought by a 50% shareholder because the petition was verified by the shareholder’s attorney instead of by the shareholder. For readers who don’t know, under New York practice dissolution is sought by way of a petition in a special proceeding, as opposed to filing a complaint in a regular action. The petition must be verified, meaning the petitioner/shareholder must sign before a notary public an acknowledgment that he or she has read the petition and that its allegations are true to his or her own knowledge. A properly verified petition also functions as an affidavit and thus can be considered by the court as evidence. Under certain circumstances specified by statute (typically because the client does not reside in the same county as the attorney) the attorney is allowed to verify even though the attorney has no personal knowledge of the petition’s factual allegations.
What some attorneys may not appreciate, however, is that dissolution proceedings essentially start off as a paper trial, that is, the court can decide the case on the merits based on the dissolution petition and the answering papers. If the petition is verified by an attorney who lacks personal knowledge of the petition’s allegations, and there is no additional client affidavit supporting the merits, then the court cannot treat the petition as an affidavit, and the petitioner is left with no evidence in support of dissolution. Case over.
In this age of nearly instant communication and document transmission via email and overnight courier, there is little or no reason ever to forego client verification of a dissolution petition.
Update (June 3, 2008): Following the dismissal of his case, the petitioner filed a new dissolution proceeding supported by the petitioner's own affidavit alleging deadlock and dissension between the two 50% shareholders. The respondent moved to dismiss the new proceeding based on the doctrine of collateral estoppel, arguing that the prior dismissal had been for lack of any evidence to support dissolution. Justice Thomas Feinman ruled that the prior decision was not on the merits and denied the dismissal motion (read decision here).
Partnership Agreement Controls Dissolution Notwithstanding Conversion to Corporation
It is not uncommon for written joint venture or partnership agreements to include a buy-sell agreement. If the joint venture or partnership later converts to a corporation or limited liability company, and the owners do not make a superseding shareholder or operating agreement, is the prior agreement enforceable when a shareholder or LLC member wants out or seeks judicial dissolution?
The answer is complicated by a long line of New York case precedent, most notably Weisman v Awnair Corp., 3 NY2d 444 (1957), decided by New York’s highest court, holding that a partnership may not exist where the business is conducted in corporate form, and parties may not be partners between themselves while using the corporate shield to protect themselves against personal liability.
A couple of newer decisions by intermediate appellate courts, however, take a modified approach to the issue permitting enforcement of the pre-conversion agreement. In Matter of Hochberg (Manhattan Pediatric Dental Group, P.C.), 41 AD3d 202 (1st Dept 2007), two dentists formed a practice and entered into a partnership agreement containing an arbitration clause and also requiring that a partner seeking dissolution first offer his interest to the other. Years later they converted the practice to a professional corporation, but without making a new agreement. When one of them later sought dissolution, the other sought to compel arbitration under the old partnership agreement. The appellate court, reversing the trial court’s decision, ruled that such pre-conversion agreements are enforceable as long as the rights of creditors or other third parties are not involved and the parties’ rights under the partnership agreement are not in conflict with the corporation’s functioning. Judicial dissolution of the dental practice would be inappropriate, the court added, in that it would allow avoidance of the buyout provisions by seeking such dissolution.
The best practice, of course, is to make a new written agreement when converting to a new form of entity, or at least indicate in writing whether the old agreement survives the conversion.
Dissolution and Restrictive Covenants
A dissolution case decided earlier this year raised the issue anew in an interesting context. In Matter of Autz, 16 Misc 3d 1140(A) (Sup Ct Nassau County 2008), the antagonists were minority and majority shareholders in a professional corporation that operated walk-in medical clinics. The petitioner sought dissolution as an oppressed minority shareholder under Section 1104-a of the Business Corporation Law (BCL). The majority shareholder did not elect to purchase the petitioner’s shares. Rather, he consented to dissolution and asked the court (a) to determine that the corporation is not a going concern, and (b) to order a liquidation sale of the corporation’s hard assets and the division of its receivables. The petitioner sought a sale of the corporation as a going concern, inclusive of good will, along with a determination that such a sale is voluntary and therefore imposes a restrictive covenant upon the unsuccessful shareholder-bidder.
In a decision by Justice Leonard B. Austin of the Nassau County Supreme Court, Commercial Division, the court ruled that there was evidence that the corporation had saleable good will, but that a transfer of shares resulting from an involuntary dissolution, in the absence of an election to purchase the petitioner’s shares for fair value under BCL Section 1118, is a sale under compulsion and thus does not implicate the non-solicitation covenant.
Like so many other issues that come to haunt partners who find themselves embroiled in business divorce litigation, covenants not to compete or to solicit customers and employees are most efficiently dealt with in a shareholders agreement made at the beginning of the relationship.
Big News for BIG Discount
Once in a while a more exotic discount makes the news. Case in point: the discount for built-in capital gains (BIG) affecting subchapter C corporations. A recent appellate decision scores a major victory for estate taxpayers, and ultimately may also become a factor in valuation cases arising out of dissolution proceedings involving C corporations. First, some background.
Under changes made by the Tax Reform Act of 1986, proceeds from the sale of appreciated assets held by a C corporation upon liquidation are subject to gains tax at the corporate level. A buyer of C corporation shares therefore is willing to pay less for the shares than if the same assets were held by a subchapter S corporation. A C corporation can avoid capital gains taxes at the corporate level upon sale of all its assets by converting to a subchapter S corporation. [IRC §1361 et seq]. However, this option is of limited use since, among other things, the corporation must retain the appreciated assets for ten years from the date of conversion in order to avoid the tax. [See IRC §1374(d)(7)].
In a 2005 decision in a case called Estate of Jelke, in valuing an estate’s 6.44% stock interest in an investment holding company, the Tax Court reduced a $51 million BIG tax liability to $21 million by computing the present value of tax liabilities assuming the future sale of company assets over a 16-year period. On November 15, 2007, the U.S. Court of Appeals for the Eleventh Circuit ordered the Tax Court to recalculate the stock value using a dollar-for-dollar reduction of the entire $51 million in BIG tax liability, under the assumption that the company is liquidated on the date of death and all assets sold.
Jelke likely will not have wide impact on valuation contests in dissolution cases, for two main reasons. First, the great majority of dissolution cases involve S corporations and other entities that opt for pass-through partnership tax treatment. Second, the standard of value in estate tax cases such as Jelke is fair market value as opposed to the fair value standard specified by New York’s buyout statute. In a BCL §1118 valuation case involving a real estate holding C corporation called Matter of La Sala, a New York trial court refused to apply a discount for BIG tax liability on the ground that it was required to value the corporation as a going concern and, therefore, it would not consider capital gains taxes triggered upon liquidation. Undoubtedly, this will not be the last word on the subject of BIG discounts in stock valuation proceedings.
Be Aware of Differences Between LLC and Corporation Dissolution
Article 11 of the BCL is more expansive. Section 1104(a) authorizes a petition for judicial dissolution by a 50% shareholder based on various deadlock scenarios. Section 1104-a permits judicial dissolution at the behest of an “oppressed” minority shareholder or where the controlling shareholders divert or waste company assets or otherwise are guilty of illegal or fraudulent actions toward the other shareholders.
Depending on the provisions of the LLC operating agreement, conduct that would constitute grounds for dissolution under Article 11 of the BCL also may constitute grounds under LLCL Section 702. But not always, as one minority member of an LLC recently found out when the court dismissed his request for judicial dissolution. According to the court’s decision, the minority member alleged that the majority members engaged in “illegal, fraudulent and oppressive conduct” – terms that are lifted right out of BCL Section 1104-a. The court ruled that “[w]hile such allegations are grounds for dissolution under [BCL] § 1104-a, they are not grounds for dissolution of a limited liability company”. The case, Bonanni v. Horizons Investors Corp., was decided by Justice Elizabeth Hazlitt Emerson of the Suffolk County Supreme Court, Commercial Division.
The lesson is clear: A complaint or petition for dissolution of an LLC should reflect Section 702’s provisions by alleging a genuine conflict between, on the one hand, the adverse member’s alleged misconduct or other conditions warranting dissolution and, on the other hand, the terms of the operating agreement or articles of organization.
