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Anesthesiology Practice Undergoes “Legal Equivalent of a Proctology Exam” in Shareholder Dispute

Posted in Derivative Actions, Expulsion and Removal, Professional Corporations, Restrictive Covenants

The cringe-worthy phrase, “legal equivalent of a proctology exam,” gained notoriety about ten years ago when its use by an attorney in a pre-litigation demand letter was cited by a federal judge as partial justification for a $50,000 sanction award which was later reversed on appeal. The phrase involuntarily leapt to mind when I read the recent post-trial decision by Suffolk County Commercial Division Justice Emily Pines in Suffolk Anesthesiology Associates, P.C. v. Verdone, 2012 NY Slip Op 50728(U) (Sup Ct Suffolk County Apr. 25, 2012), a bare-knuckles contest pitting an expelled physician-shareholder of a large Long Island anesthesiology practice against the 11 other physician-shareholders.

The parties’ very public charges and counter-charges of improper financial dealings, conflicts of interest and potentially serious healthcare law violations, none of which ultimately swung the case outcome, if nothing else offer a compelling argument for inclusion of a binding arbitration clause in the shareholder and employment agreements, thereby ensuring that the airing of the practice’s allegedly “dirty linen” will be confined to a private, confidential setting.

The Verdone case also offers healthcare transactional attorneys a cautionary lesson on drafting mandatory buyback provisions triggered by a shareholder’s departure from the practice, to avoid a draining battle as took place in Verdone over whether the expelled shareholder was terminated with or without cause.

The Practices

The Practices (as I’ll refer to them collectively) consist of three separate anesthesiology practices –Suffolk Anesthesiology Associates, P.C. (SAA), United Anesthesia, P.C. (United), and Office Based Anesthesia, PLLC (OBA) – all owned by the same 12 anesthesiologists. The Practices provide anesthesiology services at hospitals, medical offices and ambulatory surgery centers on Long Island and elsewhere in the New York City metropolitan area.

The Agreements

Dr. Verdone and his co-owners signed identical shareholders’ agreements (or operating agreement in OBA’s case) and employment agreements for each of the Practices.

The employment agreement permits termination of the physician without cause upon vote of 75% of the shareholders and for cause upon vote of two-thirds of the shareholders. “For cause” is defined as acts of “personal dishonesty, gross negligence, or willful misconduct that has a material adverse effect on the Corporation, its business operations, financial condition, assets, prospects or reputation” or that “materially breached any fiduciary duty to the Corporation involving personal profit.”

Upon termination “for any cause” and subject to a five-year vesting schedule, the terminated physician is entitled to receive deferred compensation in an amount equal to his pro rata share of the “total accounts receivable,” payable over the following year.

The employment agreement includes a post-termination three-year covenant not to compete within a 20-mile radius of any location where the Practices provide services, and a three-year covenant not to solicit employees, clients, contractors, or business of the Practices, or to “disrupt, damage, impair, or interfere with the business” of the Practices.

The shareholders’ agreement requires the Practices to purchase the physician’s shares at a nominal par value (plus the deferred compensation due under the employment agreement) upon a “Call Event” defined as the physician’s death, voluntary termination or retirement, disability or termination “for cause” under the employment agreement. Notably missing from the definition of Call Event is the involuntary termination of the physician without cause. 

The Underlying Dispute

Justice Pine’s decision includes a lengthy and highly detailed recitation of the facts elicited at the 11-day trial including the testimony of 15 witnesses and over a hundred exhibits. The following, boiled-down summary hopefully will whet your appetite enough to read the entire decision.

According to Dr. Verdone, starting around 2005 he began to have questions about excessive administrative billing and payments to the Practices’ president, Dr. Kurlander, and about undocumented arrangements with certain outside surgical practices for which the Practices provided anesthesiology services and paid them fees not based on a fair market evaluation in possible violation of federal and state anti-kickback laws.

A separate and ultimately more explosive controversy surrounding Dr. Kurlander grew out of an effort that began in 2006 to acquire a Bronx-based ambulatory surgery center known as Surgicare for approximately $7.4 million. In April 2007, without getting approval of the other shareholders, Dr. Kurlander entered into a purchase agreement for the acquisition of Surgicare by the 12 shareholders to close by October 2008, but also including agreements by SAA to subsidize Surgicare pending the culmination of the purchase and authorizing a line of credit from SAA to Surgicare. Dr. Kurlander also used SAA funds for the down payment which was not held in escrow. Dr. Verdone through his personal counsel wrote letters to the Practices’ counsel objecting to the acquisition and also specifically objecting to the “improper” use of corporate assets for the acquisition, which Dr. Verdone contended constituted an unlawful kickback. The Practices’ counsel wrote back in early 2008, assuring Dr. Verdone that the individual shareholders would be the purchasers and that no shareholder of SAA would be financially compromised.

At an April 2008 meeting of the shareholders, according to Dr. Verdone a “verbal deal” was struck allowing any shareholder to pull out of the Surgicare deal at a later time. He also testified that he stayed in the deal for some months afterward at the request of another shareholder pending approval of the acquisition by the Health Department.

At a shareholders meeting in May 2008, a forensic accounting firm engaged by the Practices presented a report focusing on Dr. Kurlander’s financial management. The report made findings regarding certain unsubstantiated payments to outside physicians and for personal expenses. Shortly thereafter Dr. Kurlander was suspended as president. He subsequently repaid the Practices $500,000 and ultimately withdrew as a shareholder.

The copies of the forensic accountant’s report provided to the shareholders at the May meeting had been collected at the end of the meeting, to maintain their confidentiality. In July 2008, Dr. Verdone brought an Article 78 proceeding against SAA to obtain a copy of the report, which the court granted by order dated August 14, 2008. At least one of the other physicians, who submitted an affidavit opposing the Article 78 proceeding, testified that he believed that Dr. Verdone was interested in causing trouble for the practice for some ulterior motive. Another physician testified that the only complaints he heard from Dr. Verdone over the years related to his view that the method of assigned calls was unfair.

In September 2008, Dr. Verdone saw financing proposals for the Surgicare acquisition identifying SAA as the borrower. He then wrote to the other shareholders demanding that he be permitted to withdraw from the purchase of Surgicare. He also demanded that no action be taken by the Practices to encumber any of their assets in connection with the Surgicare deal, and he warned that if such assets were used he would voice his objections to the prospective lending banks.

Meanwhile, the Practices’ regular outside accountant recommended, and all the shareholders except Dr. Verdone agreed, to a finance structure using OBA as the borrower with the shareholders as guarantors. Dr. Verdone also rejected a proposal that he participate in the deal with a proviso that he could sell his Surgicare interest to the other shareholders within 5 days after the closing.

A shareholders’ meeting was held on October 2, 2008, at which they approved by a vote of 11-1 the closing of the Surgicare purchase, the terms of a proposed loan from JPMorgan Chase to OBA, and certain by-law amendments permitting the transaction. If the deal did not close, the physicians stood to lose about $2.1 million already invested in the acquisition. Immediately after the meeting, and again the following morning, Dr. Verdone emailed a Chase banker asking her to contact his lawyer and attaching copies of his prior letters stating his objections to any encumbrance of corporate assets, and the Practices’ outside counsel’s early 2008 letter pledging that the assets of the Practices would not be encumbered.

Chase decided not to proceed with the loan, final approval for which was still pending, after getting the emails from Dr. Verdone. The shareholders scrambled to raise the over $5 million in funds on their own, which they were able to do, in order to close the Surgicare acquisition by the October 6 deadline. Dr. Verdone also contributed his share exceeding $400,000.

On October 14, 2008, notices were sent out for shareholder meetings to terminate Dr. Verdone’s employment with each of the Practices, both “with cause” and “without cause”. The meetings ultimately were held on December 15, 2008, at which the shareholders voted 11-0 to terminate Dr. Verdone’s employment both with and without cause.

The Lawsuits

The Practices and Dr. Verdone each filed suit against the other. The Practices’ suit against Dr. Verdone sought a declaratory judgment that he was properly terminated for cause based on his alleged breach of contract, breach of fiduciary duty and tortious interference with business relations. The Practices claimed that such termination required a forfeiture of Dr. Verdone’s deferred compensation under his employment agreements. They also counterclaimed in Dr. Verdone’s suit for a declaration that his termination for cause constituted a Call Event requiring him to redeem his shares and cutting off any right to further compensation or distributions from the Practices. The Practices also counterclaimed for damages as a result of Dr. Verdone’s alleged breach of the non-solicitation provision in the employment agreements.

In his counterclaims in the Practices’ suit and in his own suit against the Practices, Dr. Verdone sought a declaration that his termination was not for cause and that it was motivated solely as a result of his role as a whistle blower against improper business practices and a vocal opponent to the Surgicare acquisition. He also claimed that the Practices were liable for his deferred compensation under his employment agreements and for his share of distributions and benefits under the shareholders’ agreements. Dr. Verdone also asserted derivative claims for misappropriation of corporate assets, and for dissolution of the entities.

The Pre-Trial Rulings

Between the onset of litigation in October 2008 and the trial in 2012, there were a number of pre-trial rulings that shaped and propelled the litigation.

In late November 2008, the Practices won an order granting partial summary judgment validating their right to terminate Dr. Verdone’s employment without cause.

In September 2009, apparently at the same time the court granted a preliminary injunction, the court denied the Practices’ motion for partial summary judgment for a permanent injunction against Dr. Verdone under the restrictive covenants in his employment agreements. The court’s ruling, that Dr. Verdone raised triable issues based on his defense that the Practices breached the agreements’ implied contractual duty of good faith, was affirmed on appeal (read here).

In March 2010, the court required the Practices to post a $7 million bond to secure the preliminary injunction against Dr. Verdone enforcing the restrictive covenants (read here). The Practices’ later request to reduce the bond was denied in February 2012 (read here).

In April 2010, the court denied the Practices’ motion to dismiss Dr. Verdone’s derivative claims on the ground that the termination of his employment also terminated his shareholder status. The court’s order (read here) noted that the definition of Call Event in the shareholders’ agreements did not include an involuntary termination other than for cause, and that there were triable issues surrounding his termination for cause. This ruling also was affirmed on appeal (read here).

The Post-Trial Decision

Neither side obtained a clear-cut victory in Justice Pines’ post-trial decision. Both sides were found to have breached duties owed to the other.

For his part, the court found that Dr. Verdone breached his fiduciary duty of loyalty when he contacted officials at Chase prior to its decision not to approve the loan to OBA for the Surgicare acquisition. As Justice Pines explained:

As closely held corporations (and in the case of OBA, a PLLC) the shareholders/members thereof owed each other and the corporate entities an undivided duty of loyalty and trust. In the case at bar, the events leading to the ultimate purchase by the individual shareholders of the Surgicare ambulatory facility, via prospective loans and guarantees by the corporate entities, was approved by 11 of the 12 shareholders/members after numerous meetings, discussions and negotiations on their behalf with various lending institutions. While Dr. Verdone expressed his disagreement with the method of proposed funding for almost one year before the October 3, 2008 incidents, as was clearly his right, his co-shareholders/ members in the various entities disagreed with him. They voted, in addition, by a vote of a super majority, in accordance with BCL § 908, to change the by-laws of the various entities, to allow the borrowing by one of the corporate entities to occur. When Dr. Verdone telephoned and e-mailed bank officials, without the knowledge or acquiescence of his co-shareholders in the three entities, he clearly breached the required duty of loyalty. Although Dr. Verdone did not wish any of the corporate entities to encumber their assets in connection with the purchase, that is the decision the shareholders/ members made in Dr. Verdone’s presence. In this context, the Court found most credible the testimony of both Stolzenberg [the Practices' CPA] and the many other physicians who testified that Dr. Verdone was present during the lengthy presentation by the entities’ CFO, Stolzenberg, who informed the physicians that the tax consequences of allowing the PLLC to be the named borrower inured to the benefit of each of the members. In addition, the Court found extremely convincing the testimony of the corporations’ former counsel, an expert in the area of health law, that by amending the by-laws and providing for an accounting, the purchase as structured to be based on loans and guarantees by the corporate entities could become legal.

Justice Pines next found that the Practices were justified in terminating Dr. Verdone for cause, likewise based on his conduct surrounding the aborted bank loan. His unauthorized contacts with the bank, Justice Pines concluded, although they were not shown to be a “but for” cause for the bank’s decision not to approve the loan, constituted “willful misconduct” that “did cause damage to the reputations of the shareholders/members and the entities involved” and to OBA’s members “to the extent of a lost tax benefit.” The fact that the Practices and other physicians did not seek damages arising directly from the loss of the loan opportunity made no difference, as Justice Pines further explained:

The Employment Agreements include within their definition of a basis for “termination for cause” a breach of fiduciary duty. In the Court’s opinion, reading the documents as a whole in the context of their purpose, which was, at least, in part, to create and sustain a relationship among co-shareholders within a closely held group of entities, who practiced medicine and engaged in various business ventures to act with a degree of loyalty towards each other, the nighttime and early morning telephone calls [to Chase] clearly fall outside the duty of trust contemplated. A finding of breach of fiduciary duty sufficient to satisfy a termination for cause under the Agreements does not require proof of damages such as would be required as an independent element of the cause of action itself.

Justice Pines also found that Dr. Verdone was terminated “solely for his actions in connection with the loans for Surgicare and not, as he insisted at trial, as a result of his role as a whistle blower.” She credited the testimony of the other physicians that Dr. Verdone “was not instrumental” in the actions taken by the Practices in regard to Dr. Kurlander’s financial management, and that the only issue of concern to Dr. Verdone was “control over the call schedule.”

Justice Pines acknowledged the concerns raised at trial by Dr. Verdone with regard to the outside practice requirements under federal and state anti-kickback laws, but found them to be immaterial. While the Practices contended their outside practices “are based on fair market evaluations” and Dr. Verdone contended that the arrangements were non-compliant, Justice Pines observed that

[i]t is for the appropriate authorities to make such determinations; and such has no effect on the parties’ Shareholders or Employment Agreements, which are enforceable under the rules . . . [that] sanction actions that are malum prohibitum. Thus, even if certain of the agreements were found to have violated fee splitting and/or anti-kickback injunctions, such violations are not related to the employment and shareholder agreements which are at the center of this case and which are entitled to be enforced.

Then it was the Practices’ turn to take some lumps, with Justice Pines finding that they breached Dr. Verdone’s employment agreements by refusing to pay him his deferred compensation due in the amount of $2.35 million, plus his unpaid 2008 expenses and income due him as a shareholder through the date of termination. Justice Pines rejected the Practices’ contention that Dr. Verdone lost entitlement to his termination benefits by allegedly engaging in wrongful solicitation, which did not cause any harm to the Practices. ”[M]ore significant to the Court,” she continued:

the corporate entities did themselves engage in less than professional behavior in their takeover of outside practice anesthesiology services for the two east end practices, which they knew had hired Dr. Verdone after his termination from their practice and which were located in geographic locations into which they had not ventured in their many years of operation. In other words, it appears to the Court that each of the parties herein attempted to harm the other financially after the termination and during the pendency of these lawsuits. To the extent that either party seeks damages from the other in either of the pending actions for this post-termination conduct, they are barred from accomplishing the same by the doctrine of in pari delicto. As a court of equity, this court will not sanction nor award such acts by either side of the equation.

Justice Pines next determined that the termination of Verdone for cause constituted a Call Event under the shareholders’ agreements, entitling him to payment for his shares at par value. The downside for Dr. Verdone was that, having been found to have lost his shareholder status as of December 2008, the court dismissed his dissolution and derivative claims on the Practices’ behalf, and also rejected his claims for post-termination compensation and pro rata distributions.

On the brighter side for Dr. Verdone, Justice Pines dismissed the Practices’ claim against him for tortious interference with business relations, and it upheld his claim for repayment of his investment in Surgicare as well as his share of distributions, in amounts to be determined in subsequent proceedings.

A Few Closing Observations

  • As an outside observer, with no knowledge of the case other than what appears in the court’s decisions, my overall impression is that Justice Pines’ decision put the parties in the same or similar position they reasonably should have settled for at the outset, that is, Dr. Verdone is out of the Practices with no further equity interest or claim to ongoing distributions; he gets paid the deferred compensation and whatever he was owed through termination; he gets back his investment in Surgicare which was offered to him even before the litigation; and he continues his medical career elsewhere, subject to the three-year restrictive covenants.
  • Absent a settlement, the only way for the court to get to this result under the constraints of the parties’ agreements was to find that Dr. Verdone was terminated for cause, and therein lies what, in my humble opinion, was the fundamental problem: the omission of involuntary termination without cause as a defined Call Event in the shareholders’ agreements. Had it been included, Dr. Verdone would have had very limited ability to mount an offensive campaign seeking a multi-million damages award via derivative claims and staking out a share of ongoing and future distributions. By the same token, the Practices would have had much less incentive to mount their own offensive campaign to show that Dr. Verdone had engaged in misconduct justifying termination for cause. The Practices’ need to prove termination for cause, and Dr. Verdone’s commensurate need to cast himself as a whistle blower, under the pressures of the Surgicare transaction quickly escalated to a DEFCON 1 situation in which each side had little choice but to launch their biggest missiles against the other, necessitating public disclosure of embarrassing and potentially troublesome information about the Practices.
  • The decisions make no reference to an arbitration clause in the parties’ agreements, so I assume there was none. In my view, a provision requiring the parties to privately arbitrate all disputes relating to the agreements and their enforcement would have reduced the level of hostilities, avoided unflattering public disclosures, and produced a much faster resolution than the almost 4 years the parties have spent so far in the court system.

Update June 15, 2012:   Healthcare mediator Richard J. Webb comments here on the case. His ultimate point, that disputes like this one ought best to be resolved through private mediation, is a good one.