Franklin C. McRoberts, counsel in the Uniondale office of Farrell Fritz and a member of the firm’s Business Divorce Group, prepared this article.
When a romantic affair evolves into a business relationship, the eventual falling out can be especially messy. Even more so if the former lovers try to keep the business going after the romance ends. That is a theme from a recent post-trial decision by Queens County Justice Timothy J. Dufficy in Shih v Kim, 2017 NY Slip Op 50281(U) [Sup Ct Queens County Mar. 2, 2017].
Among other interesting issues in Shih was whether a capital investment in a business can be considerd a “gift made in contemplation of marriage” under Section 80-b of the New York Civil Rights Law, a statute which requires return of an engagement or wedding gift — often a ring — to the giver if the marriage does not occur. Let’s see how Judge Dufficy ruled on that and the other legal issues in the case.
Shih was a piano teacher at the Brooklyn Music Conservatory when she fell in love with one of her students, Kim. Kim proposed marriage to Shih and they became engaged. While engaged, they started a music school together. They formed the eponymous Shih & Kim Corp. in 2008 as 50/50 owners. Kim had financial expertise as an undergraduate finance major and graduate finance student at Columbia University. For this reason, they agreed that Kim would handle the company’s management and finances and act as Chief Financial Officer. Shih agreed to provide most of the initial capital investment and give part-time piano lessons at the school, otherwise being a “silent partner.” At trial, Shih testified that she “would not have invested in the corporation if the parties were not going to be married.”
Kim found a location in Bayside, New York, which he leased on behalf of the corporation. The corporation did business for several years under the trade name “Apollo Music and Art Institute,” with Kim handling the day-to-day operations. Shih testified that she “relied upon defendant Kim to operate the business completely because she thought they would soon be married.” Judge Dufficy “credit[ed] her testimony in this regard.”
In early 2012, Shih and Kim “ended their personal relationship, but maintained their business relationship at the school.” A recipe for trouble. The unraveling of Shih and Kim’s personal relationship led to the predictable demise of their business relationship. Shih eventually learned that Kim committed a litany of misbehavior.
As proven at trial, Kim “systematically transferred funds” belonging to the corporation to his personal bank account and a joint account he owned with his mother. He made unauthorized withdrawals and used corporate funds to support his personal securities day-trading activities. He failed to pay employees, failed to pay rent, and failed to pay taxes. The school did not maintain any accounting records, including records of income or expenses, other than a “cash book” of student tuition deposits, which was “conveniently missing during the disclosure process and at trial.” Unbeknownst to Shih, Kim incorporated a similarly-named, competing entity, Apollo Arts Group, Inc., with Kim and his sister as 50% owners, which took over the operations of Apollo Music and Arts Institute. Eventually Kim stopped managing the business altogether to focus on day trading, totally delegating management of the business to his mother and sister. When Shih learned of these events, she sued Kim for breach of fiduciary duty and other claims.
The trial lasted six days. In his post-trial decision, Judge Dufficy made four principal legal rulings. Kim won on the issue of whether Shih’s investment was a gift in contemplation of marriage. But all in all, the Court threw the book at Kim.
First, Judge Dufficy dismissed Shih’s claim that her capital investment in the business was a “gift made in contemplation of marriage” under Civil Rights Law § 80-b. The Court ruled that Shih “failed to demonstrate that the sole consideration for her investment in the music school was a contemplated marriage.” The Court also said it doubted Shih’s argument that “the statute [was] intended to cover investments in business ventures.”
Second, Judge Dufficy held that Kim breached his fiduciary duties to Shih. The Court recited the familiar rule that the “relationship between shareholders in a close corporation, vis-a-vis each other, is akin to that between partners and imposes a high degree of fidelity and good faith” (Brunetti v Musallam, 11 AD3d 280, 281 [1st Dept 2004]). The Court continued: “This is especially the case where, as here, the parties have an expectation of marriage, and a bond of mutual trust and reliance.” So according to the Court, the existence of a pre-marital relationship among shareholders in a close corporation can strengthen their fiduciary obligations to one another. Moving on to the element of breach, the Court held:
Kim knew or should have known that [Shih] relied upon his expertise in finance to manage the business. . . . Instead, he misappropriated funds belonging to the corporation, he failed to keep any records to account for his expenditures, he failed to conduct corporate activities in conformity with corporate strictures, he used corporate funds for personal purposes, including day-trading, he failed to record corporate revenues using a failsafe system which was backed up, he failed to pay rents, thereby causing the corporation to be evicted, he failed to pay taxes, thereby causing a lien and garnishment of the corporation’s back account.
In short, Kim breached his fiduciary duties.
Third, the Court flatly rejected Kim’s defense that his conduct was protected by the business judgment rule. According to the Court, “Kim did not act in good faith when he co-mingled corporate monies with his own, and then left the business to take another full-time position. His actions smack of misconduct, and were not reasonably calculated to advance the legitimate interests of the corporation.” Accordingly, the Court held, “the business judgment rule cannot be raised as a shield under these circumstances.”
Fourth, the Court granted Shih’s petition to “pierce the corporate veil” to hold Kim personally liable for the entity’s indebtedness to Shih, a relatively rare occurrence in New York. As the Court explained, “the corporate veil will be pierced to achieve equity, even absent fraud, when a corporation has been so dominated by an individual or another corporation and its separate entity so ignored that it primarily transacts the dominator’s business instead of its own and can be called the other’s alter ego.” As the Court held:
[T]here was no evidence of adherence to corporate formalities, such as the maintenance of records documenting the purpose for the cash expenditures that appeared targeted for the personal use and benefit of the individual defendant. There were no minutes of annual shareholders meetings . . .. There were no records of receivables, other than a cash book that was conveniently ‘lost’ sometime prior to trial. The evidence was overwhelming that defendant Kim used corporate funds for personal purposes, including day-trading, that he co-mingled corporate monies with his own, and that he essentially performed his duties as Chief Financial Officer in a manner that was calculated to, and actually did, impede the rights of the plaintiff as a shareholder, and doomed the corporation to failure. . .. Accordingly, defendant Kim abused the privilege of doing business in the corporate form to perpetrate a wrong and thus it is appropriate for this court to intervene in equity and pierce the corporate veil.
As a result of piercing the corporate veil, the Court found Kim personally liable for repaying Shih’s entire lost capital investment in the business, with pre-judgment interest at the statutory annual rate of 9% going all the way back to January 1, 2012, when Kim “began working full-time as a day trader, thereby abandoning the parties’ enterprise.” They say all’s fair in love and war. Not so true when one owes fiduciary duties.
A careful reader may wonder why the Court did not issue a damages award for business and profits diverted to Kim’s separate company and for other corporate assets Kim misappropriated, including money diverted to his personal accounts. In a latter section of the decision, the Court dismissed portions of Shih’s petition, including claims for waste and mismanagement, as being incorrectly brought in Shih’s individual capacity rather than as derivative claims on the corporation’s behalf. Although the decision was not explicit on the issue, Shih’s apparent decision not to sue derivatively may be why the Court imposed the remedy of restitution of Shih’s capital investment, rather than a broader damages award payable to the corporation based on misappropriation of assets and waste.