Roundup of 2007 Business Divorce Cases
The New York Law Journal recently published, for the 9th consecutive year, my annual review of business divorce cases (read it here). Most of the cases discussed in the article have been mentioned in previous postings.
Here's a rundown of the article's choices for 2007's most interesting business divorce cases, with links provided to the cases and to previous postings:
- Dissolution and Right of First Refusal: Matter of Schneck (R&J Components Corp.) (discussed here) and Matter of Schwimmer (El-Roh Realty Corp.), where two judges reached opposite results on the issue of whether the petitioner's filing of a dissolution petition triggered a right of first refusal and mandatory buyback under the shareholders' agreement.
- LLCs and Temporary Receivers: At the Airport, LLC v. Isata, LLC (discussed here) in which the court held that the LLC Law does not authorize the court to appoint a temporary receiver until after dissolution is ordered.
- Grounds for Dissolution: Matter of Cheung (Ho Foong Shiu Realty Corp.) and Matter of Livolsi (111 Glen Street Corp.) (discussed here) in both of which the courts denied dissolution petitions brought by 50% shareholders claiming oppression by the other shareholder.
- Restrictive Covenants: Matter of Autz (Ronald C. Fagan, M.D. and Arthur Lutz, M.D., P.C.) (discussed here) where the court ruled that the sale in liquidation of the company's good will is a sale "under compulsion" and therefore does not trigger an implied covenant not to solicit customers.
- Pre-Conversion Agreements: Matter of Hochberg (Manhattan Pediatric Dental Group, P.C.) (discussed here) in which the court compelled arbitration of a dissolution case under an arbitration clause in a partnership agreement that pre-dated the conversion of the business to a professional corporation.
- Partner Limited Liability Shield: Ederer v. Gursky (discussed here) where New York's top court interpreted Section 26(b) of the Partnership Law as not shielding partners in limited liability partnerships from personal liability against claims for breach of the partnership's or partners' obligations to each other.
If you'd like to read some of my previously published annual reviews, look under Links on the right sidebar of this blog's home page where you'll find links to my articles covering the years 2003 through 2006.
Next week, New York Business Divorce returns to Anatomy of a Dissolution Slugfest, Part III.
One Case, Three Great Issues
When it comes to reading court decisions in business divorce cases, I have a number of pet issues. If I come across a decision with one such issue, I’m happy. Two in the same opinion, I’m thrilled. Three in the same opinion, it’s like hitting the trifecta.
A recent decision by Nassau County Commercial Division Justice Stephen A. Bucaria offers a winning threesome: (1) arbitrability of corporate dissolution petitions; (2) petitions seeking dissolution of out-of-state corporations; and (3) dissolution petitions that trigger mandatory buybacks under a shareholders’ agreement.
The case, Matter of Schneck (R&J Components Corp.), involves two brothers who went into, and eventually each inherited 50% interests in, an electronic parts business founded by their father who died in 1990. The business came to be organized as six separate companies, two of which were formed as out-of-state corporations but all of which operated in New York. The complaining Brother A claimed that Brother B had frozen him out of the business, denied him access to business records, and took hundreds of thousands of dollars more each year than Brother A was getting. Brother A sought judicial dissolution of all the companies based on internal dissension and deadlock under Business Corporation Law § 1104.
Brother B raised several defenses. First, he asked the court to stay the proceedings pending arbitration pursuant to a mandatory arbitration clause in the shareholders’ agreement. Such clauses routinely are enforced in dissolution proceedings. In this case, however, the court found that Brother B had waived arbitration by moving for summary judgment on the merits. Here’s the money quote: "The courtroom . . . may not be used as a convenient vestibule to the arbitration hall so as to allow a party to create his own unique structure combining litigation and arbitration."
Brother B fared better on his next defense aimed at the two non-New York corporations, successfully arguing that a New York court may not dissolve a foreign corporation even if its principal place of business is New York. The argument invoked the so-called "internal affairs" doctrine under which courts traditionally refuse to rule on the regulation and management of a foreign corporation. I have followed this issue for many years in the hope -- thus far unrealized -- that courts will re-analyze the wisdom of the internal affairs doctrine as applied to the dissolution of a corporation operating wholly within New York whose only connection to the other state is the place of incorporation. After all, New York courts routinely interpret and apply the law of other states in many other types of corporate governance disputes. Although the idea of a New York court ordering, e.g., Delaware's secretary of state to dissolve a Delaware corporation is no less repugnant than that of a Delaware judge ordering New York's secretary of state to dissolve a New York corporation, so long as the court has personal jurisdiction of the business owners it seems to me that either judge in either jurisdiction could order the parties to file a certificate of voluntary dissolution without offending the incorporating state's sovereignty. Also, there is at least one lower court decision (Matter of Dohring [CVC Products, Inc.], 537 NYS2d 767 [1989]) holding that, even if dissolution of a New York based foreign corporation technically is not within the court's power, it may adjudicate the case and fashion a lesser or alternative remedy that achieves "substantial justice" between the parties.
The third issue is one of my all-time favorites, about which a colleague and I wrote an article published in July 2006 in the New York Law Journal. Shareholders’ agreements frequently have stock transfer restrictions that grant a right of first refusal under certain circumstances, generally involving a shareholder who wishes voluntarily to sell his or her shares. Such provisions often include broad language that can be construed as triggering the duty to offer the shares for sale – typically at a formula price well below fair value – whenever there is an attempt to dispose of one's shares through any means, including judicial dissolution. In this case, the court concluded that the language was not broad enough and therefore it denied Brother B’s request to compel Brother A to convey his shares.
Expelling an LLC Member
Let's say you're one of the many thousands of business owners who have opted to organize their business as a limited liability company (LLC) rather than as a traditional shareholder corporation. Let's also say you have a business partner, Member X, who has a 25% membership interest in the business. Time passes and, unfortunately, Member X has become an impediment to the business's success to the point you conclude that the business can't continue with Member X. Finally, let's say Member X rejects every reasonable offer you make to buy him out of the business.
What are your choices? Do you have to hire a lawyer to bring an expensive legal action to be rid of Member X? Is that possible? Wouldn't it be much easier if, as Brooklyn Dodger fans famously taunted, you could just "Throw da bum out!"?
Utah is a long way from Brooklyn, but a recent decision by that state's highest court got me thinking about the issue.
In the Utah case, Duke v. Graham, the issue was whether an arbitrator was legally authorized to expel LLC members as a remedy for breach of their duties owed to the remaining members. In upholding the expulsion, the court examined Utah law that expressly authorizes LLC members to expel another member either when so authorized by the parties' Operating Agreement or by applying to a court based on the member's misconduct.
Unlike Utah, New York's LLC Law (LLCL) has no express provision authorizing non-judicial member expulsion or authorizing one member to bring a legal proceeding to expel another. The only tangential mention of the issue is in Section 701(b) of the LLCL under which, absent contrary provision in the operating agreement, member expulsion is one of several occurrences that do not result in dissolution unless the other members agree to dissolve.
So where does that leave you and Member X? As with most issues surrounding the internal affairs of LLCs, the answer lies in the operating agreement. A carefully drafted operating agreement should include dispute resolution and buy-sell provisions that enable the parties to separate their interests when they no longer can get along. The key is, at the outset of the business relationship, to create efficient exit mechanisms that provide all parties with a fair degree of financial security and business continuity. If the operating agreement provides for expulsion of a member under specified circumstances or by a specified majority vote, to avoid disruption and legal expense it also should provide the expelled member with payment for the fair value of his or her membership interest. At the same time payment terms must ensure the company's future viability. Absent such agreement, the fate of the business will be dictated by negotiating muscle or expensive legal proceedings including possible dissolution.
Partnership Agreement Controls Dissolution Notwithstanding Conversion to Corporation
Individuals and companies have a choice of entities – some requiring more formalities than others – through which to pool their resources and efforts in pursuit of a common business goal. Joint ventures and general partnerships are on the less formal side of the spectrum and are often used in the early stages of a business project to keep costs down before the project’s viability is established, and before limited liability becomes an issue. Until the proliferation of limited liability partnerships and like statutory business forms, many professional firms including lawyers and doctors traditionally operated as general partnerships.
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.
