Beware Unreasonable Restraints on Alienation When Drafting Shareholder and Operating Agreements
Our English common-law heritage includes what's known as the rule against unreasonable restraints on alienation. Law students first encounter the rule in their property class, where they learn about the abolishment of the feudal "fee tail" which restricted the transfer of real property to a specific line of male heirs. Basically, our laws and public policy strongly favor the right of persons to freely dispose of their property both real and personal. Agreements that place ownership of property in the hands of one person and the right to alienate, i.e., sell or otherwise convey the property, in the hands of another, are unenforceable.
The rule is not absolute. It only prohibits unreasonable restraints on alienation. For instance, where a niece agreed to pay $15,000 to her uncle and aunt for a $100,000 farm that was in the family for generations on condition that, during the uncle's and aunt's lifetimes, the niece wouldn't mortgage the farm or convey it to her husband, a court enforced a reversion clause in the recorded deed giving the property back to her relatives when the niece placed mortgages on the farm that subsequently were foreclosed. The court found it reasonable to enforce the restraint to preserve family ownership of the farm for a limited duration. Moreover, the niece's interest in free alienation was outweighed by her agreement to the restraint in consideration for a drastically reduced price. (Example taken from Alby v. Banc One Financial, 128 P3d 81 [Sup. Ct. Wa. 2006].)
What's this got to do with shareholder and operating agreements?
Continue Reading...No Exception to Arbitration for Deadlock Dissolution Petition, Court Rules
As I've previously pointed out (read here), when shareholder disputes arise, including corporate dissolution contests, courts will readily stay litigation proceedings in favor of arbitration where the parties' shareholders' agreement provides for mandatory arbitration. There is no exception for dissolution cases arising from 50-50 deadlock, as the unsuccessful petitioner recently learned in Matter of Brooks (Aqua Shield Inc.), Short Form Order, Index No. 1572/09 (Sup Ct Nassau County June 5, 2009).
Aqua Shield Inc. was formed in 2000 to market a patented telescopic swimming pool enclosure invented by co-founder and petitioner Bob Brooks who, along with his wife, holds 50% of the company's shares. The other 50% is held by investor Igor Korsunsky and his wife.
The October 2001 shareholders' agreement has a broad arbitration clause requiring arbitration of "any controversy or claim arising out of or relating to [this] Agreement or its breach . . .."
In November 2008, the Korsunskys commenced an arbitration proceeding with the American Arbitration Association (AAA) against the Brookses who interposed an answer. The AAA issued an order on motions and scheduling orders in February 2009, and scheduled a preliminary hearing for April 2009.
Continue Reading...Mediation and Business Divorce: Interview with Mediator Leona Beane
In last week's post, entitled "Winning the Dissolution Battle, Losing the War," I wrote about two cases in which business partners remained locked in protracted litigation even after one side's gambit for dissolution failed. I was very pleased to get an email from Leona Beane who read the post and commented, "Your ending statements refer to both situations with utter gloom and despair. It's a perfect segue-way into describing the benefits of mediation as an alternative."
Leona Beane, you see, is a former law professor turned full-time mediator/arbitrator based in New York City. I first met her when she was assigned by the court as mediator in a difficult business divorce case of mine pitting sibling against sibling. Much to my surprise, the case settled after a long day of candid dialog led by Leona.
I've long thought that mediation is under-utilized in business divorce matters. So inspired by Leona's email, I decided to ask her some questions about mediation in general, and about mediating business divorce cases in particular. I think you'll find her answers enlightening.
PM: I find that many people are unfamiliar with mediation. How do you describe it?
Continue Reading...Court Rejects Attempt to Vary Statutory Valuation Date in Oppressed Shareholder Buyout
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CLE SUPER SUNDAY: MIND YOUR OWN BUSINESS! On Sunday, January 11, 2009, from 9 a.m. to 3:30 p.m., the Nassau County Bar Association is sponsoring a terrific, multi-panel CLE program (6 credits including 1 ethics) on business formation, sale of business, and dissolution. I'll be on the dissolution panel along with Nassau County Commercial Division Justice Stephen Bucaria, attorney Erica Garay of Meyer Suozzi and appraiser Phil Kanyuk of Holtz Rubenstein. Here are links to the program description and registration. Hope to see you there! |
The value of a business can change from year to year, month to month or even week to week. Sales trends go up and down. New products take off or flame out. Major contracts are gained or lost. Industry-wide prospects wax and wane.
When an oppressed minority shareholder petitions for judicial dissolution under Business Corporation Law (BCL) 1104-a, and the controlling shareholders or corporation elect to avoid dissolution by purchasing the petitioner's shares for fair value under BCL 1118, the latter statute requires the court to determine fair value "as of the day prior to the date on which such petition was filed."
The statute's language leaves no wiggle room. The few reported attempts by parties to vary the valuation date uniformly have met defeat under the courts' strict construction of the statute. See, e.g., Matter of Vetco, 260 AD2d 642 (2d Dept 1999); Matter of Davis (Shayne-Levy Associates, Inc.), 174 AD2d 449 (1st Dept 1991).
But that didn't stop the purchaser from taking a valiant run at the statute in Matter of Kurins (SilverSeal Corp.), 2008 NY Slip Op 33328(U) (Sup Ct NY County Dec. 2, 2008). And little wonder that it didn't: at stake was a $1,000,000 increase in the value of the parties' investigative and security business as of the statutory valuation date versus the valuation date three months earlier proposed by the purchaser.
Continue Reading...Poorly Drafted Disability Clause in Operating Agreement Provides Novel Defense to LLC Dissolution Proceeding
"You can't dissolve the company, you're crazy!"
That more or less sums up one of the most novel defenses I've ever come across in a dissolution proceeding, in which the respondent 50% member of an LLC argued that the petitioning 50% member could not dissolve the company because he was under a mental disability as defined in the parties' operating agreement. Although the defense ultimately failed in this case, there's a lesson to be learned about the proper drafting of disability clauses in shareholder and operating agreements.
The case is Matter of Swett (Factors Walk, LLC) decided several years ago by Monroe County Commercial Division Justice Kenneth R. Fisher. In 2002, Bradford Swett and W. Curtis Barnes as 50/50 members formed a limited liability company known as Factors Walk, LLC to develop and sell real estate consisting of a 75-acre subdivided tract. The operating agreement vested management in the two members equally. It also appears to have included a provision, not fully described in the court's decision, authorizing a member to precipitate voluntary dissolution simply by giving notice to the other member.
In 2005, Swett gave Barnes the prescribed notice following which he commenced a proceeding for judicial supervision of the winding up of the LLC pursuant to LLC Law Section 703(a). The statute authorizes a member to seek such relief for an LLC that has been dissolved either voluntarily or by judicial decree under LLC Section 702.
Continue Reading...Mandatory Arbitration of Dissolution Proceedings
Many shareholders' agreements include clauses requiring the parties to arbitrate their disputes. Do such clauses apply when a shareholder seeks judicial dissolution of the corporation based on deadlock or shareholder oppression under Sections 1104 and 1104-a of the Business Corporation Law?
Courts answer the question with an emphatic "Yes". As a matter of public policy, courts strongly favor arbitration and will readily stay litigation proceedings and compel arbitration when the dispute falls within the scope of the applicable agreement's arbitration clause. Generally speaking, where the arbitration clause is broad, there arises a presumption of arbitrability, and arbitration of even a collateral matter will be ordered if the issues in the case implicate issues of construction of the shareholders' agreement or the parties’ rights and obligations under it. Judicial dissolution proceedings alleging deadlock or oppression invariably raise allegations of breach or, even absent breach allegations, turn on the parties' rights and obligations under the shareholders' agreement. But even absent specific allegations of breach, courts will find that the dissolution petition is arbitrable.
Continue Reading...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.), 2007 NY Slip Op 32966(U) (Sup Ct Nassau County Sept. 17, 2007), 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.
Continue Reading...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, 2007 UT 31, 158 P3d 540 (2007), 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.
