Two-Member LLC Operating Agreement Contains Recipe for Dissension and Litigation
Last month, in Lola Cars International, Ltd. v. Krohn Racing, LLC, No. 4479-VCN (Del. Ch. Nov. 12, 2009), Vice Chancellor John W. Noble of the Delaware Court of Chancery issued a 31-page letter opinion addressing a number of important issues, including the adequacy of a deadlock dissolution claim, in a dispute involving a two-member Delaware LLC that built and sold Daytona-class Lola race cars (pictured). The case is noteworthy in the business divorce arena for two reasons, one spot-lighted by the decision and the other further off-stage.
The plaintiff, Lola Cars International, Ltd. ("LCI"), as 51% member teamed with defendant Krohn Racing, LLC ("Krohn"), as 49% member, to form Proto-Auto, LLC ("Proto") to manufacture and sell Grand Am Series professional race cars. Despite LCI's majority interest, under Proto's operating agreement the two members were equally represented on its governing board. As one of Krohn's primary obligations under the Operating Agreement, it agreed to provide the services of its manager, Jeff Hazell, as Proto's chief executive officer. LCI and Krohn had a falling out within the first two years of their venture, prompting LCI to sue for dissolution.
Center stage in Lola is Vice Chancellor Noble's analysis of the standard for judicial dissolution of LLCs under Section 18-802 of the Delaware LLC Act, which substantially resembles Section 702 of New York's LLC Law in requiring a showing that it is "not reasonably practicable to carry on the business in conformity with" the LLC operating agreement. Lola makes no new law. Rather, it builds on Chancellor Chandler's analysis in Fisk Ventures, LLC v. Segal, 2009 WL 73957 (Del Ch. Jan. 13, 2009) (read my prior post on Fisk with a link to that decision here), summarized as follows in Lola:
Continue Reading...Bankruptcy Court's Ruling Does Not Establish "Floor" Value in Subsequent Stock Appraisal Proceeding
When bankruptcy interrupts corporate dissolution proceedings, it usually means bad news for the petitioner. For instance, last year I wrote about a petition for corporate dissolution doomed by the petitioner's failure to disclose his stock interest in prior bankruptcy proceedings. A recent decision presents an interesting departure from the norm, involving a dissolution case commenced in 1990 that took a 10-year detour through bankruptcy court before returning to state court to resume a buyout proceeding. The case, Smith v. Russo, 2009 NY Slip Op 32785(U) (Sup Ct Queens County Nov. 13, 2009), raised the question whether the bankruptcy court's basis for rejecting as inadequate a buyout settlement proposed by the bankruptcy trustee should be given collateral estoppel effect -- for the benefit of the former bankrupt -- in the subsequent state court valuation proceeding.
Husband and wife Richard and Nelsi Smith were 27.5% shareholders of Meadow Mechanical Corporation formed in 1980. In 1990, the other shareholders removed Richard as president and barred both Smiths from the business premises, prompting the Smiths to sue for dissolution under Section 1104-a of the Business Corporation Law. The other shareholders then elected to purchase the Smiths' shares for fair value under BCL Section 1118.
Continue Reading...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...Valuing Shares in a Residential Co-op Corporation: Is the Whole Worth More Than the Sum of its Parts?
The residential co-operative corporation is a strange breed of closely held business entity. In New York, the co-op is formed as a for-profit corporation under the Business Corporation Law (BCL), yet it doesn't operate for profit in the traditional sense of returning cash dividends to shareholders. Instead, ownership of co-op shares entitles the shareholder to occupancy of an apartment under an appurtenant long-term proprietary lease. The co-op's income derives mostly if not entirely from tenant-shareholder maintenance payments, the level of which is designed merely to cover the common charges for building expenses. The market value of the shares held by individual shareholders within the same co-op can vary greatly, not just due to the number of shares allocated to the particular apartment, but also due to the unique characteristics of the apartment.
One of the consequences of being a for-profit corporation is that co-ops in New York are subject to the same statutes governing voluntary and involuntary dissolution as any other closely held business corporation, including BCL Section 1104-a authorizing a petition for judicial dissolution by an "oppressed" minority shareholder holding at least 20% of the corporation's shares. At least in New York City, where co-ops tend to have many apartments, the shares usually are too widely dispersed for any single tenant-shareholder to own 20%. In addition, and with all due respect to noise and odor complaints, the idea of a co-op dweller being oppressed by her neighbors is a far cry from the usual freeze-out/squeeze-out scenarios involving loss of employment, removal from the board, financial abuse by the majority, and lack of a market exit.
The fact is, however, that New York City also has many smaller co-op buildings such as converted townhouses and brownstones featuring four or five apartments, each of which may be allocated 20% or more of the co-op's shares. And, New York City being a litigious kind of town when it comes to expensive real estate (think Trump), it's inevitable that an alienated tenant-shareholder in such a co-op would opt to bring a dissolution proceeding instead of exiting by selling her apartment on the open market. A rational shareholder presumably would do so only if she believes she'll get more value from a liquidation of the corporation's assets than from selling her apartment, i.e., that the value of the entire building is greater than the sum of its parts.
Continue Reading...Court Rejects Unconscionability Argument in Family Partnership Valuation Case, Concludes that "Full and True Value" Equals "Net Book Value" as Defined by Agreement
Those who follow the society pages may recall that gossip columnist, television reporter and socialite Claudia Cohen married, had a child with and later divorced billionaire Ronald Perelman, and that she died tragically young in 2007. Less well known is the fact that Cohen herself came from family wealth; her father, Robert Cohen, built a highly successful media distribution business known as Hudson Media. It is from the Cohen-family wealth, and the sorting out of Claudia Cohen's estate, that the following tale of partnership valuation controversy emerges, culminating with a recent New Jersey court decision in Estate of Cohen v. Booth Computers, Memorandum Decision, C.A. Docket No. BER-C-135-08 (N.J. Super. Ct. Aug. 4, 2009).
In 1978, when Claudia was 27 and her two brothers were 21 and 19, their parents set up a general partnership called Booth Computers (the "Partnership") with the children as equal one-third partners. The idea was to provide income for the children and to shift assets for tax and estate planning purposes from the parents to the children. The children did not negotiate the Partnership Agreement which was prepared at the parents' direction by one of their lawyers. Later the same year, a limited partnership was formed called HCMJ Realty Ltd. ("HCMJ") of which the parents owned a 55% general partner interest and the Partnership was given a 45% limited partner interest. HCMJ's limited partnership certificate reflected a $90,000 cash contribution by the Partnership.
HCMJ's sole asset was a Palm Beach ocean front estate used as the Cohen family vacation home, which was transferred by another Robert Cohen entity to HCMJ in 1978. In addition to its 45% interest in HCMJ, the Partnership directly owned a pair of New Jersey commercial warehouses acquired in 1980 and 1984. The court's opinion doesn't disclose the warehouse purchase prices or indicate if they were conveyed to the Partnership by other Cohen-owned entities. In any event, none of the three Cohen children put their own money into the Partnership.
Continue Reading...Case Illustrates Importance of Clear Valuation Parameters in Buy-Sell Agreement Among Owners of Closely Held Business
When properly designed, buy-sell provisions in shareholders' agreements of closely held corporations, or in operating agreements of limited liability companies, can avoid disruptive and costly litigation triggered by the voluntary or involuntary dissociation of a shareholder or member. The key elements of a workable buy-sell agreement for lifetime dispositions are (1) defining the circumstances under which a shareholder or member can leave voluntarily or be forced out, (2) setting the valuation date, (3) fixing the value of, or a mechanism to value, the interest of the departing shareholder or member, and (4) setting forth the terms of payment.
Sassower v. 975 Stewart Avenue Associates, LLC, 2009 NY Slip Op 31901(U) (Sup Ct Nassau County Aug. 14, 2009), recently decided by Nassau County Commercial Division Justice Ira B. Warshawsky, illustrates the mayhem that can result when the buy-sell agreement renders uncertain the basis for valuing the departing owner's interest in the entity.
Cardiologist Michael Sassower was one of seven physician-shareholders of a Long Island cardiology practice organized as a professional corporation. He and his fellow shareholders also were members of a real estate holding company called 975 Stewart Avenue Associates, LLC (the "Company") that owned the premises housing the medical practice. In December 2007, Sassower gave six-months notice of his resignation from the medical practice. The Company's operating agreement provided that, upon his departure from the practice, Sassower was required to offer his 12.5% membership interest to the Company and the other members. Section 8.5(c) of the operating agreement described the following process to determine the price to be paid for his interest:
Continue Reading...Court Grants Dissolution, Rejects Claim that Failed Buy-Sell Agreement Was "Ploy" by Petitioner to Take Over Corporation's Retail Store Lease for His New Business
Has anyone else noticed an uptick in the number of cases asserting claims for breach of fiduciary duty and fraud arising from stock buy-outs among owners of closely held companies? Perhaps it should be called the Littman Effect, after the First Department's 2008 decision in Littman v. Magee, where the court upheld this type of claim notwithstanding broad releases and disclaimers in the buy-out agreement. (Read my post on Littman here.)
The most recent example is a case called Matter of Lerman (Tive Clothing, Inc.), Short Form Order, Index No. 2947/09 (Sup Ct Nassau County July 8, 2009), involving a single-outlet clothing store known as Effie's owned 50-50 by two shareholders. Although Lerman offers a twist on the usual fact pattern -- the fight was over the consequences of a contemplated buy-out that did not occur -- it flows from the same idea, viz, that Shareholder A wrongfully induced Shareholder B to enter into a buy-out agreement by withholding material information that Shareholder A was duty-bound to disclose.
The facts in Lerman are not complicated. The two owners, Lerman and Knaffo, set up their corporation, called Tive Clothing Inc. ("Tive"), and operated the store in leased space for almost 20 years before their relationship began to unravel over profitability and other financial issues. In June 2007 they reached an interim solution in the form of a stockholders' agreement with a buy-sell provision that permitted either of them to offer their shares to the other at a fixed price. If the offeree declined to purchase, Tive was to be dissolved and the inventory liquidated.
Continue Reading...Majority Shareholders of Accounting Firm Held Liable for Value of Deceased Minority Shareholder's Interest After They Formed New Firm Using Old Firm's Assets and Good Will
It may surprise some of you to learn that the Surrogate's Courts in New York have jurisdiction to hear petitions for judicial dissolution of closely held corporations involving the estate of a deceased shareholder. These cases are relatively rare -- most shareholder agreements contain provision for mandatory stock redemption upon death -- but they do happen from time to time. Case in point: last month the Appellate Division, Second Department, affirmed a ruling by the Surrogate's Court awarding the estate of a deceased minority shareholder the value of its stock interest, to be paid by the surviving shareholders in proportion to their stock interests. Matter of Verdeschi, 2009 NY Slip Op 05355 (2d Dept June 23, 2009).
As laid out more fully in the underlying September 2006 Decision and Order issued by Westchester County Surrogate's Court Justice Anthony Scarpino, Jr., Verdeschi involves an accounting firm known as G.B. Tepper & Associates Ltd. ("Tepper & Associates") organized in 1992 as a business corporation (as opposed to the more common professional corporation) with four shareholders: the decedent, Carl Verdeschi (35%), Gerald Tepper (35%), Monte Tepper (15%) and Jay Samuels (15%). They had no shareholders agreement. Prior to Verdeschi's death in late 2003, each shareholder received a salary and a share of profits proportionate to their stock percentage. After Verdeschi died, the surviving shareholders conducted no further business through Tepper & Associates. Instead, Monte Tepper and Jay Samuels formed a new firm known as Tepper Tax Associates, Inc. ("Tepper Tax") which occupies the same office used by Tepper & Associates, provides the same accounting services to the old firm's clients, and uses all of the old firm's office equipment, computers and furnishings. The new firm also employed Gerald Tepper.
Continue Reading...Appellate Ruling in Stock Valuation Case Further Muddies the Marketability Discount Waters
In determining the fair value of corporate shares, should the discount for lack of marketability (DLOM) apply only to the company's good will value, or to the entire enterprise value including tangible assets? Court decisions in New York tend to apply DLOM in the 25% range, so the answer can make a big difference in the ultimate award, particularly when the business is asset-heavy.
I've written before (read here) about conflicting case precedents in the Manhattan-based First Department (DLOM applies to enterprise value) and the Brooklyn-based Second Department (DLOM applies to good will value). Permit me to quote from that prior post, where I wrote:
With locked horns in the two downstate appellate departments, and no decisions on the subject from the two upstate appellate departments, it'll likely take some yet-to-be-born big-money valuation case to wend its way up to New York's highest court, the Court of Appeals, before we get a definitive answer.
Well, we still don't have a definitive answer from the Court of Appeals, but we do have a new decision on the subject from one of the upstate departments. The result aligns the Rochester-based Fourth Department with the First Department (DLOM applies to enterprise value), but the decision offers no analysis and, if anything, further muddies the DLOM waters.
Continue Reading...Pay Attention to the Latent Power of Corporate Bylaws
The lead-up to business divorce litigation is a tense pas de deux in which, once the dispute reaches critical mass, the two sides "lawyer up" and begin tactical maneuvers to best position themselves for the coming court battle. Sometimes the maneuvering consists of a series of back-and-forth letters between the lawyers staking out their positions and attacking the other's. Especially when one faction owns a controlling interest in the company, the maneuvering also may include formal meetings of the shareholders or the corporation's board of directors (or members/managers in the case of an LLC) to authorize actions adverse to the non-controlling faction.
Never mind that the owners never once held a formal meeting or kept minutes or adopted written resolutions since the day the corporation was formed. Never mind that the corporate kit, containing the organizational documents, stock ledger and certificates, has been sitting untouched, gathering dust since day one.
Among the likely neglected documents in the corporate kit are the corporation's bylaws. Bylaws are to be distinguished from the shareholders' agreement. The latter typically sets forth the stock interests of the individual shareholders, designates directors and officers, and contains restrictions on the transfer of shares, among other provisions. In contrast, think of bylaws as the corporation's operating system, consisting of internal rules not specific to any named individuals, governing such matters as quorum and notice requirements for meetings of the shareholders and board of directors; procedures for the election and replacement of directors; the number and term of directors; and the titles and duties of the corporation's officers. Section 601 of the Business Corporation Law mandates the adoption of bylaws by the incorporators at the initial organization meeting required under BCL Section 404.
I can't say whether all the parties and counsel in Matter of McDaniel (162 Columbia Heights Housing Corp.), 23 Misc 3d 784, 2009 NY Slip Op 29047 (Sup Ct Kings County 2009), were cognizant of the bylaws as they maneuvered prior to commencement of dissolution proceedings. I can say that the bylaws played a dispositive role in the court's determination of their preliminary dispute over a certain stock transfer involving shares of a residential co-operative corporation.
Continue Reading...What's the Difference Between Marketability and Minority Discounts?
The following testimony was given by an accredited business appraiser, testifying on behalf of the purchasing majority shareholders in a buy-out valuation proceeding under Section 1118 of the Business Corporation Law, to determine the "fair value" of the petitioner's 45% interest in two related companies:
Q: . . . I see that for the [first] appraisal there was no separate marketability discount analysis, but there is one for the [second] appraisal. Could you explain the basis of that?
A: After the issuance of both reports, . . . we were asked to come up with a value on a fully enterprise, the value of both entities. After the second report, [the majority shareholders' lawyer] asked me to address it because the case had become a 1118 case, and in that case the definition of value is fair value, and under that definition of value for the minority interest, what other considerations would one take into consideration, and I said, well, you would address the marketability discount of that specific block of stock under that statute. And he asked me then could I quantify what the marketability discount would be applicable to the stock.
Q. Applicable to the minority interest?
A. To the block of stock, the 45 percent interest.
The same expert, in a written report, wrote that "[a] minority equity holder of [the two companies] owns an equity interest for which no market exists. . . . It is our opinion that no less than a 30%-to-35% discount for lack of marketability is appropriate for the equity interest in [the two companies] to derive the fair value of the specific fractional interest in each company . . .."
The judge in that case rejected the expert's position and refused to apply the proposed discount. Can you guess why?
Continue Reading...Court Rejects Experts' Appraisals in Fair Value Proceeding, Relies on Own Computation Using Income Approach
No matter how many times I see it happen, I'm always intrigued when a new stock valuation decision comes along in an oppressed shareholder buyout proceeding in which the opposing experts come up with valuations light years apart. How is it that two impeccably credentialed business appraisers, operating under the same independence principle, looking at the same data, and following the same valuation guidelines, can produce such divergent numbers? Is the court required to accept one or the other, or should it appoint its own neutral appraiser, or compute value itself?
Last December I wrote about one ill-fated valuation decision in which the lower court adopted wholesale one of the two widely divergent expert appraisals, only to be reversed on appeal and remanded for a new valuation hearing. Today I write about another valuation decision in which the trial court rejected both experts' appraisals and came up with its own computation of fair value. Matter of Beattie (PlanData Systems Corp.), 2009 NY Slip Op 30181(U) (Sup Ct Suffolk County Jan. 15, 2009).
PlanData Systems Corp., located in Huntington, New York, offers space management services to owners and facility managers of commercial buildings. The business uses a proprietary computer program called SpaceMan to design and manage the clients' commercial properties. In 2006, 40% shareholder Ronald Beattie sought judicial dissolution of PlanData under the oppressed minority shareholder statute, Section 1104-a of the Business Corporation Law. The 60% shareholder, Steven Smith, elected to purchase Beattie's shares for fair value under the buyout statute, BCL Section 1118. After the two shareholders failed to reach agreement on price, the fair value question went to a hearing before Suffolk County Commercial Division Justice Elizabeth Hazlitt Emerson.
Continue Reading...Stock Valuation, Dr. Pangloss, Mr. Scrooge and Do-Overs
It's a common courtroom scene in stock valuation proceedings: two credentialed business appraisers locked in a "battle of the experts," ostensibly describing the same company using the same raw data, offering two conclusions of value light years apart. Former Vice Chancellor Steele of the Delaware Court of Chancery, in a case called Gilbert v. MPM Enterprises, Inc., 1997 WL 633298 (Del. Ch. Oct. 9, 1997), described the phenomenon thusly (keep in mind this was written in Apple's dark days, before it launched the iPod):
One might expect the experts' desire to convince the Court of the reasonableness and validity of their assumptions and financial models would produce a somewhat narrow range of values, clearly and concisely supported, despite the individual parties' obvious conflicting incentives. Unfortunately, as this case and other cases most decidedly illustrate, one should not put much faith in that expectation, at least when faced with appraisal experts in this Court . . .. Reading petitioner's submissions, one might easily conclude that MPM was poised to become the Microsoft of the SMT industry. By contrast, respondent's submissions give the impression that a more likely comparison, given MPM's myriad management, technical and legal problems, is Apple. In sum, one report is submitted by Dr. Pangloss, and the other by Mr. Scrooge.
Closer to home, in one of the earliest reported decisions to address the problem under New York's buyout statute (BCL 1118), the court in Matter of Taines (Gene Barry One Hour Photo Process, Inc.), 123 Misc. 2d 529 (Sup Ct NY County 1983), aff'd, 108 AD2d 630 (1st Dept 1985), disregarded the testimony of both sides' experts, whose determinations of the fair value of the subject company's shares differed by almost 30,000 percent, writing as follows:
Continue Reading...Top 10 Business Divorce Cases of 2008
The nominations are in, the votes are counted, envelope please! Following are my picks for last year's top 10 business divorce cases, all of which were featured in prior posts:
- Tzolis v. Wolff, 10 NY3d 100 (2008), in which the Court of Appeals resolved conflicting First and Second Department decisions on the question whether LLC members can bring derivative actions on the LLC's behalf. They can.
- Matter of Beverwyck Abstract, LLC, 53 AD3d 503 (3d Dept 2008), in which an appellate court upheld a lower court's ruling that the de facto dissolution of an LLC did not terminate the members' fiduciary duty to account for ongoing profits up until formal dissolution.
- Tal v. Superior Vending, LLC, 20 Misc 3d 1103(A) (Sup Ct Westchester County 2008), in which the court crafted an equitable remedy in an LLC dissolution by ordering a return of the petitioner's investment.
- Dingle v. Xtenit, Inc., 20 Misc 3d 1123(A) (Sup Ct NY County 2008), in which the court required a bona fide purpose for a controlling shareholder's dilution of the minority shareholder's interest.
- Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, 19 Misc 3d 1138(A) (Sup Ct Monroe County May 12, 2008), subsequent decision, 20 Misc 3d 1104(A), in which the court upheld the petitioner's standing to seek LLC dissolution after finding that the other member lacked authority to engage the LLC's attorney who had accepted the petitioner's resignation.
- Hellman v. Hellman, 19 Misc 3d 695 (Sup Ct Monroe County 2008), modified, 2009 NY Slip Op 02418 (4th Dept Mar. 27, 2009). involving a corporation owned 50-50 by brothers, in which the court upheld a new company lease executed by the brother who served as president over the other's objection that the lease required board approval.
- Murphy v. U.S. Dredging Corp., 2008 NY Slip Op 31535 (Sup Ct Nassau County May 19, 2008), a valuation proceeding involving shares in a subchapter C real estate holding corporation in which the court applied a discount for built-in capital gains.
- Matter of Youngwall, 2008 NY Slip Op 30811(U) (Sup Ct Nassau County Mar. 14, 2008), adhered to upon reargument in unreported decision dated July 28, 2008, in which the court granted dissolution of an unprofitable LLC and also ruled that a provision in the operating agreement waiving the right to seek judicial dissolution is void as against public policy.
- Ross v. Nelson, 54 AD3d 258 (1st Dept 2008), in which the court enforced the LLC's default statute in upholding a majority vote of the members to remove one of the managers.
- Manitaras v. Beusman, 56 AD3d 735 (2d Dept 2008), in which the court found that an LLC operating agreement's silence on the sale of the LLC's sole asset permitted majority approval under the default statute even though the sale automatically triggered dissolution.
What will 2009 bring? It's not illogical to think that the stress of the economic meltdown will lead to an increase in business divorce. But in my years watching the scene I've never detected any correlation between business cycles and the rate of litigious business break-ups involving closely held companies. If anything, I would lean in favor of the theory that financial success and opportunity in a business create even more incentive for dissension among co-owners. A recent NY Times article pointed out how falling real estate values are impeding marital divorces by eliminating the primary resource for financial settlement. I think a similar phenomenon could be at play with businesses in the current climate, by reducing the upside for a disgruntled owner contemplating a tactical lawsuit designed to induce a buyout.
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...Timing is Everything When it Comes to the Buyout Election in Corporate Dissolution Cases
A recent decision by Queens County Commercial Division Justice Orin R. Kitzes in Matter of Weingarten (Thirty First Street Realty Corp.) calls attention to a critical issue in corporate dissolution proceedings, namely, the timing of the statutory election to purchase the petitioning shareholders' stock interest. First, some background.
Section 1104-a of New York's Business Corporation Law authorizes a petition for judicial dissolution of a close corporation brought by a shareholder holding at least 20% of the voting stock on the ground of "oppressive actions" by the controlling shareholders. The dissolution statute is counterbalanced by BCL Section 1118 which gives the respondent shareholders the absolute right to stay the dissolution proceeding and, ultimately, to avoid dissolution altogether by electing to purchase the petitioner's shares for fair value.
The right of election is not open-ended. Section 1118 requires that the election be made within 90 days after the petition is filed. Practitioners know that only the rare dissolution petition is decided on the merits within 90 days. This poses a quandary for the respondent inclined to fight the allegations of oppression but also not willing to put the company at risk of dissolution if the petitioner prevails on the merits.
Section 1118(c)(1) provides a semi-safety valve for this situation. It provides that if an election is made after 90 days,
Continue Reading...and the court allows such petition, the court, in its discretion, may award the petitioner his reasonable expenses incurred in the proceeding prior to such election, including reasonable attorneys' fees.
Dissolution May Be Sole Remedy When Minority Shareholder's At-Will Employment is Terminated
It's among the most common scenarios seen by business divorce lawyers: A minority shareholder of a non-dividend paying close corporation -- let's call him Joe the Shareholder -- for years has been a full-time employee, officer and director of a company he co-founded. Joe the Shareholder's salary and occasional bonus are the sole source of return on his investment in the company. Without any advance notice, the majority shareholders fire Joe the Shareholder, remove him from the payroll, cut off his access to the company computer and change the office locks. Joe the Shareholder can't believe that, as a company owner, he can be fired and thrown out by his business partners just like that. Joe the Shareholder wants to know what his remedies are and, in particular, whether he can sue for wrongful termination of his employment to recover lost salary and other damages.
Joe the Shareholder has a standard shareholders' agreement that gives a majority of the Board of Directors control of all company business affairs. The shareholders' agreement does not fix any definite term of employment for any of the company's shareholders, and it has no language limiting the Board's authority to terminate an officer or employee with or without cause. Joe the Shareholder has no separate employment agreement with the company.
So what's the answer to Joe the Shareholder's question? In New York, without any agreement for employment of a definite duration, Joe the Shareholder is considered an at-will employee of his own company who can be fired for any or no reason (except for reasons made illegal under federal and state workplace anti-discrimination laws), and therefore he has no claim for wrongful termination of his employment. If Joe the Shareholder has any remedy, he must look to his statutory right to seek judicial dissolution for shareholder oppression under Section 1104-a of the Business Corporation Law.
Continue Reading...Court Enforces Stock Buyout Triggered by Shareholder's Death Notwithstanding Pending Dissolution Proceeding
According to one online review, Greek restaurant Telly's Taverna located in Astoria, Queens, "exudes Mediterranean calm with its beach mural, bucolic back garden and airy main dining room."
Nine miles away, in the courtroom of Queens County Commercial Division Justice Orin R. Kitzes, the atmosphere has been anything but bucolic as the restaurant's 50-50 owners have waged a bitter shareholder dispute for over two years, including a deadlock dissolution proceeding under Section 1104 of the Business Corporation Law.
In the midst of those proceedings, the 50% shareholder who petitioned for dissolution died. The ensuing, convoluted legal proceedings ultimately boiled down to one question: Did the petitioner's death entitle the surviving shareholder to enforce the valuation and buyout provision in the shareholders' agreement, thereby mooting the dissolution proceeding?
The short answer is "yes". Here's the full story:
In January 2001, Joanna ("Nana") Loiselle and Aristotelis ("Telly") Vagianderis as 50-50 shareholders formed Kalamaki Taverna, Inc. to operate the restaurant known as Telly's Taverna. A month later they entered into a written shareholders' agreement including an optional provision for stock buyout upon death, as follows:
Continue Reading...In the event of the death of a stockholder, the Corporation business may be continued by the surviving parties on giving notice of such election to continue to the legal representative of said deceased party within thirty (30) days following the death of such deceased party. The deceased party's interest in the Corporation shall terminate on the date of his or her death and the value of the interest of such deceased party in the Corporation shall be determined as of the date of such deceased party's death. The interest so determined shall be paid to his or her legal representative . . ..
Terminated Member of Professional Corporation is Not Entitled to Statutory Stock Redemption
Professional service corporations are "interesting" and "strange creatures". So says Nassau County Commercial Division Justice Ira B. Warshawsky in an interesting (but not strange) post-trial decision issued last month, rejecting a claim for statutory buyout in a suit brought by a terminated partner in a law firm organized as a professional corporation.
The case is Lubov v. Welikson, 2008 NY Slip Op 28392 (Sup Ct Nassau County Sept. 29, 2008). You can read the decision here. Additional background is found in the court's January 2008 decision denying summary judgment motions (read here).
The law firm in Lubov initially was organized in 1989 as a general partnership. In 1993 it converted to a professional service corporation ("P.C.") under Article 15 of the Business Corporation Law. P.C.s are a popular form of limited liability entity eligible for partnership tax treatment, available to lawyers, doctors, accountants and other regulated professions.
The plaintiff alleged that prior to the firm's conversion to a P.C. the partners made an agreement to redeem the interest of a withdrawing partner for the sum of the partner's capital contribution and percentage of accounts receivable. Plaintiff also alleged that the shareholders nee partners of the P.C. adopted the same agreement.
Plaintiff's percentage interest in the P.C. started at 30%. In 1994 he voluntarily surrendered half his interest at the same time he began working fewer days and pursued other personal business affairs. At the time, he allegedly asked about redemption of the surrendered shares, but supposedly was put off by the majority shareholder. Plaintiff's percentage interest rose to 16% in 1997 when another 10% shareholder left the firm.
Continue Reading...A Case of Mutual Frustration: Minority Member of LLC Can't Compel Dissolution, Majority Can't Compel Buyout
It's the perfect LLC storm: Accusations by the minority member of overreaching and breach of fiduciary duty by the controlling members, no operating agreement, and an LLC statute that affords neither party a judicial means of achieving the separation they each want.
The case, Matter of Koutelos (Mouhlas Realty, LLC), was decided last month by Queens County Supreme Court Justice Patricia P. Satterfield (read decision here). The petitioner, Mary Koutelos, holds approximately 15% membership interest in Mouhlas Realty, LLC which was formed in 2000 as a member-managed LLC. The decision doesn't describe the LLC's business or tell us if Koutelos is actively involved in running it. All we can glean is that Koutelos filed a petition under LLC Law Section 702 for judicial dissolution of the LLC based on allegations of overreaching and breach of fiduciary duty by two of the other three members, apparently involving a capital call and/or loan to be used for compensation of one or more member-managers; the members have no operating agreement; and the other members refused Koutelos's request to adjourn a meeting.
The decision also tells us that the "respondent" -- we don't find out if this refers to the LLC or one of the other members individually -- filed an answer with a counterclaim for an "equitable buyout" conditioned on the court applying a 30% discount for lack of marketability in valuing the petitioner's interest.
Continue Reading...Court Discounts Fair Value Award for Built-In Gains Tax in Shareholder Oppression Case
In a posting last December I wrote about an important estate tax case, Jelke v Commissioner, in which a federal appeals court adopted a bright-line rule requiring 100% discount for built-in capital gains tax ("BIG") in the valuation of C corporation assets. At the time I made the following prediction about Jelke's impact on stock valuation in corporate dissolution cases:
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.
I was right about one thing: it was not the last word on BIG and §1118 stock valuation proceedings. As it turns out, when I wrote those words there already was percolating in Nassau County Supreme Court a buy-out proceeding in a shareholder oppression case, Murphy v. U.S. Dredging Corp., requiring the court to decide the same issue presented in the La Sala case, namely, the appropriateness under the fair value standard of applying a BIG discount to the appreciated assets of a real estate holding C corporation. The Murphy court's answer -- applying a partial discount based on the present value of future gains taxes -- lands between Jelke's 100% discount and La Sala's zero discount.
Continue Reading...Decision Lowers the Bar for Former Partner's Claims of Fraudulent Buyout
When non-controlling partner A sells out to controlling partner B, following which B sells the company to a third party at a disproportionately high premium over A's price, A may suspect that B withheld information pertaining to the company's value at the time of A's sale. The question is, does A have a valid claim against B to recover a share of the re-sale profits? Does caveat venditor give way to a fiduciary-based, affirmative obligation on B's part to disclose to A any and all information material to the sale price?
An opinion handed down last week by an appellate court in Manhattan appears to lower the bar for such a lawsuit, and sends a cautionary message to transactional counsel concerning the effectiveness of seller representations and releases in partner buyout agreements.
In Littman v. Magee, 54 AD3d 14 (1st Dept 2008), Steven Littman held an 18.7% membership interest in Rockwood Realty Associates LLC, a real estate investment firm formed in 1996 and managed by another LLC controlled by Rockwood's majority owners. Littman's 28-page complaint essentially alleged that the majority owners engaged in a squeeze-out through property sales that forced Littman to incur large personal tax bills on undistributed K-1 profits, contrary to an alleged "understanding" when the company was formed that distributions sufficient to cover taxes would be made.
Dissenting Shareholder Loses Right to Receive Dividends Upon Merger Consummation
Like most states, New York's Business Corporation Law (BCL) permits a shareholder to opt out of mergers and certain other corporate restructurings by electing to be cashed out for the "fair value" of his or her shares. The so-called dissenting shareholder statute, BCL Section 623, sets forth procedures and deadlines for submission of the shareholder's written objection to the proposed transaction, for the corporation's making of a price offer, and for the filing of a judicial appraisal proceeding in the event the shareholder rejects the corporation's offer. A statutory appraisal proceeding also may result from a "freeze-out merger" in which the controlling shareholders compel minority shareholders to redeem their shares for cash. The dissenting shareholder statute typically comes into play with merger transactions involving corporations with relatively large capitalization and whose minority shareholders include passive investors. Section 1005 of the New York Limited Liability Company Law likewise permits members to dissent and cash out from mergers or consolidations involving LLC's.
A recent court decision, in a case called McCully v. Jersey Partners, Inc., 18 Misc 3d 1138(A) (Sup Ct NY Co 2008), raises a caution flag for dissenting shareholders and their counsel when it comes to asserting claims for dividends that accrue prior to merger consummation but are not payable until afterward.
Continue Reading...LLC Member's Marital Woes Lead to Loss of Membership Interest
Shareholder agreements for close corporations often include provisions designed to protect the company and its shareholders against involuntary stock transfers or other potentially disruptive court decrees arising from the dissolution of a shareholder's marriage. The same holds true for limited liability company (LLC) operating agreements and their members. Sometimes, as this week's featured case illustrates, such provisions can backfire when a member's marital woes coincide with internal disputes among the LLC's members.
Matter of Madelone (Viscomm Group, LLC), 18 Misc 3d 1131(A) (Sup Ct Albany County 2008), involved an LLC formed in 2003 by three members to engage in advertising and public relations. Initially, the three members -- Whitten, Harrington and Madelone -- each held a one-third interest. Whitten served as manager. Subsequently, a fourth person was brought in as a 10% member, reducing the others to 30% each.
In 2005, when Whitten was experiencing marital difficulties, he proposed certain amendments to the operating agreement which the membership adopted. The amendments required a member who files, or whose spouse files, for legal separation or divorce to sell, and the other members to buy, the membership interest of the member involved in the marital proceedings. The amendments also established a method for computing the purchase price and the payment terms. The following year, Whitten filed for separation from his wife whereupon he relinquished his position as manager and was appointed to a salaried position with the company, only to be reinstated as a member and manager upon reconciling with his wife.
Continue Reading...Appellate Court Enforces Stock Buyback Triggered by Dissolution Petition
One of my pet issues, on which I've written a number of times (see here, here and here), is whether the filing of a dissolution petition triggers a mandatory stock buyback under a shareholders' agreement that provides a right of first refusal (RFR). The cases raising the issue have all been deadlock dissolution petitions brought by 50% shareholders under Business Corporation Law Section 1104(a). That statute, unlike Section 1104-a governing minority shareholder oppression, does not give the respondent shareholders the right to purchase the petitioner's shares under Section 1118.
If the shareholders' agreement expressly provides that the filing of a dissolution petition triggers the RFR, unquestionably it should be enforced. The problem arises with the more typical RFR that does not contain such express language, but instead contains what most would consider boilerplate reference to stock transfers. Is enforcement by reason of such general language consistent with a shareholder's reasonable expectations, and with the statutory right to seek dissolution? The issue has very serious ramifications for the petitioner (and for petitioner's lawyer who may be unwary of the trap) because the RFR typically provides a below-market price for the buyback with a long-term payout.
A 2006 appellate decision by the First Department in a case called Matter of Johnsen (ACP Distribution, Inc.) ruled that a dissolution petition triggered an RFR containing the operative terms, "donate, hypothecate, pledge, transfer or otherwise dispose of his Stock in any manner whatsoever." A September 2007 trial court decision in Matter of Schneck (R&J Components Corp.) (previously blogged here) went the other way where the operative terms were "sell, assign, mortgage, hypothecate, transfer, pledge, create a security interest or lien, encumber, give or otherwise dispose of any of the shares."
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...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 Section 1118 of the Business Corporation Law, when a minority shareholder files a petition for judicial dissolution of a close corporation based on oppressive conduct by the conrolling shareholders or directors, the respondent shareholders may avoid dissolution by electing to purchase the petitioner’s shares for fair value.
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.
