Court Invalidates Control-Shifting Stock Transfer Made in Violation of Corporation's Right of First Refusal
The right of first refusal (RFR) is a type of stock transfer restriction found in shareholder agreements of closely held corporations. Under the most common form of RFR, the shareholder seeking to transfer his or her shares to another person is required to submit sequentially to the corporation and, if the corporation declines, to the other shareholders the opportunity to purchase the shares on the same terms as are being offered by the proposed purchaser. The courts routinely enforce RFRs in recognition of the special partnership-like character of close corporations.
A recent decision by the Appellate Division, First Department, in Giaimo v. EGA Associates Inc., 2009 NY Slip Op 09277 (1st Dept Dec. 15, 2009), illustrates the mischief that can occur when the RFR is not properly spelled out in a shareholders' agreement but, instead, is set forth in abbreviated and incomplete form on the back of the share certificates. Giaimo also illustrates the paramount importance New York courts place on the fiduciary duties owed by majority shareholders and directors of close corporations to minority shareholders, arguably to the point of preempting the statutory scheme governing director's self-interested transactions.
EGA Associates Inc. (EGA) is a closely held New York corporation formed in 1961 to own and operate real estate. According to the complaint filed by Robert Giaimo (read here), the stock of EGA was held one-third each by Robert and his siblings, Edward and Janet. Edward died after a long illness in March 2007. Edward's will bequeathed his EGA shares in equal parts to Robert and Janet, which would have left them as equal 50% shareholders. Two weeks before his death, however, Edward sold one of his shares to Janet for $80,000, thereby giving her majority ownership upon Edward's death. Some months later, Janet gave notice of meetings of the shareholders and directors at which she obtained voting control of the board by electing herself and her lawyer as two of the three directors.
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...New York Court Follows Delaware Law to Construe Advancement and Indemnification Provisions of Florida LLC's Operating Agreement
Presiding Justice Jonathan Lippman of the Appellate Division, First Department, who was recently nominated by Governor Paterson to become New York's Chief Judge on the Court of Appeals, has written a significant decision addressing rights of advancement and indemnification for litigation expenses in the limited liability company setting. Ficus Investments, Inc. v. Private Capital Management, LLC, 61 AD3d 1, 2009 NY Slip Op 00263 (1st Dept Jan. 20, 2009).
Not only is the substantive issue in the case -- affirming the right of an LLC member-manager to require the LLC to advance legal expenses defending an action brought by another LLC member -- one of great importance, the decision also reads like a legal travelogue in which a New York court looks to Delaware law to construe an operating agreement of a Florida LLC headquartered in New York.
Private Capital Group (Capital) is a Florida LLC owned 80% by the plaintiff Ficus Investments, Inc. (Ficus) and 20% by defendant Private Capital Management, LLC (Management). Capital buys, manages and sells non-performing mortgages, and was capitalized by loans from Ficus over $300 million. Capital began operations in December 2005. A dispute arose after Management's two owners, Thomas Donovan and Lawrence Cline, transferred about $10 million from Capital to Management. Under Capital's operating agreement, Donovan served as Capital's CEO and Cline as its President. In March 2007, Ficus adopted resolutions taking over Capital's management and it also commenced a lawsuit against Donovan, Cline and Management for breach of fiduciary duty, conversion and unjust enrichment.
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.
Fiduciaries, the Duty to Disclose and the Incredible Shrinking Release
As a matter of public policy, we want people to settle their disputes without resort to courts. Enforceability and finality are the twin pillars of settlements. General releases in settlement agreements advance the goals of dispute resolution by encouraging due diligence by the releasor and by fixing the releasee's exposure.
The law of fiduciaries can complicate dispute resolution among business partners, and occasionally clashes with the settlement goals of enforceability, finality, diligence and certainty.
I wrote about such a clash earlier this year in the case of Littman v. Magee (read here). In Littman, an appellate court permitted a damages suit by a minority member of an LLC, brought over a year after he sold his interest to the controlling members allegedly at an artificially low price, to recover the "true value" of his interest based on financial information allegedly withheld from him at the time of sale. The court refused to give effect to a general release in the buyout agreement, expressly covering claims known and unknown, citing the controlling members' fiduciary duty to disclose all material facts bearing on the transaction. As I wrote at the time, Littman struck me as "lowering the bar" for claims of tainted buyout by former business partners.
A recent trial court ruling in a case called Arfa v. Zamir illustrates the Littman rationale's potential reach beyond the buyout context, and raises new questions about the utility of releases in out-of-court settlement agreements between business partners.
Continue Reading...Appellate Court Finds Operating Agreement "Silent" on Sale of LLC's Sole Asset, Upholds Approval by Majority Vote Under Statute's Default Rule
There have been amazingly few New York appellate court rulings on LLC governance issues since the LLC Law's enactment 14 years ago, and even fewer of any real significance. That's why I'm excited to write about a ruling last month by the Appellate Division, Second department in Manitaras v. Beusman, 56 AD3d 735 (2d Dept 2008), in which the court grappled with a disputed sale of an LLC's sole asset in a fight between majority and minority members. Lawyers who draft LLC operating agreements should pay close attention to the decision and its underlying issues concerning LLC control and the interplay between the operating agreement and statutory default rules.
Kisco Radio Circle Associates, LLC ("Kisco") was formed in 2001 to own and operate a single real property located in Mount Kisco, New York. Anastasios Manitaras held either a 49.74% or 49.89% membership interest (the parties disagreed as to the precise figure) and a group of seven individuals collectively held the remaining majority interest. Manitaras and three other members were the managing members.
In August 2007, counsel for the majority members notified Manitaras of an outside offer to purchase Kisco's property for $5.8 million. Under the operating agreement, the sale of the property was defined as an event triggering the LLC's dissolution and winding up. Manitaras opposed the sale and withheld his consent. The majority members signed written consents authorizing the managing members to enter into a contract of sale.
Continue Reading...Controlling Shareholder's Dilution of Minority Interest Requires Bona Fide Business Purpose
Squeeze-out of minority shareholders in close corporations can take many different forms. One common technique is stock dilution. The careful minority shareholder will insist, before investing capital or sweat equity, on a shareholders' agreement that preserves his or her percentage by a combination of preemptive rights, super-majority approval requirements for changes in authorized and issued shares, and other protective devices. Absent such bargained-for protection, however, is a minority shareholder's stake at the mercy of the controlling faction?
The answer is a qualified "no", according to a recent decision by New York County Commercial Division Justice Herman Cahn in Dingle v. Xtenit, Inc., 20 Misc 3d 1123(A) (Sup Ct NY Co 2008), where the court elevated the controlling shareholder's fiduciary duty over his reliance on statute and the business judgment rule in refusing to dismiss the minority shareholder's wrongful dilution claim.
Continue Reading...Delaware and New York Courts Agree that 50% LLC Member May Not Hire Lawyer to Represent Company Adverse to Other 50% Member
There's been a recent flurry of courtroom battles over the authority of one 50% owner to engage counsel to represent the company adverse to the other 50% owner in dissolution proceedings or other types of internecine corporate warfare. I've previously written about some of these cases, including Sports Legends, Inc. v. Carberry, in which the court dismissed as unauthorized a suit by the corporation initiated by one 50% shareholder against the other for conversion of company assets (read here), and the infinitely fascinating Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, where one 50% LLC member hired company counsel in a multi-faceted litigation with the other 50% member that included dueling dissolution applications (read here and here).
Two new decisions reinforce the general proscription against the hiring and militant alignment of company counsel by one 50% owner against the other. One comes out of the Delaware Court of Chancery, which many -- present company excluded, I'm a dyed-in-the-wool New York partisan -- consider the premier business law court. The other decision appears to be the final word in the Caplash saga.
Continue Reading...Indemnity Provision Can Tilt the Playing Field in Litigation Between Business Partners
For the business owner without access to the company checkbook, and who therefore must foot his own legal bills, about the only thing worse than litigating a business divorce with a co-owner is seeing her use company funds to pay her lawyer.
Case precedent makes it pretty clear that, in a straightforward dissolution proceeding in which the company is a nominal party rather than an active litigant, neither side has the right to tap company funds for legal fees. But often the dissolution claim by the non-controlling owner is tied to other claims seeking to impose personal liability against officers or managers of the company. When that happens, the defending officer-owners may invoke a contractual right to indemnity including advancement of legal expenses by the company. Alternatively, where the defending officer-owners have board control, they may authorize indemnity and advancement under indemnification statutes.
The latter occurred in Van Der Lande v. Stout, 3 AD3d 261 (1st Dept 2004), where a minority member of an LLC brought a derivative action accusing the majority members of waste, fraud and mismanagement, alongside a separate proceeding to dissolve the LLC. Over the plaintiff's objection the defendant majority members made a substantial capital call upon all members -- including the plaintiff -- to fund the advancement of legal fees in defense of the derivative action. The plaintiff moved for a preliminary injunction to prevent the LLC from compelling him to make contributions. The trial court denied the motion. The appeals court upheld the order under the authority of Section 420 of the New York Limited Liability Company Law, which allows the LLC to advance and pay its members' legal expenses absent a final adjudication that the individual defendants acted in bad faith, were dishonest or personally gained profit to which they were not entitled. "That plaintiff commenced the lawsuit which caused the need for the additional contribution", the court added, "does not constitute an exception to his obligations to the LLC."
Continue Reading...Caplash Redux: 50% Member Cannot Hire Lawyer to Represent LLC in Dispute with Other 50% Member
When 50-50 business partners have a falling out, the ensuing battle for the high ground can lead one of them to take hostile action in the company's name without the other's consent.
Examples of the phenomenon, recently featured in this blog, include the case of Hellman v. Hellman, where the court upheld the authority of a 50% shareholder as president to enter into a lease opposed by the other shareholder, and Sports Legends, Inc. v. Carberry, where the court refused to authorize a lawsuit brought in the company's name by one 50% shareholder against the other.
Then there's Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC. About four months ago I wrote about an appellate decision in the Caplash case in which the court reversed a trial court order dissolving a medical practice LLC because of unresolved factual issues concerning the plaintiff's standing to seek dissolution. The issue before the court was whether to give legal effect to the plaintiff's letter to the company resigning his employment, and thereby terminating his LLC membership, where the company's requisite acceptance of the resignation was by letter from an attorney whose authority under the operating agreement to act on the company's behalf was not established. The appellate court sent the case back to the trial court for a hearing to determine the issue.
Since then, there's been a flurry of activity in the Caplash case and a new trial court decision (reported at 19 Misc 3d 1138(A)) which, I'm happy to report, supplies many of the underlying facts missing from the appellate decision. The recent decision, by Justice Kenneth R. Fisher of the Monroe County Supreme Court, Commercial Division, addresses two issues of interest. First, it examines the interplay between the parties' operating agreement and the LLC Law in deciding whether the lawyer engaged by one member with 50% voting power had the authority to accept on the LLC's behalf the other member's resignation. Second, it determines whether the same lawyer could act on the entity's behalf in asserting claims against the resigning member for wrongful competition and other economic injury to the LLC.
Continue Reading...Statute and Cases Create Uncertainty Over LLC Member's Right to Inspect Books and Records
Strained relations between managing and non-managing members of limited liability companies (LLC) sometimes lead to fights over the former's denial to the latter of access to company records. Section 1102 of the New York Limited Liability Company Law (LLCL) sets forth a three-part scheme governing the maintenance of, and member access to, LLC records.
The first part, Section 1102(a), requires that every LLC maintain five specific categories of records:
(1) if the limited liability company is managed by a manager or managers, a current list of the full name set forth in alphabetical order and last known mailing address of each such manager;
(2) a current list of the full name set forth in alphabetical order and last known mailing address of each member together with the contribution and the share of profits and losses of each member or information from which such share can be readily derived;
(3) a copy of the articles of organization and all amendments thereto or restatements thereof, together with executed copies of any powers of attorney pursuant to which any certificate or amendment has been executed;
(4) a copy of the operating agreement, any amendments thereto and any amended and restated operating agreement; and
(5) a copy of the limited liability company's federal, state and local income tax or information returns and reports, if any, for the three most recent fiscal years.
Note that the preceding list limits financial information to recent tax returns. This becomes more important under the second part, Section 1102(b), which provides for member access to LLC records including all the records mandated under Section 1102(a), as follows:
Continue Reading...Any member may, subject to reasonable standards as may be set forth
in, or pursuant to, the operating agreement, inspect and copy at his or her
own expense, for any purpose reasonably related to the member's interest
as a member, the records referred to in subdivision (a) of this section, any
financial statements maintained by the limited liability company for the three
most recent fiscal years and other information regarding the affairs of the
limited liability company as is just and reasonable.
50% Shareholder May Not Sue Other 50% Shareholder in Company's Name
The concept of the corporation as a separate "person", with a legal identity distinct from its shareholders and the ability to sue and be sued in its own name, is the cornerstone of the corporate form of business organization. The essential corporate attribute of limited liability and the attendant imposition of fiduciary duties of loyalty and care on those entrusted to manage the corporation's affairs, could not comfortably exist without corporate separateness.
Okay, I admit that's a highfalutin way to introduce the discussion that follows, of a trite lawsuit between shareholders of a two-bit sports memorabilia business, but that's the beautiful thing about the law, its noblest notions inform even the most mundane of disputes.
The dispute in question is the subject of a decision last month by New York County Supreme Court Justice Joan Madden in a case called Sports Legends, Inc. v. Carberry, 2008 NY Slip Op 30718(U) (Sup Ct NY County Mar. 10, 2008) (read decision here). The case arose when one of two 50% shareholders of a sports memorabilia business caused a suit to be filed in the name of the corporation against the other shareholder, asserting claims to recover company merchandise allegedly taken by the defendant and not returned. The primary issue in the court's decision, of no interest here, was whether the action was barred by the statute of limitations (the court found that it was). Secondarily, and the reason I'm discussing the case, the court addressed the issue whether the shareholder who brought the suit in the company's name had the authority to do so.
Continue Reading...Court Upholds Authority of 50% Shareholder/President to Sign Lease Without Co-Owner's Approval
Internal shareholder disputes involving closely held corporations can take several different forms when they land in court. The type of litigation addressed primarily by this blog is the dissolution proceeding, in which the ultimate objective is the company's liquidation or, as usually happens, a buyout. Sometimes, as a prelude to dissolution proceedings or negotiated buyout, one shareholder files suit accusing another shareholder of engaging in unauthorized company transactions. Such tactical lawsuits can be particularly effective with companies with 50/50 shareholders where the complainant believes with some justification the court is more likely to enforce the rights of a co-equal owner to an equal say in the company's business affairs.
Along these lines comes the fascinating case of Hellman v. Hellman (read decision here) involving a fight between two brothers each owning 50% of the shares in a lighting business founded by their father in the 1950s, called Maynards Electric Supply. The decision, written by Justice Kenneth R. Fisher of the Commercial Division in Rochester, is a scholarly and highly instructive exegesis on the interplay between officer and board authority in the closed corporation setting where, typically, no one pays attention to corporate formalities until it's too late.
Brothers Glenn and Bruce Hellman are Maynards' sole shareholders and directors. Both are actively employed in the business. Bruce is President and Treasurer. Glenn is Vice-President and Secretary. The business operated since 1985 in a building owned jointly by the two brothers and two other siblings. The lease was scheduled to expire at the end of June 2005. In 2004, Bruce began lease negotiations with the owner of another building ("Stockwood"). Bruce informed Glenn of the negotiations. Glenn disagreed with the proposed relocation. Lawyers for the two exchanged letters in which Glenn warned that Bruce lacked authority on his own to make commitments on the company's behalf. Bruce's lawyer sent Glenn the proposed form of lease. Glenn objected anew to Bruce's authority to enter into the lease. In May 2005, Bruce announced that the company would not be renewing the existing lease upon termination. Two days before the termination date, Bruce as President executed in the company's name a five-year lease with Stockwood. Shortly thereafter he informed Glenn of the new lease and advised of a planned move the coming Fall. Glenn's lawyer wrote to Stockwood maintaining that Maynards had not approved the lease.
Continue Reading...