Advancement and Indemnification

Food-Fight1A little over three years ago I reported on the first round of a fascinating “food fight” among four siblings, each of whom is a 25% shareholder of a Brooklyn-based, second-generation food distributor known as Jersey Lynne Farms, Inc. (the “Corporation”), and each of whom also is a 25% member of Catarina Realty, LLC (the “LLC”) which leases its sole realty asset to the Corporation.

The occasion back then was the court’s decision in Borriello v Loconte denying a dismissal motion in a derivative suit brought by Dorine Borriello on the LLC’s behalf in which she alleged that her three siblings breached fiduciary duty by leasing its realty to the Corporation at a drastically below-market rent and by imposing on the LLC certain expenses that ought to be borne by the Corporation as tenant.

In 2011 — the same year her siblings entered into the challenged lease — they ousted Dorine as a director, officer, and employee of the Corporation. In 2012 Dorine and her siblings negotiated a Separation Agreement and General Release setting forth terms for payment of compensation and benefits along with non-compete and non-disclosure provisions. The agreement left intact Dorine’s 25% stock interest in the Corporation.

Dorine’s derivative suit filed in 2013 claimed that the 2011 below-market lease rendered the LLC unprofitable while increasing the Corporation’s income used to pay salaries and other benefits to her siblings. The first round went to Dorine when the court ruled that her General Release did not encompass her derivative claim and enjoined her siblings from advancing their legal expenses from LLC funds.

In the end, however, and subject to any appeals Dorine may bring, it appears that the siblings have won the food fight’s final rounds. Continue Reading “Food Fight” Sequel Ends Badly for Ousted Sibling

spaceballs

To Mel Brooks’ collection of hit films, Oscars, and countless other comedic works and awards can now be added the distinction of having his 1987 Star Wars parody, Spaceballs, cited by the decidedly non-comedic Delaware Court of Chancery in support of its construction of an LLC agreement’s provision for advancement and indemnification in a lawsuit arising from a soured business relationship between the majority and minority members of a Delaware company formed in 2007 called Quivus Systems, LLC.

The transcript decision by Vice Chancellor Tamika Montgomery-Reeves in Harrison v Quivus Systems, LLC, C.A. No. 12084-VCMR [Del Ch Aug. 5, 2016], granted summary judgment on a claim for advancement of legal expenses in favor of the plaintiff Harrison, a principal of Quivus’s 45% member and its former CEO who was terminated in 2014 and then sued the following year in Washington D.C. Superior Court by the 55% member, Soroof International Corp., allegedly for mismanagement, incompetence, and looting.

Harrison filed his Chancery Court action after Soroof rejected his demand for advancement for all expenses, including legal fees, he incurred and would continue to incur in defending against all but one count in the D.C. action, as well as in prosecuting his counterclaims in the D.C. action. Continue Reading When Will Then Be Now? Court Construes LLC Agreement’s Advancement Provision With An Assist From Spaceballs

Despite its pejorative-sounding name, “jerk insurance” — it’s more vulgar name is “schmuck insurance” — can serve a useful purpose in addressing a business owner’s concern about looking, well, like a jerk by selling his or her equity stake to a co-owner who then turns around and sells the company or its assets to an outside buyer at a much higher value. Basically it works by guaranteeing the seller additional monies in the event of a company sale within a defined post-buyout period, usually computed as a percentage of the net sale proceeds above a threshold value specified in the buyout agreement.

It’s a type of deal protection, for example, that would have avoided the seller’s remorse suffered by the unsuccessful plaintiffs in the well-known New York case, Pappas v Tzolis, who sold their majority stake for $1.5 million to the minority owner who, within months, sold the company’s sole asset to a third party for $17.5 million.

I can’t cite statistics, but I’d venture to say the great majority of buyers who are willing to give jerk insurance do so because they have no intention of selling the company within the defined post-buyout period. In that sense it’s giving away ice in winter, but it nonetheless can facilitate the buyout agreement by giving additional comfort to the seller that he or she is not losing out on a better deal the buyer may already have lined up to sell the company.

All of which makes all the more unusual and instructive the recently decided case of Charron v Sallyport Global Holdings, Inc., Opinion and Order, 12-cv-06837 [SDNY Dec. 10, 2014], in which one 50% shareholder bought out the other 50% shareholder for almost $41 million pursuant to a buyout agreement with a jerk insurance provision setting a $65 million threshold and, in the event of a company sale within the following year, giving the seller 20% of the entire proceeds of the sale rather than 20% of the difference between the threshold and the sale price. Continue Reading “Jerk Insurance” Takes on New Meaning in Buyout Dispute

Nassau County Commercial Division Justice Vito M. DeStefano (pictured) last month handed down an important ruling in Schlossberg v Schwartz, 43 Misc 3d 1224(A), 2014 NY Slip Op 50760(U) [Sup Ct, Nassau County May 14, 2014], addressing rights of indemnity and advancement when a company brings claims against its own officer or director for alleged misconduct undertaken in a corporate capacity. The scholarly decision, which traces the convoluted history of the governing Business Corporation Law (BCL), rejects the company’s position that its bylaws and the BCL preclude advancement and indemnification for intra-company claims, i.e., claims brought directly by the company against an officer/director, as opposed to extra-company claims, i.e., claims brought by outside, third parties.

Schlossberg also is noteworthy:

  • for upholding the right to seek advancement and indemnity for expenses incurred in the defense of the company’s counterclaims, on an apportioned basis, in a suit initiated by a minority shareholder, director and former officer asserting direct and derivative claims against the controlling shareholder, inter alia, for breach of fiduciary duty, breach of contract and common law dissolution; and
  • for its numerous citations to decisions of the Delaware Chancery Court, which rightfully boasts an advanced jurisprudence in the area of indemnification and advancement.  Continue Reading Court Upholds Former Officer’s Right to Seek Indemnity and Advancement in Intra-Company Dispute

Housing cooperatives, or “co-ops” as they’re commonly known, occupy an unusual niche among forms of joint stock enterprises. Like any corporation, the tenant-shareholders have a common interest in maximizing for everyone’s benefit the value of the co-op’s assets, i.e., the apartment building and its common elements, but being neighbors who live above, below and beside one another, the tenant-shareholders also have intrinsically competitive interests regarding rights of access, use, development, transferability, etc., that can have a direct, disparate impact on quality of life and the resale value of their individual apartment units.

In large co-ops, where no single tenant-shareholder has a significant percentage of voting power, the centralized management authority of a democratically elected board of directors, exercised pursuant to the co-op’s by-laws, can regulate and mute any divergence between common and individual stockholder interests. Such centralized management, as in any corporation with widely dispersed ownership, effectively compartmentalizes decision-making at the board and shareholder levels.

But not all co-ops are large. In Manhattan and other parts of New York City there are many small co-op properties, including converted walk-up tenements and industrial loft buildings, with as few as four, five or six units where each tenant-shareholder may have a seat on the co-op’s board of directors and material voting power, thereby melding into one the theoretically distinct realms of director and shareholder authority and likewise conflating common and individual concerns.

Which also means that relations between tenant-shareholders in small co-ops can fall victim to the same kinds of infighting and dissension that afflict any small, closely held, owner-operated business enterprise. Some years ago I wrote about a Brooklyn co-op shareholder who petitioned for judicial dissolution of a five-unit co-op on grounds of oppressive conduct by the majority shareholders, which led to a statutory buy-out and contested valuation proceeding (read here and here). A Manhattan appellate panel’s decision last month in Akasa Holdings, LLC v Sweet, 2014 NY Slip Op 01822 [1st Dept Mar. 20, 2014], illustrates another kind of co-op shareholder dispute involving a battle for board control of a four-unit co-op, pitting one tenant-shareholder owning a majority of the voting shares against the other three tenant-shareholders. Continue Reading Legal Battle Over Board Seats Splits Neighbors in Manhattan Co-op

Section 420 of New York’s LLC Law authorizes an LLC, “subject to the standards and restrictions, if any, set forth in its operating agreement,” to indemnify and hold harmless, and advance expenses to, any member, manager or other person “against any and all claims and demands whatsoever.” The statute goes on to prohibit indemnification if a “judgment or other final adjudication adverse to such member, manager or other person” establishes that his or her acts were committed in bad faith or resulted from deliberate dishonesty, or that he or she gained a wrongful financial advantage.

In plain English, (1) if an LLC member, manager or other agent is successfully sued for actions relating to the LLC’s business and is hit with a damages award, so long as that person didn’t act in bad faith, dishonestly or profit illegally, when it’s all over the LLC can pay the award and reimburse the person’s legal expenses, and (2) the LLC also can fund (“advance”) the person’s legal expenses during the lawsuit, but the funds will have to be repaid if ultimately there’s a final judgment against the person and his or her conduct fails the bad-faith test.

There are few reported decisions by New York courts addressing claims for advancement in internecine lawsuits among LLC members. Best known is the 2009 Ficus decision in which the Appellate Division, First Department followed Delaware law to enforce advancement rights in litigation among members of a Florida LLC, emphasizing that rights of advancement and indemnification are “independent of one another” and that a court’s finding of misconduct for purposes of interim relief does not defeat advancement rights granted under the company’s operating agreement (read here). And then there’s the Borriello case, about which I wrote here, in which Justice Demarest enjoined an LLC from advancing the controlling members’ legal expenses in the face of the operating agreement’s provision which authorized indemnification only.

As those two cases illustrate, sometimes it’s the non-controlling member trying to use advancement to shift his or her defense costs indirectly to the controlling members, and sometimes it’s the other way around. Such cost-shifting can give one side or the other a huge and sometimes decisive litigation advantage. In a recent, novel ruling by Nassau Commercial Division Justice Stephen A. Bucaria, the court decided to “level the playing field” by ordering the LLC to advance legal expenses of both sides. PFT Technology LLC v Wieser, Short Form Order, Index No. 8679/12 [Sup Ct Nassau County Feb. 20, 2014]. Continue Reading Novel Ruling on Advancement in LLC Dissolution Case “Levels the Playing Field”

According to its website, Brooklyn-based wholesale food distributor Jersey Lynne Farms traces its roots to the 1940’s when Vito Loconte began a door-to-door business selling loose eggs in mushroom baskets. Seventy years later, Jersey Lynne Farms is a major, full line food distributor selling to supermarkets, institutions, convenience and bagel stores, delicatessens, diners and restaurants throughout the metropolitan New York area.

In the 1990’s, a few years before he died, Loconte transferred stock ownership and management of Jersey Lynne Farms to his son Michael and daughters Dorine, Diane and Maria, some of whose spouses also took jobs in the family business. In 1999, the four siblings transferred ownership of the building that houses the distribution business to a newly formed limited liability company, named Caterina Realty, LLC, of which each sibling is a 25% member-manager. Since then Caterina Realty leases the property to Jersey Lynne Farms as sole tenant.

The Falling Out

Family unity fractured in 2011 when Michael, Diane and Maria banded together to oust Dorine as an officer, director and employee of Jersey Lynne Farms. They also fired Dorine’s husband from his position in charge of purchasing. That same year, a dispute erupted over the terms of a new lease between Jersey Lynne Farms and Caterina Realty. Relying on widely disparate appraisals, Dorine argued for an annual base rent of $600,000 compared with the $342,000 annual base rent adopted in the lease ultimately approved by her three siblings in late 2011.    Continue Reading Court Limits Scope of Release, Denies Advancement of Defense Costs in Sibling “Food Fight”

A little over a year ago, in the Ficus Investments case, the Manhattan-based Appellate Division, First Department, looked to Delaware case law for guidance in holding that an LLC manager named as defendant in an action brought by a member alleging conversion and fiduciary breach was entitled to advancement of his legal defense costs notwithstanding preliminary injunction rulings against him.  (Read my prior post on Ficus here.)

Last month, in 546-552 West 146th Street LLC v. Arfa, 70 AD3d 512, 2010 NY Slip Op 01416 (1st Dept Feb. 18, 2010), the First Department again looked to Delaware precedent in another ruling of apparent first impression involving indemnification rights in the LLC internal warfare context.  The issue this time:  Is the defendant LLC manager entitled to indemnification for winning the non-merits dismissal of Action No. 1 prior to the adjudication on the merits of Action No. 2 asserting the same or similar claims?  The Delaware Chancery Court answered “yes”, and now so too does the First Department.

The Arfa litigation saga begins in 2006, when several real estate holding LLCs sued their former managers for failing to make certain disclosures to the LLC members when they were being solicited to invest in the LLCs.  In February 2007, Manhattan Commercial Division Justice Charles E. Ramos dismissed the case on the ground that the LLCs lacked standing to pursue the claims, which properly belonged to their members.  In September 2008, the First Department rejected the LLCs’ appeal in a decision reported at 54 AD3d 543 (1st Dept 2008).  

Meanwhile, even before the appeal was decided, the law firm that initiated the first suit on behalf of the LLCs started a second lawsuit on behalf of the members asserting the same claims against the managers.  The second case remains pending.

Continue Reading Following Delaware Precedent, New York Appeals Court Rules that Indemnification of LLC Managers for Successful Defense in First Action Need Not Await Resolution of Second, Related Litigation

See full size imageIf there’s a more litigious partnership falling-out than that of the closely-held mortgage company, Private Capital Group (PCG), I don’t know about it.  The case, entitled Ficus Investments, Inc. v. Private Capital Management, LLC,  has racked up 87 motions since it was filed in Manhattan Supreme Court in March 2007, including several contempt applications.  The court’s docket lists over 2,300 separate documents filed, and the case isn’t even close to being tried.  There have been three interlocutory appeals decided thus far, with several others awaiting decision.  Did I mention the parties have filed at least five other, related cases?

PCG was a New York-based Florida limited liability company formed to buy, manage and sell non-performing mortgages.  Ficus Investments, Inc. (Ficus), the 80% member and sole manager of PCG, put up $300 million debt financing.  Private Capital Management (PCM), the 20% member, operated PCG’s mortgage business by PCM’s two beneficial owners, Thomas Donovan and Lawrence Cline.  The conflagration started a little over a year after operations began, in March 2007, when Ficus ousted Donovan and Cline and brought suit accusing them of misappropriating over $20 million.

The complex, high stakes litigation not surprisingly has generated millions in legal bills, which in turn has spawned a litigation within the litigation over the issue of the defendants’ entitlement to advancement and indemnification of legal expenses under the provisions of PCG’s operating agreement. 

A year ago I wrote about a January 2009 appellate decision in Ficus in which the court held that the primary defendant, Thomas Donovan, as a former officer of PCG was entitled to seek advancement of his legal defense costs under the operating agreement.  The primary issue there was whether the trial court’s issuance of preliminary injunctions against Donovan defeated his advancement rights.  Manhattan Commercial Division Justice Bernard Fried ruled (read here), and the Appellate Division affirmed (read here), that the ultimate determination of Donovan’s indemnification rights had no impact on his interim advancement rights under the operating agreement’s terms.  The rulings resulted in reimbursement to Donovan of approximately $1.5 million in legal fees incurred through the end of 2007, which was upheld by yet another appellate court ruling in June 2009 (read here).

As it turned out, 2007 was just a warm-up for the next year, in which Donovan incurred another $3.8 million in legal defense costs for which he also sought advancement.  Ficus opposed the bulk of the request, arguing that Donovan was not entitled to advancement for fees incurred opposing Ficus’s applications for discovery and contempt sanctions concerning Donovan’s alleged misconduct after he was terminated as an officer, during the course of litigation.  Donovan’s alleged misconduct included the "hacking" of former co-defendant Cline’s e-mail account — early in the case Cline and Ficus entered into settlement and cooperation agreements — and failing to turn over company books and records in violation of court order.

The arguments raised in this second go-round, and the court’s recent decision in favor of Ficus, raise novel legal issues with important ramifications for advancement and indemnification litigation in this and other cases.

Continue Reading Do Advancement and Indemnification Rights Include Defense Costs of Litigation Misconduct After Officer Leaves Company?

For years I’ve been carping about the substantive and procedural inadequacies of New York’s LLC judicial dissolution statute.  LLC Law Section 702, which was modeled after the rarely utilized limited partnership dissolution statute, consists in its entirety of the following two sentences:

On application by or for a member, the supreme court in the judicial district in which the office of the limited liability company is located may decree dissolution of a limited liability  company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.  A certified copy of the order of dissolution shall be filed by the applicant with the department of state within thirty days of its issuance.

At the time of the LLC Law’s adoption in 1994, the legislature’s minimalist approach made some sense because of tax considerations requiring avoidance of certain corporate characteristics including continuity of life.  The IRS’s subsequent implementation of check-the-box regulations freely permitting partnership tax treatment of LLCs, and the 1999 LLC Law amendments restricting member withdrawal from LLCs, largely eliminated the legislative rationale for Section 702 as enacted, leaving the statute, in my view, not up to the complex task of adjudicating LLC breakups (hence the title of my June 2002 article published in the New York State Bar Journal, Vol. 74, No. 5, "When Limited Liability Companies Seek Judicial Dissolution, Will the Statute Be Up to the Task?").

These observations are prompted by a recent decision by New York County Commercial Division Justice Bernard J. Fried in a case I’ve previously written about called Ficus Investments, Inc. v. Private Capital Management, LLC.  Ficus is a highly contentious dispute between LLC members involving accusations that the managing members misappropriated over $20 million.  Last January, an appellate ruling enforced the lead defendant’s right to advancement of his legal defense costs as provided by the operating agreement (see my earlier post here).

Continue Reading Application for Judicial Dissolution of LLC Must Be Made by Complaint or Petition, Mere Motion Will Not Suffice