Professional Corporations

exitDoes a shareholder have a fiduciary duty not to exercise a contractual right under the shareholders’ agreement to resign and demand a buy-out of his shares by the financially distressed corporation, particularly when the corporation’s default would trigger the other shareholders’ personal guarantees?

That’s the intriguing question posed in an unpublished decision last month by Nassau County Commercial Division Justice Vito M. DeStefano in Mondschein v Badillo, Decision and Order, Index No. 600307/14 [Sup Ct Nassau County Jan. 12, 2017], where a physician resigned from his struggling medical professional corporation amidst ultimately unsuccessful efforts to merge with another practice, and who then brought suit against the P.C., his fellow shareholders, and a related realty company that owned the practice’s medical office, to enforce his buy-out and retirement rights under the various agreements governing the two entities.

The agreements essentially gave senior physician-shareholders the right to retire with an obligatory buy-out by the entities of their equity interests in the practice and the realty, as well as payment of specified retirement benefits. In addition, each shareholder gave a joint-and-several personal guarantee of each other shareholder’s rights to payment. Continue Reading Race to the Exit as Professional Practice Falters

The cringe-worthy phrase, “legal equivalent of a proctology exam,” gained notoriety about ten years ago when its use by an attorney in a pre-litigation demand letter was cited by a federal judge as partial justification for a $50,000 sanction award which was later reversed on appeal. The phrase involuntarily leapt to mind when I read the recent post-trial decision by Suffolk County Commercial Division Justice Emily Pines in Suffolk Anesthesiology Associates, P.C. v. Verdone, 2012 NY Slip Op 50728(U) (Sup Ct Suffolk County Apr. 25, 2012), a bare-knuckles contest pitting an expelled physician-shareholder of a large Long Island anesthesiology practice against the 11 other physician-shareholders.

The parties’ very public charges and counter-charges of improper financial dealings, conflicts of interest and potentially serious healthcare law violations, none of which ultimately swung the case outcome, if nothing else offer a compelling argument for inclusion of a binding arbitration clause in the shareholder and employment agreements, thereby ensuring that the airing of the practice’s allegedly “dirty linen” will be confined to a private, confidential setting.

The Verdone case also offers healthcare transactional attorneys a cautionary lesson on drafting mandatory buyback provisions triggered by a shareholder’s departure from the practice, to avoid a draining battle as took place in Verdone over whether the expelled shareholder was terminated with or without cause.

Continue Reading Anesthesiology Practice Undergoes “Legal Equivalent of a Proctology Exam” in Shareholder Dispute

You’re an attorney.  It’s the year after you and your client happily settled via buy-out a dissolution case you brought on behalf of a minority shareholder in a close corporation.  Your former client leaves you a voice mail asking for a return call.  Her voice sounds upset.  When you call back, she tells you she just received a Schedule K-1 tax form from her old company for last year and, her voice rising with anxiety, that it allocates to her a substantial net income sum that she never received.  Surely, she says, it’s a mistake that must be corrected if she’s to avoid owing taxes on money she never got.  Isn’t it outrageous, she insists, that her former business partners are shifting taxes to her on earnings that stayed with the company for their benefit.

Outrageous or not, whether the client gets saddled with personal taxes on such “phantom” income likely will depend on the terms of the buy-out agreement.  If the selling shareholder and her counsel did not foresee the possibility of a positive net income allocation for that portion of the tax year preceding the buy-out’s effective date, and did not negotiate a tax payment in the buy-out agreement to the extent of any non-distributed allocation of net income, the former client likely will be writing a bigger check to Uncle Sam, and the attorney likely will not be getting repeat business from the client.  The likelihood of being stuck with a tax bill is even higher if, in addition, the parties exchanged general releases.

Case in point:  Troy v. Carolyn D. Slawski, CPA, P.C., 2011 NY Slip Op 30476(U) (Sup Ct NY County Feb. 28, 2011), decided earlier this year by Manhattan Supreme Court Justice Judith J. GischeTroy involves a law firm of four brothers organized as a P.C. (professional corporation) which, as is typically done, elected for pass-through partnership tax treatment as a subchapter “S” corporation.  The plaintiff was a 25% shareholder of the P.C.  In 2007, the majority shareholders filed a dissolution proceeding which was resolved by a stipulation and order of settlement.  Under the stipulation, plaintiff received $150,000 in exchange for surrendering his interests in the P.C. and a real estate holding company also owned by the brothers.

Continue Reading Beware Taxes on Phantom Income When Entering Into Shareholder Buy-Out Agreement

The P.C., as in professional service corporation, has been called a “strange creature.”  The strangeness stems mainly from the statutory restrictions on the voluntary or involuntary transfer of ownership in a P.C. to persons who are not licensed members of one of the regulated professions permitted to utilize the P.C. business form under Title 8 of the Education Law, including lawyers, doctors, dentists, accountants and miscellaneous others.

In New York, P.C.s are governed by the same general provisions of the Business Corporation Law (BCL) applicable to all for-profit business corporations, including Articles 10 and 11 of the BCL governing voluntary and judicial dissolution.  The P.C. ownership transfer restrictions, along with other provisions specific to the formation, operation, limited liability and disposition of P.C.s, are collected in Article 15 of the BCL.  The somewhat obscure interplay between the general dissolution provisions in BCL Articles 10 and 11 and the P.C. ownership transfer restrictions in Article 15 can create havoc for the professional in a multi-member P.C. who fails to appreciate those provisions or, worse yet, fails to enter into a shareholders’ agreement that protects the professional’s financial interests under various exit scenarios including death.

It’s hard to imagine a more painful illustration of such havoc than the case decided last week by a Brooklyn appellate court involving a P.C. dental practice in which the majority shareholder died without a shareholders’ agreement, called Matter of Bernfeld (Michael Bernfeld, D.D.S. and Yakov Kurilenko, D.D.S., P.C.), 2011 NY Slip Op 05071 (2d Dept June 7, 2011).  The deceased dentist’s widow, who had found a buyer for the practice’s assets for over a half million dollars, now stands to walk away empty handed as a result of the statutory default provisions that prevent her both from seeking judicial dissolution and from resisting the surviving shareholder’s right to have the P.C. purchase her late husband’s interest possibly at negative book value.

Continue Reading Case Illustrates How Not to Plan for the Death of a Shareholder in a Professional Corporation

The pictured courthouse in Mineola, New York, is home to the three judges of the Commercial Division of the Nassau County Supreme Court.  They are, in order of seniority on the Supreme Court bench, Justice Stephen A. Bucaria, Justice Ira B. Warshawsky and Justice Timothy S. Driscoll.  As someone who constantly monitors newly issued court decisions throughout New York State involving shareholder disputes and the like, I can say with a high degree of confidence that these three, prolific judges generate a greatly disproportionate share of the accessible decisions in business divorce cases.

Whether it’s because there’s something in Nassau County’s water that breeds dissension among business partners, or because these three judges like to write about business divorce cases, or because Nassau County Supreme Court makes more of its trial court decisions available online than other counties, I can’t say.  But I can say it provides a great service for attorneys in need of judicial guidance to help navigate and advise their clients through the perilous waters of business breakups.

Without further ado, I give you three recent decisions of interest by the three Justices of the Nassau County Commercial Division.

Justice Warshawsky Orders Arbitration of LLC Dissolution Petition 

In a post two months ago I wrote about a Montana Supreme Court decision that denied an application to compel arbitration of an LLC dissolution lawsuit because the arbitration clause in the operating agreement did not specifically mention dissolution, even though it broadly encompassed any dispute concerning “any activity conducted pursuant to” the operating agreement.  I also suggested that under New York law the outcome likely would be different.

Continue Reading New Decisions of Interest by Nassau County’s Commercial Division Judges

You’d think lawyers, of all people, would appreciate the importance of having a written agreement when teaming up to form a law firm.  If anything, the professional ethics rules guaranteeing the portability of clients make it even more imperative to plan for the comings and goings of law firm partners.  Yet I continue to see decisions in messy cases involving law firm breakups made messier by the absence of a written agreement.

I previously wrote about a trial court decision in one of the more interesting such cases involving the Nassau County law firm, Horing Welikson & Rosen, P.C., in which a trial judge ruled that an expelled 16% partner could not require the law firm to purchase his interest for book value as statutorily required for deceased or disqualified shareholders of professional service corporations.  That decision, by Nassau County Commercial Division Justice Ira B. Warshawsky, was affirmed last week on appeal to the Appellate Division, Second Department.  Lubov v. Horing & Welikson, P.C., 2010 NY Slip Op 03076 (2d Dept Apr. 13, 2010).

I’ll only briefly recap the facts which are laid out more fully in my prior post. The law firm was formed as a general partnership in 1989 and later converted to a professional service corporation.  The plaintiff started as a 30% shareholder of the professional corporation which was reduced to 16% by the time he was expelled by his partners in 1999.  After a trial, Justice Warshawsky ruled that there was no evidence of oral or written agreement requiring the defendants to redeem his shares.  The court also rejected the plaintiff’s alternative argument that he was entitled to be paid the book value of his shares under § 1510 of the Business Corporation Law.  Specifically, Justice Warshawsky held that the statute by its plain terms only requires a buyout for deceased or disqualified (i.e., de-licensed) shareholders of a professional corporation.  He also rejected the plaintiff’s public policy argument for extending the statute’s protection to involuntarily discharged shareholders.

Continue Reading Neither Statute Nor Public Policy Supports Buyout Right of Terminated Professional Corporation Shareholder

[Full disclosure: The author represented the prevailing shareholder in the dissolution proceeding and appeal discussed  below.]

After the court orders dissolution of a corporation owned 50/50 by two deadlocked shareholders, and the business’s tangible assets have been distributed equally pursuant to agreement, may one shareholder demand an appraisal of the corporation’s good will associated with the divided assets for the purpose of compelling the other shareholder to make payment for any disparity?

A decision last week by the Brooklyn-based Appellate Division, Second Department, in Matter of Ravitz (Gerard Furst and Marjorie Ravitz, DPM, P.C.), 2009 NY Slip Op 06437 (2d Dept Sept. 8, 2009), holds that the court lacks statutory authority to order such a valuation proceeding.

Ravitz involves a long-established podiatric practice organized as a professional corporation with two equal shareholders.  The practice operated out of three leased offices in Smithtown, Port Jefferson and Commack on Long Island.  In November 2007, Dr. R filed a petition for judicial dissolution of the practice based on deadlock and internal dissension under Section 1104 of the Business Corporation Law.  Dr. F opposed the petition.  The court, by Nassau County Commercial Division Justice Ira B. Warshawsky, granted the petition and dissolved the corporation in a short form order dated February 11, 2008.

The two doctors then agreed to close down the Commack office immediately; that the practice would cease operations June 30, 2008; that Dr. R would take over the Smithtown lease, furnishings and equipment; and that Dr. F would take over the Port Jefferson lease, furnishings and equipment.  They also agreed that neither one would use the practice’s trade name for their new, separate practices.

Continue Reading Appellate Court Upholds Denial of Good Will Appraisal in Deadlock Dissolution Case

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 Terminated Member of Professional Corporation is Not Entitled to Statutory Stock Redemption

A decision last week by New York’s highest court may have registered an uptick on the public’s schadenfreude meter, at least among the portion of the public who hold the legal profession in low esteem and who therefore might enjoy the sight of internecine warfare among splitting partners of a law firm.

In Ederer v. Gursky, 9 NY3d 514 (2007), Lawyer A joined and became a 30% shareholder along with Lawyer B (who then held 70%) of a small law firm organized as a professional corporation (PC). Several years later they re-organized the firm as a registered limited liability partnership (LLP) and took in three new partners who collectively held a 15% partnership interest, leaving Lawyer A with 30% and Lawyer B with 55%. Two years later, Lawyer A decided to leave the firm – according to him, because of a falling out with Lawyer B over a firm client; according to Lawyer B, because the firm was in financial dire straits for which Lawyer A was partially responsible – following which he entered into a written withdrawal agreement with the LLP setting forth various financial and case-sharing arrangements. Six months later, Lawyer A sued the LLP and each of its four remaining partners claiming breach of the withdrawal agreement and seeking an accounting and certain profit shares.

Garden variety financial disputes among former business or law partners do not usually garner the attention of New York’s Court of Appeals. This one did, however, because of the defendant partners’ reliance on a provision in the statute governing LLPs that, in general terms, shields partners of LLPs from vicarious liability for obligations of the LLP or for the negligence of their law partners. The case thus raised a novel question of statutory construction whether Section 26(b) of the Partnership Law was meant to protect only against partner liability asserted by third parties or whether, as the defendants argued, it also encompasses liabilities among the partners.

The Court’s decision traces the highly interesting history of partnership liability laws, including the nationwide surge of LLP formations in the aftermath of the savings and loan crisis of the 1980s when regulators went after deep-pocketed law firms to recover massive bank losses. In a 5-2 majority decision, the Court handed victory to Lawyer A by concluding that Section 26(b) only addresses a partner’s vicarious liability for partnership obligations to third parties and does not extend to claims among the partners of the LLP.

The dissenting judges note that Lawyer A’s withdrawal caused the firm’s finances to deteriorate and thereby rendered the firm unable to satisfy its obligations under the withdrawal agreement. They raise two provocative questions: Under these circumstances why should a former law partner be able to collect the firm’s debt from the “innocent” individual partners where a third-party creditor could not, and why should partners of an LLP be saddled with an obligation from which they would be shielded had the firm remained organized as a PC? The majority’s decision, laying emphasis on statutory construction rather than policy, means it will be up to the legislature to amend the law if it sees the same anomaly as do the dissenters.

Update (May 2, 2008)In Kuslansky v. Kuslansky, Robbins, Stechel & Cunningham, LLP, 50 AD3d 1100 (2d Dept 2008), the Appellate Division, Second Department, under the authority of the Court of Appeals’ Ederer decision, reversed a lower court’s decision dismissing an action brought by a former law firm partner for breach of contract based on the alleged failure of the defendants to pay him the value of his interest in the subject partnership as provided for in the parties’ partnership agreement upon a partner’s withdrawal from the partnership.

 

Individuals and companies have a choice of entities – some requiring more formalities than others – through which to pool their resources and efforts in pursuit of a common business goal. Joint ventures and general partnerships are on the less formal side of the spectrum and are often used in the early stages of a business project to keep costs down before the project’s viability is established, and before limited liability becomes an issue. Until the proliferation of limited liability partnerships and like statutory business forms, many professional firms including lawyers and doctors traditionally operated as general partnerships.

It is not uncommon for written joint venture or partnership agreements to include a buy-sell agreement. If the joint venture or partnership later converts to a corporation or limited liability company, and the owners do not make a superseding shareholder or operating agreement, is the prior agreement enforceable when a shareholder or LLC member wants out or seeks judicial dissolution?

The answer is complicated by a long line of New York case precedent, most notably Weisman v Awnair Corp., 3 NY2d 444 (1957), decided by New York’s highest court, holding that a partnership may not exist where the business is conducted in corporate form, and parties may not be partners between themselves while using the corporate shield to protect themselves against personal liability.

A couple of newer decisions by intermediate appellate courts, however, take a modified approach to the issue permitting enforcement of the pre-conversion agreement. In Matter of Hochberg (Manhattan Pediatric Dental Group, P.C.), 41 AD3d 202 (1st Dept 2007), two dentists formed a practice and entered into a partnership agreement containing an arbitration clause and also requiring that a partner seeking dissolution first offer his interest to the other. Years later they converted the practice to a professional corporation, but without making a new agreement. When one of them later sought dissolution, the other sought to compel arbitration under the old partnership agreement. The appellate court, reversing the trial court’s decision, ruled that such pre-conversion agreements are enforceable as long as the rights of creditors or other third parties are not involved and the parties’ rights under the partnership agreement are not in conflict with the corporation’s functioning. Judicial dissolution of the dental practice would be inappropriate, the court added, in that it would allow avoidance of the buyout provisions by seeking such dissolution.

The best practice, of course, is to make a new written agreement when converting to a new form of entity, or at least indicate in writing whether the old agreement survives the conversion.