powerlessAn appellate decision last week sounds alarm bells for minority members of New York LLCs that have no operating agreement and for anyone considering becoming a minority member of an LLC without first having in place an operating agreement.

By the same token, the decision provides opportunities for majority members of existing LLCs without operating agreements to cement and expand their control powers.

Last week’s unanimous decision by the Manhattan-based Appellate Division, First Department in Shapiro v Ettenson, 2017 NY Slip Op 00442 [1st Dept Jan. 24, 2017], affirmed the lower court’s order enforcing an operating agreement signed by two of the LLC’s three co-founding, co-equal members, adopted two years after the LLC’s formation without the signature or consent of the LLC’s third member. Among other features, the operating agreement departed from the statutory default rule by authorizing the reduction of the percentage interest of a member who fails to satisfy a capital call approved by the majority, which is exactly what the two majority members did following their adoption of the agreement, along with eliminating the minority member’s salary. Continue Reading Thinking About Becoming a Minority Member of a New York LLC Without an Operating Agreement? Think Again

CondoThis post concerns an atypical form of business organization — the condominium — in the context of disputes over access to books and records. Access to books and records is a subject that has garnered increased judicial attention in recent years as more New York litigants and their counsel discover the utility of commencing summary proceedings to enforce statutory and common-law inspection rights of shareholders in traditional corporations and of members of LLCs.

What I find most interesting is the seemingly expansive approach the courts have taken in upholding inspection rights regardless of business form based on common law rather than statute, as reflected in two cases decided last month involving condominiums.

Unincorporated Condo vs. Incorporated Co-op

The most recent government census data tallies over 300,000 co-op apartment units in New York City and over 100,000 condominium units. The approximate 3:1 ratio is destined to shrink, however, as the number of new and converted condominium buildings coming onto the market in recent years has far exceeded new and converted co-op buildings, among other reasons, due to the strong preference for condominium ownership by foreign buyers and less onerous restrictions on re-sale. Continue Reading Courts Expand Books and Records Access for Condo Owners

subsidiary

Two decisions do not a trend make, but I can’t shake the feeling that the Appellate Division, First Department, is telling trial judges to take a broader view of shareholder statutory and common-law rights to inspect corporation books and records.

The first decision, two years ago, was the McGraw-Hill case which I reported on here. In that case, the First Department reversed a lower court’s ruling denying a shareholder’s inspection petition under Section 624 of the Business Corporation Law and common law. The petitioner sought records concerning the McGraw-Hill Board of Directors’ oversight of purported wrongdoing by its wholly-owned subsidiary, the Standard & Poor’s credit rating agency. The appellate ruling focused on the proper-purpose standard, holding that the petitioner’s stated purpose to investigate alleged misconduct by McGraw-Hill’s management and obtaining information that may aid in litigation are proper purposes “even if the inspection ultimately establishes that the board had engaged in no wrongdoing.” Essentially, the ruling eliminated the Catch-22 of requiring outside shareholders to tender proof of management wrongdoing to gain access to company records enabling them — or not — to show wrongdoing.

The petition in McGraw-Hill sought records of the parent company in which the petitioners held shares, not the subsidiary. Last week, in Matter of Pokoik v 575 Realties, Inc., 2016 NY Slip Op 06648 [1st Dept Oct. 11, 2016], in a decision of apparent first impression, the First Department again reversed a lower court ruling denying inspection rights and held that the petitioner was entitled under the common law to inspect records of the corporation’s wholly-owned subsidiary. Continue Reading Ruling Upholds Shareholder’s Right to Inspect Subsidiary’s Books and Records

shortsTraditions are good. This blog has two annual traditions. First, at the end of each year I write a post listing the year’s top ten business divorce decisions. Second, each August I offer readers who are (or ought to be) on summer vacation some light reading in the form of three, relatively short case summaries.

So here we are in what’s been a particularly felicitous August weather-wise (at least here in the Northeast U.S.), with another edition of Summer Shorts. This edition’s summaries feature two out-of-state cases — one from Florida involving expulsion of an LLC member and one from Delaware involving the valuation upon redemption of an LLC member’s interest — and a New York appellate court decision involving the removal of a limited partnership’s general partner.

The Anti-Chiu: Florida Court Upholds LLC Member’s Expulsion

Froonjian v Ultimate Combatant, LLC, No. 4D14-662 [Fla. Dist. Ct. App. May 27, 2015].  The Florida intermediate appellate court’s ruling in Froonjian makes for a fascinating contrast with New York case law represented most prominently by the Second Department’s 2010 decision in Chiu v Chiu holding that, absent express authorization in the LLC’s operating agreement, a member’s involuntary expulsion is not permitted. Going 180° in the other direction, the Froonjian court upheld the majority members’ expulsion of a minority member from a Florida LLC that had no operating agreement, reasoning that the Florida default statute vesting all decision-making authority in the members acting by majority vote encompasses the authority to expel a member. Continue Reading Summer Shorts: Member Expulsion and Other Recent Decisions of Interest

Unclean HandsJudicial dissolution of a business entity, whether pursuant to statute or common law, is an equitable remedy subject to equitable defenses, including the doctrine of “unclean hands.”

As described a few years ago by Justice Emily Pines in the Kimelstein dissolution case, the unclean hands doctrine “bars the grant of equitable relief to a party who is guilty of immoral, unconscionable conduct when the conduct relied on is directly related to the subject matter in litigation and the party seeking to invoke the doctrine was injured by such conduct.”

The doctrine has been employed in dissolution cases in two ways. First, it can defeat a petitioner’s standing to seek dissolution, as in Kimelstein where Justice Pines held that the petitioner’s admitted concealment from his ex-wives, creditors and federal government of his alleged, undocumented 50% equity interest in two corporations owned by his brother barred him from asserting the requisite stock holdings to seek statutory dissolution. Second, even when the petitioner’s stock ownership is conceded, the doctrine can bar the petitioner’s dissolution claim on the merits.

The doctrine’s latter use rarely has been successful. A recent exception is Sansum v Fioratti, 128 AD3d 420 [1st Dept 2015], in which the Appellate Division, First Department, ordered the dismissal of a common-law dissolution claim brought by a 6% shareholder in an art gallery based on the plaintiff’s “embezzlement” of company funds for which he pled guilty to larceny and related charges. The decision packs an even more powerful punch by virtue of the court’s summary disposition of the claim, disagreeing with the lower court that a hearing was required and invoking the doctrine of in pari delicto (Latin for “in equal fault”) to reject the plaintiff’s counter-argument, that the defendant stockholders themselves conducted illegal business operations. Continue Reading Wash Hands Before Suing

OppressionFor the second time, a unanimous panel of the Manhattan-based Appellate Division, First Department, has upheld the pretrial dismissal of an action for judicial dissolution of a limited liability company under Section 702 of the LLC Law where the petitioning minority member based the claim solely on allegations of “oppressive” conduct by the majority member.

The first time was about two years ago, in Doyle v Icon, LLC (103 AD3d 440), in which the First Department reversed a lower court’s denial of a motion to dismiss a § 702 petition alleging that the controlling members had “systematically excluded” the minority member from the LLC’s business operations and profits. The court held that such allegations “are insufficient to establish that it is no longer ‘reasonably practicable’ for the company to carry on its business, as required for judicial dissolution under Limited Liability Company Law § 702.”

In so ruling the Doyle court adopted the standard for dissolution formulated in the Brooklyn-based Second Department’s landmark decision in the 1545 Ocean Avenue case, requiring a showing that, in the context of its operating agreement, the LLC’s stated purpose can no longer be achieved or that it is financially unfeasible. Justice Austin’s opinion in that case carefully differentiated the grounds for dissolution under LLC Law § 702 from those under Article 11 of the Business Corporation Law including the latter’s statute authorizing dissolution for “oppressive” conduct by the controlling shareholders and directors.

The First Department did it again last week in a case called Barone v Sowers, 2015 NY Slip Op 04195 [1st Dept May 14, 2015], involving a complaint brought by a 20% member of a single-asset realty holding LLC against the 80% member, alleging a series of derivative claims alongside a claim for dissolution under § 702. The unanimous appellate panel affirmed the lower court’s decision by Justice Eileen Rakower dismissing the dissolution claim and also dismissing the derivative claims for failure to adequately allege that pre-suit demand was excused.  Continue Reading Oppression Claims Don’t Cut It in LLC Dissolution Cases

RegretA Manhattan appellate panel’s unanimous decision last week in Brummer v Red Rabbit, LLC, 2015 NY Slip Op 02912 [1st Dept April 7, 2015], affirmed the dismissal of an LLC member’s claims for fraud and fiduciary breach based on the controller’s alleged concealment of impending equity investments by a pair of venture capital firms while the member was negotiating a partial buy-out of his membership interest.

The court held that the controller’s allegedly false representations regarding the company’s value and non-disclosure of investor interest “were neither relied upon nor material to plaintiff’s decision to sell.”

It’s an interesting contrast, to put it mildly, with the PF2 Securities case that I wrote about last week, in which a trial court refused to dismiss a minority shareholder’s fiduciary breach claim also based on an allegedly under-valued buy-out and the controller’s alleged withholding of financial information. In that case, the court held that the shareholder was “entitled to receive a fair market value for his stock after fair and complete disclosure and valuation.”

The complaint in Brummer (read here) alleged that around 2005 the plaintiff invested $25,000 in consideration of a 7% membership interest in a start-up venture called Red Rabbit that delivers “healthy” meals and snacks to New York metro area schools. After a period of modest growth, in 2010, the controlling member offered to buy back 6% for $28,500 using a percentage-of-revenue formula based on 2010 annual revenue of $475,000. He subsequently raised the offer to $40,000 which the plaintiff accepted, leaving plaintiff with a 1% membership interest. Continue Reading Another Case of Seller’s Remorse Bites the Dust

“[T]he Court concludes that it lacks subject-matter jurisdiction to dissolve a Delaware corporation, and thus dismisses the First Cause of Action.”

Sounds familiar? It should. The above ruling, found in Nassau County Commercial Division Justice Timothy S. Driscoll’s decision last month in Bonavita v Savenergy Holdings, Inc., Short Form Order, Index No. 603891-13 [Sup Ct Nassau County Dec. 8, 2014], adds to the growing list of cases in New York’s Second and Third Departments in which courts have declined subject-matter jurisdiction over claims for judicial dissolution of a foreign business entity. It also accentuates the schism, about which I’ve previously written, between decisions in those Departments and a smaller number of First Department rulings upholding jurisdiction in similar cases.

The plaintiffs in Bonavita, likely aware of the Second Department precedent stacked against them, took a somewhat different tack by asserting in their complaint’s First Cause of Action (read here) a claim for common-law dissolution of the subject Delaware corporation rather than a statutory claim for judicial dissolution under Article 11 of the Business Corporation Law. (Delaware has no statute authorizing judicial dissolution at the behest of a minority shareholder.) Continue Reading Court Declines Jurisdiction Over Claim for Common-Law Dissolution of Delaware Corporation

A Manhattan appellate panel’s two-page decision in Gartner v Cardio Ventures, LLC, 2014 NY Slip Op 07423 [1st Dept Oct. 30, 2014], offers a dry account of a disputed transfer of an LLC membership interest, in which the court held that the terms of an LLC subscription agreement did not bar the transfer otherwise permitted under the LLC Law’s default rules.

But the story behind the decision is anything but dry. As revealed in papers filed in the lower court proceedings, the suit was brought by the ex-husband of the transferee in an attempt to frustrate a Florida court’s final judgment of divorce, requiring him to transfer to his wife one half of his membership interest in a company that operates physical therapy offices at multiple New York locations. The judgment further provided that if the transfer couldn’t be done, the wife would receive the net economic benefits of the half-interest.

Soon after the divorce judgment was entered, the husband signed a court-approved transfer document instructing the LLC to transfer half his 4% interest to his wife. The other LLC members promptly executed a consent to the transfer, admitting the wife as a 2% member.

The now ex-husband, who had fiercely resisted the transfer in the Florida divorce proceedings and had signed the transfer directive under the court’s threat of contempt, subsequently filed suit in Manhattan Supreme Court against the LLC, its managers, and his ex-wife, claiming that the transfer was “unauthorized” and “illegal,” and should be rescinded, because of language in his LLC Subscription Agreement purportedly barring the transfer of membership interests. Continue Reading LLC Subscription Agreement No Bar to Transfer of Membership Interest

Think of it this way: At every negotiation of a shareholder buyout involving an S corporation or other passthrough entity, there are three parties at the table — the seller, the buyer, and the IRS.

Why the IRS? The commonly understood answer, even to those lacking tax expertise, is the seller’s liability for capital gains tax on buyout proceeds in excess of the seller’s basis in the shares.

Less appreciated, especially to those without tax expertise, but potentially of equal or even greater financial impact, is the seller’s liability for ordinary income taxes on undistributed a/k/a phantom income that may be reported on his or her Form K-1 issued by the passthrough entity after the buy-out closes for a tax period that preceded the buyout. For this type of tax liability, think of the IRS as a tax allocator which, at the direction of the remaining shareholders who control the company’s tax reporting, will reduce some portion of their personal income tax liability by allocating undistributed net income to the selling shareholder who will be forced to pay ordinary income taxes on phantom income. While this also should reduce the seller’s capital gain on the sale by increasing basis in the shares, overall the seller loses because of the significantly higher tax rates on ordinary income versus capital gains.

This is a topic I’ve written about several times before, featuring cases in which the seller’s release barred a post-buyout suit seeking reimbursement for taxes on phantom income (read here) or where the seller relied unsuccessfully on tax provisions in the buyout agreement that didn’t support indemnification of taxes on phantom income (read here and here). Add to this collection a case decided last month by the Appellate Division, First Department, which handed the selling shareholder a double defeat by finding that his release barred his claim to recover taxes on phantom income and also ordering him to pay attorneys’ fees incurred by the corporation and its majority shareholder defending the seller’s suit under the buyout agreement’s indemnification provision. Sina Drug Corp. v Mohyuddin, 2014 NY Slip Op 07757 [1st Dept Nov. 13, 2014]. Continue Reading Negotiating a Buyout? Don’t Overlook Taxes on Phantom Income