Judges Thinking Outside the LLC Dissolution Box
The title of this week's post is inspired by two recent decisions in LLC dissolution cases in which courts crafted remedial measures that appear to venture into new territory in an effort to achieve efficient and equitable resolution of the parties' dispute.
In one case, the court ordered an appraisal proceeding for a buyout of the petitioning member's interest after denying his request to dissolve the LLC. In the other, involving a dispute between 50/50 managing members, the court appointed a temporary receiver with limited powers to monitor the LLC's financial activity.
The appraisal remedy was ordered by Commercial Division Justice Stephen A. Bucaria in Matter of Gold (Cosmo Holdings LLC), Short Form Order, Index No. 6722/11 (Sup Ct Nassau County Oct. 26, 2011). The petitioner in Gold is a 25% member and the respondent Kanter is a 75% member of a member managed LLC called Cosmo Holdings LLC formed in 2007 to invest in other companies. Each member made an initial capital contribution over one-half million dollars. The operating agreement provides that a member who wishes to sell his or her interest must first make an offer to the other member to sell at a mutually agreed upon price.
In 2009, Kanter removed Gold as a signatory on Cosmo's bank account. In May 2011, Gold petitioned to dissolve Cosmo based upon deadlock between the managing members. Gold also alleged that Kanter withheld financial information and refused to make distributions to Gold.
Justice Bucaria's decision first summarizes the standard for judicial dissolution of LLCs under §702 of the LLC Law, as construed by the Appellate Division, Second Department, in the 1545 Ocean Avenue case:
[LLC Law] §702 provides that a court may decree judicial 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 the operating agreement. Dissolution is a drastic remedy, which is not to be granted unless management is unwilling or unable to promote the company's stated purpose or continuing the company is financially unfeasible.
Justice Bucaria then turns to Cosmo's operating agreement, which in critical part provides that members holding a majority of the capital interests shall elect the managers. "As the holder of a majority membership interest," Justice Bucaria writes, "respondent [Kanter] has the authority to exclude petitioner [Gold] from the management of Cosmo." He then finds that Gold has not established that Kanter as managing member "is unable or unwilling to promote Cosmo's purpose of investment" and has not shown that "the continuation of Cosmo is financially unfeasible." Justice Bucaria accordingly denies Gold's application for judicial dissolution.
Does Gold go home empty handed, relegated to a passive-investor role for the life of the LLC? Not quite. Justice Bucaria's decision orders a buyout appraisal of Gold's membership interest in the LLC, stating as follows:
However, absent agreement between the parties as to buyout price, petitioner has the common law right to an appraisal proceeding for the purpose of determining the fair market value of her membership interest in the limited liability company (Appleton Acquisition, LLC v. National Housing Partnership, 10 NY3d 250, 256 [2008]). The parties shall conduct discovery as to the fair market value of petitioner's interest in Cosmo Holdings as of the date of the filing of the dissolution petition, May 5, 2011.
In the cited Appleton case, New York's highest court held that under the Revised Limited Partnership Law, a limited partner could not bring a plenary action under common law to seek rescission of a merger and, instead, was restricted to his or her statutory appraisal remedy.
Other New York courts have enforced an equitable buyout of an LLC membership, albeit under special circumstances where the courts characterized the relief as a species of "liquidation" based on a finding of grounds for dissolution, such as in Lyons v. Salamone, 32 AD3d 757 (1st Dept 2006), and Matter of Superior Vending, LLC, 71 AD3d 1153 (2d Dept 2010). As far as I know, the decision in Gold is the first instance in which a court granted a straight buyout remedy for an LLC member without there being a basis for dissolution. It will be interesting to see if other courts follow Gold's lead.
The second case, involving a less momentous but still novel remedy in an LLC dissolution proceeding, is Scomello v. Pascarella, 2011 NY Slip Op 51965(U) (Sup Ct Suffolk County Nov. 2, 2011). The LLC in Scomello operates a non-medical clinic offering various skin care and "appearance enhancement" treatments. The plaintiff and defendant, each owning a 50% interest in the member-managed LLC, filed suit and counter-suit accusing each other of various financial and management irregularities. The defendant's counter-suit included a claim for dissolution under LLC Law §702 and a request for appointment of a temporary receiver to manage the business pending the litigation. Both parties also moved for preliminary injunctive relief of various sorts.
The decision by Commercial Division Justice Emily Pines comments that the two members present "diametrically opposed allegations of what has occurred in their business relationship," and that "the continued operation of the LLC may depend on an equitable accounting in accordance with the [Operating] Agreement's provisions." To maintain the status quo and preserve the LLC's assets, Justice Pines permits the plaintiff member to continue managing the LLC but under a preliminary injunction that restrains either member from withdrawing LLC funds for himself without the other's consent, or otherwise transferring funds except in the ordinary course of business.
The novelty in Scomello is Justice Pine's appointment of a temporary receiver, not to manage the business, but simply to monitor its financial activities. Here's how she describes the scope of the receiver's duties:
Thus a limited preliminary injunction should remain in effect along with the appointment of a temporary receiver with limited powers to receive monthly statements and back up documents, setting forth all income received and expenses paid by the LLC as well as all member withdrawals and payments of any kind.
Why is this novel? As explained in a decision some years ago by Justice Leonard Austin before his elevation to the Appellate Division, the LLC Law's provisions governing judicial dissolution have no provision for appointment of a receiver until after dissolution is decreed. This omission stands in contrast to §1113 of the Business Corporation Law, which expressly authorizes a court in dissolution cases involving close corporations to appoint a temporary receiver with broad powers to preserve company assets while the dissolution case is pending. An alternative path to receivership for any type of business entity is provided in Article 64 of the Civil Practice Law and Rules, but the courts apply a much more rigorous showing of imminent harm to the business before acting under that Article -- a showing that does not appear to have been made in Scomello.
The monitoring powers granted by Justice Pines in Scomello effectively address a recurring problem in many dissolution proceedings -- not just LLCs -- where one side has little or no access to real-time financial information while the case goes on. Courts often will direct the controlling side to make ongoing disclosure but, almost invariably, new disputes will arise over the adequacy or timeliness of the disclosure. An independent receiver serving only as monitor, acting with the imprimatur of the court, is in a far superior position to enforce disclosure obligations and to convey information the non-controlling side as needed.
Sassower Case Illustrates Anew the Price of Poorly Drafted Buy-Sell Agreement
The case of Sassower v. 975 Stewart Avenue Associates, LLC is fast approaching poster-child status as an illustration of the headaches that can follow from poorly drafted valuation criteria in the buy-sell provision of a shareholders' or operating agreement.
The case involves a medical practice known as Cardiovascular Medical Associates, P.C. ("CMA"), whose seven doctors also owned the building housing the practice through a separate limited liability company named 975 Stewart Avenue Associates, LLC ("975 Stewart"). Dr. Sassower resigned from CMA in late 2007, triggering his obligation to offer his interest in 975 Stewart to the remaining doctors.
The CMA shareholders' agreement set forth an appraisal procedure for fixing the purchase price, whereby the exiting member and the company each hire an appraiser followed by an exchange of appraisal reports within 30 days. If the appraisals fall within 10% of each other, the purchase price is the average of the two; if more than 10%, the two appraisers select a third appraiser whose valuation opinion determines the price.
Nothing unusual about this arrangement. Rather, the problem is seeded in the provision's vague and inarticulate language purporting to establish either a standard or method of valuation. Specifically, the operative Section 8.5(c) of the agreement states that the two, party-appointed appraisers must use "the market value approach appraisal methodology" while further providing that the opinion of the third, neutral appraiser "shall establish the fair market value" of the offered interest.
In August 2008 the two sides exchanged appraisal reports based on an enterprise "market value" of $7.8 million (Dr. Sassower) versus $6.8 million (the company) and a purchase price for Dr. Sassower's 12.5% interest of $962,500 (Dr. Sassower) versus $850,000 (the company). Being more than 10% apart, the parties were required under Section 8.5(c) to engage a third appraiser.
Before that happened, however, the company's appraiser issued an amendment to its report stating as follows:
It is the understanding of this appraiser that there is an outstanding mortgage balance on the property in the amount of $2,668,750.00. At the request of the client, we have deducted the mortgage balance from the final value to arrive at an equity position value.
The deduction reduced the purchase price to about $512,000. (The amendment also newly applied a 20% discount, further reducing the purchase price to about $350,000, but the discount subsequently was withdrawn.)
The amendment ignited litigation which is about to enter its third year without resolution and in which, I hazard to guess, the parties are destined to incur attorney and expert fees rivaling if not surpassing the difference between their competing valuation figures.
Dr. Sassower struck first with a lawsuit seeking a declaratory judgment that the purchase price should not be reduced by the mortgage balance on the property. The company moved to dismiss the complaint based on documentary evidence, arguing that the agreement requires determination of the "equity" in the building net of the mortgage balance. In December 2008, in the first of several substantive decisions in the case, Nassau County Commercial Division Justice Ira B. Warshawsky denied the motion on the ground that the term "market value approach methodology" used in Section 8.5(c) is ambiguous. (Read decision here.)
In March 2009, the remaining doctors voted to voluntarily dissolve and liquidate 975 Stewart, which they contended mooted Dr. Sassower's buy-out. This led to a second written opinion by Justice Warshawsky in which he ordered the company to proceed with the buy-out, observing that the company "cannot opt to buy out the Plaintiff, then, when unhappy with the outcome of that decision, choose to dissolve the entity." (Read decision here.)
In that same decision, which I previously reported on here, Justice Warshawsky offered some future guidance for the unresolved valuation dispute, stating that "the sought after number is fair market value" and that the phrase "market value approach methodology"
is not an appraisal methodology, but a defined value to be arrived at by one of the three traditional appraisal approaches, namely, direct sales comparison, income capitalization, or replacement cost. For a building of the type owned by 975 Stewart, the most appropriate approach is the direct income capitalization approach, upon which both appraisers apparently relied. . . . The deduction of the outstanding mortgage on the property from the estimate of fair market value does not produce market value, but rather equity position value.
I won't say the guidance was all for naught, but based on yet another, recent decision by Justice Warshawsky, it's hard to discern any real evolution over the last year in the parties' diametrically opposed, all-or-nothing approaches.
The latest decision dated June 29, 2010 (read here) denied cross motions for summary judgment on the same, bedeviling question whether the mortgage balance must be deducted from the market value of the realty. Justice Warshawsky reframes the issue as follows, with a finishing hint of exasperation:
The Court concludes that the role of the Appraisers retained by the parties, or the Appraiser selected by the original two appraisers, is, at a starting point, to determine the market value of the subject property. This however, does not conclude their responsibility, because the Agreement calls upon them to establish the "purchase price of the Offered Interests". It appears that the question which should have been asked of the appraisers is "What would a typical buyer pay for an investment of a 12.5% interest in a building with a continuing first mortgage of what was $2,668,750 at the time of valuation?" This question has never been asked of them.
Justice Warshawsky then offers a series of observations explaining why summary judgment is inappropriate and, again, offering the parties future guidance on the path toward determination of the contractual purchase price.
First, he notes that the third appraisal was completed and that the parties agreed to accept $7.1 million as the fair market value of the realty on an unencumbered basis.
Second, he finds that the statements and deposition testimony of the doctors, offering their recollections of discussions (or lack thereof) and beliefs surrounding the mortgage deduction question, do not provide "adequate clarification to avoid the conclusion that there remains a question of fact as to what the parties intended."
Third, and perhaps most importantly, he offers a nuanced view of how an appraiser should approach the mortgage question, writing:
This may or may not involve simply deducting the mortgage principal from the estimated fair value. The value estimate may, for example, treat the mortgage interest payment as an additional expense in valuing the property under the Income Capitalization Approach, which the appraisals to date have not done. It may also consider whether or not the mortgage interest rate is above or below market, which could impact on the valuation process. This involves consideration as to whether a reasonably prudent investor would refinance so as to reduce interest payments if the existing rate is significantly above the currently available rates.
In the concluding portion of his opinion, Justice Warshawsky acknowledges the illogic of ignoring the mortgage, stating that it is "mathematically clear that distributing a proportionate share of full market value to a departing member will result in a depletion of the equity before the departure of the last members," and that this "unlikely" was the parties' intent. "But neither is it clear," he continues, "that the simplistic solution of deducting the mortgage from market value was unquestionably the intention of the parties."
I said it in my prior post on this case, and I'll say it again: the proper time to carefully consider and specify valuation parameters is when the company co-owners and their counsel sit down to draft the buy-sell provisions of the shareholders' or operating agreement. When parties fail to do so or, as in Sassower, employ confusing terminology, the temptation to adopt extreme valuation positions on both ends can take over, generating employment opportunity for lawyers and great expense to business owners.
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:
The Company and the Offering Member/New Member shall have ten (10) days to appoint a Qualified Appraiser. Upon appointment, both Qualified Appraisers shall each establish the purchase price of the Offered Interests, using the market value approach appraisal methodology, in a written opinion to the Company each such opinion to be delivered within thirty (30) days of the appointment of the latter of appraisers. If the difference between the two (2) appraisals is less than ten (10%) percent, then the valuation of the Offered Interests shall be the average of the appraisals. However, if the difference between the two (2) appraisals is more than ten (10%) percent, then the Qualified Appraisers shall mutually appoint a third Qualified Appraiser whose sole written opinion shall establish the fair market value of the Offered Interests. [Emphasis added.]
The Company and Sassower each retained an appraiser. The Company's appraiser valued Sassower's 12.5% interest at $850,000 versus Sassower's appraiser's valuation of $962,500 based on "market values" of $6.8 million and $7.8 million, respectively, for the entirety. The difference being more than 10%, the parties were required by Section 8.5(c) to secure a third, decisive appraisal.
The appraisals were exchanged in August 2008. Things started to go haywire when the Company sent Sassower an amendment to its appraiser's report, noting that the Company's property carried an outstanding mortgage balance of approximately $2.7 million and stating that, "at the request of the client [i.e., the Company]," it was reducing the value of the Company's equity by the amount of the mortgage, to a little over $4.1 million, which reduced the value of Sassower's 12.5% interest to about $350,000.
Sassower commenced a lawsuit the following month, seeking a declaration that the mortgage balance should not be deducted from the appraised market value in determining the price for his interest. Justice Warshawsky denied the Company's initial pre-answer motion to dismiss the complaint in a Short Form Order dated December 3, 2008, finding that the meaning of "market value approach methodology" as used in Section 8.5(c) was "not clear on its face" and could not be determined without further proceedings.
A month later, in January 2009, the Company's counsel wrote to the court contending that both appraisers had erroneously failed to deduct from their estimate of value the principal balance of the existing mortgage. The Company further contended that both appraisers had used overstated figures for the property's net operating income, and that utilizing the actual figures based on the existing net lease held by the medical practice would bring the two appraisals within 10% of each other and therefore obviate the third appraisal.
Two months after that, in March 2009, the remaining members of the Company voted to dissolve and liquidate the Company voluntarily, by virtue of which they sought anew to dismiss as moot Sassower's complaint to enforce the buy-out. Sassower countered with his own motion to enforce a September 2008 stipulation whereby the two sides had agreed to go forward with the third appraisal.
Justice Warshawsky's decision earlier this month denied the Company's motion to dismiss and granted Sassower's motion to enforce the stipulation. As to the former, the operating agreement specified that the remaining members' right to elect to dissolve in lieu of purchasing the departing member's interest was time-limited by the operating agreement's express terms. The purported voluntary dissolution in March 2009 therefore was too late, particularly given the remaining members' interim election to purchase and the exchange of appraisals. "In the opinion of the Court," Justice Warshawsky commented pointedly, "the Defendant cannot opt to buy out the Plaintiff, then, when unhappy with the outcome of that decision, choose to dissolve the entity."
The court's decision to enforce the stipulation also appears to provide some guidance for the third appraiser as to the underlying valuation dispute. Justice Warshawsky notes that, while the language in the operating agreement "is less than crystal clear," in his opinion "the sought after number is fair market value." The phrase "market value approach methodology," he concludes,
is not an appraisal methodology, but a defined value to be arrived at by one of the three traditional appraisal approaches, namely, direct sales comparison, income capitalization, or replacement cost. For a building of the type owned by 975 Stewart, the most appropriate approach is the direct income capitalization approach, upon which both appraisers apparently relied. . . . The deduction of the outstanding mortgage on the property from the estimate of fair market value does not produce market value, but rather equity position value.
It appears that in applying the income capitalization approach, both party-retained appraisers constructed a market rate rather than using the existing net lease between the Company and the medical practice -- presumably at a below-market rate -- prompting Justice Warshawsky to observe:
It would be inappropriate to rely upon this lease to determine market value. There is a good practical reason for not considering it. Certainly, if CMA decided to relocate and sell the property to a third party, they would sell free and clear of the existing lease and the arm's length purchaser would be free to impose market rent on his prospective tenants.
I frequently see buy-sell provisions in shareholder and operating agreements that leave it entirely to the appraisers how to arrive at their appraisal. I also see many agreements containing very specific appraisal parameters, e.g., dictating use of book value, specifically excluding or including good will or other identified assets and liabilities, and specifically including or excluding minority and marketability discounts. Counsel drafting such agreements must carefully consider the nature of the business, its tangible and intangible assets, and its actual and potential liabilities. Better yet, counsel not adequately familiar with appraisal methodology should consult with the company's outside accountant or a business appraiser before the agreement is signed.
It's impossible to know from the language used in Sassower whether the drafter and/or the doctors who signed the agreement thought the words "market value" meant the sale value of the unencumbered real estate less the mortgage balance, or, as Justice Warshawsky construed it, an income-based valuation. What's clear is that the ambiguous buy-sell provision in Sassower failed its essential purpose to provide a certain, speedy and litigation-free procedure for valuing a departing member's interest.
