It Only Took 16 Years: New York Appellate Court Defines Standard for Judicial Dissolution of Limited Liability Companies
No more complaining about the absence of appellate guidance on the standard for judicial dissolution of limited liability companies under §702 of the LLC Law. Finally, almost 16 years after the cryptically-worded statute became law, the Appellate Division, Second Department, in Matter of 1545 Ocean Avenue, LLC, 2010 NY Slip Op 00688 (2d Dept Jan. 26, 2010), offers a carefully considered explanation of what §702 means -- and what it doesn't mean -- in a decision also notable for a two-judge dissent from the majority's disposition of the case without an evidentiary hearing.
As discussed below, the 1545 Ocean opinion's motif is fidelity to the LLC's operating agreement. This contract-centric approach sharply distinguishes LLC dissolution from partnership and close corporation dissolution cases in which implied fiduciary duties and untethered notions of fairness permeate the courts' analysis. It also brings New York LLC jurisprudence closer in line with Delaware's approach to LLC dissolution fueled by the admonition contained in §1101(b) of the Delaware LLC Act, to give "maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements."
It's no surprise that the signed opinion's author is Associate Justice Leonard B. Austin (pictured) who was appointed to the appellate bench in 2009 after serving ten years as trial judge in the Commercial Division of the Nassau County Supreme Court. Justice Austin's Commercial Division caseload, among other types of business disputes, included a steady influx of judicial dissolution proceedings involving closely held corporations and LLCs. That experience undoubtedly gave him a first-hand feel for the analytical and practical difficulties posed by these cases and an appreciation of the legal and business community's need for greater certainty in applying the broad and undefined terms of the dissolution statutes.
There's another reason I'm not surprised by Justice Austin's authorship. In June 2002, I wrote an article for the New York State Bar Association Journal on LLC dissolution (read it here) in which I observed that most of the few cases decided to that point freely borrowed from corporate dissolution norms applicable in cases involving oppressed minority shareholders and internal dissension. I did, however, cite a trial court decision in a case called Matter of Quinn, NYLJ Apr. 20, 2000, p. 32, col. 6 (Sup. Ct. Nassau County), as the sole example I'd found of a court, consistent with §702's language, focusing on whether the complained-of grounds for dissolution conformed to the members' operating agreement. The judge who decided Quinn? Justice Austin.
Now let's examine the 1545 Ocean decision.
The Facts
1545 Ocean Avenue, LLC ("1545 LLC") was formed in late 2006 as a manager-managed LLC with two 50% members, Crown Royal Ventures, LLC ("Crown Royal") and Ocean Suffolk Properties, LLC ("Ocean Suffolk"). Crown Royal and Ocean Suffolk entered into a written operating agreement for 1545 LLC in which Crown Royal designated its principal, John King, as one of the two managers and Ocean Suffolk designated its principal, Walter Van Houten, as the other manager.
Article 4.1 of the operating agreement contained a somewhat atypical management clause for 50-50 LLCs, authorizing "any one Manager [to] take any action permitted under the Agreement, unless the approval of more than one of the Managers is expressly required [by the Agreement]."
The two members each contributed 50% of the capital used to purchase commercial real estate located in Bohemia on Long Island. 1545 LLC's purpose was to purchase the property, rehabilitate an existing building (Building A) and build a second building on the property (Building B) for commercial rental.
King and Van Houten agreed to solicit third-party bids for the demolition and construction work. They also agreed that Van Houten, who owned his own construction company, Van Houten Construction ("VHC"), could submit bids subject to the managers' approval.
Ultimately VHC undertook the work on Building A, with Crown Royal later alleging that VHC did so without King's consent whereas Ocean Suffolk contended that the two managers agreed to hire VHC when there were no bona fide third-party bids. King also claimed that VHC began the work without necessary permits, did not have the proper equipment and consequently overbilled for the work. King alleged that he agreed to pay VHC's invoice on condition that it would cease further work without King's consent. VHC continued working on the site without King's consent.
Tensions between King and Van Houten further escalated following a dispute over hiring a contractor for environmental remediation work. According to King, Van Houten refused to meet on a regular basis, proclaimed himself to be a "cowboy" and stated that he would "just get it done". In April 2007, King announced that he wanted to withdraw his investment from 1545 LLC and proposed to notify all vendors that Van Houten was taking over. Van Houten viewed King as having resigned as manager. King's attorney sent Van Houten a "stop work" demand which was ignored. The two exchanged competing buy-out proposals of each other's interest, without resolution. Meanwhile, VHC continued to work unilaterally on the construction project which was within weeks of completion when Crown Royal sued for judicial dissolution and obtained an interim injunction preventing further work.
The Dissolution Petition
Crown Royal's petition alleged, as the sole ground for dissolution, deadlock between the managers arising from Van Houten's claimed violations of Article 4 of the operating agreement. The petition did not allege fraud or frustration of the purpose of 1545 LLC on the part of Ocean Suffolk, Van Houten or VHC.
Ocean Suffolk's answer to the petition opposed dissolution and denied any violation of the operating agreement. It alleged, without dispute, that the renovation of Building A was within 3-4 weeks of completion when the litigation commenced. It also alleged that, in anticipation of a buy-out of Crown Royal's interest, the parties had been operating as if Van Houten was sole manager. Ocean Suffolk thus contended that there could be no manager deadlock as a result of King's resignation as manager, even though King did not submit a written resignation as required by Article 4.8 of the operating agreement.
The Lower Court's Dissolution Order
In December 2007, the lower court issued a bare-bones order granting the dissolution petition (read it here). The order makes no factual findings, merely stating that judicial dissolution of an LLC "will be ordered only where the complaining member can show that the business sought to be dissolved is unable to function as intended, or else that it is failing financially," and that review of the papers submitted and the conferences conducted with the court "clearly demonstrates to this Court that 1545 is unable to function as intended."
Justice Austin's Majority Opinion
Ocean Suffolk appealed the order of dissolution to the Brooklyn-based Appellate Division, Second Department. Justice Austin's opinion for the 5-judge panel reverses the lower court's order, denies the petition and dismisses the proceeding. Presiding Justice Steven Fisher, joined by Associate Justice Cheryl Chambers, wrote a partial dissent in which he would have remitted the matter to the lower court for a fact-finding hearing to determining whether Crown Royal's petition met the newly-articulated standard for dissolution.
- The LLC Dissolution Statute Distinguished from its Corporate and Partnership Counterparts
The analysis section of Justice Austin's opinion in 1545 Ocean, as its first order of business, tells the bench and bar what the standard for LLC dissolution is not, namely, it is not the standard developed for close corporations under the Business Corporation Law (BCL).
Upon the enactment of New York's LLC Law in 1994, the statute contained a single section denominated §702 governing judicial dissolution of the newly recognized entity. The section provides in its entirety as follows:
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. [Emphasis added.]
As I wrote in my 2002 article on LLC dissolution, the section's sparse language -- drawn from the limited partnership dissolution statute but rarely examined in the partnership case law -- created a vacuum into which many judges imported the relatively well-developed grounds for dissolution employed in cases involving close corporations under BCL §§1104 and 1104-a. It's easy to understand why courts did so given the many similarities between, on the one hand, corporate shareholder-officers and, on the other, LLC member-managers, at least when it comes to the day-to-day realities of their internal relations and the pressures that lead to internal dissension.
Justice Austin notes that §702 was left unchanged when the LLC Law was amended in 1999 to conform to changes in federal tax treatment of LLCs (citing my 2002 article in that regard), and from that concludes:
since the Legislature, in determining the criteria for dissolution of various business entities in New York, did not cross-reference such grounds from one type of entity to another, it would be inappropriate for this Court to import dissolution grounds from the Business Corporation Law or Partnership Law to the LLCL.
He then observes that, while there is no definition of "not reasonably practicable" in the context of LLC dissolution, "[s]uch standard . . . is not to be confused with the standard for the judicial dissolution of corporations or partnerships" (citations omitted). He notes that the BCL and Partnership Law by statutory definition apply only to business corporations and partnerships, respectively, and that "[l]imited liability companies thus fall within the ambit of neither the Business Corporation Law nor the Partnership Law." He also cites §102(m) of the LLC Law, which likewise excludes corporations and partnerships from its ambit, in concluding that "the existence and character of these various entities are statutorily dissimilar as are the laws relating to their dissolution."
- The Court's Articulation of the Standard for Dissolution under §702
Having told us what the statute is not, Justice Austin next turns to the central question of §702's meaning. He notes that prior New York cases involving LLC dissolution "have avoided discussion of this standard altogether" leaving the issue unresolved. He also remarks upon the absence of case precedent construing the similarly-worded standard for dissolution under the limited partnership law.
The "not reasonably practicable" standard is linked textually in §702 to "conformity with the articles of organization or operating agreement." This linkage leads Justice Austin to state, quite significantly, that
LLCL 702 is clear that unlike the judicial dissolution standards in the Business Corporation Law and the Partnership Law, the court must first examine the limited liability company's operating agreement (see Matter of Spires v Lighthouse Solutions, LLC, 4 Misc 3d at 432) to determine, in light of the circumstances presented, whether it is or is not "reasonably practicable" for the limited liability company to continue to carry on its business in conformity with the operating agreement (id. at 433). Thus, the dissolution of a limited liability company under LLCL 702 is initially a contract-based analysis. [Emphasis added.]
The absence of New York precedent leads Justice Austin to look to LLC caselaw in other states with the same statutory standard for dissolution. Prominent among these cases is the Delaware Chancery Court's decision last year in Matter of Arrow Investment Advisors, LLC, 2009 WL 1101682 (Del Ch Apr. 23, 2009), where the court dismissed a minority member's application for dissolution of an investment advisory firm that had ceased its advisory business and essentially was reduced to a holding company for the firm's remaining cash and securities assets. The Chancery Court looked to the LLC agreement's broad purpose clause ("such . . . lawful business as the Management Committee chooses to pursue") in holding that, as quoted in 1545 Ocean,
"The court will not dissolve an LLC merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC's owners originally envisioned; such events are, of course, common in the risk-laden process of birthing new entities in the hope that they will become mature, profitable ventures. In part because a hair-trigger dissolution standard would ignore this market reality and thwart the expectations of reasonable investors that entities will not be judicially terminated simply because of some market turbulence, dissolution is reserved for situations in which the LLC's management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock or where the defined purpose of the entity has become impossible to fulfill. . . . Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue."
Other out-of-state cases cited by Justice Austin include Dunbar Group, LLC v Tignor, 267 Va 361, 593 SE2d 216 (2004), where the Supreme Court of Virginia, calling the statutory standard for dissolution a "strict one," reversed an order of dissolution based on deadlock between two 50-50 members of an LLC after the lower court had expelled one of the two members from participating in management; Kirksey v Grohmann, 2008 SD 76, 754 NW2d 825 (2008), where the South Dakota Supreme Court found the standard satisfied in a deadlock situation that left two of four sisters without any meaningful say in the LLC's business affairs contrary to the operating agreement; and a partnership case, Taki v Hami, 2001 WL 672399 (Mich. App. 2001), in which a Michigan appellate court granted dissolution where the two partners had not spoken in years and there were allegations of violence and expulsion.
Drawing on these cases, as well as the language of §702, Justice Austin announced the court's interpretation of the standard for LLC dissolution as follows:
After careful examination of the various factors considered in applying the "not reasonably practicable" standard, we hold that for dissolution of a limited liability company pursuant to LLCL 702, the petitioning member must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.
Notice how the two prongs of the standard -- I'll call them failed purpose and financial failure --are stated in the disjunctive but that each must be analyzed through the prism of the operating agreement or, if there is no operating agreement, in light of the LLC Law's default provisions. This is a significant shift from the less refined and arguably more liberal standard articulated in the one trial court decision that had gained a following, Schindler v. Niche Media Holdings, 1 Misc 3d 713 (Sup Ct NY County 2003), where the court wrote that dissolution of an LLC under §702 is available only if the company "is unable to function as intended, or else that is it failing financially." Henceforth, financial failure alone will not be enough to justify the drastic remedy of dissolution unless such failure is accompanied by, or results from, a frustration of the LLC's purpose that cannot be addressed or remediated by the operating agreement or articles of organization.
Notice also that, in contrast with the formulation recently used by the Delaware Chancery Court in the Lola Cars v. Krohn Racing case (read my post on Lola here), the 1545 Ocean court's formulation does not specify manager deadlock as a basis for dissolution. Indeed, Justice Austin elsewhere in his opinion states that deadlock, while expressly made a basis for dissolution of close corporations under BCL §1104, is not an "independent ground for dissolution" under §702. The court instead "must consider the managers' disagreement in light of the operating agreement and the continued ability of [the LLC] to function in that context." Presumably such consideration of deadlock fits within the unable-to-achieve-LLC's-purpose aspect of the failed-purpose prong, whereas the unwilling-to aspect seems better suited to dissolution cases brought by petitioners holding a minority membership interest.
- The Court's Application of the Standard
Crown Royal argued for dissolution based on the parties' failure to hold regular meetings, failure to achieve quorums, and deadlock over the construction work and, in particular, Van Houten's continuation of the work using VHC despite King's objections. Writing for the 3-judge majority, Justice Austin held that Crown Royal's allegations "failed to meet the standard for dissolution enunciated here" and that, additionally, "there are numerous factors which support the conclusion that dissolution of 1545 LLC is inappropriate under the circumstances of this case."
Why did Crown Royal's petition fall short of the standard? First and foremost, Article 4.1 of the operating agreement (quoted above in the Facts section) permits one manager to act unilaterally unless the other manager's approval is expressly required. As Justice Austin noted, "[t]his provision does not require that the managers conduct the business of 1545 LLC by majority vote." Rather, he continued,
[i]t empowers each manager to act autonomously and to unilaterally bind the entity in furtherance of the business of the entity. The 1545 LLC operating agreement, however, is silent as to the issue of manager conflicts. Thus, the only basis for dissolution can be if 1545 LLC cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created. In this case, that is the development of the property which purpose, despite the disagreements between the managing members, was being met.
The operating agreement likewise did not require regular meetings or quorums. Instead, it merely provided for meetings to be held at such times as the managers "may from time to time determine." The record before the court, Justice Austin found, "demonstrates that the managers, King and Van Houten, communicated with each other on a regular basis without the formality of a noticed meeting which appears to conform with the spirit and letter of the operating agreement and the continued ability of 1545 LLC to function in that context."
What other circumstances rendered dissolution inappropriate? Justice Austin identifies three. First, the dispute between King and Van Houten "was not shown to be inimicable to achieving the purpose of 1545 LLC." King "never objected to the quality of Van Houten's construction work, but only to its expense". King "approved and praised" the work which was all but complete as to Building A.
Second, LLC Law §411 permits an LLC to avoid contracts entered into between it and an interested manager or another company in which a manager has an interest, unless the manager can prove the contract was fair and reasonable. Crown Royal could have, but did not, take action against the contract with VHC under §411. On the contrary, Justice Austin stressed, Crown Royal "ratified, albeit grudgingly at times, Van Houten's unilateral efforts." In any event, he continued, "a fair reading of LLCL 702 demonstrates that an application to dissolve 1545 LLC does not flow from a claim under LLCL 411."
Third, if aggrieved by Van Houten's actions as manager Crown Royal has an alternative remedy in the form of a common law derivative action under Tzolis v. Wolff, 10 NY3d 100 (2008). Such remedy, however, "cannot serve as the basis for dissolution unless the wrongful acts of a managing member which give rise to the derivative claim are contrary to the contemplated functioning and purpose of the limited liability company."
Justice Fisher's Partial Dissent
Justice Fisher's partial dissent begins with the observation that he has "no serious quarrel" with the standard for dissolution adopted by the majority. He briefly recounts the "growing disputes" between King and Van Houten over the latter's alleged mismanagement and billing improprieties in connection with the construction project. Justice Fisher states that Van Houten disputed many of King's allegations, and he notes that the lower court "made no findings of fact." Without such factual findings, he continues,
we cannot meaningfully decide whether the Supreme Court providently exercised its discretion in finding that the actions of the parties rendered it not reasonably practicable for 1545 LLC to carry on its business in conformity with its articles of organization or operating agreement. Accordingly, I would remit the matter to the Supreme Court, Suffolk County, for a fact-finding hearing and thereafter for a new determination on the petition (cf. Business Corporation Law § 1109; Sobol v Les Pieds Nickels, 262 AD2d 194, 196; Matter of Giordano v Stark, 229 AD2d 493, 494-495).
The requirement or not of a hearing in judicial dissolution proceedings can be as important to the outcome of the dispute as the formulation of the dissolution standard. I've seen dozens of appellate decisions reversing the grant or denial of a dissolution petition due to the lower court's failure to conduct an evidentiary hearing in the presence of conflicting affidavits concerning material issues of fact. I doubt that the majority's summary dismissal of Crown Royal's petition is intended to signal a change in direction on that score. Rather, the majority's disposition likely reflects its belief, not shared by the dissenters, that even crediting all of Crown Royal's factual allegations, along with its admissions as to the quality of VHC's work, it still does not meet the threshold for judicial dissolution of 1545 LLC.
Under §5601(a) of the Civil Practice Law and Rules, the dissent by two justices of the Appellate Division may permit Crown Royal to appeal as of right to New York's highest court, known as the Court of Appeals, at least with respect to the issue of its entitlement to a hearing. We'll just have to wait and see whether Crown Royal exercises its appellate rights or, perhaps, reaches some buy-out agreement or other accommodation with its business partner.
Addendum: Read here Professor Larry Ribstein's commentary on the Ocean 1545 case, from which I here quote his concluding paragraph emphasizing the importance of careful drafting of the LLC agreement:
In short, it seems that NY is joining Delaware in emphasizing the role of the operating agreement in judicial dissolution cases. As noted above, this could emerge as an important distinction between LLCs and close corporations, and therefore a factor in choice of form. It also places new emphasis on the need for care in drafting the operating agreement. However, New York has not yet explicitly embraced the operating agreement as determinative. We will have to await further developments to see if New York can shed its long legacy of close corporation law in LLC dissolution cases.
Contender to 50% Stock Interest Wins Decisive Round in Battle Over Nominee Agreement
I previously reported on a March 2009 appellate decision in a case called Yemini v. Goldberg involving a fight over stock ownership in a holding company called ANO, Inc. The appeals court reversed a trial court decision denying Oded Goldberg's application for a preliminary injunction against Ari Yemini. The dispute centered on the enforceability of a Nominee Agreement that identified Goldberg as the "true owner" of a 50% interest in ANO and designated Yemini as Goldberg's nominee to act on the latter's behalf with respect to the acquisition and operation by ANO of what became a two-thirds interest in another company called Candlewood Holdings, Inc. The appeals court held that the Nominee Agreement was an enforceable "declaration of trust" notwithstanding that Goldberg's 50% interest never was reflected in ANO's corporate records or tax returns, or that other corporate documents including a shareholders agreement expressly identified Yemini as 100% stockholder, or that Goldberg omitted ANO in his net worth affidavit in legal proceedings with his ex-wife.
Now the other shoe has dropped on Yemini. Following the appellate decision Goldberg moved for partial summary judgment prohibiting Yemini from holding himself out as ANO's 100% owner and directing Yemini to issue and deliver certificates to Goldberg's wholly-owned assignee, Goldberg Commodities, Inc., reflecting its 50% ownership of ANO. In addition to the Nominee Agreement, Goldberg offered evidence of his funding of the Candlewood acquisition and a subsequent $1.5 million loan agreement that identified each of Goldberg and Yemini as 50% owners of ANO.
In opposition, Yemini contended that the Nominee Agreement was subject to a verbal agreement conditioning its effectiveness on Goldberg investing in the Candlewood acquisition. Yemini alleged that the approximately $200,000 Goldberg claimed to have invested in fact was cash provided by Yemini to Goldberg, which Goldberg deposited and then wire transferred to ANO's account, and thus represented Yemini's contribution, not Goldberg's. Yemini also offered a $122,000 promissory note dated over a year later from Goldberg to Yemini, and a letter from Goldberg a few years after that referring generally to a "verbal agreement" surrounding the Nominee Agreement.
The decision dated November 17, 2009 (2009 NY Slip Op 32745(U)), by Nassau County Commercial Division Justice Stephen A. Bucaria, rejected Yemini's contentions as unsupported by any probative evidence, and it therefore granted Goldberg's summary judgment motion. Justice Bucaria found that Yemini offered no documentary proof that he gave the funds to Goldberg, such as a signed receipt, or that Yemini even had the cash available. He found no connection between the promissory note and the funds used to finance the Candlewood acquisition. Justice Bucaria also cited Yemini's testimony that those funds eventually were repaid to Goldberg, and he found that Goldberg's letter referring to a "verbal agreement" reinforced Goldberg's position rather than weakened it. In the letter, Goldberg revoked Yemini's authority as his nominee, which made no sense unless Yemini was Goldberg's nominee in the first place.
Justice Bucaria also faulted Yemini's position for attempting to vary the terms of the Nominee Agreement, writing as follows:
When the parties set forth their entire agreement in a writing, a party may not introduce extrinsic evidence or prior or contemporaneous statements to establish that a different oral agreement exists. (See, e,g., W.W.W. Associates, Inc. v. Giancontieri, 77 NY2d 157, 162) ("Evidence outside the four corners of the document as to what was really intended but unstated or misstated is generally inadmissible to add or vary the writing."); Braten v. Bankers Trust Co., 60 NY2d 155 (refusing to enforce oral agreement that contradicted the terms of the parties' written agreement); Harris v. Hallberg, 36 AD2d 857, 2nd Dept., 2007). Plaintiff's [Yemini] argument is contradicted by the express wording of the ANO Nominee Agreement that states the agreement is effective as of the date of the agreement.
The second issue addressed in the decision is Goldberg's transfer of his 50% interest in ANO to his company, Goldberg Commodities. Goldberg asserted that he wanted the interest to be held by Commodities because the funds for his capital contribution came from Commodities via its lending facility and to take advantage of Commodities' tax situation. Yemini argued that he never would have consented to the transfer because Commodities' pre-existing debt might impair Candlewood's ability to secure outside financing. He also argued that a provision in the Candlewood shareholders' agreement prohibited any transfer of Goldberg's ANO interest without the consent of the third Candlewood investor named Moore.
Justice Bucaria readily dispatched Yemini's objections. First, there was no written agreement with Goldberg, or any provision in ANO's bylaws, that prohibited the transfer to Commodities. Second, Moore testified at the hearing that he had no objection to the transfer so long as Goldberg remained the 100% owner of Commodities.
Re-reading the prior lower court decision by Justice Leonard Austin (who subsequently was elevated to the Appellate Division) denying Goldberg's injunction motion, what comes through is the court's disdain for Goldberg's "unclean hands" based on the concealment of his interest in ANO from his ex-wife and tax authorities. The subsequent appellate reversal paid no attention to those factors in finding that the Nominee Agreement was enforceable in accordance with its plain terms. Perhaps what makes this case different from others in which the courts have refused relief based on somewhat similar circumstances is Yemini's apparent knowing participation in at least some of the artifices.
Nominee Agreement Trumps Corporation Records in Fight Over Stock Ownership
I recently did a series of postings on challenges to standing in corporate dissolution cases where the petitioners lacked stock certificates or other conclusive evidence of their share ownership (see here, here and here). I didn't expect to return to the topic so soon, but a new decision out of the Appellate Division, Second Department, reversing a lower court's order denying injunctive relief, warrants another visit.
The case, Yemini v. Goldberg, involves a fight over the ownership of a New York corporation called ANO, Inc. which is an acronym for Ari N Oded, Ari being plaintiff Ari Yemini and Oded being defendant Oded Goldberg.
ANO was formed in June 1999 to purchase an interest in another company called Candlewood Holdings, Inc. The only ANO stock certificate ever issued was issued on June 22, 1999, to Yemini who also was identified as sole director and shareholder in corporate resolutions adopted the same date.
On July 1, 1999, ANO acquired a 50% interest in Candlewood (later increased to two-thirds). On that same date, Yemini and Goldberg entered into a "Nominee Agreement" denominating Goldberg as "Principal" and Yemini as "Nominee". The Nominee Agreement contains the following two recitals:
WHEREAS, the Principal is the true owner of fifty (50%) percent of the common stock of ANO, Inc., a New York corporation (the "Corporation");
WHEREAS, the Nominee shall act as nominee for the Principal in connection with said Corporation and in connection with the Stock Acquisition Agreement by and between ANO and Candlewood Holdings, Inc.("Candlewood"), dated as of July 1, 1999 (the "Stock Acquisition Agreement".
The Nominee Agreement contains provisions authorizing the Nominee to take all actions required to purchase the Candlewood interest; requiring the Nominee to provide the Principal with all documents concerning ANO; prohibiting the Nominee from taking any action with regard to the Principal's interest in ANO without the Principal's express instructions; and appointing the Principal the Nominee's attorney-in-fact with the power to execute all agreements, instruments, etc. required to be signed by the Nominee.
In 2005, Yemini sued Goldberg for the latter's alleged failure to make certain capital contributions for a separate business venture. Apparently, by this time Yemini refused to acknowledge Goldberg as owning any interest in ANO, prompting a countersuit by Goldberg and an application by him for preliminary injunction with regard to a meeting of the shareholders of Candlewood.
The matter proceeded to an 11-day evidentiary hearing before Nassau County Commercial Division Justice Leonard B. Austin (recently elevated to Associate Justice of the Second Department), who denied Goldberg's injunction motion in a decision reported at 15 Misc 3d 1142(A), 2007 NY Slip Op 51117(U) (Sup Ct Nassau County 2007).
Justice Austin found that, other than the Nominee Agreement and ANO's name, there were "no indicia of ownership of ANO or any interest therein" by Goldberg. In addition to the stock certificate and resolutions mentioned above, Justice Austin pointed to a Candlewood shareholders agreement and employment agreement that identified Yemini as sole shareholder, both of which agreements Goldberg knew about when they were executed in July 1999, and to ANO's tax returns which, with Goldberg's knowledge, also identified Yemini as sole shareholder. Justice Austin further noted that, until the litigation, Goldberg never asserted rights as a shareholder of ANO or demanded a turnover of the ANO stock.
Justice Austin also held that Goldberg was unlikely to succeed on the merits because he lacked "clean hands" and was estopped from taking inconsistent positions. This arose primarily from Goldberg's involvement in legal proceedings with his ex-wife in 2002, in which he filed a net worth affidavit that omitted mention of ANO as an asset. "A party, such as Goldberg", Justice Austin wrote,
who has hidden an interest in ANO from his wife in a matrimonial action, has failed to disclose this interest to a lender and repeatedly failed to disclose the interest in ANO to the tax authorities, has unclean hands and cannot obtain relief.
Not so fast, says the Second Department in a decision on Goldberg's appeal ordering that he be granted a preliminary injunction based on the Nominee Agreement. Yemini v. Goldberg, 60 AD3d 935, 2009 NY Slip Op 02353 (2d Dept 2009). Here's the key passage from the appellate decision:
Parties are free to make their own arrangements regarding beneficial ownership of securities as definitive between them (see UCC § 8-207[a], Official Comment 3; Delaware v New York, 507 US 490, 505). This nominee agreement "constituted a declaration of trust" (Brotman v Meyers, 41 AD2d 547, 547). It is irrelevant that Yemini at all times retained ownership of the ANO stock certificates (see Matter of Benincasa v Garrubbo, 141 AD2d 636, 638).
The appellate decision does not comment on the issue of unclean hands relating to Goldberg's non-disclosure of his ANO stock interest in his matrimonial case. It does state, however, that judicial estoppel does not apply because there is no evidence that Goldberg "secured a judgment in his favor in the proceeding in which he allegedly took an inconsistent position".
The lower court and appellate decisions do not relate Goldberg's reasons for wanting the Nominee Agreement, or refer to any testimony from Yemini explaining his reasons for executing it. In my experience, such arrangements usually are driven by tax considerations. In other cases courts have refused to uphold undocumented stock ownership claims in the face of contradictory tax or other official filings. This case is different because the lawyer-prepared Nominee Agreement contains the adverse shareholder's explicit, signed recognition of the disputed stock interest.
Mandatory Arbitration of Dissolution Proceedings
Many shareholders' agreements include clauses requiring the parties to arbitrate their disputes. Do such clauses apply when a shareholder seeks judicial dissolution of the corporation based on deadlock or shareholder oppression under Sections 1104 and 1104-a of the Business Corporation Law?
Courts answer the question with an emphatic "Yes". As a matter of public policy, courts strongly favor arbitration and will readily stay litigation proceedings and compel arbitration when the dispute falls within the scope of the applicable agreement's arbitration clause. Generally speaking, where the arbitration clause is broad, there arises a presumption of arbitrability, and arbitration of even a collateral matter will be ordered if the issues in the case implicate issues of construction of the shareholders' agreement or the parties’ rights and obligations under it. Judicial dissolution proceedings alleging deadlock or oppression invariably raise allegations of breach or, even absent breach allegations, turn on the parties' rights and obligations under the shareholders' agreement. But even absent specific allegations of breach, courts will find that the dissolution petition is arbitrable.
Here's an example. In Matter of Tlapanco (Las Pobanitas Inc.), the petitioner filed a court petition for judicial dissolution of a corporation with two 50% shareholders under BCL Section 1104. The corporation operated a restaurant. Petitioner alleged that the restaurant had never shown a profit and that he was no longer employed there. His petition also alleged various breaches of the shareholders' agreement. The other shareholder asked the court to stay the litigation and to compel arbitration under the following, typical clause in the shareholders' agreement:
Any dispute arising under the terms of this Agreement shall be resolved by arbitration in accordance with the rules of the American Arbitration Association then obtaining in New York, New York and judgment on the award of the arbitrators may be entered in any court having jurisdiction thereof. Such arbitration shall be a condition precedent to any suit upon or by reason of such claim or controversy.
The court granted the application to compel arbitration. After noting that state policy favors arbitration as a means of resolving disputes and conserving judicial resources, the court continued:
When parties adopt a "'broad' arbitration clause agreeing . . . to submit to arbitration all disputes arising out of the contract," the court's inquiry is limited to determining whether there is a reasonable relationship between the dispute and the contract. [Citation omitted.] Even a judicial dissolution proceeding has been submitted to arbitration on the ground that the issues of whether and how "shareholders should sever their corporate ties is more than reasonably related to the general subject matter of the agreement establishing those ties." (Ehrlich v. Stein, 143 AD2d 908, 910 [2d Dept 1988]).
In a similar case, Matter of Kushner (Smiles Candy Corp.), decided by Nassau County Commercial Division Justice Leonard B. Austin, the court compelled arbitration of a shareholder oppression dissolution proceeding even though the respondent majority shareholder never formally moved to compel arbitration.
The lesson of these cases is clear: A broad arbitration clause in the shareholders' agreement will require arbitration of an involuntary dissolution petition whether or not the petitioner alleges specific breaches of the agreement. In my experience, this is more of an issue, and a bigger disappointment for a petitioner, when the dissolution proceeding does not convert to a buyout and valuation proceeding, thereby likely requiring extensive discovery and adjudication of complex deadlock or oppression issues, and where the hostile parties are likely to encounter ongoing disputes as co-managers of the business while they pursue their legal remedies.
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:
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.
The third part, Section 1102(c), authorizes limitations on member access to LLC records to protect trade secrets and other confidential information, if set forth in the operating agreement, as follows:
If provided in the operating agreement, certain members or managers shall have the right to keep confidential from other members for such period of time as such certain members or the managers deem reasonable, any information which such certain members or the managers reasonably believe to be in the nature of trade secrets or other information the disclosure of which such certain members or the managers in good faith believe is not in the best interest of the limited liability company or its business or which the limited liability company is required by law or by agreement with a third party to keep confidential.
It's worth taking a moment to compare Section 1102 to its counterpart under the New York Business Corporation Law (BCL). BCL Section 624 is less generous than LLCL Section 1102 in its specification of the types of records that shareholders may inspect, although courts also have recognized a broader, common-law right of inspection of corporate records. Section 624 also sets forth a more complicated procedural apparatus for asserting inspection rights, including a requirement that the shareholder furnish an affidavit that the inspection is not desired for any purpose other than the business of the corporation, and that the shareholder has not within five years sold or offered to sell a list of the corporation's shareholders. LLCL Section 1102 has no affidavit requirement. Section 624, unlike Section 1102, also contains express authorization for a spurned shareholder to commence a special proceeding by order to show cause to enforce inspection rights.
My case research has uncovered only two decisions in proceedings by a non-managing LLC member to enforce inspection rights under LLCL Section 1102. The earlier of the two cases, Matter of Hay, Index No. 602587 (Jan. 16, 2007) (read decision here), arose from a family business dispute involving several real estate companies organized as LLCs in which the petitioners, John Hay and his Trust, held a one-third interest. Petitioner's brother, Henry Hay, managed the LLCs. Prior to commencing the proceeding, John demanded that Henry permit inspection of various records including operating statements, lease-related documents, loan documents, appraisals, documentation of company expenses, and meeting minutes, articles of organization, etc. Petitioners claimed that the documents were needed to investigate possible mismanagement by Henry. Henry initially objected to the demand as burdensome, overbroad and harassing. Subsequently he turned over some of the records and agreed to produce the balance requested but only on condition that John pay charges for the time and expenses incurred by the LLCs' management company and accounting firm, as well as copying expenses. John rejected the conditions and commenced the legal proceeding. Henry maintained his willingness to provide all the requested records upon the previously stated conditions, and asked the court to deny the petition if John refused to accept them.
In a decision by Justice Marilyn G. Diamond of the New York County Supreme Court, the court held that John failed to justify the broad scope of his inspection demand and did not adequately explain his refusal to absorb the expenses identified by Henry. The court ordered that Henry was entitled to inspect, at his expense, only those items falling within the five document categories specified in LLCL Section 1102(a), stating as follows:
Here, petitioners suggest that the phrase "just and reasonable" [as used in LLCL Section 1102(b)] should be broadly interpreted so as to allow them the right to inspect records which go well beyond the scope of the type of documents detailed in the Limited Liability Company Law. The court declines to do so. Petitioners have not offered any justification for their request to inspect documents such as leases, invoices and checks other than a vague interest in investigating the possibility that Henry Hay has defrauded or mismanaged the companies. Indeed, petitioners have offered no proof of any wrongdoing by Henry Hay and have not explained why the information they seek would not be available in a lawsuit and/or in an arbitration proceeding which is already pending and apparently involves at least some of the same parties. Petitioners also have not adequately explained the basis for their rejection of respondents' offer to produce the documents at petitioners' expense given that the statute itself provides that it is the requesting member who must bear the expense of any such inspection. Under the circumstances, petitioners' inspection of records maintained by the three LLC respondents should be limited to the five categories of documents specifically mentioned in section 1102(a) of the Limited Liability Company Law and the inspection must be at their expense.
A more liberal approach to inspection rights of non-managing LLC members is reflected in the second decision, Matter of O'Neill, Index No. 15126/06 (May 9, 2007) (read decision here). In O'Neill, two non-managing members of an LLC, each with a 5% interest, brought a Section 1102 special proceeding to obtain access to the LLC's books and records. The LLC operated a nursing home. The petitioners alleged that the LLC's managing director improperly entered into a management contract with a certain third party in violation of Department of Health regulations. Petitioners contended that the contract jeopardized the LLC's ability to acquire interests in other nursing homes. They also contended that inspection of records was needed because the managing director had sold, or was in the process of selling, his membership interest to the third party in violation of petitioner's first refusal rights under the operating agreement.
The company opposed the petition. It argued that the petitioners offered no proof of the management contract's illegality or of any sale or impending sale of the director's membership interest. It also argued that the operating agreement gave the managing director full discretion to enter into management contracts. It further argued that petitioners were entitled to inspect only those documents specified in LLCL Section 1102(a)'s five categories.
The court's ruling, by Justice Leonard B. Austin of the Nassau County Supreme Court Commercial Division, rejected the company's restrictive reading of inspection rights and emphasized Section 1102(b)'s broadening of those rights beyond the five Section 1102(a) categories, to include inspection of financial statements "and other information regarding the affairs of the limited liability company as is just and reasonable". Here's the decision's key passage:
Limited Liability Company Law Section 1102(b) also gives any member of a limited liability company the right to inspect all of the limited liability company's records so long as such inspection is reasonably related to the member's interest. See, 16 NY Jur2d Business Relationships Section 2070. Restrictions on a member's right to inspect the records of a limited liability company must be contained in the operating agreement. Limited Liability Company Law Sections 1102(b), (c). Respondent does not assert any of these limitations are relevant to this application.
Respondent's assertion that petitioners must demonstrate a need to review the records before such records are made available is without merit. The only statutory requirements for obtaining full access to the records is that the person demanding access is a member at the time the demand is made and that the demand is reasonably related to the member's interest.
Under this standard, Justice Austin had no trouble finding that the O'Neill petitioners' request for inspection based on their stated concerns, over the third-party management contract and possible impairment of their first refusal rights, was reasonably related to their membership interest.
It is possible to reconcile the different outcomes in Hay and O'Neill, if for no other reason, based on the refusal by the petitioners in Hay to pay the inspection expenses. The fact that there was a concurrent arbitration in Hay may also have suggested to the court that the proceeding was being used to bypass discovery restrictions in the arbitration. Nonetheless, it is hard to ignore the disparate approaches taken by the two courts on the core issue of statutory inspection rights under LLCL Section 1102. Hay places the burden squarely on the member seeking inspection to justify access to company records beyond the five categories listed in Section 1102(a). In contrast, O'Neill presumes broad inspection rights of all company records and places the burden on the company to justify restrictions based on either the operating agreement's provisions or the need to maintain confidentiality, as provided in Sections 1102(b) and (c).
New York's LLC Law is "only" 14 years old. Like so many other issues under the LLC Law, it will take more time for the courts to work out all the kinks, including the issue of inspection rights.
LLC Dissolution and Receivers
New York’s statutory scheme for dissolution of closely held business entities sometimes looks like a crazy quilt. For instance, for reasons that defy all logic, a petition for dissolution of a business corporation based on shareholder oppression triggers an absolute right on the part of the other shareholders to avoid dissolution by purchasing the petitioner’s shares for fair value, but if the petition is based on director or shareholder deadlock, there’s no buyout right. A petition for dissolution of a business corporation requires service upon the state tax commission and publication notice of the order to show cause in advance of the hearing, but no such service or publication is required in a proceeding for judicial dissolution of a limited liability company (LLC).
Here’s another. The statute governing judicial dissolution of LLCs, contained in Section 702 of the LLC Law (LLCL), has no provision for appointment of a temporary receiver to protect the company’s assets pending the dissolution proceeding. In contrast, Section 1113 of the Business Corporation Law (BCL) expressly authorizes a court to appoint a temporary receiver for that purpose in a dissolution proceeding.
The divergence on this point between the BCL and the LLCL is highlighted in a recently decided case called At the Airport, LLC v. Isata, LLC, 15 Misc 3d 1145(A) (Sup Ct Nassau County June 6, 2007). The case was brought by a 20% member of an LLC seeking its dissolution based on income diversion, financial mismanagement, and denial of access to company records. In a decision by Nassau County Supreme Court Justice Leonard B. Austin, the court notes that the only provision of the LLCL authorizing appointment of a receiver or liquidating trustee, found in LLCL Section 703(a), by its terms applies after the company has been dissolved. Said the court, "[petitioner] is putting the cart before the horse since there must first be a finding of the right to judicial dissolution before a receiver can be appointed."
The petitioner in that case was forced to seek appointment of a temporary receiver under the more formidable standards for receivership found in Article 64 of the Civil Practice Law and Rules. The court held that he failed to make the requisite clear showing that the company’s property was in imminent danger of being materially injured or destroyed, and therefore denied the application for appointment of a receiver.
The petitioner in the same case fared no better on a subsequent application for reconsideration based on newly discovered evidence (read opinion here). If anything, the court's second ruling makes the point more emphatically, that compared to applications involving corporations under the BCL, the courts have strictly limited authority to appoint a temporary receiver for an LLC prior to an order of dissolution.
Dissolution and Restrictive Covenants
Under the Mohawk Maintenance doctrine, named after a case decided by New York’s highest court, the seller of a business including its good will is under an implied covenant not to solicit the seller’s former customers. Yet to be decided by the same court, although it’s come close on a couple of occasions, is whether a stock buyout resulting from an election to purchase in a dissolution proceeding likewise triggers the implied covenant. The key issue in these cases in whether the sale is deemed to be one “under compulsion” and therefore not within the Mohawk Maintenance rule. Lower court decisions have been less than uniform in their approach and the results.
A dissolution case decided earlier this year raised the issue anew in an interesting context. In Matter of Autz, 16 Misc 3d 1140(A) (Sup Ct Nassau County 2008), the antagonists were minority and majority shareholders in a professional corporation that operated walk-in medical clinics. The petitioner sought dissolution as an oppressed minority shareholder under Section 1104-a of the Business Corporation Law (BCL). The majority shareholder did not elect to purchase the petitioner’s shares. Rather, he consented to dissolution and asked the court (a) to determine that the corporation is not a going concern, and (b) to order a liquidation sale of the corporation’s hard assets and the division of its receivables. The petitioner sought a sale of the corporation as a going concern, inclusive of good will, along with a determination that such a sale is voluntary and therefore imposes a restrictive covenant upon the unsuccessful shareholder-bidder.
In a decision by Justice Leonard B. Austin of the Nassau County Supreme Court, Commercial Division, the court ruled that there was evidence that the corporation had saleable good will, but that a transfer of shares resulting from an involuntary dissolution, in the absence of an election to purchase the petitioner’s shares for fair value under BCL Section 1118, is a sale under compulsion and thus does not implicate the non-solicitation covenant.
Like so many other issues that come to haunt partners who find themselves embroiled in business divorce litigation, covenants not to compete or to solicit customers and employees are most efficiently dealt with in a shareholders agreement made at the beginning of the relationship.
