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.
"Unclean Hands" Defense Can Backfire in Deadlock Dissolution Case
The seminal New York case defining "oppressive" conduct under the statute authorizing a minority shareholder to seek corporate dissolution, Matter of Kemp & Beatley, Inc., 64 NY2d 63, 74 (1984), cautioned that a minority shareholder "whose own acts, made in bad faith and undertaken with a view toward forcing an involuntary dissolution, give rise to the complained-of oppression should be given no quarter in the statutory protection." This language gave birth to what has become known as the "unclean hands" defense in shareholder oppression cases under Section 1104-a of the Business Corporation Law (BCL). The unclean hands defense often is based on allegations that the petitioning minority shareholder secretly is involved with or planning to launch a competing business to steal the customers and good will of the company whose dissolution is sought.
Over the years since Kemp, the unclean hands defense also has crept into dissolution cases brought by a 50% shareholder under BCL Section 1104 based on deadlock and internal dissension. Unlike oppression cases under Section 1104-a, where the minority shareholder must prove some form of at-fault or unfair conduct by the majority, cases under Section 1104 focus on the deterioration of the relationship between the two 50/50 shareholders and the resulting corporate paralysis, without necessarily assigning fault to one side or the other.
A recent decision by Nassau County Commercial Division Justice Stephen A. Bucaria, in Matter of Rieger (Airmarine Electroplating Corp.), Short Form Order, Index No. 010524/09 (Sup Ct Nassau County Aug. 27, 2009), illustrates the difficulty of maintaining the unclean hands defense in a deadlock dissolution case where, absent compelling proof, the allegations of inequitable conduct by the petitioner can themselves contribute to the court's sense of shareholder hostility and corporate dysfunction warranting dissolution.
Rieger involved a fight between brother and sister Ernest and Laurie Rieger. The Riegers are 50/50 shareholders of Airmarine Electroplating Corp. which is in the business of refurbishing airplane parts. The Riegers also co-own a second company called Airlift Hydraulics which holds the FAA certificate enabling Airmarine to receive FAA aircraft component refurbishing manuals.
Ernest filed a petition for judicial dissolution of Airmarine under Section 1104 based on animosity and dissension between himself and his sister. He alleged that they could not reach agreement on how to manage the corporation; that the ensuing deadlock prevents the corporation from benefiting the shareholders; and that no purpose would be served by holding a shareholders or directors meeting.
Laurie sought dismissal of the petition based on Ernest's "unclean hands". As described in Justice Bucaria's decision, Laurie claimed that Ernest was seeking to dissolve Airmarine
to create his own personal corporation using the same clients and the same FAA certificate that are used by [Airmarine]. Laurie alleges that her theory is bolstered by the fact that Ernest does not seek to dissolve Airlift Hydraulics, because then he would no longer be in possession of the FAA certificate and would not be able to open his own personal Aircraft refurbishing corporation.
Laurie also alleged that her brother was misappropriating corporate funds, taking excessive salary, and "hiding" documents from her.
The court's reference to Laurie's "theory" may or may not indicate a lack of hard proof of her brother's plans to start his own refurbishing business. In any event, Justice Bucaria held that her unclean hands defense was not adequate to stave off dissolution since "'the critical consideration is the fact that dissension exists and has resulted in a deadlock precluding the successful and profitable conduct of the corporation's affairs'" (quoting Matter of Goodman v. Lovett (200 AD2d 670)). Laurie's allegations of misconduct by her brother, Justice Bucaria wrote,
essentially demonstrate that the standard for involuntary dissolution has been met. Laurie and Ernest clearly do not agree on how the Corporation should be run, and act in a hostile manner towards one another. Laurie further admits that the company has not been operating at a profit as of late, and she has provided no plan that the company will do so in the future. Laurie states that Ernest has breached his good faith duty to her as a co-shareholder, and this only re-iterates that the standard for involuntary dissolution has been met.
The fact that Laurie claims Ernest acted in bad faith regarding the management of the Corporations is of no moment, inasmuch as the dissension and distrust is palpable and real. The petitioner showed, and the respondent reinforced, that the disagreements between the two parties "pose an irreconcilable barrier to the continued functioning and prosperity of the corporation." [Citations omitted.]
It would be an overstatement to say that the unclean hands defense has no application in the deadlock dissolution context. I can readily imagine a scenario in which a 50% shareholder deliberately manufactures dissension and brings a dissolution proceeding in furtherance of a plan to walk off with the company's customers. It really boils down to a matter of proof and, as Rieger illustrates, in the absence of compelling proof the allegations of unclean hands only serve to reinforce the atmosphere of irreconcilable hostility supporting involuntary dissolution.
Controlling Shareholder's Unreasonable Refusal to Admit Petitioners' Stock Ownership Constitutes Ground for Corporate Dissolution, Incurs Award of Attorney's Fees
"Well over one and a half years have been wasted on a defense which is utterly without support."
Pretty strong stuff, coming from a recent decision by Nassau County Commercial Division Justice Stephen A. Bucaria in Rosenfeld v. Luccaro, 2009 NY Slip Op 30963(U) (Sup Ct Nassau County Apr. 23, 2009), where the court granted dissolution of two closely held corporations based on "hopeless" deadlock and bitter dissension between two 50% shareholder factions. The court's sharp words were provoked by the respondent's assertion that the petitioners were not -- and had never been -- shareholders, despite a seeming avalanche of corporate and tax records to the contrary.
The subject corporations were formed in the 1970s by 50-50 shareholders Anthony Luccaro's father and Walter Rosenfeld to own and operate a marina called Toms Point Marina located in Port Washington on Long Island. Anthony Luccaro subsequently acquired his father's interest, and Rosenfeld died some time in the 1980s. His estate's distributees included his second wife, Judith, and his three children from a prior marriage.
Fast forward to 2007, when the Rosenfeld children commenced judicial dissolution proceedings under Sections 1104 and 1104-a of the Business Corporation Law, claiming deadlock and oppression by Luccaro who allegedly refused to recognize the election of petitioner Todd Rosenfeld as director, refused access to the bylaws and other books and records, threatened the life of petitioner Steven Rosenfeld if he entered the marina property, operated the marina as a cash business without proper controls and employed his family members without proper accounting, refused to issue K-1 tax forms to the Rosenfelds, and took cash and other distributions for himself without making any distributions to the Rosenfelds.
Luccaro initially opposed dissolution by affidavit contending that the estate of Walter Rosenfeld had sold the decedent's 50% stock interest to Luccaro, and that the sale proceeds were paid to the estate and distributed to the decedent's heirs. Luccaro's affidavit further alleged that Luccaro's father, as a prerequisite of his son's purchase of the father's interest, insisted that his son protect himself with a buy/sell cross purchase agreement with Walter Rosenfeld whereby the survivor would acquire all of the decedent's shares. The Rosenfeld petitioners denied the existence of any cross purchase agreement -- which it appears Luccaro never produced -- and, in support of their stock ownership, submitted their father's will, company tax returns, stock certificates and a 1986 affidavit of Judith, their father's second wife, attesting to her conveyance to the Rosenfeld children of her 7.5% interest. In reply, Luccaro contended that the petitioners introduced falsified documents and he denied the genuineness of his signature on various documents.
By decision dated October 29, 2007, Justice Bucaria denied the petitioners' motion for summary judgment of dissolution as premature (Luccaro had not yet served an answer) and because of the need for a hearing to resolve Luccaro's challenge to the legitimacy of the petitioners' evidence concerning their stock ownership. The decision noted that Luccaro had the burden of proof at such hearing.
Immediately afterward, the Rosenfelds served Luccaro with a formal notice requiring him to admit or deny that none of the companies' tax returns from 1985 to 2005 showed Luccaro as anything other than a 50% shareholder, and also to admit or deny the genuineness of the tax returns submitted by the Rosenfelds in support of their dissolution application. Luccaro denied all.
The hearing began in November 2007 before Special Referee Thomas Dana. Luccaro failed to appear. The Special Referee granted a continuance to allow the Rosenfelds to seek discovery from Luccaro of all of the company's tax returns from 1983 to date, all stock certificates, minutes of all shareholder and director meetings, and all records concerning the formation of the two companies. In January 2008, after Luccaro failed to produce documents, the Rosenfelds moved to compel the company's accountant to release tax returns, also contending that Luccaro was evading the court's production order because the records would undermine his claim to be sole owner. By decision dated March 14, 2008, Justice Bucaria ordered production of the companies' tax records for in camera inspection by the Special Referee.
After the in camera inspection, the Special Referee directed that the records be turned over to the Rosenfelds and indicated that, before any continuance of the hearing, a summary judgment motion would be appropriate based upon the records produced. The Rosenfelds did just that, contending that the undisputed documentary evidence merited a finding that they owned 50% of the corporations, and that the evidence of deadlock and oppression likewise supported a summary determination in favor of dissolution.
Justice Bucaria's April 23, 2009 decision granted dissolution. He found that the Rosenfelds established their 50% stock ownership based on the companies' stock ledgers and tax records, none of which Luccaro refuted. The only contrary evidence that Luccaro could point to was the hearing testimony by Walter Rosenfeld's second wife in which she denied her signature on the 1986 assignment of her 7.5% stock interest to the Rosenfeld children. If credited, her testimony would have relegated the Rosenfeld children to minority shareholder status, thereby depriving them of standing to seek dissolution based on deadlock under BCL Section 1104 (but not oppression under Section 1104-a). Justice Bucaria observed that the notarized assignment was entitled to a "presumption of due execution" rebuttable only by "clear and convincing evidence to the contrary" which he found lacking due to Judith's testimony admitting that her handwriting had changed after she suffered a stroke in 1995, that the stroke affected her memory, and her "confused" statement that she did not inherit any shares from her late husband. Accordingly, Justice Bucaria concluded, Luccaro failed to meet his burden of proof to show that the Rosenfelds were not 50% shareholders.
Justice Bucaria predicated his order of dissolution on deadlock under Section 1104 without any explicit mention of oppression under Section 1104-a. He wrote that "Luccaro has shown a complete disregard for the rights of petitioners, going so far as to refuse recognition of their ownership interests altogether, offering sworn statements averring that he and he alone owns the Corporations." Finding that the parties were "hopelessly deadlocked," and that Luccaro's affidavits refusing to recognize the Rosenfelds' shareholder rights evidenced a "high degree of hostility," Justice Bucaria ordered an accounting, the appointment of a receiver and the immediate dissolution of the two companies by public sale. Justice Bucaria conditioned his order of dissolution, however, on giving the parties 30 days to agree to a private sale of the companies either among themselves or to a third party.
The judicial dissolution statutes have no provision for awarding counsel fees to a successful petitioner. In this case, Justice Bucaria awarded fees based on Luccaro's unreasonable denials of the Rosenfelds' stock interests in his response to their formal Notice to Admit which was served pursuant to Section 3123 of the Civil Practice Law and Rules. The statute authorizes the court to award a party forced to prove the unreasonably denied admissions its "reasonable expenses incurred in making such proof, including reasonable attorney's fees." Justice Bucaria's decision directed the determination of the fees as part of the accounting.
Putting aside its peculiar litigation tactics, the Rosenfeld case fits a familiar pattern among multi-family, second-generation business owners, particularly when one family remains active in running the business and the other doesn't. The bonds of friendship and trust that existed between the original partners may not exist between the descendants. The active family owner has greater incentive to reinvest profits, and can feel under-compensated for his or her contributions to running and growing the business. The inactive family owner has greater incentive to take out profits or sell the business, and may be resentful of the compensation drawn by the active owner. The divergent interests of the two factions can fester over time and, absent a buyout agreement, will often lead to litigation. If anyone's to blame, it's the first-generation founders of the business for failing to put in place a plan of succession and written shareholders' agreement with provisions for buyout at a fair price on reasonable terms.
New Jersey Courts Apply State's Dissolution Statute to Foreign Corporations: Can it Happen in New York?
Many New York businesses are incorporated in other states, Delaware being the traditional favorite. In most instances these corporations are foreign in name only, i.e., their offices, assets, employees, shareholders and directors all are located in New York. Can a shareholder sue for dissolution of a New York-based foreign corporation in a New York court under New York's dissolution statutes?
The lead article in this month's online newsletter published by Drinker Biddle highlights two recent, unpublished New Jersey court decisions in which that state's dissolution statute was applied to foreign corporations based in New Jersey. In Krzastek v. Global Resource Industrial and Power, Inc., No. A-1815-06T2 (App. Div. Sept. 11, 2008), the New Jersey appellate court upheld application of the state's oppressed minority shareholder dissolution statute in a suit brought by a minority shareholder of a Massachusetts corporation. In Conway v. DialAmerica Marketing, Inc., No. BER-C-116-08 (Super.Ct. Sept. 30, 2008), the trial court did the same in a case brought by a minority shareholder of a Delaware corporation. In both cases, the courts applied New Jersey law based on an interests-based conflict of laws analysis. In both cases, the New Jersey dissolution statute afforded the plaintiffs rights and/or remedies (especially in regard to buyout) broader than those available under the laws of the states of incorporation. In both cases, the defendants unsuccessfully argued for dismissal based on the the "internal affairs doctrine" under which courts traditionally refused to exercise jurisdiction where the determination of the rights of the litigants involves regulation and management of the internal affairs of a foreign corporation.
Could it happen in New York? Case precedent suggests not, although the issue is not fully settled.
The leading New York precedent on the internal affairs doctrine is Langfelder v. Universal Laboratories, Inc., 293 NY 200 (1944), decided by the New York Court of Appeals (the state's highest court). The case was brought in New York by dissenting shareholders objecting to the terms of a merger involving two Delaware corporations. Here's the court's description of the internal affairs doctrine under which the case was dismissed:
There are cases in which our courts will entertain jurisdiction in suits against foreign corporations where suitors, even stockholders, are entitled to some relief which the State court is competent to grant. But it is well settled that jurisdiction in any case will be declined either in the absence of jurisdiction in the strict sense or where a determination of the rights of litigants involves regulation and management of the internal affairs of the corporation dependent upon the laws of the foreign State or where the court in which jurisdiction is sought is unable to enforce a decree if made or where the relief sought may be more appropriately adjudicated in the courts of the State or country to which the corporation owes its existence.
Although the doctrine generally has fallen out of favor in the ensuing decades (see former Justice Herman Cahn's highly informative discussion of the issue in Matter of Topps Co., Inc. Shareholder Litigation, 19 Misc 3d 1103(A), 2007 NY Slip Op 52543(U)), it has retained vitality in the realm of judicial dissolution proceedings brought under Article 11 of the New York Business Corporation Law.
This is due in large part to a pair of rulings by the Appellate Division, Second Department, in Warde-McCann v. Commex, Ltd., 135 AD2d 541 (2d Dept 1987), and Matter of Porciello, 253 AD2d 467 (2d Dept 1998), where, with virtually no discussion, the court invoked the internal affairs doctrine in dismissing proceedings to dissolve Delaware and Florida corporations. These cases have been followed in numerous lower court decisions within and outside the Second Department. (A recent example is Justice Bucaria's Schneck decision about which I wrote last year.)
The First Department's decision in Matter of Hospital Diagnostic Equipment Corp., 205 AD2d 459 (1st Dept 1994), arguably points in a different direction. There, the court upheld the dismissal of a deadlock dissolution proceeding involving a Delaware corporation on the discretionary ground of forum non conveniens due to the corporation's lack of substantial contacts with New York. The New York Attorney General also had moved for dismissal on the ground the court lacked jurisdiction to dissolve a foreign corporation. In its decision the First Department expressly rejected the Attorney General's argument that, whatever the court's authority to grant other forms of relief, under principles of comity it lacks jurisdiction to order dissolution of a foreign corporation.
There's been little, subsequent case activity putting Hospital Diagnostic's jurisdictional view to the test. In Sokol v. Ventures Education Systems Corp., 10 Misc 3d 1055(A) (Sup. Ct. NY County 2005), the court held that it could not entertain a request to dissolve a New York-based Delaware corporation but that it had jurisdiction to grant remedies short of dissolution. Here's how New York County Commercial Division Justice Richard B. Lowe III navigated the cross currents created by the First and Second Department precedents:
"It is well settled that 'a foreign corporation is controlled, as to its dissolution, by the laws of its domicile, and is not affected by laws which are intended to govern the dissolution of corporations created under local laws' " (Matter of Warde-McCann v Commex, Ltd., 135 AD2d 541, 542 [2d Dept 1987], quoting 17A Fletcher's Cyclopedia of the Law of Private Corporations § 8579, at 516 [Perm ed] [now, at 454-55 (1998 rev ed)]; Matter of Porciello v Sound Moves, Inc., 253 AD2d 467 [2d Dept 1998]; Mook v Berger, 26 AD2d 925 [1st Dept 1966], appeal granted 19 NY2d 581 [1967]; see BCL § 1104-a). A corporation is domiciled only in the state where it is incorporated (Sease v Central Greyhound Lines, Inc., of New York, 306 NY 284 [1954]). VESC is incorporated under the laws of Delaware and, therefore, may be dissolved only by order of a Delaware court.
For these reasons, the branches of Sokol's cross motion for dissolution of VESC and appointment of a liquidating receiver are denied.
However, this court may exercise subject matter jurisdiction over the other issues raised by the parties. Subject matter jurisdiction over the internal affairs, short of dissolution, of a foreign corporation may be found, in the court's discretion, to exist in equity where the corporation's sole connection to a foreign state or country is its place of incorporation and the corporation has significant and substantial ties with New York (Matter of Dissolution of Hospital Diagnostic Equip. Corp. [Klamm], 205 AD2d 459 [1st Dept 1994]; Broida v Bancroft, 103 AD2d 88 [2d Dept 1984]; Tosi v Pastene & Co., 34 AD2d 520 [1st Dept 1970]). Where jurisdiction exists, "the fact that the relief nominally sought (i.e., dissolution and forfeiture of the corporate charter) is not technically within the power of the Court does not bar the award of lesser or alternative relief in this action . . . which will attain substantial justice between the parties" (Matter of Dohring for the Dissolution of CVC Prods., Inc., 142 Misc 2d 429, 433 [Sup Ct, Monroe County 1989]).
Significantly, in Sokol Justice Lowe rejected the plaintiff's request to apply New York's substantive law to the plaintiff's claim of minority shareholder oppression. Rather, Justice Lowe held that the claim had to be decided under the more demanding standards of Delaware statutory and common law because the corporation's charter and bylaws demonstrated that the founders (including the plaintiff) "agreed to govern VESC's internal affairs in accordance with the laws of Delaware." In this regard, Sokol seems incompatible with the New Jersey courts' analysis in Krzastek and Conway.
I did not find in the two New Jersey opinions any acknowledgment of the "technical" barrier to dissolution of a foreign corporation noted in the New York cases, namely, the inability of a court in one state to order the secretary of state in another state to dissolve a corporation. The practical answer may lie in New Jersey's strong policy in favor of buyouts, as reflected in the New Jersey dissolution statute's express provisions authorizing the court to compel the respondent shareholders to purchase the petitioner's shares or vice versa. New York courts have rarely compelled buyouts and, to my knowledge, never in the form of a compelled buyout of a respondent by a petitioner.
Perhaps some day one of the other Appellate Division Departments will unequivocally split with the Second Department, requiring the New York Court of Appeals to decide once and for all the scope of judicial authority to entertain a petition for judicial dissolution of a foreign corporation. Until then, New York shareholders of closely held foreign corporations who seek the remedy of judicial dissolution must do so in the state of incorporation. In the case of a minority shareholder of a Delaware corporation, this can be a daunting challenge given Delaware's lack of a minority shareholder oppression statute (except for statutory close corporations) and given Delaware case law that is generally more hostile to oppression claims than New York's.
Shareholders unwilling to sue for dissolution in the state of incorporation alternatively may consider bringing a derivative action, e.g., for breach of fiduciary duty, in New York state court as specifically authorized by Section 1319 of the New York Business Corporation Law. As explained by Justice Kenneth Fisher in Potter v. Arrington, 11 Misc 3d 962, 2006 NY Slip Op 26062 (Sup. Ct. Monroe County 2006), in such an action the court is still required to apply New York's conflict of laws rules, which likely will result in application of the foreign state's substantive law.
My thanks to Brian Waters at Drinker Biddle for providing copies of the Krzastek and Conway decisions.
Further Thoughts on Youngwall and Judicial Dissolution of the Unprofitable LLC
Matter of Youngwall debuted on this blog last April (read here) when I wrote about a March 2008 decision (read here) by Nassau County Commercial Division Justice Stephen A. Bucaria, dissolving and appointing a receiver for a manager-managed LLC owned by two brothers. The court premised dissolution primarily on its finding that the LLC was not currently profitable.
Perry Youngwall, who opposed the dissolution petition brought by his brother, Nils, subsequently moved for reconsideration and to vacate the decision on various grounds. The headline grabber from Justice Bucaria's July 2008 decision denying the motion, which I wrote about last week (read here), was his ruling that the operating agreement's waiver of a member's right to seek judicial dissolution was unenforceable as against public policy.
This week, I want to re-examine the court's justification for dissolving the LLC, this time with the benefit of some additional facts brought out in the July 2008 decision.
By way of brief background, the LLC's sole asset is a commercial building profitably leased for many years by a company, Transaero, originally owned by the brothers' deceased father and currently controlled by Perry. Perry inherited all of his father's Transaero shares after the father disinherited Nils who is contesting the father's will in Surrogate Court. Transaero vacated the building on November 30, 2007, upon the expiration of its lease with the LLC. About two weeks later, Nils petitioned for dissolution of the LLC, contending that Perry rejected his requests to sell or re-let the building. Nils also claimed that the LLC's non-member manager, Thomas Megale, was allied with Perry and that deadlock existed because the approval of a lease requires both brothers' consent. Perry opposed dissolution on various grounds including the LLC's long track record of profitable leasing, the existence of a separate management agreement governing re-letting, and because the LLC continued to operate under the management of Megale who was pursuing the LLC's best interests.
In its initial decision, the court explained the factual basis for dissolving the LLC as follows:
Transaero was the only tenant, and there is no dispute that the LLC is not a profit-making entity at this time. Nor is there any admissible documentary proof that either the manager or the members are actively pursuing a future/current replacement for Transaero, notwithstanding the self-serving statements of the respondent [Perry] and the manager, whose motives are questionable, given the concurrent litigation in Surrogate Court and the latter's employment. The respondent's submission of an "agreement" purportedly dated October 8, 2001 does not qualify as documentary proof, inasmuch as there are numerous cross-outs and changes with no signature by either Nils Youngwall or Perry Youngwall.
In his subsequent motion to reconsider and vacate the court's decision, Perry claimed to have subsequently discovered a fully-executed copy of the October 2001 management agreement. He further asserted that in the prior proceedings Nils "defrauded the Court" by misrepresenting that he did not recall the document. Perry argued that the management agreement demonstrates that the LLC has procedures in place to go forward with re-letting the building. Perry also submitted an affidavit from a real estate broker showing that the LLC's building has substantial value as a rental property. Finally, Perry contended that retaining the property for rental will provide the LLC's members with a substantial annual profit.
In opposition, Nils denied any fraud or deception in regard to the October 2001 management agreement and pointed out that neither side had a signed copy on the original submission. Nils also contended that Perry and Megale had prior knowledge for over four months of Transaero's impending departure without taking any steps to market or rent the property and that there was no proof that anyone did so. He also argued that Perry's "belated" attempts to evaluate and propose to rent the property were irrelevant and improper on a motion for reconsideration.
Justice Bucaria's July 2008 decision rejected each of Perry's arguments. The October 2001 management agreement, which the court disregarded in its prior decision,
did not take the form of any contract with a real estate agent or broker to rent or lease the subject property. Taking note that the respondent [Perry] had given notice prior to September 2007 that Transaero would not be renewing the lease, the respondent and the manager [Megale] had not demonstrated any desire to rent or lease the subject premises for a period in excess of three months. That is the lack of demonstrable proof that formed the basis of this Court's ruling that the historical profit stream of the LLC was and had been effectively severed.
After noting that Perry did not proffer a reasonable excuse for his belated discovery of the executed management agreement, Justice Bucaria dismissed Perry's reliance on the agreement, writing:
[T]he management agreement does not prove that the LLC was an ongoing viable entity, only that the LLC was "prepared to deal with the re-letting of the [subject premises] . . .", not that it had done so. In fact, as provided in Section II, "The principal objective of the Managing Agent will be to operate the Property in such a manner as will maximize the financial return to the Company, with an emphasis on current income" (emphasis supplied). That mandate was not fulfilled. Nor is there any evidence that the manager had complied with Section IV of the management agreement, i.e., "Managing Agent shall advertise vacancies by all reasonable and proper means; provided, Managing Agent shall not incur expenses for advertising in excess of $500.00 during any calendar quarter without the prior written consent of the Company."
My first piece on the original Youngwall decision posed a series of questions roughly falling into two categories. First, is the decision consistent with the limited scope of Section 702 of New York's LLC Law, authorizing judicial dissolution "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement"? Second, as a policy matter do we want courts to decide dissolution contests based on the complex set of factors and management prerogatives that influence a company's short and long term profitability?
I'll address those in reverse order. The facts brought out in the July decision paint a much clearer picture of a deliberate plan by Perry, with Megale's support, to let the LLC's building lie fallow indefinitely to exert financial pressure on Nils concurrent with the battle over the father's estate. Perry decided to relocate Transaero months before it happened, yet he and Megale took no steps whatsoever even to begin the process of re-letting. True, Nils filed for dissolution only two weeks after Transaero vacated the building at the end of November 2007. But even by the time the original court submissions were made in February 2008, there still was no sign of re-letting activity. That adds up to about 6 months of inactivity from the time Perry caused Transaero to give notice. The belated appearance of the signed management agreement, with its specific provisions for re-letting, only adds to the appearance of deliberate inaction. On these facts, it's hard to quarrel with the court's conclusion that Perry and Megale had no intention of re-letting the building, i.e., restoring the LLC to profitability.
The first question remains the harder one to answer. Nothing in the court's July decision augments the first decision's legal reasoning, namely, that because LLCs are formed to engage in business for pecuniary profit, an LLC whose operating agreement or articles of organization recite that is it formed for "any lawful business purpose" may be judicially dissolved on the ground that it is not making a profit. To be clear, the issue is not that an LLC's financial condition and prospects are immaterial to the overall propriety of dissolution in any specific case, it's whether the statute's core requirement, of the inability to carry on the LLC's business "in conformity with" the operating agreement or articles, should be predicated on frustration of an implied business purpose to make a profit.
If Youngwall involved a close corporation instead of an LLC, and the facts otherwise were the same, it would have the makings of a classic shareholder impasse and squeeze-out triggering a judicial dissolution remedy for deadlock and oppression under Section 1104 and 1104-a of the Business Corporation Law. I find Youngwall so fascinating precisely because it highlights Section 702's shortcomings as a judicial tool for resolving the most common varieties of LLC breakups which, contrary to assumptions seemingly underlying Delaware's "contractarian" school of LLC jurisprudence, do not involve LLCs with custom-tailored operating agreements carefully negotiated across the table with the assistance of highly sophisticated corporate counsel. More likely they involve an accountant's recommended use of an LLC for tax reasons with nary a thought given to governance issues, followed by the use of a recycled, non-negotiated form LLC agreement slapped together by the financial partner's lawyer without any other lawyer's participation.
Speaking of Delaware, Chancellor Chandler's R&R Capital opinion, discussed alongside Youngwall in last week's post on judicial dissolution waivers, posits Delaware's statutory covenant of good faith and fair dealing as a member's judicial backstop against abusive conduct by a controlling member when dissolution is not available. Does this suggest that Youngwall could be a case of a member seeking an inappropriate remedy based on the wrong claim? What about a derivative action for injunctive relief (to compel re-letting the building) and damages (for lost rental income) against the LLC's manager for breach of (1) New York's implied duty of good faith and fair dealing that attaches to the operating agreement, and (2) the manager's statutory duties of good faith and care under LLC Law Section 409? Section 1104-a(b)(1) of the BCL expressly requires the court to consider whether dissolution is the "only feasible means" for a shareholder to obtain a fair return on investment. Unfortunately, LLC Law Section 702 has no similar provision.
One final note. Justice Bucaria's July 2008 decision mentions that the court-appointed receiver listed the LLC's building with a broker for sale. Following the decision, Perry Youngwall filed a motion in the Appellate Division, Second Department, asking for a stay of sale pending his appeal from the March 2008 and July 2008 decisions. By order dated August 22, 2008, the appellate court denied the motion. In typical fashion the court's order offers no reasons, so it can't be read as an explicit approval of the underlying orders. I'm sure many lawyers nonetheless would opine that the denial of the stay motion, cognizant that an impending sale of the building likely will render moot Perry's appeal from the order of dissolution, implicitly takes a dim view of the merits of his appeal. I, for one, will be disappointed if the appellate court does not decide the case, but what do you expect from a blogger?
Update February 15, 2009: In a decision dated January 29, 2009, Justice Bucaria approved the sale of the LLC's building to an entity controlled by the respondent, Perry Youngwall, for $3.5 million, in preference to a proposed sale to an unrelated third-party buyer for $3.3 million.
WWDD (What Would Delaware Do) With an In Terrorem LLC Dissolution Waiver Clause?
I can't resist asking the above question in the wake of two recent decisions, one from Delaware Chancery Court invoking freedom of contract to enforce an LLC operating agreement's waiver of a member's right to seek judicial dissolution, and the other from New York's Commercial Division refusing on public policy grounds to enforce an operating agreement's in terrorem provision forfeiting the interest of any member who files for judicial dissolution.
The names if not the issues in both cases may sound familiar to regular readers of this blog.
The Delaware case is R&R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318 (Del. Ch. Aug. 19, 2008) (read decision here). The factions in R&R have been waging a multi-front battle for years, with simultaneous lawsuits in Pennsylvania state and federal courts, New York state court, and most recently Delaware Chancery Court. At issue is control of nine Delaware LLCs that own and operate a number of horse farms. The Russet brothers put up most of the almost $10 million capital but gave 50% member Linda Merritt sole management authority under the operating agreements.
I recently posted about a pair of decisions in the New York case in which the Russets sued to oust Merritt as sole manager based on allegations of fraud and mismanagement (see here). In January 2008, the New York court ruled that Merritt had authority to sell company assets to pay off various debts including her own legal fees under the operating agreement's indemnity provision. The Russets then asked the judge to recuse himself based on allegations that he engaged in improper communications with a mediator who supposedly tried to "fix" the case at Merritt's behest. In a May 2008 decision, the judge denied the motion and referred the matter to the District Attorney for investigation of possible perjury.
The next month, the Russets through their membership-holding company, R&R Capital, LLC, petitioned the Delaware Chancery Court to dissolve the LLCs. The petition alleges that most of the LLCs have had their certificates of formation canceled for failing to designate a registered agent or pay annual taxes, and it also alleges fraud and self-dealing by Merritt. The LLCs moved to dismiss the petition -- I presume Merritt exercised her authority as sole manager to engage and pay for the LLCs' counsel -- on the grounds, first, that R&R lacked standing to seek dissolution of two of the LLCs (the "Pandora Entities") and, second, that R&R waived the right to seek judicial dissolution of the seven other LLCs (the "Waiver Entities") under the terms of their operating agreements.
Chancellor William B. Chandler III agreed with the LLCs on both counts. With respect to the Pandora Entities, Section 18-802 of the Delaware LLC Act confers standing to seek judicial dissolution on "a member or manager." Since R&R only held an indirect interest in the Pandora Entities, through its membership in the sole member of each, it lacked standing to seek judicial dissolution.
As for the Waiver Entities, the LLCs relied on identical provisions in the operating agreements, captioned "Waiver of Dissolution Rights," providing as follows:
The Members agree that irreparable damage would occur if any member should bring an action for judicial dissolution of the Company. Accordingly each member accepts the provisions under this Agreement as such Member's sole entitlement on Dissolution of the Company and waives and renounces such Member's right to seek a court decree of dissolution or to seek the appointment by a court of a liquidator for the Company.
Chancellor Chandler rejects R&R's arguments, that the waiver provision is unenforceable under the LLC Act and as a matter of public policy, emphasizing that "the public policy of Delaware with respect to limited liability companies is freedom of contract," and that "the freedom of contract principle must be assiduously guarded lest the courts erode the primary attraction of limited liability companies." As for the operating agreements at hand, he writes:
Here, the LLC Agreement is a contract between sophisticated parties. The business relationships between the individuals behind the petitioners and Lynda Merritt is extensive; clearly these were parties who knew how to make use of the law of alternative entities. The mere fact that the business relationship has now soured cannot justify the petitioners' attempt to disregard the agreement they made. Therefore, contrary to petitioners' argument that Delaware's public policy will not countenance their unambiguous contractual waiver, the state's policy mandates that this Court respect and enforce the parties' agreement.
The Chancellor's opinion also notes that "there are legitimate business reasons why members of a limited liability company may wish to waive their right to seek dissolution or the appointment of a receiver," such as to avoid default under loan agreements that make the filing of a dissolution petition a noncurable event of default. In response to R&R's argument that enforcement of the waiver leaves them without a remedy for abuse by Merritt, the Chancellor states that Section 18-1101(c) of the Delaware LLC Act "preserves the implied covenant of good faith and fair dealing." He continues:
It is the unwaivable protection of the implied covenant that allows the vast majority of the remainder of the LLC Act to be so flexible. There is no threat to equity in allowing members to waive their right to seek dissolution, because there is no chance that some members will be trapped in a limited liability company at the mercy of others acting unfairly and in bad faith.
Chancellor Chandler ends his opinion on a literary note, putting a contractarian spin on Helena's soliloquy in Act I, Scene 1 of All's Well That End's Well, where she says, "Recall--lest another court these parties try--'Our remedies oft in ourselves do lie.'" Let me therefore introduce the second case for discussion, Matter of Youngwall, with another Shakespeare quote chosen for its anti-contractarian message, spoken by Claudio in Act IV, Scene 1, lines 19-20 of Much Ado About Nothing: "What men daily do, not knowing what they do!"
A few months ago, under the banner, "Judicial Dissolution of the Unprofitable LLC" (see here), I posted about a March 2008 decision in Youngwall by Nassau County Commercial Division Justice Stephen A. Bucaria in which he ordered dissolution of a real estate holding LLC owned by two brothers. The brother who opposed dissolution subsequently moved for reconsideration of the court's order on several grounds, including that the court overlooked the following waiver of dissolution provision in the operating agreement:
Neither member may seek judicial dissolution of this Company, and any withdrawal shall not be deemed an act causing dissolution of the Company. Any member who seeks judicial dissolution of the Company will be deemed to have withdrawn as a member of the Company, thereby forfeiting all rights, interests and entitlements to the Company and its assets.
This type of in terrorem clause is more typically found in a will. Perhaps it's no coincidence since, from what I can surmise from the prior Youngwall decision, the brothers' membership interests in the company were given to them by their father.
In a decision issued three weeks before Chancellor Chandler's R&R ruling (read decision here), Justice Bucaria denied the reargument motion both on procedural and substantive grounds. Procedurally, the waiver argument was not raised on the original motion and therefore cannot serve as a basis for reargument. On the merits, Justice Bucaria simply states: "The courts of this state have held that to absolutely prohibit judicial dissolution is void and unenforceable as against public policy." The decision cites to Matter of Validation Review Associates, Inc., 223 AD2d 134 (2d Dept 1996), rev'd as moot, 91 NY2d 840 (1997), where the intermediate appellate court held that a provision in a shareholders' agreement waiving common law and statutory rights to seek judicial dissolution of a closely held corporation was void as against public policy.
The Youngwall court does not base its decision on the forfeiture feature of the provision, which in my view renders the holdings in R&R and Youngwall at complete odds. This should come as no surprise to those who follow New York and Delaware case law developments concerning closely held business entities. Delaware's fervent embrace of freedom of contract in the LLC realm, made explicit in Section 18-1101(b) of the Delaware LLC Act and rigorously applied in cases such as R&R and those it cites such as Fisk Ventures, is unmatched in New York's LLC statute or case law. In fact, I would venture to say that there is a growing schism between Delaware and New York LLC jurisprudence, and that Youngwall is consistent with a growing number of New York LLC decisions that liberally draw upon case law involving closely held corporations where the courts are not hesitant to employ fiduciary and equitable principles to protect shareholder rights.
Which brings me back to my opening question: After R&R, what would a Delaware court do if called upon to enforce a Youngwall-type waiver of dissolution and forfeiture provision in an LLC operating agreement? Obviously, this begs the questions, (1) Who in their right mind, in an arm's-length transaction, who would ever agree to such a forfeiture provision?, and (2) Who in their right mind would file for dissolution without first seeking a declaratory judgment as to the provision's enforceability? That aside, I read R&R as compelling enforcement of the bargain including its draconian forfeiture. On the other hand, maybe there's some superseding Delaware doctrine, along the lines of equity abhors a forfeiture, that might leave the petitioner without a dissolution claim but still holding his or her membership interest.
Finally, there are some terrific posts by Francis Pileggi who first broke news of R&R (here), Professor Larry Ribstein whose work is cited in R&R (here) and Professor Gary Rosin at the Unincorporated Business Law Prof Blog (here and here) for anyone looking for more extensive analysis of the R&R decision.
Judicial Dissolution of the Unprofitable LLC
This is a tale of two cases, decided five years apart, involving my all-time favorite business divorce topic: judicial dissolution of the limited liability company (LLC). The cases raise the interesting question whether a member may seek dissolution on the ground that the LLC is not profitable.
First, a bit of background for the uninitiated. The LLC is an unincorporated business entity that combines the limited liability benefits of the corporation with the favorable pass-through tax treatment of partnerships. Compared to the highly structured, mandatory provisions of the business corporation laws, the LLC laws offer far more flexibility and freedom of contract among the LLC members to order their ownership, economic and managerial relations as they see fit. LLCs are fast on the way to becoming the preferred form of closely held business organization. Already, in a number of states including Delaware, new LLC filings outnumber new corporation filings.
The New York LLC Law's sparsely worded provision for judicial dissolution, codified in Section 702 of the LLC Law, borrowed its language from the limited partnership law. Section 702 provides in relevant part:
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.
The articles of organization generally parrot the minimal informational requirements set forth in LLC Law Section 203(e). Dissolution under Section 702 therefore is all about whether the member who seeks to dissolve the LLC can demonstrate that its business is not functioning as called for by the terms of the operating agreement. This is a narrower standard than that found in Sections 1104 and 1104-a of the Business Corporation Law governing closely held corporations. (For readers who'd like to learn more about the background of Section 702 and its treatment in the early case law, grab a hold of my June 2002 article published in the New York State Bar Association Journal, entitled "When Limited Liability Companies Seek Judicial Dissolution, Will the Statute Be Up to the Task?")
Now lets turn to the two cases, the first of which was decided in 2003 and is entitled Schindler v. Niche Media Holdings, LLC (read decision here). The case was brought by a one-third member of an LLC that owned and published magazines. The plaintiff, Schindler, accused the company's CEO, who held a 35.7% interest, of misappropriating company assets and wrongfully terminating Schindler's employment. The complaint included a claim to dissolve the LLC under Section 702 on the ground that liquidation was the only feasible means for the members to obtain a fair return on their investment.
Schindler moved to preliminarily enjoin the CEO from using LLC funds to pay his legal fees in defense of the action. New York County Supreme Court Justice Shirley Werner Kornreich denied the motion on the ground, among others, that Schindler had no likelihood of success on the merits of his underlying dissolution claim. Schindler, according to the judge, admitted the LLC's magazine business was flourishing and offered no evidence that the LLC was unable to carry on its business in accordance with the articles of organization or operating agreement. In so ruling, the judge construed Section 702 as follows:
While this standard has never been construed in the case law, the Court interprets it to mean that judicial dissolution 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. [Italics added.]
I have no quarrel with the first part of the judge's statement, but the second part -- "or else that it is failing financially" -- struck me when I first read it as judicial fiat. There's nothing in Section 702 that even hints at financial failure as an independent basis for dissolution. The decision cites no case precedent for the proposition, which appears to be pure dicta in any event. Nor does the judge cite any statutory or case authority under the Business Corporation Law. On the contrary, BCL Section 1111(b)(3) says that dissolution should not be denied "merely because it is found that the corporate business has been or could be conducted at a profit." Profitability or the lack thereof, by itself, clearly is no basis to grant or deny dissolution, assuming the operating agreement itself does not set forth some measure of financial distress as ground for dissolution.
In subsequent years I have seen the Schindler formulation quoted on numerous occasions in published and unpublished decisions. In none of the cases, however, did the court grant or deny dissolution on the sole basis that the LLC was or wasn't operating profitably.
That is, none until last month, in a case called Matter of Youngwall (Youngwall Realty, LLC) decided by Nassau County Supreme Court Justice Stephen A. Bucaria (read decision here). The LLC involved in Youngwall had two members, brothers Nils (the one seeking dissolution) and Perry, and a non-member manager named Megale who allegedly was aligned with Perry. The decision does not specify the membership percentage interests held by the brothers. The LLC owned a commercial building profitably leased for many years to a company named Transaero Inc. that had been 80% owned by the members' father until his death in 2006. The father's bequest of all of his Transaero shares to Perry was being challenged by Nils in surrogate's court. Meanwhile, in September 2007 Transaero's lease expired and it vacated the property in November 2007. The next month Nils filed for dissolution, alleging that Perry rejected his requests to cause the LLC either to sell the now-vacant property or to find a new tenant, that without a rent-paying tenant the building had become a liability, and that the animosity between the two brothers made it impossible for them to confer or cooperate to carry on the LLC's business. Perry countered that there was no risk to the assets of the LLC which continued to operate under Megale's management who was pursuing its best interests.
Justice Bucaria begins his analysis by distinguishing the grounds for dissolution under LLC Law Section 702 from those governing closed corporations under BCL Sections 1104 and 1104-a. He aptly characterizes Section 702 as "more general, while being more specific" in its tie-in to the operating agreement. He then notes the provision in the parties' operating agreement stating that the LLC "is formed for any lawful business purpose," and observes that the term "business" is defined in LLC Law Section 102(e) as meaning "every trade, occupation, profession or commercial activity." He next refers to the Practice Commentary to the LLC Law in which the commentator states that "the drafters intended that LLCs form for pecuniary profit". He also cites the statement in Perry's affidavit that the LLC "can continue to operate and make further profit for its members," leading him to find that the "plain and ordinary content and intent of the parties and the Operating Agreement of the LLC was, and is, to make a profit for the members, Perry Youngwall and Nils Youngwall." Dissolution is warranted, Justice Bucaria concludes, because the LLC is no longer a profit-making entity. Here's the key passage from the decision:
The Court is cognizant of the past history of the LLC and its profit stream, and the uninterrupted income provided by the LLC . . . to the litigants/members herein. While instructive, it is not decisive of LLCL 702. The statute, as written, that a dissolution may be decreed when ". . . it is not reasonably practicable to carry on the [profitability] . . ." That language clearly contemplates the future of the LLC, i.e., after November 30, 2007 (when Transaero vacated the premises). Transaero was the only tenant, and there is no dispute that the LLC is not a profit-making entity at this time. Nor is there any admissible documentary proof that either the manager or the members are actively pursuing a future/current replacement for Transaero, notwithstanding the self-serving statements of the respondent and the manager, whose motives are questionable, given the concurrent litigation in Surrogate Court and the latter's employment. . . .
. . . Due to the intense personal animosity between the members, the lack of any proof of the current profitability of the LLC, the apparent inability ". . . to function as intended . . ." (Schindler v. Niche Media Holdings, LLC, 1 Misc3d 713, 772 NYS2d 781, 785, C.CT., NY County 2003), dissolution is appropriate. [Emphases in original.]
Note the citation to Schindler whose questionable dicta has now become the basis for dissolving the LLC in Youngwall, though in quoting from Schindler Justice Bucaria omits the phrase, "or else that it is failing financially."
I've got a bunch of questions, beginning with, what inconsistency is there between the express terms of the operating agreement in Youngwall and the fact that the building's current vacancy is causing a cash drain? If every LLC is formed for pecuniary profit (this seems self evident), is every LLC that fails to make a profit for any given period prone to judicial dissolution at any member's request? What motive would Perry have to keep vacant a valuable commercial property in which he has at least as much a beneficial interest as his brother? How much equity does the LLC have in the property? Is the property listed with brokers for sale or lease? Is it all that unusual for a one-tenant commercial property to experience vacancy for some months between tenants? Does the LLC have adequate cash reserves to weather a period of vacancy?
Also note the court's reliance on the brothers' personal animosity even though the operating agreement vests management of the LLC exclusively in Megale. Should it make a difference that Megale appears to be on Perry's side? Are Nils' grievances better suited for a derivative action asserting claims against Perry and Megale for breach of fiduciary duty for keeping the property off the market against the LLC's best interests?
Youngwall would be an easier, more compelling case for dissolution if it was a member-managed LLC with the two brothers in a 50-50 deadlock over the disposition of the property. I can only speculate that the deceased father foresaw fraternal strife and for that reason set up the LLC with a third-party manager.
The biggest question raised by Schindler and Youngwall is whether courts should ever consider dissolving an LLC solely on the ground of its unprofitability in the absence of some express provision in the operating agreement that creates the nonconformity required by Section 702. Here's how the argument against might go: Responsibility for LLC finances, business planning and profitability is vested in the managers of the LLC. Courts routinely defer to determinations by a corporation's board of directors on such matters under the business judgment rule. It should be no different for LLC managers. There are untold numbers of companies, public and private, that run in the red for periods of time before they either turn around or file for bankruptcy. Opening up LLCs for dissolution on the ground of unprofitability takes courts where they should not go and creates yet another, undesirable dissonance with the law governing dissolution of business corporations.
I suspect it will be far less than another five years before the next case raising this issue comes along. Stay tuned.
One Case, Three Great Issues
When it comes to reading court decisions in business divorce cases, I have a number of pet issues. If I come across a decision with one such issue, I’m happy. Two in the same opinion, I’m thrilled. Three in the same opinion, it’s like hitting the trifecta.
A recent decision by Nassau County Commercial Division Justice Stephen A. Bucaria offers a winning threesome: (1) arbitrability of corporate dissolution petitions; (2) petitions seeking dissolution of out-of-state corporations; and (3) dissolution petitions that trigger mandatory buybacks under a shareholders’ agreement.
The case, Matter of Schneck (R&J Components Corp.), 2007 NY Slip Op 32966(U) (Sup Ct Nassau County Sept. 17, 2007), involves two brothers who went into, and eventually each inherited 50% interests in, an electronic parts business founded by their father who died in 1990. The business came to be organized as six separate companies, two of which were formed as out-of-state corporations but all of which operated in New York. The complaining Brother A claimed that Brother B had frozen him out of the business, denied him access to business records, and took hundreds of thousands of dollars more each year than Brother A was getting. Brother A sought judicial dissolution of all the companies based on internal dissension and deadlock under Business Corporation Law § 1104.
Brother B raised several defenses. First, he asked the court to stay the proceedings pending arbitration pursuant to a mandatory arbitration clause in the shareholders’ agreement. Such clauses routinely are enforced in dissolution proceedings. In this case, however, the court found that Brother B had waived arbitration by moving for summary judgment on the merits. Here’s the money quote: "The courtroom . . . may not be used as a convenient vestibule to the arbitration hall so as to allow a party to create his own unique structure combining litigation and arbitration."
Brother B fared better on his next defense aimed at the two non-New York corporations, successfully arguing that a New York court may not dissolve a foreign corporation even if its principal place of business is New York. The argument invoked the so-called "internal affairs" doctrine under which courts traditionally refuse to rule on the regulation and management of a foreign corporation. I have followed this issue for many years in the hope -- thus far unrealized -- that courts will re-analyze the wisdom of the internal affairs doctrine as applied to the dissolution of a corporation operating wholly within New York whose only connection to the other state is the place of incorporation. After all, New York courts routinely interpret and apply the law of other states in many other types of corporate governance disputes. Although the idea of a New York court ordering, e.g., Delaware's secretary of state to dissolve a Delaware corporation is no less repugnant than that of a Delaware judge ordering New York's secretary of state to dissolve a New York corporation, so long as the court has personal jurisdiction of the business owners it seems to me that either judge in either jurisdiction could order the parties to file a certificate of voluntary dissolution without offending the incorporating state's sovereignty. Also, there is at least one lower court decision (Matter of Dohring [CVC Products, Inc.], 537 NYS2d 767 [1989]) holding that, even if dissolution of a New York based foreign corporation technically is not within the court's power, it may adjudicate the case and fashion a lesser or alternative remedy that achieves "substantial justice" between the parties.
The third issue is one of my all-time favorites, about which a colleague and I wrote an article published in July 2006 in the New York Law Journal. Shareholders’ agreements frequently have stock transfer restrictions that grant a right of first refusal under certain circumstances, generally involving a shareholder who wishes voluntarily to sell his or her shares. Such provisions often include broad language that can be construed as triggering the duty to offer the shares for sale – typically at a formula price well below fair value – whenever there is an attempt to dispose of one's shares through any means, including judicial dissolution. In this case, the court concluded that the language was not broad enough and therefore it denied Brother B’s request to compel Brother A to convey his shares.
Dissolution and the 50% Shareholder
In the judicial dissolution arena, one of the trickiest decisions faced by counsel representing a 50% shareholder of a closely held New York corporation is whether to ask for dissolution based on deadlock under Section 1104 of the Business Corporation Law (BCL), or based on allegations that the other 50% shareholder is guilty of illegal, fraudulent or oppressive conduct or has looted, wasted or diverted corporate assets under BCL Section 1104-a, or under both statutes.
The choice can have a dramatic effect on the outcome of the proceedings, not just because of the different proofs required, but because only one of the statutes – BCL Section 1104-a – triggers the other shareholder’s right to avoid dissolution by electing to purchase for “fair value” the shares of the petitioning shareholder. (See previous post on the subject.)
In many business divorce cases involving two 50% shareholders there nonetheless is one natural buyer and one natural seller. Sometimes it’s because one of the two controls more of the client relationships. Sometimes it’s because one of the two personally or through a separate company owns the realty leased by the co-owned company. Sometimes it’s because one of the two has far deeper pockets. In these situations, the 50% shareholder who wants out and his or her counsel must think long and hard about whether they gain or lose bargaining leverage by handing the opposing shareholder the right to force a buyout. In my experience, a deadlock petition under BCL Section 1104 usually packs a bigger wallop than an 1104-a petition by denying the automatic buyout and thereby putting added pressure on the shareholder who may be more motivated to keep the company as a going concern.
Here’s a recent case where things took a different and unhappier direction for the petitioning 50% Shareholder A who sought dissolution under BCL Section 1104-a alleging that he was frozen out by 50% Shareholder B. The case involved a real estate holding company that leased the property to a separate business solely owned by Shareholder B. The troubles started when Shareholder A’s employment with the tenant business terminated. The court denied Shareholder A’s application to dissolve upon finding no evidence of oppression, looting or other misconduct by Shareholder B.
Would Shareholder A have done better seeking deadlock dissolution under Section 1104? It’s hard to say without knowing more facts. Establishing deadlock in a relatively passive real estate holding company can pose a challenge. The fact that he did proceed under Section 1104-a suggests that he made a losing bet that Shareholder B would elect to purchase his shares. One also can speculate that the lease held by Shareholder B’s separate company was of the sweetheart variety, thereby taking away some measure of Shareholder B’s incentive to opt for a buyout.
The case, Matter of Livolsi (111 Glen Street Corp.), 2007 NY Slip Op 32911 (U) (Sup Ct Nassau County Sept. 13, 2007), was decided by Justice Stephen A. Bucaria of the Nassau County Supreme Court, Commercial Division.
Update November 24, 2009: The petitioner in Livolsi started a new 1104-a proceeding in 2009. By order dated November 9, 2009, Justice Bucaria dismissed the new petition because it was "grounded on precisely the same allegations" raised in the first dismissed proceeding. Justice Bucaria took it a step further, hinting that he might have granted sanctions had the other side asked for them, and cautioning the petitioner against any future such application.
Improper Verification of Dissolution Petition Leads to Case Dismissal
A recent court decision reminds us how the simple, easily avoidable mistakes made by counsel at the outset of a dissolution case can end in a misfire -- and likely an angry client.
In Matter of Cohen (Last Choice Real Estate Corp.), Index No. 5940/07 (Sup Ct Nassau County July 18, 2007), Justice Stephen A. Bucaria of the Nassau County Supreme Court, Commercial Division, dismissed a deadlock dissolution petition brought by a 50% shareholder because the petition was verified by the shareholder’s attorney instead of by the shareholder. For readers who don’t know, under New York practice dissolution is sought by way of a petition in a special proceeding, as opposed to filing a complaint in a regular action. The petition must be verified, meaning the petitioner/shareholder must sign before a notary public an acknowledgment that he or she has read the petition and that its allegations are true to his or her own knowledge. A properly verified petition also functions as an affidavit and thus can be considered by the court as evidence. Under certain circumstances specified by statute (typically because the client does not reside in the same county as the attorney) the attorney is allowed to verify even though the attorney has no personal knowledge of the petition’s factual allegations.
What some attorneys may not appreciate, however, is that dissolution proceedings essentially start off as a paper trial, that is, the court can decide the case on the merits based on the dissolution petition and the answering papers. If the petition is verified by an attorney who lacks personal knowledge of the petition’s allegations, and there is no additional client affidavit supporting the merits, then the court cannot treat the petition as an affidavit, and the petitioner is left with no evidence in support of dissolution. Case over.
In this age of nearly instant communication and document transmission via email and overnight courier, there is little or no reason ever to forego client verification of a dissolution petition.
Update (June 3, 2008): Following the dismissal of his case, the petitioner filed a new dissolution proceeding supported by the petitioner's own affidavit alleging deadlock and dissension between the two 50% shareholders. The respondent moved to dismiss the new proceeding based on the doctrine of collateral estoppel, arguing that the prior dismissal had been for lack of any evidence to support dissolution. Justice Thomas Feinman ruled that the prior decision was not on the merits and denied the dismissal motion (read decision here).
