Court Charges Receiver's Legal Fees in Corporate Dissolution Against 50% Shareholder's Distributive Share Based on Misconduct
Last week's post on the Deblinger case examined a first-impression decision in a corporate dissolution proceeding concerning the court's authority under Section 1008 of the New York Business Corporation Law to compel a shareholder to present a derivative claim against another shareholder-director. The same statute occupies center stage in yet another novel decision handed down last month in Matter of Darvish (Haslacha, Inc.), 2010 NY Slip Op 32339(U) (Sup Ct NY County Aug. 23, 2010). This time, the issue is whether Section 1008 authorizes the court to assess against one shareholder's distributive share of the liquidation proceeds the court-appointed receiver's legal fees incurred as a result of the shareholder's misconduct.
You can tell Darvish is one of those protracted, rancorous shareholder disputes just from the "01" suffix in the case's index number -- indicating the case is nine years old -- and from the most recent motion sequence number indicating that the parties have filed over 50 separate motions since the case began.
The petitioner, Darvish, as 50% shareholder filed for judicial dissolution of three single-asset real estate companies based on deadlock and dissension with the other 50% shareholder, Lavian, under BCL Section 1104. In 2004, Manhattan Commercial Division Justice Herman Cahn (since retired) granted the petition as to two of the three corporations, named Urban Homes, Inc. ("Urban") and Primary Residence, Inc. ("Primary"). Justice Cahn directed further proceedings with respect to the third corporation, Haslacha, Inc. ("Haslacha"), based on Lavian's assertion that he was sole shareholder of that entity. (Read Justice Cahn's decision here.)
Justice Cahn subsequently referred the issue of Haslacha's ownership to a Special Referee who, in October 2008, issued a report that Justice Cahn subsequently confirmed, finding that Darvish and Lavian each own 50% of Haslacha's shares. (Read report here.)
In November 2008, Justice Cahn granted dissolution of Haslacha and appointed a Receiver to manage its commercial property located in Manhattan and to collect rents and profits. (The buildings owned by Urban and Primary were put under the same Receiver's control in 2004.)
In 2009, the Receiver made a series of motions, contested by Lavian, relating to tenancies at Haslacha's building, and for approval of payments to his appointed counsel from the corporation's receipts. Darvish supported the Receiver's motions and filed a cross motion asking that the Receiver's counsel fees be paid not from the corporation's funds, but from Lavian's share of any final distribution from Haslacha, Urban and Primary. Darvish contended that the court had authority to charge Lavian's interest under BCL Section 1008(5) on the grounds that the Receiver's counsel fees were incurred solely as a result of Lavian's acts, misconduct and interference with the receivership.
The motions were referred to the Special Referee who issued a report in June 2010 (read here) granting the Receiver's motions but denying Darvish's cross motion to charge Lavian's distributive share, explaining as follows:
BCL 1008(5) authorizes the court to determine and enforce the liability of any "director, officer, shareholder or subscriber for shares, to the corporation or for the liabilities of the corporation," but does not authorize the court to charge an award of attorney's fees to any distributive share of a "director, officer, shareholder or subscriber" of a corporation, upon the grounds of misconduct.
In a subsequent report the Special Referee approved the Receiver's counsel fees in the sum of approximately $200,000.
Darvish then moved before Manhattan Commercial Division Justice Melvin L. Schweitzer, who had taken over the case from the retired Justice Cahn, to reject the Special Referee's report insofar as it denied Darvish's cross motion to charge the Receiver's counsel fees against Lavian's distributive share. Here's how Justice Schweitzer frames the issue in his August 23, 2010 decision:
The court now turns to the issue of how the costs and fees are to be allocated: should they be borne by the Haslacha Estate and/or the Primary Residence and Urban Homes Estates irrespective of share ownership or should they be borne exclusively from Mr. Lavian's distributive shares in those Estates as advocated by Petitioner?
The answer is foretold in Justice Schweitzer's immediately following observation, that the Special Referee's reports "leave no doubt" that Lavian's conduct, such as "filing numerous motions, refusing to obey the orders of the court and the Receiver, and by engaging in sham leasing transactions," required "the appointment of the Receiver in the first place and caused him to incur the costs and attorneys' fees awarded to" the Receiver's counsel.
Justice Schweitzer next explicitly rejects the Special Referee's reading of BCL 1008, which "invests broad discretion in the court 'without limitation' to issue orders with respect to 'all matters' in connection with the winding up of the affairs of the corporation." Citing BCL 1008(5), Justice Schweitzer states that "it is clear that the corporation's liability for the Receiver's legal fees" to be paid from the sale proceeds of the corporation's assets have
arisen due to the acts of a shareholder, i.e., Mr. Lavian [whose] refusal to comply with the court's orders, and his vexatious litigation, is responsible for the corporation's liability to pay legal fees. The court is invested by the statute with the power to "determine" Mr. Lavian's liability and to "enforce" that liability, by ordering Mr. Lavian to pay the liability he caused out of his distributive share.
Justice Schweitzer also grounds his decision on subdivision (6) of Section 1008, which authorizes the court to enter orders for the "payment, satisfaction or compromise of claims against the corporation . . .." Lavian's actions, the court continues,
have wasted the corporation's assets and he should not benefit by the petitioner's being required to pay one-half the costs. . . . It would be unfair to allocate the costs and fees attributable solely to Mr. Lavian's fault or vexatious litigation tactics equally between Mr. Darvish and Mr. Lavian by virtue of the fact that they are each 50% owners in the Estates of Haslacha, Primary Residence and Urban Homes.
Notwithstanding the court's harsh assessment of Lavian's conduct, in the end he is not assessed 100% of the $200,000 in attorney's fees incurred by the Receiver. Instead, Justice Schweitzer orders that the fees be paid 65% from Lavian's distributive share and 35% from Darvish's distributive share. Justice Schweitzer does not explain the allocation, though presumably it reflects some quantum of services by the Receiver's counsel not directly related to Lavian's actions.
Taken together, the Deblinger and Darvish cases, decided within days of each other by two different judges, underscore the potent and extremely broad judicial powers granted in BCL Section 1008. Counsel involved in the winding up of a judicially dissolved corporation must familiarize themselves with this important statute.
Update January 2, 2010: By Supplemental Order dated December 20, 2010, Justice Schweitzer clarified his prior order by also allocating to Lavian 65% of the $25,200 settlement costs of the related mortgage foreclosure proceeding.
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.
Court Rejects Attempt to Vary Statutory Valuation Date in Oppressed Shareholder Buyout
The value of a business can change from year to year, month to month or even week to week. Sales trends go up and down. New products take off or flame out. Major contracts are gained or lost. Industry-wide prospects wax and wane.
When an oppressed minority shareholder petitions for judicial dissolution underBusiness Corporation Law (BCL) 1104-a, and the controlling shareholders or corporation elect to avoid dissolution by purchasing the petitioner's shares for fair value under BCL 1118, the latter statute requires the court to determine fair value "as of the day prior to the date on which such petition was filed."
The statute's language leaves no wiggle room. The few reported attempts by parties to vary the valuation date uniformly have met defeat under the courts' strict construction of the statute. See, e.g., Matter of Vetco, 260 AD2d 642 (2d Dept 1999); Matter of Davis (Shayne-Levy Associates, Inc.), 174 AD2d 449 (1st Dept 1991).
But that didn't stop the purchaser from taking a valiant run at the statute in Matter of Kurins (SilverSeal Corp.), 2008 NY Slip Op 33328(U) (Sup Ct NY County Dec. 2, 2008). And little wonder that it didn't: at stake was a $1,000,000 increase in the value of the parties' investigative and security business as of the statutory valuation date versus the valuation date three months earlier proposed by the purchaser.
Andris Kurins and John Silverman were the 49% and 51% shareholders, respectively, of SilverSeal. On July 31, 2007, Kurins filed a demand for arbitration including a claim for dissolution of SilverSeal under BCL 1104-a. SilverSeal (controlled by Silverman) contested arbitrability and succeeded in obtaining a court order staying the arbitration. On October 26, 2007, Kurins filed a dissolution petition with the court. On November 28, 2007, SilverSeal filed an election to purchase Kurins' shares.
The parties then filed a joint application seeking a determination of the correct date for valuing Kurins' shares. SilverSeal contended that July 30, 2007, being the day before the date on which Kurins filed his arbitration demand, was the correct valuation date. Kurins contended that October 25, 2007, being the day before the date on which Kurins filed his court petition, was the correct valuation date. Kurins also pointed out that the November 28, 2007, election to purchase was outside the statutory 90-day period to elect to purchase if measured from the date of the arbitration demand. Both sides agreed that the difference in dates was significant because in the interim, SilverSeal increased its assets by an excess of $1,000,000 in cash.
Kurins prevailed. The decision by New York County Commercial Division Justice Herman Cahn concludes that
the statute is clear that the relevant date for determining the valuation of Kurins' shares is the day prior to his filing the Petition. . . . Moreover, when Respondents elected to purchase Petitioner's interest in SilverSeal, it did so over a month from the Court filing, well within its time to elect -- but only if measured from the date of the Court filing. If, however, Respondents' election to purchase is looked at from the date the demand for arbitration was filed, the election was significantly outside the time limit. . . . It therefore strains credulity to view the election to purchase as a response to any filing other than that in this Court.
Moral of the story: Be careful what you wish for. Had SilverSeal not objected to the arbitration demand, presumably the valuation date in the arbitration proceeding would have been July 30, 2007, and the subsequent $1,000,000 cash receipt would have been off the balance sheet for valuation purposes.
Controlling Shareholder's Dilution of Minority Interest Requires Bona Fide Business Purpose
Squeeze-out of minority shareholders in close corporations can take many different forms. One common technique is stock dilution. The careful minority shareholder will insist, before investing capital or sweat equity, on a shareholders' agreement that preserves his or her percentage by a combination of preemptive rights, super-majority approval requirements for changes in authorized and issued shares, and other protective devices. Absent such bargained-for protection, however, is a minority shareholder's stake at the mercy of the controlling faction?
The answer is a qualified "no", according to a recent decision by New York County Commercial Division Justice Herman Cahn in Dingle v. Xtenit, Inc., 20 Misc 3d 1123(A) (Sup Ct NY Co 2008), where the court elevated the controlling shareholder's fiduciary duty over his reliance on statute and the business judgment rule in refusing to dismiss the minority shareholder's wrongful dilution claim.
Xtenit is a closely-held New York corporation engaged in the business of developing, marketing and supporting computer software. Brian McFadden is Xtenit's Chairman, CEO and majority shareholder. In 2001 Mark Dingle joined Xtenit as its COO. Under his employment agreement, because Xtenit was a start-up, Dingle agreed to accept 1.5 million Xtenit shares representing a 15% equity interest in lieu of salary until such time as the company had sufficient funds to pay its executives. Dingle's shares were fully vested and issued by the time he resigned from Xtenit in September 2002. Apparently Dingle's employment agreement did not require him to redeem his shares upon resignation.
According to Dingle's complaint, when he contacted McFadden three and a half years later, in March 2006, to ask how Xtenit was doing financially, and to assess the value of his shares, McFadden told him that new shares had been issued and that he no longer had a 15% interest. It turned out that in October 2004, McFadden convened a special meeting of Xtenit's board to approve an increase in Xtenit's authorized shares from 10 million to 500 million. The meeting minutes stated that the shares "will be awarded to current officers of [Xtenit] and future employees" and that "[no] additional provisions will be made for existing shareholders of [Xtenit's] common stock."
Dingle's complaint alleged that McFadden was the only officer and director of Xtenit, and that McFadden received all the additional shares without paying for them, thereby diluting Dingle's stock interest to less than 1%.
Dingle asserted derivative claims for rescission, unjust enrichment and breach of fiduciary duty, and individual claims seeking recovery in quantum meruit and unjust enrichment.
McFadden moved pre-discovery for summary dismissal of the complaint on the ground that his actions were authorized under provisions of the Business Corporation Law including Section 501(a), regarding the corporation's power to issue shares authorized in its certificate of incorporation, and Section 801(b)(7) governing amendment of the certificate of incorporation to authorize additional shares. He also argued that his actions were shielded by the business judgment rule.
Justice Cahn denied the motion, holding that Dingle presented "a prima facie case of unequal shareholder treatment" in violation of McFadden's fiduciary duty owed to minority shareholders as director and majority shareholder. Justice Cahn's decision includes the following quotation from a 1975 decision by New York's highest court in Schwartz v. Marien (37 NY2d 487, 492):
Departure from precisely uniform treatment of stockholders may be justified, of course, where a bona fide business purpose indicates that the best interests of the corporation would be served by such departure. The burden of coming forward with proof of such justification shifts to the directors where, as here, a prima facie case of unequal stockholder treatment is made out. Particularly is this so when it appears that members of the board of directors favored themselves individually over the complaining shareholder.
The burden of justification as articulated in Schwartz is to establish a bona fide independent business objective which "could not have been accomplished substantially as effectively by other means which would not have disturbed proportionate stock ownership."
Applying this standard, Justice Cahn ruled that:
Plaintiff has presented a prima facie case of unequal shareholder treatment by proof that new shares were authorized and issued, that they were not offered to plaintiff, and that McFadden obtained the new shares, with the result that plaintiff's percentage interest in Xtenit went from 15% to less than 1%. McFadden has failed to present even a scintilla of evidence regarding a bona fide purpose for the dramatic increase in the number of authorized and issued shares in Xtenit. The statement in the minutes of the special meeting of the Board at which this action was approved, that the "extra shares will be awarded to current officers of the Corporation and future employees" fails to provide any such justification (Notice of Mot., Exh. B). In fact, no business justification at all is offered to sustain the authorization and issuance. Even if McFadden had offered a corporate purpose for this increase, which appears to have benefited only himself, there would be factual issues as to his motives and credibility. Moreover, without any discovery, plaintiff has not even had the opportunity to determine the facts and motives surrounding the authorization and issuance. (Citations omitted.)
Justice Cahn also rejected McFadden's reliance on the business judgment rule, noting that the rule does not apply to self-interested decisions by directors and officers.
Absent from the court's discussion is any mention of BCL Section 505(d) which authorizes close corporations, upon majority shareholder vote, to issue rights and options for shares to directors, officers and employees as an incentive to service or continued service with the corporation. Since it appears uncontested that Dingle was not given notice of the October 2004 increase in authorized shares, it also seems likely that McFadden did not hold a shareholders' meeting in connection with the October 2004 board meeting, hence Section 505 doesn't apply. Even assuming McFadden had followed proper shareholder authorization procedure, and further assuming the absence of independent directors recommending the increased stock authorization, a different outcome is unlikely assuming Dingle were to prove at trial his allegation that the company actually issued to McFadden the additional shares for no consideration.
There clearly are circumstances where a close corporation has a legitimate interest in authorizing and issuing additional shares to executives as incentive compensation or in lieu of salary. McFadden's failure to articulate any business purpose for a fifty-fold increase in Xtenit's authorized and issued shares naturally invites a high degree of suspicion. Perhaps McFadden was motivated by plans to sell the company. Whatever it was, it seems likely that after Dingle departed and was out of touch for two years, McFadden must have believed that Dingle had lost interest entirely. I'm also guessing that Xtenit is a subchapter C corporation, so Dingle was not getting K-1s that would have alerted him earlier to the dilution. The March 2006 phone call from Dingle must have been an unpleasant surprise for McFadden. In any event, as Justice Cahn's Xtenit decision highlights, a controlling shareholder in a close corporation must be attuned to his or her fiduciary obligations before authorizing and issuing additional shares in a manner that dilutes minority shareholders.
