A Toxic Mix of Family and Business
It's not surprising that the ancient adage, "Never mix family and business," is more honored in the breach than the observance. After all, as the late Professor Larry Ribstein observed in his terrific 2010 research paper entitled "Close Corporation Remedies and the Evolution of the Closely Held Firm" (reviewed here):
The earliest small firms were partnerships, which began as intimate, usually family, relationships. They were referred to as 'compagnia,' which means those sharing bread, reflecting their origins in households. Kinship ties were an important mechanism for controlling agency costs. As Kerim told James Bond in From Russia with Love, "all of my key employees are my sons. Blood is the best security in this business."
Blood may be the best security in some family-owned businesses, but in many others the same bonds of kinship and trust that induce family members to enter into a business association in the first place, when abused or perceived to be abused, can and often do instigate conflict, entropy, and ultimately the dissolution of the firm and destruction of family ties. In other words, the emotional ties that encourage family members to dispense with diligence and formalities when starting and operating a business can also drive them apart with even greater force when things go wrong, in no small part due to those very dispensations.
For this column I've chosen three recent, illustrative cases presenting dissolution and related claims involving family-owned businesses. The substantive issues in each case are interesting and informative, if not novel. I wasn't involved in any of the cases, so I can't really say to what extent the blood relations of the parties contributed to the outbreak of hostilities or the underlying problems. But I think it's fair to say that each case in its own way shows tell-tale signs of the dysfunctional circumstances and dissension peculiar to business divorce, family style.
The case summaries follow after the jump.
Billanti v. Billanti, Short Form Order, Index No. 4536-11 (Sup Ct Nassau County Dec. 15, 2011)
Billanti Casting Co., located in New Hyde Park, Long Island, is a family-owned business since 1955 servicing the jewelry industry. One of the founders, Joseph Billanti, eventually brought his children Frank and Rosemarie into the business. In 1992, Joseph, Frank, Rosemarie and Joseph's brother John (a co-founder of Billanti Casting) and John's wife as co-equal partners formed a general partnership called the Billanti Family Investment Partnership. The Partnership's purpose was to invest profits from Billanti Casting as venture capital in connection with potential expansion of the casting business, which never took place. The Partnership's assets consist of fixed income assets held with an investment firm and a loan made to Billanti Casting to cover a tax obligation. Starting around 2000, Rosemarie became head of the casting business while Joseph and John became less involved. Frank stopped working at Billanti Casting in 2008 apparently after losing a fight for control with his sister Rosemarie. Their father, Joseph, died in 2010.
In 2011, Frank brought suit for judicial dissolution of the Partnership under §63 of the Partnership Law based on his sister Rosemarie's alleged conduct including her exclusive control over its books and records, for an accounting, and for other relief concerning the Partnership and Billanti Casting. Rosemarie and the other defendants denied Frank's allegations of misconduct and opposed the request for dissolution of the Partnership.
In his decision earlier this month, Nassau County Commercial Division Justice Timothy S. Driscoll granted Frank's motion for summary judgment dissolving the Partnership, but not under Partnership Law §63 as requested. Because the Partnership has no agreement establishing its duration, Justice Driscoll explained, it "is a partnership at will, that may be dissolved at any time by any partner" under Partnership Law §62(1)(b). Frank's expression of his desire to dissolve the Partnership suffices without need for proof of other partner misconduct. Justice Driscoll also ordered the defendants to provide Frank with an accounting of the Partnership's assets and its affairs since commencement, and he appointed a receiver to direct the dissolution of the Partnership, the sale of its assets, the collection of all monies and the division of the proceeds.
Zekry v. Zekry, 2012 NY Slip Op 30104(U) (Sup Ct NY County Jan. 18, 2012)
In 2004, plaintiff Nicole Zekry and her husband, defendant Pinhas Zekry, formed David Ben Barouck Corp. to operate a hair salon, spa and cosmetology business on Columbus Avenue in Manhattan. They entered into a shareholders agreement which recited that Pinhas held a 60% stock interest in consideration of his payment of $283,680 and for his "know-how and managerial experiences, and infrastructure and availability of selling and work force and personnel, which he has invested in the corporation and in facilitating the construction of the premises." The agreement also recited that Nicole held a 40% stock interest for her payment of $189,120.
In 2008, after Nicole sued to dissolve their marriage, Nicole filed a complaint against Pinhas (read here) for fraud, breach of fiduciary duty and to reform the shareholders agreement to enlarge her stock ownership to 71.1% based on evidence that Pinhas only contributed about $77,000 at the inception rather than $283,680 as recited in the agreement.
In her decision issued earlier this month, New York County Justice Deborah A. Kaplan denied Nicole's motion for a summary judgment of equitable reformation of the stock percentages on the ground that the agreement by its terms did not condition Pinhas's share allocation based only on his payment of $283,680 "but also his personal investment in the business, including, inter alia, his knowledge and managerial experiences, his work force and personnel, and his facilitation of the construction of the premises." In other words, since the agreement did not provide for the division of share ownership based solely on the parties' respective initial capital contribution, Nicole failed to establish as a matter of law that Pinhas "fraudulently induced unilateral mistake regarding his capital contribution" such that their agreement "does not express the intended agreement" as a basis for reformation.
Kimelstein v. Kimelstein, 2011 NY Slip Op 32949(U) (Sup Ct Suffolk County Oct. 26, 2011)
The Van Depot, Inc. was formed in 1999 by brothers Jeffrey and Larry Kimelstein to operate a used car sales business in Lindenhurst, Long Island, on a lot owned by a second corporation also co-owned by the brothers.
Larry sued Jeffrey in 2008, claiming breach of an oral agreement by Jeffrey to pay Larry $350,000 in exchange for Larry's alleged 50% ownership interests in the two companies. Jeffrey denied Larry's ownership of shares in either company. In a February 2010 decision, Suffolk County Commercial Division Justice Emily Pines dismissed Larry's claims for breach of oral agreement and specific performance, denied Jeffrey's motion to dismiss the claim to impose a constructive trust, and granted Larry leave to amend his complaint to add a claim, among others, for corporate dissolution as an oppressed shareholder under §1104-a of the Business Corporation Law.
In her latest decision, Justice Pines summarized the contest as one "between brothers concerning the extent of their business relationship and what, if anything the Defendant's brother and the two corporate Defendants, in which Plaintiff claims ownership, owe the Plaintiff for his investment in time and sweat equity, following Plaintiff's departure from what may or may not constitute a closely held family business." In opposition to Jeffrey's motion to dismiss the amended complaint, Larry offered a number of checks from his brother allegedly representing partial payment for his shares, along with affidavits from non-party witnesses attesting that Jeffrey held Larry out to them as his equal partner in the family business.
Justice Pines agreed with Jeffrey to the extent of dismissing Larry's claims for breach of fiduciary duty and a formal accounting which were asserted individually instead of derivatively as required. Justice Pines nonetheless refused to dismiss Larry's claim for dissolution based on lack of standing because "there exists documentary evidence presented on both sides of this issue," and she allowed Larry to proceed with his equitable claims in the alternative. Finally, she also ruled that, should the court find that Larry has standing and proves oppression, the court is empowered "to order a less drastic remedy than dissolution, such as an accounting."
Court Orders Dissolution of Unprofitable Real Estate LLC
Back in 2008, I wrote a couple of posts about the Youngwall case in which the court ordered involuntary dissolution of a commercial real estate limited liability company (LLC) owned 50/50 by two brothers who also were involved in a bitter dispute over their father's will, based on the personal animosity between the brothers and because the vacant building was losing money (read here and here).
Youngwall foreshadowed the landmark decision in 2010 by the Appellate Division, Second Department, in the 1545 Ocean Avenue case, which redefined the standard for judicial dissolution of LLCs under §702 of the LLC Law as requiring the petitioner to show "in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible."
I emphasize the disjunctive "or" in the quoted passage because the cases involving judicial dissolution petitions based solely on financially failing LLCs are few and far between, as opposed to the more common scenarios involving management and/or money disputes between members of otherwise profitable ventures. The explanation may well be that most business people don't like to pay lawyer's fees fighting over a corpse.
LLCs being the entity of choice for real estate holding companies, and the real estate market having remained in a slump the last four years, it was only a matter of time before another Youngwall case appeared. And so it has, in the form of Mizrahi v. Cohen, 2012 NY Slip Op 50030(U) (Sup Ct Kings County Jan. 12, 2012), decided last week by Brooklyn Commercial Division Justice Carolyn E. Demarest.
Mizrahi, like Youngwall, is a family feud between brothers-in-law -- one a dentist, the other an optometrist -- who in 1999 purchased a property in Brooklyn's Gravesend section and subsequently built a mixed-use building to house their own businesses and to rent to other tenants. They formed an LLC named 372-376 Avenue U Realty, LLC to own the property and entered into a written Operating Agreement as 50/50 managing members.
The LLC obtained mortgage financing, personally guaranteed by both members, for the purchase of the realty and construction of the four-story building which wasn't completed and occupied until 2006 when the original mortgage was refinanced in the sum of $4.7 million. The plaintiff dentist, Mizrahi, occupied a second floor office and the defendant optometrist, Cohen, occupied a smaller ground floor unit.
At the outset the two members contributed $100,000 each. The Operating Agreement required no additional capital contribution absent the members' unanimous consent. The Operating Agreement also generally provided for unanimous approval of "any matter coming before the Members."
Until 2003, the two members made additional capital contributions in equal shares to cover expenses. After 2003, Mizrahi made substantial, unmatched contributions and loans to the LLC. By the time of trial in 2011, Mizrahi's capital contributions totaled almost $1.2 million compared to about $300,000 for Cohen.
In 2010, Mizrahi filed a complaint seeking judicial dissolution of the LLC and asserting claims against Cohen for an accounting and damages for alleged embezzlement of LLC funds and failure to make his share of capital contributions.
Justice Demarest's analysis of the dissolution claim begins by citing 1545 Ocean Avenue and other cases for the proposition that "the court must look to the Operating Agreement to determine the rules applicable to the operation of a particular LLC" and that "[o]nly where the Operating Agreement is ambiguous, contrary to law or does not contain any provision for the particular matter at issue, do the statutory provisions of the [LLC Law] control."
Mizrahi centered his dissolution claim on Cohen's alleged failure to carry his "fair share" of the financial responsibility for the real estate business under the terms of the Operating Agreement. He also claimed, and Justice Demarest agreed, that Cohen breached fiduciary duty by withdrawing $230,000 that the LLC could ill afford as a loan to himself, after Mizrahi withheld his consent.
Cohen argued that the dissolution claim should be dismissed because the Operating Agreement limits the conditions under which the LLC can be dissolved to the members' unanimous consent or certain defined events of "involuntary withdrawal" by a member which were not present. Justice Demarest labeled the argument "specious," stating:
Such interpretation of the law would void the statutory provision for judicial dissolution pursuant to Section 702 of the LLCL in any situation in which an operating agreement provided for dissolution only on consent or at the end of a definite term of duration for the LLC, and would thus thwart the obvious legislative intent of LLCL §702, to provide a mechanism to equitably terminate a business relationship that is dysfunctional or abusive, without the consent of all of the members.
Justice Demarest instead posed the central question in the case as
whether plaintiff has borne his burden to demonstrate that it is impracticable to continue the operation of the LLC in light of Cohen's failure to provide needed financial support and his undermining of the LLC's financial integrity so as to warrant dissolution of the LLC.
The answer came largely from the LLC's accountant, who testified that the LLC consistently operated at annual losses totaling over $1.1 million in the years 2006 (when the building was first occupied) through the trial in 2011, which loss was covered by application of mortgage proceeds to the day-to-day operations of the LLC and by Mizrahi's capital contributions which prevented foreclosure on the property. Justice Demarest also credited the accountant's testimony that the monthly carrying charges for mortgage, taxes and building expenses totaling over $51,000 exceeded the rent roll by about $12,000 per month. Cohen's contention that the LLC "going forward" will show a profit, Justice Demarest commented, "appears to be based on speculation and wishful thinking."
Justice Demarest concluded that "given the significant losses sustained over the years, which were covered by plaintiff, it is not plausible that continuing the LLC, as presently constituted, is feasible." Under the Operating Agreement's terms, the plaintiff Mizrahi is under no obligation to continue making capital contributions to keep the LLC afloat. Justice Demarest's fuller explanation is worth reading:
In 1545 Ocean, the Appellate Court cautioned that "[d]issolution is a drastic remedy", not to be lightly ordered merely based upon disagreement, or even deadlock, among the members of the LLC, but that "where the economic purpose of the limited liability company is not met, dissolution is appropriate"(72 AD3d at 129-131). In the case here, the agreed purpose of the LLC is the development and management of a mixed-use building, presumably for the economic benefit of its members. That purpose was achieved by the construction and occupancy of the building, but the expected profit has not been realized and the building does not support the costs of its maintenance, including payment of the mortgage taken to finance the project. The deficit has consistently been financed unilaterally by plaintiff, who, under the terms of the Operating Agreement, cannot be liable for the debts of the LLC (Section 3.2). Defendant not only has failed to contribute equally in meeting the losses, but has affirmatively undermined the financial integrity of the LLC by withdrawing a substantial portion of his capital contributions, thus evidencing his inability or unwillingness to permit or promote the purpose of the LLC. Under these circumstances, it is only a matter of time, should plaintiff choose to exercise his right to refrain from making additional capital contributions or loans to the LLC, before the LLC will default upon its mortgage and the mortgage will be foreclosed, thus eliminating the sole purpose of the LLC. Accordingly, plaintiff has established that continuing the LLC is financially unfeasible and that the LLC should be dissolved. (See Mehraban v McIntosh, 2011 WL 486101, p.3 [Sup St, Nassau Co., 2011]).
The plaintiff also contended that, upon dissolution, he should be allocated a greater than 50% interest in the LLC proportional to his capital contributions and should be permitted to purchase Cohen's diminished interest. The plaintiff relied on Matter of Superior Vending, about which I wrote here, where the court ordered an equitable "liquidation" by means of requiring one member of the LLC to pay the other an amount equal to his investment in the LLC plus interest. Justice Demarest didn't buy it, distinguishing the two cases as follows:
Superior Vending involved a limited liability company formed to acquire and operate a vending machine company. The business had been originated by one of the members through his own corporation and was expanded to a second company through investments made by the other member three years later. No operating agreement was ever executed and the relationship of the LLC members terminated after two years, but the LLC continued to operate under the management of the original member. An initial effort to dissolve Superior Vending was abandoned by the departing member, but a new petition was brought three years later to recover his share of the assets and interim distributions. Unlike the case here, the members consented to dissolution and had severed their mutual operation of the business years prior to the litigation. Because one member had continued to operate, and had expanded, the business in the intervening years, the court found it appropriate, after determining the departing member's right to recovery on his investment, to permit the remaining member to purchase, or buy-out, the other member's interest for that sum, notwithstanding the absence of a provision for such relief in the LLCL. As is apparent from the stated facts of that case, the equities of the Superior Vending case differ from the circumstances at bar in which both members have remained active in the operation of the LLC and there has been no hiatus in their joint participation, other than that created by plaintiff's removal of the bank account from access by defendant.
The Mizrahi opinion, besides ordering dissolution and appointing the company accountant to perform an accounting, addresses a number of other interesting factual and legal issues, so do yourself a favor and read it in its entirety.
