It Only Took 16 Years: New York Appellate Court Defines Standard for Judicial Dissolution of Limited Liability Companies
No more complaining about the absence of appellate guidance on the standard for judicial dissolution of limited liability companies under §702 of the LLC Law. Finally, almost 16 years after the cryptically-worded statute became law, the Appellate Division, Second Department, in Matter of 1545 Ocean Avenue, LLC, 2010 NY Slip Op 00688 (2d Dept Jan. 26, 2010), offers a carefully considered explanation of what §702 means -- and what it doesn't mean -- in a decision also notable for a two-judge dissent from the majority's disposition of the case without an evidentiary hearing.
As discussed below, the 1545 Ocean opinion's motif is fidelity to the LLC's operating agreement. This contract-centric approach sharply distinguishes LLC dissolution from partnership and close corporation dissolution cases in which implied fiduciary duties and untethered notions of fairness permeate the courts' analysis. It also brings New York LLC jurisprudence closer in line with Delaware's approach to LLC dissolution fueled by the admonition contained in §1101(b) of the Delaware LLC Act, to give "maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements."
It's no surprise that the signed opinion's author is Associate Justice Leonard B. Austin (pictured) who was appointed to the appellate bench in 2009 after serving ten years as trial judge in the Commercial Division of the Nassau County Supreme Court. Justice Austin's Commercial Division caseload, among other types of business disputes, included a steady influx of judicial dissolution proceedings involving closely held corporations and LLCs. That experience undoubtedly gave him a first-hand feel for the analytical and practical difficulties posed by these cases and an appreciation of the legal and business community's need for greater certainty in applying the broad and undefined terms of the dissolution statutes.
There's another reason I'm not surprised by Justice Austin's authorship. In June 2002, I wrote an article for the New York State Bar Association Journal on LLC dissolution (read it here) in which I observed that most of the few cases decided to that point freely borrowed from corporate dissolution norms applicable in cases involving oppressed minority shareholders and internal dissension. I did, however, cite a trial court decision in a case called Matter of Quinn, NYLJ Apr. 20, 2000, p. 32, col. 6 (Sup. Ct. Nassau County), as the sole example I'd found of a court, consistent with §702's language, focusing on whether the complained-of grounds for dissolution conformed to the members' operating agreement. The judge who decided Quinn? Justice Austin.
Now let's examine the 1545 Ocean decision.
The Facts
1545 Ocean Avenue, LLC ("1545 LLC") was formed in late 2006 as a manager-managed LLC with two 50% members, Crown Royal Ventures, LLC ("Crown Royal") and Ocean Suffolk Properties, LLC ("Ocean Suffolk"). Crown Royal and Ocean Suffolk entered into a written operating agreement for 1545 LLC in which Crown Royal designated its principal, John King, as one of the two managers and Ocean Suffolk designated its principal, Walter Van Houten, as the other manager.
Article 4.1 of the operating agreement contained a somewhat atypical management clause for 50-50 LLCs, authorizing "any one Manager [to] take any action permitted under the Agreement, unless the approval of more than one of the Managers is expressly required [by the Agreement]."
The two members each contributed 50% of the capital used to purchase commercial real estate located in Bohemia on Long Island. 1545 LLC's purpose was to purchase the property, rehabilitate an existing building (Building A) and build a second building on the property (Building B) for commercial rental.
King and Van Houten agreed to solicit third-party bids for the demolition and construction work. They also agreed that Van Houten, who owned his own construction company, Van Houten Construction ("VHC"), could submit bids subject to the managers' approval.
Ultimately VHC undertook the work on Building A, with Crown Royal later alleging that VHC did so without King's consent whereas Ocean Suffolk contended that the two managers agreed to hire VHC when there were no bona fide third-party bids. King also claimed that VHC began the work without necessary permits, did not have the proper equipment and consequently overbilled for the work. King alleged that he agreed to pay VHC's invoice on condition that it would cease further work without King's consent. VHC continued working on the site without King's consent.
Tensions between King and Van Houten further escalated following a dispute over hiring a contractor for environmental remediation work. According to King, Van Houten refused to meet on a regular basis, proclaimed himself to be a "cowboy" and stated that he would "just get it done". In April 2007, King announced that he wanted to withdraw his investment from 1545 LLC and proposed to notify all vendors that Van Houten was taking over. Van Houten viewed King as having resigned as manager. King's attorney sent Van Houten a "stop work" demand which was ignored. The two exchanged competing buy-out proposals of each other's interest, without resolution. Meanwhile, VHC continued to work unilaterally on the construction project which was within weeks of completion when Crown Royal sued for judicial dissolution and obtained an interim injunction preventing further work.
The Dissolution Petition
Crown Royal's petition alleged, as the sole ground for dissolution, deadlock between the managers arising from Van Houten's claimed violations of Article 4 of the operating agreement. The petition did not allege fraud or frustration of the purpose of 1545 LLC on the part of Ocean Suffolk, Van Houten or VHC.
Ocean Suffolk's answer to the petition opposed dissolution and denied any violation of the operating agreement. It alleged, without dispute, that the renovation of Building A was within 3-4 weeks of completion when the litigation commenced. It also alleged that, in anticipation of a buy-out of Crown Royal's interest, the parties had been operating as if Van Houten was sole manager. Ocean Suffolk thus contended that there could be no manager deadlock as a result of King's resignation as manager, even though King did not submit a written resignation as required by Article 4.8 of the operating agreement.
The Lower Court's Dissolution Order
In December 2007, the lower court issued a bare-bones order granting the dissolution petition (read it here). The order makes no factual findings, merely stating that judicial dissolution of an LLC "will be ordered only where the complaining member can show that the business sought to be dissolved is unable to function as intended, or else that it is failing financially," and that review of the papers submitted and the conferences conducted with the court "clearly demonstrates to this Court that 1545 is unable to function as intended."
Justice Austin's Majority Opinion
Ocean Suffolk appealed the order of dissolution to the Brooklyn-based Appellate Division, Second Department. Justice Austin's opinion for the 5-judge panel reverses the lower court's order, denies the petition and dismisses the proceeding. Presiding Justice Steven Fisher, joined by Associate Justice Cheryl Chambers, wrote a partial dissent in which he would have remitted the matter to the lower court for a fact-finding hearing to determining whether Crown Royal's petition met the newly-articulated standard for dissolution.
- The LLC Dissolution Statute Distinguished from its Corporate and Partnership Counterparts
The analysis section of Justice Austin's opinion in 1545 Ocean, as its first order of business, tells the bench and bar what the standard for LLC dissolution is not, namely, it is not the standard developed for close corporations under the Business Corporation Law (BCL).
Upon the enactment of New York's LLC Law in 1994, the statute contained a single section denominated §702 governing judicial dissolution of the newly recognized entity. The section provides in its entirety as follows:
On application by or for a member, the supreme court in the judicial district in which the office of the limited liability company is located may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement. A certified copy of the order of dissolution shall be filed by the applicant with the department of state within thirty days of its issuance. [Emphasis added.]
As I wrote in my 2002 article on LLC dissolution, the section's sparse language -- drawn from the limited partnership dissolution statute but rarely examined in the partnership case law -- created a vacuum into which many judges imported the relatively well-developed grounds for dissolution employed in cases involving close corporations under BCL §§1104 and 1104-a. It's easy to understand why courts did so given the many similarities between, on the one hand, corporate shareholder-officers and, on the other, LLC member-managers, at least when it comes to the day-to-day realities of their internal relations and the pressures that lead to internal dissension.
Justice Austin notes that §702 was left unchanged when the LLC Law was amended in 1999 to conform to changes in federal tax treatment of LLCs (citing my 2002 article in that regard), and from that concludes:
since the Legislature, in determining the criteria for dissolution of various business entities in New York, did not cross-reference such grounds from one type of entity to another, it would be inappropriate for this Court to import dissolution grounds from the Business Corporation Law or Partnership Law to the LLCL.
He then observes that, while there is no definition of "not reasonably practicable" in the context of LLC dissolution, "[s]uch standard . . . is not to be confused with the standard for the judicial dissolution of corporations or partnerships" (citations omitted). He notes that the BCL and Partnership Law by statutory definition apply only to business corporations and partnerships, respectively, and that "[l]imited liability companies thus fall within the ambit of neither the Business Corporation Law nor the Partnership Law." He also cites §102(m) of the LLC Law, which likewise excludes corporations and partnerships from its ambit, in concluding that "the existence and character of these various entities are statutorily dissimilar as are the laws relating to their dissolution."
- The Court's Articulation of the Standard for Dissolution under §702
Having told us what the statute is not, Justice Austin next turns to the central question of §702's meaning. He notes that prior New York cases involving LLC dissolution "have avoided discussion of this standard altogether" leaving the issue unresolved. He also remarks upon the absence of case precedent construing the similarly-worded standard for dissolution under the limited partnership law.
The "not reasonably practicable" standard is linked textually in §702 to "conformity with the articles of organization or operating agreement." This linkage leads Justice Austin to state, quite significantly, that
LLCL 702 is clear that unlike the judicial dissolution standards in the Business Corporation Law and the Partnership Law, the court must first examine the limited liability company's operating agreement (see Matter of Spires v Lighthouse Solutions, LLC, 4 Misc 3d at 432) to determine, in light of the circumstances presented, whether it is or is not "reasonably practicable" for the limited liability company to continue to carry on its business in conformity with the operating agreement (id. at 433). Thus, the dissolution of a limited liability company under LLCL 702 is initially a contract-based analysis. [Emphasis added.]
The absence of New York precedent leads Justice Austin to look to LLC caselaw in other states with the same statutory standard for dissolution. Prominent among these cases is the Delaware Chancery Court's decision last year in Matter of Arrow Investment Advisors, LLC, 2009 WL 1101682 (Del Ch Apr. 23, 2009), where the court dismissed a minority member's application for dissolution of an investment advisory firm that had ceased its advisory business and essentially was reduced to a holding company for the firm's remaining cash and securities assets. The Chancery Court looked to the LLC agreement's broad purpose clause ("such . . . lawful business as the Management Committee chooses to pursue") in holding that, as quoted in 1545 Ocean,
"The court will not dissolve an LLC merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC's owners originally envisioned; such events are, of course, common in the risk-laden process of birthing new entities in the hope that they will become mature, profitable ventures. In part because a hair-trigger dissolution standard would ignore this market reality and thwart the expectations of reasonable investors that entities will not be judicially terminated simply because of some market turbulence, dissolution is reserved for situations in which the LLC's management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock or where the defined purpose of the entity has become impossible to fulfill. . . . Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue."
Other out-of-state cases cited by Justice Austin include Dunbar Group, LLC v Tignor, 267 Va 361, 593 SE2d 216 (2004), where the Supreme Court of Virginia, calling the statutory standard for dissolution a "strict one," reversed an order of dissolution based on deadlock between two 50-50 members of an LLC after the lower court had expelled one of the two members from participating in management; Kirksey v Grohmann, 2008 SD 76, 754 NW2d 825 (2008), where the South Dakota Supreme Court found the standard satisfied in a deadlock situation that left two of four sisters without any meaningful say in the LLC's business affairs contrary to the operating agreement; and a partnership case, Taki v Hami, 2001 WL 672399 (Mich. App. 2001), in which a Michigan appellate court granted dissolution where the two partners had not spoken in years and there were allegations of violence and expulsion.
Drawing on these cases, as well as the language of §702, Justice Austin announced the court's interpretation of the standard for LLC dissolution as follows:
After careful examination of the various factors considered in applying the "not reasonably practicable" standard, we hold that for dissolution of a limited liability company pursuant to LLCL 702, the petitioning member must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.
Notice how the two prongs of the standard -- I'll call them failed purpose and financial failure --are stated in the disjunctive but that each must be analyzed through the prism of the operating agreement or, if there is no operating agreement, in light of the LLC Law's default provisions. This is a significant shift from the less refined and arguably more liberal standard articulated in the one trial court decision that had gained a following, Schindler v. Niche Media Holdings, 1 Misc 3d 713 (Sup Ct NY County 2003), where the court wrote that dissolution of an LLC under §702 is available only if the company "is unable to function as intended, or else that is it failing financially." Henceforth, financial failure alone will not be enough to justify the drastic remedy of dissolution unless such failure is accompanied by, or results from, a frustration of the LLC's purpose that cannot be addressed or remediated by the operating agreement or articles of organization.
Notice also that, in contrast with the formulation recently used by the Delaware Chancery Court in the Lola Cars v. Krohn Racing case (read my post on Lola here), the 1545 Ocean court's formulation does not specify manager deadlock as a basis for dissolution. Indeed, Justice Austin elsewhere in his opinion states that deadlock, while expressly made a basis for dissolution of close corporations under BCL §1104, is not an "independent ground for dissolution" under §702. The court instead "must consider the managers' disagreement in light of the operating agreement and the continued ability of [the LLC] to function in that context." Presumably such consideration of deadlock fits within the unable-to-achieve-LLC's-purpose aspect of the failed-purpose prong, whereas the unwilling-to aspect seems better suited to dissolution cases brought by petitioners holding a minority membership interest.
- The Court's Application of the Standard
Crown Royal argued for dissolution based on the parties' failure to hold regular meetings, failure to achieve quorums, and deadlock over the construction work and, in particular, Van Houten's continuation of the work using VHC despite King's objections. Writing for the 3-judge majority, Justice Austin held that Crown Royal's allegations "failed to meet the standard for dissolution enunciated here" and that, additionally, "there are numerous factors which support the conclusion that dissolution of 1545 LLC is inappropriate under the circumstances of this case."
Why did Crown Royal's petition fall short of the standard? First and foremost, Article 4.1 of the operating agreement (quoted above in the Facts section) permits one manager to act unilaterally unless the other manager's approval is expressly required. As Justice Austin noted, "[t]his provision does not require that the managers conduct the business of 1545 LLC by majority vote." Rather, he continued,
[i]t empowers each manager to act autonomously and to unilaterally bind the entity in furtherance of the business of the entity. The 1545 LLC operating agreement, however, is silent as to the issue of manager conflicts. Thus, the only basis for dissolution can be if 1545 LLC cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created. In this case, that is the development of the property which purpose, despite the disagreements between the managing members, was being met.
The operating agreement likewise did not require regular meetings or quorums. Instead, it merely provided for meetings to be held at such times as the managers "may from time to time determine." The record before the court, Justice Austin found, "demonstrates that the managers, King and Van Houten, communicated with each other on a regular basis without the formality of a noticed meeting which appears to conform with the spirit and letter of the operating agreement and the continued ability of 1545 LLC to function in that context."
What other circumstances rendered dissolution inappropriate? Justice Austin identifies three. First, the dispute between King and Van Houten "was not shown to be inimicable to achieving the purpose of 1545 LLC." King "never objected to the quality of Van Houten's construction work, but only to its expense". King "approved and praised" the work which was all but complete as to Building A.
Second, LLC Law §411 permits an LLC to avoid contracts entered into between it and an interested manager or another company in which a manager has an interest, unless the manager can prove the contract was fair and reasonable. Crown Royal could have, but did not, take action against the contract with VHC under §411. On the contrary, Justice Austin stressed, Crown Royal "ratified, albeit grudgingly at times, Van Houten's unilateral efforts." In any event, he continued, "a fair reading of LLCL 702 demonstrates that an application to dissolve 1545 LLC does not flow from a claim under LLCL 411."
Third, if aggrieved by Van Houten's actions as manager Crown Royal has an alternative remedy in the form of a common law derivative action under Tzolis v. Wolff, 10 NY3d 100 (2008). Such remedy, however, "cannot serve as the basis for dissolution unless the wrongful acts of a managing member which give rise to the derivative claim are contrary to the contemplated functioning and purpose of the limited liability company."
Justice Fisher's Partial Dissent
Justice Fisher's partial dissent begins with the observation that he has "no serious quarrel" with the standard for dissolution adopted by the majority. He briefly recounts the "growing disputes" between King and Van Houten over the latter's alleged mismanagement and billing improprieties in connection with the construction project. Justice Fisher states that Van Houten disputed many of King's allegations, and he notes that the lower court "made no findings of fact." Without such factual findings, he continues,
we cannot meaningfully decide whether the Supreme Court providently exercised its discretion in finding that the actions of the parties rendered it not reasonably practicable for 1545 LLC to carry on its business in conformity with its articles of organization or operating agreement. Accordingly, I would remit the matter to the Supreme Court, Suffolk County, for a fact-finding hearing and thereafter for a new determination on the petition (cf. Business Corporation Law § 1109; Sobol v Les Pieds Nickels, 262 AD2d 194, 196; Matter of Giordano v Stark, 229 AD2d 493, 494-495).
The requirement or not of a hearing in judicial dissolution proceedings can be as important to the outcome of the dispute as the formulation of the dissolution standard. I've seen dozens of appellate decisions reversing the grant or denial of a dissolution petition due to the lower court's failure to conduct an evidentiary hearing in the presence of conflicting affidavits concerning material issues of fact. I doubt that the majority's summary dismissal of Crown Royal's petition is intended to signal a change in direction on that score. Rather, the majority's disposition likely reflects its belief, not shared by the dissenters, that even crediting all of Crown Royal's factual allegations, along with its admissions as to the quality of VHC's work, it still does not meet the threshold for judicial dissolution of 1545 LLC.
Under §5601(a) of the Civil Practice Law and Rules, the dissent by two justices of the Appellate Division may permit Crown Royal to appeal as of right to New York's highest court, known as the Court of Appeals, at least with respect to the issue of its entitlement to a hearing. We'll just have to wait and see whether Crown Royal exercises its appellate rights or, perhaps, reaches some buy-out agreement or other accommodation with its business partner.
Addendum: Read here Professor Larry Ribstein's commentary on the Ocean 1545 case, from which I here quote his concluding paragraph emphasizing the importance of careful drafting of the LLC agreement:
In short, it seems that NY is joining Delaware in emphasizing the role of the operating agreement in judicial dissolution cases. As noted above, this could emerge as an important distinction between LLCs and close corporations, and therefore a factor in choice of form. It also places new emphasis on the need for care in drafting the operating agreement. However, New York has not yet explicitly embraced the operating agreement as determinative. We will have to await further developments to see if New York can shed its long legacy of close corporation law in LLC dissolution cases.
Appellate Court Affirms Caplash Ruling Rejecting Authority of 50% LLC Member to Hire Company Counsel in Proceedings Against Other 50% Member
The fascinating case of Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, involving a multi-faceted litigation between 50-50 members of a dental surgery practice, was fodder last year for several appellate and trial court decisions which in turn were fodder for several posts on this blog (see here, here and here). In what likely is the case's last hurrah, the Appellate Division, Fourth Department, earlier this month affirmed a series of trial court rulings by Monroe County Commercial Division Justice Kenneth R. Fisher including orders upholding the plaintiff's standing to seek dissolution and granting dissolution based on deadlock.
The threshold issue in the case was whether an attorney hired by the defendant 50% member, Dr. Mohammed Salahuddin, had authority under the operating agreement (a) to accept on the company's behalf a letter of resignation from the plaintiff Dr. Jolly Caplash, and (b) to assert counterclaims in the LLC's name against Dr. Caplash. If the attorney had authority to accept the resignation letter, which in turn depended on which of the two doctors held the office of President in the aftermath of a June 2007 member meeting, Dr. Caplash's membership was terminated and he lacked standing to seek dissolution.
In February 2008, the Fourth Department ruled that the issue could not be resolved without a trial of disputed factual issues. In a May 2008 mid-trial decision, Justice Fisher dismissed the counterclaims brought against Dr. Caplash in the LLC's name, concluding that even if Dr. Salahuddin was President of the LLC with general authority to hire company counsel, he had no authority to hire company counsel to prosecute an action against a co-equal 50% member. Justice Fisher's June 2008 post-trial decision found that Dr. Caplash held the President's office and, therefore, the attorney hired by Dr. Salahuddin had no authority to accept Dr. Caplash's resignation letter on the company's behalf which left intact the latter's entitlement to judicial dissolution of the deadlocked company.
On June 12, 2009, the Fourth Department issued a memorandum decision and order reported at 2009 NY Slip Op 04810 batting down all of Dr. Salahuddin's arguments on appeal. In upholding the dismissal of the counterclaims brought against Dr. Caplash in the LLC's name, the court quoted case precedent involving closely held corporations as follows:
" [W]here there are only two stockholders each with a 50% share, an action [or counterclaim] cannot be maintained in the name of the corporation by one stockholder against another with an equal interest and degree of control over corporate affairs; the proper remedy is a stockholder's derivative action' " (Stone v Frederick, 245 AD2d 742, 744-745).
The Fourth Department also upheld Dr. Caplash's standing as a member to seek judicial dissolution, although its analysis differed from Justice Fisher's. Whereas Justice Fisher concluded that the operating agreement effectively created a manager-managed LLC, with management authority vested in the President subject to override by (unanimous) action of the members, the Fourth Department saw the company as member-managed and, therefore, the question was whether Dr. Salahuddin's hiring of company counsel was within the agency authority of a member under Section 412 of the LLC Law. Here's what the court said:
[W]e conclude that the court did not err in concluding that plaintiff has standing to seek dissolution pursuant to Limited Liability Company Law § 702 (see generally Matter of Roller [W.R.S.B. Dev. Co.], 259 AD2d 1012), despite his submission of a letter of resignation. In our view, the company was a "member-managed LLC," rather than a "manager-managed LLC" (see generally § 412 [a]). Our analysis thus turns on the issue whether Salahuddin was authorized to appoint as company counsel an attorney who accepted plaintiff's resignation letter transmitted to him by plaintiff before plaintiff cross-moved for dissolution. "An act of a member . . . that is not apparently for the carrying on of the business of the limited liability company in the usual way does not bind the limited liability company unless authorized in fact by the limited liability company in the particular matter" (§ 412 [c]). Since the appointment of company counsel by Salahuddin was neither for carrying on the usual business of the company, i.e., dental surgery, nor, as required by the terms of the operating agreement, sanctioned by majority vote of the company's members, the company counsel allegedly appointed by Salahuddin was not authorized to represent the company and thus could not have accepted plaintiff's purported resignation letter.
Even assuming, arguendo, that the company counsel was properly appointed by Salahuddin, we conclude that he was neither retained to address general business matters on behalf of the company nor authorized by the operating agreement to act on behalf of that entity (see Limited Liability Company Law § 102 [c]). . . . Moreover, there is no indication that the attorney in question in fact accepted plaintiff's purported resignation before plaintiff cross-moved for dissolution (see Siegel, NY Prac § 249 [4th ed]), or that the purported resignation letter concerned plaintiff's membership in the company, as opposed to his employment with the company.
The different approaches of Justice Fisher and the Fourth Department raise interesting issues of statutory construction and interplay with the operating agreement's management provisions. In this case they both lead to the same result, but I suspect there will be other cases where the analyses and results could diverge.
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.
Poorly Drafted Disability Clause in Operating Agreement Provides Novel Defense to LLC Dissolution Proceeding
"You can't dissolve the company, you're crazy!"
That more or less sums up one of the most novel defenses I've ever come across in a dissolution proceeding, in which the respondent 50% member of an LLC argued that the petitioning 50% member could not dissolve the company because he was under a mental disability as defined in the parties' operating agreement. Although the defense ultimately failed in this case, there's a lesson to be learned about the proper drafting of disability clauses in shareholder and operating agreements.
The case is Matter of Swett (Factors Walk, LLC) decided several years ago by Monroe County Commercial Division Justice Kenneth R. Fisher. In 2002, Bradford Swett and W. Curtis Barnes as 50/50 members formed a limited liability company known as Factors Walk, LLC to develop and sell real estate consisting of a 75-acre subdivided tract. The operating agreement vested management in the two members equally. It also appears to have included a provision, not fully described in the court's decision, authorizing a member to precipitate voluntary dissolution simply by giving notice to the other member.
In 2005, Swett gave Barnes the prescribed notice following which he commenced a proceeding for judicial supervision of the winding up of the LLC pursuant to LLC Law Section 703(a). The statute authorizes a member to seek such relief for an LLC that has been dissolved either voluntarily or by judicial decree under LLC Section 702.
Swett's petition alleged that he and Barnes had been unable to agree on business matters for more than two years and that judicial supervision was necessary to ensure that Barnes did not take actions harmful to the interests of Swett or the LLC. Swett accused Barnes of mishandling the LLC's funds, retaining engineers without Swett's approval, failing to communicate with the LLC's lawyers, and excluding Swett from the LLC's management.
Barnes told a different tale, to say the least. His opposing affidavit disclosed that, in 2003, Barnes commenced arbitration against Swett for excluding Barnes from company management and barring him from access to books and records. The arbitrator's August 2005 award in Barnes' favor confirmed his 50% interest and awarded him legal fees. Following the award, and before Swett filed his court petition, Barnes served Swett with a demand to submit to a medical examination under Section 9.3(e) of the LLC's operating agreement, setting forth the procedure for determination of a "Disabled" member as follows:
The term Disabled shall mean and a person shall be considered Disabled when he is unable to participate in the business of the Company because of physical or mental impairment, and such condition has continued for at least 180 days. In the event of dispute as to the existence of Disability, a Member or Designated Person shall submit to examination by two physicians, one selected by the person whose Disability is in question and the other selected by the other Member(s). If the two physicians agree, their decision shall be binding and final. If the two physicians disagree, they shall select a third physician, whose determination shall be final and binding. If the physicians determine with reasonable medical certainty before the end of the 180-day period that a person is unable to participate in the business of the Company because of physical or mental impairment and is unlikely to recover within the remainder of such period, the person shall be considered Disabled upon such determination.
Barnes contended that Swett had a mental impairment based on his "irrational", "obsessive" and "destructive" behavior, and that such disability disqualified Swett from pulling the dissolution trigger under the operating agreement. Swett disputed his obligation to undergo a mental analysis as demanded by Barnes under Section 9.3(e).
Justice Fisher's decision is based on principles of contract construction. He finds that the "provisions for a mental examination made in Section 9.3(e) are clear and unambiguous" and that the members agreed to submit to an examination in the event of dispute as to the existence of disability. "Despite this clear language," he continues, "the court disagrees with Barnes' interpretation of Section 9.3(e) and consequently opts not to sua sponte require the parties to comply with the provisions of Section 9.3(e)." Barnes' argument, that Section 9.3(e) authorizes a 180-day retrospective disability determination and thereby negates actions taken by Swett during such period,
defies both logic and the language implemented in Section 9.3(e) to state that physicians would be able to assess Swett and, assuming a mental disability was found, determine that said disability had been in existence for 180 days previous, or any other period of time prior to the time the physicians examined him. Rather, a simple reading of Section 9.3(e) reveals that a disability will only be found where physicians observe that a disability exists and continues "for at least 180 days." . . . A contrary interpretation of Section 9.3(e) would render the last sentence of the section [concerning] a physician's ability to make such a disability determination prior to the end of the 180 day period meaningless.
Since a subsequent determination of Swett's alleged mental disability, i.e., made after he gave notice of dissolution and petitioned for judicial supervision of dissolution, would not negate his standing to take those actions,
the only effect compelling examinations pursuant to Section 9.3(e) would have at this juncture would be to forestall the inevitable dissolution and wreak havoc on decision making within this troubled LLC. . . .
. . . Consequently, as Swett was both a fifty percent member and a member holding a right to vote as of the date of his petition, he validly caused the dissolution of the LLC on that date. See N.Y. LLCL 701 ("A limited liability company is dissolved and its affairs shall be wound up upon the first to occur of the following . . . the happening of events specified in the operating agreement . . ."). As the dissolution has already occurred pursuant to Section 10.1(b), the issue remaining is the winding up of Factors Walk.
Based on the members' mutual distrust, their longstanding dispute over control, and their ongoing inability to function as business members of the LLC, Justice Fisher granted Swett's petition for judicial supervision and also appointed a receiver to wind up the LLC's affairs.
I make no comment on the bona fides of Barnes' ultimately unsuccessful reliance on the disability clause as a foil to Swett's action to dissolve the LLC. The disability mechanism called for in their operating agreement nonetheless appears poorly thought out and subject to abuse. Buy-sell agreements frequently include death and disability as trigger events for the company's obligation to purchase the affected owner's interest. Typically, the disability clause will incorporate by reference the definition and procedures for determination of disability found in the waiver-of-premium provision in the life insurance policies purchased to fund buyout upon death or, alternatively, they may initially require a written opinion of disability by the affected owner's personal physician. Such mechanisms appropriately give to the putatively disabled owner the sole right and initial burden to institute a disability determination, in contrast with the scheme used in Swett permitting one owner at will to initiate a disability determination of the other owner. The disability clause should be designed to serve its salutary purpose to resolve transfer of ownership interests and payment in the unfortunate event of a physical or mental impairment, and not as a potential sword or shield in a battle for company control.
Delaware and New York Courts Agree that 50% LLC Member May Not Hire Lawyer to Represent Company Adverse to Other 50% Member
There's been a recent flurry of courtroom battles over the authority of one 50% owner to engage counsel to represent the company adverse to the other 50% owner in dissolution proceedings or other types of internecine corporate warfare. I've previously written about some of these cases, including Sports Legends, Inc. v. Carberry, in which the court dismissed as unauthorized a suit by the corporation initiated by one 50% shareholder against the other for conversion of company assets (read here), and the infinitely fascinating Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC, where one 50% LLC member hired company counsel in a multi-faceted litigation with the other 50% member that included dueling dissolution applications (read here and here).
Two new decisions reinforce the general proscription against the hiring and militant alignment of company counsel by one 50% owner against the other. One comes out of the Delaware Court of Chancery, which many -- present company excluded, I'm a dyed-in-the-wool New York partisan -- consider the premier business law court. The other decision appears to be the final word in the Caplash saga.
Maitland
The Delaware case, Maitland v. Int'l Registries, LLC, 2008 WL 2440521 (Del. Ch. June 6, 2008), is an action to inspect books and records brought by a 50% member of a member-managed Delaware LLC. The other 50% member hired counsel who filed an answer on the LLC's behalf opposing the relief. The plaintiff moved to strike the answer and disqualify company counsel.
In his letter ruling granting the plaintiff's motion, Chancellor William B. Chandler III focuses on the operating agreement's provision vesting management of the LLC's affairs in the members by majority rule. So long as the LLC has only two co-equal members, the Chancellor concludes, neither one "can unilaterally control the LLC". "Where they disagree," he continues, "the LLC is deadlocked" and a "deadlocked LLC cannot validly retain counsel and file an answer." Were the rule otherwise, the Chancellor further notes, the court might face the impossible situation of two competing company counsel hired separately by each member.
Does that leave the company defenseless against the plaintiff's action? Chancellor Chandler deals with this by granting the non-party LLC member leave to intervene as a party defendant with authority to defend on behalf of the LLC. Assuming the non-party member could have intervened in the first place, you might further ask, what's this skirmish over representation really about? The answer: legal fees. As hinted in the letter ruling, both sides appear to be jousting in an effort to have the LLC foot the bill for their side's fees (but not the other's), either in the first instance or by way of indemnification. Footnote 1 of the letter ruling puts this to rest by clearly indicating that, per the so-called American Rule, each side must pay its own legal fees.
Caplash
When we last visited this case, Monroe County Commercial Division Justice Kenneth R. Fisher issued a mid-trial decision (1) denying Dr. Salahuddin's summary judgment application to dismiss Dr. Caplash's request to dissolve the LLC for lack of standing, and (2) dismissing counterclaims against Dr. Caplash filed on behalf of the LLC by a lawyer hired by Dr. Salahuddin. On the first issue, the central inquiry requiring completion of the trial was whether the putative company lawyer was authorized to accept Dr. Caplash's December 2007 letter resigning from the LLC which, in turn, depended on which of the two doctors held the office of President in the aftermath of a June 2007 member meeting. This issue took on importance because of Justice Fisher's finding that, under the terms of the operating agreement, the LLC was managed by the President absent a superseding directive by a majority of the members. A secondary issue requiring trial was whether the resignation letter was unequivocal or conditioned on the release of Dr. Caplash from restrictive covenants and, therefore, ineffective because the conditions were not accepted regardless of the lawyer's authority.
Justice Fisher's 21-page post-trial decision (20 Misc 3d 1104(A), 2008 NY Slip Op 51216) is characteristically rich with evidentiary detail and analysis. Court opinion junkies will particularly enjoy reading the judge's descriptions and resolution of the conflicting witness accounts of the June 2007 member meeting, and of the fast-paced procedural ping-pong preceding and post the December 2007 Caplash resignation letter. The court ultimately finds that Dr. Caplash was validly elected President at the June 2007 meeting, hence the putative company lawyer was not authorized to accept the resignation letter, hence Dr. Caplash had standing to file his request for dissolution following the letter, hence the LLC's dissolution is ordered based on unquestionable, dysfunctional deadlock. Justice Fisher also finds that Dr. Caplash's resignation letter was conditional on the LLC releasing him from his employment agreement containing restrictive covenants, which release was never accepted. "Any other result," Justice Fisher writes, "would lead to manifest unfairness."
Justice Fisher's opinion cites Chancellor Chandler's Maitland letter ruling in rejecting Dr. Salahuddin's contention that, as a 50% member of the LLC, he was authorized to hire company counsel. I don't think either case would come out differently in a court of either state, but I find interesting the somewhat different approaches taken in the Delaware and New York cases addressing LLC governance. Delaware case law views LLCs as creatures of contract (see, e.g., Fisk Ventures, LLC v. Segal, 2008 WL 1961156 [Del. Ch. May 7, 2008]) and decides governance disputes strictly based on the terms of the operating agreement, as reflected in Maitland. The New York cases, particularly those involving member-managed LLCs, implicitly if not explicitly cut against Delaware's contractarian approach in the ease and frequency with which they will resolve LLC governance disputes based on equitable, common law principles including the imposition of implied fiduciary duties. Professor Larry Ribstein's Ideoblog and the Unincorporated Business Law Prof Blog are good places to explore more learned viewpoints on the subject, including Professor Gary Rosin's recent posting on the Maitland and Caplash cases.
Caplash Redux: 50% Member Cannot Hire Lawyer to Represent LLC in Dispute with Other 50% Member
When 50-50 business partners have a falling out, the ensuing battle for the high ground can lead one of them to take hostile action in the company's name without the other's consent.
Examples of the phenomenon, recently featured in this blog, include the case of Hellman v. Hellman, where the court upheld the authority of a 50% shareholder as president to enter into a lease opposed by the other shareholder, and Sports Legends, Inc. v. Carberry, where the court refused to authorize a lawsuit brought in the company's name by one 50% shareholder against the other.
Then there's Caplash v. Rochester Oral & Maxillofacial Surgery Associates, LLC. About four months ago I wrote about an appellate decision in the Caplash case in which the court reversed a trial court order dissolving a medical practice LLC because of unresolved factual issues concerning the plaintiff's standing to seek dissolution. The issue before the court was whether to give legal effect to the plaintiff's letter to the company resigning his employment, and thereby terminating his LLC membership, where the company's requisite acceptance of the resignation was by letter from an attorney whose authority under the operating agreement to act on the company's behalf was not established. The appellate court sent the case back to the trial court for a hearing to determine the issue.
Since then, there's been a flurry of activity in the Caplash case and a new trial court decision (reported at 19 Misc 3d 1138(A)) which, I'm happy to report, supplies many of the underlying facts missing from the appellate decision. The recent decision, by Justice Kenneth R. Fisher of the Monroe County Supreme Court, Commercial Division, addresses two issues of interest. First, it examines the interplay between the parties' operating agreement and the LLC Law in deciding whether the lawyer engaged by one member with 50% voting power had the authority to accept on the LLC's behalf the other member's resignation. Second, it determines whether the same lawyer could act on the entity's behalf in asserting claims against the resigning member for wrongful competition and other economic injury to the LLC.
The Facts and Litigation Proceedings
The facts in Caplash portray a medical practice buyout gone seriously awry almost from the get-go. The practice initially consisted of Drs. Vernon Loveless and Mohammed Salahuddin. Along comes Dr. Jolly Caplash who agrees to purchase Dr. Loveless's membership interest and gives him a $400,000 promissory note on which he makes only two payments before things start to fall apart. Dr. Caplash accuses Dr. Loveless of hiding certain problems in the business including strife between Drs. Loveless and Salahuddin. He also alleges that Dr. Loveless had foreknowledge that Dr. Salahuddin would interfere with Dr. Loveless's introduction of referring doctors to Dr. Caplash, and that he failed to disclose Dr. Salahuddin's intention to leave the practice.
In 2006, Drs. Loveless and Caplash filed separate lawsuits, the former to recover from Dr. Caplash on the promissory note and against Dr. Salahuddin for tortious interference, and the latter against Dr. Salahuddin seeking a declaratory judgment that Dr. Caplash is president and CEO of the LLC. Dr. Caplash's complaint named the LLC as a party defendant but sought no relief against it. Dr. Salahuddin's original answer (I'm guessing it was filed prior to Dr. Caplash's disputed resignation letter in December 2006) asserted derivative counterclaims against Dr. Caplash and also sought to dissolve the LLC. Dr. Salahuddin's amended answer (I'm guessing it was filed after the resignation letter) dropped the dissolution counterclaim.
Dr. Salahuddin also hired his personal attorney to represent the LLC to defend it in the declaratory judgment action. The attorney filed an answer by the LLC with counterclaims seeking a money judgment against Dr. Caplash for wrongful competition, failure to remit earnings to the LLC, and improper use of a company credit card.
Following the appellate court's remand, Justice Fisher commenced a hearing and took testimony of Dr. Salahuddin's lawyer concerning his authority to act on the LLC's behalf. The court then issued an order inviting a motion directed to the issues: (1) the propriety of the LLC's interposition of a counterclaim for dissolution, (2) whether the LLC's participation in the case had improperly assumed a militant alignment on the side of one of two co-equal members, and if so (3) whether the LLC's funds were properly being used for litigation expenses.
FIVE motions followed. Of interest here are two of them: Dr. Salahuddin's motion for summary judgment closing the evidentiary hearing and declaring that Dr. Caplash has no standing to seek judicial dissolution, and the LLC's motion for summary judgment on its counterclaims against Dr. Caplash.
The Court Refuses to Close the Hearing or Declare that Dr. Caplash Lacks Standing
Dr. Salahuddin argued that, under Section 401 and Section 412 of the LLC Law, he had the authority as an agent of the LLC to hire counsel who in turn could accept on the LLC's behalf Dr. Caplash's December 2006 letter of resignation. Justice Fisher found two insuperable problems with the argument. The first was the appellate court's "unequivocal direction to hold a hearing" which, Justice Fisher observes, "is not lightly discarded in favor of summary disposition, even at the behest of the party which originally opposed the summary judgment motion reviewed by the Appellate Division". Second, Justice Fisher writes that Dr. Salahuddin's contention
is fully undermined by the provisions in the Operating Agreement for management of the company by its officers . . ., including a President who is by the Operating Agreement given unrestricted authority as "Chief Executive Officer of the Company" to engage in "the general management of the affairs of the company" in the absence of contrary "direction of the members"'.
Here, the default provisions in LLC Law Sections 401 and 412, vesting management in the members in the absence of contrary provisions in the operating agreement, are trumped by the Operating Agreement's plenary delegation of management authority to the LLC's President, subject only to duly adopted member directive. As Justice Fisher explains further:
The structure of this operating agreement compels the conclusion that ROMSA is a manager-managed LLC and not a member-managed LLC unless the members take action at a duly convened meeting or by written consent. [Citations omitted.] Similarly, Salahuddin's contention that he was an agent of ROMSA for the purpose of hiring counsel for the entity to defend it against a simple declaratory judgment action relative to the June 2006 members meeting and election, and thereby to convert ROMSA's status in that action as a mere nominal defendant into an active litigant on one side of this 50-50 membership dispute (complete with counterclaims against the other 50% member) is wholly misplaced. Section 412(a) speaks only of an agency "for the purpose of . . . [an LLC's] business" and the execution of instruments "for apparently carrying on in the usual way the business of the limited liability company." It does not address the extraordinary transformation of an LLC as a nominal defendant in a declaratory judgment action into an active litigant against one of its members.
Based on the documentary evidence and the testimony of Dr. Salahuddin's lawyer, were the hearing to be closed, it was clear that Dr. Salahuddin was not President of the LLC and therefore did not have the authority to hire LLC counsel to accept Dr. Caplash's letter of resignation. Posing an ironic twist, Justice Fisher also notes that:
At the time, Salahuddin might have himself accepted the resignation as the only other member of ROMSA, but there is no evidence that he did so before the motion for dissolution was argued or before Caplash subsequently rescinded his resignation. In any event, Salahuddin had at the time interposed a counterclaim for dissolution and a motion for the same in the Caplash action, thus implicitly recognizing Caplash's membership status, a recognition that was not withdrawn until Salahuddin decided at the eleventh hour to withdraw his motion for dissolution.
The Court Summarily Dismisses the LLC's Counterclaims
Justice Fisher employs a dual analysis with respect to the LLC's active participation as counterclaimant in the litigation brought by Dr. Caplash for declaratory relief. Each one leads to the same conclusion, namely, that Dr. Salahuddin had no authority to engage entity counsel who had no authority to pursue litigation in the LLC's name against one of the LLC's two co-equal members.
First, based on his prior finding that the LLC is manager-managed in the absence of duly authorized action of the members, he concludes that Dr. Salahuddin as a 50% member had no authority to hire counsel to represent the LLC. "No evidence has been adduced", writes Justice Fisher, "that a meeting of ROMSA was held during which the retainer was authorized by a vote of the members, nor is there any evidence that the initiation of a lawsuit in the entity's name against one of its members was duly authorized".
Second, even assuming Dr. Salahuddin was president of the LLC at the relevant times, Justice Fisher finds that:
he had no authority to hire counsel for ROMSA for the purpose of prosecuting in the LLC's name an action against a co-equal 50% member; the sole remedy was the derivative suit he instituted by way of his own counterclaim. See Stone v. Frederick, 245 AD2d 742, 744-45 (3d Dept. 1997)(collecting authorities), discussed in Hellman, supra, slip opn. at 12. Contrary to Kristal's repeated characterization, Caplash did not sue ROMSA. Drawing an analogy from the partnership context, "[s]ince this is a dispute between partners over the interpretation of the rights and obligations under the partnership agreement, it is not a proceeding by or against the partnership [citation omitted], even though the partnership is made a nominal party plaintiff." Tesco Properties, Inc. v. Troy Rehabilitation and Insp. Project, Inc., 166 AD2d 839, 841 (3d Dept. 1990). [Footnote omitted.]
For these reasons, and invoking the court's authority on a summary judgment motion to search the record and grant judgment to the non-moving party, Justice Fisher granted summary judgment dismissing all counterclaims interposed by the LLC.
No doubt about it, the Caplash scorecard is a messy one. In a portion of the decision redacted from the published version, the court rejected Dr. Caplash's fraudulent inducement defense and granted Dr. Loveless summary judgment enforcing Dr. Caplash's $400,000 note obligation. I suspect this one will go a few more rounds before it's over.
Court Upholds Authority of 50% Shareholder/President to Sign Lease Without Co-Owner's Approval
Internal shareholder disputes involving closely held corporations can take several different forms when they land in court. The type of litigation addressed primarily by this blog is the dissolution proceeding, in which the ultimate objective is the company's liquidation or, as usually happens, a buyout. Sometimes, as a prelude to dissolution proceedings or negotiated buyout, one shareholder files suit accusing another shareholder of engaging in unauthorized company transactions. Such tactical lawsuits can be particularly effective with companies with 50/50 shareholders where the complainant believes with some justification the court is more likely to enforce the rights of a co-equal owner to an equal say in the company's business affairs.
Along these lines comes the fascinating case of Hellman v. Hellman (read decision here) involving a fight between two brothers each owning 50% of the shares in a lighting business founded by their father in the 1950s, called Maynards Electric Supply. The decision, written by Justice Kenneth R. Fisher of the Commercial Division in Rochester, is a scholarly and highly instructive exegesis on the interplay between officer and board authority in the closed corporation setting where, typically, no one pays attention to corporate formalities until it's too late.
Brothers Glenn and Bruce Hellman are Maynards' sole shareholders and directors. Both are actively employed in the business. Bruce is President and Treasurer. Glenn is Vice-President and Secretary. The business operated since 1985 in a building owned jointly by the two brothers and two other siblings. The lease was scheduled to expire at the end of June 2005. In 2004, Bruce began lease negotiations with the owner of another building ("Stockwood"). Bruce informed Glenn of the negotiations. Glenn disagreed with the proposed relocation. Lawyers for the two exchanged letters in which Glenn warned that Bruce lacked authority on his own to make commitments on the company's behalf. Bruce's lawyer sent Glenn the proposed form of lease. Glenn objected anew to Bruce's authority to enter into the lease. In May 2005, Bruce announced that the company would not be renewing the existing lease upon termination. Two days before the termination date, Bruce as President executed in the company's name a five-year lease with Stockwood. Shortly thereafter he informed Glenn of the new lease and advised of a planned move the coming Fall. Glenn's lawyer wrote to Stockwood maintaining that Maynards had not approved the lease.
In August 2005, Glenn filed a lawsuit against Bruce and Stockwood. Glenn asserted (1) that Bruce lacked authority to execute the lease without the prior affirmative vote of the board of directors, (2) that the Stockwood lease constituted waste of corporate assets, (3) that the lease should be set aside and declared null and void, (4) that Stockwood refund all lease payments made by Maynards, and (5) that Bruce reimburse the company for any damages occasioned by the lease and pay Glenn's attorney's fees.
Following discovery the brothers both moved for summary judgment on the two main issues surrounding the lease: First, was Bruce authorized to enter into the Stockwood lease without getting the prior approval of Maynards' board of directors consisting of the two brothers? Second, even with such authority, could Glenn challenge the lease as corporate waste, or was it beyond judicial scrutiny under the business judgment rule?
Justice Fisher begins his analysis with the two, basic sources of authority for action by a board and its officers. The first is New York's Business Corporation Law, section 701 of which states that "the business of a corporation shall be managed under the direction of its board of directors" and section 715(g) of which states that "[a]ll officers as between themselves and the corporation shall have such authority and perform such duties in the management of the corporation as may be provided in the by-laws or, to the extent not so provided, by the board." The second is Maynards' by-laws which essentially restate BCL section 701 as far as the board's role, and provide as follows concerning the duties of president:
The president shall be the chief executive officer of the corporation; he shall preside at all meetings of the shareholders and of the board; he shall have the management of the business of the corporation and shall see that all orders and resolutions of the board are carried into effect.
The quoted by-law provision, states Justice Fisher, places "[n]o limitations of any sort . . . upon the president in fulfilling management duties as chief executive officer". This in turn forms the legal framework for the judge's analysis of the facts. "In the absence of any express restriction in the by-laws or otherwise," says Justice Fisher, "the actual conduct of the business by its president must inform the decision whether the president had the presumptive power to enter into the lease without the prior authorization of the board of directors."
The decision includes lengthy excerpts from the brothers' deposition testimony, the gist of which Justice Fisher describes as follows:
Both depositions demonstrate that decisions of corporate management were not made by a vote of the board of directors and that Bruce Hellman, as president of Maynards, made most, if not all major decisions (as had his father before him), taking into consideration input from Glenn Hellman only as he saw fit.
Justice Fisher accordingly concludes that Bruce "had presumptive implied authority to execute the lease with Stockwood without pre-approval from the board of directors, and even when he knew that Glenn Hellman would object at a duly convened board meeting if one were scheduled." In reaching his conclusion, Justice Fisher rejects Glenn's reliance on Sterling Industries, Inc. v. Ball Bearing Pen Corp., 298 NY 483 (1947). In Sterling the New York Court of Appeals held that the presumption of actual implied authority was rebutted, or did not apply in the first instance, where the president initiated a lawsuit notwithstanding that the corporation's board, by a deadlocked vote, had failed to authorize the litigation. "A similar situation is not present here," writes Justice Fisher, "where Glenn Hellman offers no admissible proof, or allegation even, that the board of Maynards was called to meeting, formal or otherwise, and he offers 'no minutes as to corporate action in such capacity by them [as members of the board of directors], with respect to this action' in executing the lease by the corporate president." In other words:
The context of this case requires the court, in determining whether Bruce Hellman has met his initial burden on summary judgment, to sustain the exercise of the president's presumptive, actual, implied power to act in executing a lease in the normal course of business, in the face of objections interposed by Glenn Hellman and his attorneys without any effort to convene the board for the purpose of restricting the president in his exercise of the management powers conferred on him by the by-laws and past practice in general, or for the specific purpose of forbidding the lease with Stockwood in particular.
Justice Fisher next addresses what he calls the "more difficult question" whether Bruce is entitled to summary judgment dismissing Glenn's claim of waste based on allegations that the lease with Stockwood is detrimental to the company's interests. The difficulty arises, Justice Fisher writes, because there is no New York case precedent that squarely addresses whether the action of an officer, not taken in the dual role of officer/director, is entitled to protection under the business judgment rule. Under the rule, corporate decisions are immune from judicial scrutiny unless they lack a legitimate business purpose or are tainted by a conflict of interest, bad faith or fraud.
Justice Fisher highlights commentary taking both sides of the issue, but ultimately concludes that "the great weight of authority favors application of the business judgment rule to officers acting in their capacity as officers within the scope of their delegated authority." As applied to the facts before him, Justice Fisher holds in favor of Bruce as follows:
Bruce Hellman executed the lease within the scope of his delegated authority, as detailed at length above, and therefore is entitled to have that discretionary decision reviewed under the rubric of the business judgment rule just as if the board of directors had made the decision itself. Any other approach would encroach on a president/general manager's presumptive powers as set forth in the New York caselaw set forth above, and would by judicial fiat effectively "surrende[r]" a corporate board's otherwise sustainable "delegation decision" and thereby "interfere with corporate management by subjecting the officer to greater scrutiny" than the board would be subjected to if it had made the decision itself.
* * * * * * * *
As set forth, no evidence or allegation is made that the transaction ultimately made by Bruce Hellman was self-interested. Bruce Hellman establishes on his motion the economic and other reasons for the decision to enter into the Stockwood lease and abandon the family owned premises on North Clinton Avenue, and therefore he establishes his good faith. Glenn Hellman fails to raise an issue as to whether the decision was not made in good faith.
So what are the lessons of the Hellman case? First and foremost, when 50/50 shareholders are on a collision course, regardless whether formal board meetings have been conducted in the past, the shareholder looking to block corporate action by the other shareholder/officer should call a meeting of the board (and/or a shareholders meeting, depending on the circumstances) to consider the disputed corporate action. If both shareholders/directors attend, the resulting deadlock vote on a resolution to approve the disputed action presumably will terminate officer authority to undertake the very same action. If the other shareholder boycotts the meeting and thereby defeats quorum requirements under the by-laws -- an issue not addressed in Hellman -- I'll hazard a guess the court will deem such conduct the equivalent of board deadlock.
The second lesson is, dust off the by-laws and read them closely. You may be surprised at the variance between what they say and how the principals have operated the company.
Finally, I presume there was no written shareholders' agreement in Hellman since Justice Fisher does not mention one. Shareholders' agreements frequently specify major decisions requiring unanimous or super-majority approval by the shareholders. Typically included are merger and sale of the company, along with other important decisions involving mortgages, leasing, engagement of lawyers and accountants, and expenditures over defined dollar thresholds. The point is, particularly in the 50/50 corporation where negotiating leverage presumably is equal at the outset, the parties can use a written shareholders' agreement to avoid one shareholder "pulling rank" based on his or her designation as president.
Update March 30, 2009: On Glenn Hellman's appeal from the decision, last week the appellate court vacated the grant of summary judgment, and reinstated his complaint, on the ground that Glenn had raised issues of fact requiring trial as to Bruce's authority to act without Board authority. 2009 NY Slip Op 02418 (4th Dept Mar. 27, 2009). Here's what the court wrote:
The record establishes that, pursuant to the bylaws of "Maynard's Holding Corp.," the president, i.e., defendant, was vested with "the management of the business of the corporation," and he thus had the presumptive authority to enter into contracts on the corporation's behalf in the course of the business of the corporation (see generally Goldston v Bandwidth Tech. Corp., 52 AD3d 360, 362-363, lv dismissed 11 NY3d 904; Odell v 704 Broadway Condominium, 284 AD2d 52, 56-57). The record further establishes that defendant previously had signed leases on behalf of the corporation, although plaintiff contends in this instance that he did not agree to the lease and also did not agree that defendant had the authority to bind the corporation to it. Plaintiff also established in opposition to the cross motions that the previous leases signed by defendant were the subject of Board resolutions granting defendant the authority to sign them, or they were signed by defendant "by authority of the Board of Directors of [the] corporation." We thus conclude that plaintiff raised an issue of fact whether, pursuant to past practice, defendant had the authority to lease property without prior authorization by the Board (see Arrow Communication Labs. v Pico Prods., 206 AD2d 922, 923; see also 56 E. 87th Units Corp. v Kingsland Group, Inc., 30 AD3d 1134, 1134-1135). In light of our determination, we do not reach the parties' remaining contentions.
It's hard to square the appellate court's finding of evidence of prior leases receiving Board approval with the deposition testimony summarized in the lower court's decision, but that's what makes appeals so hard to predict.
