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.
Appellate Ruling in Stock Valuation Case Further Muddies the Marketability Discount Waters
In determining the fair value of corporate shares, should the discount for lack of marketability (DLOM) apply only to the company's good will value, or to the entire enterprise value including tangible assets? Court decisions in New York tend to apply DLOM in the 25% range, so the answer can make a big difference in the ultimate award, particularly when the business is asset-heavy.
I've written before (read here) about conflicting case precedents in the Manhattan-based First Department (DLOM applies to enterprise value) and the Brooklyn-based Second Department (DLOM applies to good will value). Permit me to quote from that prior post, where I wrote:
With locked horns in the two downstate appellate departments, and no decisions on the subject from the two upstate appellate departments, it'll likely take some yet-to-be-born big-money valuation case to wend its way up to New York's highest court, the Court of Appeals, before we get a definitive answer.
Well, we still don't have a definitive answer from the Court of Appeals, but we do have a new decision on the subject from one of the upstate departments. The result aligns the Rochester-based Fourth Department with the First Department (DLOM applies to enterprise value), but the decision offers no analysis and, if anything, further muddies the DLOM waters.
The Fourth Department's decision in Matter of Rateau (DAPA Communications, Inc.), 59 AD3d 1037, 2009 NY Slip Op 00890 (4th Dept 2009), took an unusual path. DAPACom, founded in 1989 and based in Allegany, New York, manufactures and installs tower and antenna systems. The case started as a petition by 34% shareholders to dissolve the company under the minority shareholder oppression statute, Section 1104-a of the Business Corporation Law (BCL). The majority shareholders then caused DAPACom to elect to purchase the petitioner's shares for fair value under BCL Section 1118. At the valuation trial, the petitioner's expert valued the company between $728,000 and $755,000 using the adjusted net asset value method. This method, which basically adopts the company's book value as adjusted for fair market value of assets and liabilities, normally undervalues an operating business and therefore is rarely given much if any weight by either side, and even less so by the party being bought out. In any event, using this method the petitioner's expert computed the pro rata value of petitioner's 34% interest around $250,000. DAPACom's expert, using the income and market approaches to value the company as a going concern, testified that the petitioner's shares had zero value, reflecting the company's cumulative losses of $1.9 million in the four years prior to the valuation date. He alternatively valued the shares at $26,000 using the adjusted net asset approach after applying a 25% minority discount a/k/a discount for lack of control (DLOC) and a 30% DLOM.
In the first of two lower court decisions leading to the appeal, Cattaraugus County Judge Larry M. Himelein noted the three basic methods used to determine the going-concern value of a company: market value, investment or income value, and net asset value. The problem with DAPACom's expert's income and market approaches, observed Judge Himelein, was that "if the business were truly worth nothing, it would not continue to operate." Therefore, he went on, "based on the information provided, the court has no choice but to ascertain the company's net asset value." Judge Himelein criticized the petitioner's valuation of the company's equipment because it was based, at least in part, on advertised prices without any indication of what the actual selling prices of the items were. Based on the court's review of the testimony and the exhibits, Judge Himelein arrived at a "liquidation value" of the company of $180,000.
Judge Himelein then tackled discounts. First, citing numerous case authorities, he found "inappropriate" DAPACom's expert's application of a 25% minority discount (DLOC). He next addressed DLOM, writing as follows:
[Respondents' expert] also applied a 30% lack of marketability discount, which is appropriate for an operating business. However, a lack of marketability discount may or may not be appropriate when talking about selling hard assets. On the other hand, there would be significant costs involved in selling off the equipment, i.e., advertising, auctioneers and the like. Therefore, whether deemed a lack of marketability discount or a cost of sale discount, the court will apply a discount of thirty percent. [Citations omitted.]
With a 30% discount, the value of the petitioner's 34% interest was computed at $42,840.
The case took another turn pre-appeal, when the petitioners made a post-trial motion challenging the court's valuation including its consideration of a cost-of-sale discount. In the second of his two written decisions, Judge Himelein expressed his "discomfort" using net asset value to value the company, but he went on to say that he had no choice but to use it given his rejection of DAPACom's expert's zero valuation of the company "as a going concern." Judge Himelein rebuffed the petitioner's critique of his valuation of the company's equipment based on the conflicting trial testimony, but he agreed with the petitioners that he should not have considered cost-of-sale discount, writing as follows:
The court noted that it was not clear that a lack of marketability discount was appropriate when selling off hard assets but there clearly would be costs associated with such a sale. However, petitioners are correct in their contention that no proof of an appropriate discount was introduced, and theoretically, if the company sold its assets, there might be little, if any, costs associated with the sale.
On that basis Judge Himelein vacated the 30% discount and increased the petitioner's valuation award to $61,200.
DAPACom appealed from the modified award. It argued that (1) the case authorities require application of marketability discount; (2) the lower court should have valued DAPACom as a going concern and not based on its liquidation value; and (3) the lower court's $180,000 net asset valuation was "arbitrary and capricious". It did not argue for application of a cost-of-sale discount as postulated in Judge Himelein's original order. (See bottom of page for links to all the appellate briefs.)
In their brief opposing the appeal, the petitioners cited Second Department case law, including Matter of Cinque, 212 AD2d 608 (1995), Matter of Whalen, 234 AD2d 552 (1996), and Cohen v. Cohen, 279 AD2d 599 (2001), to argue that the lower court properly excluded DLOM since the company's valuation based on adjusted net asset value did not include any good will. They also argued that the lower court's use of the adjusted net asset value was proper because (1) DAPACom's expert acknowledged that the company had a "tangible net value" even if it was losing money from its operations, and (2) liquidation value generally is lower than going concern value, so DAPACom had no basis to complain.
DAPACom's reply brief argued that under the Court of Appeals' decision in a matrimonial valuation case, Amodio v. Amodio, 70 NY2d 5 (1987), the court must apply DLOM in valuing the shares of a closely held corporation. The brief did not directly respond to petitioner's Second Department cases, nor did it refer to the First Department's decision in Hall v. King, 265 AD2d 244 (1999), which affirmed a lower court ruling that applied DLOM to net asset value and expressly disagreed with the Second Department cases. (DAPACom's initial appeal brief cites Hall v. King but without any discussion of it.)
The Fourth Department's decision on the appeal is disappointingly brief, devoting only one sentence to the DLOM controversy which it decided in DAPACom's favor as follows:
We agree with DAPACom, however, that the court erred in failing to apply a discount for the lack of marketability of petitioners' shares in DAPACom (see Seagroatt Floral Co., 78 NY2d at 445-446; Amodio v Amodio, 70 NY2d 5, 7 [1987]; Hall, 265 AD2d 244 [1999]; cf. Matter of Whalen v Whalen's Moving & Stor. Co., 234 AD2d 552, 554 [1996]; Matter of Quill v Cathedral Corp., 215 AD2d 960, 963 [1995], lv dismissed 86 NY2d 838 [1995]).
Note how the decision cites both Hall v. King and Matter of Whalen even though the two cases disagree on the very issue before the court. The cite to Whalen is preceded by the "cf." signal which means the case cited supports by analogy the stated proposition. I find that very hard to fathom given Whalen's express limitation of DLOM to the good will component of a company's value of which there was none in the case at hand. Go figure.
DAPACom did not fare as well on its argument that the lower court failed to value the company as a going concern. Here's what the Fourth Department said:
Contrary to DAPACom's contentions, we conclude that the court properly valued DAPACom " 'as an operating business' " and that the court properly used the net asset valuation method. We further conclude that the court's valuation of DAPACom falls "within the range of testimony presented" and should not be disturbed. [Citations omitted.]
I'm advised by case counsel that, on remand following the appeal and without a written decision, Judge Himelein entered amended judgment using a 20% DLOM (down from 30%) to value the petitioner's shares.
No doubt about it, Matter of Rateau is a quirky case that not only fails to shed new light on an important facet of New York stock valuation proceedings, but only confuses the matter by its reliance on contradictory precedent. I wish the lower court decisions, and the appellate briefs, had focused more directly on the issue whether DLOM applies to entire enterprise value or only good will. I wish the Fourth Department had written a decision that acknowledged the split between the downstate departments and that offered a reasoned explanation for its seeming agreement with the First Department's position in Hall v. King.
Update October 13, 2009: Readers interested in this topic will want to read my recent post on the Jamaica Aquisition case in which the Nassau County trial court sided with Hall v. King in applying 25% DLOM to the entire enterprise value of several real estate holding corporations.
Appellate Court Enforces Stock Buyback Triggered by Dissolution Petition
One of my pet issues, on which I've written a number of times (see here, here and here), is whether the filing of a dissolution petition triggers a mandatory stock buyback under a shareholders' agreement that provides a right of first refusal (RFR). The cases raising the issue have all been deadlock dissolution petitions brought by 50% shareholders under Business Corporation Law Section 1104(a). That statute, unlike Section 1104-a governing minority shareholder oppression, does not give the respondent shareholders the right to purchase the petitioner's shares under Section 1118.
If the shareholders' agreement expressly provides that the filing of a dissolution petition triggers the RFR, unquestionably it should be enforced. The problem arises with the more typical RFR that does not contain such express language, but instead contains what most would consider boilerplate reference to stock transfers. Is enforcement by reason of such general language consistent with a shareholder's reasonable expectations, and with the statutory right to seek dissolution? The issue has very serious ramifications for the petitioner (and for petitioner's lawyer who may be unwary of the trap) because the RFR typically provides a below-market price for the buyback with a long-term payout.
A 2006 appellate decision by the First Department in a case called Matter of Johnsen (ACP Distribution, Inc.) ruled that a dissolution petition triggered an RFR containing the operative terms, "donate, hypothecate, pledge, transfer or otherwise dispose of his Stock in any manner whatsoever." A September 2007 trial court decision in Matter of Schneck (R&J Components Corp.) (previously blogged here) went the other way where the operative terms were "sell, assign, mortgage, hypothecate, transfer, pledge, create a security interest or lien, encumber, give or otherwise dispose of any of the shares."
Now comes another case, Matter of El-roh Realty Corp., where the operative trigger language in the RFR referred to any transfer of shares "including, without limitation, transfers that are voluntary, involuntary, by operation of law or with or without valuable consideration." The February 1, 2008, decision by the Appellate Division, Fourth Department, affirmed the lower court's order (see decision here) holding that the filing of a dissolution petition by a 50% shareholder triggered the RFR. Here's what the appellate court said:
In examining the terms of the agreement as a whole and giving a practical interpretation to the language employed, the court properly concluded that respondents' construction of the agreement is the only construction which can fairly be placed thereon and thus properly refused to consider the extrinsic evidence offered by the petitioner. Contrary to petitioner's further contention, such a construction does not violate public policy. [Citations omitted.]
I remain troubled by cases such as Johnsen and El-roh, for several reasons. First, as a matter of contract interpretation I am not convinced that a petition to dissolve a corporation entails a stock "transfer" or "disposition". To file a dissolution petition is not to transfer or dispose of one's shares. Even when dissolution occurs, there is no transfer or disposition of shares, rather, all shares are extinguished. I have yet to see any court decision addressing this point.
Second, I fear the courts may be favoring the expediency of a compelled buyout at the expense of shareholder rights to seek dissolution. It is no secret that dissolution cases can be especially acrimonious and typically involve heavy motion practice placing disproportionate demands on scarce judicial resources. Such considerations should have no role in determining shareholder rights.
Third, the effect of Johnsen and El-roh will be to deter dissolution proceedings in favor of plenary actions seeking injunctive relief and damages based primarily on claims for breach of fiduciary duty and the like. Ultimately the courts will not be spared the Sturm und Drang of intense shareholder disputes. In my view, the aggregate uncertainty and risk on both sides in dissolution contests is greater than in such a plenary action, and therefore is more conducive to settlement.
Decision Highlights Interplay Between Employment Status and LLC Membership
Closely held companies with multiple owners actively involved in the business sometimes use employment agreements between the company and the owners, separate and apart from the shareholders’ agreement (for corporations) or operating agreement (for LLCs). Such employment agreements are especially prevalent in medical practices where, among other reasons, restrictive covenants are routinely used to prevent departing doctors from establishing competing practices in the same locality.
Quite often the shareholders’ or operating agreement and the employment agreement will provide that, upon termination of employment, the shareholder or member is required to redeem his or her interest in the company on specified terms. Disputes and litigation, including proceedings for judicial dissolution of the business, may erupt when the outgoing owner perceives enough of a disparity between the specified compensation (or lack thereof) and the “real” value of his or her interest.
A decision last week by an intermediate appellate court in Rochester, involving a medical practice organized as an LLC, highlights the interplay between the interest redemption triggered by termination of employment and the threshold issue of standing to seek judicial dissolution of an LLC under Section 702 of the Limited Liability Company Law. The statute confers standing to seek dissolution upon members only.
In Caplash v Rochester Oral & Maxillofacial Surgery Assoc., LLC, 48 AD3d 1139 (4th Dept 2008), the trial court summarily granted the plaintiff’s application to dissolve the practice. On appeal by defendant, the panel of five appellate judges unanimously reversed the lower court’s decision on the ground that defendant raised a genuine issue for trial whether, based on plaintiff’s apparent resignation, he was a member of the company within the meaning of the statute when he sought dissolution. Here’s what the court said:
Defendant submitted a letter from plaintiff to the company indicating that plaintiff was resigning as an employee of the company, and he also submitted a letter from an attorney who purported to accept plaintiff's resignation on behalf of the company. The company operating agreement unequivocally provides for the termination of membership in the event of the termination of a member's employment with the company, and plaintiff's employment agreement specifies that "This Agreement shall terminate . . . at any time by mutual agreement in writing by Employer and Employee." The record does not disclose the circumstances under which the attorney came to represent the company and whether such representation was authorized by the operating agreement. We thus conclude that there is an issue of fact whether plaintiff has standing to seek dissolution.
The appellate decision does not reveal any additional facts, such as the percentage membership interest of the plaintiff and whether, for instance, the issue concerning the attorney’s authority to act on behalf of the company arose because the plaintiff and defendants were 50/50 members. In any event, the decision is another reminder that, no matter how high temperatures rise when business partners are on the brink of breakup, careful reading of agreements and obtaining advise of counsel should precede any decisive steps.
