Do Advancement and Indemnification Rights Include Defense Costs of Litigation Misconduct After Officer Leaves Company?
If there's a more litigious partnership falling-out than that of the closely-held mortgage company, Private Capital Group (PCG), I don't know about it. The case, entitled Ficus Investments, Inc. v. Private Capital Management, LLC, has racked up 87 motions since it was filed in Manhattan Supreme Court in March 2007, including several contempt applications. The court's docket lists over 2,300 separate documents filed, and the case isn't even close to being tried. There have been three interlocutory appeals decided thus far, with several others awaiting decision. Did I mention the parties have filed at least five other, related cases?
PCG was a New York-based Florida limited liability company formed to buy, manage and sell non-performing mortgages. Ficus Investments, Inc. (Ficus), the 80% member and sole manager of PCG, put up $300 million debt financing. Private Capital Management (PCM), the 20% member, operated PCG's mortgage business by PCM's two beneficial owners, Thomas Donovan and Lawrence Cline. The conflagration started a little over a year after operations began, in March 2007, when Ficus ousted Donovan and Cline and brought suit accusing them of misappropriating over $20 million.
The complex, high stakes litigation not surprisingly has generated millions in legal bills, which in turn has spawned a litigation within the litigation over the issue of the defendants' entitlement to advancement and indemnification of legal expenses under the provisions of PCG's operating agreement.
A year ago I wrote about a January 2009 appellate decision in Ficus in which the court held that the primary defendant, Thomas Donovan, as a former officer of PCG was entitled to seek advancement of his legal defense costs under the operating agreement. The primary issue there was whether the trial court's issuance of preliminary injunctions against Donovan defeated his advancement rights. Manhattan Commercial Division Justice Bernard Fried ruled (read here), and the Appellate Division affirmed (read here), that the ultimate determination of Donovan's indemnification rights had no impact on his interim advancement rights under the operating agreement's terms. The rulings resulted in reimbursement to Donovan of approximately $1.5 million in legal fees incurred through the end of 2007, which was upheld by yet another appellate court ruling in June 2009 (read here).
As it turned out, 2007 was just a warm-up for the next year, in which Donovan incurred another $3.8 million in legal defense costs for which he also sought advancement. Ficus opposed the bulk of the request, arguing that Donovan was not entitled to advancement for fees incurred opposing Ficus's applications for discovery and contempt sanctions concerning Donovan's alleged misconduct after he was terminated as an officer, during the course of litigation. Donovan's alleged misconduct included the "hacking" of former co-defendant Cline's e-mail account -- early in the case Cline and Ficus entered into settlement and cooperation agreements -- and failing to turn over company books and records in violation of court order.
The arguments raised in this second go-round, and the court's recent decision in favor of Ficus, raise novel legal issues with important ramifications for advancement and indemnification litigation in this and other cases.
Here's a summary of the proceedings leading to the latest decision:
- The litigation began in March 2007, shortly after which Justice Fried issued orders requiring Donovan to turn over Ficus books and records.
- In September 2007, Ficus filed a motion by Order to Show Cause (read here) seeking to hold Donovan in civil contempt of court for failing to return company funds along with certain books and records.
- In a November 2007 order (read here), based on the parties' conflicting allegations, Justice Fried referred the books and records dispute to a Special Referee to hear and report.
- In May 2008, Ficus filed another motion by Order to Show Cause (read here) asking the court to impose various sanctions against Donovan allegedly for gaining unauthorized access to (i.e., hacking) Cline's e-mail account beginning in November 2007, and thereby obtaining confidential attorney-client communications.
- In a July 2008 order (read here), Justice Fried found disputed issues of fact requiring a hearing, and again referred the matter to the same Special Referee to hear and report.
The Special Referee held lengthy evidentiary hearings and issued two reports, in August 2009 (read here) and November 2009 (read here) in which she concluded: (1) that Donovan deliberately violated Justice Fried's orders requiring the turnover of Ficus books and records and should be held in contempt with appropriate sanctions including costs engendered by his actions; and (2) that Donovan without authorization accessed Cline's confidential e-mail communications and should be sanctioned by the dismissal of his claims against Cline and others, and reimbursement of Cline's and Ficus's counsel fees. Both reports currently are the subject of dueling motions to confirm and to reject the Special Referee's findings and recommendations.
The Special Referee also conducted a separate evidentiary hearing as to Donovan's request for advancements totaling $3.8 million for legal expenses incurred in 2008. Her July 2009 report (read here) found that Donovan's acts of hacking e-mail and his removal and non-disclosure of books and records occurred well after he left office at Ficus and were never intended for the benefit of anyone but himself. The Special Referee recommended that Donovan was only entitled to advancement of counsel fees in the approximate amount of $1.8 million, or about $2 million less than he sought, reflecting her exclusion of expenses incurred primarily for the books and records and e-mail hacking proceedings.
Ficus and Donovan filed motions to confirm and to reject, respectively, the Special Referee's July 2009 report insofar as it excluded fees for the books and records and e-mail hacking proceedings. The lengthy briefs submitted by both sides raise a host of issues and arguments, factual and legal, beyond the space limitations of this post. In a nutshell, Ficus contended that the operating agreement's provision for advancement and indemnification of expenses of an officer "who is a Party to a Proceeding because he or she is a[n] . . . Officer" does not encompass expenses unrelated to the person's conduct as an officer. Donovan countered that the agreement's quoted language does not permit the extraneous consideration whether the particular subject matter of a motion or hearing within the "Proceeding" concerns the defendant's conduct as an officer. (For anyone interested in reading the parties' briefs, here they are: Donovan Brief; Ficus Brief; Donovan Reply Brief; Ficus Reply Brief).
In his Decision and Order dated December 22, 2009, Justice Fried sided with Ficus and upheld the Special Referee's determination to exclude the $2 million relating to the books and records and e-mail hacking proceedings. Here's the key passage from the court's decision:
There is no dispute that if Donovan were made a party to this action on the basis of conduct other than that which he engaged in as an Officer of PCG, he would not be entitled to advancement or indemnification under the Operating Agreement. Likewise, Donovan cannot expect to be advanced funds to cover the expenses incurred in connection with defending against allegations of misconduct that commenced after he left PCG. That the misconduct complained of was undertaken in connection with the suit against Donovan the Officer is of no moment; it was Donovan the individual who took the actions, for the benefit of and on behalf of, Donovan the individual. There is no requirement within the Operating Agreement that PCG advance the litigation expenses of Donovan the individual. The Special Referee's conclusion that the mere fact that certain expenses arose out of the action in which Donovan the Officer was sued "is not necessarily sufficient to mandate that the fees" are advanceable, and her conclusion that fees for hearings on activities undertaken - admittedly - on Donovan's own behalf and not on behalf of the Company are outside the scope of advanceable fees, are thus not erroneous.
The arguments on both sides raise important considerations of contract construction, the policies underlying advancement and indemnification of company officers, and conservation of judicial resources. The threshold analytical hurdle stems from the fact that all conduct undertaken by a former officer in the course of a company-brought litigation for abuse of office, by definition, is conduct not undertaken "as an officer" of the company. What principal distinguishes conduct within or outside the duty to advance and indemnify? Donovan's bright-line, contract-based argument offers the advantage of certainty -- not a small consideration given the purpose of advancement and indemnification clauses to encourage service as a company officer or director -- and reduced judicial intervention. Yet it also could encourage a former officer to engage in abusive extra-judicial tactics under the guise of defense measures, or force the company to commence a separate lawsuit for post-termination litigation misconduct so as not to implicate the advancement and indemnification provisions.
Justice Fried undoubtedly is correct in suggesting that, had Ficus sued Donovan in a separate lawsuit for damages or other relief not directly impairing Donovan's defense of Ficus's claims in the main action, Donovan would not have a basis to seek advancement and indemnification. The relief requested in the Orders to Show Cause (linked above) submitted by Ficus in support of its motions relating to the books and records and e-mail hacking proceedings appears to include preclusion orders directed at Donovan's use of evidence in his defense of Ficus's claims against him for his conduct as a former officer, as well as seeking other preclusion orders directed against Donovan's prosecution of his own claims against Ficus. On the other hand, the Special Referee's recommended sanctions, assuming they're adopted by the court, don't appear to include any preclusion of Donovan vis-a-vis his defense of the main action. Should any of these factors make a difference?
More questions: Does a litigation-misconduct exception to advancement and indemnification pose a slippery slope, implicating many, easily imagined scenarios in which the defendant's actions relating to the litigation cannot readily be pigeon-holed as related solely to defense of the company claims versus in pursuit of personal objectives? Will the court be required to make factual inquiry and findings in each instance whether the conduct somehow relates to the defense of the company's claims versus promotion of the former officer's extra-litigation objectives? Should company counsel revise the advancement and indemnification clauses used in bylaws and agreements to carve out conduct such as that at issue in Ficus, and if they do so, will it have a chilling effect on willingness to serve as an officer or director?
It looks like these questions are destined to be answered by a higher authority. Donovan's counsel recently filed a notice of appeal from Justice Fried's ruling and, given the amount at stake, it's probably a safe bet that the appeal will be perfected and that, some time later this year, the appellate court will have its say. Stay tuned.
Update March 8, 2010: My prediction for an appeal looks shakier in light of a decision on March 2, 2010, by Justice Fried in an unrelated action brought by a prior judgment creditor of Donovan, in which the court ruled that Donovan's advancement and indemnification rights vis-a-vis PCG constitutes a "debt" subject to levy under New York's judgment collection statutes. The decision can be read here. Might this ruling, cutting off payment of future advances to Donovan's counsel, effectively bring down the curtain on the Ficus litigation juggernaut? We shall see.
Court Permits Direct Rather Than Derivative Recovery in Post-Dissolution Action Against Controlling Shareholder for Misappropriation of Assets Held by Second Corporation Found to be "Mere Continuation" of Dissolved Corporation
New York County Commercial Division Justice Bernard J. Fried recently handed down a post-trial decision in a fascinating shareholder dispute between family members that required the court to address two significant issues:
Can a shareholder action for misappropriation of corporate assets be brought individually rather than derivatively after the corporation's dissolution?
Does the "mere continuation" doctrine, under which a creditor of a dissolved corporation may reach assets of a de facto successor corporation, apply even absent a transfer of assets to the successor?
The case is Miot v. Miot, 2009 NY Slip Op 51605(U) (Sup Ct NY County July 15, 2009).
Miot is the story of one brother, Alvin, who for many years owned and ran a construction and real estate business, and who in March 1985 gifted to his brother, Sanford, a 70% stock interest in a corporation called Madcat Realty Corp. ("Madcat I") which owned a commercial building on Kane Street in Brooklyn. Sanford knew of the shares, but had no knowledge of Madcat I's business affairs or even whether it owned any assets. The other 30% was owned by Alvin's wife, Harriet, who nominally served as secretary-treasurer and signed whatever corporate documents were given to her for signature, but who also had no knowledge of the company's business affairs. There were no shareholder or director meetings, and neither Sanford nor Harriet ever exercised shareholder rights. Alvin, who died in 2001, maintained sole control of the corporation. With respect to the corporation's records, Justice Fried found it "unclear" whether they exist or ever existed, with the exception of a blank stockbook that was located.
As fate would have it, some time between March 1985 (when Sanford was gifted his shares) and December 1985, Madcat I was administratively dissolved by the New York Secretary of State for non-payment of franchise taxes. Though reinstatement was possible, it never was attempted. Madcat I nonetheless continued to collect rents and pay real estate taxes on the Brooklyn property until it was sold in 1987.
It may be helpful to pause the narrative at this point to explain that the case does not involve any claim by Sanford for a share of the proceeds from the 1987 sale of the Brooklyn property, even though he received none. The court's decision notes without explanation that those sale proceeds are not in dispute, presumably because any such claim was barred by the statute of limitations by the time litigation commenced in 2006.
Back to the story. In February 1986, Alvin filed a certificate of incorporation for a new corporation with the identical name ("Madcat II") the shares of which were owned 100% by his wife Harriet. In May 1986, Alvin transferred ownership of a Manhattan commercial property from another of his companies to Madcat II. The closing statement listed Madcat II's business address as the Kane Street, Brooklyn property owned by Madcat I.
The Manhattan property was Madcat II's sole asset. Justice Fried's decision quotes the trial testimony of Alvin's lawyer at the time, that he believed there was no transfer of the Brooklyn property from Madcat I to Madcat II because "it was always the same corporation."
Madcat II owned and managed the Manhattan property under Alvin's direction through the 1990s. Harriet took over Madcat II after Alvin's death in 2001. In 2005, an outside buyer purchased the property from Madcat II for $1.2 million. The net proceeds of about $1.1 million were deposited in the account of Madcat II and eventually distributed to Harriet. Sanford received no proceeds from the sale, nor did Harriet inform him of the sale.
Sanford first learned of the Manhattan property sale through the course of separate litigation in Florida in 2006. In September 2006, Sanford filed a complaint in which he asserted a number of claims seeking recovery in his own name and right against Harriet for breach of fiduciary duty, an accounting and misappropriation of his 70% share of the proceeds from Madcat II's sale of the Manhattan property.
Harriet raised procedural and substantive defenses. First, she argued that Sanford's action should be dismissed because it was improperly brought in Sanford's individual capacity instead of as a shareholder's derivative suit. Second, she argued that Madcat I and Madcat II are distinct and separate entities, and that the interest Sanford had in Madcat I ended when that corporation wound up its affairs with the sale of the Brooklyn property in 1987.
Justice Fried conducted a bench trial in early 2009. For anyone interested in reading Sanford's and Harriet's post-trial briefs, click here and here.
Individual vs. Derivative Action
Justice Fried disagreed with Harriet's procedural argument based on the derivative nature of Sanford's claims. He noted that, while claims for misappropriation of corporate assets generally must be brought derivatively, and even though such derivative claims can be brought post-dissolution,
the court may use its equitable powers to "dispense with the presence of [the] defunct corporation" if the shareholder "is in reality the only one injured." Geltman v. Levy, 11 AD2d 411, 413 (1st Dept. 1960) (quoting Weinert v. Kinkel, 296 NY 151, 152, 153 (1947) and Di Tommasso v. Loverro, 250 A.D. 206 (2d Dept. 1937), aff'd 276 NY 551 (1937)); see also First Nat. Bank of Maryland v. Fancy, 268 AD2d 229, 229 (1st Dept. 2000) (affirming the trial court's decision to award direct payment to the plaintiff, instead of the defunct corporation, to "prevent[] unnecessary circuity and hardship"). In Geltman v. Levy, stockholders of a liquidated corporation brought a suit against a third party for breach of fiduciary duty. 11 AD2d at 412. Though the Appellate Division ultimately held that the claim, as brought, was not derivative in nature, the Court explained that assuming the claim had been derivative in nature, dismissal would not have been appropriate. Id. at 413. As the Court explained, insisting on a derivative suit where the plaintiffs were the only injured parties by the wrongdoing of the defendants would "encourage circuity and [] compel them to follow a meaningless legal procedure in complete disregard of the realities of the situation." Id. at 414.
In Miot, the subject S corporation had no creditors, and the only persons with rights to receive the net sale proceeds from the sale of the Manhattan property were Harriet and Sanford. "Thus," Justice Fried concluded, "the misappropriation of funds, while technically a misappropriation of corporate funds and thus, an injury to the corporation, injured no one but Plaintiff," and therefore "dismissing this claim where only Plaintiff and Defendant have any interest in the long-ago dissolved corporation would ignore the 'realities' of the case and encourage 'circuity.'"
Madcat II as "Mere Continuation" of Madcat I
Sanford contended that Harriet misappropriated corporate funds by distributing the proceeds from the sale of the Manhattan property to herself without distributing any funds to him; that his shares in Madcat I entitled him to proceeds from the sale of the Manhattan property because Madcat II was a "mere continuation" of Madcat I; and that Harriet should be estopped from asserting that the two companies are distinct and separate entities because Madcat II was incorporated only to avoid paying franchise taxes on Madcat I. Harriet countered that Madcat I and Madcat II are distinct and separate entities and that the interest Sanford had in Madcat I ended when the corporation wound up its affairs with the sale of the Brooklyn property in 1987.
Justice Fried sided with Sanford, essentially finding that Madcat II had been incorporated so as to continue the business of Madcat I without having to pay the franchise tax arrears, contrary to the public policy underlying the franchise tax statutory scheme. Justice Fried cited a number of cases in which courts enforced creditor claims against successor corporations formed after the debtor corporation was administratively dissolved. He reasoned that "[t]he statutory scheme would be similarly undermined if the court allowed a corporation to avoid its obligations to its shareholders through its dissolution for failure to pay franchise taxes."
On the key question, whether Madcat II was a mere continuation of Madcat I, Justice Fried set forth the following criteria:
Generally, when a successor corporation is in essence a reorganization of a now extinguished predecessor, the successor may be considered a "mere continuation" of its predecessor and liable for its predecessor's obligations. Although no one factor is dispositive, other courts have considered certain factors as evidence tending to show that a successor corporation was a mere continuation of its predecessor: (1) all or substantially all assets are transferred to the successor corporation, (2) only one corporation exists after the transfer, (3) assumption of an identical or nearly identical name, (4) retention of the same corporate officers and\or directors, and (5) continuation of the same business. [Citations omitted.]
Harriet argued that since there was no transfer of assets from Madcat I to Madcat II, the mere continuation doctrine did not apply under the above factors. Justice Fried disagreed, stating:
None of the cases cited by either party . . . stands for an absolute test where each factor must be present to find that one entity is a mere continuation of the other. More importantly, Alvin's disregard of corporate formalities by not transferring the assets of Madcat I to Madcat II does not change the fact that Alvin continued the business of Madcat I through the incorporation of Madcat II. Furthermore, as a practical matter, though there was no transfer, only one corporation existed after the dissolution and reincorporation of Madcat. Alvin was the only one benefitting from the assets of both Madcats, and to any outsider, there appeared to be only one Madcat entity. [Citations omitted.]
Moreover, the last three factors weigh heavily in favor of finding that Madcat II was a mere continuation of Madcat I. First, each corporation had an identical name. Second, Alvin was the President of both corporations and the only officer making any decisions for either corporation. And lastly, Madcat I and Madcat II were engaged in substantially the same business. Both corporations owned, managed, and collected rents from properties in New York City. Under these circumstances, I conclude that Madcat II was a mere continuation of Madcat I despite the fact that there was no formal transfer of assets.
Justice Fried accordingly awarded judgment in Sanford's favor against Harriet for $765,709, representing 70% of the net proceeds from the sale of the Manhattan property, plus pre-judgment interest from November 2005, when Harriet received her distribution from Madcat II.
Miot is one of those perfect-storm cases: the central witness (Alvin) died years before; the surviving shareholders were in the dark as to the corporation's affairs; the corporation kept no records; and the events in question occurred 20 years before the litigation was brought. It's superficially tempting to think that the outcome might have been different had Alvin chosen a different name for the corporation when he incorporated Madcat II, but I think that begs the question ultimately resolved by Justice Fried whether the overall relationship of the two entities rendered them one and the same.
Court Grants 50% LLC Member's Petition for Judicial Dissolution of Passive Holding Company
A recent decision by New York County Commercial Division Justice Bernard J. Fried addresses issues of interest concerning (a) the standing of an assignee of a member's economic interest to seek judicial dissolution of an LLC, and (b) grounds for dissolution of a two-member, 50-50 LLC that functioned as a holding company for a non-managing minority interest in another company.
The memorandum decision in Matter of Cline (Private Capital Management, LLC), Index No. 650117/09 (Sup Ct NY County May 29, 2009), grows out of a mega-lawsuit started by Ficus Investments, Inc. (Ficus) against Thomas Donovan, Lawrence Cline and Private Capital Management, LLC (PCM). PCM, a New York LLC co-owned 50-50 by Donovan and Cline, was the managing 20% member of a Florida LLC called Private Capital Group, LLC (PCG) that purchased, managed and sold non-performing mortgages. Ficus, which invested $300 million in the venture, held the remaining 80% interest. In 2007, Ficus terminated PCM as PCG's manager and brought suit against it along with Donovan and Cline allegedly for misappropriating over $20 million.
Early on Cline settled with Ficus and entered into a cooperation agreement as part of which he conveyed to a Ficus-owned entity called PCM Interest Holding, LLC (Holding) all of Cline's economic interest in PCM and his irrevocable voting proxy. Meanwhile, amidst burgeoning litigation proceedings between Donovan and Ficus, in April 2008 Justice Fried ruled that Donovan was entitled to advancement of his legal expenses under PCG's operating agreement. Ficus's appeal from that ruling was rejected in January 2009 (read here my post on the appellate ruling). In February 2009, Justice Fried also granted PCM's motion for advancement of its legal expenses. As part of the same ruling, Justice Fried denied without prejudice a procedurally defective cross-motion by Ficus and nominal defendant Cline seeking judicial dissolution of PCM (read here my post on that ruling).
In March 2009, Cline and Holding responded by filing a separate, new proceeding seeking judicial dissolution of PCM pursuant to Section 702 of the New York LLC Law under which dissolution is warranted "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement." Their petition (read a copy here) alleged that PCM was formed solely to hold Donovan's and Cline's 20% interest in PCG; that since the Ficus litigation began, in which Donovan and Cline became adverse parties, the direction and control of PCM is "hopelessly deadlocked"; that Donovan is "misusing PCM for his own tactical advantage" in the litigation; that Donovan and Cline had ceased speaking to one another; and that the plethora of extremely hostile litigations between the two doomed any possibility of restoring the relationship. Notably, the petition also alleged that PCM lacks a written operating agreement.
Donovan moved to dismiss the petition. First, he contended that Holding, as transferee solely of Cline's economic interest in PCM, was not a member and therefore lacked standing to petition for dissolution. Second, citing the Delaware Chancery Court's 2008 decision in Seneca Investments LLC v. Tierney (read here my post on Seneca), he contended that deadlock between two 50% managing members of an LLC cannot provide a basis for dissolution where the LLC's sole purpose is to be a passive investor in another company. (Read here Donovan's counsel's affirmation in support of dismissal of the petition.)
In response, Cline and Holding argued that Section 702 does not require a showing that it is impossible to carry on the LLC's business, only that it is not reasonably practicable; that the petition's allegations set forth a "bitterly hostile, intractable and litigious battle" between the two sides; that PCM was formed for the specific purpose of doing business with Ficus; and that such purpose no longer was viable due to the irreconcilable split between Donovan and Ficus. They also argued that, even though Holding as assignee of Cline's economic interest was not a member and could not bring a dissolution proceeding on its own, it nonetheless could join Cline's dissolution petition. (Read here the opposition memorandum of Cline and Holding).
Interestingly, the issue whether PCM had a valid written operating agreement was raised subsequently, after Justice Fried requested the parties to provide him with copies of PCM's organizational documents. Donovan submitted an operating agreement allegedly signed by him and Cline, in which the company's purpose was stated as "managing the purchase, and resolution of non-performing mortgage as agreed from time to time by the Managers." Cline denied signing the operating agreement which he called "fraudulent".
Addressing first the issue of Holding's standing, Justice Fried agreed with Donovan that Holding lacked standing to join the petition for dissolution. Sections 603 and 604 of the LLC Law make it clear that, except as provided in the operating agreement, the assignee of a membership interest does not become a member of the LLC without the consent of the remaining members and is entitled only to the economic rights of the assignor to the extent assigned. Under Section 702, only a member has standing to seek dissolution.
Justice Fried nonetheless granted the dissolution petition, holding that Cline -- whose standing as a member was not contested -- had established
that it is not reasonably practicable to carry on PCM's business in conformity with the articles of organization or operating agreement thereby warranting dissolution. That Cline and Donovan dispute whether there exists an operating agreement for PCM, and Cline asserts that the purported operating agreement for PCM that Donovan submitted is fraudulent, is indicative of the litigious nature of their relationship. Dissolution is warranted regardless of the validity of PCM's purported operating agreement. [Citation omitted.].
According to Cline, in addition to the absence of a PCM operating agreement, PCM never followed corporate formalities, and it is merely an alter ego for Cline and Donovan. PCM's sole function is to hold their 20% interest in PCG. Thus, because of the acrimonious nature of the parties' business relationship, and the fact that dissolution will not interfere with an on-going business, dissolution is justified.
Even were he to find the operating agreement submitted by Donovan valid, Justice Fried added, it would further support dissolution in that the purpose clause (quoted above) "is inconsistent with Donovan's assertion that PCM was formed merely as a passive investment entity, and it would entail even more cooperation between the members as would be the case under Cline's characterization of PCM's purpose. Either way, dissolution is warranted."
In the Seneca case relied upon by Donovan, the Delaware Chancery Court dismissed a dissolution petition brought by a minority member of a Delaware LLC who asserted that the company had ceased all active business operations. The company retained passive investments worth over $2 million. The Chancery Court looked to the operating agreement's broad purpose clause, which included "any lawful act or activity," and concluded that the company's status as a passive investment holding company was consistent with its stated purpose.
Are Seneca and Cline reconcilable? One can argue they are, based on the fact that Cline was a deadlock petition brought by a 50% member whereas Seneca was brought by a non-controlling member who therefore was forced to make the harder argument that, even with effective majority control, the company could no longer operate consistent with its broad purpose clause. In addition, if it is assumed that PCM's operating agreement is valid, its narrow purpose clause ("managing the purchase, and resolution of non-performing mortgage as agreed from time to time by the Managers"), subsequently rendered unattainable by Ficus's expulsion of PCM as manager of PCG, is materially different from Seneca's broad purpose clause. If, on the other hand, PCM's operating agreement is deemed invalid, and therefore by statutory default the company's purpose is deemed to be "any lawful business activity" (LLC Law Section 201), it becomes a closer argument, but only if it is further assumed that the antagonism between Cline and Donovan would not interfere with PCM's reduced, passive role as the recipient of distributions and profit and loss allocations as 20% member of PCG.
One final note on procedure. In opposing dissolution, Donovan opted as permitted by CPLR Article 4 (governing special proceedings) to make a motion to dismiss the petition for failure to state a valid claim for dissolution, and requested leave to file an answer in the event the court denied his motion. Such leave is discretionary (CPLR 404[a]) and therefore always entails some risk that the court will grant the petition summarily, particularly when the respondent does not submit client affidavits or other evidentiary materials contesting the petition's factual allegations.
Application for Judicial Dissolution of LLC Must Be Made by Complaint or Petition, Mere Motion Will Not Suffice
For years I've been carping about the substantive and procedural inadequacies of New York's LLC judicial dissolution statute. LLC Law Section 702, which was modeled after the rarely utilized limited partnership dissolution statute, consists in its entirety of the following two sentences:
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.
At the time of the LLC Law's adoption in 1994, the legislature's minimalist approach made some sense because of tax considerations requiring avoidance of certain corporate characteristics including continuity of life. The IRS's subsequent implementation of check-the-box regulations freely permitting partnership tax treatment of LLCs, and the 1999 LLC Law amendments restricting member withdrawal from LLCs, largely eliminated the legislative rationale for Section 702 as enacted, leaving the statute, in my view, not up to the complex task of adjudicating LLC breakups (hence the title of my June 2002 article published in the New York State Bar Journal, Vol. 74, No. 5, "When Limited Liability Companies Seek Judicial Dissolution, Will the Statute Be Up to the Task?").
These observations are prompted by a recent decision by New York County Commercial Division Justice Bernard J. Fried in a case I've previously written about called Ficus Investments, Inc. v. Private Capital Management, LLC. Ficus is a highly contentious dispute between LLC members involving accusations that the managing members misappropriated over $20 million. Last January, an appellate ruling enforced the lead defendant's right to advancement of his legal defense costs as provided by the operating agreement (see my earlier post here).
In a follow-up ruling dated February 23, 2009, Justice Fried granted a motion by the LLC's 20% member, Private Capital Management, LLC ("PCM"), also enforcing its advancement rights. According to Justice Fried's April 2008 decision, PCM is owned 50-50 by defendant Thomas Donovan and Lawrence Cline. In an apparent effort to lessen or avoid PCM's advancement rights, the plaintiff (or more likely Cline, who earlier settled with the plaintiff under a cooperation agreement) made a cross motion to dissolve PCM. This required Justice Fried to determine whether, absent a pleading containing a claim for dissolution, the court can decree dissolution on application by motion. As far as I know, this is the first decision to address the issue.
Justice Fried notes that the operative language in Section 702 (court may decree dissolution "on application by or for a member . . .") does not expressly deny the right to seek dissolution by way of motion. He also contrasts Section 702 with the detailed procedural provisions in Article 11 of the Business Corporation Law requiring the commencement of a special proceeding for judicial dissolution of closely held business corporations by way of verified petition and order to show cause. Notwithstanding the legislative omission in the LLC Law, Justice Fried concludes that
the better practice is to apply for judicial dissolution by way of a plenary action. This would provide [the dissolution proponent] the opportunity to plead a cause of action for judicial dissolution, and it would enable [the dissolution opponent] to answer this claim, rather than merely oppose the [motion]. . . . Moreover, the vast majority of the cases applying Section 702 involve an application for dissolution that is made by way of cause of action contained in the complaint, counterclaim, or plenary petition [citations omitted]. . . . Here, Plaintiffs have not sought summary judgment on a claim or counterclaim for judicial dissolution, but rather, have merely cross-moved for the relief sought. Defendant PCM has neither interposed a counterclaim for dissolution nor indicated in any way that it would favor such relief. As stated above, I believe the preferable way to proceed with this application for judicial dissolution is by way of petition, and, exercising my discretion, I therefore deny Plaintiffs' cross-motion without prejudice.
There's no question that Justice Fried's conclusion reflects the practical reality. I have brought, defended and otherwise seen any number of LLC dissolution cases commenced by summons and complaint in a plenary action, as well as by order to show cause and verified petition in a special proceeding whose accelerated procedures are governed by CPLR Article 4.
Curiously, the courts routinely accept petitions for LLC dissolution by way of special proceeding notwithstanding the absence of statutory authority for doing so, as seemingly required by CPLR 103(b) ("All civil judicial proceedings shall be prosecuted in the form of an action, except where prosecution in the form of a special proceeding is authorized.").
New York Court Follows Delaware Law to Construe Advancement and Indemnification Provisions of Florida LLC's Operating Agreement
Presiding Justice Jonathan Lippman of the Appellate Division, First Department, who was recently nominated by Governor Paterson to become New York's Chief Judge on the Court of Appeals, has written a significant decision addressing rights of advancement and indemnification for litigation expenses in the limited liability company setting. Ficus Investments, Inc. v. Private Capital Management, LLC, 61 AD3d 1, 2009 NY Slip Op 00263 (1st Dept Jan. 20, 2009).
Not only is the substantive issue in the case -- affirming the right of an LLC member-manager to require the LLC to advance legal expenses defending an action brought by another LLC member -- one of great importance, the decision also reads like a legal travelogue in which a New York court looks to Delaware law to construe an operating agreement of a Florida LLC headquartered in New York.
Private Capital Group (Capital) is a Florida LLC owned 80% by the plaintiff Ficus Investments, Inc. (Ficus) and 20% by defendant Private Capital Management, LLC (Management). Capital buys, manages and sells non-performing mortgages, and was capitalized by loans from Ficus over $300 million. Capital began operations in December 2005. A dispute arose after Management's two owners, Thomas Donovan and Lawrence Cline, transferred about $10 million from Capital to Management. Under Capital's operating agreement, Donovan served as Capital's CEO and Cline as its President. In March 2007, Ficus adopted resolutions taking over Capital's management and it also commenced a lawsuit against Donovan, Cline and Management for breach of fiduciary duty, conversion and unjust enrichment.
The hostilities escalated after suit was filed, with Ficus accusing the defendants of removing books and financial records and misappropriating an additional $12.5 million. Then Cline and some other defendants settled with Ficus and gave statements supporting Ficus's ongoing litigation against Donovan and the remaining defendants. Meanwhile, Donovan set up a new business and took with him virtually all of Capital's employees, which triggered a new round of accusations by Ficus and a series of interim injunctions against the defendants.
In the course of these proceedings, Donovan and two other defendants moved for indemnification and advancement of their legal expenses totaling over $2.7 million related to the litigation under the terms of Capital's operating agreement. New York County Commercial Division Justice Bernard J. Fried, in a written decision dated April 24, 2008, granted Donovan's request but denied it as to the two others, finding that advancement of their expenses was discretionary with Capital since they were not officers under the operating agreement. An appeal followed.
This being a question of contractual rather than statutory rights to advancement and indemnification, Justice Lippman's opinion for the appellate court focuses on the terms of Capital's operating agreement, which provides that it will be construed under and governed by Florida law. Section 3.4.3 of the Operating Agreement, entitled "Advance for Expenses," provides that
The Company must, before final disposition of a Proceeding, advance funds to pay for or reimburse the reasonable Expenses incurred by a Person who is a Party to a Proceeding because he or she is a Member, Manager or Officer if such Person delivers to the Company a written affirmation of his or her good faith belief that his or her conduct does not constitute behavior that would result in Liability for (i) intentional misconduct or a knowing violation of law, or (ii) any transaction for which such Member, Manager or Officer received a personal benefit in violation or breach of any provision of this Agreement; and such Member, Manager or Officer furnishes the Company a written undertaking, executed personally or on his or her behalf, to repay any advances if it is ultimately determined that he or she is not entitled to indemnification under this Section 3.4 or the Florida [Limited Liability Company] Act" (subd [a]).
Another provision, Section 3.4.2, entitled "Obligation to Indemnify; Limits," relieves Capital of the obligation to indemnify a member, manager or officer who "is adjudged liable to the Company or is subjected to injunctive relief in favor of the Company" for intentional misconduct or a knowing violation of law or for any transaction for which the individual received an unauthorized personal benefit.
Ficus argued that since the trial court already issued multiple interim injunctions against Donovan, ultimately he would not be entitled to indemnification under the language of Section 3.4.2, thereby rendering "academic" his entitlement to advancement of expenses.
The appellate court disagreed, with Justice Lippman writing that
the section referring to injunctive relief pertains solely to indemnification. It is separate and distinct from section 3.4.3, which imposes the obligation to advance funds. Advancement is contingent only upon the person's submission of a written affirmation that he or she has not engaged in prohibited conduct and an undertaking to repay any funds disbursed.
Justice Lippman's opinion cites no Florida law on the subject of contractual advancement and indemnification. It's not unusual for New York courts to look to Delaware case precedent in deciding issues of corporate law, and in this case Justice Lippman does exactly that. His analysis of Delaware law is worth quoting in full:
Delaware courts have had ample opportunity to address these issues of indemnification for and advancement of expenses and, although not binding as to either Florida or New York law, their holdings can be instructive. Under Delaware law, a clear distinction is drawn between the two provisions: whether an officer is entitled to advancement is determined in a summary proceeding, while the right to indemnification is delayed until the conclusion of the matter (see Kaung v Cole National Corp., 884 A2d 500, 509 [Del 2005]). The rights are recognized as independent of one another, in that "an advancement proceeding is summary in nature and not appropriate for litigating indemnification or recoupment. The detailed analysis required of such claims is both premature and inconsistent with the purpose of a summary proceeding" (id. at 510). Delaware has also noted that one of the beneficial purposes behind both indemnification and advancement is to help attract capable individuals into corporate service by easing the burden of litigation-related expenses (see Homestore, Inc. v Tafeen, 888 A2d 204, 211 [Del 2005]). In particular, "[a]dvancement provides corporate officials with immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings" (id.).
Capital's operating agreement, Justice Lippman concludes, "distinguishes between the relief available to a corporate officer at the conclusion of the proceedings and that which is available while the proceedings are ongoing." In other words, "advancement does not depend on whether or not the officer will eventually be indemnified." So while Donovan may have to return the advances in the end, depending on the outcome of the litigation, in the meantime he enjoys top-notch legal defense effectively at his adversaries' expense.
As I've written before, the advancement and indemnification of legal expenses can tilt the playing field in litigation between co-owners of closely held companies. In some circumstances it can put decisive pressure on the non-indemnified side to settle. Although the players in Ficus seem to possess fat checkbooks, and while I don't pretend to know the effect of the court's ruling on the majority owner's appetite for this litigation -- judging from the ever burgeoning size of the court's docket listings viewable online, I'd have to say the appetite on both sides remains voracious -- I still have to think that laying out millions for Donovan's legal defense, secured only by his non-collateralized written undertaking in the event he's ultimately compelled to repay the advancements, is a bitter pill to swallow.
Decision Lowers the Bar for Former Partner's Claims of Fraudulent Buyout
When non-controlling partner A sells out to controlling partner B, following which B sells the company to a third party at a disproportionately high premium over A's price, A may suspect that B withheld information pertaining to the company's value at the time of A's sale. The question is, does A have a valid claim against B to recover a share of the re-sale profits? Does caveat venditor give way to a fiduciary-based, affirmative obligation on B's part to disclose to A any and all information material to the sale price?
An opinion handed down last week by an appellate court in Manhattan appears to lower the bar for such a lawsuit, and sends a cautionary message to transactional counsel concerning the effectiveness of seller representations and releases in partner buyout agreements.
In Littman v. Magee, 54 AD3d 14 (1st Dept 2008), Steven Littman held an 18.7% membership interest in Rockwood Realty Associates LLC, a real estate investment firm formed in 1996 and managed by another LLC controlled by Rockwood's majority owners. Littman's 28-page complaint essentially alleged that the majority owners engaged in a squeeze-out through property sales that forced Littman to incur large personal tax bills on undistributed K-1 profits, contrary to an alleged "understanding" when the company was formed that distributions sufficient to cover taxes would be made.
In late 2004, one of the defendants initiated buyout discussions with Littman, allegedly telling him that the company's profits that year would result in substantial tax obligations but that no tax distributions would be made to members. In response to Littman's requests for financial information, he received an internal balance sheet and income statement for the nine months ended September 2004, and tax returns and financial statements for 2002 and 2003. In response to Littman's further requests for information on projected values, allegedly one of the defendants replied that "no other information was or would be made available".
In April 2005, Littman agreed to sell his interest for over $2 million. Littman was represented by an attorney and also had the assistance of his own accountant. The agreement contained Littman's representation that he had "such knowledge and experience in financial and business matters such that [he] is capable of evaluating the terms and provisions of this Agreement and the other Transaction Documents". He also executed a general release containing an acknowledgment that he
is aware that [he] may hereafter discover claims presently unknown or unsuspected, or facts in addition to or different from those which [he] now know[s] or believe[s] to be true, with respect to the matters released herein.
A little over a year later, in May 2006, Rockwood announced that a publicly held British company, DTZ Holdings PLC, had acquired for $45 million plus other consideration a 50% interest in Rockwood, which changed its name to DTZ Rockwood. A month later Littman filed his lawsuit asserting claims for breach of fiduciary duty and to declare his release void. Littman alleged that defendants concealed information in their possession concerning the prospects of Rockwood, and sought damages over $16 million representing the supposed difference between what he was paid and his proportionate share of Rockwood's "true value" as of April 2005.
The trial court's decision, authored by Justice Bernard J. Fried of the New York County Supreme Court, Commercial Division, granted the defendants' dismissal motion. Justice Fried found that Littman's claims were barred by his release which "refers to the specific subject matter as to which the representations are alleged, with precise specificity to put the plaintiff Littman on notice as to the clause's intended effect". Furthermore, Justice Fried concluded, Littman was put on "inquiry notice" of his potential claims for misrepresenting Rockwood's profitability when the defendants rebuffed his specific requests for projected values.
The appellate court disagreed and reinstated Littman's complaint. The court's opinion, written by Associate Justice David B. Saxe, states that
defendants, as shareholders, and particularly as active managing shareholders in a closely held corporation, owed a fiduciary duty to plaintiff, a minority shareholder. Plaintiff was therefore entitled to expect defendants to disclose any information in their possession that could reasonably bear on his consideration of defendants' offer, since "when a fiduciary, in furtherance of its individual interests, deals with the beneficiary of the duty in a matter relating to the fiduciary relationship, the fiduciary is strictly obligated to make full disclosure of all material facts". [Citations omitted.]
The internal quote is from a much-cited case called Blue Chip Emerald LLC v. Allied Partners, Inc., 299 AD2d 278 (1st Dept 2002), in which the appellate court upheld a complaint for fraud and breach of fiduciary duty brought by 50% partners in a real estate partnership who sold their interest to the other partners based on an $80 million valuation when the other partners already had received -- but did not disclose to the plaintiffs -- a $200 million third-party offer which they accepted shortly after the partner transaction.
In opposing Littman's appeal, the defendants argued that Littman in his complaint acknowledged that the information they provided to him was insufficient for him to properly value his interest in the company, and thus he could not have relied on the defendants' alleged misrepresentations or omissions. The court rejected this argument, stating that "the crux of plaintiff's claim is that [defendants] misinformed him that there were no other financial documents, forcing him to proceed with the evaluation with the limited information they made available, when they possessed other vital information".
The court also gave short shrift to defendants' argument based on the acknowledgment contained in Littman's release, of claims and information "unknown", stating that while such language may be effective in an arm's length business transaction, it does not preclude a claim against a fiduciary with a duty to disclose "all material facts bearing on the transaction".
After Littman, can business owners pursue and exploit the profitable sale of their business or its assets without risk of liability to a former partner whose interest was acquired at a "cheaper" price? The sale of Rockwood to DTZ occurred about 13 months after Littman's deal. Would it have made a difference if the DTZ transaction came two years later? Three years later? For that matter, under the decision's fiduciary rationale, wouldn't Littman have the same right to recover the "true value" of his interest even if there had never been a subsequent third-party sale? If so, Littman appears to go well beyond the Blue Chip case, where the defendant partners were accused of concealing a superior third-party offer at the very same time they were negotiating the partner buyout.
More questions: Would the outcome have been different if, in response to Littman's requests for projections, the defendants simply refused to provide them instead of (allegedly) denying that they had any? What if Littman's agreement had explicitly identified the limited financial information given to him, and explicitly represented that Littman was not relying on any other information in the buyer's possession known or unknown to Littman? Would such language preclude allegations of reliance and thereby enable dismissal of a complaint at the pre-discovery stage? These questions, and many others raised by Littman, will have to await further case law developments.
Dissenting Shareholder Loses Right to Receive Dividends Upon Merger Consummation
Like most states, New York's Business Corporation Law (BCL) permits a shareholder to opt out of mergers and certain other corporate restructurings by electing to be cashed out for the "fair value" of his or her shares. The so-called dissenting shareholder statute, BCL Section 623, sets forth procedures and deadlines for submission of the shareholder's written objection to the proposed transaction, for the corporation's making of a price offer, and for the filing of a judicial appraisal proceeding in the event the shareholder rejects the corporation's offer. A statutory appraisal proceeding also may result from a "freeze-out merger" in which the controlling shareholders compel minority shareholders to redeem their shares for cash. The dissenting shareholder statute typically comes into play with merger transactions involving corporations with relatively large capitalization and whose minority shareholders include passive investors. Section 1005 of the New York Limited Liability Company Law likewise permits members to dissent and cash out from mergers or consolidations involving LLC's.
A recent court decision, in a case called McCully v. Jersey Partners, Inc., 18 Misc 3d 1138(A) (Sup Ct NY Co 2008), raises a caution flag for dissenting shareholders and their counsel when it comes to asserting claims for dividends that accrue prior to merger consummation but are not payable until afterward.
Robert McCully was a shareholder of Jersey Partners, Inc. ("Jersey"). In August 2001, Jersey solicited shareholder approval for a corporate reorganization involving the merger of two of its subsidiaries. McCully dissented. The reorganization was consummated on November 30, 2001. Jersey offered McCully $3.2 million for his shares, which McCully rejected. A judicial appraisal proceeding followed in which McCully obtained, in June 2006, a judgment for an additional $12.8 million with 9% interest from the consummation date, plus his costs and attorney's fees of almost $2 million. The judgment was affirmed on appeal in December 2007.
Meanwhile, in December 2006, McCully started a separate action against Jersey to recover tax dividend distributions for the years 2000 and 2001 under a shareholders' agreement providing that:
If, and as long as [Jersey] is an S Corporation, then not later than two and one half months after the end of each fiscal year of [Jersey], [Jersey] shall declare and pay a dividend in an amount not less than the amount of income tax that would have been payable by [Jersey] for the most recently ended fiscal year if no election by the Stockholders of S Corporation treatment had been in effect, calculated using the highest incremental rate in effect in the jurisdictions in which [Jersey] maintains its principal place of business.
McCully's complaint asserted that under this provision, he was entitled to receive in excess of $500,000 as distributions to pay income tax on the company's income allocated to him on his K-1's for the 2000 and 2001 fiscal years. McCully alleged that, although he received a tax dividend payment for 2000, he was entitled to receive an additional dividend due to amended 2000 tax returns filed by Jersey. He also alleged that he had received no tax dividend with respect to the 2001 fiscal year.
Jersey moved to dismiss McCully's complaint on the grounds of a defense founded upon documentary evidence and failure to state a cause of action. Justice Bernard J. Fried of the New York County Supreme Court, Commercial Division, agreed with Jersey and dismissed the complaint.
As to the year 2000 tax dividend, Jersey submitted unrefuted documentary evidence showing that the amended tax returns and K-1's did not increase McCully's personal tax liability and that none of the other Jersey shareholders received any additional tax payment dividend as a result of the amendments.
Of greater interest is the court's discussion of McCully's claim for 2001 tax payment dividend. Justice Fried's decision lays out a three-part analysis as follows:
- Under the terms of the shareholders' agreement (quoted above), Jersey was not obligated to pay a tax dividend for 2001 until two and a half months after the end of the 2001 fiscal year, i.e., March 15, 2002.
- By exercising his dissenting shareholder rights under BCL Section 623, McCully "lost the right to receive dividends declared and paid by [Jersey] after the consummation of the reorganization on November 30, 2001".
- McCully offered no proof that Jersey actually declared and paid a tax dividend for year 2001 prior to November 30, 2001.
Subdivision (e) of BCL Section 623 expressly provides that upon consummation of the corporate reorganization, "the [dissenting] shareholder shall cease to have any of the rights of a shareholder except the right to be paid the fair value of his shares and any other rights under this section". The right to receive dividends, Justice Fried observes, "is clearly among the rights lost upon consummation of the corporate action".
Further support for this conclusion is drawn from Section 623(e)'s provision, that a shareholder who loses his dissenter's rights by revoking his objection or otherwise, shall be "reinstated to all his rights as a shareholder as of the consummation of the corporate action, including . . . the right to payment of any intervening dividend or other distribution". "The right to receive any dividend paid following the consummation of the corporate action", Justice Fried writes, "could only be 'reinstated' upon a dissenting shareholder's loss of his dissenter's rights if, as a prior matter, the shareholder's exercise of his dissenter's rights had triggered his loss of the right to receive any such dividend".
The decision does not disclose whether or exactly when a 2001 tax payment dividend was distributed to the non-dissenting shareholders following the consummation. Perhaps it was not in the record of the court proceedings because the case was decided on a pre-discovery dismissal motion. In any event, it's probably safe to assume that by dissenting, McCully missed out on a substantial tax payment dividend for his allocable share of the company's 2001 net income.
Or did he? The real question is whether McCully's valuation experts accounted for future tax dividends in their appraisal reports and testimony at the valuation hearing. Justice Fried alludes to this when he points out:
Moreover, if McCully were permitted to recover herein the amount of a dividend paid on his shares after November 30, 2001, such a recovery would be duplicative of his recovery of the fair value of those shares in the Appraisal Proceeding, since that fair value presumably encompassed the value of the right to receive future dividends that would be paid on the shares. (Emphasis added.)
That's all the court's opinion says on the subject, so we don't know whether, in fact, McCully's follow-up lawsuit effectively sought a double recovery, or whether his experts in the appraisal proceeding omitted the 2001 tax dividend in their valuation. Here's what the statute, BCL Section 623(h)(4), says about valuing shares in an appraisal proceeding:
In fixing the fair value of the shares, the court shall consider the nature of the transaction giving rise to the shareholder's right to receive payment for shares and its effects on the corporation and its shareholders, the concepts and methods then customary in the relevant securities and financial markets for determining fair value of shares of a corporation engaging in a similar transaction under comparable circumstances and all other relevant factors.
The language of the statute certainly is broad enough to encompass distributions in the nature of foreseeable post-consummation dividends payable on account of pre-consummation tax liabilities. The important lesson of McCully, therefore, is to understand that Section 623(e)'s cut-off of shareholder rights as of the consummation date does not foreclose the dissenting shareholder from receiving, as part of the fair value award, elements of value arising from future payments of contractual origin under the shareholders' agreement. Equally important, McCully teaches that if such value is omitted at the appraisal stage, the dissenting shareholder will not get a second chance to recover it.
Update March 26, 2009: The plaintiff McCully appealed Justice Fried's decision to the Appellate Division, First Department. The appellate court today issued an order affirming Justice Fried's dismissal of the claim for 2001 tax dividend but reinstated McCully's claim for additional tax dividend for 2000 on the procedural ground that the defendants' documentary evidence failed to establish that McCully's 2000 tax liability did not increase as a result of the company's amended 2000 tax return.
