Judicial Estoppel Doctrine Defeats Ex-Convict's Standing to Bring Shareholder Derivative Action Based on Failure to Disclose Alleged Stock Interest to Probation Authorities at Time of Sentencing
The doctrine of judicial estoppel in general prevents a party who asserts a factual position in one legal proceeding from taking an inconsistent position in subsequent litigation. Judicial estoppel occasionally comes into play in shareholder disputes when the complaining party's status as a shareholder, and thus his or her standing to sue, is challenged based on the failure to disclose the stock interest in prior legal proceedings.
For example, last year I wrote about a case called Light v. Boussi in which the court dismissed a corporate dissolution proceeding brought by a putative 50% shareholder due to his failure to list the shares as an asset in his prior bankruptcy proceeding. A recent decision by Suffolk County Commercial Division Justice Emily Pines provides another example, this time involving a shareholder's derivative action in which the plaintiff failed to disclose his alleged stock interest at the time of his sentencing in prior criminal proceedings. Watkins v. J C Land Development, Ltd., Short Form Order, Index No. 30679-08 (Sup Ct Suffolk County June 19, 2009).
The plaintiff, William "Chip" Watkins, filed a shareholder's derivative action in 2007 alleging that he owned a 50% stock interest in a real estate company called J C Land Development, Ltd. ("JCLD") formed on March 25, 1999. Watkins alleged that he invested $600,000 in JCLD including $130,000 in start-up cash. Watkins claimed that the other 50% shareholder, John Cenci, and another co-defendant as "agent" subsequently diverted ownership of JCLD's real properties by placing title in their own names for "no adequate consideration". The suit asked to set aside the allegedly improper transactions and to have the title to the real properties transferred to the corporation.
Cenci's answer to the complaint asserted that he was the sole shareholder of JCLD. He also counterclaimed against Watkins for $600,000 allegedly owing on the sale of a property developed by JCLD and sold to Watkins.
Watkins, however, had a bigger problem. The same year he and Cenci allegedly formed JCLD, Watkins pleaded guilty to federal narcotics charges. At the time of his guilty plea on March 5, 1999 -- only 20 days before the formation of JCLD -- SDNY District Judge Rakoff stated that "no fine will be imposed because the Court made a finding that, in his present circumstances and in the foreseeable future, [Watkins] will not be able to pay any material fine."
Based on the discrepancy between that statement and Watkins' allegations in his derivative action, Cenci applied to Judge Rakoff for disclosure of Watkins' sealed Presentence Report ("PSR"). Over Watkins' opposition, Judge Rakoff ordered partial disclosure of the PSR which reflected Watkins' omission of any disclosure to the Probation Department of his alleged, contemporaneous interest in JCLD. Here's what Judge Rakoff said in his June 2009 order, as quoted in Justice Pines' decision:
Throughout all proceedings before this Court, [Watkins] was represented by court-appointed counsel, based on his representations to the Court that he was financially unable to employ counsel himself. . . . In the New York action and dissolution [sic] proceeding, however, [Watkins] alleges that on or about March 25, 1999, i.e., twenty days after [Watkins] pleaded guilty before this Court, he and [Cenci] formed a real estate development company, and that, beginning a month after being incarcerated, [Watkins] invested approximately $600,000 in that corporation. . . . After pleading guilty, [Watkins] provided certain information to the probation department concerning his finances for use in his PSR. At [Watkins'] sentencing hearing, the Court adopted the factual findings of the PSR, . . . and, as noted, declined to impose any fine based on its determination concerning [Watkins'] inability to pay.
Justice Pines' decision also notes that, under the applicable Sentencing Guidelines, the federal court was required to impose a fine unless the defendant establishes both his inability to pay and the likelihood that such inability will continue.
Cenci argued that the statements made by Watkins and relied upon by Judge Rakoff at his sentencing judicially estopped Watkins from asserting his stock ownership in JCLD in the state court derivative action. Watkins argued that there was no evidence of any on-the-record statement by Watkins regarding his financial situation and that there were many reasons for the sentencing including Watkins' personal family situation at the time of sentencing.
Justice Pines agreed with Cenci and granted summary judgment dismissing the action. Her decision summarizes the doctrine of judicial estoppel as follows:
The well recognized doctrine of judicial estoppel is designed to protect the integrity of the court system as a whole by prohibiting deliberate alteration of a stated position before the same or different courts in order to obtain favorable treatment. The doctrine prohibits a party who, having obtained a favorable ruling based upon an asserted position, seeks to alter the position simply because the litigant's interests have changed. [Citations omitted.]
Justice Pines concluded that Watkins failed to raise any genuine issue of material fact in response to Cenci's prima facie showing of entitlement to summary judgment based on judicial estoppel. Here's what she wrote:
Applying the doctrine set forth above, and Judge Rakoff's statements in his Order and the released portions of the PSR, the Court cannot imagine a more apt scenario for application of the doctrine of judicial estoppel. The Federal Court specifically relied on Watkins' assertions of penury in declining to impose an otherwise mandatory fine in connection with Watkins' pleas of guilty to the crime of conspiracy to violate the federal narcotics laws. Thus, Watkins obtained a judgment in his favor based upon his statements, including those declaring the lack of assets. The same litigant will not be permitted to utilize the State Court system to litigate his claims to real property or accountings based on funds he now states he began transferring at the precise time of his contradictory statements to probation, relied upon by a federal judge. Plaintiff has not raised any issue [of] fact, and indeed cannot do so, when faced with the statements of the sentencing judge, and the admissions contained in the PSR.
As Watkins illustrates, the doctrine of judicial estoppel obviates the court's determination of the plaintiff's asserted stock ownership rights. In theory -- and I'm not referring here to the Watkins case -- the "other" shareholders could reap a windfall if, in fact, the plaintiff acquired an ownership interest but then, for whatever reason, he or she concealed it in bankruptcy or criminal proceedings. But such forfeiture is the price exacted by the doctrine, in the greater interest of ensuring the integrity of judicial proceedings.
Note: Farrell Fritz, P.C. represented one of the co-defendants in the Watkins case.
Undocumented Stock Interests Invite Challenges to Standing in Corporate Dissolution Cases: Part One
In the world of closely held corporations, what makes a shareholder a shareholder?
Section 508 of New York's Business Corporation Law states that "the shares of a corporation shall be represented by certificates or shall be uncertificated shares." Scattered throughout the BCL are references to "shareholders of record". BCL Section 624 requires every corporation to keep "a record containing the names and addresses of all shareholders" and makes such record "prima facie evidence of the facts stated therein" in any action or special proceeding against the company, its directors, officers or shareholders.
However, ask lawyers about their experiences with small, closely held corporations and you will hear countless stories about companies that never issued stock certificates, never kept a stock ledger, never adopted bylaws, never had a written shareholders' agreement, and never held formal shareholder meetings much less kept meeting minutes.
Such widespread record keeping lapses create fertile ground for disputes over shareholder status in many different legal settings, including corporate dissolution contests. Sometimes the dispute is over the stock percentage held by an otherwise acknowledged shareholder. This kind of dispute is geared toward either supporting or defeating the specific stock-holding percentage requirements for bringing a deadlock dissolution proceeding under BCL 1104 (50%) or an oppressed minority shareholder dissolution proceeding under BCL 1104-a (20%).
Then there are the cases in which the respondent contends that the petitioner never held a stock interest. More often than not, these cases are brought under the oppression statute by putative minority shareholders who lack control of, or access to, the corporation's books and records.
This is the first of three consecutive posts on the standing challenges to be overcome by a petitioner who holds no stock certificate or other direct evidence of a stock interest. Each of the three cases highlighted in these posts presents a distinct factual scenario. All three cases remind us of the substantial additional litigation costs and time involved when an initial evidentiary hearing must be held to determine the petitioner's standing before proceeding to a hearing on the merits of the dissolution petition.
The first case is Matter of Schwartzman (First Rate Capital Corp.), 2009 NY Slip Op 30457(U) (Sup Ct Suffolk County Feb. 24, 2009) decided by Suffolk County Commercial Division Justice Emily Pines. Harlin Schwartzman brought a petition to dissolve a mortgage banking business called First Rate Capital Corp. under BCL 1104-a in which he alleged that he is one of three 33 1/3% shareholders; that the other two shareholders withheld his share of profits and diverted business to their separate mortgage company; and that when he demanded to be bought out they denied that he was a shareholder. Schwartzman's evidence of his shareholder status included a 2002 shareholders' agreement identifying him as one of four shareholders (the fourth shareholder later dropped out) and income tax K-1 statements issued to him for the years 2003-2006 listing his ownership interest at either 25% or 33.33%.
The respondents moved to dismiss the petition for lack of standing, claiming that Schwartzman did not own the requisite 20% stock interest. First, they argued that prior to bringing his petition, in May 2007, Schwartzman gave a written "resignation" of his stock ownership. Alternatively, they argued that he never acquired a stock interest because he defaulted in payment on his 2002 promissory note and stock purchase agreement. They admitted Schwartzman's receipt of the K-1s but argued that they were "erroneous" and that "K-1 statements are not proof of ownership."
Schwartzman replied that the resignation letter was a forgery, that his note payments were deducted from his share of the profits, and that, while he did tender his resignation as an officer and director, he never resigned as a shareholder.
The respondents submitted the report of a forensic document examiner who opined that the resignation letter contains Schwartzman's authentic signature.
Justice Pines' ruling cites a number of Second Department decisions for the proposition that a preliminary hearing must be held on the issue of stock ownership where the parties' affidavits create questions of fact. And that is exactly what she ordered in the case before her, stating:
In the case at bar, the conflicting assertions by the parties create questions of fact regarding petitioner's ownership interest, if any, in First Rate, which must be resolved before the Court can consider the merits of the petition. The Court notes that petitioner was receiving K-1 income tax statements reflecting a varied degree of stock ownership, which respondents merely dismiss as being either erroneous or not probative of the issue of ownership. Moreover, while the Court finds persuasive the May 21, 2007 purported resignation letter as evidence of petitioner's surrender of his shareholder interest, petitioner denies the authenticity of this document. Equally disconcerting is the disparate claims as to whether petitioner made payments on the promissory notes via deductions from his share of the profits. Although petitioner submits an affidavit from [First Rate's former controller] claiming that such payments were made, respondents similarly dismiss these allegations as the machinations of a disgruntled former employee who is currently engaged in a business venture with petitioner.
I see two noteworthy aspects of Schwartzman, beyond illustrating the need for a hearing to resolve the parties' disputed factual assertions. First, the presence or absence of K-1s supporting or refuting the petitioner's claimed stock ownership usually takes top priority in cases like this. The Marciano case I wrote about last year in my Anatomy of a Dissolution Slugfest series is another good example of this. Schwartzman presents the more unusual case in which the respondents argue against tax records that, as controlling shareholders, presumably they approved before filing.
Second, a shareholder's surrender (redemption) of his or her stock interest usually occurs under a written shareholders' agreement on specified terms or, absent such written agreement, pursuant to a voluntary tender and acceptance. All we know from the court's decision in Schwartzman is the one sentence quoted from the petitioner's alleged letter stating, "Please accept this letter as my resignation as 1/3 shareholder of First Rate Capital Mortgage Bankers effective immediately." We do not know if the parties' 2002 shareholders' agreement addresses voluntary redemption and, if so, whether the letter complies with it. Assuming the shareholders' agreement doesn't govern, we also don't know if there was an acceptance of the stock redemption by the company's Board of Directors. Of course, these issues will remain unanswered if, at the upcoming hearing, the court rejects the letter's authenticity.
Disputed Allegations of Shareholder Oppression Require Evidentiary Hearing
There's nothing special about the corporate dissolution case brought by David Wenger involving a family-owned construction business. The facts of the case are garden variety, as these things go. The case presents no novel legal issues. The court's decision, ordering an evidentiary hearing to determine the petition's disputed allegations of oppression, is nothing if not anti-climactic.
But that's exactly why I want to write about it, to illustrate what happens in the ordinary dissolution case, where there are no knockout punches in the first round. That plus, it's my first occasion to highlight a decision by Suffolk County Commercial Division Justice Emily Pines.
The court's decision in Matter of Wenger (L.A. Wenger Contracting Co.), Index No. 31701/08 (Sup Ct Suffolk County Nov. 12, 2008), describes a case of corporate and family dysfunction pitting father against son. In August 2008, the son, David, as a 31% shareholder filed a petition to dissolve L.A. Wenger Contracting Co. of which his father, Louis, is majority owner. Upon filing the petition David obtained a temporary restraining order enjoining his father from disbursing company funds to any shareholder, officer or director except in the ordinary course of business. David's petition also sought appointment of a receiver pursuant to Section 1113 of the Business Corporation Law.
The petition sought dissolution under BCL Section 1104-a based on allegations of shareholder oppression and fraudulent conduct by his father over a period of years, including the conveyance of company-owned real property to David's father and sister for no consideration; denying David access to company information; and failure to make distributions. Louis's answer to the petition denied that he wasted or improperly diverted corporate assets; denied that David was frozen out of corporate governance; and contended that the alleged real property transfers were for the corporation's benefit. Louis also countered that David had "deliberately removed himself" from the family business over seven years earlier and was using the dissolution proceeding "in an improper attempt to take over a business run by [Louis] for over fifty nine years."
What happens when the litigants file such contradictory written submissions at this early stage in the proceedings? The answer requires some familiarity with judicial dissolution procedure. Unlike lawsuits commenced by ordinary summons and complaint, BCL Section 1106 requires that a corporate dissolution case be commenced by petition and Order to Show Cause signed by a judge which, among other things, fixes a so-called "return date" for the hearing of the petition. The initial return date normally is not an evidentiary hearing. Rather, it typically is handled by the court as a conference or oral argument by the lawyers to state their positions for and against dissolution. Some judges take the papers "on submission", i.e., without any in-court appearance by the lawyers, and will later issue a written decision. Either way, the threshold question for the court is whether, based on the papers alone, it can make a ruling granting or denying the dissolution petition, or whether the papers raise material issues of fact that cannot be determined without an evidentiary hearing. Essentially it's the same question judges face all the time when deciding motions for summary judgment: Are there disputed issues of fact?
In the Wenger case, Justice Pines concluded that the determination of David's petition requires an evidentiary hearing because of the disputed facts. Here she succinctly states the governing law and its application to the case before her:
The appropriateness of an order of dissolution or other related remedy pursuant to [BCL Section 1104-a] is in each case vested in the sound discretion of the court considering the application. Matter of Kemp & Beatley v. Gardstein, 64 NY2d 63, 484 NYS2d 799 (1984).
Where the allegations in a Petition by a minority shareholder to dissolve a closely held corporation pursuant to BCL 1104-a are disputed, the courts of this State have held that a hearing is mandatory both to determine whether the oppressive conduct set forth by the statute exists and to decide the appropriate remedy. In re WTB Properties, Inc., 291 AD2d 566, 737 NYS2d 654 (2d Dept 2002) ; Matter of Steinberg v. Cross Country Paper Products Corp., 249 AD2d 341, 671 NYS2d 341 (2d Dept 1998). . . .
In this case, the minority and majority shareholders have set forth far differing versions of the facts. When contested as they are here, the Court must, through a full record, including the testimony of the parties, determine whether the majority shareholder has, in fact, been engaged in improper transfers, self dealing, or whether, as stated by [Louis], all actions have been appropriate under the circumstances.
Justice Pines also ruled that there was not "sufficient information at this stage" to determine that appointment of a receiver was necessary to preserve the assets of the corporation. She did, however, continue the temporary restraining order barring disbursements to preserve the status quo.
There have been numerous cases in which courts grant or deny dissolution without holding an evidentiary hearing. For instance, in Matter of HGK Asset Management, Inc., 228 AD2d 246 (1st Dept 1996), the appellate court affirmed an order of dissolution without a hearing where the respondent shareholders' papers opposing the petition failed to raise a factual issue of oppression. Wenger nonetheless is a good reminder for petitioners that their ultimate objective, whether it be liquidation of the company or inducing the other side to purchase their shares, may not be achievable in the first round of litigation, and that they may have to incur the additional time and considerable expense of an evidentiary hearing.
