A Toxic Mix of Family and Business
It's not surprising that the ancient adage, "Never mix family and business," is more honored in the breach than the observance. After all, as the late Professor Larry Ribstein observed in his terrific 2010 research paper entitled "Close Corporation Remedies and the Evolution of the Closely Held Firm" (reviewed here):
The earliest small firms were partnerships, which began as intimate, usually family, relationships. They were referred to as 'compagnia,' which means those sharing bread, reflecting their origins in households. Kinship ties were an important mechanism for controlling agency costs. As Kerim told James Bond in From Russia with Love, "all of my key employees are my sons. Blood is the best security in this business."
Blood may be the best security in some family-owned businesses, but in many others the same bonds of kinship and trust that induce family members to enter into a business association in the first place, when abused or perceived to be abused, can and often do instigate conflict, entropy, and ultimately the dissolution of the firm and destruction of family ties. In other words, the emotional ties that encourage family members to dispense with diligence and formalities when starting and operating a business can also drive them apart with even greater force when things go wrong, in no small part due to those very dispensations.
For this column I've chosen three recent, illustrative cases presenting dissolution and related claims involving family-owned businesses. The substantive issues in each case are interesting and informative, if not novel. I wasn't involved in any of the cases, so I can't really say to what extent the blood relations of the parties contributed to the outbreak of hostilities or the underlying problems. But I think it's fair to say that each case in its own way shows tell-tale signs of the dysfunctional circumstances and dissension peculiar to business divorce, family style.
The case summaries follow after the jump.
Billanti v. Billanti, Short Form Order, Index No. 4536-11 (Sup Ct Nassau County Dec. 15, 2011)
Billanti Casting Co., located in New Hyde Park, Long Island, is a family-owned business since 1955 servicing the jewelry industry. One of the founders, Joseph Billanti, eventually brought his children Frank and Rosemarie into the business. In 1992, Joseph, Frank, Rosemarie and Joseph's brother John (a co-founder of Billanti Casting) and John's wife as co-equal partners formed a general partnership called the Billanti Family Investment Partnership. The Partnership's purpose was to invest profits from Billanti Casting as venture capital in connection with potential expansion of the casting business, which never took place. The Partnership's assets consist of fixed income assets held with an investment firm and a loan made to Billanti Casting to cover a tax obligation. Starting around 2000, Rosemarie became head of the casting business while Joseph and John became less involved. Frank stopped working at Billanti Casting in 2008 apparently after losing a fight for control with his sister Rosemarie. Their father, Joseph, died in 2010.
In 2011, Frank brought suit for judicial dissolution of the Partnership under §63 of the Partnership Law based on his sister Rosemarie's alleged conduct including her exclusive control over its books and records, for an accounting, and for other relief concerning the Partnership and Billanti Casting. Rosemarie and the other defendants denied Frank's allegations of misconduct and opposed the request for dissolution of the Partnership.
In his decision earlier this month, Nassau County Commercial Division Justice Timothy S. Driscoll granted Frank's motion for summary judgment dissolving the Partnership, but not under Partnership Law §63 as requested. Because the Partnership has no agreement establishing its duration, Justice Driscoll explained, it "is a partnership at will, that may be dissolved at any time by any partner" under Partnership Law §62(1)(b). Frank's expression of his desire to dissolve the Partnership suffices without need for proof of other partner misconduct. Justice Driscoll also ordered the defendants to provide Frank with an accounting of the Partnership's assets and its affairs since commencement, and he appointed a receiver to direct the dissolution of the Partnership, the sale of its assets, the collection of all monies and the division of the proceeds.
Zekry v. Zekry, 2012 NY Slip Op 30104(U) (Sup Ct NY County Jan. 18, 2012)
In 2004, plaintiff Nicole Zekry and her husband, defendant Pinhas Zekry, formed David Ben Barouck Corp. to operate a hair salon, spa and cosmetology business on Columbus Avenue in Manhattan. They entered into a shareholders agreement which recited that Pinhas held a 60% stock interest in consideration of his payment of $283,680 and for his "know-how and managerial experiences, and infrastructure and availability of selling and work force and personnel, which he has invested in the corporation and in facilitating the construction of the premises." The agreement also recited that Nicole held a 40% stock interest for her payment of $189,120.
In 2008, after Nicole sued to dissolve their marriage, Nicole filed a complaint against Pinhas (read here) for fraud, breach of fiduciary duty and to reform the shareholders agreement to enlarge her stock ownership to 71.1% based on evidence that Pinhas only contributed about $77,000 at the inception rather than $283,680 as recited in the agreement.
In her decision issued earlier this month, New York County Justice Deborah A. Kaplan denied Nicole's motion for a summary judgment of equitable reformation of the stock percentages on the ground that the agreement by its terms did not condition Pinhas's share allocation based only on his payment of $283,680 "but also his personal investment in the business, including, inter alia, his knowledge and managerial experiences, his work force and personnel, and his facilitation of the construction of the premises." In other words, since the agreement did not provide for the division of share ownership based solely on the parties' respective initial capital contribution, Nicole failed to establish as a matter of law that Pinhas "fraudulently induced unilateral mistake regarding his capital contribution" such that their agreement "does not express the intended agreement" as a basis for reformation.
Kimelstein v. Kimelstein, 2011 NY Slip Op 32949(U) (Sup Ct Suffolk County Oct. 26, 2011)
The Van Depot, Inc. was formed in 1999 by brothers Jeffrey and Larry Kimelstein to operate a used car sales business in Lindenhurst, Long Island, on a lot owned by a second corporation also co-owned by the brothers.
Larry sued Jeffrey in 2008, claiming breach of an oral agreement by Jeffrey to pay Larry $350,000 in exchange for Larry's alleged 50% ownership interests in the two companies. Jeffrey denied Larry's ownership of shares in either company. In a February 2010 decision, Suffolk County Commercial Division Justice Emily Pines dismissed Larry's claims for breach of oral agreement and specific performance, denied Jeffrey's motion to dismiss the claim to impose a constructive trust, and granted Larry leave to amend his complaint to add a claim, among others, for corporate dissolution as an oppressed shareholder under §1104-a of the Business Corporation Law.
In her latest decision, Justice Pines summarized the contest as one "between brothers concerning the extent of their business relationship and what, if anything the Defendant's brother and the two corporate Defendants, in which Plaintiff claims ownership, owe the Plaintiff for his investment in time and sweat equity, following Plaintiff's departure from what may or may not constitute a closely held family business." In opposition to Jeffrey's motion to dismiss the amended complaint, Larry offered a number of checks from his brother allegedly representing partial payment for his shares, along with affidavits from non-party witnesses attesting that Jeffrey held Larry out to them as his equal partner in the family business.
Justice Pines agreed with Jeffrey to the extent of dismissing Larry's claims for breach of fiduciary duty and a formal accounting which were asserted individually instead of derivatively as required. Justice Pines nonetheless refused to dismiss Larry's claim for dissolution based on lack of standing because "there exists documentary evidence presented on both sides of this issue," and she allowed Larry to proceed with his equitable claims in the alternative. Finally, she also ruled that, should the court find that Larry has standing and proves oppression, the court is empowered "to order a less drastic remedy than dissolution, such as an accounting."
An Ill-Fated Solution to an Ill-Fated Buy-Sell Agreement
Let's face it: If you have a close corporation shareholders' agreement or LLC operating agreement including a buy-sell provision with a fixed share price that's supposed to be updated periodically, there's a good chance you (or your estate) are in for a nasty fight when the buy-out is triggered by the death, disability or retirement of one of the owners. Why so? Because more often than not the owners never update the agreed share price, so that when a buy-out is triggered many years later, the last agreed value no longer reflects a fair value for the ownership interest due to the growth (or decline) of the business in the interim, e.g., the Nimkoff case about which I wrote here.
Many such buy-sell agreements include an alternative valuation method when the agreed price -- often memorialized in a so-called Certificate of Value appended to the shareholders' agreement -- is not updated within a stated number of years before the trigger event, such as using an appraiser to perform a current evaluation. Such alternatives are no panacea, however, especially when the agreement fails to specify valuation parameters including the standard of value (e.g., fair market value, fair value, book value) and level of value (e.g., controlling, marketable minority, nonmarketable minority). The Sassower case, about which I wrote here and here, is a textbook illustration of the litigation woes that can follow when the buy-sell fails to articulate relevant valuation parameters.
If there's anything worse than failing to specify standards for the alternative valuation, it's providing no alternative, as when the buy-sell mandates use of the stale fixed price, which brings us to this week's featured case, DeMatteo v. DeMatteo Salvage Co., 2011 NY Slip Op 09586 (2d Dept Dec. 27, 2011).
DeMatteo is a poster child for all that can go wrong with a poorly designed buy-sell agreement. DeMatteo Salvage Co. is a Long Island based, family-owned business since the 1920's, designing and installing machinery and equipment for scrap paper and solid waste customers. In 1966, siblings Domenick, Edward, Carmine and Joseph DeMatteo entered into mirror image buy-sell agreements for DeMatteo Salvage and a second company they owned called E&J Holding Corp. The agreement requires the estate of a deceased shareholder to sell, and the companies to buy, the decedent's shares at a fixed price. The agreement does not require that the agreed value be updated periodically. Rather, it merely provides that the agreed price "may be redetermined at any time by mutual agreement of the Corporation and the Stockholders" and then goes on to specify that the failure to redetermine value for however long does not disable the last, agreed value:
The last value established preceding the death of a Stockholder shall be the value of his stock for purposes of this agreement. This provision shall not be altered by the fact that the Corporation and the Stockholders for any reason have failed to redetermine such value at any time or from time to time. All redeterminations of value shall be endorsed upon Schedule A hereof, dated and signed by the Corporation and the Stockholders.
Fifteen years later, in 1981, Schedule A was formally endorsed with new values of $7,500 per DeMatteo Salvage share and $10,000 per E&J share. Although Schedule A thereafter never was amended, on several occasions in 1984-86 there were shareholder meetings whose minutes reflected redetermined values, the last of which set per-share prices of $20,000 for DeMatteo Salvage and $37,500 for E&J.
Further muddying the issue, minutes of a shareholder meeting in March 1992 reflect a resolution to "table" the re-evaluation of the shares until October 1992, and to keep the previously set values of $66,197 per DeMatteo Salvage share and $66,666 per E&J share. (The court decisions don't reveal when those share values were set or how they were recorded.)
It appears that all of these share re-evaluations were done by the shareholders themselves without the assistance of an appraisal professional.
The eldest brother, Joseph, died sometime before 2000, which sparked the first buy-out litigation culminating with a settlement that forced the surviving three siblings to borrow funds to pay the estate. In April 2000, apparently hoping to avoid a repeat, the three surviving shareholders adopted a formal resolution stating "that the values for the shares of stock in both corporations [are] voluntarily canceled at their present value" and that "Paul Iadanza at the office of Delle Fave & Tarasco, has been retained to value both corporations."
Edward DeMatteo died two years later, in June 2002. In the interim, for reasons never made clear to the court, the designated company accountant, Mr. Iadanza, did not perform the evaluations authorized by the April 2000 resolution.
Thus began an 8-year litigation saga, commencing in 2003 when Edward's widow, Gloria, as executrix, sued DeMatteo Salvage and E&J to enforce a buy-out of the Estate's shares based on what she claimed was the last validly determined value of approximately $66,000 per share for each company based on the March 1992 resolution.
In 2004, Gloria moved for summary judgment on her buy-out claim at $66,000 per share. The companies, now owned by the two surviving siblings, cross moved for summary judgment based on what they claimed were the last valid determinations of value, namely, the 1981 endorsements on Schedule A at $7,500 per DeMatteo Salvage share and $10,000 per E&J share.
In a decision and order dated February 8, 2005, Suffolk County Commercial Division Justice Elizabeth Hazlitt Emerson concluded there were factual issues precluding a summary determination of the buy-out price. In so ruling, she found that the 1992 resolution was not binding because Dominick DeMatteo was not present at the meeting and because the values were not endorsed on Schedule A. She also found that the 1984-86 re-evaluations evidenced the siblings' intent to redetermine the value of their stock after the 1981 valuation, but that they were not conclusive as to "whether [the shareholders] took all steps necessary to redetermine the value in accordance with the buy/sell agreements."
At some point during the litigation, Mr. Iadanza prepared current appraisals of both companies, reporting values not disclosed in the court's decisions other than mentioning that they were less than the values adopted in the 1981 endorsements to Schedule A. The surviving siblings thereupon sought to enforce a buy-out based on Mr. Iadanza's valuation. In June 2009, Suffolk County Commercial Division Justice Emily Pines held a framed-issue hearing at which the surviving siblings testified that their deceased brother, Edward, drafted the April 2000 resolution and specifically chose Mr. Iadanza to perform new valuations, and that all the siblings agreed to accept Mr. Iadanza's valuations in lieu of the prior valuations over which there had been years of litigation following Joseph's death.
In her decision dated July 2, 2009, Justice Pines credited the surviving siblings' testimony and granted them summary judgment to the extent of finding that they and Edward agreed in April 2000 to scrap the prior valuations and to be bound by new valuations as of that date to be performed by Mr. Iadanza. As Justice Pines further explained:
While [Gloria's] counsel has suggested that the Iadanza evaluation that was in fact performed should not be accepted as it was lower than the one set forth by the shareholders themselves in 1981, clearly that was part of their purpose in enacting the 2000 resolution; i.e., for the valuation to reflect a number which would not place the corporations in extremis when the estate of the next shareholder was entitled to payment. They made the decision consciously with the imprimatur of [Edward] who chose the evaluator.
However, since the valuations prepared by Mr. Iadanza valued the companies as of a date some years after April 2000, Justice Pines also ordered him to prepare new valuations as of April 2000.
Approximately one year later, in August 2010, Justice Pines entered judgment based on Mr. Iadanza's new valuation reports, awarding Edward's estate the sum of approximately $500,000 for his combined interests in both companies based on an aggregate valuation of both companies of approximately $1.3 million.
Both sides thereafter appealed to the Appellate Division, Second Department which in its December 27, 2011 order, reduced the award to Edward's estate by approximately $100,000. The appellate court found that Justice Pines should not have disregarded minority and marketability discounts applied by Mr. Iadanza to the value of one of the company's shares (the decision does not specify which company), thereby reducing the per-share value for that company by a combined 30% discount, from $12,379 to $8,665. By the way, the fact that the parties litigated the applicability of discounts tends to confirm the fact that the April 2000 resolution authorizing an appraisal by Mr. Iadanza was silent concerning standards and levels of value.
Gloria's appeal argued that, pursuant to the April 2000 resolution, the shareholders did not intend to be bound by Mr. Iadanza's new report, but the appellate court declined to reach the issue on procedural grounds based on that court's dismissal of Gloria's previous appeal from Justice Pines' July 2009 decision for failure to prosecute.
[Note: The buy-sell agreements provided for the companies to procure insurance policies on the lives of the shareholders for the purchase of their shares. In September 2006, Gloria won a prior appeal to the Second Department which ordered the companies to pay Edward's estate approximately $440,000 in life insurance proceeds (read here). It's not clear if that amount is in addition to, or is applicable in satisfaction of, the lesser sum awarded in the recently decided appeal.]
Between the first buy-out litigation following the eldest brother Joseph's death, and the second lawsuit started by Gloria after Edward's death, the DeMatteo family has been warring in the courts over the value of the companies' shares for more than a decade. Whatever one thinks of the outcome, what's absolutely clear is that the buy-sell agreement failed miserably, both in its design and its implementation, in its intended purpose to ensure family control of the businesses while providing the shareholders' heirs with a measure of financial security based on a consensual, non-litigated, fair valuation of the companies' equity.
- It was a mistake to design the buy-sell agreement without requiring periodic updates.
- It was a mistake to design the buy-sell agreement without providing an alternative valuation method when a buy-out event occurs more than a year or two after the last agreed valuation.
- It was a mistake for the shareholders to come up with their own valuations over the years without seeking the guidance of a professional appraiser.
- It was a mistake for the shareholders to agree to rescind the prior valuations in favor of obtaining a professional appraisal, and then not following through by having the professional perform the appraisal until long after the death of a shareholder, when the financial interests of the surviving shareholders and the deceased shareholder's estate became antagonistic.
Business appraiser and author Z. Christopher Mercer, a leading authority on buy-sell agreements, has described fixed pricing in a buy-sell agreement as a "ticking time bomb". The DeMatteo case is a powerful demonstration of the accuracy of Chris's warning.
Update January 14, 2012: Chris Mercer has written a post on the DeMatteo case on his highly informative blog, ValuationSpeak.
Judges Thinking Outside the LLC Dissolution Box
The title of this week's post is inspired by two recent decisions in LLC dissolution cases in which courts crafted remedial measures that appear to venture into new territory in an effort to achieve efficient and equitable resolution of the parties' dispute.
In one case, the court ordered an appraisal proceeding for a buyout of the petitioning member's interest after denying his request to dissolve the LLC. In the other, involving a dispute between 50/50 managing members, the court appointed a temporary receiver with limited powers to monitor the LLC's financial activity.
The appraisal remedy was ordered by Commercial Division Justice Stephen A. Bucaria in Matter of Gold (Cosmo Holdings LLC), Short Form Order, Index No. 6722/11 (Sup Ct Nassau County Oct. 26, 2011). The petitioner in Gold is a 25% member and the respondent Kanter is a 75% member of a member managed LLC called Cosmo Holdings LLC formed in 2007 to invest in other companies. Each member made an initial capital contribution over one-half million dollars. The operating agreement provides that a member who wishes to sell his or her interest must first make an offer to the other member to sell at a mutually agreed upon price.
In 2009, Kanter removed Gold as a signatory on Cosmo's bank account. In May 2011, Gold petitioned to dissolve Cosmo based upon deadlock between the managing members. Gold also alleged that Kanter withheld financial information and refused to make distributions to Gold.
Justice Bucaria's decision first summarizes the standard for judicial dissolution of LLCs under §702 of the LLC Law, as construed by the Appellate Division, Second Department, in the 1545 Ocean Avenue case:
[LLC Law] §702 provides that a court may decree judicial 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 the operating agreement. Dissolution is a drastic remedy, which is not to be granted unless management is unwilling or unable to promote the company's stated purpose or continuing the company is financially unfeasible.
Justice Bucaria then turns to Cosmo's operating agreement, which in critical part provides that members holding a majority of the capital interests shall elect the managers. "As the holder of a majority membership interest," Justice Bucaria writes, "respondent [Kanter] has the authority to exclude petitioner [Gold] from the management of Cosmo." He then finds that Gold has not established that Kanter as managing member "is unable or unwilling to promote Cosmo's purpose of investment" and has not shown that "the continuation of Cosmo is financially unfeasible." Justice Bucaria accordingly denies Gold's application for judicial dissolution.
Does Gold go home empty handed, relegated to a passive-investor role for the life of the LLC? Not quite. Justice Bucaria's decision orders a buyout appraisal of Gold's membership interest in the LLC, stating as follows:
However, absent agreement between the parties as to buyout price, petitioner has the common law right to an appraisal proceeding for the purpose of determining the fair market value of her membership interest in the limited liability company (Appleton Acquisition, LLC v. National Housing Partnership, 10 NY3d 250, 256 [2008]). The parties shall conduct discovery as to the fair market value of petitioner's interest in Cosmo Holdings as of the date of the filing of the dissolution petition, May 5, 2011.
In the cited Appleton case, New York's highest court held that under the Revised Limited Partnership Law, a limited partner could not bring a plenary action under common law to seek rescission of a merger and, instead, was restricted to his or her statutory appraisal remedy.
Other New York courts have enforced an equitable buyout of an LLC membership, albeit under special circumstances where the courts characterized the relief as a species of "liquidation" based on a finding of grounds for dissolution, such as in Lyons v. Salamone, 32 AD3d 757 (1st Dept 2006), and Matter of Superior Vending, LLC, 71 AD3d 1153 (2d Dept 2010). As far as I know, the decision in Gold is the first instance in which a court granted a straight buyout remedy for an LLC member without there being a basis for dissolution. It will be interesting to see if other courts follow Gold's lead.
The second case, involving a less momentous but still novel remedy in an LLC dissolution proceeding, is Scomello v. Pascarella, 2011 NY Slip Op 51965(U) (Sup Ct Suffolk County Nov. 2, 2011). The LLC in Scomello operates a non-medical clinic offering various skin care and "appearance enhancement" treatments. The plaintiff and defendant, each owning a 50% interest in the member-managed LLC, filed suit and counter-suit accusing each other of various financial and management irregularities. The defendant's counter-suit included a claim for dissolution under LLC Law §702 and a request for appointment of a temporary receiver to manage the business pending the litigation. Both parties also moved for preliminary injunctive relief of various sorts.
The decision by Commercial Division Justice Emily Pines comments that the two members present "diametrically opposed allegations of what has occurred in their business relationship," and that "the continued operation of the LLC may depend on an equitable accounting in accordance with the [Operating] Agreement's provisions." To maintain the status quo and preserve the LLC's assets, Justice Pines permits the plaintiff member to continue managing the LLC but under a preliminary injunction that restrains either member from withdrawing LLC funds for himself without the other's consent, or otherwise transferring funds except in the ordinary course of business.
The novelty in Scomello is Justice Pine's appointment of a temporary receiver, not to manage the business, but simply to monitor its financial activities. Here's how she describes the scope of the receiver's duties:
Thus a limited preliminary injunction should remain in effect along with the appointment of a temporary receiver with limited powers to receive monthly statements and back up documents, setting forth all income received and expenses paid by the LLC as well as all member withdrawals and payments of any kind.
Why is this novel? As explained in a decision some years ago by Justice Leonard Austin before his elevation to the Appellate Division, the LLC Law's provisions governing judicial dissolution have no provision for appointment of a receiver until after dissolution is decreed. This omission stands in contrast to §1113 of the Business Corporation Law, which expressly authorizes a court in dissolution cases involving close corporations to appoint a temporary receiver with broad powers to preserve company assets while the dissolution case is pending. An alternative path to receivership for any type of business entity is provided in Article 64 of the Civil Practice Law and Rules, but the courts apply a much more rigorous showing of imminent harm to the business before acting under that Article -- a showing that does not appear to have been made in Scomello.
The monitoring powers granted by Justice Pines in Scomello effectively address a recurring problem in many dissolution proceedings -- not just LLCs -- where one side has little or no access to real-time financial information while the case goes on. Courts often will direct the controlling side to make ongoing disclosure but, almost invariably, new disputes will arise over the adequacy or timeliness of the disclosure. An independent receiver serving only as monitor, acting with the imprimatur of the court, is in a far superior position to enforce disclosure obligations and to convey information the non-controlling side as needed.
Court Sends Everyone Home Empty Handed in Bitter Business Breakup
Reading the post-trial decision by Suffolk County Commercial Division Justice Emily Pines in Nastasi v. Carlino, 2011 NY Slip Op 30626(U) (Sup. Ct. Suffolk County Mar. 8, 2011), one can't help but be struck by the utter futility of an intense three-year litigation between business partners over a now-defunct company in which the court finds them all at fault and sends them all home empty handed.
Aletto & Nastasi Ltd. ("A&N") was formed in 2004 by shareholders Nastasi (40%), Carlino (40%) and Aletto (20%) to operate a marble and granite sales business including warehouse and showroom in Bohemia, New York. Nastasi managed the business until early 2008 when Carlino and Aletto held a shareholders meeting without proper notice at which they voted to remove Nastasi from management and, as described in the court's decision, "had him thrown off the property" after they determined that Nastasi was running sales through a separate company wholly owned by Nastasi.
In May 2008, Nastasi filed a petition for judicial dissolution of A&N as an oppressed minority shareholder under Section 1104-a of the Business Corporation Law. Carlino and Aletto responded in kind with their own suit against Nastasi and his separately owned companies seeking an accounting based on Nastasi's alleged conversion of corporate funds for his own personal use and breach of fiduciary duty.
In October 2008, Justice Pines denied Nastasi's dissolution petition, finding that "[t]he conclusory allegations of ouster, irreconcilable differences and financial damage to the corporation, are insufficient to demonstrate 'oppressive conduct' as to warrant dissolution."
The claims by Carlino and Aletto against Nastasi proceeded to trial before Justice Pines, whose decision last month paints an unflattering picture of bad behavior on both sides. For his part, Nastasi is found to have installed his own, separate company as lessee of A&N's showroom which he then subleased to A&N at a substantially higher rent. Justice Pines also found that Nastasi kept A&N's books and records at an office run by one of his other companies; that he prevented Carlino and Aletto from learning A&N's revenues and expenses over a two-year period; that almost all the invoices for A&N's sales for the period 2006 through early 2008 were invoiced by Nastasi's wholly owned company; and that "Nastasi's testimony with regard to his financial contributions to A&N is simply unfounded and not credible."
Carlino and Aletto also took some lumps. In March 2009, following an eviction proceeding brought by Nastasi's sublessor company against A&N, Nastasi regained control of the showroom and found that Carlino and Aletto had broken granite, smashed sinks and removed all the fixtures along with the cabinets and tiling. The repair costs subsequently incurred by Nastasi were over $180,000. Justice Pines also discredited their testimony that A&N "never really existed," and she concluded that, because the now-defunct company never made a profit, Carlino and Aletto at most were entitled to "amounts necessary to equalize the respective contributions of the shareholders" and not, as they requested, the return of their investments and loans to A&N which totaled around $450,000.
In furtherance of such equalization, the court calculated Nastasi's capital contribution shortfall at around $180,000 which, as coincidence would have it, matched the amount he laid out to fix the showroom damage caused by Carlino and Aletto. Justice Pines accordingly found that neither side was entitled to a money judgment against the other. Here's what she wrote:
On balance, Nastasi breached his fiduciary duty to Aletto and Carlino by allowing his other corporation (Tiffany Manufacturing) to profit at the expense of A&N. Nastasi should have made, but was unable to demonstrate at trial, contributions of between $180,000 and $185,000 to the corporation representing his 40% share. On the other hand, Carlino and Aletto had a fiduciary obligation, once in possession of the showroom, to prevent its destruction and dismantling. Their actions in permitting such destruction also amount to a breach of their fiduciary duty to A&N, and they should have contributed the over $180,000 toward the renovation of the showroom. As A&N is no longer functioning, which counsel for both parties have confirmed with the Court, and it appears to the Court that both Plaintiffs and Defendant owe a defunct corporation approximately equal amounts, the Court finds that neither is entitled to judgment against the other as the defunct corporation will receive no benefit from any influx of funds, when no party seeks to continue its existence. In reaching this conclusion the Court finds credible the testimony of Carlino that he contributed approximately $50,000 other than the specific checks set forth in the record for the set up of the showroom, and the testimony of Nastasi that he and/or his various corporations contributed approximately $180,000 to the restoration of the showroom after he retook possession.
In retrospect it's easy to say, with such negatives on both sides, that the case should have settled long before trial. Perhaps the parties felt they had more to prove than financial damages, but if so, it seems to me that neither side got what they wanted.
The Emerging Influence of 1545 Ocean Avenue on Judicial Dissolution of LLCs
It's been a year since the Appellate Division, Second Department, altered the LLC dissolution landscape in New York with its decision in the 1545 Ocean Avenue case. Justice Leonard Austin's scholarly opinion for the court in that case articulates, for the first time since New York adopted the LLC form in 1994, a cogent standard for involuntary dissolution of LLCs under section 702 of the LLC Law (LLCL) whereby courts must assess the company's financial feasibility, and its ability to fulfill its stated purpose, "in the context of the terms of the operating agreement or articles of organization." Equally important, the court's contract-based analysis carefully distinguishes itself from, and instructs courts in LLC cases not to mimic, the more nebulous, equity-infused standards applied by courts under Article 11 of the Business Corporation Law in dissolution cases involving close corporations. (For a more detailed examination of 1545 Ocean, read here my February 2010 post.)
Over the last year I've been waiting to see how the lower courts apply the new standard. My patience was rewarded with a trio of unpublished decisions issued last month by three different judges in three different counties within the Second Department. The scorecard is an interesting one: dissolution granted in one, denied in another, and a hearing ordered in the third. While none of the three puts 1545 Ocean to a hard test, it seems clear that the appellate decision is already making a difference. Let's take a look at the three decisions:
Mehraban v. McIntosh, Short Form Order, Index No. 001683/09 (Sup Ct Nassau County Jan. 19, 2011)
The case involves a convoluted real estate venture gone sour. The two defendants jointly owned real estate where they operated a nursery school. To save the property from foreclosure, they entered into a written joint venture agreement (JVA) with the plaintiff under which the deed was transferred to a new LLC owned 25% by each of the defendants and 50% by plaintiff, with the latter serving as manager. The overall plan was to subdivide and develop the parcels, after which the portion with the school would be re-conveyed to defendants in exchange for their assignment of their LLC membership interest to plaintiff. The JVA obligated the three members individually to fund the mortgage redemption along with the expenses of the subdivision, development and maintenance.
The mortgage was redeemed but the venture later stalled amid cross-accusations between the two factions of failing to pay expenses as required by the JVA. Due to its growing debts and liens, the LLC could not obtain a certificate of occupancy for the school, which in turn prevented it from getting approval for the subdivision.
Noting that the defendants did not "directly" contest the plaintiff's request for dissolution under LLCL 702, the decision by Nassau County Commercial Division Justice Ira B. Warshawsky discusses the dissolution standard under 1545 Ocean and accordingly begins its analysis by looking at the LLC's articles of organization and operating agreement, both of which contain the same, broad purpose clause "to engage in any lawful act or activity." Justice Warshawsky then focuses on another provision in the operating agreement stating that the "prime intent of the members, initially, is to implement the Joint Venture Agreement." Given the LLC's growing debt, its lack of an income stream, and its doubtful ability to obtain subdivision approval -- the latter being critical to achievement of the JVA's ultimate goal of separating ownership of the subdivided parcels -- Justice Warshawsky granted dissolution, concluding that, "in the context of the terms of the operating agreement and articles of [organization], that continuing the entity is financially unfeasible."
The case involves a dispute between minority and majority members of an LLC in the business of document process outsourcing. The minority petitioners sought dissolution under LLCL 702 based on various claims of malfeasance by the majority including improper decision making, improper loans and check signing, and co-mingling of funds.
The decision by Queens County Supreme Court Justice Sidney F. Strauss denies dissolution based on the petitioners' failure to satisfy the standard for dissolution set forth in1545 Ocean. Specifically, Justice Strauss finds that the petitioners fail to make any showing that the LLC "can no longer meet its business purpose regarding the intake of consumer database," and also fail to make any "showing that the company is financially unfeasible." A petitioner "must plead facts reflecting the inability of the entity to carry on its business in accordance with the articles of organization" and may not merely "parrot" the language of LLCL 702. The "palpable" animosity between the parties, Justice Strauss adds, "alone will not support a petition for dissolution."
The third case bears a very close likeness to the above-discussed Mehraban case. It, too, is a real estate development venture using an LLC owned 50% by one member and 25% each by the two opposing members. It, too, ended up in foreclosure and experienced problems obtaining site plan approval from local authorities, forcing it to change its original development plans. The petitioning members sought dissolution based on the inability to implement the original plan; because the respondent member "mismanaged" the property "resulting in a drastically reduced value"; and because of the pending foreclosure. The respondent member countered that the petitioners were aware of, and approved, the modified site plans; that the petitioners failed to respond to cash calls forcing respondent to make up the shortfall; and that the operating agreement's broad purpose clause ("to engage in any lawful act or activity") "is being achieved and that the development plan for the LLC's property is extremely close to approval and fruition."
The decision by Suffolk County Commercial Division Justice Emily Pines offers the following quote from 1545 Ocean Avenue before ruling that the petition raises factual issues requiring discovery and trial:
The court will not dissolve an LLC merely because the LLC has not experienced a smooth glide to profitability or because events have not turned out exactly as the LLC's owners originally envisioned.
(Actually, the quoted passage belongs to the Delaware Chancery Court's decision in Matter of Arrow Investment Advisors, LLC, 2009 WL 1101682 (Del Ch Apr. 23, 2009), which is quoted in 1545 Ocean Avenue.) Justice Pines explains further:
The records both in support and in opposition to the dissolution present numerous issues of fact as to the operations and purpose of The LLC as well as whether or not, it is reasonably practicable to carry on The LLC. In addition, attached to the opposition papers, the Respondent has provided copies of letters from 3rd parties, expressing interest in the Subject Property, which may weigh in on the issue of financial feasibility.
Therefore, the Court cannot determine as a matter of law, that it is no longer reasonably practicable to carry out the purpose of The LLC and judicial dissolution at this time, is not warranted.
* * * * * * *
It's hard to say whether the result in any of these three cases would have been different in the free-wheeling, pre-1545 Ocean era. But it does seem clear that the courts are approaching the issue in a uniform fashion guided by the appellate decision's contract-based analysis.
Splitting the Baby: Court in Oppressed Shareholder Dissolution Case Divides the Company Assets
Over two years ago I posted about a decision by Suffolk County Commercial Division Justice Emily Pines in a father vs. son corporate dissolution case called Matter of Wenger. I characterized Wenger as a classic illustration of the "ordinary" dissolution case in which "there are no knockout punches in the first round" and where the court orders an evidentiary hearing based on disputed issues of fact.
Two years, one fruitless summary judgment motion and a six-day trial later, Wenger has turned into anything but the ordinary dissolution case.
Justice Pines' December 14, 2010, post-trial decision in Matter of Wenger (L.A. Wenger Contracting Co.), 2010 NY Slip Op 52236(U) (Sup Ct Suffolk County), contains two novel rulings. First, the court holds that the father/69% shareholder is estopped from denying his son's position as 31% shareholder notwithstanding the failure of the Grantor Retained Annuity Trust (GRAT) under which shares were to be transferred to the son. Second, after finding that the son demonstrated oppression by his 87-year old father, in lieu of dissolution or compelled buyout the court orders that the multiple real properties and certain escrow funds held by the subject corporations be appraised and distributed such that the son winds up with 31% of the net value of the properties and cash.
The threshold issue in the case was the son David Wenger's shareholder standing to seek dissolution of L.A. Wenger Contracting Co. (L.A. Wenger) and a series of affiliated companies. It was undisputed that, in 1996, the father, Louis Wenger, had his attorneys draw up documents to create a GRAT under which 31% of the company's outstanding shares valued at $1.25 million would be transferred to the GRAT's trustee and distributed to David over four years in exchange for four annual cash payments of $200,000 each. The transaction was reflected in the stock ledger, but share certificates never were delivered to the named trustee and David did not make the cash payments. Nonetheless, beginning in 1996 and continuously thereafter, all of the corporate tax returns for L.A. Wenger, and for the affiliates that were subsequently created to hold assets of L.A. Wenger, consistently identified Louis and David as the 69% and 31% shareholders, respectively. In addition, there were adjusting entries in the financials and deemed "distributions" of $800,000 reflected in the tax returns that apparently correlated to the GRAT payment schedule.
Prior to trial, Louis moved for summary judgment dismissing David's petition on the ground he was not a shareholder. He supported his motion with expert testimony to the effect that the GRAT was never properly funded and therefore failed under Section 7-1.18 of the Estates, Powers & Trusts Law. In her ruling dated September 23, 2010, reported at 2010 NY Slip Op 32675(U), Justice Pines denied the motion, stating that "the Court is faced with issues that require a trial, which will likely involve both questions of fact and a battle of the experts."
In her post-trial decision, and having had the benefit of the "battling" experts' complete testimony, Justice Pines concludes that the GRAT "failed under state law, since it was never properly funded." She nonetheless goes on to hold that Louis is "equitably estopped" from denying David's 31% shareholder status, based primarily on the corporate tax returns. Here's what she writes:
[B]oth Louis Wenger and the five corporations that are the subject of these combined lawsuits are equitably estopped from denying David Wenger's position as a 31% shareholder. Nine years of corporate tax returns filed by the five corporations as well as corporate K-1's given to David Wenger by those entities, many of which are beyond the reach of the IRS at this point, cannot be ignored. When combined with the clear intent set forth in Louis Wenger's years of actions, the statements by Louis Wenger to sureties and lenders to the corporations, and the numerous correspondence, including that written after the parties were in dispute (Petitioner's 165) cannot be ignored. All the corporations and their majority shareholder, Louis Wenger, acted for years as though and for their mutual advantage, David Wenger was a 31% share holder. The Court finds that he remains so to this date. The Court, therefore, agrees with Petitioner's counsel that the validity of the GRAT at this point is irrelevant.
Next, Justice Pines holds that David "has met the requirements to demonstrate 'oppressive conduct' under BCL 1104-a" based on the father's improper actions which began "as soon as David Wenger began to question Louis Wenger's handling of the corporation's finances," including "demanding that he [David] turn over his interests in corporations holding over $10 million in assets for $10" and unilaterally transferring corporate assets to other relatives.
Now we come to the most interesting part: the remedy. The statutes governing judicial dissolution provide no express remedial authority for oppressive conduct other than dissolving the corporation and liquidating its assets (see BCL Section 1111). There is appellate case law, cited in Justice Pines' decision, that expands the court's remedial powers to include buyout of the minority shareholder on a voluntary or compelled basis. Justice Pines orders neither dissolution nor buyout. Instead, in an exercise of equitable discretion in the circumstances of a family dispute, she orders a distribution in kind to David, consisting of a portion of the subject companies' realty plus whatever cash is required such that he receives 31% of the net value of the corporate assets, thereby leaving Louis as 100% shareholder of the going concern, reduced-asset companies. Here's how Justice Pines explains it:
[T]his is a case, where dissolution does not appear to the Court to be in the best interests of the majority shareholder, who has reached 87 years of age, nor is it the only solution to provide the minority shareholder with his due, in view of the significant amount of real property held by the five subject corporations. Petitioner's counsel has recommended an alternate remedy, which the Court adopts, in part. Under the circumstances, by appraising the net values of the real properties in question; transferring sufficient real property and cash from the escrow account holding the proceeds of the sale of 770 Railroad Avenue so that David Wenger or his designee receives 31% of the net value of such properties and cash, the Court finds that David Wenger's claims will be satisfied without the need for the drastic remedy of dissolution. In order to accomplish such task, the Court is appointing Robert Lynn, Esq., by separate order, as a Temporary Receiver, with limited powers, to retain a real estate broker; and to obtain the net values of the real properties (taking into account all mortgages and liens) on the real properties currently held by the five corporations that are the subject of these proceedings. To this will be added the net value of the real property transferred without David Wenger's consent to his sister located in Palm Beach, Florida and the amount of $50,000 removed by Louis Wenger from the proceeds of the sale of 770 Railroad Avenue. The Court determines the net value of the Florida property, based on appraisals placed into evidence by both parties to be $150,000 (Petitioner's 186), since such was the appraised value at the time of the improper act of transfer. After calculating the 31% figure, the Temporary Receiver will have the authority to choose a property or properties, other than that located in Palm Beach, Florida and owned by David Wenger's sister, to transfer to David Wenger or David Wenger's designee, utilizing the remains of the escrow account, if necessary.
In the Old Testament story, Solomon pretended he would physically split the baby claimed by two women rather than allowing either one to win at the other's expense, to trick them into revealing the true mother's identity. Wenger has what I'll call a reverse Solomonic twist, in which the judge actually splits the assets in order to preserve the companies rather than liquidate them. We can only hope it returns some measure of harmony to the Wenger family.
Contract Trumps Shareholder Expectations in Recent Case Denying Judicial Dissolution of Close Corporation
For the vast majority of non-publicly traded close corporations, there is little or no market for minority shareholders to sell their shares. Likewise, the default rules under the statutes governing close corporations do not require the corporation or the controlling shareholders to redeem or buy out the stock interest of a minority shareholder who seeks an exit. Most states, including New York, partially alleviated the problem of minority shareholder lock-in by enacting laws that authorize a minority shareholder to sue for judicial dissolution of a close corporation where the majority engages in undefined "oppressive conduct" and, at the same time, that give the majority an elective right to avoid a dissolution contest by purchasing for "fair value" the shares of the suing shareholder.
New York adopted such laws in 1979, codified in Sections 1104-a and 1118 of its Business Corporation Law. Over the next 30-plus years, the task has fallen to the courts to resolve on a case-by-case basis the myriad shareholder disputes leading to dissolution petitions, using what's known as the "reasonable expectations" test for gauging majority oppression. Under this test, first formulated in Gardstein v. Kemp & Beatley, 64 NY2d 63 (1984), oppression exists when the majority conduct "substantially defeats expectations that, objectively viewed, were both reasonable under the circumstances and were central to the [petitioning minority shareholder's] decision to join the venture."
Part of the difficulty for courts in these cases is balancing the minority shareholder's reasonable expectations against the rights and obligations flowing from a shareholders' agreement -- when one exists. As Professor Larry Ribstein writes in a recently published paper (about which I'll be posting in coming weeks), "[t]he indeterminacy of close corporation law is especially evident when the oppression remedy meets an actual contract." To what extent should courts rein in the statutory oppression remedy on account of express contractual provisions dealing with rights of continued employment, distributions, redemption or buyout? How should courts assess reasonable expectations when the shareholders' agreement is silent as to the circumstances constituting the alleged oppression?
A good illustration of the how these questions play out in real life is last month's decision by Suffolk County Commercial Division Justice Emily Pines in Matter of Hack (National Employee Assistance Providers, Inc.), 2010 NY Slip Op 33024(U) (Sup Ct Suffolk County Oct. 25, 2010), where the court dismissed a dissolution petition based in part on evidence that the parties had discussed, but failed to include in their written shareholders' agreement, a provision for buyout of shareholders who wished to sell their shares during their lifetime.
In Hack, the petitioner Michael Hack held 24.5% of the shares in two affiliated companies (the "Companies") that provide employee assistance programs for corporate human resources departments. Hack co-founded the Companies in 2000 and served as CEO for eight years, until September 2008, when he voluntarily left to pursue another opportunity. In May 2010, Hack filed a petition for judicial dissolution of the Companies under BCL 1104-a, claiming oppressive conduct by the two remaining shareholders (the "Respondents") who together held 75.5% of the Companies' shares. Hack alleged that the Respondents had scheduled a shareholders meeting for the purpose of authorizing and issuing additional capital shares which would dilute and devalue Hack's stock interest. Hack also alleged that one of the Respondents made repeated promises that if Hack wanted to sell his shares, they would be purchased.
Justice Pines' decision describes as follows Hack's allegations concerning his efforts over the years to secure a written buyout agreement:
Hack further contends that in the eight years he worked for the company and was a shareholder, he tried to memorialize an agreement which would define the roles of the shareholders and memorialize Detor's undertakings and promises to provide a market for Hack's shares if he decided to sell. Hack states that an agreement of the shareholders was finally entered into by all the shareholders in 2004 however, it did not define the rights of the shareholders in the event any shareholder wished to sell his shares. Rather, it only defined the shareholders' rights in the event of a shareholder's death.
Hack contended that the "pattern of behavior" by the Respondents, including turning down a million dollar offer by an independent third-party to buy the Companies, will dilute his shares, reduce their value, and "make it impossible to sell his shares in the Companies which is oppressive conduct by the majority shareholders entitling him to dissolution of the Companies."
The Respondents countered that Hack is a "passive, minority shareholder" who is "frustrated because there is no present market for his shares" and who "brought the petition for dissolution to force the respondents to purchase his shares in the Companies" even though they have "no legal or contractual obligation" to do so. With respect to lifetime stock dispositions, they argued that the 2004 shareholders' agreement merely gave the Companies a non-obligatory right of first refusal if a shareholder sought to sell his shares to a third party. They argued that the Companies are viable, profitable going concerns whose dissolution is not warranted. They also submitted affidavits in which they represented that they were withdrawing the proposed resolution to authorize additional shares, and pledged not to authorize additional shares in the future without unanimous shareholders' consent.
Justice Pines' legal analysis summarizes the statutory provisions and sets forth the applicable standards under the reasonable expectations test. Applying the law to the facts set forth in the petition and in the Respondents' motion to dismiss, she finds that Hack "has failed to demonstrate that he has been oppressed by the majority shareholders." She explains:
It is undisputed that Hack voluntarily left the employment of [the Companies] to pursue another opportunity. It is also evidenced by the executed shareholder agreement attached to the motions that there was no provision/agreement to be bought out in the event one or more of the shareholders wished to sell. While Hack argues that this provision was discussed and contemplated by the parties, it was never reduced to writing and incorporated in the agreements between the shareholders.
Although Hack also argues that the shareholders expressly stated that the strategy amongst the three of them was to grow and then sell the business, Detor argues that his plan for the companies differed. However, the agreements between the shareholders do not reflect any anticipated buy-out other than that which would occur upon the death of one of the shareholders.
It would be tempting to downgrade Hack's significance based on the fact that Hack voluntarily left his employment with the Companies well before he sued for dissolution. After all, you may ask, how can someone voluntarily leave and later claim oppression? But that would be wrong. In the seminal Gardstein v. Kemp & Beatley case mentioned above, in which New York's highest court upheld an order dissolving the corporation, one of the two petitioners also voluntarily left his company before seeking dissolution.
How then should Hack be read? One way to read it is that, whatever reasonable expectations Hack may have had at the Companies' inception about being able eventually to liquidate his stock interest, such expectations are trumped by the parties' contractual intent as reflected in the 2004 shareholders' agreement, not to grant shareholders the right to put their shares to the Companies or the other shareholders whenever they wished to exit. If so, one also can say that Justice Pines resisted the invitation to rewrite the parties' agreement under the guise of divining their reasonable expectations.
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.
Update October 2, 2010: By short form order dated September 23, 2010 (2010 NY Slip Op 32675[U]), Justice Pines denied summary judgment motions filed by both sides and scheduled the case for trial on October 4, 2010. The summary judgment motions focused on the disputed issue whether son David validly held a stock interest in the company pursuant to a grantor retained annuity trust created by his father.
