Appellate Court Reinstates LLC Manager in Dispute with Investor in Vodka Venture
The highly competitive and lucrative market for premium vodka has spawned some of the most creative advertising and promotional campaigns known to consumers (think Absolut). A new market entrant offering vodka imported from Holland under the brand name Medea, sold in special bottles designed with an interactive LED ticker display, has spawned a different kind of competition, of the litigious sort, involving a fight for control between an angel investor and the managing member of the company.
An appellate court decision issued last week in Lehey v. Goldburt, 2011 NY Slip Op 08670 (1st Dept Dec. 1, 2011), reinstated the managing member whom the lower court had removed and replaced with the investor on the latter's application for interim relief. The decision reinforces the constraints lower courts face in granting provisional remedies without holding an evidentiary hearing to resolve conflicting allegations. The decision also addresses an interesting issue of contract construction arising from an arguable inconsistency between the operating agreement's provisions for the appointment and removal of managers.
Medea vodka is the brainchild of company co-founders Tim Goldburt and Matt Sandy. The brand's patented bottle design has a programmable LED display that can scroll six customized messages of up to 255 characters each. In June 2007, Goldburt, Sandy and a few others formed a Delaware limited liability company known as FSJ, LLC to develop and market the Medea brand. The sole source of start-up financing was Joseph Lehey, a 10% member who agreed to invest $10 million payable in four equal installments over two years, pursuant to a subscription agreement, letter of intent and operating agreement that promised him a priority return of his investment before profit distributions to members. Article II(2) of the operating agreement (read here) designated Goldburt and fellow member David Perillo as sole managers of FSJ.
Sales of Medea vodka launched in 2010 with a splash of publicity fueled by its unique packaging. By then, however, the relationship between Lehey and his operating partners had soured, depending on which side's version, because of Lehey's failure to fund his final $2.5 million contribution or because of the operating partners' waste and looting of Lehey's investment and the vodka sales proceeds.
In September 2010, Lehey filed suit in Manhattan Supreme Court asserting individual and derivative claims against Goldburt, Sandy, Perillo and others seeking damages and injunctive relief including the removal of Goldburt as FSJ's manager (read complaint here). In November 2010, Commercial Division Justice Charles E. Ramos denied Lehey's application to appoint a temporary receiver for FSJ but ordered the defendants to turn over all relevant financial and business records.
In January 2011, by which time all of FSJ's members other than Goldburt and Sandy had assigned their membership interests to Lehey, giving him at least a two-thirds membership interest, Lehey noticed a meeting of the members at which he voted to appoint himself FSJ's manager over Goldburt's and Sandy's objection.
In March 2011, claiming that the defendants had failed to comply with the court's prior order to turn over records and that he was still being frozen out of management, Lehey moved for an order removing Goldburt as manager (Perillo previously resigned his manager position) and designating Lehey as FSJ's sole manager. Lehey alternatively asked the court to reconsider his prior application for appointment of a temporary receiver. Lehey's supporting memorandum of law (read here) argued that "in order to avert complete destruction of [Lehey's] investment at Defendants' hands, [Lehey] or a temporary receiver must be put in control of the Company immediately." Defendants' opposing memorandum (read here) argued that Lehey has no relevant experience running a company such as FSJ; that the defendants had complied fully with the court's order to produce company information; and that Lehey's application failed to demonstrate the requisite danger to FSJ's property to justify the "drastic" remedy of receivership.
At the oral argument of the motion on May 2, 2011 (read transcript here), Defendants' counsel argued that under Article II(2) of the operating agreement, designating Goldburt manager "for the duration of the Company," he could only be removed by unanimous vote of the other members for "theft, fraud or forgery." This did not, however, mollify the court's concern for the company's assets upon learning that there was an unpaid $250,000 warehouseman's charge for storage of the company's vodka inventory worth between $3 million and $4 million.
The colloquy took a different direction after the court noticed the provision in Article II(2) stating that the designated managers (Goldburt and Perillo) shall continue as such "until they shall no longer own any part of the Membership Interest." Since Goldburt only held an indirect membership interest in FSJ through his ownership of RAM Phosphorix, LLC, which held a 27% membership interest in FSJ, as the court saw it "there is no manager" of FSJ. Therefore, the court reasoned, Lehey must be appointed as receiver unless permitted to act as FSJ's sole manager based on the January 2011 appointment of Lehey by his own vote.
On May 27, 2011, Justice Ramos signed a written order (read here) removing Goldburt and installing Lehey as FSJ's sole manager. The order also required the defendants to turn over to Lehey's control all of FSJ's tangible and intangible property, bank accounts and books and records.
The defendants immediately filed a notice of appeal and one day later obtained from the Appellate Division, First Department, a stay of Justice Ramos's order pending their appeal which was argued on November 10, 2011, and decided on December 1, 2011.
The First Department's decision begins by cautioning that the purpose of a provisional remedy is not to determine the ultimate rights of the parties, but only to maintain the status quo until there can be a full hearing on the merits. The decision further notes that where conflicting affidavits raise sharp issues of fact, injunctive relief should not be granted without a hearing.
The court then finds that the lower court erred by granting "any provisional relief, let alone the extraordinary one granted here," without holding an evidentiary hearing. Here's how the court explains it:
Plaintiff established some likelihood of success on the merits by demonstrating the various expenditures that were made without his written consent and by raising issues regarding the ownership of the patents, trademarks and FSJ's inventory. However, he did not clearly establish that he would be irreparably harmed in the absence of a preliminary injunction or that FSJ's property was in danger of being injured or destroyed such that the appointment of a temporary receiver was warranted (see CPLR 6301; 6401). Indeed, the status of FSJ's assets was disputed, as was the propriety of the various expenditures and transfers of funds. Defendants also raised legitimate concerns about the future of FSJ should Goldburt be removed and plaintiff installed as manager. In particular, they noted Goldburt's intimate knowledge of the company and its technology as well as the fact that Goldburt made many personal contacts with distributors, suppliers and others that were essential to the health of the company. Accordingly, an evidentiary hearing is warranted to the extent indicated.
The decision then addresses Goldburt's status as manager under the operating agreement. The court observes that, although the Article II(2) provision appointing Goldburt and Perillo as managers "presumed that a manager had a membership interest in FSJ, Goldburt had an indirect membership interest in the company through his interest in defendant RAM Phosphorix, LLC, which had a membership interest, and Goldburt executed the agreement on RAM's behalf." The court also cites the removal provision in Article II(2), stating that Perillo and Goldburt shall be managers "unless removed as permitted hereby, or until they shall no longer own any part of the Membership Interest." The court then registers its sharp disagreement with the lower court's conclusion, stating:
For the motion court to read this language to mean that Goldburt was never properly a manager because he did not own a direct membership interest in the company leads to an absurd result and ignores the parties' clear intent to have Goldburt serve as a manager. Thus, we read the agreement to unambiguously permit Goldburt to serve as manager, as this construction effectuates the parties' intent.
The Appellate Division's ruling leaves intact the lower court's order insofar as it enjoins the defendants from transferring any of FSJ's property, assets, inventory or funds, except as required in the ordinary course of business, and insofar as it declared that the parties' operating agreement remains in full force and effect. But, at least for the time being, Goldburt continues to act as FSJ's sole manager while the litigation rages onward including a newly filed amended complaint in which Lehey seeks treble damages for defendants' alleged violations of the federal RICO Act.
It probably would have made no difference to the outcome, but I can't help but point out that the Lehey decision nowhere acknowledges that FSJ is a Delaware limited liability company whose operating agreement in Article VII(10) states that "[t]his agreement shall be governed by and construed according to the laws of the State of Delaware." It's also noteworthy that the same provision includes a forum selection clause stating that the courts in New York County will have "exclusive jurisdiction" over any controversies arising from the agreement, which could create quite a sticky wicket if one side or the other were to ask for judicial dissolution of a Delaware LLC by a New York court (see my prior posts on that subject here, here and here).
"So If We Shut the Lights on This Sucker" and Other Things Not to Say on Tape When Squeezing Out a Fellow Shareholder
Litigation between co-owners of closely-held businesses frequently devolves into a "he-said-she-said" contest in which each side testifies about oral statements made by the other--which the alleged speaker invariably denies--that either evidence or refute intent to impair shareholder rights and other misdeeds. Such testimony, if credited by the court, can shed important light on actions that superficially may accord with proper business activities and motives but, in reality, are designed to gain improper advantage in a battle for control and financial gain.
Naturally the recorded word has far greater reliability and evidentiary power than the unrecorded one, but rare is the case in which clients have the forethought and opportunity to capture their business partner's inculpatory words on tape.
Feinberg v. Silverberg, 2011 NY Slip Op 32299(U) (Sup Ct Nassau County Aug. 18, 2011), decided last month by Nassau County Commercial Division Justice Ira B. Warshawsky, is the rare exception in which a business owner's words captured on tape played a decisive role in undermining his credibility and in supporting his opponent's request for judicial relief.
Feinberg involves a successful Long Island-based company founded in 1993 called L&E International Ltd. co-owned 50/50 by plaintiff Samuel Feinberg and defendant Errol Silverberg. According to its website, L&E is "a leading global supplier of hardline & softline print packaging and packaging related materials to the footwear, athletic and retail consumer product industries." Justice Warshawsky's decision notes that L&E's gross annual revenues have exceeded $100 million.
In March 2011, Feinberg filed a lawsuit against his co-owner, Silverberg, accusing him of scheming with several other L&E executives to oust Feinberg and gain complete control of L&E. Feinberg claimed that the scheme included secret meetings; excluding Feinberg from his role as head of the sales department and undermining his business relationships with suppliers; opening a secret overseas bank account to siphon funds from L&E; cutting off his monthly compensation and unilaterally announcing that no dividends or distributions would be paid despite the requirement that such decisions be made by the unanimous Board of Directors; and assisting L&E's general counsel to form a shell corporation which is being paid by L&E.
Simultaneously with filing his lawsuit Feinberg sought and obtained a temporary restraining order (TRO) enjoining Silverberg, among other things, from interfering with Feinberg's duties and rights as shareholder and President, Treasurer and Director of L&E and from depriving Feinberg of his regular compensation.
Silverberg subsequently opposed Feinberg's request for a preliminary injunction, submitting an affidavit in which he asserted business justification for the withholding of dividends and distributions and, as described in the court's decision, expressing "incredibility and surprise toward Feinberg's claims."
But it appears that Feinberg had a different kind of surprise in store for Silverberg. Somehow--the decision gives no details--Feinberg secretly taped conversations among Silverberg and other executives sometime after the court issued the TRO. Feinberg then sprang the taped conversations on Silverberg in Feinberg's reply affidavit. What he caught on tape was devastating to Silverberg's position.
As Justice Warshawsky puts it, "particularly damning to Silverberg's credibility" is a conversation in which Silverberg spoke about "his plan to oust [Feinberg] by forcing a breach on L&E's contracts and then offering L&E's clients identical contracts by a new company formed by Silverberg and his associates." The decision quotes the following snippet from the taped conversation, in which Silverberg says:
So if we shut the lights on this sucker, at the same time we march into Adidas and say, hey, this is what's happening here . . . Forget about the name of the company . . .
Justice Warshawsky also cites another blatant passage from the same conversation, in which L&E's Chief Financial Officer states:
You know, two-man board, two owners, who needs all that crap?
Based on the taped conversations, and on the shareholders' agreement and by-laws confirming Feinberg's management role and right of access to company information, Justice Warshawsky grants Feinberg's motion for preliminary injunction finding that he is likely to succeed on the merits of his claim and that injunctive relief is necessary to preserve Feinberg's management rights pending the litigation. On the latter point, Justice Warshawsky cites case precedent holding that "money damages for violations of a shareholders' agreement or corporate by-laws are insufficient and the element of irreparable injury is established." When the violation includes withholding of compensation to a shareholder, he further explains, although the withheld amounts are compensable damages it also causes "non-compensable injury to the plaintiff's rights under the Shareholders' Agreement or Corporate By-laws, because the plaintiff has a right to participate in decisions regarding compensation and any distributions." Justice Warshawsky then concludes:
In this case, it is patently clear that the withholding of salary or dividend payments to Feinberg is part of Silverberg's plan to force [Feinberg] out of the company and usurp the balance of power that is reflected in the Shareholders' Agreement. Indeed, the telephone conversation which was transcribed reveals an apparent effort to deprive [Feinberg] even of services provided by his company to employees, such as use of company cars, in order to further Silverberg's efforts to oust Feinberg.
A word of caution before you run out and buy miniature recording devices to plant in the office. State laws vary on the legality of non-consensual audio recordings, especially telephone conversations, so be sure to check local law first. Also, extreme caution must be taken to avoid the surreptitious recording of confidential conversations between one's business partner and his or her lawyer.
A Tale of Two Preliminary Injunction Applications in Corporate Dissolution Cases Decided Three Days Apart, Same Issue, Same Judge, Different Outcomes
The dynamic and often volatile nature of business partnership break-ups can necessitate the petitioner's application at the outset of a dissolution case for a preliminary injunction to restrain the other party from taking corporate actions pending determination of the petition. Depending on the circumstances and immediacy, the petitioner may seek to enjoin particular, threatened actions -- mortgaging company assets, signing a lease, terminating employees, making distributions, etc. -- and/or present the court with a generic request to restrain the respondent from engaging in any transactions on the company's behalf outside the "ordinary course" of business. As in any litigation, the grant or denial of injunctive relief at the earliest stage of the case can have a profound effect on the future course of the dissolution proceedings and the relative strengths of each side's negotiating position, and thus must be carefully considered by counsel before taking the plunge.
Recent back-to-back decisions by Queens County Commercial Division Justice Orin R. Kitzes illustrate the risk and reward of preliminary injunction skirmishes in corporate dissolution contests. In Matter of Vassilakis (150-11 Corp.), Short Form Order, Index No. 21248/08 (Sup Ct Queens County May 19, 2009), Justice Kitzes denied a 20% shareholder's application to preliminarily enjoin the majority shareholder from selling the business or, alternatively, sequestering the sale proceeds. Three days later, in Matter of Kan (3 Win, Inc.), Short Form Order, Index No. 6265/09 (Sup Ct Queens County May 22, 2009), Justice Kitzes granted the petitioner-50% shareholder's application to preliminarily enjoin the other 50% shareholder from doing any business outside the ordinary course, including selling any of the several companies at issue or relocating them to another state.
What makes these cases especially interesting is that in both, the respondent shareholder asserted the same primary defense of lack of standing, based on assertions that the petitioner was not a shareholder. In both, Justice Kitzes concluded that the defense could not be determined without an evidentiary hearing. Why, then, did he grant the injunction in one case and not the other?
In Vassilakis, the alleged 20% shareholder of a pizza/delicatessen business petitioned for judicial dissolution under Section 1104-a of the Business Corporation Law on the ground of oppression. He alleged that the majority shareholder expelled him from the day-to-day operation and management of the company and terminated his relationship with the corporation. The majority shareholder contended that the petitioner was never a shareholder by reason of his failure to pay his portion of the amount invested in the corporation; that he did not sign any closing documents for the purchase of the business; and that he worked as an employee only at the corporation. The petitioner, who never was issued a stock certificate, countered by submitting various tax documents identifying him as a shareholder.
Justice Kitzes first concluded that the petitioner had sufficiently pleaded a cause of action for dissolution based on oppression under BCL Section 1104-a(a)(1), and that his affidavit and tax documents on the one side, and the respondent's denial of petitioner's shareholder status on the other, required an evidentiary hearing to determine petitioner's standing to seek dissolution. Turning to the preliminary injunction application, Justice Kitzes denied the petitioner's request to restrain the majority shareholder from selling the business or, alternatively, sequestering the sale proceeds, writing as follows:
As noted, this action is primarily one for the dissolution of a pizza/delicatessen and there is conflicting evidence regarding Petitioner being an owner of the corporation. While the mere existence of an issue of fact does not preclude a finding of likelihood of success on the merits, this Court finds that the submitted evidence suggests that the resolution of this matter is likely to be resolved without the dissolution of the corporation. Consequently, Petitioner has not established the first element in procuring injunctive relief, likelihood of success on the merits.
Justice Kitzes also found that the petitioner, who sought "to recoup money invested and payments for the sale of his shares of ownership in the corporation when it is sold," failed to establish that he would suffer irreparable injury without an injunction, and that the burden upon the corporation of enjoining a potential sale outweighed the threatened harm to petitioner.
Now let's turn to the Kan case, in which a 50% shareholder petitioned under BCL 1104-a for judicial dissolution of a series of commonly-owned corporations involved in the trucking business. The petitioner alleged that the other 50% shareholder "looted" corporate funds to purchase a private residence and for other non-corporate purposes. The petitioner asked to preliminarily enjoin him from transacting any unauthorized business and from exercising any corporate powers except in the ordinary course of business; from taking any action to dissolve the corporations(presumably meaning voluntarily); and otherwise compelling the respondent to maintain the status quo pending the dissolution proceeding. As in Vassilakis, the respondent asserted the defense of lack of standing based on evidence not specified in the court's decision, although it does note that no stock certificates were issued reflecting the ownership interests of either party. Also as in Vassilakis, Justice Kitzes ordered an evidentiary hearing to determine the petitioner's shareholder status.
With respect to the application for preliminary injunction, Justice Kitzes employed the same analysis (and virtually the same wording) used in Vassilakis but reached the opposite conclusion to grant the application, as follows:
As noted, this action is for the dissolution of several trucking corporations and there is conflicting evidence regarding petitioner being an owner of the corporation. The Court notes that the mere existence of an issue of fact does not preclude a finding of the likelihood of success on the merits and this Court finds that the submitted evidence suggests that, assuming standing is found, the resolution of this matter is likely to be resolved with the dissolution of the corporation. Consequently, Petitioner has established the first element in procuring injunctive relief, likelihood of success on the merits.
Justice Kitzes went on to find that the relief sought by petitioner, "to recoup corporate assets and preventing further looting of the corporations," was "sufficiently unique" to establish irreparable injury, and that the balance of equities weighed in his favor as compared to the burden upon the corporations from preventing a sale or relocating operations to New Jersey.
The pair of decisions in Vassilakis and Kan lack detailed recitations of the facts and the parties' contentions, making it more difficult to draw lessons from the different outcomes notwithstanding some basic similarities in the two cases. We don't know, for instance, if the evidence of the 50% petitioner's shareholder status in Kan was significantly stronger than the 20% petitioner's in Vassilakis. Is that why the court found a likelihood of ultimate dissolution in the former but not the latter? Or was it based on the comparative strength of the underlying merits of the oppression and/or looting allegations? Or -- this is pure speculation -- perhaps the respondent shareholder in Vassilakis but not in Kan indicated his willingness to elect a buyout of the petitioner in the event the court sustains the petitioner's stock ownership after a hearing?
One final note. BCL Section 1115 grants the court in judicial dissolution proceedings broad authority at any stage of the proceeding to grant injunctive relief against the corporation, its directors, officers and creditors to preserve corporate assets. There are decisions in the Manhattan-based Appellate Division, First Department (e.g., Matter of Greenhouse (HGK Asset Management, Inc.), 238 AD2d 291 (1st Dept 1997)) holding that an applicant for injunctive relief under Section 1115 need not show a probability of irreparable injury, which is one of the elements of the traditional tri-partite test for interim injunctive relief under Section 6301 of the Civil Practice Law and Rules, and which Justice Kitzes applied in Vassilakis and Kan. I have not seen any decisions treating this issue by the Second Department, which encompasses Queens County where Justice Kitzes presides, nor do I know if the point was raised by the litigants' counsel in Vassilakis and Kan.
