New York Business Divorce : New York Business Dissolution Lawyer & Attorney : Farrell Fritz Law Firm : Buy-outs, Shareholder Disputes : New York, NY

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).

The plaintiffs allege that in late 2004, Zamir recommended that the parties acquire Academy Street based on various income and expense projections, and that in reliance on Zamir's recommendation and presentations they approved the deal which closed in April 2005.  Plaintiffs allege that in the summer of 2005, they learned of serious problems with the building's physical condition which allegedly were known to Zamir and withheld from plaintiffs at the time Zamir solicited their approval.

Meanwhile, plaintiffs and Zamir entered into a Governance Agreement dated June 9, 2005, which was intended to resolve growing frictions between them over management and control of the entire real estate portfolio.  The plaintiffs allege that they "reluctantly agreed" to Zamir's "demand" that they enter into the Governance Agreement "to appease Zamir and prevent him from destroying the value of the real estate portfolio . . .."  Mutual veto power over management decisions appears to be the main thrust of the Governance Agreement.  The Governance Agreement also contains a mutual general release in which the parties release one another from "any and all claims . . . known or unknown" arising from events that pre-date the Governance Agreement.

Zamir moved to dismiss the plaintiffs' Fifth Cause of Action for fraudulent inducement, arguing that it was barred by the release contained in the Governance Agreement.  Justice Ramos's December 2008 decision denied the motion, holding that under the First Department's decision in Littman v. Magee, 54 AD3d 14 (1st Dept 2008),

to the extent that Zamir owed Plaintiffs a fiduciary duty by virtue of being co-managers, he may not rely upon the Release to insulate himself from liability where he intentionally concealed from Plaintiffs the physical condition of the Academy Street Property, and which misrepresentation was an inducement to enter into the release from the outset.

Zamir appealed.  On July 13, 2010, the First Department handed down its decision, reported at 2010 NY Slip Op 06070, reversing Justice Ramos's ruling and dismissing the fraudulent inducement claim.  The court's unanimous decision was authored by Associate Justice David Friedman who also wrote the majority opinion in the First Department's 3-2 ruling in the Centro case discussed in last week's post.

Justice Friedman's Arfa opinion emphasizes factors closely tracking those found critical in Centro.  He notes that the fraudulent inducement claim:

• "falls squarely within the scope of the general release";
• that the Governance Agreement "was the result of rigorous, arm's-length negotiations between the highly sophisticated parties";
• that "by the time the parties began negotiating the Governance Agreement, they had already developed an adversarial, even hostile relationship";
• that given the plaintiffs' own allegations of Zamir's dishonesty, they had a "heightened" affirmative duty to protect themselves from misrepresentations by investigating all of the circumstances and details surrounding the Governance Agreement;
• that had the plaintiffs performed the requisite due diligence, the matters concerning the Academy Street Building's physical condition, about which Zamir allegedly made misrepresentations, "presumably would have been revealed"; and
• that the plaintiffs could not establish reasonable reliance on Zamir's alleged misrepresentations when they failed to make "any use of the means available to them to ascertain the truth of the alleged misrepresentations at issue before they entered into the Governance Agreement."

Justice Friedman, quoting from his Centro opinion, also rejects what he calls the "implication" of the plaintiffs' position, i.e., that "a fiduciary can never obtain a valid release without first making a full confession of its sins to the releasor," and then goes on to distinguish Littman v. Magee, writing: 

In Littman, a general release in the agreement for the sale of the plaintiff's interest in a closely-held business was held not to bar a fraud action against a former fiduciary at the pleading stage because the complaint was deemed to allege that the defendant fiduciary had told the plaintiff that no further documentation bearing on the valuation of the enterprise existed. While Littman reaffirmed that even a fraud claim against a fiduciary must establish justifiable reliance on the alleged misstatement, the case held that the alleged misrepresentation concerning the availability of information relevant to the transaction raised an issue as to whether plaintiff justifiably relied on the defendant's statements without making further investigative efforts (54 AD3d at 19). Here, by contrast, Arfa/Shpigel do not allege that Zamir did or said anything to impede their ability to investigate the truth and completeness of his representations concerning the Academy Street building. On the contrary, assuming the truth of the complaint, Arfa/Shpigel never asked Zamir for even a page of documentation of the condition of the building.

So there you have it.  Two First Department decisions, Centro and Arfa, both of which limit Littman to its specific facts and implicitly reject Littman's broader pronouncements suggesting that a release given to a fiduciary does not protect against a nondisclosure-based, fraudulent inducement claim.  As noted last week, the Centro plaintiffs filed a notice of appeal as of right to the Court of Appeals, which will have the last word, so stay tuned. 

Update October 12, 2010:  Today the Appellate Division, First Department, granted a motion by Arfa/Shpigel for leave to appeal to the New York Court of Appeals, where it will join the already pending Centro appeal.   

Update May 2, 2011:  The oral argument of the appeal in Arfa to the Court of Appeals was heard on April 27, 2011.  Click here to watch the video. 

The minority shareholders either can accept the cash or other consideration offered by the corporation, or dissent and compel a judicial appraisal proceeding under BCL § 623.  In the latter event, the specified standard of value is "fair value" which is the same standard used in oppressed minority shareholder buyout proceedings under BCL § 1118.  (For background on the difference between "fair value" and "fair market value," see here).

Section 623 fixes the valuation date as of the close of business on the day prior to the authorization date of the merger or other triggering transaction.  In 1982, the statute was amended to give courts broad discretion to consider the impact on valuation of post-merger factors, as follows:

In fixing the fair value of the shares, the court shall consider the nature of the transaction giving rise to the shareholder's right to receive payment for shares and its effects on the corporation and its shareholders, the concepts and methods then customary in the relevant securities and financial markets for determining fair value of shares of a corporation engaging in a similar transaction under comparable circumstances and all other relevant factors.

Now let's turn back to Mandelbaum and BIG.  According to the petition in Mandelbaum, the Mandelbaum Estate owned about 4% of the outstanding shares of Five Ivy Corp. ("Old Five Ivy") which was formed in 1959.  In December 2007, the controlling shareholders implemented a short-form, freeze-out merger through an exchange of stock with a newly formed Delaware corporation ("New Five Ivy") pursuant to BCL § 913.  The plan valued the Estate's shares at approximately $450,000.  The Estate rejected the offer on the alleged ground "that there was insufficient information provided to evaluate the offer."

In April 2008, the Estate filed its petition demanding a judicial appraisal of the fair value of its shares as of the valuation date on December 27, 2007.  In August 2009, the Estate filed a pre-trial motion demanding disclosure of the 2008-09 tax returns, and any Subchapter S election, of New Five Ivy and of any predecessor or parent corporation.  The supporting affirmation of the Estate's counsel (read here) argued that the documents were relevant to the question whether, or to what extent, "there should be a discount applied to the value of the Estate's shares to reflect unrealized built-in capital gains taxes with respect to the assets owned by" the corporation.  The Estate's counsel cited the Murphy case for the proposition that:

Where a corporation has made a Subchapter S election, and holds corporate property owned at the time of the election for at least 10 years, the corporation is not liable for capital gains taxes with respect to sales of such property after expiration of the 10-year period.  Accordingly, the existence of a Subchapter S election bears directly on the issue of the valuation discount, if any, to reflect built-in capital gains taxes.

The corporation submitted its counsel's opposing affirmation (read here) stating that "any events subsequent to the valuation date are irrelevant" and that "[a]s of the valuation date . . . Five Ivy could not convert from a C to an S corporation."  Counsel cited a 2008 appellate decision in a matrimonial case called Wechsler v. Wechsler (58 AD3d 62) in support of a 100% BIG discount.  Counsel also pointed out that, because the S election entails a 10-year holding period to avoid the corporate gains tax,

any request by Petitioner for the court to consider a post-valuation date Subchapter S election with respect to the built-in gains would require the court to speculate as to future events, something which is inappropriate in valuing the corporation at the valuation date.

The lower court, in a decision by Manhattan Commercial Division Justice Charles E. Ramos dated November 23, 2009 (read here), agreed with the corporation's position, writing as follows:

[T]he Estate's request for discovery, while permissible, is statutorily limited to documents that predate the shareholder's authorization date.  Therefore, the possibility of a Subchapter S election will not be considered in the valuation of the Shares, unless a basis to do so is substantiated by other discovery.

The Estate appealed to the Appellate Division, First Department, which devoted all of two sentences to the issue in its order last week upholding Justice Ramos's ruling:

The motion court properly denied production of information regarding events subsequent to the undisputed valuation date of December 27, 2007.  Contrary to petitioner's contention, the statute's requirement that the court consider "all other relevant factors" in fixing value does not modify its time frame for fixing value "as of the close of business on the day prior to the shareholders' authorization date" (Business Corporation Law § 623[h]).

The decision seems compatible with appellate precedent that limits post-valuation date factors to those known as of the valuation date.  Along those lines, New York's highest court, in its 1988 Cawley decision (72 NY2d 465), wrote that the 1982 amendment to § 623 was

intended [to permit] courts to supplement [the established valuation] approaches by also considering "[e]lements of future value arising from the accomplishment or expectation of the merger which are known or susceptible of proof as of the date of the merger and not the product of speculation" (Alpert v 28 Williams St. Corp., 63 NY2d, at 571, supra; see, Weinberger v UOP, Inc., 457 A2d 701, 713 [Del]).

Unfortunately for the Mandelbaum Estate, all it could do was speculate.  It had no seat on Old Five Ivy's board and, presumably, no access to discussions among the controlling shareholders concerning the reasons for, and future tax structuring of, the reorganization.  Also, since the short-form merger used in Mandelbaum required no shareholder vote, the board was not required to disseminate information to the shareholders describing the objectives and post-merger implementation of the reorganization.  So, even though it's not an unreasonable inference that the planned reorganization contemplated conversion to S corporation status -- interestingly, the corporation in its opposition to the Estate's motion never denied a post-merger conversion -- the inference alone is not enough to warrant the disclosure of post-valuation date transactions.  As mentioned above, the lower court's decision left open the possibility that the Estate, through other discovery, might still be able to show that an S election was part of the mix as of the valuation date.

Assuming an appraisal hearing goes forward, it will be interesting to see if the court applies a 100% discount for BIG taxes as advocated by the corporation, which, to  my knowledge, would make it a first under New York's fair value standard.

Arfa is a convoluted, multi-layered litigation among the controlling members of a series of real estate holding companies organized as LLCs, outside investors who intervened in the case, and a court-appointed temporary receiver.  The case is assigned to New York County Commercial Division Justice Charles E. Ramos who wrote a helpful summary of the factual background in an earlier decision dated September 8, 2008 (21 Misc3d 1101(A)).

The plaintiffs, Rachel Arfa and her husband, Alexander Shpigel, filed a 54-page Second Amended Complaint which includes a Fifth Cause of Action for fraud against defendant Gadi Zamir relating to one of the realty venture's acquisitions known as Academy Street.  The plaintiffs allege that in late 2004, Zamir recommended that the parties acquire Academy Street based on various income and expense projections, and that in reliance on Zamir's recommendation and presentations they approved the deal which closed in April 2005.  Plaintiffs allege that in the summer of 2005, they learned of serious problems with the building's physical condition which allegedly were known to Zamir and withheld from plaintiffs at the time Zamir solicited their approval.

Meanwhile, plaintiffs and Zamir entered into a Governance Agreement dated June 9, 2005, which was intended to resolve growing frictions between them over management and control of the entire real estate portfolio.  The plaintiffs allege that they "reluctantly agreed" to Zamir's "demand" that they enter into the Governance Agreement "to appease Zamir and prevent him from destroying the value of the real estate portfolio . . .."  Mutual veto power over management decisions appears to be the main thrust of the Governance Agreement.  The Governance Agreement also contains a mutual general release in which the parties release one another from "any and all claims . . . known or unknown" arising from events that pre-date the Governance Agreement.

Zamir moved to dismiss the fraud claim based on the release.  As summarized in Justice Ramos's decision denying the motion dated December 8, 2008 (2008 NY Slip Op 33348(U)), the plaintiffs argued that 

to the extent that Zamir owed Plaintiffs a fiduciary duty by virtue of being co-managers, he may not rely upon the Release to insulate himself from liability where he intentionally concealed from Plaintiffs the physical condition of the Academy Street Property, and which misrepresentation was an inducement to enter into the release from the outset.

Justice Ramos agreed with plaintiffs, citing Littman for the proposition that "a fiduciary cannot, by a general release, insulate itself of its fiduciary obligation of full disclosure by wrongfully withholding the very information that a party requires to make a reasoned judgment on whether to agree to the general release at the outset."  The decision continues:

As a fiduciary, Zamir was under an affirmative duty to disclose any information that could reasonably bear on Plaintiffs' consideration to enter into the general release (Littman, 54 AD3d at 18).  Accepting the [Second Amended Complaint's] allegations as true, as the Court must do at this stage, Zamir failed to disclose to Plaintiffs vital material facts in order to permit them to make a reasoned judgment as to whether to agree to the terms of the Release.  In addition to failing to disclose to Plaintiffs, it is alleged that Zamir intentionally concealed from Plaintiffs material facts, including the engineering reports' findings concerning the structural defects in the property, and the Violations Undertaking.

I don't know whether the plaintiffs were facing potential claims by Zamir when they executed the Governance Agreement with mutual general releases.  In any event, I have to assume that Zamir bargained for the release as part of the consideration for whatever concessions he made in the Governance Agreement.  Had he understood that the release would not shield him from future claims based on alleged nondisclosures concerning Academy Street or any of their other real estate projects, would he have entered into the Governance Agreement?  Obviously I can't  answer the question or speculate whether it would have induced him to make additional disclosures that may or may not have soured the deal.  The broader question, which I'll also leave for others to answer, is whether it makes sense, and at what cost to public policy favoring out-of-court settlement, to expand the fiduciary exception to enforcement of general releases based on an intrinsically amorphous duty of disclosure.

Update July 19, 2010:  The First Department handed down two decisions in June and July 2010 significantly pruning Littman's broad pronouncements.  One of those decisions reverses the lower court's Arfa ruling discussed above.  Read here the first of two posts on the subject, highlighting the First Department's decision last month in the Centro Empresarial case.

Update July 29, 2010:  Read here the second post discussing the First Department's July 13, 2010, decision reversing Justice Ramos's above-discussed ruling in Arfa.