Liquidation of Real Estate Holding Company: Public Auction or Private Sale?
Of all the types of small, closely held businesses caught in the maelstrom of a judicial dissolution proceeding, in my experience the one that's most likely to go all the way to liquidation -- as opposed to a buyout settlement -- is the real estate holding company. Probably that's because there's an active, ready market to sell real estate assets, unlike the situation facing many other sorts of businesses with relatively few hard assets whose going concern value lies to a large degree in the good will derived from the individual talents and efforts, and customer relations, of the disputing owner-managers.
When a court orders dissolution of a real estate holding company whose owners are not cooperating with each other, the court may appoint a receiver to wind up the business and sell the realty. Can the receiver sell the realty in a private sale transaction, or must the receiver conduct a public auction sale to maximize the liquidation proceeds?
Even though the answer lies in plain sight in the governing statutes, the question nonetheless prompted a noteworthy decision earlier this month in a deadlock dissolution case that I highlighted last year called Matter of Darvish. The decade-old case involves a fight between two 50/50 shareholders of several single-asset real estate holding companies, all of which eventually were ordered dissolved and placed in receivership. In an August 2010 decision by Manhattan Supreme Court Commercial Division Justice Melvin L. Schweitzer, the court imposed a disproportionate share of the receiver's fees against the distributive share of one of the two shareholders based on his "vexatious litigation tactics" (read here my prior post on the decision).
Following that decision, the receiver filed a motion for authority to sell one of the properties by negotiated private sale rather than at public auction as stipulated in the court's original order of appointment. The property at issue is a valuable four-story building on Manhattan's Upper East Side. One of the shareholders, Lavian, objected to a private sale while the other, Darvish, agreed with a private sale but objected to the receiver's proposed $2.8 million asking price which Darvish believed should be higher based on a $3.9 million valuation estimate he obtained from his own broker.
Justice Schweitzer's latest decision in Matter of Darvish (Haslacha, Inc.), 2011 NY Slip Op 30134(U) (Jan. 19, 2011), summarizes as follows the rationale for the receiver's request:
Based on his experience in the real estate business, Mr. Landis believes that a public auction of the Property would not attract purchasers willing to pay the market price because they would view the auction as a foreclosure sale of distressed property, and would expect a substantial discount. On the other hand, Mr. Landis argues, a private sale would allow him to "pre-screen potential purchasers and negotiate only with those willing to pay market rate for the property."
The receiver proposed to engage two qualified real estate brokers to market the property at an asking price of $2.8 million based on the broker's "initial valuation" between $2,550,000 and $2,575,000. The proposed single 6% broker's commission would be paid even if the successful purchaser is an insider, i.e., one of the shareholders or the current tenant who apparently held a right of first refusal.
Lavian argued that case law prohibits a receiver from liquidating assets in dissolution other than by means of public auction, citing Matter of Oak Street Management, Inc., 307 AD2d 320 (2d Dept 2003). In that dissolution case, an appellate panel reversed a lower court's order appointing a referee to value the corporation's properties and leasehold interests and to recommend the appropriate procedures following dissolution. The appellate court noted that the post-dissolution procedures set forth in Sections 1005 through 1008 of the Business Corporation Law do not include appointment of a referee. It then added:
Absent an agreement between the parties to sell the shares of the corporation to each other or to an outside buyer, the only authorized disposition of corporate assets is liquidation at a public sale. Thus, no appraisal of the value of the corporation's asset was warranted in this case.
In rejecting Lavian's position, Justice Schweitzer narrowly reads Oak Street's holding as simply restricting a court's authority to appoint a referee for valuation purposes. More to the point, Justice Schweitzer relies on the explicit authorization for private sale found in BCL Section 1206(b)(2), which empowers a receiver in dissolution cases:
To sell at public or private sale all the property vested in him, in such manner and on such terms and conditions as the court shall direct, and to make necessary transfers and conveyances thereof.
The receiver's statutory authority to sell at public or private sale mirrors a corporation's own post-dissolution statutory authority found in BCL Section 1005(a)(2):
The corporation shall proceed to wind up its affairs, with power to fulfill or discharge its contracts, collect its assets, sell its assets for cash at public or private sale, discharge or pay its liabilities, and do all other acts appropriate to liquidate its business.
Justice Schweitzer's ruling also finds support in the Oak Street decision's citation to Matter of Sternberg, 181 AD2d 897 (2d Dept 1992), where the Second Department held that "if there is no agreement between the parties within a reasonable time, and no outside buyer of the business as a whole can be found, a liquidation of the corporation's assets by public sale shall be held." In contrast, Justice Schweitzer continues,
That is not the case here, since finding an outside buyer is exactly what Mr. Landis purports to intend to do. Indeed, Mr. Landis wants to hire [brokers] to obtain a substantially higher price for the Property than would otherwise be available at a public sale. . . . Therefore, the court agrees with Mr. Landis that a negotiated private sale is in the best interest of the Haslacha estate.
Responding to shareholder Darvish's objection to the proposed $2.8 million asking price as too low, Justice Schweitzer states that the court "will not impose a minimum threshold for the asking price." Justice Schweitzer further observes that Darvish, having already consented to the appointment of the broker that ascertained the appropriate pricing, "cannot now try to impose another broker's valuation opinion." He also notes the receiver's representation that the proposed brokers' initial valuation and proposed asking price are both "works in progress" and that he has asked his brokers to review Darvish's broker's valuation opinion and the comparables on which it is based. "Since its commission is tied to the ultimate success of the sale," Justice Schweitzer adds, "[the receiver's broker] has a strong incentive to seek out the best available price, and the court need not needlessly restrain its business judgment."
One can infer from the decision the back story of this latest episode in Darvish: one shareholder wants to bid on the building himself and therefore has an economic incentive to depress third-party bids, while the other shareholder likely is not a potential buyer and therefore wants the highest possible third-party bids.
It is generally true that bidders at a real estate public auction sale will offer less than bidders in a private sale, for several reasons. First, particularly for high-end properties such as the one in Darvish, a broker's marketing efforts can generate greater buyer interest. Second, bidders at public auction usually cannot obtain as much information about the property and perform as much due diligence as private buyers. Third, the terms of sale at a public auction are usually harsher than a private sale, generally requiring the successful bidder to pay a 10% deposit by certified funds the day of the auction and to close within 30 days.
That is not to say I agree entirely with the receiver's stated rationale for private sale as quoted by the court, i.e., that a prospective private buyer will not view the offering as a distress sale opportunity to buy at discount. If not disclosed upfront by the broker, any interested bidder with internet access can quickly ascertain that the property is owned by a dissolved corporation in receivership with the attendant mandate by court order to sell the property. Heck, in the case of the building being sold in Darvish, all they have to do is read this blog post!
Update September 10, 2011: The receiver's broker subsequently procured, and the receiver applied for court approval of, a $2.4 million offer. Darvish opposed the application and asked the court to order the receiver to accept a $2.7 million offer from another buyer apparently procured by Darvish. By Order dated August 16, 2011 (read here), the court agreed with Darvish, stating that "the court fails to understand why the receiver prefers" the lower offer and ordering the receiver to accept the higher offer.
Court Charges Receiver's Legal Fees in Corporate Dissolution Against 50% Shareholder's Distributive Share Based on Misconduct
Last week's post on the Deblinger case examined a first-impression decision in a corporate dissolution proceeding concerning the court's authority under Section 1008 of the New York Business Corporation Law to compel a shareholder to present a derivative claim against another shareholder-director. The same statute occupies center stage in yet another novel decision handed down last month in Matter of Darvish (Haslacha, Inc.), 2010 NY Slip Op 32339(U) (Sup Ct NY County Aug. 23, 2010). This time, the issue is whether Section 1008 authorizes the court to assess against one shareholder's distributive share of the liquidation proceeds the court-appointed receiver's legal fees incurred as a result of the shareholder's misconduct.
You can tell Darvish is one of those protracted, rancorous shareholder disputes just from the "01" suffix in the case's index number -- indicating the case is nine years old -- and from the most recent motion sequence number indicating that the parties have filed over 50 separate motions since the case began.
The petitioner, Darvish, as 50% shareholder filed for judicial dissolution of three single-asset real estate companies based on deadlock and dissension with the other 50% shareholder, Lavian, under BCL Section 1104. In 2004, Manhattan Commercial Division Justice Herman Cahn (since retired) granted the petition as to two of the three corporations, named Urban Homes, Inc. ("Urban") and Primary Residence, Inc. ("Primary"). Justice Cahn directed further proceedings with respect to the third corporation, Haslacha, Inc. ("Haslacha"), based on Lavian's assertion that he was sole shareholder of that entity. (Read Justice Cahn's decision here.)
Justice Cahn subsequently referred the issue of Haslacha's ownership to a Special Referee who, in October 2008, issued a report that Justice Cahn subsequently confirmed, finding that Darvish and Lavian each own 50% of Haslacha's shares. (Read report here.)
In November 2008, Justice Cahn granted dissolution of Haslacha and appointed a Receiver to manage its commercial property located in Manhattan and to collect rents and profits. (The buildings owned by Urban and Primary were put under the same Receiver's control in 2004.)
In 2009, the Receiver made a series of motions, contested by Lavian, relating to tenancies at Haslacha's building, and for approval of payments to his appointed counsel from the corporation's receipts. Darvish supported the Receiver's motions and filed a cross motion asking that the Receiver's counsel fees be paid not from the corporation's funds, but from Lavian's share of any final distribution from Haslacha, Urban and Primary. Darvish contended that the court had authority to charge Lavian's interest under BCL Section 1008(5) on the grounds that the Receiver's counsel fees were incurred solely as a result of Lavian's acts, misconduct and interference with the receivership.
The motions were referred to the Special Referee who issued a report in June 2010 (read here) granting the Receiver's motions but denying Darvish's cross motion to charge Lavian's distributive share, explaining as follows:
BCL 1008(5) authorizes the court to determine and enforce the liability of any "director, officer, shareholder or subscriber for shares, to the corporation or for the liabilities of the corporation," but does not authorize the court to charge an award of attorney's fees to any distributive share of a "director, officer, shareholder or subscriber" of a corporation, upon the grounds of misconduct.
In a subsequent report the Special Referee approved the Receiver's counsel fees in the sum of approximately $200,000.
Darvish then moved before Manhattan Commercial Division Justice Melvin L. Schweitzer, who had taken over the case from the retired Justice Cahn, to reject the Special Referee's report insofar as it denied Darvish's cross motion to charge the Receiver's counsel fees against Lavian's distributive share. Here's how Justice Schweitzer frames the issue in his August 23, 2010 decision:
The court now turns to the issue of how the costs and fees are to be allocated: should they be borne by the Haslacha Estate and/or the Primary Residence and Urban Homes Estates irrespective of share ownership or should they be borne exclusively from Mr. Lavian's distributive shares in those Estates as advocated by Petitioner?
The answer is foretold in Justice Schweitzer's immediately following observation, that the Special Referee's reports "leave no doubt" that Lavian's conduct, such as "filing numerous motions, refusing to obey the orders of the court and the Receiver, and by engaging in sham leasing transactions," required "the appointment of the Receiver in the first place and caused him to incur the costs and attorneys' fees awarded to" the Receiver's counsel.
Justice Schweitzer next explicitly rejects the Special Referee's reading of BCL 1008, which "invests broad discretion in the court 'without limitation' to issue orders with respect to 'all matters' in connection with the winding up of the affairs of the corporation." Citing BCL 1008(5), Justice Schweitzer states that "it is clear that the corporation's liability for the Receiver's legal fees" to be paid from the sale proceeds of the corporation's assets have
arisen due to the acts of a shareholder, i.e., Mr. Lavian [whose] refusal to comply with the court's orders, and his vexatious litigation, is responsible for the corporation's liability to pay legal fees. The court is invested by the statute with the power to "determine" Mr. Lavian's liability and to "enforce" that liability, by ordering Mr. Lavian to pay the liability he caused out of his distributive share.
Justice Schweitzer also grounds his decision on subdivision (6) of Section 1008, which authorizes the court to enter orders for the "payment, satisfaction or compromise of claims against the corporation . . .." Lavian's actions, the court continues,
have wasted the corporation's assets and he should not benefit by the petitioner's being required to pay one-half the costs. . . . It would be unfair to allocate the costs and fees attributable solely to Mr. Lavian's fault or vexatious litigation tactics equally between Mr. Darvish and Mr. Lavian by virtue of the fact that they are each 50% owners in the Estates of Haslacha, Primary Residence and Urban Homes.
Notwithstanding the court's harsh assessment of Lavian's conduct, in the end he is not assessed 100% of the $200,000 in attorney's fees incurred by the Receiver. Instead, Justice Schweitzer orders that the fees be paid 65% from Lavian's distributive share and 35% from Darvish's distributive share. Justice Schweitzer does not explain the allocation, though presumably it reflects some quantum of services by the Receiver's counsel not directly related to Lavian's actions.
Taken together, the Deblinger and Darvish cases, decided within days of each other by two different judges, underscore the potent and extremely broad judicial powers granted in BCL Section 1008. Counsel involved in the winding up of a judicially dissolved corporation must familiarize themselves with this important statute.
Update January 2, 2010: By Supplemental Order dated December 20, 2010, Justice Schweitzer clarified his prior order by also allocating to Lavian 65% of the $25,200 settlement costs of the related mortgage foreclosure proceeding.
The Perils of For-Cause Expulsion Provisions in LLC Agreements
A number of valuable lessons can be learned from a recent decision by Manhattan Commercial Division Justice Melvin L. Schweitzer (pictured) in Jain v. Rasteh, Decision and Order, Index No. 109920-09 (Sup Ct NY County Feb. 1, 2010), where the court summarily dismissed a complaint by a minority member of a limited liability company who was expelled from the LLC for breach of its operating agreement.
The last time I wrote on the subject (read here) I noted that, unlike some other states, New York's LLC Law has no express provision authorizing or prohibiting member expulsion, although LLCL Section 701(b) mentions member expulsion in the context of various events (death, retirement, bankruptcy, etc.) not requiring the LLC's dissolution. Jain involved an LLC formed under Delaware's LLC Act, which, unlike New York's law, expressly authorizes the LLC agreement to provide for the elimination or forfeiture of a member's interest for failure to comply with the LLC agreement, or under any other circumstances specified in the LLC agreement (see Delaware LLC Act Section 18-306 and Section 18-502(c)).
The subject of Jain is a New York based, two-member company formed in Delaware in 2008 to provide investment management and advisory services for a hedge fund. The defendant Majority Member contributed most of the firm's capital and held an 83% profit interest. The plaintiff Minority Member held the balance. Section 5 of the LLC agreement designated the two as co-managers, however it also gave the Majority Member the final say in case of disagreement on any issue with specified exceptions such as dissolution and admission of new members.
Section 12 of the LLC agreement, entitled "Withdrawal of a Managing Member," included a subsection (a)(ii) governing involuntary withdrawal by the Minority member, authorizing the Majority Member to "require" him to withdraw at any time for "Cause" as defined. The definition included conviction for felony or violation of securities laws, fraud, or "a material breach of this Agreement." Section 13 of the LLC agreement entitled the Minority Member to be paid specified percentages of the firm's net profit over the three years following any such involuntary withdrawal, depending on the number of years of service. For termination after less than two years -- which is what happened -- the Minority Member's share of net profit goes from 4.25% in the first year down to about 1.4% in the third year. Under Section 17 of the LLC agreement, following his termination for any reason the Minority Member is prohibited for six months from competing with the company or soliciting any of its clients or employees.
According to the Minority Member's amended complaint (which includes a copy of the LLC agreement), in February 2009, the Majority Member barred him from the company's business office, threatened to have him "escorted out" if he tried to gain entry, and refused him access to the company's books and records. According to the Majority Member's submissions in support of his motion to dismiss the complaint, between February and the end of June 2009, the Minority Member agreed to, and did, work from home with remote access to the necessary databases and company information, and he also received a tax distribution as provided in the LLC agreement.
On June 30, 2009, the Minority Member's attorneys received a letter from company counsel informing them that he was terminated for cause under Section 12(a)(ii) of the LLC agreement. The letter gave as the basis for termination two material breaches of the LLC agreement. First, the letter cited the Minority member's refusal to comply timely with company requests for his personal trading information for an SEC compliance audit. Second, the letter accused him of disobeying the Majority Member's directive not to communicate with the company's largest client concerning their internal dispute after the Minority Member suggested seeking its assistance with their settlement discussions. In both instances, the letter characterized the Minority Member's conduct as a breach of Section 5 of the LLC agreement giving the majority Member the final say in the event of any disagreement between them concerning the LLC's business affairs.
Shortly thereafter the Minority Member filed his initial complaint against the Majority Member and the company for breach of the LLC agreement. He also applied for a preliminary injunction requiring the defendants to give him access to the company's office and books and records. By order dated August 13, 2009, Justice Schweitzer denied preliminary relief and granted the defendants' cross motion to dismiss the complaint for pleading defects with leave to replead, following which the Minority Member filed his amended complaint.
The defendants again opted to move for dismissal rather than answer the amended complaint, this time on the basis of documentary evidence establishing their defenses as a matter of law, as permitted by Section 3211(a)(1) of the Civil Practice Law and Rules. As Justice Schweitzer's subsequent decision notes, the standard under Section 3211(a)(1) is "high" and requires evidence that "utterly refutes" the plaintiff's allegations which must be deemed true.
Defendants argued that they met the standard, and that their expulsion of the Minority Member complied with the LLC agreement as a matter of law. Primarily they relied on a series of email exchanges between the parties and their legal counsel evidencing the Minority Member's failure to disclose his personal trading information, and his disclosure of their internal dispute to a company client over the Majority Member's objection. The Minority Member countered that his complaint must be "liberally construed" and that the documentary evidence was contradictory, however, Justice Schweitzer agreed with the defendants, writing:
It is clear from the record currently before the court . . . that [the Minority Member's] personal trading account information was requested for an annual compliance audit, and that [he] failed to provide it in a timely fashion. Although [the Minority Member] correctly notes that dismissal of an action is not appropriate unless no significant dispute between the parties remains, he has failed to provide credible evidence to contradict defendants' documentary evidence.
So what are the lessons to be learned from the case? I can think of four:
- The inclusion of a for-cause expulsion provision in the LLC agreement is a delicate matter to be carefully considered on all sides when the agreement is under negotiation. Sure, it's nice for the majority to have the power to expel, but particularly in a very small company where the members work closely together, the spectre of expulsion of the minority member based on some finding of misconduct, especially if on financial terms highly unfavorable to the expelled member, can poison inter-member relations and the company's long-term prospects for stability and success.
- If you're a minority member of an LLC whose operating agreement includes a provision authorizing your expulsion at the behest of the majority, depending how broadly or narrowly the clause is drafted, do not take too much comfort from the fact that the grounds for expulsion are limited to defined circumstances constituting "cause" for removal. I've seen a number of LLC agreements such as the one in this case with for-cause expulsion provisions predicated on a catch-all material breach of the LLC agreement. At a minimum you may be buying yourself an expensive lawsuit over the existence or not of the requisite breach, and you may be doing so after being locked out of the company with no salary.
- Once it becomes apparent that the members' relationship is in jeopardy, the minority member must walk on eggshells, so to speak, to avoid giving the majority member any excuse for triggering the for-cause expulsion. It's interesting to note that, in this case, although the complaint alleged that the Minority Member effectively was thrown out of the company in February 2009, the grounds for his formal expulsion concerned only his subsequent actions in the following months.
- The case also teaches lawyers a practice pointer, namely, never underestimate the power of a well-supported pre-answer motion to dismiss the case based on documentary evidence. Over many years of following court decisions I've seen relatively few successful Section 3211(a)(1) motions, and those that do succeed usually rely on some dispositive provision in the parties' contract without need for extraneous evidence of the parties' conduct. In that sense, this is an unusual case because the court had to look outside the LLC agreement for evidence of the claimed breach. In defending against such a motion, the better practice is to treat the motion as if it were one for summary judgment and put in the record, whether by way of affidavit or documentary exhibits, any and all available evidence raising a factual dispute.
