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

Petitioner Herman Poritzky and respondent Stephen DeName, who had been working together since 1996 in Poritzky's lending businesses, became 50-50 shareholders of Dream Weaver Realty, Inc. in July 2000.  Dream Weaver was in the business of owning and developing real properties.  The parties' written shareholders' agreement memorialized their equal stock ownership and positions as sole directors and officers, but little else.

Between 2001 and 2004, Dream Weaver acquired four properties, three of them income-producing improved properties and one unimproved lot.  Around 2005, Poritzky and DeName had a falling out over management, record-keeping and finances of the several companies they co-owned.  In 2007, Poritzky filed a lawsuit against DeName relating not to Dream Weaver but to two of their other businesses, alleging breach of fiduciary duty and seeking an accounting and damages.  DeName counter sued for damages.  By this time virtually all communications between the two were through their attorneys.

While this other action was still pending, in January 2009, Poritzky petitioned for judicial dissolution of Dream Weaver under BCL §1104 based on deadlock and internal dissension.  Poritzky's petition (read here) alleged that the two of them were "embroiled in litigation"; were no longer communicating directly; that DeName had stopped payments of interest due Poritzky for monies loaned by him to acquire one of Dream Weaver's properties; that the board of directors had ceased to function; that their differences were "irreconcilable"; that all attempts to mediate the dispute had failed; and that even though Dream Weaver was solvent, liquidation of the corporation was the only feasible means to obtain a fair return on Poritzky's investment.

DeName's answer (read here) did not really contest the state of hostilities between the two co-owners.  Rather, he contended that judicial dissolution was not warranted because the parties and their attorneys agreed and took action beginning in 2007 to wind up the company's business affairs by selling its real properties.  He further alleged that in late 2008 they agreed on terms of sale of two of the four properties to specific buyers, and also agreed on the marketing of the other two properties.  DeName accused Poritzky of bad faith and "reneging" on these agreements to squeeze financial concessions from DeName in violation of fiduciary duty.  DeName alleged that consummation of the private sales would result in net proceeds of $540,000, whereas the "forced sale" of the properties by a receiver unnecessarily would engender substantial fees and expenses and "will result in lower purchase prices being paid by the ultimate purchasers in the court proceedings than the amounts that have been offered by the existing prospective purchasers following arms length negotiations."    

In an unpublished decision and order dated April 21, 2009, Westchester County Supreme Court Justice Kenneth W. Rudolph (since retired) granted the dissolution petition.  After reciting the parties' contentions, the decision simply concluded that

petitioner has established, on the clear record before the Court and without necessity of a hearing, that the corporate affairs are rife with dissension and have ultimately resulted in a deadlock precluding the successful and profitable conduct of the corporation's business.

The order also appointed a receiver under direction "to sell at public sale all of the property and assets of the corporation." 

DeName's appeal brief to the Second Department (read here) argued that the "areas of disagreement relied on by the court below did not involve the conduct of the business which had been pursued by both sides, namely, the sale of Dream Weaver's assets," and that the lower court committed reversible error by failing to conduct a hearing on the issue of Poritzky's alleged "bad faith refusal to pursue what had been agreed upon by the parties."  DeName's brief principally relied on Matter of Hayes v. Festa, 202 AD2d 277 (1st Dept 1994), where a Manhattan appeals court panel denied dissolution notwithstanding the lack of communication between the two shareholders, based on the referee's finding that "operation of the business continued, while negotiations on the division of assets came to a stalemate only because one side unilaterally ended negotiations and commenced this proceeding in the acknowledged hope of avoiding a more expensive buy-out of the other side."

Poritzky's opposing brief (read here) argued that the lower court properly exercised its discretion in granting dissolution without a hearing, quoting from Matter of Eklund Farm Machinery, Inc., 40 AD3d 1325 (3d Dept 2007), as follows:

[E]ven if petitioners were shown to have created dissension to obtain dissolution, Supreme Court could not conclude that it was in bad faith or that the parties' differences were reconcilable.  Given these circumstances, "the underlying reason for the dissension is of no moment"  and a judicial remedy is appropriate.

As noted above, the Second Department's affirmance of the dissolution order in Dream Weaver provides no additional analysis or insight.

So what lesson does Dream Weaver teach us?  In my view, it tells us that absent some compelling explanation to the contrary supported by facts sufficient to require a hearing, which was missing in Dream Weaver, courts will presume that if a voluntary, private sale of the corporation's assets outside of dissolution is achievable and in the collective best interests of the two owners, they will make it happen.  Otherwise, an irreconcilable impasse over the winding up of the corporation's business affairs is no less a viable ground for judicial dissolution than an impasse in the operation of the business as a going concern.  It also tells us that the "mere" likelihood that a voluntary, private sale will maximize proceeds from sale of the corporation's assets does not by itself permit an inference of bad faith on the part of the shareholder seeking dissolution.

My thanks to attorney Kenneth Gunshor, who represented the petitioner in Dream Weaver, for providing me with copies of the appellate briefs and record.

The Facts

1545 Ocean Avenue, LLC ("1545 LLC") was formed in late 2006 as a manager-managed LLC with two 50% members, Crown Royal Ventures, LLC ("Crown Royal") and Ocean Suffolk Properties, LLC ("Ocean Suffolk").  Crown Royal and Ocean Suffolk entered into a written operating agreement for 1545 LLC in which Crown Royal designated its principal, John King, as one of the two managers and Ocean Suffolk designated its principal, Walter Van Houten, as the other manager.

Article 4.1 of the operating agreement contained a somewhat atypical management clause for 50-50 LLCs, authorizing "any one Manager [to] take any action permitted under the Agreement, unless the approval of more than one of the Managers is expressly required [by the Agreement]."

The two members each contributed 50% of the capital used to purchase commercial real estate located in Bohemia on Long Island.  1545 LLC's purpose was to purchase the property, rehabilitate an existing building (Building A) and build a second building on the property (Building B) for commercial rental.

King and Van Houten agreed to solicit third-party bids for the demolition and construction work.  They also agreed that Van Houten, who owned his own construction company, Van Houten Construction ("VHC"), could submit bids subject to the managers' approval.

Ultimately VHC undertook the work on Building A, with Crown Royal later alleging that VHC did so without King's consent whereas Ocean Suffolk contended that the two managers agreed to hire VHC when there were no bona fide third-party bids.  King also claimed that VHC began the work without necessary permits, did not have the proper equipment and consequently overbilled for the work.  King alleged that he agreed to pay VHC's invoice on condition that it would cease further work without King's consent.  VHC continued working on the site without King's consent.

Tensions between King and Van Houten further escalated following a dispute over hiring a contractor for environmental remediation work.  According to King, Van Houten refused to meet on a regular basis, proclaimed himself to be a "cowboy" and stated that he would "just get it done".  In April 2007, King announced that he wanted to withdraw his investment from 1545 LLC and  proposed to notify all vendors that Van Houten was taking over.  Van Houten viewed King as having resigned as manager.  King's attorney sent Van Houten a "stop work" demand which was ignored.  The two exchanged competing buy-out proposals of each other's interest, without resolution.  Meanwhile, VHC continued to work unilaterally on the construction project which was within weeks of completion when Crown Royal sued for judicial dissolution and obtained an interim injunction preventing further work.

The Dissolution Petition

Crown Royal's petition alleged, as the sole ground for dissolution, deadlock between the managers arising from Van Houten's claimed violations of Article 4 of the operating agreement.  The petition did not allege fraud or frustration of the purpose of 1545 LLC on the part of Ocean Suffolk, Van Houten or VHC.

Ocean Suffolk's answer to the petition opposed dissolution and denied any violation of the operating agreement.  It alleged, without dispute, that the renovation of Building A was within 3-4 weeks of completion when the litigation commenced.  It also alleged that, in anticipation of a buy-out of Crown Royal's interest, the parties had been operating as if Van Houten was sole manager.  Ocean Suffolk thus contended that there could be no manager deadlock as a result of King's resignation as manager, even though King did not submit a written resignation as required by Article 4.8 of the operating agreement.

The Lower Court's Dissolution Order

In December 2007, the lower court issued a bare-bones order granting the dissolution petition (read it here).  The order makes no factual findings, merely stating that judicial dissolution of an LLC "will be ordered only where the complaining member can show that the business sought to be dissolved is unable to function as intended, or else that it is failing financially," and that review of the papers submitted and the conferences conducted with the court "clearly demonstrates to this Court that 1545 is unable to function as intended."

Justice Austin's Majority Opinion

Ocean Suffolk appealed the order of dissolution to the Brooklyn-based Appellate Division, Second Department.  Justice Austin's opinion for the 5-judge panel reverses the lower court's order, denies the petition and dismisses the proceeding.  Presiding Justice Steven Fisher, joined by Associate Justice Cheryl Chambers, wrote a partial dissent in which he would have remitted the matter to the lower court for a fact-finding hearing to determining whether Crown Royal's petition met the newly-articulated standard for dissolution.  

1. The LLC Dissolution Statute Distinguished from its Corporate and Partnership Counterparts 

The analysis section of Justice Austin's opinion in 1545 Ocean, as its first order of business, tells the bench and bar what the standard for LLC dissolution is not, namely, it is not the standard developed for close corporations under the Business Corporation Law (BCL).

Upon the enactment of New York's LLC Law in 1994, the statute contained a single section denominated §702 governing judicial dissolution of the newly recognized entity.  The section provides in its entirety as follows:

On application by or for a member, the supreme court in the judicial  district  in  which the office of the limited liability company is located may decree 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 operating  agreement.  A certified copy of the order of dissolution shall be filed by the applicant with the department of state within thirty days of its issuance.  [Emphasis added.]

As I wrote in my 2002 article on LLC dissolution, the section's sparse language -- drawn from the limited partnership dissolution statute but rarely examined in the partnership case law -- created a vacuum into which many judges imported the relatively well-developed grounds for dissolution employed in cases involving close corporations under BCL §§1104 and 1104-a.  It's easy to understand why courts did so given the many similarities between, on the one hand, corporate shareholder-officers and, on the other, LLC member-managers, at least when it comes to the day-to-day realities of their internal relations and the pressures that lead to internal dissension.

Justice Austin notes that §702 was left unchanged when the LLC Law was amended in 1999 to conform to changes in federal tax treatment of LLCs (citing my 2002 article in that regard), and from that concludes:

since the Legislature, in determining the criteria for dissolution of various business entities in New York, did not cross-reference such grounds from one type of entity to another, it would be inappropriate for this Court to import dissolution grounds from the Business Corporation Law or Partnership Law to the LLCL.

He then observes that, while there is no definition of "not reasonably practicable" in the context of LLC dissolution, "[s]uch standard . . . is not to be confused with the standard for the judicial dissolution of corporations or partnerships" (citations omitted).  He notes that the BCL and Partnership Law by statutory definition apply only to business corporations and partnerships, respectively, and that "[l]imited liability companies thus fall within the ambit of neither the Business Corporation Law nor the Partnership Law."  He also cites §102(m) of the LLC Law, which likewise excludes corporations and partnerships from its ambit, in concluding that "the existence and character of these various entities are statutorily dissimilar as are the laws relating to their dissolution."   

2. The Court's Articulation of the Standard for Dissolution under §702

Having told us what the statute is not, Justice Austin next turns to the central question of §702's meaning.  He notes that prior New York cases involving LLC dissolution "have avoided discussion of this standard altogether" leaving the issue unresolved.  He also remarks upon the absence of case precedent construing the similarly-worded standard for dissolution under the limited partnership law.

The "not reasonably practicable" standard is linked textually in §702 to "conformity with the articles of organization or operating agreement."  This linkage leads Justice Austin to state, quite significantly, that  

LLCL 702 is clear that unlike the judicial dissolution standards in the Business Corporation Law and the Partnership Law, the court must first examine the limited liability company's operating agreement (see Matter of Spires v Lighthouse Solutions, LLC, 4 Misc 3d at 432) to determine, in light of the circumstances presented, whether it is or is not "reasonably practicable" for the limited liability company to continue to carry on its business in conformity with the operating agreement (id. at 433). Thus, the dissolution of a limited liability company under LLCL 702 is initially a contract-based analysis. [Emphasis added.]

The absence of New York precedent leads Justice Austin to look to LLC caselaw in other states with the same statutory standard for dissolution.  Prominent among these cases is the Delaware Chancery Court's decision last year in Matter of Arrow Investment Advisors, LLC, 2009 WL 1101682 (Del Ch Apr. 23, 2009), where the court dismissed a minority member's application for dissolution of an investment advisory firm that had ceased its advisory business and essentially was reduced to a holding company for the firm's remaining cash and securities assets.  The Chancery Court looked to the LLC agreement's broad purpose clause ("such . . . lawful business as the Management Committee chooses to pursue") in holding that, as quoted in 1545 Ocean,

"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; such events are, of course, common in the risk-laden process of birthing new entities in the hope that they will become mature, profitable ventures. In part because a hair-trigger dissolution standard would ignore this market reality and thwart the expectations of reasonable investors that entities will not be judicially terminated simply because of some market turbulence, dissolution is reserved for situations in which the LLC's management has become so dysfunctional or its business purpose so thwarted that it is no longer practicable to operate the business, such as in the case of a voting deadlock or where the defined purpose of the entity has become impossible to fulfill. . . . Dissolution of an entity chartered for a broad business purpose remains possible upon a strong showing that a confluence of situationally specific adverse financial, market, product, managerial, or corporate governance circumstances make it nihilistic for the entity to continue."

Other out-of-state cases cited by Justice Austin include Dunbar Group, LLC v Tignor, 267 Va 361, 593 SE2d 216 (2004), where the Supreme Court of Virginia, calling the statutory standard for dissolution a "strict one," reversed an order of dissolution based on deadlock between two 50-50 members of an LLC after the lower court had expelled one of the two members from participating in management; Kirksey v Grohmann, 2008 SD 76, 754 NW2d 825 (2008), where the South Dakota Supreme Court found the standard satisfied in a deadlock situation that left two of four sisters without any meaningful say in the LLC's business affairs contrary to the operating agreement; and a partnership case, Taki v Hami, 2001 WL 672399 (Mich. App. 2001), in which a Michigan appellate court granted dissolution where the two partners had not spoken in years and there were allegations of violence and expulsion.

Drawing on these cases, as well as the language of §702, Justice Austin announced the court's interpretation of the standard for LLC dissolution as follows:

After careful examination of the various factors considered in applying the "not reasonably practicable" standard, we hold that for dissolution of a limited liability company pursuant to LLCL 702, the petitioning member must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.

Notice how the two prongs of the standard -- I'll call them failed purpose and financial failure --are stated in the disjunctive but that each must be analyzed through the prism of the operating agreement or, if there is no operating agreement, in light of the LLC Law's default provisions.  This is a significant shift from the less refined and arguably more liberal standard articulated in the one trial court decision that had gained a following, Schindler v. Niche Media Holdings, 1 Misc 3d 713 (Sup Ct NY County 2003), where the court wrote that dissolution of an LLC under §702 is available only if the company "is unable to function as intended, or else that is it failing financially."  Henceforth, financial failure alone will not be enough to justify the drastic remedy of dissolution unless such failure is accompanied by, or results from, a frustration of the LLC's purpose that cannot be addressed or remediated by the operating agreement or articles of organization.

Notice also that, in contrast with the formulation recently used by the Delaware Chancery Court in the Lola Cars v. Krohn Racing case (read my post on Lola here), the 1545 Ocean court's formulation does not specify manager deadlock as a basis for dissolution.  Indeed, Justice Austin elsewhere in his opinion states that deadlock, while expressly made a basis for dissolution of close corporations under BCL §1104, is not an "independent ground for dissolution" under  §702.  The court instead "must consider the managers' disagreement in light of the operating agreement and the continued ability of [the LLC] to function in that context."   Presumably such consideration of deadlock fits within the unable-to-achieve-LLC's-purpose aspect of the failed-purpose prong, whereas the unwilling-to aspect seems better suited to dissolution cases brought by petitioners holding a minority membership interest.

3. The Court's Application of the Standard

Crown Royal argued for dissolution based on the parties' failure to hold regular meetings, failure to achieve quorums, and deadlock over the construction work and, in particular, Van Houten's continuation of the work using VHC despite King's objections.  Writing for the 3-judge majority, Justice Austin held that Crown Royal's allegations "failed to meet the standard for dissolution enunciated here" and that, additionally, "there are numerous factors which support the conclusion that dissolution of 1545 LLC is inappropriate under the circumstances of this case."

Why did Crown Royal's petition fall short of the standard?  First and foremost, Article 4.1 of the operating agreement (quoted above in the Facts section) permits one manager to act unilaterally unless the other manager's approval is expressly required.  As Justice Austin noted, "[t]his provision does not require that the managers conduct the business of 1545 LLC by majority vote."  Rather, he continued,

[i]t empowers each manager to act autonomously and to unilaterally bind the entity in furtherance of the business of the entity. The 1545 LLC operating agreement, however, is silent as to the issue of manager conflicts. Thus, the only basis for dissolution can be if 1545 LLC cannot effectively operate under the operating agreement to meet and achieve the purpose for which it was created. In this case, that is the development of the property which purpose, despite the disagreements between the managing members, was being met.

The operating agreement likewise did not require regular meetings or quorums.  Instead, it merely provided for meetings to be held at such times as the managers "may from time to time determine."  The record before the court, Justice Austin found, "demonstrates that the managers, King and Van Houten, communicated with each other on a regular basis without the formality of a noticed meeting which appears to conform with the spirit and letter of the operating agreement and the continued ability of 1545 LLC to function in that context."

What other circumstances rendered dissolution inappropriate?  Justice Austin identifies three.  First, the dispute between King and Van Houten "was not shown to be inimicable to achieving the purpose of 1545 LLC."  King "never objected to the quality of Van Houten's construction work, but only to its expense".  King "approved and praised" the work which was all but complete as to Building A.

Second, LLC Law §411 permits an LLC to avoid contracts entered into between it and an interested manager or another company in which a manager has an interest, unless the manager can prove the contract was fair and reasonable.  Crown Royal could have, but did not, take action against the contract with VHC under §411.  On the contrary, Justice Austin stressed, Crown Royal "ratified, albeit grudgingly at times, Van Houten's unilateral efforts."  In any event, he continued, "a fair reading of LLCL 702 demonstrates that an application to dissolve 1545 LLC does not flow from a claim under LLCL 411."

Third, if aggrieved by Van Houten's actions as manager Crown Royal has an alternative remedy in the form of a common law derivative action under Tzolis v. Wolff, 10 NY3d 100 (2008).  Such remedy, however, "cannot serve as the basis for dissolution unless the wrongful acts of a managing member which give rise to the derivative claim are contrary to the contemplated functioning and purpose of the limited liability company."     

Justice Fisher's Partial Dissent

Justice Fisher's partial dissent begins with the observation that he has "no serious quarrel" with the standard for dissolution adopted by the majority.  He briefly recounts the "growing disputes" between King and Van Houten over the latter's alleged mismanagement and billing improprieties in connection with the construction project.  Justice Fisher states that Van Houten disputed many of King's allegations, and he notes that the lower court "made no findings of fact."  Without such factual findings, he continues,

we cannot meaningfully decide whether the Supreme Court providently exercised its discretion in finding that the actions of the parties rendered it not reasonably practicable for 1545 LLC to carry on its business in conformity with its articles of organization or operating agreement.  Accordingly, I would remit the matter to the Supreme Court, Suffolk County, for a fact-finding hearing and thereafter for a new determination on the petition (cf. Business Corporation Law § 1109; Sobol v Les Pieds Nickels, 262 AD2d 194, 196; Matter of Giordano v Stark, 229 AD2d 493, 494-495).

The requirement or not of a hearing in judicial dissolution proceedings can be as important to the outcome of the dispute as the formulation of the dissolution standard.  I've seen dozens of appellate decisions reversing the grant or denial of a dissolution petition due to the lower court's failure to conduct an evidentiary hearing in the presence of conflicting affidavits concerning material issues of fact.  I doubt that the majority's summary dismissal of Crown Royal's petition is intended to signal a change in direction on that score.  Rather, the majority's disposition likely reflects its belief, not shared by the dissenters, that even crediting all of Crown Royal's factual allegations, along with its admissions as to the quality of VHC's work, it still does not meet the threshold for judicial dissolution of 1545 LLC.     

Under §5601(a) of the Civil Practice Law and Rules, the dissent by two justices of the Appellate Division may permit Crown Royal to appeal as of right to New York's highest court, known as the Court of Appeals, at least with respect to the issue of its entitlement to a hearing.  We'll just have to wait and see whether Crown Royal exercises its appellate rights or, perhaps, reaches some buy-out agreement or other accommodation  with its business partner.

Addendum:    Read here Professor Larry Ribstein's commentary on the Ocean 1545 case, from which I here quote his concluding paragraph emphasizing the importance of careful drafting of the LLC agreement: 

In short, it seems that NY is joining Delaware in emphasizing the role of the operating agreement in judicial dissolution cases. As noted above, this could emerge as an important distinction between LLCs and close corporations, and therefore a factor in choice of form. It also places new emphasis on the need for care in drafting the operating agreement. However, New York has not yet explicitly embraced the operating agreement as determinative. We will have to await further developments to see if New York can shed its long legacy of close corporation law in LLC dissolution cases.

The estate's administrator commenced a turnover proceeding in Surrogate's Court pursuant to Section 2103 of the Surrogate's Court Practice Act and Section 1104-a of the Business Corporation Law, to compel the surviving shareholders of Tepper & Associates to turn over to the estate the decedent's interest therein.  The administrator's petition alleged that the surviving shareholders had engaged in "oppressive actions" toward the estate under BCL 1104-a(a)(1) and had looted, wasted and diverted the corporation's property for non-corporate purposes under BCL 1104-a(a)(2).

The administrator thereafter moved for summary judgment of liability, and the respondents cross moved to dismiss the petition.  After discussing the applicable legal principals, Justice Scarpino granted the administrator's motion under BCL 1104-a(a)(2) on the basis of the undisputed evidence that the surviving shareholders had misappropriated Tepper & Associates' assets for their own private purposes in forming and operating Tepper Tax.  Justice Scarpino found that the surviving shareholders' defenses, based in part on allegations that prior to his death the decedent orally disavowed any expectation of a death benefit to any shareholder, were either unsupported by competent affidavit or barred by the Dead Man's Statute (CPLR 4519).

The court subsequently appointed a Judicial Hearing Officer to hear and determine the appropriate remedy and to value the decedent's 35% stock interest.  The JHO held a two-day trial at which each side presented the expert testimony of an appraiser.  The JHO's September 2007 post-trial decision notes that, prior to trial, the parties stipulated that both appraisers were qualified as experts, but that had the qualifications of respondents' expert been challenged, it is "doubtful" that he would have been found qualified.  In any event, the JHO for the most part accepted the administrator's expert's valuation using a 1.2 multiple of Tepper & Associates' 2003 gross revenues which, after various adjustments, resulted in a value of the estate's 35% interest of about $260,000.  In rejecting the respondents' appraiser's zero valuation of the stock interest, he specifically challenged the appraiser's contention that the firm had no good will value, observing that

the fact that the remaining partners after dissolving its firm to exclude one partner but immediately reconstitute themselves as a new firm using the same name, address, facilities and client list as the dissolved firm, indicates that the dissolved firm had good will to distribute.

The JHO subsequently entered a Decree awarding the estate $260,000 payable by the three surviving shareholders in proportion to their stock interests, plus statutory interest from December 31, 2003.  The Decree also awarded judgment for the entire amount against Tepper Tax jointly and severally.

On appeal by the respondents, the Second Department upheld the Surrogate's Court's rulings across the board.  Here's what the court said on the issue of liability under BCL 1104-a:

As corporate officers, the surviving shareholders stood in a fiduciary relationship to their corporation and were not allowed to divert and exploit for their own benefit any opportunity that should be deemed an asset of the corporation.  Their establishment of a new corporation with two of the same principals, which used the same office, equipment, and furniture, and which served many of the same clients, violated that duty.  In opposition, the appellant [Gerald Tepper], who was a surviving shareholder and a full-time employee in the new corporation, failed to raise a triable issue of fact sufficient to defeat summary judgment on the issue of his liability.  Specifically, he failed to adduce any evidence in support of his contention that the administrator had steered the decedent's clients away from the corporation in an attempt to force a judicial dissolution.  [Citations omitted.]

The Second Department with equal force rejected the respondents' challenge to the valuation award, writing as follows:

Contrary to the appellant's contention, the judicial hearing officer was directed to "hear and determine" all issues concerning the "judicial dissolution" of the corporation and, thus, possessed the same powers as the Surrogate's Court to conduct a nonjury trial on the issue of damages and to render a final decree.  In reviewing that determination, "this Court's authority is as broad as that of the trial court, and this Court may render a judgment it finds warranted by the facts, taking into account in a close case the fact that the trial judge had the advantage of seeing the witnesses".   Here, the judicial hearing officer properly credited the testimony of the administrator's expert witness regarding the value of the decedent's share of the value of the corporation, including the value of goodwill, and properly rejected the testimony of the expert testifying for the surviving shareholders.  As the Surrogate's order properly granted summary judgment on the issue of liability upon the establishment of grounds for the dissolution of the corporation pursuant to Business Corporation Law § 1104-a(a)(2), the court was authorized, in its discretion, to provide for the distribution of the decedent's interest in the corporation to the estate pursuant to Business Corporation Law § 1111(c). The court providently exercised its discretion in fashioning a remedy, and we see no reason to disturb it.  [Citations omitted.]

Interestingly, the Decree did not actually order the dissolution of Tepper & Associates which, as of this writing, remains listed as an active corporation on the Department of State's online database listing.  From that standpoint, and given that the surviving shareholders never elected to purchase the decedent's shares as permitted by BCL Section 1118, the award seems to be in the nature of a compelled buyout even though the Decree also omits any directive requiring the transfer of the estate's shares upon payment.

     WHEREAS, the Principal is the true owner of fifty (50%) percent of the common stock of ANO, Inc., a New York corporation (the "Corporation");

     WHEREAS, the Nominee shall act as nominee for the Principal in connection with said Corporation and in connection with the Stock Acquisition Agreement by and between ANO and Candlewood Holdings, Inc.("Candlewood"), dated as of July 1, 1999 (the "Stock Acquisition Agreement".

The Nominee Agreement contains provisions authorizing the Nominee to take all actions required to purchase the Candlewood interest; requiring the Nominee to provide the Principal with all documents concerning ANO; prohibiting the Nominee from taking any action with regard to the Principal's interest in ANO without the Principal's express instructions; and appointing the Principal the Nominee's attorney-in-fact with the power to execute all agreements, instruments, etc. required to be signed by the Nominee.

In 2005, Yemini sued Goldberg for the latter's alleged failure to make certain capital contributions for a separate business venture.  Apparently, by this time Yemini refused to acknowledge Goldberg as owning any interest in ANO, prompting a countersuit by Goldberg and an application by him for preliminary injunction with regard to a meeting of the shareholders of Candlewood.

The matter proceeded to an 11-day evidentiary hearing before Nassau County Commercial Division Justice Leonard B. Austin (recently elevated to Associate Justice of the Second Department), who denied Goldberg's injunction motion in a decision reported at 15 Misc 3d 1142(A), 2007 NY Slip Op 51117(U) (Sup Ct Nassau County 2007).

Justice Austin found that, other than the Nominee Agreement and ANO's name, there were "no indicia of ownership of ANO or any interest therein" by Goldberg.  In addition to the stock certificate and resolutions mentioned above, Justice Austin pointed to a Candlewood shareholders agreement and employment agreement that identified Yemini as sole shareholder, both of which agreements Goldberg knew about when they were executed in July 1999, and to ANO's tax returns which, with Goldberg's knowledge, also identified Yemini as sole shareholder.  Justice Austin further noted that, until the litigation, Goldberg never asserted rights as a shareholder of ANO or demanded a turnover of the ANO stock.

Justice Austin also held that Goldberg was unlikely to succeed on the merits because he lacked "clean hands" and was estopped from taking inconsistent positions.  This arose primarily from Goldberg's involvement in legal proceedings with his ex-wife in 2002, in which he filed a net worth affidavit that omitted mention of ANO as an asset.  "A party, such as Goldberg", Justice Austin wrote,

who has hidden an interest in ANO from his wife in a matrimonial action, has failed to disclose this interest to a lender and repeatedly failed to disclose the interest in ANO to the tax authorities, has unclean hands and cannot obtain relief.

Not so fast, says the Second Department in a decision on Goldberg's appeal ordering that he be granted a preliminary injunction based on the Nominee Agreement.  Yemini v. Goldberg, 60 AD3d 935, 2009 NY Slip Op 02353 (2d Dept 2009).  Here's the key passage from the appellate decision:

Parties are free to make their own arrangements regarding beneficial ownership of securities as definitive between them (see UCC § 8-207[a], Official Comment 3; Delaware v New York, 507 US 490, 505).  This nominee agreement "constituted a declaration of trust" (Brotman v Meyers, 41 AD2d 547, 547).  It is irrelevant that Yemini at all times retained ownership of the ANO stock certificates (see Matter of Benincasa v Garrubbo, 141 AD2d 636, 638).

The appellate decision does not comment on the issue of unclean hands relating to Goldberg's non-disclosure of his ANO stock interest in his matrimonial case.  It does state, however, that judicial estoppel does not apply because there is no evidence that Goldberg "secured a judgment in his favor in the proceeding in which he allegedly took an inconsistent position".

The lower court and appellate decisions do not relate Goldberg's reasons for wanting the Nominee Agreement, or refer to any testimony from Yemini explaining his reasons for executing it.  In my experience, such arrangements usually are driven by tax considerations.  In other cases courts have refused to uphold undocumented stock ownership claims in the face of contradictory tax or other official filings.  This case is different because the lawyer-prepared Nominee Agreement contains the adverse shareholder's explicit, signed recognition of the disputed stock interest.

Manitaras promptly filed a lawsuit seeking a declaration that, under their operating agreement, the consent of all members was required for the sale of Kisco's sole asset.  The majority members contended that the sale was authorized by majority consent under LLC Law Section 402(d)(2) which states that,

Except as provided in the operating agreement . . . the vote of at least a majority in interest of the members entitled to vote thereon shall be required to . . . approve the sale, exchange lease mortgage, pledge or other transfer of all or substantially all of the assets of the limited liability company.

It's not possible in this short treatment to capture the full scope and nuances of Manitara's argument based on the various provisions of Kisco's operating agreement, which is why I've provided links to the appellate briefs (see below).  The gist of it seems to be:

1. The members have only those powers expressly given them by the operating agreement.
2. The operating agreement does not expressly give the members the right to sell Kisco's sole asset, or to authorize the managing members to do the same.
3. The operating agreement limits the managing members' actions to those in the ordinary course of business for the purpose of owning and operating the property.
4. The operating agreement expressly mandates dissolution upon the sale of Kisco's sole asset.
5. The operating agreement expressly requires the consent of all members for dissolution.

In the lower court the two sides moved for summary judgment which was granted in favor of the majority members by Westchester County Commercial Division Justice Kenneth R. Rudolph.  Justice Rudolph's decision dated November 26, 2007, agreed with the majority that its consent to the sale was effective under § 402(d)(2); that the managing members' acceptance of the purchase offer as authorized by the majority was an "appropriate act in furtherance of the LLC's purpose;" and that the "operating agreement does not mandate that the managing members' actions be measured by a majority of the membership interest held by the managing members."

Manitaras appealed.  The Second Department's short, unsigned decision does not delve into the many issues raised by the appeal.  In pertinent part, it notes that under the operating agreement,

[Kisco's] management is vested in its managing members; only they may bind the company.  However, the defendants demonstrated that the operating agreement of Kisco Radio is silent on the issue of the sale of the company's sole asset.  Therefore, the default provisions of the Limited Liability Company Law apply (see Overhoff v Scarp, Inc., 12 Misc 3d 350, 359; Matter of Spires v Lighthouse Solutions, LLC, 4 Misc 3d 428, 435; Rich, Practice Commentaries, McKinney's Cons Laws of NY, Book 32A, 1[A], at 176).  In relevant part, Limited Liability Company Law § 402(d)(2) provides that the vote of at least the majority in interest of the members entitled to vote is required to approve the sale of all the assets of a limited liability company. That requirement was met here.

The Overhoff decision cited in the above passage is an interesting one.  The court there held that the default rule in LLC Law § 407(a), authorizing member action without a meeting by written consent of the minimum percentage of members required to take such action at a meeting, was not trumped by the operating agreement's 100% quorum requirement for member meetings.  The Overhoff court refused, however, to enforce majority written consents as to certain actions, including the sale of company assets, as to which the operating agreement expressly required unanimous member approval.

The latter point parallels the opposing contentions in Manitaras.  The majority contended that the operating agreement was silent on the issue of an asset sale thereby defaulting to § 402(d)(2), whereas Manitaras relied on a pastiche of provisions, setting forth general limitations on the powers of the members and managers, to fill the silence and thereby avoid the default rule.  In siding with the majority, the Second Department seems to be saying that if a minority member wants to vary the default rule favoring the majority, it must obtain such protection in the operating agreement unequivocally with specific reference to the type of transaction at issue.

Another possible lesson concerns the effect of omnibus purpose clauses in operating agreements.  Kisco's operating agreement defined Kisco's purpose as "to own and operate the Property and to engage in any lawful act or activity for which limited liability companies may be formed under the Act, and to engage in any and all activities necessary, advisable or incidental thereto."  Manitaras relied on the first clause ("to own and operate the Property") as a limitation on the powers of the members and managers to sell the LLC's realty, whereas the majority emphasized the omnibus purpose language that follows.  Justice Rudolph's decision specifically noted that the managing members' acceptance of the purchase offer was an "appropriate act in furtherance of the LLC's purpose," which presumably is a reference to the omnibus purpose language.  In this respect Manitaras is of a kind with the Delaware Chancery Court's Seneca decision about which I wrote last October (see here) in which the court rejected a minority LLC member's dissolution petition -- the company had ceased business operations and merely held investment securities -- largely based upon the LLC's omnibus purpose clause.

Two final observations:  First, in his reply brief Manitaras argues that the operating agreement's standard merger or integration clause preempts application of the LLC Law's default rules.  The Second Department's decision does not comment on the argument, but this raises an interesting theoretical question, whether a provision in an operating agreement expressly barring application of some or all of the LLC's default rules would be enforceable even if the operating agreement otherwise is silent on the issue in dispute.   Second, the dispute in Manitaras would not have arisen prior to 1999, when the legislature amended § 402(d) by lowering from two-thirds to a bare majority the member voting requirement for dissolution, sale of assets and merger.  

I am grateful to the attorneys in the Manitaras case, Leonard Benowich and Martin J. King, for sharing copies of their appellate briefs.  To read them, click on the below links.

Appellant's Brief

Respondents' Brief

Appellant's Reply Brief

The biggest, open controversy concerning DLOM concerns whether it should be applied to the entire enterprise value or only to the company's intangible assets, i.e., goodwill.  The answer may depend on which court you're in.

In the Second Department (which covers all of downstate New York including Long Island and the lower Hudson Valley but excluding Manhattan and the Bronx), the prevailing rule appears in two appellate decisions from the mid 1990's holding that DLOM applies only to goodwill.  In the first case, Matter of Whalen, 204 AD2d 468 (2d Dept 1994), which decided several issues in advance of the valuation hearing, the court declared without further elaboration that "the discount [for lack of marketability] should only be applied to the portion of the value attributable to goodwill", citing the Blake case.  A year later, in Matter of Cinque, 212 AD2d 608 (2d Dept 1995), the court affirmed a lower court decision insofar as it refused to apply DLOM in valuing the shares of a real estate holding company, stating:

Such a discount should only be applied to the portion of the value of the corporation that is attributable to goodwill. Here, the value of the corporation is attributable solely to real property and cash.

Later that same year, the Whalen case was back before the Second Department on a post-valuation appeal (234 AD2d 552) in which it found improper the lower court's application of a 20% DLOM where "the operating value of the corporation is attributable solely to tangible assets."

Precedent in the First Department, which covers Manhattan and the Bronx, points in the opposite direction.  In Hall v. King, 177 Misc.2d 126 (Sup Ct NY Co 1998), aff'd, 265 AD2d 244 (1st Dept 1999), the trial court confirmed a referee's report valuing shares of a closely held corporation dealing in high quality reproduction antique furniture and accessories.  The referee used a net asset approach but also added a goodwill value by computing the amount of business a buyer could expect to retain after purchase of the corporation in the absence of a non-compete clause.  The referee then applied a 25% DLOM to the sum derived by adding goodwill to the adjusted net asset value. 

In an extended discussion the trial judge in Hall explicitly disagrees with the Second Department's Whalen and Cinque decisions.  He criticizes those decisions' reliance on Blake in which, he says:

It just so happens that the calculation in that case applied this discount only to goodwill. There was no discussion of this limitation in the application of the lack of marketability discount anywhere else in the opinion. Indeed, in one of the authorities Blake cited in approving use of such a discount, Lyons and Whitman, Valuing Closely Held Corporations and Publicly Traded Securities with Limited Marketability: Approaches to Allowable Discounts from Gross Values (33 Bus Law 2213), there is not the slightest hint that the discount is restricted to goodwill.

Hall then takes aim at the analytical foundation for the Second Department's rulings, stating:

The conceivable basis for the restriction, though not discussed in Whalen or Cinque, is that the tangible assets of the corporation are readily saleable but not so its goodwill or other intangibles. Not only does such an explanation fly in the face of controlling language in opinions of the Court of Appeals, it rests on a faulty foundation. Goodwill is certainly a vendable asset.  Indeed, goodwill is subject to the same fluctuations in value as are tangible assets. Thus, the line of Second Department cases limiting the unmarketability discount appears to lack any valid theoretical underpinning.  [Citations omitted.]

 

The Hall decision was appealed to the Appellate Division, First Department, which affirmed the lower court's valuation determination in a short memorandum decision finding "appropriate" the "application of a 25% lack of marketability discount to all of the corporate assets in light of the absence of a noncompete clause between the parties." 

However economical its language, the First Department's affirmance in Hall clearly signals a parting of the ways with its sister court's Whalen and Cinque decisions.  I was hoping in the years following Hall that the Second Department would revisit the issue in another Section 1118 valuation case, particularly after the trial judge in Hall, Stephen Crane, joined the Second Department where he sat as an appellate judge from 2001 through 2007.  Not only has my wish not been granted, but in a matrimonial equitable distribution case decided in 2001 called Cohen v. Cohen (279 AD2d 599), the Second Department repeated that DLOM "should only be applied to the portion of the value of the corporation that is attributable to goodwill".  You can probably guess which cases the Cohen opinion cites:  Blake, Whalen and Cinque.  Take that, First Department!

With locked horns in the two downstate appellate departments, and no decisions on the subject from the two upstate appellate departments, it'll likely take some yet-to-be-born big-money valuation case to wend its way up to New York's highest court, the Court of Appeals, before we get a definitive answer.