Court Addresses Necessary Party, Res Judicata Issues in Shareholder Oppression Case Pitting Uncle Against Nephews
It's a Vlasic classic story of a second-generation family business dispute. Over four decades ago, the three Adelstein brothers started a pickle distribution business in Brooklyn. The brothers jointly made all business decisions including salary, hiring and firing of employees. In 1995, brothers Sydney and Jack brought their sons Steven and Larry, respectively, into the business.
In 2006, the business was incorporated as Finest Food Distributing Co. Sydney and Jack transferred their one-third stakes to their sons, leaving brother Joel co-owning the business with his two nephews. In 2007, Joel was sidelined by health problems leaving his nephews in charge of all operations. According to Joel, when he later returned to work, and after he turned down the nephews' buyout offer, they initiated a squeeze-out by excluding him from company decision-making and withholding distributions.
In February 2009, the nephews terminated Joel's employment prompting Joel to file a lawsuit against them for breach of contract, breach of fiduciary duty and unjust enrichment. In January 2010, Nassau County Commercial Division Justice Timothy S. Driscoll granted the nephews' motion to dismiss the complaint, holding that Joel's employment was terminable at will, that they owed him no fiduciary duty as an employee, and that his remaining claims of malfeasance must be brought derivatively on the corporation's behalf. Adelstein v. Finest Food Distributing Co. N.Y. Inc., 2010 NY Slip Op 30149(U) (Sup Ct Nassau County Jan. 13, 2010).
Two months later, Joel commenced a dissolution proceeding in Queens County under Section 1104-a of the Business Corporation Law alleging minority shareholder oppression. The nephews made a two-part motion to dismiss the petition on the grounds, first, that the nephews were "necessary parties" whom the petition failed to name as respondents and, second, that the dismissal of Joel's prior action barred the dissolution proceeding under principles of res judicata (claim preclusion) and collateral estoppel (issue preclusion).
The decision by Queens County Commercial Division Justice Orin R. Kitzes in Matter of Adelstein (Finest Food Distributing Co. N.Y. Inc.), 2010 NY Slip Op 31719(U) (Sup Ct Queens County June 15, 2010), rejected both of the nephews' contentions and ordered a hearing to resolve the disputed factual issues as to whether the nephews "have been guilty of oppressive action or whether the assets of the corporations are being wasted, looted or diverted."
Necessary Party
The necessary-party issue was easily resolved as a matter of law. BCL Article 11 contains no express requirement that the petition name as a respondent each of the corporation's shareholders. The statutory notice provisions are contained in BCL Section 1106, subsection (a) of which states that upon presentation of the petition, "the court shall make an order requiring the corporation and all persons interested in the corporation to show cause" why the corporation should not be dissolved. Section 1106(c) merely requires initial service of the papers "upon the state tax commission and the corporation and upon each person named in the petition." Justice Kitzes' decision also cites Matter of Finando, 226 AD2d 634 (2d Dept 1996), in which the appellate court rejected the argument made by an out-of-state shareholder that, because the petition did not name her as a respondent, the court lacked jurisdiction over a necessary party.
I have seen many petitions that name the other shareholders as respondents, and many that do not. At least in the case of a deadlock dissolution petition brought by a 50% shareholder under BCL Section 1104, it's my view that the better practice is to name the other 50% shareholder as a respondent, if nothing else, to deflect respondent's possible use of the corporation's funds for legal defense costs. The circumstances under which it may make more or less sense to name and serve other shareholders as respondents in shareholder oppression cases are too varied to generalize.
Res Judicata/Collateral Estoppel
The second prong of the nephews' dismissal application required the court to determine the extent to which, if any, Joel's dissolution petition improperly sought to relitigate claims and/or factual issues deemed determined or actually decided in the prior, dismissed lawsuit. This, in turn, required Justice Kitzes to examine the interplay between minority shareholder oppression and the at-will employment doctrine involved in the prior lawsuit.
The issue has generated a fair amount of case law over the years, starting most prominently with Ingle v. Glamore Motor Sales, Inc., 73 NY2d 183 (1989), where the court indicated that a minority shareholder, whose at-will status negated any claim for fiduciary breach arising from termination of employment, nonetheless could seek recourse for oppression under BCL Section 1104-a. (Read here my prior post discussing Ingle.) A more recent example, to the same effect, is Ambar v. Devington Technologies, Ltd., 2009 NY Slip Op 32373(U) (Sup Ct NY County Oct. 13, 2009), where the court refused to dismiss a petition for involuntary corporate dissolution brought by a minority shareholder whose employment was terminated by the controlling shareholders, notwithstanding at-will employment provisions in their shareholders' agreement. (Read here my post on Ambar.)
Justice Kitzes' ruling in Finest cites no case law but reflects the same underlying principle in rejecting the nephews' argument for dismissal of their uncle's petition based on the dismissal of his prior Nassau County action. Here's what he wrote:
The acts underlying the breach claims and the alleged oppressive acts that form the dissolution claim are substantially similar. However, the analysis of these acts is substantially different in an action regarding an employee’s claims and one regarding a shareholder. An employee’s rights and obligations toward his or her employer are substantially different than those a shareholder has toward a corporation in which ownership interests exist. This results in the law treating their relationships very differently in every issue that arises in their respective relationships. Accordingly, the Nassau Action which dealt with petitioner’s rights as an employee in no way decided the instant cause of action which involves petitioner’s rights as a one third owner of the corporation.
It's not unusual, when respondents move to dismiss an oppression petition, also to ask the court to extend the 90-day statutory window to elect to purchase the petitioner's shares for fair value under BCL Section 1118. In Finest, the nephews requested an additional 60 days from the date of the court's decision. Justice Kitzes granted the request but only for 30 days in accordance with the parties' stipulation made in advance of the decision.
Interview with Law Professor Douglas Moll, Leading Authority on Shareholder Oppression
Douglas K. Moll is Professor of Law at the University of Houston Law Center, where he teaches corporate and commercial law, and is one of the nation's leading authorities on shareholder oppression in the closely held business entity. His scholarly writings on the subject have been cited in numerous cases including, in New York, Horning v. Horning Construction LLC, 12 Misc 3d 402 (Sup Ct Monroe County 2006), in which the court relied on Professor Moll's analysis of the impact of the 1999 amendments to the LLC Law on relations between minority and majority members of LLCs.
I've had an occasional correspondence with Professor Moll for a number of years, so when I heard that he and co-author Robert Ragazzo had published a new treatise called The Law of Closely Held Corporations (Aspen Publishing 2009), I figured it would be a great opportunity to pose some questions about his views on shareholder oppression and about his new book. I think you'll find his answers interesting.
Mahler: Professor, how did you get interested in problems of the close corporation and shareholder oppression?
Moll: I practiced at Fulbright & Jaworski in Houston before becoming a law professor. While I was at Fulbright, I worked on several close corporation disputes, including the appeal of a shareholder oppression judgment. I read the briefs and the allegations of “shareholder oppression” and I couldn’t understand the operation of such a doctrine. What happened to the business judgment rule? What happened to employment at will? The area fascinated me and I read every court decision and secondary source that I could get my hands on. That has basically continued for the past fifteen years. I have now written multiple articles on the closely held corporation and the shareholder oppression doctrine; a casebook on closely held businesses, including close corporations; a second casebook on business organizations generally; and a just-published treatise on the law of closely held corporations.
Mahler: Some argue that courts shouldn't give minority shareholders protection they didn't see fit to bargain for when they became shareholders. Your reaction?
Moll: Well, first of all, there are a host of minority shareholders who have no opportunity to bargain before they become shareholders (e.g., shareholders who receive their stock via gift, inheritance, or in a divorce settlement). So denying these shareholders protection for their lack of bargaining doesn’t make sense to me. Second, there are many impediments to effective contracting that make such a position untenable in my mind. A few examples: (1) Because close corporation owners are frequently linked by family or other personal relationships, there is often an initial atmosphere of mutual trust that diminishes the sense that contractual protection is needed. (2) Even if an investor did recognize that planning for dissension was useful, barriers to effective contracting would still exist. In light of the countless ways in which oppressive conduct can occur, it is quite difficult to foresee all (if not most) of the situations that may require contractual protection. This inability to appreciate the universe of potential problems may result in incomplete contracting or, possibly, in no contracting at all. (3) Ex ante contracting is expensive, as it often requires the assistance of an attorney. In fact, effective ex ante contracting may require the services of multiple attorneys -- one (or more) representing the majority's interests, and one (or more) representing the minority's interests. This level of expense may be prohibitive for many small businesses, especially at their inception. I discuss these and other arguments in the treatise referenced above, as well as in an article that I wrote in the Wake Forest Law Review.
Mahler: In Delaware, unless the corporation elects to file as a statutory close corporation, there seems to be little or no remedy for the oppressed minority shareholder. Do you think it's a case of neglect or deliberate policy choice by the Delaware legislature, and do you see it ever changing?
Moll: Even if one elects to file as a statutory close corporation, what is the ex post judicial remedy? There isn’t one. Subchapter XIV of the Delaware General Corporation Law allows parties to contract for protection in advance, but if the parties do not, there is no provision providing for court-ordered dissolution for example. I do think this is a deliberate policy choice by the Delaware legislature, but I don’t think it is due to a hostility toward minority shareholders. I believe the Delaware legislature simply believes that their existing fiduciary duty doctrines and other provisions allowing for contractual protections are sufficient. In a sense, they are right. For example, many oppression lawsuits involve disguised dividend payments to the controlling shareholder or other violations of traditional shareholder rights. Those claims, in my view, are all actionable under Delaware law. They won’t be called “oppression” claims, but they will work as fiduciary duty, illegal dividend, conversion, or similar claims. What may be different about Delaware law is that they do not seem to offer protection to “non-traditional” shareholder rights – such as a right to employment or an active management role in a close corporation – absent a contractual right providing for such. In other states with oppression doctrines, those non-traditional shareholder rights can be protected even in the absence of a contract. It is also not clear whether Delaware would allow for a buyout as a remedy. It is hard to know if this will ever change. It would be interesting to see what Delaware would do with a classic freeze-out dispute in a close corporation, a la Wilkes v. Springside Nursing Home out of Massachusetts. A case like that would really test whether Delaware is serious about not providing special common-law protections for close corporation shareholders.
Mahler: Over the last decade LLCs have become the preferred form of new business entity filings in most states. Are minority members of LLC any more or less prone to majority abuse than minority shareholders of close corporations, and does LLC legislation adequately deal with the issue?
Moll: In my opinion, minority members of LLCs are just as prone to majority abuse as their close corporation brethren. The lack of a market exit and the same principles of majority rule set the stage for possible abuse. Several states provide a dissolution-for-oppression statute in the LLC setting, but such statutes are not as prevalent as they are in the corporation context. Some argue that LLC owners will be more likely to contract for protection because LLC statutes contain far fewer default rules than comparable corporate statutes. The fact that owners may need to contract for governance rules, however, does not mean that they will also contract for protections from abusive majority conduct – a problem that they may not even foresee. I have written somewhat extensively on this LLC and oppression issue in a 2005 Wake Forest Law Review article.
Mahler: You also published an article in the Duke Law Journal weighing the arguments for and against marketability and minority discounts in fair value proceedings tiriggered by oppression lawsuits. Where do you come out on the question?
Moll: This is a hard one to answer succinctly. (In fact, it took me on the order of 80-90 pages in the Duke article that you mention). I’ll just jump to the conclusion: I do not believe that discounts are appropriate in an oppression buyout. Discounts are discussed in great detail in the treatise referred to above as well as in the Duke Law Journal article that you mention.
Mahler: You and your co-author, Robert Ragazzo, have just completed a new treatise called The Law of Closely Held Corporations. Why did you write it, and who did you write it for?
Moll: We wrote the treatise because we have been researching, writing, and teaching about close corporations for years, and we have both served frequently as consulting and testifying experts in close corporation disputes (and disputes involving business organizations generally). Although there are some helpful resources out there, we found that a number of recurring and difficult issues are not adequately addressed by existing treatises, and some of those publications have become dated. We decided, therefore, to write a comprehensive and up-to-date treatise for practicing lawyers that would deal with the recurring problems that arise in close corporations and, more importantly, would provide answers and guidance for many of those problems. Plus, we thought it would be fun. After all, what could be more fun than spending two years writing a treatise? Hmmm.
Mahler: Lawyers who form private entities involving multiple owners don't always appreciate the problems that can occur down the road. How does your book help them?
Moll: I am obviously biased, but I believe that the treatise covers all of the major litigation and transactional issues related to the closely held corporation. The treatise discusses the common (and not-so-common) problems that can and often do occur down the road. Perhaps more importantly, the treatise discusses ways to avoid or mitigate those problems. Different jurisdictional approaches to major issues are covered (some in 50-state chart form), and a set of forms is also provided. We attempted to make the materials comprehensive and up-to-date, and it is our hope that practicing lawyers will find them to be useful.
Mahler: Does the book have a section on oppression and other bases for dissolution?
Moll: Yes. One of the largest chapters in the treatise is on oppression. There is another chapter on remedies for oppression and other forms of dissension. There is also a section on deadlock.
Mahler: How about variations in state laws governing closely held business entities -- does your book address them?
Moll: It does. As I mentioned above, we have several 50-state charts on some major issues. Even where there is not a chart, our goal was to provide authority for all of the major jurisdictional approaches to a problem or issue. To this end, the footnotes are extensive and there are references to multiple jurisdictions. The treatise, simply put, is intended to be national in scope.
Mahler: Thanks for taking the time Professor, and I look forward to reading the treatise.
Professor Moll's articles on shareholder oppression are available on the Social Science Research Network (click here for his author page). Click here for more information about the new treatise.
Fired Minority Shareholder's Oppression Claim Not Barred by At-Will Employment Provisions in Shareholders' Agreement
Some months ago, in a post about the intersection of the at-will employment doctrine and fiduciary duty among shareholders in close corporations, I wrote:
The most common allegation of oppression by minority shareholders involves termination of employment by the controlling shareholders. The Court of Appeals in Matter of Kemp & Beatley noted that obtaining employment is often the main reason for becoming a shareholder in a closely held company that typically pays no shareholder dividends. As I've pointed out before, case law holds that the majority's termination of the minority's at-will employment does not give rise to a wrongful termination remedy under either a contract or tort theory, but it may be oppressive for purposes of seeking judicial dissolution where the shareholder joined the venture with the reasonable expectation of getting and keeping a job.
This principle is vividly on display in a recently decided case called Ambar v. Devington Technologies, Ltd., 2009 NY Slip Op 32373(U) (Sup Ct NY County Oct. 13, 2009), where the court refused to dismiss a petition for involuntary corporate dissolution brought by a minority shareholder whose employment was terminated by the controlling shareholders, notwithstanding at-will employment provisions in their shareholders' agreement.
Devington Technologies Ltd. is a closely held New York corporation in the business of providing financial management computer software and programming to offices of medical providers. In 2002, founder Paul Ambar as 30% shareholder and Gershon and Tibor Klein, as combined 70% shareholders, executed a shareholders' agreement containing fairly typical provisions for election of the shareholders as directors and officers, spending authorization limits, and a right of first refusal ("RFR") fixing stock value at $8,335 per share unless otherwise agreed unanimously.
After five years, due to their dissatisfaction with his job performance, the Kleins attempted to buy out Ambar. They proffered an amendment to the shareholders' agreement reducing the board to two directors and replacing the existing RFR with a provision requiring Ambar to sell his 12 shares to the Kleins for a small fraction of the RFR share value. After Ambar refused to sign the amendment, the Kleins scheduled a special meeting of the stockholders and directors at which Gershon was elected president, Tibor was elected secretary, and Ambar was removed from Devington's board of directors and his employment terminated.
Ambar then filed a petition to dissolve Devington under Section 1104-a of the Business Corporation Law, primarily alleging oppressive conduct based on the Kleins' termination of his employment and their refusal to redeem his shares under the RFR at $8,335 per share. The Kleins opposed dissolution and moved to dismiss the petition, arguing that Ambar had no reasonable expectation of continued employment and a board position due to his at-will status under the terms of the shareholders' agreement. The Kleins also contended they were justified in firing Ambar for poor job performance and for causing Devington to incur major business losses.
The court's decision, by New York County Supreme Court Justice Marilyn Shafer, framed the issue as follows:
In opposition to the dismissal motion, Ambar details a different set of facts as to how and why Devington declined . . .. However, for purpose of the motions, it is not necessary for the court to evaluate or decide who or what triggered the corporate failures. It is sufficient to say that petitioner and respondents present diverse interpretations as to the factors that led the business to lose money, and submit dueling affidavits blaming each other for poor business decisions and incompetent day-to-day management. What is relevant to the court at this juncture is whether the petition sufficiently alleges that respondents, as the directors in control of Devington, engaged in conduct toward Ambar which entitles him to seek a judicial dissolution of the corporation.
Majority conduct is oppressive, Justice Shafer observed, when it "substantially defeats the reasonable expectations of minority shareholders," including the expectation to be actively involved in the company's management and operation. "When majority and minority shareholders can no longer work together in their day-to-day decision-making and management, judicial dissolution becomes an option."
Justice Shafer concluded that Ambar's petition (read here), while "not artfully drafted," sufficiently alleged grounds for dissolution based on the Kleins' termination of his employment. In addition, the Kleins' attempt to buy out Ambar's shares "at a severely discounted price ($125.00 rather than $8,335.00 per share) supports his claim of mistreatment by the majority shareholders and states a ground for involuntary judicial dissolution."
Cases like Devington are an important reminder to owners of closely held businesses of the need to include fair and workable shareholder exit mechanisms in the shareholders' agreement. The type of RFR used in Devington rarely succeeds, for at least two reasons. First, in the probable absence of any outside buyers for the minority interest, neither the minority nor majority can compel a buyout at any price. Second, the share price fixed at the outset almost always is doomed to obsolescence, either on the upside or downside. The shareholder agreements' unanimity requirement for any change in the share price effectively deters any later adjustments as the value of the business grows -- in which event the majority will resist adjustment -- or, as in Devington, shrinks -- in which event the minority will resist adjustment.
There are a number of techniques for overcoming the pricing problem, which in turn can ease mutual acceptance of a compulsory buyout trigger. One of the more popular ones is the use either of a single, independent business appraiser whose valuation is binding on the parties, or each side hiring their own appraiser. In the latter design, the agreement usually will provide for averaging the two appraisals if they fall within a specified range of each other or, if not, the appointment by those two of a third, independent appraiser whose valuation will either be determinative alone or is averaged with the first two, or is averaged with the closer of the first two.
None of the buyout mechanisms is perfect, but all are preferable to the uncertainty, expense and angst of dissolution litigation.
Dissolution May Be Sole Remedy When Minority Shareholder's At-Will Employment is Terminated
It's among the most common scenarios seen by business divorce lawyers: A minority shareholder of a non-dividend paying close corporation -- let's call him Joe the Shareholder -- for years has been a full-time employee, officer and director of a company he co-founded. Joe the Shareholder's salary and occasional bonus are the sole source of return on his investment in the company. Without any advance notice, the majority shareholders fire Joe the Shareholder, remove him from the payroll, cut off his access to the company computer and change the office locks. Joe the Shareholder can't believe that, as a company owner, he can be fired and thrown out by his business partners just like that. Joe the Shareholder wants to know what his remedies are and, in particular, whether he can sue for wrongful termination of his employment to recover lost salary and other damages.
Joe the Shareholder has a standard shareholders' agreement that gives a majority of the Board of Directors control of all company business affairs. The shareholders' agreement does not fix any definite term of employment for any of the company's shareholders, and it has no language limiting the Board's authority to terminate an officer or employee with or without cause. Joe the Shareholder has no separate employment agreement with the company.
So what's the answer to Joe the Shareholder's question? In New York, without any agreement for employment of a definite duration, Joe the Shareholder is considered an at-will employee of his own company who can be fired for any or no reason (except for reasons made illegal under federal and state workplace anti-discrimination laws), and therefore he has no claim for wrongful termination of his employment. If Joe the Shareholder has any remedy, he must look to his statutory right to seek judicial dissolution for shareholder oppression under Section 1104-a of the Business Corporation Law.
Employers' common law rights to terminate at-will employees are entrenched in New York case precedent stretching back over 100 years (e.g., Martin v. New York Life Ins. Co., 148 NY 117 [1895]). More recently, in Murphy v. American Home Products Corp., 58 NY2d 293 (1983), New York's Court of Appeals (the state's highest court) held that an employer has no implied obligation of good faith and fair dealing in an employment at will, and it rejected any tort claim for abusive or wrongful discharge of an at-will employee.
Six years after its Murphy decision, the Court of Appeals specifically addressed application of the at-will doctrine in the shareholder context in a case called Ingle v. Glamore Motor Sales, Inc., 73 NY2d 183 (1989). Philip Ingle started with Glamore Motor Sales as a sales manager in 1964, which was then owned 100% by James Glamore. In 1966, Ingle became a 22% shareholder, and later 40%. He paid a total of $75,000 for the shares. In 1982, the corporation issued new shares to Glamore and his two sons, reducing Ingle's holding to 25%. The shareholders' agreement included a stock repurchase provision giving the company the option to redeem the shares of any shareholder who "shall cease to be an employee of the Corporation for any reason". Ingle had no separate employment agreement.
In 1983, at a Board of Directors meeting, the Glamores voted Ingle out of his corporate posts and terminated his employment as operating manager. They immediately gave Ingle notice that the company was exercising its right under the shareholders' agreement to redeem Ingle's shares for $96,000.
Ingle accepted the payment but then sued for damages for breach of fiduciary duty and of contract. As summarized in the court's majority opinion, Ingle argued that
his employment status should not be governed by the employment at-will doctrine but, rather, that as a minority shareholder in a close corporation he should be treated as a co-owner, equivalent to a partner, whose employment rights flow from a special duty of loyalty and good faith. He [also] urges that an implicit covenant of good faith and fair dealing under the shareholders' agreement precluded his termination without cause, despite the express language and nature of the agreement in that regard. He concludes that even if he is an at-will employee, an action properly lies for the respondents' breach of fiduciary duties and for wrongful interference with his employment.
Five of the Court's seven judges rejected Ingle's arguments in favor of applying the at-will rule. Here's what they said:
A minority shareholder in a close corporation, by that status alone, who contractually agrees to the repurchase of his shares upon termination of his employment for any reason, acquires no right from the corporation or majority shareholders against at-will discharge. There is nothing in law, in the agreement, or in the relationship of the parties to warrant such a contradictory and judicial alteration of the employment relationship or the express agreement. It is necessary in this case to appreciate and keep distinct the duty a corporation owes to a minority shareholder as a shareholder from any duty it might owe him as an employee.
The Court then went a step further, by explicitly uncoupling its holding from the repurchase provision in the shareholders' agreement, as follows:
Under the established common-law rule—and without any reference to the shareholders' agreement—the corporation had the right to discharge plaintiff at will (Sabetay v Sterling Drug, 69 NY2d 329, 333; O'Connor v Eastman Kodak Co., 65 NY2d 724, 725; Murphy v American Home Prods. Corp., 58 NY2d 293, 305; Weiner v McGraw-Hill, Inc., 57 NY2d 458, 465-466; Martin v New York Life Ins. Co., 148 NY 117, 121).
The twist in this fact pattern is an asserted liability based on allegations that the corporate officers breached fiduciary duties of good faith and fair dealing arising from the shareholders' agreement and on tortious interference with Ingle's employment. The twist does not support a deviation from the governing principle in this case.
Calling this result "egregiously unfair," the two dissenting judges countered that "the relationship of a minority shareholder to a close corporation, if fairly viewed, cannot possibly be equated with an ordinary hiring and, in the absence of a contract, regarded as nothing more than an employment at will." They also noted that the "singular vulnerability of the minority shareholder in a close corporation" underlies the ""solicitude toward the rights of minority shareholders' shown by our Legislature in enacting Business Corporation Law §§ 1104- a, 1118" (citations omitted).
Which leads to my final point. The majority in Ingle noted that the case did not require it to decide any issue of the legal rights afforded a minority shareholder to seek judicial dissolution under BCL § 1104-a for oppressive conduct by the majority. Indeed, subsequent cases confirm that a minority shareholder's at-will employee status does not bar equitable relief of dissolution under § 1104-a, and that the shareholder's employment may be considered an incident of stock ownership, cloaking him with a reasonable expectation of continued employment. In other words, the majority's frustration of Joe the Shareholder's reasonable expectation of continued employment may not give rise to a claim for lost wages based on wrongful termination of employment, but it does enable him to seek relief by way of a proceeding for judicial dissolution which, in turn, will trigger the majority's statutory right to avoid dissolution by electing to purchase his shares for fair value under BCL § 1118.
