Decision Breaks New Ground in Dispute Over Enforcement of Stock Buyback Triggered by Filing of Dissolution Petition
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Does the mere filing of a petition for corporate dissolution bring about "a succession to a third person by operation of law or court order" or the transfer of the right to "control or vote" the petitioner's shares? The question, upon which turns the non-petitioning shareholders' right to enforce a book-value buyout provision in the shareholders' agreement, lies at the heart of a multi-faceted ruling earlier this month in Matter of Piekos (Home Studios Inc.), 2010 NY Slip Op 51408(U) (Sup Ct Westchester County Aug. 3, 2010).
In his 23-page decision, Westchester Commercial Division Justice Alan D. Scheinkman undertakes a thorough review of the case law before concluding (a) the filing of the dissolution petition triggers the buyout clause, but (b) an evidentiary hearing is required to determine whether the petitioner had a "meaningful choice as to whether to sign the [shareholders'] agreement" and whether it would be "unconscionable" to enforce the buyout against an oppressed minority shareholder.
There are at least two reasons you'll want to read the Piekos decision. First, it collects and dissects the relevant case law to date on this important and recurring issue on which I have written numerous times, including an article in the New York Law Journal which Justice Scheinkman cites (read here) and several posts on this blog (read here, here and here). Second, wholly apart from the legal issues, the decision's detailed recital of the factual background tells a gripping story of broken relationships, bruised egos and sharp tactics amidst a fight for economic primacy and survival among business partners.
The Start-Up
The story begins in 2004, when three experienced location managers formed a company called Home Studios Inc. to develop and manage a studio with home sets for the filming and photographing of commercials. Each contributed $90,000 and became a one-third stockholder. The petitioner, Richard Piekos, served as studio designer. Respondents David Fitzgerald and John Maher handled financial and operational matters, respectively. Justice Scheinkman, before whom all three gave live testimony, describes Maher as "a very assertive, if not arrogant, and controlling individual" who "views his fellow shareholders as less than equal partners." He describes Fitzgerald as "dominated by" and "subservient to" Maher, and Piekos as "less dominated by Maher."
The company incurred modest losses in 2004-05, the beginning of healthy net income in 2006-08, followed by business shrinkage in the 2009 downturn which required it to let its studio manager go before business started picking up again in 2010.
The three partners took compensation beginning in 2006, some of which was reported for tax purposes as W-2 wages and the rest as officer compensation. The company's CPA testified that the allocation was designed to reduce social security taxes and allow the owners to fund an IRA plan.
The 2006 Shareholders' Agreement
Tensions arose in 2006 when the studio turned profitable. Maher, supported by Fitzgerald, complained that he was doing more work than the others and deserved more compensation, and that Piekos was doing too little to merit compensation. At that point the three jointly engaged a lawyer who helped them prepare and execute a shareholders' agreement. The agreement guaranteed that all three would hold positions as directors and officers so long as they were shareholders, and assigned each separate duties as officers. The agreement also included stock transfer restrictions that, upon the happening of certain events, required a shareholder to sell his shares to the corporation or the other shareholders at book value as reflected in the corporation's balance sheet for the preceding fiscal year. The trigger events set forth in Section 2(a) of the agreement included:
(i) an Individual Shareholder desires to sell any of his shares; or
(ii) if the Individual Shareholder is employed by the Corporation and such employment is terminated for any reason and with or without cause; or
(iii) if any event occurs, such as bankruptcy of, or appointment of a committee for, or a divorce by an Individual Shareholder which would bring about a succession to a third person by operation of law or a court order of all or part of the Individual Shareholder's Shares, or the right in anyone other than the Individual Shareholder to control or vote any such Shares.
The Outbreak of Hostilities
Fast forward to April 2010, when the three shareholders met at the office of a different attorney, representing Maher and Fitzgerald only, to discuss a growing internal feud over compensation and workload imbalance. According to Piekos, Maher and Fitzgerald stated that the business was "going in a new direction"; that they didn't "really need" Piekos; and they proposed to pay themselves $8,500 per month which, based on then-current projections, would result in Piekos receiving $20,000 annual compensation compared to $120,000 each for Maher and Fitzgerald. Piekos testified that he was "in shock" and "rendered speechless" by the proposal.
A couple of weeks later, Maher and Fitzgerald noticed a board meeting at their attorney's office for the purpose of determining officer compensation. As Justice Scheinkman put it, "Fitzgerald and Maher, having not heard from Piekos, decided to force his hand by simply using their majority voting power to put their proposal into effect."
In an email to Maher and Fitzgerald on April 25, 2010, Piekos told them, "In this situation, I think the fair thing to do is buy me out at fair market value." At the subsequent board meeting Maher and Fitzgerald offered a $50,000 buyout payable over two years, which they viewed as an "opening bid" in expectation of further negotiations. Piekos rejected the offer. Maher and Fitzgerald proceeded to adopt a resolution, over Pieko's protest that they were "looting" the company of profits, to pay themselves $8,500 per month.
Piekos Sues for Dissolution
In May 2010, Piekos commenced a proceeding under Section 1104-a of the Business Corporation Law for judicial dissolution of Home Studios on the ground of shareholder oppression. Subsequently, Maher sent Piekos a letter purporting to terminate his "employment" at Home Studios for cause.
In opposition to the dissolution petition, Maher and Fitzgerald took the position that Piekos was required to sell back his shares at book value under all three of the trigger events contained in Section 2(a) of the Shareholders' Agreement.
First, they argued that Piekos' April 25 email proposing a buyout at fair market value evidenced his "desire to sell his shares" under Section 2(a)(i). Justice Scheinkman disagreed, reasoning that the word "desire" in context means a voluntary and present offer to sell and not, as proposed by Piekos, a method to resolve the parties' dispute requiring further negotiation and agreement on price and terms.
Second, Maher and Fitzgerald contended that their purported termination of Piekos' "employment" after he filed for dissolution triggered buyout under Section 2(a)(ii). Justice Scheinkman again disagreed, noting that the clause used the conditional "if . . . employed" and concluding that all of Piekos' efforts and compensation on behalf of Home Studios was in his capacity as a corporate officer and not as an employee.
Does Filing Trigger Buyback?
Third -- and here at last we come to the key legal issue -- Maher and Fitzgerald argued that Piekos' filing of a petition for judicial dissolution would cause the issuance of a court order bringing about a succession of his shares to a third person thereby triggering buyback under Section 2(a)(iii). Justice Scheinkman launches his analysis by reviewing the pertinent appellate authorities, beginning with Matter of Pace Photographers, 71 NY2d 737 (1988), where New York's highest court acknowledged in dicta the right of shareholders to provide for a mandatory buyback at a stipulated price upon the filing of a dissolution petition.
He then discusses a quartet of intermediate appellate rulings in dissolution-triggered buyback cases, in three of which (Matter of Doniger, 122 AD2d 873 (2d Dept 1986), Matter of Johnsen, 31 AD3d 172 (1st Dept 2006), and Matter of El-Roh Realty Corp., 48 AD3d 1190 (4th Dept 2008)), the courts enforced buybacks based on provisions for the disposition of shares "in any manner whatsoever" or similar wording, and in one of which (Matter of Stevens, 74 AD3d 1757 (4th Dept 2010)) the court denied enforcement for other reasons peculiar to that case.
Justice Scheinkman's ensuing discussion of the provision in Piekos has two parts. In the first part, he notes that the provision lacks the "in any manner whatsoever" language found dispositive in the appellate precedents. Instead, he focuses on the court's statutory powers under BCL Article 11 to appoint a receiver and otherwise to exercise broad authority over the corporation during dissolution proceedings, and concludes that the filing of the dissolution petition would bring about a transfer of "control" and thereby trigger a buyback under Section 2(a)(iii). Here's what he writes:
Given the broad powers to supplant the authority of the majority interest that come into being with the commencement of a judicial dissolution proceeding, the Court concludes the commencement of a dissolution proceeding is an event which would bring about a succession to a third person or entity by operation of law or court order, if only because it brings about succession of effective control over all of the shareholders to the court. As the Appellate Division, Fourth Department, recognized in El-Roh Realty, the commencement of a dissolution proceeding under Section 1104-a is an involuntary transfer. While it may be true that the court might deny dissolution, as where the grounds for same are not established, it remains that, at least during the pendency of the proceeding, the general authority of shareholders to run their business as they determine is disrupted and ultimate decision-making authority is transferred to the court.
"This, however, does not end the matter," adds Justice Scheinkman as he segues into part two of his analysis. He notes that in Piekos, unlike in Doniger, Johnsen and El-Roh Realty involving deadlock dissolution proceedings between 50-50 shareholders, the respondents have a statutory right to elect to purchase the petitioner's shares for fair value under BCL Section 1118. In non-oppression cases where a shareholders' agreement contains a buyback provision with an agreed-upon valuation methodology, the fact that the price or formula provided is below market value does not vitiate the disappointed shareholder's assent. "On the other hand," Justice Scheinkman continues:
in cases involving oppressive conduct or corporate waste or looting, the majority may be encouraged to continue abusing the minority if the majority realizes the minority must either tolerate that behavior or else be forced to sell to the majority at a heavily discounted price on unfavorable terms (see Mahler and Schoenberg, Outside Counsel: Dissolution Petition Can Unwittingly Trigger Stock Buyback, NYLJ, July 21, 2006 at 4, col 4). Conversely, the minority may be deterred from seeking judicial redress by the prospect that the mere act of seeking relief from a court will mandate that the minority sell out at a heavily discounted price. Forcing a buyout on unfavorable agreement terms is particularly troublesome where the parties' agreement does not in specific words spell out that the buyout will be triggered by the commencement of a Section 1104-a proceeding. Where that result is made clear, the minority knows the consequences of its agreement in advance. Here, while the language employed is sufficient, under the case precedents binding upon this Court, for a buyout to be triggered by the commencement of this proceeding, the minority was not specifically warned, in advance, that this would be the result. (Emphasis added.)
So what's the result in Piekos? An evidentiary hearing is required, Justice Scheinkman concludes, with respect to "the substance of the negotiations that led to the shareholder's agreement". He then elaborates:
Specifically, the Court has not heard whether Piekos had a meaningful choice as to whether to sign the agreement, bearing in mind the business sophistication of the parties, whether the negotiations were arms-length, whether there was a disparity of bargaining power, and whether pressure tactics were used, among other factors. Further, it seems, at least plausible that the agreement may be construed as containing at least an implied agreement by the parties to refrain from oppressive, unjust or unreasonable acts that would deprive a party of the benefits of the bargain struck. It may well be that it is unconscionable to permit the majority to oppress a minority into signing a shareholders' agreement that would trigger a unfavorable buyout, thereafter oppress the minority to such an extent that it is compelled to seek judicial relief, and then assert that the oppressed minority must sell out under unfavorable terms (see Day Op of North Nassau, Inc. v Viola, 16 Misc 3d 1122[A], 2007 WL 2305035 [Sup Ct Nassau County 2007]).
Where it appears from the record before the court that unconscionability may exist, and the issue is not free from doubt, the court must hold a hearing where the parties may present evidence with regard to the circumstances of the signing of the contract, and the disputed terms' setting, purpose and effect (State v Wolowitz, 96 AD2d 47, 68-69 [2d Dept 1983]).
Additionally, the amount of discrepancy between the book value-based price formula and "fair value" as determined by the court would be relevant.
For these reasons, the Court will hold a full hearing on both Petitioner Piekos' petition for dissolution and on the Corporation's counterclaim for enforcement of its right to buyout Piekos under Paragraph 2(a)(iii) of the Shareholder's Agreement.
I see the thrust of Piekos as twofold. First, it continues and arguably broadens the trend seen in Doniger and its progeny toward liberal interpretation of language in the shareholders' agreement sufficient to trigger the buyback. I can imagine another jurist just as easily deciding that the court's power to supersede shareholder control of the corporation's business affairs pending determination of the petition does not constitute a "succession" or a change in the right to control or vote the petitioner's shares.
Pushing in the opposite direction, Piekos also offers minority shareholders seeking dissolution on oppression grounds a new avenue to counteract the majority's effort to enforce a below-market buyout under the shareholders' agreement -- as opposed to electing to purchase for fair value under BCL Section 1118. Indeed, the logic of Piekos could be extended even to a shareholders' agreement that explicitly deems the filing of a dissolution petition to be a voluntary offer to sell. Depending on the spread between the contractual price and fair value, the costs and delay associated with the prospect of having to undergo discovery and an evidentiary hearing on the issues surrounding the formation of the shareholders' agreement, and effectively having to litigate the issue of oppression as a predicate for enforcing the contractual buyout, may be enough to dissuade the majority from even attempting to enforce the contractual buyout.
Appellate Court Rejects Mandatory Stock Buyback Triggered by Dissolution Petition
A decision earlier this month by an upstate appellate court in a corporate dissolution proceeding called Matter of Stevens (Allied Builders, Inc.), 2010 NY Slip Op 05066 (4th Dept June 11, 2010), adds uncertainty to the already fuzzy array of precedents surrounding the question whether the filing of a dissolution petition triggers a mandatory buyback of the petitioner's shares under the provisions of a right of first refusal ("RFR") in the shareholders' agreement.
I'll first set the stage with some basics, then I'll dig into Stevens.
What's an RFR?
RFRs are most familiar in the real estate setting, e.g., a tenant's right to match a third-party purchase offer during the lease term. Less well known is the use of RFRs in the close corporation setting as a stock transfer restriction found in shareholders' agreements. This type of RFR requires each shareholder to sell his or her shares to the corporation and other shareholders before they can be sold to an outside buyer. The shareholder RFR primarily serves as a further deterrent to any sale of non-controlling interests which, for the vast majority of closely held corporations, are non-marketable unless very steeply discounted.
There are infinite variations on how to draft RFR trigger events and pricing mechanisms. A narrow version, analogous to the tenant's right to match a third-party purchase offer, is triggered only by a bona fide third-party offer for the shares, which then must be offered back to the corporation or the other shareholders at the same price and on the same terms. The third-party sale can proceed only if the corporation or the other shareholders turn down the purchase opportunity.
Very frequently, however, a much broader RFR is used, with attributes more akin to a right of first offer, which mandates a stock buyback triggered by any event constituting a voluntary or involuntary transfer of shares. The broad-form RFR more often than not will fix share price at book value or use some other formula or pre-determined price unfavorable to the selling shareholder.
What's the Issue?
When relations among fellow shareholders in close corporations deteriorate beyond repair, a petition for judicial dissolution may be the only effective remedy. The issue is whether the mere filing of a petition for judicial dissolution triggers the RFR.
Courts unquestionably will enforce an RFR triggered by the filing of a dissolution petition where the RFR expressly provides that the filing is deemed an offer to sell. The interpretive problem arises, as it did in the Stevens case, when the RFR contains no express reference to a dissolution petition, but only uses general references to "involuntary transfer" or to a shareholder who seeks to "otherwise dispose" of his or her shares.
What's at Stake?
The consequences of triggering the RFR can be huge and, I daresay, with potential malpractice ramifications for the lawyer who files for dissolution without appreciating or advising his or her client of the risks.
If the RFR does not apply, an oppressed minority shareholder seeking dissolution under Business Corporation Law ("BCL") § 1104-a can anticipate the remaining shareholders electing to purchase the shares for "fair value" under BCL § 1118. If the parties cannot agree on fair value the issue is determined by the court, which will not apply a minority discount. If the RFR does apply, the minority shareholder may decide to forgo dissolution rather than accept a fixed or formula buyout price that is substantially below fair value and may entail a long-term, unsecured payout.
The stakes can be equally high for 50/50 shareholders when one of them seeks dissolution based on deadlock under BCL § 1104 which, unlike its § 1104-a cousin, does not give the other shareholder the right to purchase the petitioner's shares. If the RFR is not triggered, any eventual buyout must be negotiated. If it is triggered, the petitioner loses all negotiating leverage and must accept the RFR price and terms.
Prior Case Law
Prior to Stevens, the arc of appellate precedent is traced by three cases:
- The Brooklyn-based Second Department's 1986 Doniger decision. In Doniger the court held that the dissolution petition triggered an RFR that included "any proposed passage or disposition of shares whatsoever" including "under judicial order [or] legal process." Over the next 20 years, a handful of lower court decisions interpreted Doniger narrowly as requiring an express reference to share disposition by judicial process.
- The Manhattan-based First Department's 2006 Johnsen decision. Johnsen enforced a buyout triggered by a judicial dissolution petition where the RFR applied to any shareholder seeking to "transfer or otherwise dispose of his stock in any manner whatsoever." The court ignored the additional Doniger element of judicial process. (Read here an article I wrote with a colleague for the New York Law Journal analyzing the Johnsen decision.)
- The Rochester-based Fourth Department's 2008 El-Roh decision. El-Roh enforced a buyout triggered by a dissolution petition where the RFR referred to any transfer of shares "including, without limitation, transfers that are voluntary, involuntary, by operation of law or with or without valuable consideration." As in Johnsen, the court put no weight on the absence of express reference to judicial process. Also notable is the El-Roh RFR's omission of the "any disposition whatsoever" language found in Doniger and Johnsen. (Read here my prior posting on the El-Roh decision.)
Whether you agree or disagree with these decisions, their unmistakable thrust is a liberal interpretation of general language in RFR provisions in favor of compelling buyout triggered by the filing of a dissolution petition. Now along comes Stevens with an opposite outcome.
What Happened in Stevens?
Stevens involved a corporate dissolution petition brought in 2008 by a 24.5% shareholder alleging minority shareholder oppression under BCL § 1104-a. The petitioner acquired his shares under a 10-year Option Agreement dated June 25, 1996 (click here to view) at the specified price of $240 per share. Section 7(a) of the Option Agreement contained the following stock transfer restriction:
. . . Purchaser shall not sell, transfer, assign, give, bequeath, hypothecate, pledge, create a security interest in, or lien on, encumber, place in trust (voting or other) or otherwise dispose of all or any portion of the shares of capital stock of the Corporation, or any interest therein, now owned or hereafter acquired, held or controlled by Purchaser, whether voluntarily or through any bankruptcy or other insolvency proceedings, adjudication of insanity, death or otherwise, and intending to apply to intershareholder, causa mortis, and transfers of any and every nature, kind and description [defined as "Transfer of Stock"] unless and until each of the terms and conditions of this Agreement shall have been met. [Emphases added.]
Section 7(c) prohibited Stevens from any Transfer of Stock without first giving the other shareholders 30-days written notice offering to sell the shares to them. Section 7(e) set the price at $240 per share subject to any future change in purchase price (which apparently never happened in the intervening 12 years before the dissolution proceeding).
After Stevens filed for dissolution, the other shareholders sought to dismiss the proceeding and to enforce their alleged Section 7 right to purchase Stevens's shares for $240 per share on the ground that the filing of the petition was a Transfer of Stock as defined in Section 7(a). They also argued that Stevens was required to sell his shares at the same price under Section 8 of the Option Agreement giving them the option to purchase his shares upon the termination of his employment at any time within 10 years from the date of the Option Agreement. Although Stevens's termination occurred more than 10 years after the Option Agreement, the other shareholders contended the term was extended by later amendments.
Significantly, unlike Section 7, Section 8(c) expressly provided that the filing of a dissolution petition under BCL § 1104-a:
shall be deemed to be an offer pursuant to this paragraph 8 to sell all shares of the Corporation then owned by the petitioner or subject to any option created hereunder.
In an unreported Decision and Order dated March 9, 2009 (read here), Monroe County Commercial Division Justice Kenneth R. Fisher ruled against the respondent shareholders on their Section 8 argument, finding that the 10-year term was never extended, but agreed with their argument under Section 7. Here's the key passage, which includes a citation to my above-mentioned New York Law Journal article:
[R]espondents contend, and this court agrees, that the unambiguous language of §7 is invoked by the institution of a dissolution proceeding. Matter of El-Roh Realty Corp., 48 AD3d 1190, 1191-92 (4th Dept 2008); Hesek v. 245 Fourth Main St., Inc., 170 AD2d 956 (4th Dept 1991); Matter of Doniger v. Rye Psychiatric Hosp. Center, Inc., 122 AD2d 873, 876-77 (2d Dept 1986). The failure of §7 to explicitly enumerate as one of its triggering mechanisms the institution of a dissolution proceeding does not deprive §7 of its unambiguous effect on the petition in this case. This much is made clear in In re Johnsen v. ACP Distr., Inc., 31 AD3d 172, 177-78 (1st Dept 2006), and Peter A. Mahler & Michael A.H. Schoenberg, Outside Counsel: Dissolution Petition Can Unwittingly Trigger Stock Buyback, N.Y.L.J., vol. 236, July 21, 2006 at p. 4, col. 4 (under Johnsen, unambiguous language sweeps in commencement of a dissolution proceeding despite lack of specific reference to it in the RFR buyback provisions). Accordingly, application of §7, which does not have a 10 year term, is established on this record.
The petitioner appealed to the Appellate Division, Fourth Department, whose Memorandum and Order dated June 11, 2010, reversed the lower court's order and reinstated the dissolution petition. The appellate court gave two reasons. First, it held that to construe Section 7 as applicable to the filing of a dissolution petition would render the explicit reference to dissolution in Section 8 "meaningless." Second, it held that the language of Section 7, as a matter of law, did not encompass a dissolution proceeding. Here's what the court said:
[S]ection 7 is not so broad as to include dissolution proceedings (see Matter of Pace Photographers [Rosen], 71 NY2d 737, 747-748). Respondents' reliance on Matter of El-Roh Realty Corp. (48 AD3d 1190) is misplaced. In that case, the shareholders' agreement "prohibited the transfer of any shares, including, without limitation, transfers that are voluntary, involuntary, by operation of law or with or without valuable consideration' " (id. at 1191). A dissolution proceeding pursuant to Business Corporation Law § 1104-a, however, is an involuntary transfer (see § 1104-a [b]), and section 7 (a) of the Option Agreement does not prohibit involuntary transfers except as explicitly listed, e.g., through bankruptcy.
Are the reasons given persuasive? You can decide for yourself, but let me offer some food for thought:
- Is it clear that Section 8, with its express reference to a dissolution petition, would be rendered meaningless if Section 7(a) is construed as including a dissolution petition? Isn't it really just a question of divining the parties' intent behind the more general language used in Section 7(a)? In other words, does the court's point beg the question as to the scope of 7(a)?
- In distinguishing the RFR in El-Roh, the court appears to overlook the words, "or otherwise dispose of" in Section 7(a) of the Stevens RFR. It was those precise words that convinced the First Department in Johnsen to enforce the RFR.
- Section 7(a) does not expressly refer to the "involuntary" transfer or disposition of shares, but it does use the words, "or otherwise," after listing several involuntary dispositions, to wit, "bankruptcy, . . . adjudication of insanity, [and] death . . ." Would the court have reached the same conclusion if the clause had referred generally to any "involuntary" disposition (as did the clause in El-Roh) and, if so, does the distinction withstand scrutiny?
As explained in the lower court's decision, very early in the case the parties entered into a stipulation whereby, should the court determine that the RFR does not apply, the corporation shall be deemed to have elected to purchase the petitioner's shares pursuant to BCL § 1118 for fair value. The stipulation further provided that fair value shall be determined either by the price fixed in Section 7(e) of the Option Agreement, if the court determines that it controls, or if not, by the court pursuant to a valuation hearing. I will be sure to report on any further case developments concerning the valuation question.
Not the Final Word
Trying to make sense of Stevens and its forebears has the feel of a talmudic exercise, in which a slight rearrangement of the words or punctuation can lead to diametrically opposed conclusions. The courts are not to blame. They didn't write these RFR provisions. But it does add to the disquieting sense that these provisions are a trap for the unwary.
It's a safe bet that there are many, many thousands of shareholders' agreements (and, more recently, LLC operating agreements) out there containing RFR provisions not unlike the ones used in Stevens and the other cases mentioned above. The reason is not because they're well drafted -- I would describe them as legal gobbledygook -- but because lawyers don't want to charge, and clients don't want to pay, for reinventing the wheel every time they prepare an agreement. So lawyers tend to use the same forms they or their colleagues used before. Even those lawyers that follow case law developments may have a hard time convincing all concerned to spend money amending their shareholders' agreement to avoid what seems like a remote contingency. Thus, the odds are good we'll be seeing more cases of this sort.
