Beware Unreasonable Restraints on Alienation When Drafting Shareholder and Operating Agreements
Our English common-law heritage includes what's known as the rule against unreasonable restraints on alienation. Law students first encounter the rule in their property class, where they learn about the abolishment of the feudal "fee tail" which restricted the transfer of real property to a specific line of male heirs. Basically, our laws and public policy strongly favor the right of persons to freely dispose of their property both real and personal. Agreements that place ownership of property in the hands of one person and the right to alienate, i.e., sell or otherwise convey the property, in the hands of another, are unenforceable.
The rule is not absolute. It only prohibits unreasonable restraints on alienation. For instance, where a niece agreed to pay $15,000 to her uncle and aunt for a $100,000 farm that was in the family for generations on condition that, during the uncle's and aunt's lifetimes, the niece wouldn't mortgage the farm or convey it to her husband, a court enforced a reversion clause in the recorded deed giving the property back to her relatives when the niece placed mortgages on the farm that subsequently were foreclosed. The court found it reasonable to enforce the restraint to preserve family ownership of the farm for a limited duration. Moreover, the niece's interest in free alienation was outweighed by her agreement to the restraint in consideration for a drastically reduced price. (Example taken from Alby v. Banc One Financial, 128 P3d 81 [Sup. Ct. Wa. 2006].)
What's this got to do with shareholder and operating agreements?
As mentioned, the rule also applies to personal property. Certificated and uncertificated shares in a corporation are considered personal property as are membership interests in a limited liability company (see LLC Law Section 601). One of the main purposes of shareholder agreements for closed corporations and LLC operating agreements is to restrict the transfer of shares and membership interests. Sometimes the restrictions are designed to keep ownership in the family if it's a family-owned business. More generally, such restrictions emulate a partnership model in which the owners are actively involved in company management and therefore need to maintain control over the admission of new owners.
Restrictions that effectively prohibit share transfer are not enforceable. As New York's highest court stated in Wildenstein & Co. v. Wallis, 79 NY2d 641 (1992), factors in assessing reasonableness of the restriction include price, duration and purpose. For example, in Lam v. Li, 222 AD2d 290 (1st Dept 1995), the court invalidated a provision giving one party a perpetual option to purchase 50% of the corporation's shares for $10. In Rafe v. Hinden, 29 AD2d 481 (2d Dept), aff'd, 23 NY2d 759 (1968), a stockholder successfully invalidated a provision requiring him to get written permission from the other stockholder before selling to a third party where the other shareholder retained the arbitrary power to forbid a transfer.
The seminal New York case cited in support of stock transfer restrictions is Allen v. Biltmore Tissue Corp., 2 NY2d 534 (1957), where the court upheld a bylaw provision that gave the corporation the option to purchase the shares of a deceased shareholder at their original purchase price, which was below market value at the date of death. The court explained (citations omitted):
As the cases thus make clear, what the law condemns is, not a restriction on transfer, a provision merely postponing sale during the option period, but an effective prohibition against transferability itself. Accordingly, if the by-law under consideration were to be construed as rendering the sale of the stock impossible to anyone except to the corporation at whatever price it wished to pay, we would, of course, strike it down as illegal. But that is not the meaning of the provision before us. The corporation had its option only for a 90-day period. If it did not exercise its privilege within that time, the deceased stockholder's legal representative was at liberty to "dispose of said stock as he [saw] fit" (§ 30), and, once so disposed of, it would thereafter be free of the restriction. In a very real sense, therefore, the primary purpose of the by-laws was to enable a particular party, the corporation, to buy the shares, not to prevent the other party, the stockholder, from selling them.
Generally speaking, these restrictions are employed by the so-called "close corporation" as part of the attempt to equate the corporate structure to a partnership by giving the original stockholders a sort of pre-emptive right through which they may, if they choose, veto the admission of a new participant. Obviously, the case where there is an easily ascertainable market value for the shares of a closely held corporate enterprise is the exception, not the rule, and, consequently, various methods or formulae for fixing the option price are employed in practice e.g. book or appraisal value, often exclusive of good will, or a fixed price, or the par value of the stock. In sum, then, validity of the restriction on transfer does not rest on any abstract notion of intrinsic fairness of price. To be invalid, more than mere disparity between option price and current value of the stock must be shown.
The restriction upheld in Allen, triggered by the shareholder's death, is akin to a more general right of first offer found in many shareholder and operating agreements. These provisions require a shareholder or member who seeks to exit during his or her lifetime to offer the shares or membership interest back to the corporation/LLC, or to the other shareholders/members, before selling to a third party. The typical first offer provision requires the offerees to accept or decline the offer within a reasonable period (e.g., 30 to 60 days) and uses any of a variety of pricing mechanisms including fixed price, formula, or various appraisal procedures.
The right of first offer should not be confused with the right of first refusal, also commonly found in shareholder and operating agreements. Under the right of first refusal, a shareholder or member may solicit and accept a bona fide purchase offer from a third party, subject to the corporation's or LLC's (or their owners') pre-emptive right to acquire the interest at the same price. The right of first refusal generally is less susceptible to challenge under the rule against unreasonable restraints on alienation because the pricing necessarily is at market value.
A very recent example of a transfer restriction running afoul of the rule is found in Verderber v. Commander Enterprises Centereach, LLC, Short Form Order, Index No. 007691/09 (Sup Ct Nassau County Oct. 15, 2009), decided by Nassau County Commercial Division Justice Ira Warshawsky. Verderber involves a complicated fact pattern with multiple LLCs and operating agreements, in which the primary issue for pretrial decision was the applicability of an arbitration clause -- the court found that the clause applied but was waived by the parties' litigation conduct. Also at issue was the operating agreement's provision that, in the event any member desires to transfer all or any part of his or her interest, it must be transferred to the LLC at a price based on a specified multiple of the company's net operating income, less the current mortgage balance, payable over five years. The plaintiffs (husband and wife), who wanted to transfer their combined 20% membership interests to another LLC wholly owned by them, sought a declaration that the restriction violated the rule against unreasonable restraints on alienation. The defendants, who held the other 80% interests, asked the court for a preliminary injunction to prevent the transfer pending the litigation.
Justice Warshawsky denied the requested injunction on the ground that the defendants were unlikely to succeed in showing that the transfer restriction could overcome the rule against unreasonable restraints on alienation. Here's the pertinent part of the decision:
A provision in a certificate of incorporation requiring a shareholder to give a "first option" to the corporation or the other shareholders to purchase the stock, at an agreed price or then-existing book value, before offering it to outsiders is ordinarily enforceable (Allen v. Biltmore Tissue Corp., 2 NY2d 534, 541 [1957]). However, the option must be for a limited period. "[O]wnership of property cannot exist in one person and the right of alienation in another" (Id. at 542). "An effective prohibition against transferability itself" is not enforceable (Id.). A limited liability company bears resemblance to a close corporation, at least as to the limited liability feature. Thus, it appears that an operating agreement covering a limited liability company may contain a first option provision, but it may not prohibit a member from selling his interest to a third party. In any event, defendants have not shown a likelihood of success on the merits with respect to the enforceability of the provision restricting transfer of plaintiffs' membership interest.
The decision does not quote the defective provision, so it's not 100% clear what went wrong with it. The decision's language suggests that the transfer restriction contains an outright prohibition on a sale of membership interest to anyone other than the LLC. The court's reference to a time limitation also suggests that the LLC may have been able arbitrarily and indefinitely to delay purchase.
I'm aware of only one other decision, by a Georgia state court in a case called RTS Landfill, Inc. v. Appalachian Waste Systems, LLC, 598 SE2d 798 (Ct App Ga 2004) (written up by L. Andrew Immerman in the March 2005 Pubogram), applying the rule against unreasonable restraints on alienation to invalidate a transfer restriction involving an LLC membership interest. Keep in mind, Section 603 of New York's LLC Law states that an LLC membership interest may be assigned in whole or in part "except as provided in the operating agreement." Does the statute arguably trump the common law rule, such that an operating agreement could prohibit outright the transfer of a membership interest? Given New York case law developments applying other common law rules to LLCs such as derivative action and equitable accounting, and finding void as against public policy a waiver in the operating agreement of the right of judicial dissolution, one might predict a similarly victorious outcome for the pro-alienation common law rule. I'd love to see how Delaware Chancery Court would handle the issue under that state's LLC Act which expressly states, in Section 18-1101(a) and (b), that the "rule that statutes in derogation of the common law are to be strictly construed shall have no application to this chapter," and that "it is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements."
Court Determines Fair Value in Dissenting Shareholder Case Triggered by REIT Conversion
The opening lines of Nassau County Commercial Division Justice Ira B. Warshawsky's 41-page opinion in Matter of Jamaica Acquisition, Inc., 2009 NY Slip Op 32320(U) (Sup Ct Nassau County Sept. 29, 2009), wax nostalgic about several privately operated bus lines that primarily served New York City's Queens County from the 1920's until the 1990's, when the routes were taken over by the Metropolitan Transportation Authority. These included the Green Bus Lines, Triboro Coach and Jamaica Buses. The rest of the opinion in this dissenting shareholder appraisal case is anything but nostalgic, as it referees a classic "battle of the experts" in which the two sides clashed over numerous issues including capitalization rates, deductions for built-in capital gains and income tax liabilities, marketability and minority discounts, and the award of attorney's fees and interest.
Shares in the three bus companies were widely dispersed among approximately 200 descendants of the original shareholders, many of whom owned shares in two or all three companies. While each shareholder technically was a minority shareholder, for decades there were voting trust agreements that ensured a stable, common management of the bus companies under the control of Jerome Cooper, the son of the founder of the Green Bus Lines.
In 2005, the City paid the companies $25 million to acquire their routes, tangible personal property and good will. The companies retained eight real estate parcels consisting mainly of bus depots and maintenance facilities which were then leased to the City and private interests, in most instances under long-term triple net leases generating aggregate annual revenues of about $9.5 million.
As Subchapter "C" corporations, the bus companies' income was subject to double taxation at the corporate and shareholder levels. In addition, a sale of the fully depreciated real estate would have generated a capital gains tax of $58 million. Therefore, in February 2007, management formally proposed merging the three companies into a REIT (real estate investment trust) which would achieve pass-through taxation and, after a 10-year holding period, the ability to sell the realty free of capital gains tax. The merger was structured as a share swap under which shares in each bus company entitled the holder to a specified number of REIT shares based on an allocation formula utilizing a February 2006 appraisal of the real estate assets by Cushman & Wakefield (the "Pre-Merger Appraisal"). The Pre-Merger Appraisal concluded an aggregate valuation of over $153 million using a discounted cash flow analysis for certain properties and direct capitalization and market approaches for others.
The shareholders overwhelmingly approved the merger agreement in March 2007. Eight shareholders holding approximately 2.5% of the potential REIT interests objected to the merger and demanded an appraisal pursuant to Section 623(h) of the New York Business Corporation Law. Management offered the dissenters an amount equivalent to $7 per REIT share based on an April 2007 appraisal by Empire Valuation Consultants. As Justice Warshawsky's opinion repeatedly notes, the 2007 Empire Report incorrectly valued the REIT shares as of the day after the merger whereas the statute required payment for the fair value of the dissenters' shares in the pre-merger companies as of the day before the approval of the merger. This also became an issue in the court's assessment whether the offer was made in "good faith" for purposes of an award of counsel fees (see below).
The dissenters rejected the offer. As required by statute, the companies then paid the dissenters 80% of the offered amount and commenced a judicial proceeding to determine the fair value of the dissenters' shares.
Eventually, following discovery proceedings (read here the court's December 2007 discovery rulings) and a succession of modified appraisal reports by the companies' experts, Justice Warshawsky conducted a lengthy trial featuring sharply conflicting opinions and approaches by the dueling experts. Readers who want the full flavor and complexity of the contested valuation issues and testimony will just have to read the entire opinion. For everyone else, here are the highlights:
- Built-In Gains and Post-Merger Corporate Taxes (pp. 21-22). The companies and their experts argued that a hypothetical willing buyer of the shares would take into account the capital gains tax, estimated at $58 million, that would be due when the fully depreciated properties are sold. Justice Warshawsky disagreed, based on the language of BCL Section 623(h)(4) ("in fixing the fair value of the shares, the court shall consider the nature of the transaction giving rise to the shareholder's right to receive payment for shares and its effects on the corporation and its shareholders") and on the explicit statement in the merger proposal that the real properties would not be sold for at least 10 years after reconstitution as a REIT. For the same reason Justice Warshawsky rejected the companies' experts' valuation based on capitalization of earnings insofar as it failed to eliminate income taxes at the corporate level. (Read here and here for my prior posts on treatment of built-in gains tax in fair value cases.)
- Marketability Discount (pp. 22-26). In what I view as the single-most important ruling in the case, Justice Warshawsky agreed with the companies that a 25% discount for lack of marketability should be applied against the value of the entire enterprise, i.e., should not be limited to good will of which there was none since the 2005 sale to the City included all good will. Justice Warshawsky's opinion discusses conflicting precedent in the First and Second Departments, and concludes that the cases limiting the discount to good will "do not support this position and on their face appear inconsistent with the cases of the Court of Appeals [New York's highest court]." (Read here and here my prior posts concerning the conflicting case law on marketability discount application.)
- Minority Discount (pp. 26-30). Fair value case law in New York uniformly rejects application of a discount for lack of control a/k/a minority discount. The companies argued unsuccessfully that their case was exceptional because (a) the proposed merger was not a squeeze-out merger and (b) all shareholders of the pre- and post-merger companies were minority shareholders. In applying the prevailing rule, Justice Warshawsky opined that it is of no moment the reason why a shareholder exercises his or her statutory appraisal rights, and that case precedent does not "graft on to BCL 623 an additional burden of proof to show some type of corporate wrongdoing by the majority; and, yes, the court considers everyone else the majority." (Read here my prior post on the difference between marketability and minority discounts.)
- Valuation (pp. 30-38). It's impossible in one paragraph to capture the complexities and conflicts of the opposing appraisal methodologies, so I won't even try. Justice Warshawsky repeatedly chastised the bus companies' experts for what he described as a series of shifting valuation reports, inconsistencies and selective use of data. The companies' experts' "final" appraisal valued the dissenters' shares (with discounts) at slightly less than the original $7 offer, whereas the dissenters' expert arrived at a value of $18.37 (without discounts). One "monumental difference" between the two was the companies' experts' use of a 9% capitalization rate versus the dissenters' expert's use of the same 6.5% rate used by Cushman & Wakefield in its real estate appraisal. Justice Warshawsky agreed with the lower rate. On the other hand, Justice Warshawsky disagreed with the dissenters' expert's disregard of interest expense on the money borrowed to fund the dividend that had to be paid for the new entity to qualify as a REIT, which Justice Warshawsky viewed as part and parcel of the REIT conversion. In the end, Justice Warshawsky favored a modified version of the dissenters' expert's Adjusted Book Value ("ABV") approach rather than the weighted combination of Net Asset Value ("NAV") and earnings approach of the companies' expert. This produced (after applying the 25% marketability discount) a value of about $137 million for the three companies, from which Justice Warshawsky deducted about $20.5 million for capitalized going-concern costs, arriving at a value of $116,923,409 or the equivalent of $11.69 per REIT share.
- Attorney's Fees and Costs (pp. 38-39). The general rule under BCL Section 623(h)(7) is that each side pays its own costs including attorney and expert fees. The statute also authorizes the court to shift costs against the dissenters if their refusal of the company's offer was arbitrary, vexatious or otherwise not in good faith, and against the company if its offer was arbitrary, etc. or if the award "materially exceeds" the company's offer. Both sides asked Justice Warshawsky to impose costs against the other. Justice Warshawsky found that the $11.69 per share award materially exceeded the $7 offer, and that the "ongoing changing fair value calculations proffered by [the bus companies], even during trial, was vexatious to the [dissenters]." On that basis he ordered that the companies reimburse the dissenters for 50% of their costs and legal fees to be determined at a later hearing.
- Interest (pp. 40-41). BCL Section 623(h)(6) directs the court to award interest at an "equitable" rate on the unpaid portion of the award, unless the shareholder's refusal to accept the offer was arbitrary, vexatious or not in good faith. Justice Warshawsky granted interest at 6.5% which was the rate paid by the bus companies on their line of credit at the time of the merger. He rejected the dissenters' request for interest on their costs, attorney's fees and expert's fees.
Trial lawyers are fond of saying that every case partakes something of a crap shoot. The dissenting shareholder statute raises the stakes for both sides in the fair value casino. As the Jamaica Acquisition case illustrates, the statute invites uncertainty by requiring valuation on a pre-merger basis as of the date prior to consummation and, at the same time, requiring a forward-looking analysis of the post-merger impact on valuation. The statute further heightens the risks by imposing liability for the other side's legal fees, for making what turns out to be an unreasonable offer (in the company's case) or arbitrarily rejecting what turns out to be a reasonable offer (in the dissenter's case). The fair value award in Jamaica Acquisition, at the approximate mid-point between the $7 per share offered by the companies and the $18 sought by the dissenters, suggests that both sides made comparable misjudgments of value. However, the companies alone faced a greater statutory risk, and ended up paying a higher price for their misjudgment, in the form of an assessment for half the dissenters' legal fees and costs based on the material discrepancy (67%) between the offer and the award.
Appellate Court Upholds Denial of Good Will Appraisal in Deadlock Dissolution Case
[Full disclosure: The author represented the prevailing shareholder in the dissolution proceeding and appeal discussed below.]
After the court orders dissolution of a corporation owned 50/50 by two deadlocked shareholders, and the business's tangible assets have been distributed equally pursuant to agreement, may one shareholder demand an appraisal of the corporation's good will associated with the divided assets for the purpose of compelling the other shareholder to make payment for any disparity?
A decision last week by the Brooklyn-based Appellate Division, Second Department, in Matter of Ravitz (Gerard Furst and Marjorie Ravitz, DPM, P.C.), 2009 NY Slip Op 06437 (2d Dept Sept. 8, 2009), holds that the court lacks statutory authority to order such a valuation proceeding.
Ravitz involves a long-established podiatric practice organized as a professional corporation with two equal shareholders. The practice operated out of three leased offices in Smithtown, Port Jefferson and Commack on Long Island. In November 2007, Dr. R filed a petition for judicial dissolution of the practice based on deadlock and internal dissension under Section 1104 of the Business Corporation Law. Dr. F opposed the petition. The court, by Nassau County Commercial Division Justice Ira B. Warshawsky, granted the petition and dissolved the corporation in a short form order dated February 11, 2008.
The two doctors then agreed to close down the Commack office immediately; that the practice would cease operations June 30, 2008; that Dr. R would take over the Smithtown lease, furnishings and equipment; and that Dr. F would take over the Port Jefferson lease, furnishings and equipment. They also agreed that neither one would use the practice's trade name for their new, separate practices.
Dr. F maintained all along that he was entitled to additional compensation based on his claim that the Smithtown office being taken over by Dr. R generated more revenue than Dr. F's Port Jefferson office and therefore enjoyed a disproportionate share of the company's good will. Accordingly, in April 2008, Dr. F moved for an order pursuant to BCL 1008(a) directing an appraisal of the good will associated with each of the Smithtown and Port Jefferson offices, for the purpose of awarding a monetary adjustment for any disparity. Justice Warshawsky denied the motion by short form order dated June 13, 2008. Dr. F appealed.
Dr. F's appeal contended that good will is a saleable asset that must be valued in connection with the winding up and liquidation of the corporation. Dr. R countered that there exists no statutory authority to order an appraisal and to compel payment by one shareholder to another in a judicial dissolution proceeding under BCL §1104, and that the only authorized disposition is for the corporation itself to sell its assets for cash at public or private auction. Alternatively, she contended there was insufficient factual basis to order an appraisal of good will, even assuming the court had authority to do so.
The Second Department never reached the alternative point. Rather, it agreed with the lower court that there was no authority for the requested appraisal in the absence of an agreement between the two doctors to value and distribute good will. Here's what the court said:
When the parties cannot reach an agreement amongst themselves with respect to the sale of the corporation's assets either to one another or to a third party, "the only authorized disposition of corporate assets is liquidation at a public sale" (Matter of Oak Street Mgmt., 307 AD2d at 320). Thus, the Supreme Court correctly determined that it did not have the authority to supervise postdissolution distribution of the corporation's assets as requested by Furst (see Matter of Oak Street Mgmt., 307 AD2d 320; Matter of Sternberg [Osman], 181 AD2d 899).
The absence of an agreement by the parties to value and distribute good will in the event of dissolution precludes the inclusion of good will in the corporate assets to be distributed pursuant to Business Corporation Law § 1104. The failure of the parties to acknowledge and agree that good will is an asset of the corporation precludes the relief sought by Furst (see Dawson v White & Case, 88 NY2d 666, 671; Matter of Leslie & Penny for Penny Preville, 303 AD2d 508; Saltzstein v Payne, Wood & Littlejohn, 292 AD2d 585; Kaplan v Shachter & Co., 261 AD2d 440).
In my experience, most multi-member medical practices have written shareholder agreements with provisions for buyout and liquidation explicitly including or excluding good will in regard to valuation. As the court in Ravitz noted, the two doctors had no such agreement, hence Dr. F's quest for what, in effect, amounted to a compulsory partial buyout fell flat in the absence of statutory authority for post-dissolution appraisal proceedings.
Case Illustrates Importance of Clear Valuation Parameters in Buy-Sell Agreement Among Owners of Closely Held Business
When properly designed, buy-sell provisions in shareholders' agreements of closely held corporations, or in operating agreements of limited liability companies, can avoid disruptive and costly litigation triggered by the voluntary or involuntary dissociation of a shareholder or member. The key elements of a workable buy-sell agreement for lifetime dispositions are (1) defining the circumstances under which a shareholder or member can leave voluntarily or be forced out, (2) setting the valuation date, (3) fixing the value of, or a mechanism to value, the interest of the departing shareholder or member, and (4) setting forth the terms of payment.
Sassower v. 975 Stewart Avenue Associates, LLC, 2009 NY Slip Op 31901(U) (Sup Ct Nassau County Aug. 14, 2009), recently decided by Nassau County Commercial Division Justice Ira B. Warshawsky, illustrates the mayhem that can result when the buy-sell agreement renders uncertain the basis for valuing the departing owner's interest in the entity.
Cardiologist Michael Sassower was one of seven physician-shareholders of a Long Island cardiology practice organized as a professional corporation. He and his fellow shareholders also were members of a real estate holding company called 975 Stewart Avenue Associates, LLC (the "Company") that owned the premises housing the medical practice. In December 2007, Sassower gave six-months notice of his resignation from the medical practice. The Company's operating agreement provided that, upon his departure from the practice, Sassower was required to offer his 12.5% membership interest to the Company and the other members. Section 8.5(c) of the operating agreement described the following process to determine the price to be paid for his interest:
The Company and the Offering Member/New Member shall have ten (10) days to appoint a Qualified Appraiser. Upon appointment, both Qualified Appraisers shall each establish the purchase price of the Offered Interests, using the market value approach appraisal methodology, in a written opinion to the Company each such opinion to be delivered within thirty (30) days of the appointment of the latter of appraisers. If the difference between the two (2) appraisals is less than ten (10%) percent, then the valuation of the Offered Interests shall be the average of the appraisals. However, if the difference between the two (2) appraisals is more than ten (10%) percent, then the Qualified Appraisers shall mutually appoint a third Qualified Appraiser whose sole written opinion shall establish the fair market value of the Offered Interests. [Emphasis added.]
The Company and Sassower each retained an appraiser. The Company's appraiser valued Sassower's 12.5% interest at $850,000 versus Sassower's appraiser's valuation of $962,500 based on "market values" of $6.8 million and $7.8 million, respectively, for the entirety. The difference being more than 10%, the parties were required by Section 8.5(c) to secure a third, decisive appraisal.
The appraisals were exchanged in August 2008. Things started to go haywire when the Company sent Sassower an amendment to its appraiser's report, noting that the Company's property carried an outstanding mortgage balance of approximately $2.7 million and stating that, "at the request of the client [i.e., the Company]," it was reducing the value of the Company's equity by the amount of the mortgage, to a little over $4.1 million, which reduced the value of Sassower's 12.5% interest to about $350,000.
Sassower commenced a lawsuit the following month, seeking a declaration that the mortgage balance should not be deducted from the appraised market value in determining the price for his interest. Justice Warshawsky denied the Company's initial pre-answer motion to dismiss the complaint in a Short Form Order dated December 3, 2008, finding that the meaning of "market value approach methodology" as used in Section 8.5(c) was "not clear on its face" and could not be determined without further proceedings.
A month later, in January 2009, the Company's counsel wrote to the court contending that both appraisers had erroneously failed to deduct from their estimate of value the principal balance of the existing mortgage. The Company further contended that both appraisers had used overstated figures for the property's net operating income, and that utilizing the actual figures based on the existing net lease held by the medical practice would bring the two appraisals within 10% of each other and therefore obviate the third appraisal.
Two months after that, in March 2009, the remaining members of the Company voted to dissolve and liquidate the Company voluntarily, by virtue of which they sought anew to dismiss as moot Sassower's complaint to enforce the buy-out. Sassower countered with his own motion to enforce a September 2008 stipulation whereby the two sides had agreed to go forward with the third appraisal.
Justice Warshawsky's decision earlier this month denied the Company's motion to dismiss and granted Sassower's motion to enforce the stipulation. As to the former, the operating agreement specified that the remaining members' right to elect to dissolve in lieu of purchasing the departing member's interest was time-limited by the operating agreement's express terms. The purported voluntary dissolution in March 2009 therefore was too late, particularly given the remaining members' interim election to purchase and the exchange of appraisals. "In the opinion of the Court," Justice Warshawsky commented pointedly, "the Defendant cannot opt to buy out the Plaintiff, then, when unhappy with the outcome of that decision, choose to dissolve the entity."
The court's decision to enforce the stipulation also appears to provide some guidance for the third appraiser as to the underlying valuation dispute. Justice Warshawsky notes that, while the language in the operating agreement "is less than crystal clear," in his opinion "the sought after number is fair market value." The phrase "market value approach methodology," he concludes,
is not an appraisal methodology, but a defined value to be arrived at by one of the three traditional appraisal approaches, namely, direct sales comparison, income capitalization, or replacement cost. For a building of the type owned by 975 Stewart, the most appropriate approach is the direct income capitalization approach, upon which both appraisers apparently relied. . . . The deduction of the outstanding mortgage on the property from the estimate of fair market value does not produce market value, but rather equity position value.
It appears that in applying the income capitalization approach, both party-retained appraisers constructed a market rate rather than using the existing net lease between the Company and the medical practice -- presumably at a below-market rate -- prompting Justice Warshawsky to observe:
It would be inappropriate to rely upon this lease to determine market value. There is a good practical reason for not considering it. Certainly, if CMA decided to relocate and sell the property to a third party, they would sell free and clear of the existing lease and the arm's length purchaser would be free to impose market rent on his prospective tenants.
I frequently see buy-sell provisions in shareholder and operating agreements that leave it entirely to the appraisers how to arrive at their appraisal. I also see many agreements containing very specific appraisal parameters, e.g., dictating use of book value, specifically excluding or including good will or other identified assets and liabilities, and specifically including or excluding minority and marketability discounts. Counsel drafting such agreements must carefully consider the nature of the business, its tangible and intangible assets, and its actual and potential liabilities. Better yet, counsel not adequately familiar with appraisal methodology should consult with the company's outside accountant or a business appraiser before the agreement is signed.
It's impossible to know from the language used in Sassower whether the drafter and/or the doctors who signed the agreement thought the words "market value" meant the sale value of the unencumbered real estate less the mortgage balance, or, as Justice Warshawsky construed it, an income-based valuation. What's clear is that the ambiguous buy-sell provision in Sassower failed its essential purpose to provide a certain, speedy and litigation-free procedure for valuing a departing member's interest.
Court Grants Dissolution, Rejects Claim that Failed Buy-Sell Agreement Was "Ploy" by Petitioner to Take Over Corporation's Retail Store Lease for His New Business
Has anyone else noticed an uptick in the number of cases asserting claims for breach of fiduciary duty and fraud arising from stock buy-outs among owners of closely held companies? Perhaps it should be called the Littman Effect, after the First Department's 2008 decision in Littman v. Magee, where the court upheld this type of claim notwithstanding broad releases and disclaimers in the buy-out agreement. (Read my post on Littman here.)
The most recent example is a case called Matter of Lerman (Tive Clothing, Inc.), Short Form Order, Index No. 2947/09 (Sup Ct Nassau County July 8, 2009), involving a single-outlet clothing store known as Effie's owned 50-50 by two shareholders. Although Lerman offers a twist on the usual fact pattern -- the fight was over the consequences of a contemplated buy-out that did not occur -- it flows from the same idea, viz, that Shareholder A wrongfully induced Shareholder B to enter into a buy-out agreement by withholding material information that Shareholder A was duty-bound to disclose.
The facts in Lerman are not complicated. The two owners, Lerman and Knaffo, set up their corporation, called Tive Clothing Inc. ("Tive"), and operated the store in leased space for almost 20 years before their relationship began to unravel over profitability and other financial issues. In June 2007 they reached an interim solution in the form of a stockholders' agreement with a buy-sell provision that permitted either of them to offer their shares to the other at a fixed price. If the offeree declined to purchase, Tive was to be dissolved and the inventory liquidated.
The business continued to decline, requiring the owners to contribute another $30,000 each in the months following the stockholders' agreement. Knaffo subsequently offered to sell his shares to Lerman under the buy-sell provision. Lerman did not accept the offer -- at least not in writing -- although Knaffo later claimed that Lerman (verbally) agreed to purchase his shares. As the store lease was expiring, in August 2008, the landlord agreed to extend the lease for 3 months with a 3-month option. After the lease expired, the parties vacated the store and placed unsold inventory in storage.
After Effie's closed, Lerman on his own signed a new lease for the same premises and opened a clothing store called Ler Man's. The court's decision does not reveal what, if any, discussions occurred between Lerman and Knaffo concerning voluntary dissolution of Tive. What is known is that, in February 2009, Lerman filed a petition for judicial dissolution of Tive under Business Corporation Law Section 1104 based on shareholder deadlock. He also sought appointment of a receiver to wind up the affairs of Tive.
Knaffo opposed the petition, claiming that Lerman had perpetrated a fraud upon him, and breached his fiduciary duties owed to Knaffo, by concealing his plan all along to let the store lease lapse and open his own clothing business at the same location. Knaffo alleged that Lerman had participated in the negotiations to effectuate a buy-out merely as as a ploy to push Knaffo out of the business. Lerman countered that the stockholders' agreement expressly contemplated a dissolution upon the refusal of one shareholder to purchase the shares of the other.
The decision by Nassau County Commercial Division Justice Ira B. Warshawsky agreed with Lerman's position and granted the dissolution petition. Here's the key excerpt from the ruling:
It seems clear that it was the stated intention of the parties to arrange for an organized winding down, and ultimate dissolution of the business they were operating if the offer of one of the shareholders to purchase the shares of the other was declined. . . .
Once the offer to sell his shares to Lerman was rejected, the Agreement specifically provided for the dissolution of the corporation. Under these circumstances Lerman had no obligation to continue to operate in business with Knaffo, and either of them could have taken the opportunity to start a new business in the premises at the expiration of the lease.
The decision offers no further analysis of the claims for fraud and breach of fiduciary duty. It does not appear from the decision that Knaffo made any allegation that Lerman entered into his own lease negotiations with the landlord before Lerman and Knaffo entered into the stockholders' agreement or, for that matter, at any time before Tive's lease lapsed. Absent that type of allegation, even with the benefit of Littman, it's hard to see the makings of a fraud or fiduciary breach claim under the circumstances since, as the decision notes, Knaffo had the same opportunity as Lerman to take over the space.
All that remained of the case was Knaffo's claim that the racks and shelving left in the store belonged to Tive, and therefore he was entitled to be reimbursed 50% of their value. Lerman contended the items were fixtures, the ownership of which passed to the landlord. Justice Warshawsky's order refers the issue to the Court Attorney/Referee to hear and determine.
I haven't seen the stockholders' agreement in this case, however I'll venture a guess that it did not include a provision for the loser to pay the winner's attorney's fees in the event one of them refuses to cooperate with voluntary dissolution triggered by the rejection of an offer to sell. In general, such provisions can act as a strong deterrent to noncompliance with buy-sell agreements of this sort.
No Exception to Arbitration for Deadlock Dissolution Petition, Court Rules
As I've previously pointed out (read here), when shareholder disputes arise, including corporate dissolution contests, courts will readily stay litigation proceedings in favor of arbitration where the parties' shareholders' agreement provides for mandatory arbitration. There is no exception for dissolution cases arising from 50-50 deadlock, as the unsuccessful petitioner recently learned in Matter of Brooks (Aqua Shield Inc.), Short Form Order, Index No. 1572/09 (Sup Ct Nassau County June 5, 2009).
Aqua Shield Inc. was formed in 2000 to market a patented telescopic swimming pool enclosure invented by co-founder and petitioner Bob Brooks who, along with his wife, holds 50% of the company's shares. The other 50% is held by investor Igor Korsunsky and his wife.
The October 2001 shareholders' agreement has a broad arbitration clause requiring arbitration of "any controversy or claim arising out of or relating to [this] Agreement or its breach . . .."
In November 2008, the Korsunskys commenced an arbitration proceeding with the American Arbitration Association (AAA) against the Brookses who interposed an answer. The AAA issued an order on motions and scheduling orders in February 2009, and scheduled a preliminary hearing for April 2009.
Meanwhile, in late January 2009, the Brookses filed a judicial proceeding to dissolve Aqua Shield based on deadlock pursuant to Business Corporation Law Section 1104. The Korsunskys moved to dismiss the petition or, alternatively, to compel arbitration and stay the judicial proceeding.
The Brookses argued that arbitration should not be compelled because the matter is "unique in that there is a 50%/50% deadlock among the shareholders." The argument carried no weight with Nassau County Commercial Division Justice Ira B. Warshawsky, who wrote that "the Court does not consider this unique, or, in fact, even unusual." He then elaborated:
The arbitration proceedings appear to be well underway, and it is reasonable to expect a determination in the near future. The Court declines to dismiss the current action, since jurisdiction of the Court is appropriate for a motion to confirm or disaffirm the findings of the Arbitrator. The Brooks have not sought to stay arbitration, and in fact have actively participated in the process. The commencement of a proceeding in this Court, approximately two months after the Notice of Intent to Arbitrate, is not a motion to stay arbitration, and even if it were interpreted as such, it would be untimely and inappropriate.
. . . The agreement to arbitrate is clear, the parties have participated in the arbitration proceeding, and the arbitrator has determined that the issues presented are arbitrable. Under these circumstances it is appropriate to defer further action to the agreed-upon arbitration process.
The arbitration clause in the Aqua Shield shareholders' agreement is lifted almost verbatim from the AAA-approved form. As this case teaches anew, lawyers should not assume that corporate dissolution of any type falls outside the scope of the clause.
Court Rejects Bid by Corporate Dissolution Petitioner to Voluntarily Withdraw Case Without Prejudice
If you're going to accuse your business partner of bad acts and ask for judicial dissolution of the business, be prepared to settle or take the case all the way to trial. That seems to be the message given to the petitioner in one recent dissolution proceeding when the court turned down her request to discontinue the case "without prejudice" to her bringing a future dissolution proceeding based on the same allegations. Matter of Holland (Romper Nursery, Inc.), Short Form Order, Index No. 8871/07 (Sup Ct Nassau County Dec. 30, 2008).
The underlying dispute is a fascinating one involving one of the toughest nuts to crack in the realm of business divorce: What should a court do when a 50% shareholder seeks judicial dissolution of a profitable operating company under the deadlock statute (BCL 1104) on the ground of "internal dissension" due to personal animus between the two shareholders? I wrote an October 2004 article for the New York State Bar Association Journal on the subject, in which I concluded that
Cases decided under the internal dissension statute exhibit something of a split personality, depending on whether the court views the corporation, successful or not, as more akin to a partnership terminable at will, or as an entity distinct from its owners, to be maintained if financially viable notwithstanding internecine warfare. Arguably, this duality is inherent in the statute’s requirement that the petitioner establish both the existence of internal dissension and that the factions are so divided that dissolution would be beneficial to the shareholders. In other words, the statute can be read such that the cessation of shareholder hostilities itself is an adequate benefit of dissolution, or it can be read to require some other benefit (i.e., financial) that may be hard to show when the business is otherwise viable and making money.
The Romper Nursery Case Background
The Romper Room Nursery School seems an unlikely setting for a bitter shareholder dispute. Jeanie Holland and Margaret Zack as 50-50 shareholders opened the nursery school in 1975. During the summer a day camp operates at the school's two locations in Great Neck and East Williston on Long Island. The school also offers bus transportation.
The nursery school prospered over the following three decades despite extreme alienation between the co-owners. As related in a January 2008 decision by Nassau County Commercial Division Justice Ira B. Warshawsky , for 13 years, between 1989 and 2001, Holland and Zack did not even speak to each other. They have no shareholders' agreement and never held meetings of the Board of Directors. They nonetheless devised a workable division of labor which keeps the business profitable. Each performs separate duties and works on two separate days of the week. They take equal salaries and distributions.
In 2005, Holland filed the first of two successive petitions for judicial dissolution of Romper Nursery under BCL 1104. The first proceeding was withdrawn without prejudice in March 2007 so that the parties could negotiate a buyout. As things developed, the parties could not even agree which one would be the buyer, much less could they agree on price.
Two months later, Holland filed her second deadlock dissolution petition accusing Zack of the same "divisive acts" including waste of corporate assets and property; permitting child transportation on unsafe buses; dereliction of payroll duties; keeping school open during inclement weather; and involving employees in management disputes. Zack denied all allegations of misconduct and asserted that Holland was trying to push her out of the business.
In his January 2008 decision mentioned above, Justice Warshawsky ruled that the issues raised in Holland's dissolution petition required an evidentiary hearing. The court noted with apparent understatement that the communications arrangement between the parties was "unusual," but went on to say:
Yet, the system has inured to the benefit of the corporation according to the record now before me. Seemingly, each generation of new parents send their children to the nursery school they attended. . . . There is no evidence, nor factual proof, before the court that the personal animus between the shareholder-directors prevents efficient management and corporate success. . . . Each case turns on its facts. The court cannot make a determination on the facts in the record whether this is a case of a business which is profitable, but the dissension is so pervasive that dissolution is warranted for the benefit of the shareholders.
The Bid to Withdraw the Second Proceeding
It's not clear from the decisions whether the evidentiary hearing was held. What is clear is that Holland subsequently changed lawyers and that her new lawyer applied for an order pursuant to CPLR 3217(b) permitting Holland to voluntarily discontinue the dissolution proceeding without prejudice. Holland gave as her reasons for withdrawing the case the financial and emotional costs of the litigation, and the uncertainty of its outcome despite the "rosy predictions" of her first lawyer.
Zack contended that any dissolution must be with prejudice, meaning that Holland would be unable later to start a new dissolution proceeding based on the same factual circumstances. Holland countered that a discontinuance with prejudice would "serve as an absolution of [Zack's] potentially or actually bad behavior" and that "should [Zack's] behavior in the future cause a threat to the safety and well being of the children attending Romper Nursery it would be a 'travesty' to allow [Zack's] past behavior to be considered irrelevant."
Justice Warshawsky agreed with Zack in his December 30, 2008 decision. He denied Holland's application to discontinue without prejudice and instead offered her the choice of accepting a dismissal with prejudice or proceeding to trial on a date certain. Here's the crux of his ruling, omitting the case citations:
[T]he court directs that those acts by [Zack] which are central to this special proceeding are precluded from serving as a basis for initiating another lawsuit. To allow [Holland] to sue [Zack] for the same acts as have been vigorously defended in this lawsuit would prejudice a substantial right of [Zack] to have a timely resolution of the matter after committing substantial resources to her defense, or to be free of litigation. But, subject to the application of evidentiary rules by the justice presiding over any future matter any prior acts may be introduced into evidence for other purposes.
Justice Warshawsky then elaborated on his ruling as follows:
Seemingly [Holland] has figuratively weighed the perceived danger to the nursery school children against the tangible and intangible costs she has paid to protect them, and found the costs to be greater than the danger. The future will not change the present, only perceptions of it, and [Holland's] decision based on facts known to her now is final. The law does not permit a litigant to change his or her mind based on hindsight once given a full and fair opportunity to seek redress for a wrong.
For obvious reasons, courts like it when litigants voluntarily withdraw a case. A "with prejudice" discontinuance just as obviously is a deterrent to voluntary withdrawal, so courts tend to use sparingly their power under CPLR 3217(b) to impose "with prejudice" as a condition of discontinuance. Here, a number of factors justified the condition: it was the second successive dissolution petition asserting the same claims; the respondent, Zack, incurred substantial legal fees defending herself in the two proceedings spread over three years; and the two successive requests to discontinue raise an inference that the litigation's tactical purpose to force a buyout was at least as large a factor in bringing the case as the petition's professed alarm over mismanagement and school safety issues.
Terminated Member of Professional Corporation is Not Entitled to Statutory Stock Redemption
Professional service corporations are "interesting" and "strange creatures". So says Nassau County Commercial Division Justice Ira B. Warshawsky in an interesting (but not strange) post-trial decision issued last month, rejecting a claim for statutory buyout in a suit brought by a terminated partner in a law firm organized as a professional corporation.
The case is Lubov v. Welikson, 2008 NY Slip Op 28392 (Sup Ct Nassau County Sept. 29, 2008). You can read the decision here. Additional background is found in the court's January 2008 decision denying summary judgment motions (read here).
The law firm in Lubov initially was organized in 1989 as a general partnership. In 1993 it converted to a professional service corporation ("P.C.") under Article 15 of the Business Corporation Law. P.C.s are a popular form of limited liability entity eligible for partnership tax treatment, available to lawyers, doctors, accountants and other regulated professions.
The plaintiff alleged that prior to the firm's conversion to a P.C. the partners made an agreement to redeem the interest of a withdrawing partner for the sum of the partner's capital contribution and percentage of accounts receivable. Plaintiff also alleged that the shareholders nee partners of the P.C. adopted the same agreement.
Plaintiff's percentage interest in the P.C. started at 30%. In 1994 he voluntarily surrendered half his interest at the same time he began working fewer days and pursued other personal business affairs. At the time, he allegedly asked about redemption of the surrendered shares, but supposedly was put off by the majority shareholder. Plaintiff's percentage interest rose to 16% in 1997 when another 10% shareholder left the firm.
In his summary judgment ruling, Justice Warshawsky wrote that "plaintiff was, speaking plainly, thrown out" of the firm in February 1999. Plaintiff thereafter brought suit to recover the redemption value of his claimed shares of stock in the P.C. as of 1994, with respect to the 15% stock interest he surrendered at that time, and as of February 1999 with respect to the 16% interest.
The court rejected the plaintiff's claim for breach of express redemption agreement, stating that "the proof at trial was less than convincing that there was either a written or oral agreement in existence at the time the plaintiff was removed from the firm that controlled the rights of a departing shareholder."
The plaintiff alternatively pursued redemption rights under BCL 1510 which provides that P.C.s "shall purchase or redeem the shares of a shareholder" who dies or is disqualified under BCL 1509 within six months after death or disqualification, at the book value of the shares. Section 1509 requires a shareholder who "becomes legally disqualified to practice his profession within the state" to "sever all employment with, and financial interests (other than as a creditor) in, such corporation forthwith or as otherwise provided in section 1510."
A lawyer generally becomes "legally disqualified" to practice his or her profession one of two ways: voluntary resignation from the bar, or involuntary disbarment. The plaintiff nonetheless contended that he qualified for redemption under Section 1510 because he "retired" from the practice of law in 2004 and because, as a matter of public policy, the statute should be construed to apply to instances where a shareholder is discharged from employment, as well as death or disbarment.
Justice Warshawsky declined the plaintiff's invitation, finding no "constitutional rule, legislative enactment or court decision which supports a doctrine or public policy that would support an expansion of BCL 1510." The P.C., he wrote,
has existed under our laws for over thirty-five years and there has been no amendment of the sections of the BCL which control the Professional Corporation that would either expand section 1510 or independently expand the law to cover the distribution rights of a terminated shareholder. * * * * * Section 1510 in no way indicates that an obligation exists to purchase the shares of a discharged owner. While it does state that a P.C. is obligated to purchase or redeem the shares of a deceased or disqualified shareholder, the absence of any instruction for a discharged owner in a statute rife with specificity seems to indicate that no remedy in such a case was contemplated by the legislature, in spite of what may seem illogical to plaintiff and, in fact, to the court. * * * * * Perhaps the legislature preferred that such provisions to be taken care of in the certificate, by-laws, or agreement, where P.C.s could set terms based on numerous factors, such as the value an owner brought to a practice. Perhaps the legislature felt that the partnership aspect of a P.C. is dominant, and as such shares do not have the same inherent worth as a typical corporation. Such speculation, however, is irrelevant for the court's decision making. As it stands, the legislature has written a clear statute that spells out certain conditions for redemption or purchase, and these conditions are not met by plaintiff. However unfair this may seem, the court is not about to write new laws nor replace the role of the legislature.
The decision also cites in support a number of decisions from other states, including Florida, Arizona, Illinois, Utah and Washington, reaching the same conclusion under their similar P.C. statutes.
The court also rejected the plaintiff's contention that his voluntary "retirement" from the practice of law in 2004 should be deemed legal disqualification within the meaning of BCL 1509:
Plaintiff wishes the court to equate "retirement" with "legal disqualification." This court will not. Plaintiff's retirement was, to our knowledge, voluntary. It does not fit the scenario as set forth in section 1510. Not only was the plaintiff no longer employed by [the law firm], but his disqualification to be a shareholder in a Professional Corporation came through his own voluntary acts, i.e., he was not forced out of the Professional Corporation (due to a lack of license) which would trigger the offer to sell his shares. The court rejects this theory that "retirement from the practice of law" equals "disqualification from the practice of law" for the purposes of BCL § 1510.
At first blush it may seem strange, to use the judge's word, that the statute treats more favorably a professional who is disqualified by reason of his or her serious violation of official disciplinary rules, than one who is ousted from the P.C. by action of the majority shareholders. On the other hand, it's not illogical that the legislature would craft a statute that compels a swift and certain severance of a defrocked professional from the P.C., while leaving to the realm of private negotiation the terms and conditions of disassociation from the P.C. under circumstances not implicating the state's interest in professional regulation.
Certified Partisan Accountant? Court Allows LLC Member's Suit Against Company's CPA, Alleging Improper Assistance to Other Member in Judicial Dissolution Proceeding
Judicial dissolution proceedings have spawned legal malpractice cases; I once testified as an expert witness in such a case. Likely there have been accountant malpractice cases as well, brought by company owners disappointed with their own accountant's advice in connection with buyout negotiations or judicial valuation proceedings.
But until Anda Management, LLC v. Needlemen & Schacter, LLP, 2008 NY Slip Op 31534(U) (Sup Ct Nassau County May 20, 2008) (read decision here), I'd never heard of spin-off litigation involving charges against a professional for improperly taking sides in the underlying dissolution case.
Here's what happened: Anda Management and Wilmington Paper Corp. formed a Delaware LLC called Worldwide Fibers to market paper products overseas. Worldwide retained the defendant accounting firm as its accountant without a written agreement. Three years later, Worldwide's principals had a falling out, prompting Wilmington to file a proceeding for judicial dissolution of Worldwide in Delaware Chancery Court. Wilmington accused Anda's principals of impermissibly withdrawing funds from Worldwide for personal reasons and then falsely booking them as legitimate business expenses.
The Delaware proceeding ultimately settled when Anda acquired Wilmington's interest in Worldwide.
Anda and its principals subsequently brought a New York action against the accountant for breach of fiduciary duty and malpractice arising from its conduct in the Delaware case. The plaintiffs alleged that the accountant consulted with and assisted Wilmington's trial counsel by reviewing a proposed complaint, participating in conference calls with Wilmington's counsel, and submitting affidavits supportive of Worldwide's claims in which the accountant allegedly made false and contradictory statements concerning accounting advice previously given by the accountant to the plaintiffs prior to the dissolution. The plaintiffs also alleged that the accountant was aware that the expenses challenged by Wilmington were proper, and that the accountant had affirmatively counseled the plaintiffs to take some of the disbursements challenged by Wilmington. The plaintiffs further alleged that one of the accountant's employees gave the social security numbers of Anda's principals to Wilmington's counsel in order to perform credit searches on them.
The accountant denied plaintiffs' allegations and, following discovery, moved for summary judgment. The plaintiffs cross moved for leave to amend their complaint to add claims for fraud and violation of the Fair Credit Reporting Act.
In a decision by Nassau County Commercial Division Justice Ira B. Warshawsky, the court denied the accountant's summary judgment motion and granted plaintiffs leave to amend their complaint. Justice Warshawsky found that, viewing the evidence most favorably to plaintiffs, the plaintiffs adequately raised questions of fact
with respect to their assertions that the defendant acted faithlessly, recklessly and unprofessionally by affirmatively assisting the plaintiffs' adversary in the Delaware-based dissolution proceeding through the submission of false and misleading affidavits allegedly arising out of, among other things, accounting advice the defendant itself had provided to plaintiffs. * * * Indeed, and viewed in a favorable light, the record suggests that the defendant allegedly and affirmatively dispensed expert accounting advice to Anda and its closely held and joint venturers relating to corporate disbursements, tax issues and financial matters impacting upon the internal accounting practices of Worldwide as well as its two, constituent members. (Citations omitted.)
In response to the accountant's contention that there existed no fiduciary relationship with the plaintiffs, the court found that the absence of a formal retainer agreement was "not determinative" and that the "inconclusive evidence" did not rule out a finding of a relationship that "sufficiently approached privity" to sustain the malpractice claim. Justice Warshawsky also cited case law sustaining analogous claims against accountants for failure to withdraw in the face of a conflict of interest.
It would be interesting to know what damages the plaintiffs seek to recover arising from the alleged misconduct, given that the Delaware litigation ended with a buyout. The court's decision does not say.
The moral of the story? First, one cannot overstate the importance of a written engagement letter at the outset, delimiting the professional-client relationship and scope of services. Second, in my experience the great majority of dissolution cases involve accounting issues which carry the potential for involving the company accountant as an important witness. The accountant almost always better serves his or her own interests by maintaining strict neutrality during the course of the litigation between company owners.
Court Discounts Fair Value Award for Built-In Gains Tax in Shareholder Oppression Case
In a posting last December I wrote about an important estate tax case, Jelke v Commissioner, in which a federal appeals court adopted a bright-line rule requiring 100% discount for built-in capital gains tax ("BIG") in the valuation of C corporation assets. At the time I made the following prediction about Jelke's impact on stock valuation in corporate dissolution cases:
Jelke likely will not have wide impact on valuation contests in dissolution cases, for two main reasons. First, the great majority of dissolution cases involve S corporations and other entities that opt for pass-through partnership tax treatment. Second, the standard of value in estate tax cases such as Jelke is fair market value as opposed to the fair value standard specified by New York’s buyout statute. In a BCL §1118 valuation case involving a real estate holding C corporation called Matter of La Sala, a New York trial court refused to apply a discount for BIG tax liability on the ground that it was required to value the corporation as a going concern and, therefore, it would not consider capital gains taxes triggered upon liquidation. Undoubtedly, this will not be the last word on the subject of BIG discounts in stock valuation proceedings.
I was right about one thing: it was not the last word on BIG and §1118 stock valuation proceedings. As it turns out, when I wrote those words there already was percolating in Nassau County Supreme Court a buy-out proceeding in a shareholder oppression case, Murphy v. U.S. Dredging Corp., requiring the court to decide the same issue presented in the La Sala case, namely, the appropriateness under the fair value standard of applying a BIG discount to the appreciated assets of a real estate holding C corporation. The Murphy court's answer -- applying a partial discount based on the present value of future gains taxes -- lands between Jelke's 100% discount and La Sala's zero discount.
Murphy involved a dredging company formed in the 1930's owned by several families. The company ceased dredging operations in the 1970's but continued to own valuable waterfront properties in Brooklyn and Jersey City which more recently were sold for over $30 million. Most of the proceeds were reinvested, through tax exempt §1031 like-kind exchanges, in commercial properties under long term triple net leases. A minority shareholder faction sued for judicial dissolution claiming oppression by the controlling shareholders who then elected under Business Corporation Law §1118 to purchase the minority's shares for "fair value."
The valuation hearing featured dueling business appraisal experts, each of whom used net asset value and discounted cash flow methods in valuing the company's shares. In computing net asset value the purchasing shareholders' expert subtracted 100% of deferred capital gains tax on the property sales (about $11.6 million). The selling shareholders' expert deducted the present value of the gains tax assuming a 19-year holding period for the replacement properties (about $3.4 million). This was the primary reason for the experts' widely disparate company net asset valuations, almost $25 million (sellers) versus about $15 million (purchasers). A secondary factor was the purchasers' expert's use of a 15% discount for lack of marketability (DLOM) whereas the sellers' expert objected to any DLOM.
In his 29-page decision dated May 19, 2008, Commercial Division Justice Ira B. Warshawsky sides with the sellers' expert on BIG and with the purchasers' expert on DLOM. In discussing the applicable law, Justice Warshawsky significantly observes that the determination of fair value under BCL §1118 "is not identical to the procedure of Tax Court" in estate and gift tax cases where company liquidation as of the valuation date may be assumed. Rather, the judge writes, "it is clear from the evidence that no liquidation was or is contemplated by [the controlling shareholders] in our case and thus a ‘liquidation’ or semi-liquidation scenario is not appropriate when dealing with the BIG tax." The evidence in the case included a report by the company's president, shortly before the dissolution case was filed, indicating a plan to hold the replacement properties until the financing is retired in 19 years. For that reason, among others, Justice Warshawsky agrees with the sellers' expert that a hypothetical buyer would demand, and the hypothetical seller would give, a discount equal to the present value of the BIG tax assuming liquidation in 19 years.
In the La Sala case noted above, Justice Kenneth W. Rudolph of the Westchester County Supreme Court's Commercial Division denied a deduction for BIG taxes in a §1118 valuation case also involving a real estate holding C corporation (read decision here). Justice Warshawsky in Murphy writes that he “agrees with the logic expressed by Justice Rudolph" but that "under these circumstances with the BIG representing such a large portion of corporate assets it appears that a willing purchaser would expect to deduct the present value of the BIG tax along with a percentage for lack of marketability."
The Murphy decision does not render a final award. The decision recomputes the net asset value based on the present value of the BIG tax and 15% DLOM, and directs the parties to submit new computations of their income approach valuations using a court-determined working capital figure. As of this writing the court has not issued its final ruling.
In sum, Murphy may be the first and only case to date in which a BIG discount, albeit a partial one, is granted in a valuation under the fair value standard. If another such case comes along, undoubtedly there will be an interesting debate as one side draws comparison to the facts and circumstances in La Sala while the other side does the same with Murphy.
P.S. I have written a more detailed analysis of Murphy which will be published in the upcoming August issue of Business Valuation Update. BVU is a highly informative monthly newsletter published by Business Valuation Resources in Portland, Oregon. I have subscribed to BVU for many years, and highly recommend it to lawyers who want to stay current on valuation theory and case law.
Update October 26, 2008: This past week the Appellate Division, First Department, in Wechsler v. Wechsler, 2008 NY Slip Op 07983 (Oct. 21, 2008), issued a lengthy opinion in a matrimonial case vacating the trial judge's equitable distribution award insofar as it computed BIG discount based on the historical tax rate of annual taxes paid by the husband's securities trading firm. The court ordered application of a dollar-for-dollar discount as contended by the husband's expert and the court-appointed neutral. The decision, with one judge dissenting, seems to endorse the Eleventh Circuit's Jelke approach but does not close the door under the right circumstances on a partial discount based on the present value of future gains taxes. Indeed, the majority decision explicitly notes that the latter approach was not advanced by the wife's expert in the trial court proceedings. Wechsler therefore cannot be read as mandating a dollar-for-dollar discount in all matrimonial cases applying a fair market value standard, much less in disenting or oppressed shareholder buyout proceedings applying a fair value standard.
Update December 16, 2008: The final verdict is in. In a written decision dated December 9, 2008 (2008 NY Slip Op 33318(U)), Justice Warshawsky determined a fair value award of $5,956,735 for the petitioners' 36.77% interest in United States Dredging Corp. The number, based on a 45% and 55% weighting of the net asset cost and income approaches, respectively, is eerily close to the midway point between the two experts' competing valuations at the time of trial. The decision contains detailed discussions of the discrepancies in the post-trial submissions of the parties' experts on a variety of issues. The only point of law in the decision is at the end, where Justice Warshawsky states that the First Department's Wechsler decision "is not applicable to our facts, and not binding on this court."
Anatomy of a Dissolution Slugfest: Part V
This is the last in a series of five postings about a multi-faceted corporate dissolution battle waged in Nassau County Supreme Court called Matter of Marciano (Champion Motor Group, Inc.) involving three partners and a luxury automobile dealership.
Part I of the series (read it here) reviewed the basic facts of the case as laid out in the court's September 2006 decision and discussed the court's denial of defendants' pre-discovery dismissal motion in which defendants argued that Marciano lacked standing to seek dissolution because allegedly he concealed from tax authorities and federal prosecutors his claimed stock ownership interest. Part II (read it here) covered some additional issues raised in the court’s initial decision including the defendants’ argument that they acted reasonably by excluding Marciano from the business after his criminal indictment. Part III (read it here) highlighted portions of the court’s June 2007 decision in which it denied Marciano’s motion to compel payment to him of distributions pending the litigation and granted his motion for leave to amend his complaint. Part IV (read it here) addressed the court's September 2007 decision in which it denied defendants' motion for summary judgment contesting Marciano's share ownership and arguing that Marciano's March 2007 guilty plea to unrelated stock fraud charges justified their excluding him from the business operations.
This Part V examines the court's final decision dated December 7, 2007, concerning a new twist in the proceedings triggered by the defendants' assignment of a valuable dealership lease held by a company co-owned by Marciano to another company owned solely by the defendants. A postscript follows for readers interested in the outcome of the case and some reflections on its greater meaning.
Marciano Opens a Second Front and Obtains Preliminary Injunction
Justice Ira Warshawsky's decision gives the following set-up of the relevant facts (citations to the record are omitted):
This is the latest installment in a contentiously litigated commercial dispute arising out of the parties' soured, professional relationship and the subsequent ouster of plaintiff John Marciano from involvement in the "Champion" family of high-end automobile dealership entities.
Unlike the previous motions, however, the current applications for, inter alia, stated injunctive relief and the appointment of a temporary receiver, feature an entirely new, companion action -- containing fiduciary duty and debtor-creditor causes of action -- in which both opposing counsel and the Bank of America have now been joined as party defendants.
In sum, the plaintiff contends that in August of 2007, codefendants Gary Brustein and Michael Todd -- with the alleged tortious assistance of their attorneys [ ] -- concocted a scheme by which they fraudulently, and without Marciano's participation, conveyed and then effectively appropriated a valuable dealership lease held by Champion affiliate 115 South Service Road, LLC ["South Service"].
Notably, the subject lease contained a $6.5 million option to purchase the dealership property, now allegedly valued at more than double the option price. It is undisputed that Marciano currently holds a one-third, ownership in South Service.
The decision offers other details of the transaction, such as a small upfront payment of only $25,000 by the Brustein-Todd entity ("BT") coupled with a "vague, unsecured representation" of a future appraisal to determine the balance of the assignment consideration; BT immediately exercised the purchase option and obtained a $14 million mortgage loan from Bank of America portions of which allegedly were paid out to Brustein and Todd; and Brustein and Todd had South Service give Champion Motor Group a $6 million promissory note supposedly to repay monies advanced by Champion for building improvements, which loans Justice Warshawsky noted were "entirely unsupported by the bookkeeping and accounting history pertinent to both involved entities."
Justice Warshawsky found that the defendants' opposing submissions failed to refute Marciano's fact-specific claims of a fraudulent conveyance and "bogus" promissory note. He also rejected their attempt to analogize the assignment to a freeze-out merger, stating that, in this case, there was no merger and no forced elimination of a minority interest for a prescribed fair value.
Justice Warshawsky granted Marciano a preliminary injunction only to the extent of continuing the provisions of the previously-granted temporary restraining order, the terms of which unfortunately are not described in the decision. What is known is that Justice Warshawsky did not as requested compel the defendants to disgorge and restore all allegedly diverted property; he did not as requested appoint a temporary receiver; and he did require that Marciano post a $500,000 undertaking as condition for the injunction order.
Postscript
For readers who've persevered through this series looking forward to an exciting dénouement, I have some disappointing news: there is no winner to report.
According to the court information available online, the case went to trial before Justice Warshawsky starting December 17, 2007, and settled mid-trial on December 20, 2007. I spoke with one of the attorneys involved, who advised that the terms of the settlement are confidential. Alas, we will never know how the court would have ruled on the basic questions of Marciano's share ownership and standing to seek dissolution, or whether Brustein and Todd ultimately would have justified their exclusion of Marciano from the business due to his indictment and conviction on stock fraud charges.
There nonetheless are some valuable insights to be drawn from the case. Here goes:
1. The standout feature of this case is the fact that Marciano was able to get to a trial in the face of documentary evidence, including tax returns and stock ownership records, that starkly negated Marciano's claimed 38% stock interest in the Champion group of companies. There are numerous dissolution cases in which petitioners alleging oppression have lost at the outset because of tax filings inconsistent with their claimed ownership of shares meeting the 20% threshold. Marciano overcame pretrial dismissal by weaving together a complex factual scenario suggesting that all three owners collaborated for various financial accounting and tax reasons in creating on paper an ownership structure that masked or at least departed from the parties' internal agreement. This was enough for Justice Warshawsky to subject the issue to the crucible of trial.
2. The Marciano case illustrates the dynamic nature of dissolution litigation. Unlike many if not most commercial disputes, in dissolution cases the parties remain locked in a business, financial and quasi-partner relationship while the litigation lingers, giving one or both sides opportunity and incentive to wage extra-judicial campaigns and to engage in self-help that often leads to more litigation activity. The post-commencement fights in Marciano over distributions and the lease conveyance, among others, serve as a reminder to future litigants that, when the dissolution petition is filed, the fight has just begun.
3. Last January I wrote a piece for this blog called "Get Thee to the Commercial Division!" (read it here) in which I strongly recommended that attorneys file dissolution cases in the Commercial Division whenever possible. The attention and expertise devoted to the Marciano case by Justice Warshawsky of the Nassau County Commercial Division is Exhibit A to my recommendation.
4. Finally, the December 2007 Marciano decision makes a cameo appearance in the New York Court of Appeals' controversial February 2008 decision in Tzolis v. Wolff sanctioning derivative claims by LLC members (discussed here). Tzolis holds up Marciano (albeit mistakenly citing it as a New York County case) as an example of pre-Tzolis courts "blurring, if not erasing, the traditional line between direct and derivative claims" in their effort to find a "substitute remedy" for breach of fiduciary duty by LLC members. I, for one, do not see Marciano in quite the same light. Rather, accepting as true Marciano's allegations concerning the fraudulent lease conveyance and bogus promissory note, it appears to me that Marciano was intended to suffer and did suffer a direct injury to his interests as a member of South Service for which he has a direct cause of action.
Anatomy of a Dissolution Slugfest: Part IV
This is the fourth in a series of postings on a multi-faceted corporate dissolution battle waged in Nassau County Supreme Court called Matter of Marciano (Champion Motor Group, Inc.) involving three partners and a luxury automobile dealership.
Part I of the series (read it here) reviewed the basic facts of the case and discussed the defendants’ initial, unsuccessful challenge to Marciano’s standing to seek dissolution based on allegations that he deliberately sought to conceal from tax authorities and federal prosecutors his stock ownership interest in Champion. Part II (read it here) covered some additional issues raised in the court’s initial decision in the case, including the defendants’ argument that they acted reasonably by excluding Marciano from the business after his criminal indictment. Part III (read it here) highlighted portions of the court’s second decision in the case in which it denied Marciano’s motion to compel payment to him of distributions pending the litigation and granted his motion for leave to amend his complaint.
In this Part IV, we look at Justice Warshawsky's third decision in the case dated September 19, 2007, occasioned by the defendants' renewed assertions that Marciano lacked standing to seek dissolution and that their exclusion of him from the business was reasonably required to protect the business in response to the unrelated stock fraud charges brought against him by federal prosecutors.
As noted above, defendants first advanced those assertions by way of an unsuccessful pre-answer motion to dismiss the petition-complaint. On this latter occasion, following discovery, defendants moved for a summary judgment of dismissal based on what the defendants portrayed as undisputed evidence (a) that Marciano had no legal or beneficial ownership interest in Champion and (b) that Marciano's interim plea agreement, whereby he pleaded guilty to certain of the felonies charged against him, conclusively justified defendants' decision to oust him from any participation in the dealership's business affairs.
1. Marciano's Stock Ownership
In support of their dismissal motion, defendants pointed to the fact that in accordance with the parties' express design, Leasing always owned 100% of Champion, hence Marciano owned no stock at all in Champion, and held only 1% interest in Leasing. Defendants' position was buttressed by the undisputed fact that Champion's governing corporate documents were never modified to identify Marciano as a shareholder, officer or director, and by the companies' tax returns likewise inconsistent with Marciano's claimed ownership.
In opposition, Marciano contended that the respective parent-subsidiary relationship between Leasing and Champion, together with his documented 1% interest in Leasing, was structured by the defendants and their accountants for their own benefit, and constituted only one component of the overall arrangement by which Marciano became involved with the business. Specifically, Marciano claimed that the entities were so fashioned as an accommodation for defendants who had incurred substantial carry forward losses, phantom income and other liabilities associated with their own prior leasing business for which they effectively agreed to remain liable through the organizational structure adopted, and for which they otherwise would have been required to reimburse Marciano. According to Marciano, the accommodation was not intended to alter the underlying ownership agreement reached by the parties with respect to Marciano's 38% beneficial interest in the dealership entity.
Marciano also relied on the defendants' deposition testimony that an oral or handshake agreement was reached with respect to Marciano's claimed interest in Champion; that Marciano received a 38% share of the distributions corresponding to his claimed stock interest; that defendants held out Marciano as a principal and owner in documents submitted to Bentley and their lender; and that defendants in their recordkeeping blurred the distinction between Champion and Leasing.
Justice Warshawsky denied defendants' motion. Viewing the evidence in the light most favorable to Marciano, as required on a motion for summary judgment, Justice Warshawsky concluded that Marciano had raised issues of fact requiring a trial with respect to his ownership claims. "Specifically," the judge wrote, "there is documentary evidence in the record, including the defendants' own deposition testimony, which supports Marciano's assertion that the parties intended him to be, and indeed treated him as if he were, a shareholding owner of [Champion]". Justice Warshawsky also cited case precedent for the proposition that the fact that stock certificates were never formally issued to a party is not in itself conclusive of the party's shareholder status.
2. Justifiable Freeze-Out
In July 2004, a federal grand jury in the Eastern District of New York indicted Marciano and others for conspiracy, money laundering and securities fraud arising out of an IPO involving a high-tech company known as Xybernaut. In December 2005, Marciano's partners in the Champion venture, Messrs. Todd and Brustein, barred Marciano from participating in the dealership's operations and locked him out of the business premises, justifying his exclusion in part on the negative fallout from his indictment. As discussed in Part II of this series, Justice Warshawsky in his September 2006 ruling rejected the defendants' initial argument for dismissing the case based on the criminal indictment, finding that there needed to be "further factual development through discovery" concerning "the accuracy and intensity of the claimed negative impacts identified by the defendants".
As subsequently reported in the Washington Post, in March of 2007, Marciano entered a plea agreement convicting him of a single count of money laundering the proceeds of a securities fraud. In the case before Justice Warshawsky, as part of their summary judgment motion, the defendants contended that Marciano's guilty plea definitively established that he had no legitimate interest in remaining an active player in the Champion entities in light of the Bentley dealership agreement that authorized termination upon a principal's conviction of a crime.
In response, Marciano claimed that the defendants from the inception "cynically utilized the indictment as a pretext to demonize" Marciano and then oust him from the Champion entities while attempting to "steal" his 38% ownership interest.
Justice Warshawsky focused on the evidence surrounding Bentley's termination rights and its reaction to Marciano's indictment and conviction, and concluded that he could not "assign determinative import to the newly entered plea". The Bentley agreement authorized termination if a dealership principal is convicted of a crime and if, in Bentley's opinion, the conviction will adversely affect the dealer's or Bentley's good will or reputation. According to Justice Warshawsky, the defendants "have not tendered evidence in admissible form indicating that termination is imminent or even currently under consideration based upon communications or statements from Bentley".
More specifically, Justice Warshawsky cited deposition testimony of defendant Todd to the effect that Bentley had been noncommittal and had "not passed judgment" on Marciano's indictment. The judge also highlighted a January 2006 letter from Bentley, responding to a December 2005 letter from the defendants advising it of Marciano's indictment, in which rather than expressing disapproval Bentley praised Marciano, stating that it "has always respected John's professionalism as well as the business and financial acumen which we believe he brought to the dealership". Finally, Justice Warshawsky distinguished other dissolution cases supporting ejectment of a business partner for criminal misconduct where the wrongdoing involved perpetration of acts either against the subject corporation or within the course of the corporation's business activities.
To be continued . . .
Anatomy of a Dissolution Slugfest: Part III
This is the third in a series of postings on a multi-faceted corporate dissolution battle waged in Nassau County Supreme Court called Matter of Marciano (Champion Motor Group, Inc.) involving three partners and a luxury automobile dealership.
Part I of the series (read it here) reviewed the basic facts of the case and discussed the defendants’ initial, unsuccessful challenge to Marciano’s standing to seek dissolution based on allegations that he deliberately sought to conceal from tax authorities and federal prosecutors his stock ownership interest. Part II (read it here) reviewed a number of additional issues addressed in the court’s September 2006 initial decision in the case, including the defendants’ argument that they acted reasonably by excluding Marciano from the business after his criminal indictment; Marciano’s request to dissolve the related LLC’s; and Marciano’s application for various forms of interim relief and for extensive discovery.
In this Part III, we turn to the second of Justice Warshawsky’s four written opinions in the case, dated June 15, 2007, in which he considers Marciano’s motions to compel payment to him of distributions pending the litigation and for leave to amend his complaint to add claims based on defendants' alleged financial abuses in the year following commencement of the litigation.
1. Marciano’s motion to compel interim distributions.
A minority shareholder who is frozen out of the business and subsequently files for judicial dissolution is hardly surprised when the controlling shareholders cut off distributions while the litigation rages. The Appellate Division, First Department's decision in Matter of HGK Asset Management, Inc. (Greenhouse), 238 AD2d 291 [1997], authorizes a court to order payment of salary and benefits to the excluded shareholder pending the dissolution proceeding. The Second Department's decision in Deborah Int’l Beauty Ltd. v. Quality King Distributors, Inc., 175 AD2d 791 [1991], also gives courts authority to enforce provisions in shareholder agreements mandating distribution of net income pending dissolution proceedings.
Marciano took a different tack toward the same end, but came up short. He alleged that, prior to litigation, he had received shareholder distributions including monthly payments of $6,250 on account of interest due him for his $1 million letter of credit and for "services rendered". After suit was filed, initially the defendants voluntarily continued the monthly payments which they used as evidence that Marciano was not being oppressed. A couple of months after the court’s first ruling in September 2006, however, the defendants cut off the payments after they secured a release in favor of Marciano from all liabilities arising from the letter of credit and other personal guarantees, and because Marciano was no longer providing any services.
Justice Warshawsky agreed with defendants, stating that "[u]nder these factual circumstances, the plaintiff has not established his entitlement to injunctive relief compelling the defendants to continue making the monthly payments which they have since terminated".
2. Marciano’s motion to amend his complaint.
The life cycle of a corporate dissolution case can run from a few weeks to several years. The longer it goes on, the more incentive and opportunity the excluded shareholder has to add new claims to his or her original petition or complaint for alleged post-commencement wrongdoing by the controlling shareholders who continue to operate the business and control the finances.
Marciano did just that, about a year after starting his lawsuit, by moving for leave to amend his complaint to add individual and derivative claims for an accounting, breach of fiduciary duty and for repayment of a personal loan to one of the defendants. The proposed pleading included a new section alleging wrongful acts that occurred or that Marciano discovered after initiation of the action including denial of access to corporate records, excessive compensation and personal expenses taken by the defendants, and other alleged looting and waste of corporate assets.
Citing New York’s liberal policy favoring amendment of pleadings, Justice Warshawsky granted Marciano’s motion to amend although he also cautioned that the newly added derivative claims were contingent on his being a shareholder at the time of the alleged wrong.
To be continued . . .
Anatomy of a Dissolution Slugfest: Part II
This is the second in a series of postings on a multi-faceted corporate dissolution battle waged in Nassau County Supreme Court called Matter of Marciano (Champion Motor Group, Inc.) involving three partners and a luxury automobile dealership.
Part I of the series (read it here) summarized the basic facts and discussed the defendants’ initial challenge to the plaintiff Marciano’s standing to seek dissolution. The court’s decision identified evidence suggesting that, as the defendants’ argued, the plaintiff deliberately elected not to have his alleged 38% ownership interest reflected in the corporate records or in tax filings. Ultimately, however, the court refused to dismiss the case because of the disputed facts surrounding the issue of plaintiff’s share ownership.
In this Part II, we examine the several other issues of interest addressed by Justice Ira Warshawsky in his initial decision in the case dated September 5, 2006.
1. Defendants’ argument that their exclusion of plaintiff from the business was reasonable following his indictment for stock fraud.
The majority owner defendants contended that, even assuming plaintiff Marciano could establish his ownership percentage in Champion above the minimum 20% required by the dissolution statute (BCL § 1104-a), their decision to exclude him from any involvement in the business, following his criminal indictment for stock fraud in December 2004, was reasonable as a matter of law.
As with the issue of stock ownership, Justice Warshawsky concluded that the reasonableness of defendants’ exclusionary actions "must await further factual development through discovery in the underlying action". The defendants’ evidence of damaging repercussions and concrete economic injury to the business from Marciano’s indictment, the court found, was "anecdotal" and lacked "determinative foundational support in the record".
2. Marciano’s application to dissolve the related LLCs.
Marciano’s petition-complaint also sought judicial dissolution of four related LLCs in which his minority membership interests apparently were not disputed. Section 702 of the LLC Law authorizes judicial dissolution of LLCs "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement". As noted in the decision, courts have interpreted this standard to mean that judicial dissolution will be ordered only where the complaining member can show that the business is unable to function as intended or else that it is failing financially.
Of the four subject LLCs, the court agreed that dissolution of the two inactive ones was appropriate since even defendants agreed that the purpose for which they were formed never came to fruition. Dissolution of the other two was inappropriate, the court held, because both were functioning, financially stable entities.
3. Marciano’s application to appoint a limited receiver or financial monitor, and for other interim injunctive relief concerning the business operation.
Marciano also moved with only limited success under BCL § 1113 and related statutes for various forms of interim relief, ostensibly to protect his alleged $2.2 million investment in the business.
First, the court denied his request for appointment of a limited receiver or financial monitor, finding insufficient evidence that Champion’s assets were at risk or that an outside monitor was needed to ensure proper operation of the business. The court also noted that some of the allegedly improper financial practices by the defendants existed prior to Marciano’s departure without any objection by him.
The court also denied Marciano’s requests (a) to require defendants to post a $2 million undertaking, (b) to enjoin them from taking salary, perks or distributions pending the case, and (c) to enjoin defendants from utilizing Marciano’s personal credit including the $1 million letter of credit secured by his personal assets.
The court did, however, grant Marciano’s request to require that the defendants deposit all company funds in Champion’s regular bank accounts.
4. Marciano’s application to prohibit defendants from using company funds for their legal fees in the action.
It is not unusual for controlling shareholders in dissolution proceedings and in derivative actions to hire counsel to represent both the company and themselves, and to use company funds to pay legal fees. There is a substantial body of dissolution case law, however, holding that the company in such proceedings is a nominal party and therefore the individual shareholders may not use company funds to pay fees incurred by the individuals in defending against dissolution. (If the defending shareholders elect to purchase the complaining shareholder’s stock, that’s a different story.)
Here, Marciano asked the court to prohibit the defendants from using Champion funds for their legal fees. Justice Warshawsky, noting that the defendants did not specifically address this branch of Marciano’s motion, agreed that company monies could not be used "to the extent interposed against the individual defendants Brustein and Todd". Unfortunately, exactly what this signifies in the context of a hybrid action-proceeding such as this including derivative claims, which presumably triggered director and officer indemnities and rights of advancement, is not revealed in the court’s decision.
5. Marciano’s request for access to all books and records of the business.
The last issue addressed by the court in this initial skirmish was Marciano’s broad request for "full and unfettered access to all of Champion’s and the LLC’s books, records and documents". Marciano alleged that he had been afforded only piecemeal, grudging and incomplete document access. The defendants countered that they had fully cooperated to the extent reasonable and that Marciano’s demands were excessive.
Justice Warshawsky noted that a shareholder has both common law and statutory rights under BCL § 624 to examine corporate documents, including for purposes of valuing a corporation’s shares, but that neither authorizes unlimited access to all documents in a corporation’s possession. Based on the "inconclusive and conflicting allegations advanced by the parties," the court granted relief only to the extent of scheduling a conference to determine "the extent of any further document access permissible and appropriate under the common law and/or BCL § 624."
To be continued . . .
Anatomy of a Dissolution Slugfest: Part I
Question: What do you get when you take a luxury automobile dealership consisting of multiple corporations and limited liability companies, stir in three business partners, add contradictory documents concerning one partner’s ownership interest, season with a federal indictment of that same partner for stock fraud following which the other two partners freeze him out of the business, top off with a pair of litigators and bring to a boil?
Answer: A great recipe for a corporate dissolution slugfest recently played out in Nassau County Supreme Court.
Business divorce devotees can go to school on this case, thanks to a series of fact-filled and law-laden written decisions authored by Justice Ira B. Warshawsky of the Nassau County Supreme Court, Commercial Division. About the only disappointing thing about this battle royal, entitled Matter of Marciano (Champion Motor Group, Inc.), is that the plaintiff’s first name isn't Rocky.
This first of five consecutive postings on the Marciano case summarizes the underlying facts. It then examines the court’s handling of the primary defense raised by the defendants in their initial attack on the dissolution petition, in which they challenge Marciano’s standing as a shareholder to seek dissolution. In subsequent postings New York Business Divorce will discuss a number of other issues discussed in each of the court’s four, separate decisions, including:
- whether Marciano’s criminal indictment justified the defendants’ decision to exclude him from the business;
- Marciano’s application under Section 702 of the LLC Law to dissolve the several LLCs formed by the parties;
- Marciano’s request for appointment of a limited receiver or financial monitor to oversee the business;
- Marciano’s request for access to all corporate records;
- Marciano’s request to compel distributions to him pending the proceedings;
- Marciano’s application to amend his pleading to add post-commencement derivative claims for waste and mismanagement;
- Defendants’ application made after discovery for summary judgment dismissing the action based on lack of standing and Marciano’s eventual guilty plea to unrelated federal charges;
- Marciano’s application to dismiss defendants’ “unclean hands” and estoppel defenses; and
- Marciano’s application for injunctive relief concerning the defendants’ alleged self-dealing when they assigned the dealership’s lease to a related company in which they alone are principals, following which the related entity exercised an option to purchase.
The Basic Facts
In his initial, 19-page decision dated September 5, 2006, Justice Warshawsky sets forth the relevant background as follows:
Prior to 2001, defendants Brustein and Todd operated a high-end automobile dealership engaged in the sale and service of luxury automobiles through a corporation called Champion Motor Group, Inc. (“Champion”) which was organized as a subsidiary of Champion Leasing Group, Inc. (“Leasing”). Marciano claimed that in 2001, following negotiations with defendants they agreed that he would become a 40% beneficial owner in Champion (later reduced to 38%). Champion’s governing corporate documents never were modified so as to formally identify Marciano as a shareholder, director or officer, however, he did become a record shareholder or member in several related companies and LLCs.
Marciano contended that, with his assistance including a $1 million letter of credit secured by his personal assets, Champion acquired a highly lucrative Bentley Motors franchise and relocated to new dealership premises.
Marciano also alleged that, notwithstanding his omission in Champion’s corporate records as a shareholder, director or officer, he was listed as a 30% owner and as secretary/treasurer in a “Statement of Ownership and Management” executed by the parties and submitted to Bentley; corporate distributions were made in conformity with his alleged 38% interest; and that the respective shares and membership interests in the related entities were held in similar percentages.
The defendants alleged that no new shareholders agreement was executed because Marciano himself insisted that he did not want anything in writing to reflect his ownership in Champion or Leasing. The companies’ accountant testified likewise as to his conversations with Marciano, who supposedly agreed to record ownership of only one share of stock in Leasing representing 0.99% ownership.
Champion’s subsequent distributions to defendants were reflected on their K-1’s, while distributions to Marciano were reported in a 1099 tax form. Marciano admitted receiving K-1’s reflecting his 0.99% ownership interest in Champion and Leasing, although he also claimed that he never inspected them.
In July 2004, a federal grand jury indicted Marciano and others for conspiracy, money laundering and securities fraud arising out of certain unrelated stock transactions. The indictment received coverage in major newspapers including an article in the Washington Post.
The defendants alleged, and Marciano denied, that Marciano knew of the criminal investigation as early as 2001 and deliberately hid or minimized his alleged shareholder-ownership interest in Champion from prosecutors, the IRS and creditors.
The Bentley Dealer Agreement contained provisions authorizing termination based on dealer misconduct including the conviction of dealer executives of any fraud-based felony if, in Bentley’s opinion, it would adversely affect the dealer’s business or Bentley’s goodwill or reputation.
The three parties discussed the impact of the indictment and Marciano’s role in the business pending charges. Marciano sent defendants a letter in July 2005 describing the indictment as “scandalous” and suggesting that any negative impact was overstated, but also stating that if defendants felt he was not “deserving of any consideration that would let us jointly grow our business . . . I will accept such decision.”
In the Fall of 2005, Marciano and the defendants conducted unsuccessful, acrimonious negotiations concerning a final appraisal of Marciano’s interest in the business. In December 2005, citing negative fall-out from the indictment and bad publicity, the defendants barred Marciano from the business premises and excluded him from participating in its day-to-day operations.
In January 2006, Marciano filed a combined action and proceeding for dissolution of the several related corporations and LLCs pursuant to Section 1104-a of the Business Corporation Law (BCL) and Section 702 of the Limited Liability Company Law (LLCL). The complaint-petition also included claims for monetary damages, breach of fiduciary duty, an accounting and declaratory relief to the effect that Marciano is the beneficial owner of a 38% interest in Champion.
Marciano’s Standing to Seek Judicial Dissolution of Champion
Marciano sought judicial dissolution of Champion and Leasing under BCL § 1104-a on the ground that the defendants had engaged in “oppressive conduct” by freezing him out of the business. The statute requires that the shareholder seeking dissolution hold at least 20% of the corporation’s voting shares.
The defendants argued that Marciano did not hold the requisite 20% interest in Champion and therefore could not maintain a dissolution action under BCL § 1104-a. They contended that Marciano had “unclean hands” since he allegedly hid his interest in Champion and also received without objection K-1’s confirming his minimal shareholder interest in that entity.
Justice Warshawsky began his legal analysis by addressing the general doctrine of unclean hands, which rests on the premise that one cannot prevail in an action to enforce an agreement where the basis of the action is immoral or inequitable. The court also noted that the doctrine applies only where the conduct relied on is directly related to the litigation’s subject matter and the party invoking the doctrine was injured by such conduct. Turning specifically to BCL § 1104-a dissolution proceedings, the court stated that the unclean hands doctrine is not an automatic bar to relief under the statute. Rather, only when the minority shareholder’s own acts, made in bad faith and undertaken with a view toward forcing an involuntary dissolution, give rise to the complaint of oppression should relief be barred.
Applying this standard, the court denied the defendants’ dismissal motion because of unresolved factual issues surrounding Marciano’s stock ownership. The court found no evidence that Marciano’s actions were undertaken with a view toward forcing an involuntary dissolution. It also found that the K-1’s issued to Marciano were not conclusive of his shareholder status.
At the same time, the court clearly indicated that Marciano was not out of the woods on the issue of standing: he never executed a shareholders agreement reflecting his alleged 38% interest; he did not later insist that the defendants revise the corporate records so as to formalize his shareholder status in Champion; he did not otherwise explain his acquiescence in the omission of all reference to his formal ownership status in Champion’s corporate records; and he allowed his distributions to be reported as 1099 income instead of on his K-1’s.
“In short”, the court summed up, “despite the additional indicia of ownership on which the plaintiff relies, factual questions exist as to whether, by his own election and affirmative conduct, the plaintiff effectively agreed to forego the rights and benefits which would otherwise inure to him as a formally denominated 38% shareholder in Champion.”
To be continued . . .
