Inspection1

Over the last several years, the books-and-records proceeding and its corresponding shareholder rights of inspection seem to have entered a bit of renaissance period in the courts. We here at New York Business Divorce have reported on at least nine decisions primarily addressing the topic since September 2014, going on record to proclaim the phenomenon as a “boost” for the summary proceeding, by which minority owners in closely-held businesses can get a window into the management and operation of the companies from which they’ve been shut out. We’ve even gone so far as to suggest that books-and-records proceedings may be “on a roll” of late, both in terms of an expansion what constitutes a “proper purpose” for bringing the proceeding, as well as in terms of the scope of information attainable.

That trend, at least with respect to the frequency with which issues related to inspection rights are being litigated, appears to be continuing into 2018. What follows are summaries of three of this year’s more notable decisions addressing inspection rights – all from Manhattan Supreme Court, as it happens.

But first, a quick refresher on the subject matter at hand…

Books-and-records proceedings and inspection rights generally

In New York, the books-and-record proceeding – much like the dissolution and appraisal proceedings with which readers of this blog surely are familiar – is a “special proceeding” under Article 4 of the Civil Practice Law and Rules. Special proceedings are expedited and summary in nature such that, in the language of CPLR 409, “[t]he court shall make a summary determination upon the pleadings, papers and admissions to the extent that no triable issues of fact are raised” and “may make any orders permitted on a motion for summary judgment.” In other words, the books-and-records proceeding is teed up from the outset for relief on an accelerated basis.

That relief is available with respect to all business forms – including corporations and limited liability companies, as well as co-ops, condominiums, and partnerships – and is governed by both statute and the common law. When petitioning for relief under the Business Corporation Law, BCL § 624 requires the petitioning shareholder first to have made a pre-suit demand upon the company complete with an affidavit of proper purpose. There’s no such analogue in the Limited Liability Company Law’s counterpart, LLCL § 1102.

As with dissolution and appraisal proceedings under BCL §§ 1104, 1104-a and 623, venue for the books-and-records proceeding typically is fixed in “the supreme court in the judicial district where the office of the corporation is located.” There’s no standing requirement, as in dissolution proceedings under BCL §§ 1104 and 1104-a, that the petitioner possess some minimum stock ownership percentage before running into court.

Unlike directors and managers, whose rights of inspection are “absolute and unqualified” to allow them carry out their fiduciary responsibilities in operating the business, the inspection rights of minority shareholders and members are limited in nature. This is particularly true under the governing statutes – say, BCL § 624 and LLCL § 1102 – which specifically (and with some admitted paucity) delineate the kinds of records to which a shareholder or member is entitled.

The common law is more generous, extending minority owners’ inspection rights beyond the materials itemized in the statutes and ultimately leaving the matter of scope to the presiding judge’s discretion. That scope recently has been expanded to include, for example, the right of a petitioning shareholder of a holding company to inspect the records of the company’s wholly-owned subsidiary in which the petitioner has no ownership interest (Matter of Pokoik v 575 Realties, Inc., 143 AD3d 487 [1st Dept 2016] [discussed here]). As with common-law dissolution, the common-law right of inspection was supplemented, not superseded, by subsequent statutory rights.

The standard a books-and-records petitioner must meet is one of “good faith and proper purpose.” As noted in the “boost” and “on a roll” references above, the definition of “proper purpose” also has been expanded of late to include, for example, the right of a minority owner to seek litigation fodder on the basis of suspected control-owner misconduct, “even if the inspection ultimately establishes that the board engaged in no wrongdoing” (see Retirement Plan for Gen. Empls. of City of N. Miami Beach v. McGraw Hill Cos., Inc., 120 AD3d 1052 [1st Dept 2014]; see also Novikov v Oceana Holdings Corp., 46 Misc3d 561 [Sup Ct, Kings County 2014] [discussed here]). Other commonly-asserted proper purposes include the right to obtain information in order to determine the value of one’s stock or to investigate the propriety (or impropriety) of a company’s dividend/distribution policy (or lack thereof).

If the books-and-records petitioner is able to establish that her demand for company information is relevant and necessary and for a valid purpose, then the burden shifts to the company and its control-owners to show bad faith and an improper purpose – for example, that the petitioner’s overbroad demand was meant only to harass or to obtain trades secrets or other proprietary business information to aid a competitor. In the event of sharply-conflicting and equally-persuasive allegations, the court may hold a hearing to determine issues concerning proper purpose and scope.

Now, back to our regularly-scheduled program…

Inspection rights are a gas, gas, gas!

Earlier this month, in Atlantis Management Group II LLC v Nabe (2018 NY Slip Op 32460[U] [Sup Ct, NY County, October 1, 2018]), Manhattan Commercial Division Justice Saliann Scarpulla, whose insightful decisions are no strangers to this blog, found that an outside investor-member of four NYC gas stations organized as LLCs was entitled to the books and records specifically listed in LLCL § 1102 and the parties’ operating agreement.

In Atlantis, the investor-member sued the defendant control-owners for an accounting and sought to inspect the companies’ books when the gross receipts and profits of one of the gas stations allegedly shot up after a neighboring station shut down. The control-owners countered for declaratory relief, claiming that the parties orally had amended their operating agreement under which the investor-member allegedly agreed to a flat $10K per month in lieu of any profit distributions and otherwise agreed to dispense with the control-owners’ duty to provide financial information.

Justice Scarpulla would have none of it. Never mind that, under LLCL § 102, oral operating agreements aren’t recognized in New York – an argument that the investor-member apparently didn’t make and that the court didn’t sua sponte raise in its decision – the court found not only that the investor-member had an “unconditional and distinct” right to inspect under LLCL § 1102 and the parties’ written operating agreement, but also that the control-owners’ stiff-arm tactics were “inconsistent with their fiduciary duties.”

Inspection rights and the attorney-client privilege

Speaking of the nonexistence of oral operating agreements in New York, last month in Jarmuth v Leonard (2018 NY Slip Op 32155[U] [Sup Ct, NY County, September 5, 2018]), Manhattan Supreme Court Justice Kelly O’Neill Levy – architect of the increasingly infamous Shapiro doctrine, which allows for the unilateral adoption without prior notice of an operating agreement by a majority – found that a shareholder-resident in a NYC co-op was entitled under BCL § 624 to introduce at the deposition of a board member meeting minutes allegedly memorializing advice from the co-op’s counsel given to the board.

In Jarmuth, the resident-shareholder sued the co-op and its board of directors for fiduciary breach and corporate waste when the directors decided at a board meeting to settle an underlying property-damage case against the co-op and one of the directors individually and to assume all of the co-op’s related legal fees. The shareholder-resident sought to confront the defendant-board member with a copy of the minutes at her deposition. The co-op objected on the basis of privilege, arguing in an attorney “briefirmation” that the minutes “memorializ[ed] counsel’s strategic discussions with the Board concerning the wisdom of a potential settlement of the [underlying] litigation and the ratification by the Board.”

Justice O’Neill Levy didn’t buy the co-op’s argument, particularly given the fact that the minutes otherwise were available to all of the co-op’s shareholders and thus weren’t intended to be confidential. The court then went on to cite the plaintiff’s rights of inspection under BCL § 624 and the common law and found that “[s]ince shareholders not on the Board have access to the meeting minutes, they are not privileged and may be introduced at further depositions.”

Inspection rights and pop divas

Finally, earlier this summer in Madonna Ciccone v One West 64th Street, Inc. (2018 Slip Op 31372[U] [Sup Ct, NY County, June 25, 2018]) (yes, that Madonna), Manhattan Supreme Court Justice Gerald Lebovits – who, in addition to issuing well-written and reasoned decisions, offers practitioners informative tips on legal writing and all matters New York practice in his monthly NYSBA Journal column, “The Legal Writer” – arguably bucked the recent trend in favor of shareholder inspection rights, finding that Madonna’s demand to inspect her co-op’s books and records didn’t meet the requisite standard.

In Ciccone, Madonna sued her co-op a little over two years after the board amended its proprietary lease – allegedly with the pop diva specifically in mind – to preclude her children and domestic workers from living in her apartment unless she too was “in residence.” Madonna alleged that the co-op breached the covenant of good faith and fair dealing and sought to have the amendment declared unenforceable. She also sought to inspect all documents related to amendment.

In a prior decision and order, the court dismissed Madonna’s causes of action for declaratory relief and breach of the implied covenant on the basis of the four-month limitations period for proceedings against a “body or officer” under CPLR 217. Despite the fact that the guts of her case had been dismissed, Madonna persisted with her books-and-records claim, arguing that her desire “to investigate how and why her lease was amended so she can protect her children so that they can live in [the apartment] as a family” was a proper purpose.

Justice Lebovits disagreed, finding that Madonna “does not need those materials anymore to prove a case that, by law, she is no longer allowed to prove” and that “[t]o seek the records at this phase is merely harassing.” The court stopped short of dismissing Madonna’s lone remaining claim, however, hinting that the defendant co-op hadn’t asked him to do so. According to the case docket as of the date of this post, the defendant apparently didn’t get the hint.

Much digital ink has been spilled on this blog (here, here, here, and here) and elsewhere (Tom Rutledge’s terrific article can be read here) concerning the ability of LLC controllers to adopt or amend an operating agreement without the consent of all members.

In New York, Shapiro v Ettenson kicked things off, holding that the majority members of an LLC validly adopted a post-formation operating agreement without the minority member’s consent. The agreement in that case eliminated the minority member’s salary, authorized dilution of a member interest for failing to make mandatory capital contributions (the majority members issued a capital call promptly after the amendment), and member expulsion (the majority members expelled the minority member soon after the court upheld the LLC agreement).

Next came Ho v Yen where the court denied interim injunctive relief to a minority member who challenged the majority members’ adoption of a post-formation LLC agreement that authorized member expulsion and buy-out at book value (the majority members expelled the minority member within days after the amendment).

The appellate panel in Shapiro rested its holding on LLC Law § 402 (c) (3) which speaks to the majority’s right not only to adopt an operating agreement but also to amend it subject, of course, to any contrary provision in the operating agreement and certain statutory carve-outs in LLC Law § 417 (b). But since the vast majority of operating agreements that I’ve seen expressly require the consent of all members to amend, I figured I’d have a long wait before seeing a case that tests the limits of the non-unanimous amendment power.

My wait wasn’t nearly as long as I expected. Last month, in Yu v Guard Hill Estates, LLC, 2018 NY Slip Op 32466(U) [Sup Ct NY County Sept 28, 2018], Manhattan Commercial Division Justice Saliann Scarpulla denied a motion to dismiss a minority LLC member’s claims against the majority members for breaching their fiduciary duty by adopting, without the minority member’s consent, amendments authorizing mandatory capital calls and foreclosing upon the interest of a member who fails to contribute. What makes the case even more interesting is that the pre-existing operating agreement signed by all the members included a provision generally authorizing amendment by vote of members holding 51% of the member interests.  Continue Reading Does This Decision Put the Brakes on Non-Unanimous Amendments to Operating Agreements?

Last week, this blog wrote about a decision by Manhattan Commercial Division Justice Saliann Scarpulla in the burgeoning Yu family melee, in that case pitting one brother against the other and their sister over dissolution of two single-asset real estate holding LLCs. In her decision, Justice Scarpulla denied dissolution of the LLCs, despite the plaintiff’s allegations that his brother and sister had a personal “vendetta” against him, which they carried out by amending the operating agreement to remove the plaintiff as a manager, authorizing a mandatory capital, and, when he was unable to meet the capital call, foreclosing on his membership interest.

This week, we look at a companion decision by Justice Scarpulla, issued the same day as the first, expanding the intra-family brouhaha to include the three siblings’ parents. In Matter of Yu v Bong Yu, 2018 NY Slip Op 32009(U) [Sup Ct, NY County Aug. 15, 2018], the court considered the important but novel question of what impact, if any, does a shareholder’s assignment of voting rights under a stock pledge agreement have on his or her standing to sue for statutory dissolution of the business as well as under the common law. Continue Reading Stock Pledge Agreement Defeats Minority Shareholder’s Standing to Sue for Statutory But Not Common-Law Dissolution

What’s a weaponized LLC? It’s one whose operating agreement gives the controlling majority members the authority to dilute, remove from management, or expel a non-controlling minority member, typically for failing to satisfy a mandatory capital call or engaging in conduct the majority determines to be a breach of specified standards of conduct.

Weaponization can occur openly or stealthily. Openly, the dilution, removal, or expulsion powers are spelled out explicitly in the operating agreement signed by all the members. Stealthily, the operating agreement authorizes amendment of the operating agreement by the majority, i.e., without minority consent, effectively allowing such powers to be added at a later time of the majority’s choosing.

Few tears normally are shed when a minority member is diluted, removed from management, or expelled under the express provisions of an operating agreement to which the minority member knowingly subscribed. As the saying goes, you made your bed, now lie in it.

Does the minority member hit with the stealth variety via an amendment to which he or she never consented deserve any greater sympathy? More importantly for litigators, does the majority’s adoption and implementation of such measures for the purpose of squeezing out the minority member, or otherwise gaining leverage in a dispute not necessarily related to the LLC’s governance and business affairs, provide the minority member with grounds to seek judicial dissolution of the LLC? Continue Reading Judicial Dissolution and the Weaponized LLC

C’mon, New York lawyers, do you really want to spend your time, your client’s money, and bother the court litigating a dead-end claim that your client rightfully expelled his or her LLC co-member for alleged misconduct, however egregious, when you don’t have an operating agreement that says your client can do it?

Despite clear law on the subject, some have not gotten the word as made evident by Justice O. Peter Sherwood’s ruling last month in Matter of Goyal (Vintage India NYC, LLC), 2018 NY Slip Op 31926(U) [Sup Ct NY County Aug. 7, 2018].

First, some background: Over ten years ago, in one of my earliest posts on this blog, I observed that, in contrast to states whose LLC statutes authorize judicial expulsion a/k/a dissociation of a misbehaving member, New York’s LLC Law does not authorize a judicial expulsion remedy, and that non-judicial member expulsion can only occur if and under the circumstances specified in the operating agreement.

Two years later, a far more consequential observer, namely, the Appellate Division, Second Department, in Chiu v Chiu specifically held that courts lack authority to order expulsion of an LLC member for alleged misconduct, absent language in the operating agreement expressly providing for an expulsion remedy. Continue Reading Repeat After Me: You May Not Expel a Member of a New York LLC Unless the Operating Agreement Says So

In the judicial dissolution case that John (“Jake”) Feldmeier brought after resigning as the highly paid president of the family-owned business, the central issue over which he and his opposing siblings fought was whether the siblings’ subsequent refusal to issue shareholder distributions, as Jake claimed, was the discontinuation of a longstanding practice of awarding de facto a/k/a disguised dividends to shareholders in the form of bonuses or, as the siblings contended, was the continuation of a company policy over which Jake himself presided for many years whereby the owners and managers made good-faith business judgments to award merit-based bonuses to officers and employees.

In support of his claim, and in opposition to his siblings’ summary judgment motion, Jake invoked the granddaddy of all New York minority shareholder oppression cases, Matter of Kemp & Beatley, Inc., in which the state’s highest court upheld an order of judicial dissolution in favor of terminated employee-shareholders who similarly complained about the non-issuance of dividends where the evidence showed, prior to their departures, that the company historically awarded de facto dividends based on stock ownership in the form of “extra compensation bonuses.”

In opposition to Jake’s claim, and in support of their summary judgment motion, the siblings argued, on the law, that the reasonable-expectations standard for oppression formulated in Kemp, a case brought under Section 1104-a of the Business Corporation Law, did not apply to Jake’s non-statutory claim for common-law dissolution — Jake, as a 12% shareholder, lacked standing under Section 1104-a’s 20% minimum — and, on the facts, that Kemp was distinguishable because, unlike in that case, prior to Jake’s departure and with his active participation and approval as company president, bonuses were paid disproportionately to stock ownership and not at all to non-employee shareholders.

So who prevailed? Continue Reading Past is Prologue: Refusal to Adopt Dividend Policy After Petitioner Resigns Not Ground for Dissolution

This is the final installment of a three-part series about the basics of contested New York business appraisal proceedings. The first post addresses the various ways in which business owners can steer a dispute into an appraisal proceeding. The second post addresses the legal rules and principles that apply in appraisal proceedings. This final post addresses the appraisal methodologies and principles that apply in valuation proceedings. Without further ado, let’s talk accounting.

Valuation Date

The date on which a business interest is appraised – the “valuation date” – can have a huge impact on its worth. For example, for a real estate holding company in a rising market, generally speaking, the later the valuation date the greater the value. If the valuation date is earlier, the seller may receive and the buyer may pay less for an ownership stake. For most kinds of appraisal proceedings, the valuation date is set by statute, so there is little to litigate on the subject.

Under Partnership Law 69 and 73, a wrongfully withdrawn, retired, or deceased partner is entitled to have the “value” of his or her interest determined as of the date of “dissolution,” meaning the event of withdrawal, retirement, or death. Continue Reading Basics of Valuation Proceedings – Litigating an Appraisal from Start to Finish – Part 3

Very few and very far between are cases in which the holder of a minority membership interest in a New York LLC — with or without a written operating agreement — prevails in an action brought under section 702 of the New York LLC Law for judicial dissolution. Mainly that’s because the statute’s “not reasonably practicable” standard as interpreted by the courts is limited to a showing of the LLC’s failed purpose or financial failure, and thus excludes as grounds for dissolution oppression, fraud, or other overreaching conduct by the majority directed at the minority.

Last week, in one of the rare exceptions to the general rule, Nassau County Commercial Division Justice Timothy S. Driscoll handed down a post-trial decision granting the judicial dissolution petition of two individuals holding a collective 42% membership interest in an LLC that operates a gymnastic facility. In Matter of D’Errico (Epic Gymnastics, LLC), Decision & Order, Index No. 610084/2016 [Sup Ct Nassau County Aug. 21, 2018], Justice Driscoll held that dissolution under section 702 was warranted where, after dissension arose, the majority members formed a new, similarly named entity to collect the subject LLC’s revenues and to dole them out to the subject LLC if, as, and when the majority members saw fit, thereby reducing the subject LLC to a “marionette to be manipulated at will by [the new LLC].”

The decision deserves attention, not only in respect of its navigation of the prevailing dissolution standard articulated by the Appellate Division, Second Department, in the 1545 Ocean Avenue case, but also as a cautionary lesson for business divorce counsel about the potential backfire of overly aggressive self-help measures undertaken by controllers in response to perceived acts of disloyalty or abandonment by minority members. Continue Reading Gymnastics Business Falls Off the Beam in LLC Dissolution Case

Douglas K. Moll, Professor of Law at the University of Houston Law Center, is well known to business divorce aficionados for his many scholarly articles examining minority oppression and fiduciary duty in close corporations and LLCs, and as co-author with Robert Ragazzo of one of the leading treatises on closely held business organizations. He’s also familiar to regular readers of this blog, having been featured previously in an online interview and in Episode #8 of the Business Divorce Roundtable podcast.

Professor Moll recently published yet another, terrific article entitled Judicial Dissolution of the Limited Liability Company: A Statutory Analysis (19 Tennessee Journal of Business Law 81 [2017]) in which he brings some much-needed perspective to the statutory landscape of the diverse grounds for judicial dissolution of LLCs found among the fifty states, the District of Columbia, and the several uniform and model acts promulgated since the 1990s. From the article’s abstract:

This article, prepared for the Business Law Prof Blog 2017 Symposium, examines the statutory grounds available to members who seek judicial dissolution of an LLC in all fifty states plus the District of Columbia. I also examined the judicial dissolution grounds in five model statutes: the 1992 Prototype LLC Act, the 2011 Revised Prototype LLC Act, the 1996 Uniform LLC Act, the 2006 Revised Uniform LLC Act, and the 2013 Revised Uniform LLC Act. Two charts are provided – one that provides the judicial dissolution grounds for each statute, and one that tabulates the different approaches.

Part I summarizes the methodology used and highlights the frequency of various statutory provisions. Part II analyzes two particular provisions—dissolution if it is not reasonably practicable to carry on the LLC’s business in conformity with its governing documents, and dissolution as a result of oppressive conduct by those in control. With respect to the “not reasonably practicable” language, the article argues that the impracticability of carrying on the business in conformity with either the certificate or the operating agreement should result in dissolution, but there is confusion over which statutory articulation is consistent with this result. With respect to the oppressive conduct ground, this article provides some possible explanations for why oppression-related dissolution statutes are less common in the LLC setting than in the corporation context.

Happily, Professor Moll accepted my return invitation to the podcast to discuss his findings. In the interview, a link to which appears below, Professor Moll highlights some surprising variations among the statutory expression of the prevailing not-reasonably-practicable dissolution standard. He also discusses some of the reasons for the relative scarcity — compared to close corporation statutes — of minority oppression as ground for judicial dissolution of LLCs, and the competing forces of freedom of contract and judicial paternalism that continue to shape the evolving statutory and common-law jurisprudence governing internal relations among LLC members.

Give it a listen. I guarantee you’ll be glad you did.

 

The dog days of August are upon us, a perfect time as I do each year to offer vacationing readers some lighter fare consisting of summaries of a few recent decisions of interest involving disputes between business co-owners.

This year’s summaries include a partnership appraisal case from Nebraska in which the usual “battle of the experts” turned into a romp for one side, a New York case in which one side insisted that a written “Shareholder Agreement” was not really a shareholder agreement, and a federal court decision from Illinois in which the court rejected the argument that it should abstain from hearing a statutory dissolution claim.

A Train Wreck of a Valuation Case

If you want a lesson in how not to litigate an appraisal proceeding, look no further than Fredericks Peebles & Morgan LLP v Assam, 300 Neb. 670 [Sup Ct Aug. 3, 2018], in which the Nebraska Supreme Court recently affirmed the appraisal court’s determination, pursuant to the buy-out provisions of a law firm partnership agreement, of the $590,000 fair market value of a withdrawn partner’s 23.25% partnership interest. Continue Reading Summer Shorts: Partnership Appraisal and Other Recent Decisions of Interest