Internal shareholder disputes involving closely held corporations can take several different forms when they land in court.  The type of litigation addressed primarily by this blog is the dissolution proceeding, in which the ultimate objective is the company’s liquidation or, as usually happens, a buyout.  Sometimes, as a prelude to dissolution proceedings or negotiated buyout, one shareholder files suit accusing another shareholder of engaging in unauthorized company transactions.  Such tactical lawsuits can be particularly effective with companies with 50/50 shareholders where the complainant believes with some justification the court is more likely to enforce the rights of a co-equal owner to an equal say in the company’s business affairs.

Along these lines comes the fascinating case of Hellman v. Hellman, 19 Misc 3d 695 (Sup Ct Monroe County 2008), involving a fight between two brothers each owning 50% of the shares in a lighting business founded by their father in the 1950s, called Maynards Electric Supply.  The decision, written by Justice Kenneth R. Fisher of the Commercial Division in Rochester, is a scholarly and highly instructive exegesis on the interplay between officer and board authority in the closed corporation setting where, typically, no one pays attention to corporate formalities until it’s too late.

Brothers Glenn and Bruce Hellman are Maynards’ sole shareholders and directors.  Both are actively employed in the business.  Bruce is President and Treasurer.  Glenn is Vice-President and Secretary.  The business operated since 1985 in a building owned jointly by the two brothers and two other siblings.  The lease was scheduled to expire at the end of June 2005.  In 2004, Bruce began lease negotiations with the owner of another building (“Stockwood”).  Bruce informed Glenn of the negotiations.  Glenn disagreed with the proposed relocation.  Lawyers for the two exchanged letters in which Glenn warned that Bruce lacked authority on his own to make commitments on the company’s behalf.   Bruce’s lawyer sent Glenn the proposed form of lease.  Glenn objected anew to Bruce’s authority to enter into the lease.  In May 2005, Bruce announced that the company would not be renewing the existing lease upon termination.  Two days before the termination date, Bruce as President executed in the company’s name a five-year lease with Stockwood.  Shortly thereafter he informed Glenn of the new lease and advised of a planned move the coming Fall.  Glenn’s lawyer wrote to Stockwood maintaining that Maynards had not approved the lease.

In August 2005, Glenn filed a lawsuit against Bruce and Stockwood.  Glenn asserted (1) that Bruce lacked authority to execute the lease without the prior affirmative vote of the board of directors, (2) that the Stockwood lease constituted waste of corporate assets, (3) that the lease should be set aside and declared null and void, (4) that Stockwood refund all lease payments made by Maynards, and (5) that Bruce reimburse the company for any damages occasioned by the lease and pay Glenn’s attorney’s fees.

Following discovery the brothers both moved for summary judgment on the two main issues surrounding the lease:  First, was Bruce authorized to enter into the Stockwood lease without getting the prior approval of Maynards’ board of directors consisting of the two brothers?  Second, even with such authority, could Glenn challenge the lease as corporate waste, or was it beyond judicial scrutiny under the business judgment rule?

Justice Fisher begins his analysis with the two, basic sources of authority for action by a board and its officers.  The first is New York’s Business Corporation Law, section 701 of which states that “the business of a corporation shall be managed under the direction of its board of directors” and section 715(g) of which states that “[a]ll officers as between themselves and the corporation shall have such authority and perform such duties in the management of the corporation as may be provided in the by-laws or, to the extent not so provided, by the board.”  The second is Maynards’ by-laws which essentially restate BCL section 701 as far as the board’s role, and provide as follows concerning the duties of president:

The president shall be the chief executive officer of the corporation; he shall preside at all meetings of the shareholders and of the board; he shall have the management of the business of the corporation and shall see that all orders and resolutions of the board are carried into effect.

The quoted by-law provision, states Justice Fisher, places “[n]o limitations of any sort . . . upon the president in fulfilling management duties as chief executive officer”.  This in turn forms the legal framework for the judge’s analysis of the facts.  “In the absence of any express restriction in the by-laws or otherwise,” says Justice Fisher, “the actual conduct of the business by its president must inform the decision whether the president had the presumptive power to enter into the lease without the prior authorization of the board of directors.”

The decision includes lengthy excerpts from the brothers’ deposition testimony, the gist of which Justice Fisher describes as follows:

Both depositions demonstrate that decisions of corporate management were not made by a vote of the board of directors and that Bruce Hellman, as president of Maynards, made most, if not all major decisions (as had his father before him), taking into consideration input from Glenn Hellman only as he saw fit.

Justice Fisher accordingly concludes that Bruce “had presumptive implied authority to execute the lease with Stockwood without pre-approval from the board of directors, and even when he knew that Glenn Hellman would object at a duly convened board meeting if one were scheduled.”  In reaching his conclusion, Justice Fisher rejects Glenn’s reliance on Sterling Industries, Inc. v. Ball Bearing Pen Corp., 298 NY 483 (1947).  In Sterling the New York Court of Appeals held that the presumption of actual implied authority was rebutted, or did not apply in the first instance, where the president initiated a lawsuit notwithstanding that the corporation’s board, by a deadlocked vote, had failed to authorize the litigation.  “A similar situation is not present here,” writes Justice Fisher, “where Glenn Hellman offers no admissible proof, or allegation even, that the board of Maynards was called to meeting, formal or otherwise, and he offers ‘no minutes as to corporate action in such capacity by them [as members of the board of directors], with respect to this action’ in executing the lease by the corporate president.”  In other words:

The context of this case requires the court, in determining whether Bruce Hellman has met his initial burden on summary judgment, to sustain the exercise of the president’s presumptive, actual, implied power to act in executing a lease in the normal course of business, in the face of objections interposed by Glenn Hellman and his attorneys without any effort to convene the board for the purpose of restricting the president in his exercise of the management powers conferred on him by the by-laws and past practice in general, or for the specific purpose of forbidding the lease with Stockwood in particular.

Justice Fisher next addresses what he calls the “more difficult question” whether Bruce is entitled to summary judgment dismissing Glenn’s claim of waste based on allegations that the lease with Stockwood is detrimental to the company’s interests.  The difficulty arises, Justice Fisher writes, because there is no New York case precedent that squarely addresses whether the action of an officer, not taken in the dual role of officer/director, is entitled to protection under the business judgment rule.  Under the rule, corporate decisions are immune from judicial scrutiny unless they lack a legitimate business purpose or are tainted by a conflict of interest, bad faith or fraud.

Justice Fisher highlights commentary taking both sides of the issue, but ultimately concludes that “the great weight of authority favors application of the business judgment rule to officers acting in their capacity as officers within the scope of their delegated authority.”    As applied to the facts before him, Justice Fisher holds in favor of Bruce as follows:

Bruce Hellman executed the lease within the scope of his delegated authority, as detailed at length above, and therefore is entitled to have that discretionary decision reviewed under the rubric of the business judgment rule just as if the board of directors had made the decision itself. Any other approach would encroach on a president/general manager’s presumptive powers as set forth in the New York caselaw set forth above, and would by judicial fiat effectively “surrende[r]” a corporate board’s otherwise sustainable “delegation decision” and thereby “interfere with corporate management by subjecting the officer to greater scrutiny” than the board would be subjected to if it had made the decision itself.

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As set forth, no evidence or allegation is made that the transaction ultimately made by Bruce Hellman was self-interested. Bruce Hellman establishes on his motion the economic and other reasons for the decision to enter into the Stockwood lease and abandon the family owned premises on North Clinton Avenue, and therefore he establishes his good faith. Glenn Hellman fails to raise an issue as to whether the decision was not made in good faith.

So what are the lessons of the Hellman case?  First and foremost, when 50/50 shareholders are on a collision course, regardless whether formal board meetings have been conducted in the past, the shareholder looking to block corporate action by the other shareholder/officer should call a meeting of the board (and/or a shareholders meeting, depending on the circumstances) to consider the disputed corporate action.  If both shareholders/directors attend, the resulting deadlock vote on a resolution to approve the disputed action presumably will terminate officer authority to undertake the very same action.  If the other shareholder boycotts the meeting and thereby defeats quorum requirements under the by-laws — an issue not addressed in Hellman — I’ll hazard a guess the court will deem such conduct the equivalent of board deadlock.

The second lesson is, dust off the by-laws and read them closely.  You may be surprised at the variance between what they say and how the principals have operated the company.

FinallyI presume there was no written shareholders’ agreement in Hellman since Justice Fisher does not mention one.  Shareholders’ agreements frequently specify major decisions requiring unanimous or super-majority approval by the shareholders.  Typically included are merger and sale of the company, along with other important decisions involving mortgages, leasing, engagement of lawyers and accountants, and expenditures over defined dollar thresholds.  The point is, particularly in the 50/50 corporation where negotiating leverage presumably is equal at the outset, the parties can use a written shareholders’ agreement to avoid one shareholder “pulling rank” based on his or her designation as president.

Update March 30, 2009:  On Glenn Hellman’s appeal from the decision, last week the appellate court vacated the grant of summary judgment, and reinstated his complaint, on the ground that Glenn had raised issues of fact requiring trial as to Bruce’s authority to act without Board authority.  60 AD3d 1468, 2009 NY Slip Op 02418 (4th Dept Mar. 27, 2009).  Here’s what the court wrote:

The record establishes that, pursuant to the bylaws of “Maynard’s Holding Corp.,” the president, i.e., defendant, was vested with “the management of the business of the corporation,” and he thus had the presumptive authority to enter into contracts on the corporation’s behalf in the course of the business of the corporation (see generally Goldston v Bandwidth Tech. Corp., 52 AD3d 360, 362-363, lv dismissed 11 NY3d 904; Odell v 704 Broadway Condominium, 284 AD2d 52, 56-57).  The record further establishes that defendant previously had signed leases on behalf of the corporation, although plaintiff contends in this instance that he did not agree to the lease and also did not agree that defendant had the authority to bind the corporation to it.  Plaintiff also established in opposition to the cross motions that the previous leases signed by defendant were the subject of Board resolutions granting defendant the authority to sign them, or they were signed by defendant “by authority of the Board of Directors of [the] corporation.”  We thus conclude that plaintiff raised an issue of fact whether, pursuant to past practice, defendant had the authority to lease property without prior authorization by the Board (see Arrow Communication Labs. v Pico Prods., 206 AD2d 922, 923; see also 56 E. 87th Units Corp. v Kingsland Group, Inc., 30 AD3d 1134, 1134-1135).  In light of our determination, we do not reach the parties’ remaining contentions.

It’s hard to square the appellate court’s finding of evidence of prior leases receiving Board approval with the deposition testimony summarized in the lower court’s decision, but that’s what makes appeals so hard to predict.

Update November 1, 2010:  On remand from the Appellate Division, and after holding a trial, Justice Fisher issued a written opinion again concluding that Bruce had authority as President to enter into the lease.  Read here my post on the latest decision.