In the world of closely held corporations, what makes a shareholder a shareholder? 

Section 508 of New York’s Business Corporation Law states that "the shares of a corporation shall be represented by certificates or shall be uncertificated shares."  Scattered throughout the BCL are references to "shareholders of record".  BCL Section 624 requires every corporation to keep "a record containing the names and addresses of all shareholders" and makes such record "prima facie evidence of the facts stated therein" in any action or special proceeding against the company, its directors, officers or shareholders.

However, ask lawyers about their experiences with small, closely held corporations and you will hear countless stories about companies that never issued stock certificates, never kept a stock ledger, never adopted bylaws, never had a written shareholders’ agreement, and never held formal shareholder meetings much less kept meeting minutes.

Such widespread record keeping lapses create fertile ground for disputes over shareholder status in many different legal settings, including corporate dissolution contests.  Sometimes the dispute is over the stock percentage held by an otherwise acknowledged shareholder.  This kind of dispute is geared toward either supporting or defeating the specific stock-holding percentage requirements for bringing a deadlock dissolution proceeding under BCL 1104 (50%) or an oppressed minority shareholder dissolution proceeding under BCL 1104-a (20%).

Then there are the cases in which the respondent contends that the petitioner never held a stock interest.  More often than not, these cases are brought under the oppression statute by putative minority shareholders who lack control of, or access to, the corporation’s books and records.

This is the first of three consecutive posts on the standing challenges to be overcome by a petitioner who holds no stock certificate or other direct evidence of a stock interest.  Each of the three cases highlighted in these posts presents a distinct factual scenario.  All three cases remind us of the substantial additional litigation costs and time involved when an initial evidentiary hearing must be held to determine the petitioner’s standing before proceeding to a hearing on the merits of the dissolution petition.

The first case is Matter of Schwartzman (First Rate Capital Corp.), 2009 NY Slip Op 30457(U) (Sup Ct Suffolk County Feb. 24, 2009) decided by Suffolk County Commercial Division Justice Emily Pines.  Harlin Schwartzman brought a petition to dissolve a mortgage banking business called First Rate Capital Corp. under BCL 1104-a in which he alleged that he is one of three 33 1/3% shareholders; that the other two shareholders withheld his share of profits and diverted business to their separate mortgage company; and that when he demanded to be bought out they denied that he was a shareholder.  Schwartzman’s evidence of his shareholder status included a 2002 shareholders’ agreement identifying him as one of four shareholders (the fourth shareholder later dropped out) and income tax K-1 statements issued to him for the years 2003-2006 listing his ownership interest at either 25% or 33.33%.

The respondents moved to dismiss the petition for lack of standing, claiming that Schwartzman did not own the requisite 20% stock interest.  First, they argued that prior to bringing his petition, in May 2007, Schwartzman gave a written "resignation" of his stock ownership.  Alternatively, they argued that he never acquired a stock interest because he defaulted in payment on his 2002 promissory note and stock purchase agreement.  They admitted Schwartzman’s receipt of the K-1s but argued that they were "erroneous" and that "K-1 statements are not proof of ownership." 

Schwartzman replied that the resignation letter was a forgery, that his note payments were deducted from his share of the profits, and that, while he did tender his resignation as an officer and director, he never resigned as a shareholder.

The respondents submitted the report of a forensic document examiner who opined that the resignation letter contains Schwartzman’s authentic signature. 

Justice Pines’ ruling cites a number of Second Department decisions for the proposition that a preliminary hearing must be held on the issue of stock ownership where the parties’ affidavits create questions of fact.  And that is exactly what she ordered in the case before her, stating:

In the case at bar, the conflicting assertions by the parties create questions of fact regarding petitioner’s ownership interest, if any, in First Rate, which must be resolved before the Court can consider the merits of the petition.  The Court notes that petitioner was receiving K-1 income tax statements reflecting a varied degree of stock ownership, which respondents merely dismiss as being either erroneous or not probative of the issue of ownership.  Moreover, while the Court finds persuasive the May 21, 2007 purported resignation letter as evidence of petitioner’s surrender of his shareholder interest, petitioner denies the authenticity of this document.  Equally disconcerting is the disparate claims as to whether petitioner made payments on the promissory notes via deductions from his share of the profits.  Although petitioner submits an affidavit from [First Rate’s former controller] claiming that such payments were made, respondents similarly dismiss these allegations as the machinations of a disgruntled former employee who is currently engaged in a business venture with petitioner.   

I see two noteworthy aspects of Schwartzman, beyond illustrating the need for a hearing to resolve the parties’ disputed factual assertions.   First, the presence or absence of K-1s supporting or refuting the petitioner’s claimed stock ownership usually takes top priority in cases like this.  The Marciano case I wrote about last year in my Anatomy of a Dissolution Slugfest series is another good example of this.  Schwartzman presents the more unusual case in which the respondents argue against tax records that, as controlling shareholders, presumably they approved before filing.

Second, a shareholder’s surrender (redemption) of his or her stock interest usually occurs under a written shareholders’ agreement on specified terms or, absent such written agreement, pursuant to a voluntary tender and acceptance.  All we know from the court’s decision in Schwartzman is the one sentence quoted from the petitioner’s alleged letter stating, "Please accept this letter as my resignation as 1/3 shareholder of First Rate Capital Mortgage Bankers effective immediately."  We do not know if the parties’ 2002 shareholders’ agreement addresses voluntary redemption and, if so, whether the letter complies with it.  Assuming the shareholders’ agreement doesn’t govern, we also don’t know if there was an acceptance of the stock redemption by the company’s Board of Directors.  Of course, these issues will remain unanswered if, at the upcoming hearing, the court rejects the letter’s authenticity.