See full size imageThe lead-up to business divorce litigation is a tense pas de deux in which, once the dispute reaches critical mass, the two sides “lawyer up” and begin tactical maneuvers to best position themselves for the coming court battle.  Sometimes the maneuvering consists of a series of back-and-forth letters between the lawyers staking out their positions and attacking the other’s.  Especially when one faction owns a controlling interest in the company, the maneuvering also may include formal meetings of the shareholders or the corporation’s board of directors (or members/managers in the case of an LLC) to authorize actions adverse to the non-controlling faction.

Never mind that the owners never once held a formal meeting or kept minutes or adopted written resolutions since the day the corporation was formed.  Never mind that the corporate kit, containing the organizational documents, stock ledger and certificates, has been sitting untouched, gathering dust since day one.

Among the likely neglected documents in the corporate kit are the corporation’s bylaws.  Bylaws are to be distinguished from the shareholders’ agreement.  The latter typically sets forth the stock interests of the individual shareholders, designates directors and officers, and contains restrictions on the transfer of shares, among other provisions.  In contrast, think of bylaws as the corporation’s operating system, consisting of internal rules not specific to any named individuals, governing such matters as quorum and notice requirements for meetings of the shareholders and board of directors; procedures for the election and replacement of directors; the number and term of directors; and the titles and duties of the corporation’s officers.  Section 601 of the Business Corporation Law mandates the adoption of bylaws by the incorporators at the initial organization meeting required under BCL Section 404.

I can’t say whether all the parties and counsel in Matter of McDaniel (162 Columbia Heights Housing Corp.), 23 Misc 3d 784, 2009 NY Slip Op 29047 (Sup Ct Kings County 2009), were cognizant of the bylaws as they maneuvered prior to commencement of dissolution proceedings.  I can say that the bylaws played a dispositive role in the court’s determination of their preliminary dispute over a certain stock transfer involving shares of a residential co-operative corporation.

McDaniel involves a 5-unit co-op occupying a landmarked brownstone building in Brooklyn.  In May 2004, one of the units was vacated as part of a settlement with a former shareholder.  A dispute arose among the remaining shareholders regarding the disposition of the vacant unit and its appurtenant shares which petitioner McDaniel contended were owned by her and the others believed were owned by the corporation.  In June 2005, McDaniel resigned her positions as president and as one of the board’s two directors.

McDaniel apparently hoped that by resigning as director she effectively would disable the corporation, now with a one-member board, from taking any action contrary to her claimed ownership of the disputed unit.  In August 2005, the other shareholders gave written notice of a shareholders meeting the following month to elect a new board of directors.  McDaniel’s attorney appeared at the meeting with his client’s proxy.  A vote was taken to place the disputed unit on the market for sale, to which all parties, except McDaniel through her attorney, agreed.  A process server then interrupted the meeting to serve a complaint by McDaniel to recover certain monies owed her by the corporation.  The shareholders meeting was adjourned to October 2005 on which date the other shareholders — McDaniel did not attend personally or by proxy — elected two of their number as directors.  At subsequent directors meetings the board approved the sale of the disputed unit to an outside buyer for $850,000.  The sale was completed in May 2006.

A year later, in May 2007, McDaniel petitioned for judicial dissolution of the corporation under the oppressed minority shareholder statute, BCL Section 1104-a.   The corporation elected to purchase McDaniel’s shares for fair value under BCL Section 1118.  This set the stage for the initial skirmish over the interest to be valued, i.e., 25% as claimed by McDaniel versus 20% as claimed by the remaining shareholders, with the outcome dependent on the validity of the two-member board elected in October 2005.

The decision by Kings County Commercial Division Justice Carolyn Demarest hinges primarily on the corporation’s bylaws, starting with Article III, Section 4 stating as follows:

Newly created directorships resulting from an increase in the number of directors and vacancies occurring in the board for any reason except the removal of directors without cause may be filled by vote of the board. If the number of the directors then in office is less than a quorum, such newly created directorships and vacancies may be filled by vote of a majority of the directors then in office . . . .

McDaniel argued that the remaining director could not alone constitute a “majority” with the power to appoint an interim replacement director.  Justice Demarest disagreed, calling such analysis “illogical” since “any decision taken by the only authorized director would necessarily be unanimous and thus exceed the required ‘majority.”’  McDaniel’s argument also would contradict the clear intent of the bylaws “to provide a mechanism to overcome the paralysis arising from the lack of sufficient directors to act on behalf of the Corporation.”  Justice Demarest further noted that “petitioner deliberately resigned knowing that her absence would impede the functioning of the board.”

McDaniel next contended that under Article II of the bylaws and BCL Section 605, all actions taken by the corporation following her resignation were void based on the failure to give written notice of the October 2005 meeting at which the new board was elected.  Justice Demarest again disagreed, holding that both the bylaw and statute permitted the adjournment of the properly-noticed September 2005 meeting without further written notice.  Not only did McDaniel receive written notice of the September 2005 meeting, her attorney attended the meeting and was present when it was adjourned to October after his process server showed up.  Justice Demarest also found that McDaniel waived any objection to defective notice based on Article II, Section 3 of the bylaws stating as follows:

The notice [of shareholder meetings] provided for in the two foregoing sections is not indispensable but any shareholders’ meeting whatever shall be valid for all purposes if all the outstanding shares of the Corporation are represented thereat in person or by proxy . . ..

The bylaws also contradicted McDaniel’s argument that authorization for the contract of sale of the disputed unit required a shareholders’ meeting and vote.  “A perusal of the By-Laws for the Corporation indicates that such authority is vested in the Corporation’s Board of Directors,” wrote Justice Demarest.

McDaniel also argued unsuccessfully that, even assuming a properly constituted board, she nonetheless held a 25% interest because the shares appurtenant to the disputed unit were cancelled upon reacquisition by the corporation at the time of the 2004 settlement with the former shareholder.  Citing BCL Section 515 governing reacquired shares, Justice Demarest found that the disputed shares were not cancelled but were retained as treasury shares and were subsequently sold for fair consideration.

The court accordingly determined that McDaniel is entitled to receive only 20% “of the fair value of the assets of the Corporation, including the market value of the building . . . and any other Corporate assets, less the Corporation’s liabilities.”  The case appears to have gone to trial last month; I’ll be sure to report on any written decision on valuation.