In a fight over an oddly named real estate company called Madcat Realty, New York County Commercial Division Justice Bernard J. Fried recently handed down a post-trial decision in a fascinating shareholder dispute between family members that required the court to address two significant issues:
Can a shareholder action for misappropriation of corporate assets be brought individually rather than derivatively after the corporation’s dissolution?
Does the “mere continuation” doctrine, under which a creditor of a dissolved corporation may reach assets of a de facto successor corporation, apply even absent a transfer of assets to the successor?
Miot is the story of one brother, Alvin, who for many years owned and ran a construction and real estate business, and who in March 1985 gifted to his brother, Sanford, a 70% stock interest in a corporation called Madcat Realty Corp. (“Madcat I”) which owned a commercial building on Kane Street in Brooklyn. Sanford knew of the shares, but had no knowledge of Madcat I’s business affairs or even whether it owned any assets. The other 30% was owned by Alvin’s wife, Harriet, who nominally served as secretary-treasurer and signed whatever corporate documents were given to her for signature, but who also had no knowledge of the company’s business affairs. There were no shareholder or director meetings, and neither Sanford nor Harriet ever exercised shareholder rights. Alvin, who died in 2001, maintained sole control of the corporation. With respect to the corporation’s records, Justice Fried found it “unclear” whether they exist or ever existed, with the exception of a blank stockbook that was located.
As fate would have it, some time between March 1985 (when Sanford was gifted his shares) and December 1985, Madcat I was administratively dissolved by the New York Secretary of State for non-payment of franchise taxes. Though reinstatement was possible, it never was attempted. Madcat I nonetheless continued to collect rents and pay real estate taxes on the Brooklyn property until it was sold in 1987.
It may be helpful to pause the narrative at this point to explain that the case does not involve any claim by Sanford for a share of the proceeds from the 1987 sale of the Brooklyn property, even though he received none. The court’s decision notes without explanation that those sale proceeds are not in dispute, presumably because any such claim was barred by the statute of limitations by the time litigation commenced in 2006.
Back to the story. In February 1986, Alvin filed a certificate of incorporation for a new corporation with the identical name (“Madcat II”) the shares of which were owned 100% by his wife Harriet. In May 1986, Alvin transferred ownership of a Manhattan commercial property from another of his companies to Madcat II. The closing statement listed Madcat II’s business address as the Kane Street, Brooklyn property owned by Madcat I.
The Manhattan property was Madcat II’s sole asset. Justice Fried’s decision quotes the trial testimony of Alvin’s lawyer at the time, that he believed there was no transfer of the Brooklyn property from Madcat I to Madcat II because “it was always the same corporation.”
Madcat II owned and managed the Manhattan property under Alvin’s direction through the 1990s. Harriet took over Madcat II after Alvin’s death in 2001. In 2005, an outside buyer purchased the property from Madcat II for $1.2 million. The net proceeds of about $1.1 million were deposited in the account of Madcat II and eventually distributed to Harriet. Sanford received no proceeds from the sale, nor did Harriet inform him of the sale.
Sanford first learned of the Manhattan property sale through the course of separate litigation in Florida in 2006. In September 2006, Sanford filed a complaint in which he asserted a number of claims seeking recovery in his own name and right against Harriet for breach of fiduciary duty, an accounting and misappropriation of his 70% share of the proceeds from Madcat II’s sale of the Manhattan property.
Harriet raised procedural and substantive defenses. First, she argued that Sanford’s action should be dismissed because it was improperly brought in Sanford’s individual capacity instead of as a shareholder’s derivative suit. Second, she argued that Madcat I and Madcat II are distinct and separate entities, and that the interest Sanford had in Madcat I ended when that corporation wound up its affairs with the sale of the Brooklyn property in 1987.
Individual vs. Derivative Action
Justice Fried disagreed with Harriet’s procedural argument based on the derivative nature of Sanford’s claims. He noted that, while claims for misappropriation of corporate assets generally must be brought derivatively, and even though such derivative claims can be brought post-dissolution,
the court may use its equitable powers to “dispense with the presence of [the] defunct corporation” if the shareholder “is in reality the only one injured.” Geltman v. Levy, 11 AD2d 411, 413 (1st Dept. 1960) (quoting Weinert v. Kinkel, 296 NY 151, 152, 153 (1947) and Di Tommasso v. Loverro, 250 A.D. 206 (2d Dept. 1937), aff’d 276 NY 551 (1937)); see also First Nat. Bank of Maryland v. Fancy, 268 AD2d 229, 229 (1st Dept. 2000) (affirming the trial court’s decision to award direct payment to the plaintiff, instead of the defunct corporation, to “prevent unnecessary circuity and hardship”). In Geltman v. Levy, stockholders of a liquidated corporation brought a suit against a third party for breach of fiduciary duty. 11 AD2d at 412. Though the Appellate Division ultimately held that the claim, as brought, was not derivative in nature, the Court explained that assuming the claim had been derivative in nature, dismissal would not have been appropriate. Id. at 413. As the Court explained, insisting on a derivative suit where the plaintiffs were the only injured parties by the wrongdoing of the defendants would “encourage circuity and  compel them to follow a meaningless legal procedure in complete disregard of the realities of the situation.” Id. at 414.
In Miot, the subject S corporation had no creditors, and the only persons with rights to receive the net sale proceeds from the sale of the Manhattan property were Harriet and Sanford. “Thus,” Justice Fried concluded, “the misappropriation of funds, while technically a misappropriation of corporate funds and thus, an injury to the corporation, injured no one but Plaintiff,” and therefore “dismissing this claim where only Plaintiff and Defendant have any interest in the long-ago dissolved corporation would ignore the ‘realities’ of the case and encourage ‘circuity.'”
Madcat II as “Mere Continuation” of Madcat I
Sanford contended that Harriet misappropriated corporate funds by distributing the proceeds from the sale of the Manhattan property to herself without distributing any funds to him; that his shares in Madcat I entitled him to proceeds from the sale of the Manhattan property because Madcat II was a “mere continuation” of Madcat I; and that Harriet should be estopped from asserting that the two companies are distinct and separate entities because Madcat II was incorporated only to avoid paying franchise taxes on Madcat I. Harriet countered that Madcat I and Madcat II are distinct and separate entities and that the interest Sanford had in Madcat I ended when the corporation wound up its affairs with the sale of the Brooklyn property in 1987.
Justice Fried sided with Sanford, essentially finding that Madcat II had been incorporated so as to continue the business of Madcat I without having to pay the franchise tax arrears, contrary to the public policy underlying the franchise tax statutory scheme. Justice Fried cited a number of cases in which courts enforced creditor claims against successor corporations formed after the debtor corporation was administratively dissolved. He reasoned that “[t]he statutory scheme would be similarly undermined if the court allowed a corporation to avoid its obligations to its shareholders through its dissolution for failure to pay franchise taxes.”
On the key question, whether Madcat II was a mere continuation of Madcat I, Justice Fried set forth the following criteria:
Generally, when a successor corporation is in essence a reorganization of a now extinguished predecessor, the successor may be considered a “mere continuation” of its predecessor and liable for its predecessor’s obligations. Although no one factor is dispositive, other courts have considered certain factors as evidence tending to show that a successor corporation was a mere continuation of its predecessor: (1) all or substantially all assets are transferred to the successor corporation, (2) only one corporation exists after the transfer, (3) assumption of an identical or nearly identical name, (4) retention of the same corporate officers andor directors, and (5) continuation of the same business. [Citations omitted.]
Harriet argued that since there was no transfer of assets from Madcat I to Madcat II, the mere continuation doctrine did not apply under the above factors. Justice Fried disagreed, stating:
None of the cases cited by either party . . . stands for an absolute test where each factor must be present to find that one entity is a mere continuation of the other. More importantly, Alvin’s disregard of corporate formalities by not transferring the assets of Madcat I to Madcat II does not change the fact that Alvin continued the business of Madcat I through the incorporation of Madcat II. Furthermore, as a practical matter, though there was no transfer, only one corporation existed after the dissolution and reincorporation of Madcat. Alvin was the only one benefitting from the assets of both Madcats, and to any outsider, there appeared to be only one Madcat entity. [Citations omitted.]
Moreover, the last three factors weigh heavily in favor of finding that Madcat II was a mere continuation of Madcat I. First, each corporation had an identical name. Second, Alvin was the President of both corporations and the only officer making any decisions for either corporation. And lastly, Madcat I and Madcat II were engaged in substantially the same business. Both corporations owned, managed, and collected rents from properties in New York City. Under these circumstances, I conclude that Madcat II was a mere continuation of Madcat I despite the fact that there was no formal transfer of assets.
Justice Fried accordingly awarded judgment in Sanford’s favor against Harriet for $765,709, representing 70% of the net proceeds from the sale of the Manhattan property, plus pre-judgment interest from November 2005, when Harriet received her distribution from Madcat II.
Miot is one of those perfect-storm cases: the central witness (Alvin) died years before; the surviving shareholders were in the dark as to the corporation’s affairs; the corporation kept no records; and the events in question occurred 20 years before the litigation was brought. It’s superficially tempting to think that the outcome might have been different had Alvin chosen a different name for the corporation when he incorporated Madcat II, but I think that begs the question ultimately resolved by Justice Fried whether the overall relationship of the two entities rendered them one and the same.
Update November 9, 2010: Harriet’s appeal from the judgment against her has been rejected by the Appellate Division, First Department, in a decision (read here) reported at 2010 NY Slip Op 08008 (Nov. 9, 2010). The appellate court fully endorsed Justice Fried’s conclusion that Madcat II was a “mere continuation” of Madcat I.