Has anyone else noticed an uptick in the number of cases asserting claims for breach of fiduciary duty and fraud arising from stock buy-outs among owners of closely held companies? Perhaps it should be called the Littman Effect, after the First Department’s 2008 decision in Littman v. Magee, where the court upheld this type of claim notwithstanding broad releases and disclaimers in the buy-out agreement. (Read my post on Littman here.)
The most recent example is a case called Matter of Lerman (Tive Clothing, Inc.), Short Form Order, Index No. 2947/09 (Sup Ct Nassau County July 8, 2009), involving a single-outlet clothing store known as Effie’s owned 50-50 by two shareholders. Although Lerman offers a twist on the usual fact pattern — the fight was over the consequences of a contemplated buy-out that did not occur — it flows from the same idea, viz, that Shareholder A wrongfully induced Shareholder B to enter into a buy-out agreement by withholding material information that Shareholder A was duty-bound to disclose.
The facts in Lerman are not complicated. The two owners, Lerman and Knaffo, set up their corporation, called Tive Clothing Inc. ("Tive"), and operated the store in leased space for almost 20 years before their relationship began to unravel over profitability and other financial issues. In June 2007 they reached an interim solution in the form of a stockholders’ agreement with a buy-sell provision that permitted either of them to offer their shares to the other at a fixed price. If the offeree declined to purchase, Tive was to be dissolved and the inventory liquidated.
The business continued to decline, requiring the owners to contribute another $30,000 each in the months following the stockholders’ agreement. Knaffo subsequently offered to sell his shares to Lerman under the buy-sell provision. Lerman did not accept the offer — at least not in writing — although Knaffo later claimed that Lerman (verbally) agreed to purchase his shares. As the store lease was expiring, in August 2008, the landlord agreed to extend the lease for 3 months with a 3-month option. After the lease expired, the parties vacated the store and placed unsold inventory in storage.
After Effie’s closed, Lerman on his own signed a new lease for the same premises and opened a clothing store called Ler Man’s. The court’s decision does not reveal what, if any, discussions occurred between Lerman and Knaffo concerning voluntary dissolution of Tive. What is known is that, in February 2009, Lerman filed a petition for judicial dissolution of Tive under Business Corporation Law Section 1104 based on shareholder deadlock. He also sought appointment of a receiver to wind up the affairs of Tive.
Knaffo opposed the petition, claiming that Lerman had perpetrated a fraud upon him, and breached his fiduciary duties owed to Knaffo, by concealing his plan all along to let the store lease lapse and open his own clothing business at the same location. Knaffo alleged that Lerman had participated in the negotiations to effectuate a buy-out merely as as a ploy to push Knaffo out of the business. Lerman countered that the stockholders’ agreement expressly contemplated a dissolution upon the refusal of one shareholder to purchase the shares of the other.
The decision by Nassau County Commercial Division Justice Ira B. Warshawsky agreed with Lerman’s position and granted the dissolution petition. Here’s the key excerpt from the ruling:
It seems clear that it was the stated intention of the parties to arrange for an organized winding down, and ultimate dissolution of the business they were operating if the offer of one of the shareholders to purchase the shares of the other was declined. . . .
Once the offer to sell his shares to Lerman was rejected, the Agreement specifically provided for the dissolution of the corporation. Under these circumstances Lerman had no obligation to continue to operate in business with Knaffo, and either of them could have taken the opportunity to start a new business in the premises at the expiration of the lease.
The decision offers no further analysis of the claims for fraud and breach of fiduciary duty. It does not appear from the decision that Knaffo made any allegation that Lerman entered into his own lease negotiations with the landlord before Lerman and Knaffo entered into the stockholders’ agreement or, for that matter, at any time before Tive’s lease lapsed. Absent that type of allegation, even with the benefit of Littman, it’s hard to see the makings of a fraud or fiduciary breach claim under the circumstances since, as the decision notes, Knaffo had the same opportunity as Lerman to take over the space.
All that remained of the case was Knaffo’s claim that the racks and shelving left in the store belonged to Tive, and therefore he was entitled to be reimbursed 50% of their value. Lerman contended the items were fixtures, the ownership of which passed to the landlord. Justice Warshawsky’s order refers the issue to the Court Attorney/Referee to hear and determine.
I haven’t seen the stockholders’ agreement in this case, however I’ll venture a guess that it did not include a provision for the loser to pay the winner’s attorney’s fees in the event one of them refuses to cooperate with voluntary dissolution triggered by the rejection of an offer to sell. In general, such provisions can act as a strong deterrent to noncompliance with buy-sell agreements of this sort.