Does the mere filing of a petition for corporate dissolution bring about “a succession to a third person by operation of law or court order” or the transfer of the right to “control or vote” the petitioner’s shares? The question, upon which turns the non-petitioning shareholders’ right to enforce a book-value buyout provision in the shareholders’ agreement, lies at the heart of a multi-faceted ruling earlier this month in Matter of Piekos (Home Studios Inc.), 2010 NY Slip Op 51408(U) (Sup Ct Westchester County Aug. 3, 2010).
In his 23-page decision, Westchester Commercial Division Justice Alan D. Scheinkman undertakes a thorough review of the case law before concluding (a) the filing of the dissolution petition triggers the buyout clause, but (b) an evidentiary hearing is required to determine whether the petitioner had a “meaningful choice as to whether to sign the [shareholders’] agreement” and whether it would be “unconscionable” to enforce the buyout against an oppressed minority shareholder.
There are at least two reasons you’ll want to read the Piekos decision. First, it collects and dissects the relevant case law to date on this important and recurring issue on which I have written numerous times, including an article in the New York Law Journal which Justice Scheinkman cites (read here) and several posts on this blog (read here, here and here). Second, wholly apart from the legal issues, the decision’s detailed recital of the factual background tells a gripping story of broken relationships, bruised egos and sharp tactics amidst a fight for economic primacy and survival among business partners.
The story begins in 2004, when three experienced location managers formed a company called Home Studios Inc. to develop and manage a studio with home sets for the filming and photographing of commercials. Each contributed $90,000 and became a one-third stockholder. The petitioner, Richard Piekos, served as studio designer. Respondents David Fitzgerald and John Maher handled financial and operational matters, respectively. Justice Scheinkman, before whom all three gave live testimony, describes Maher as “a very assertive, if not arrogant, and controlling individual” who “views his fellow shareholders as less than equal partners.” He describes Fitzgerald as “dominated by” and “subservient to” Maher, and Piekos as “less dominated by Maher.”
The company incurred modest losses in 2004-05, the beginning of healthy net income in 2006-08, followed by business shrinkage in the 2009 downturn which required it to let its studio manager go before business started picking up again in 2010.
The three partners took compensation beginning in 2006, some of which was reported for tax purposes as W-2 wages and the rest as officer compensation. The company’s CPA testified that the allocation was designed to reduce social security taxes and allow the owners to fund an IRA plan.
The 2006 Shareholders’ Agreement
Tensions arose in 2006 when the studio turned profitable. Maher, supported by Fitzgerald, complained that he was doing more work than the others and deserved more compensation, and that Piekos was doing too little to merit compensation. At that point the three jointly engaged a lawyer who helped them prepare and execute a shareholders’ agreement. The agreement guaranteed that all three would hold positions as directors and officers so long as they were shareholders, and assigned each separate duties as officers. The agreement also included stock transfer restrictions that, upon the happening of certain events, required a shareholder to sell his shares to the corporation or the other shareholders at book value as reflected in the corporation’s balance sheet for the preceding fiscal year. The trigger events set forth in Section 2(a) of the agreement included:
(i) an Individual Shareholder desires to sell any of his shares; or
(ii) if the Individual Shareholder is employed by the Corporation and such employment is terminated for any reason and with or without cause; or
(iii) if any event occurs, such as bankruptcy of, or appointment of a committee for, or a divorce by an Individual Shareholder which would bring about a succession to a third person by operation of law or a court order of all or part of the Individual Shareholder’s Shares, or the right in anyone other than the Individual Shareholder to control or vote any such Shares.
The Outbreak of Hostilities
Fast forward to April 2010, when the three shareholders met at the office of a different attorney, representing Maher and Fitzgerald only, to discuss a growing internal feud over compensation and workload imbalance. According to Piekos, Maher and Fitzgerald stated that the business was “going in a new direction”; that they didn’t “really need” Piekos; and they proposed to pay themselves $8,500 per month which, based on then-current projections, would result in Piekos receiving $20,000 annual compensation compared to $120,000 each for Maher and Fitzgerald. Piekos testified that he was “in shock” and “rendered speechless” by the proposal.
A couple of weeks later, Maher and Fitzgerald noticed a board meeting at their attorney’s office for the purpose of determining officer compensation. As Justice Scheinkman put it, “Fitzgerald and Maher, having not heard from Piekos, decided to force his hand by simply using their majority voting power to put their proposal into effect.”
In an email to Maher and Fitzgerald on April 25, 2010, Piekos told them, “In this situation, I think the fair thing to do is buy me out at fair market value.” At the subsequent board meeting Maher and Fitzgerald offered a $50,000 buyout payable over two years, which they viewed as an “opening bid” in expectation of further negotiations. Piekos rejected the offer. Maher and Fitzgerald proceeded to adopt a resolution, over Pieko’s protest that they were “looting” the company of profits, to pay themselves $8,500 per month.
Piekos Sues for Dissolution
In May 2010, Piekos commenced a proceeding under Section 1104-a of the Business Corporation Law for judicial dissolution of Home Studios on the ground of shareholder oppression. Subsequently, Maher sent Piekos a letter purporting to terminate his “employment” at Home Studios for cause.
In opposition to the dissolution petition, Maher and Fitzgerald took the position that Piekos was required to sell back his shares at book value under all three of the trigger events contained in Section 2(a) of the Shareholders’ Agreement.
First, they argued that Piekos’ April 25 email proposing a buyout at fair market value evidenced his “desire to sell his shares” under Section 2(a)(i). Justice Scheinkman disagreed, reasoning that the word “desire” in context means a voluntary and present offer to sell and not, as proposed by Piekos, a method to resolve the parties’ dispute requiring further negotiation and agreement on price and terms.
Second, Maher and Fitzgerald contended that their purported termination of Piekos’ “employment” after he filed for dissolution triggered buyout under Section 2(a)(ii). Justice Scheinkman again disagreed, noting that the clause used the conditional “if . . . employed” and concluding that all of Piekos’ efforts and compensation on behalf of Home Studios was in his capacity as a corporate officer and not as an employee.
Does Filing Trigger Buyback?
Third — and here at last we come to the key legal issue — Maher and Fitzgerald argued that Piekos’ filing of a petition for judicial dissolution would cause the issuance of a court order bringing about a succession of his shares to a third person thereby triggering buyback under Section 2(a)(iii). Justice Scheinkman launches his analysis by reviewing the pertinent appellate authorities, beginning with Matter of Pace Photographers, 71 NY2d 737 (1988), where New York’s highest court acknowledged in dicta the right of shareholders to provide for a mandatory buyback at a stipulated price upon the filing of a dissolution petition.
He then discusses a quartet of intermediate appellate rulings in dissolution-triggered buyback cases, in three of which (Matter of Doniger, 122 AD2d 873 (2d Dept 1986), Matter of Johnsen, 31 AD3d 172 (1st Dept 2006), and Matter of El-Roh Realty Corp., 48 AD3d 1190 (4th Dept 2008)), the courts enforced buybacks based on provisions for the disposition of shares “in any manner whatsoever” or similar wording, and in one of which (Matter of Stevens, 74 AD3d 1757 (4th Dept 2010)) the court denied enforcement for other reasons peculiar to that case.
Justice Scheinkman’s ensuing discussion of the provision in Piekos has two parts. In the first part, he notes that the provision lacks the “in any manner whatsoever” language found dispositive in the appellate precedents. Instead, he focuses on the court’s statutory powers under BCL Article 11 to appoint a receiver and otherwise to exercise broad authority over the corporation during dissolution proceedings, and concludes that the filing of the dissolution petition would bring about a transfer of “control” and thereby trigger a buyback under Section 2(a)(iii). Here’s what he writes:
Given the broad powers to supplant the authority of the majority interest that come into being with the commencement of a judicial dissolution proceeding, the Court concludes the commencement of a dissolution proceeding is an event which would bring about a succession to a third person or entity by operation of law or court order, if only because it brings about succession of effective control over all of the shareholders to the court. As the Appellate Division, Fourth Department, recognized in El-Roh Realty, the commencement of a dissolution proceeding under Section 1104-a is an involuntary transfer. While it may be true that the court might deny dissolution, as where the grounds for same are not established, it remains that, at least during the pendency of the proceeding, the general authority of shareholders to run their business as they determine is disrupted and ultimate decision-making authority is transferred to the court.
“This, however, does not end the matter,” adds Justice Scheinkman as he segues into part two of his analysis. He notes that in Piekos, unlike in Doniger, Johnsen and El-Roh Realty involving deadlock dissolution proceedings between 50-50 shareholders, the respondents have a statutory right to elect to purchase the petitioner’s shares for fair value under BCL Section 1118. In non-oppression cases where a shareholders’ agreement contains a buyback provision with an agreed-upon valuation methodology, the fact that the price or formula provided is below market value does not vitiate the disappointed shareholder’s assent. “On the other hand,” Justice Scheinkman continues:
in cases involving oppressive conduct or corporate waste or looting, the majority may be encouraged to continue abusing the minority if the majority realizes the minority must either tolerate that behavior or else be forced to sell to the majority at a heavily discounted price on unfavorable terms (see Mahler and Schoenberg, Outside Counsel: Dissolution Petition Can Unwittingly Trigger Stock Buyback, NYLJ, July 21, 2006 at 4, col 4). Conversely, the minority may be deterred from seeking judicial redress by the prospect that the mere act of seeking relief from a court will mandate that the minority sell out at a heavily discounted price. Forcing a buyout on unfavorable agreement terms is particularly troublesome where the parties’ agreement does not in specific words spell out that the buyout will be triggered by the commencement of a Section 1104-a proceeding. Where that result is made clear, the minority knows the consequences of its agreement in advance. Here, while the language employed is sufficient, under the case precedents binding upon this Court, for a buyout to be triggered by the commencement of this proceeding, the minority was not specifically warned, in advance, that this would be the result. (Emphasis added.)
So what’s the result in Piekos? An evidentiary hearing is required, Justice Scheinkman concludes, with respect to “the substance of the negotiations that led to the shareholder’s agreement”. He then elaborates:
Specifically, the Court has not heard whether Piekos had a meaningful choice as to whether to sign the agreement, bearing in mind the business sophistication of the parties, whether the negotiations were arms-length, whether there was a disparity of bargaining power, and whether pressure tactics were used, among other factors. Further, it seems, at least plausible that the agreement may be construed as containing at least an implied agreement by the parties to refrain from oppressive, unjust or unreasonable acts that would deprive a party of the benefits of the bargain struck. It may well be that it is unconscionable to permit the majority to oppress a minority into signing a shareholders’ agreement that would trigger a unfavorable buyout, thereafter oppress the minority to such an extent that it is compelled to seek judicial relief, and then assert that the oppressed minority must sell out under unfavorable terms (see Day Op of North Nassau, Inc. v Viola, 16 Misc 3d 1122[A], 2007 WL 2305035 [Sup Ct Nassau County 2007]).
Where it appears from the record before the court that unconscionability may exist, and the issue is not free from doubt, the court must hold a hearing where the parties may present evidence with regard to the circumstances of the signing of the contract, and the disputed terms’ setting, purpose and effect (State v Wolowitz, 96 AD2d 47, 68-69 [2d Dept 1983]).
Additionally, the amount of discrepancy between the book value-based price formula and “fair value” as determined by the court would be relevant.
For these reasons, the Court will hold a full hearing on both Petitioner Piekos’ petition for dissolution and on the Corporation’s counterclaim for enforcement of its right to buyout Piekos under Paragraph 2(a)(iii) of the Shareholder’s Agreement.
I see the thrust of Piekos as twofold. First, it continues and arguably broadens the trend seen in Doniger and its progeny toward liberal interpretation of language in the shareholders’ agreement sufficient to trigger the buyback. I can imagine another jurist just as easily deciding that the court’s power to supersede shareholder control of the corporation’s business affairs pending determination of the petition does not constitute a “succession” or a change in the right to control or vote the petitioner’s shares.
Pushing in the opposite direction, Piekos also offers minority shareholders seeking dissolution on oppression grounds a new avenue to counteract the majority’s effort to enforce a below-market buyout under the shareholders’ agreement — as opposed to electing to purchase for fair value under BCL Section 1118. Indeed, the logic of Piekos could be extended even to a shareholders’ agreement that explicitly deems the filing of a dissolution petition to be a voluntary offer to sell. Depending on the spread between the contractual price and fair value, the costs and delay associated with the prospect of having to undergo discovery and an evidentiary hearing on the issues surrounding the formation of the shareholders’ agreement, and effectively having to litigate the issue of oppression as a predicate for enforcing the contractual buyout, may be enough to dissuade the majority from even attempting to enforce the contractual buyout.