A successful online retail business known as BedBathStore is at the center of a bitter father-son dispute over its ownership in a case decided earlier this month by a Brooklyn appellate court in Reichman v. Reichman, 2011 NY Slip Op 07023 (2d Dept Oct. 4, 2011).
The decision, which grants in part the son’s request for preliminary injunctive relief against his father, is yet another in a long line of difficult cases in which courts are asked to sort out contested ownership claims surrounding closely held business entities, where the documentation of ownership is spotty, inconsistent and/or at odds with the parties’ testimony. (Click here to read a sampling of my numerous, prior posts on such cases.)
The son in Reichman, claiming to be an 80% owner of the business, brought suit against his father, allegedly the other 20% owner, accusing him of financial improprieties and oppressive conduct, and seeking an accounting and a declaration of the son’s ownership rights as controlling member. The father asserted his own, 100% ownership and contended that his son was no more than an employee of the business. The trial court’s findings and decision sided with the father. The appellate court modified in part, finding adequate evidence of the son’s ownership without deciding his precise percentage. How could father and son take such diametrically opposed positions on the question of ownership, and what factors led to the appellate court’s grant of injunctive relief?
The appellate decision reveals very little of the factual background. The description that follows mostly comes from the trial court’s post-hearing decision dated March 11, 2011, and from the appellate briefs, links to which appear at the bottom of this post.
The story traces back to the late 1960’s when the father, Paul Reichman, began working in his parents’ Brooklyn store called Mildred’s For Fine Linens, selling bedding and bath products. Fast forward 35 years to the internet commerce era when, in 2002, Paul and his son Michael, then 22 years old and fresh from college, formed a new limited liability company called Bedbathstore.com, LLC to operate an online retail store for the sale of curtains, bedding and bathroom accessories.
Paul and Michael gave conflicting testimony about their relative financial and non-financial contributions to the origin, development, launch and operation of the LLC’s e-tail business. What is nonetheless clear is that, upon the LLC’s formation, membership interest certificates signed by the two of them were issued allocating 80 membership units to Michael and 20 to Paul.
The trial court, which held a three-day hearing, credited the father’s testimony that, immediately after the LLC’s formation, Paul thought better of the 80/20 ownership given his extensive financial contribution, and decided to reverse and adjust the split in Paul’s favor 85/15. The court also cited Paul’s “admission” that his desire to shield assets from his wife because of marital difficulties motivated his granting shares to his son. In any event, Paul had an attorney issue new certificates in early 2003 reflecting the 85/15 split, which Michael did not sign.
Around that same time, Paul applied for a $1.2 million SBA loan and had an attorney prepare an operating agreement for the LLC. The ownership percentages reflected in a schedule annexed to the agreement indicate an ownership split of Paul 60% and Michael 40%. Both signed the operating agreement, but Michael testified that he was given the signature page only and never saw or knew about the annexed schedule. According to Michael, Paul never contested Michael’s 80% ownership until some time shortly before Michael brought suit in 2011.
The trial court’s decision relates Paul’s testimony that, upon being advised by the SBA that the loan could not close if Michael had an ownership interest because of an arrest while in college, Paul asked Michael to transfer his shares back to Paul. Paul testified, and the trial court accepted, that Michael agreed to cede his shares, telling his father in sum and substance, “whatever it takes, Dad.” The trial court observed that the share concession, which Michael denied making, “is consistent with Michael’s age, relative inexperience in the industry compared to Paul, and Paul’s capital contribution to the LLC which dwarfs any contribution by Michael.”
The LLC’s tax returns and Schedule K-1’s, beginning with its initial 2002 return filed in 2003, consistently reported Paul as 100% owner. Michael received only W-2 forms reporting his employment compensation. Michael testified that his father controlled the LLC’s financial records and signed the tax returns without ever showing them to Michael. Michael also testified that he had not been a partner in a business previously and did not understand the necessity of K-1’s. He also testified that, each year, his father told him there were no profits to distribute.
The Trial Court’s Decision for Paul
The trial court acknowledged that the written records regarding the changes in ownership “are far from conclusive” but also noted that “this is far from atypical in a small, family-run business.” Rather, the court continued,
“[i]t is the actions of the parties that are most telling as to their intent regarding ownership of the LLC. The evidence before the Court demonstrated that Paul Reichman has, throughout the history of Bedbathstore.com LLC, acted in a manner consistent with the role of an owner. By contrast, Michael has taken action consistent with the role of an employee.
In support of this conclusion, the court cited the fact that Michael has no capital account, pays only an employee’s share of his FICA taxes, and receives tax-free health insurance benefits. Michael also “has not acted like a majority owner” as evidenced by his lack of “knowledge or responsibility in several areas, such as finance and human resources, that would be typical among chief executive officers and/or owners.”
The trial court also noted its contrasting assessments of Paul’s and Michael’s demeanor on the witness stand. While Paul “came across calm and measured, with a demeanor befitting the head of a small company,” Michael’s demeanor “demonstrated aggressiveness and anger, and his answers to questions on both direct and cross examination were prone to hyperbole.”
In sum, the trial court concluded that Michael was not entitled to interim injunctive relief based on his failure to demonstrate a likelihood of success on his claim of majority ownership of the LLC. The court also found that “[a]s an employee and possibly limited shareholder, [Michael] may well have damages based on Paul’s operation of the company” but that such damages are compensable by money rather than the “drastic remedy” of a preliminary injunction. The court also found that Michael failed to show a balancing of the equities in his favor given Paul’s historical role as the company’s “decision-maker” and the risk to the LLC’s numerous employees if control were transferred to the relatively inexperienced Michael.
Michael’s Win on Appeal
Michael immediately filed a notice of appeal from the trial court’s decision and asked the appellate court for an injunction pending the appeal, to restrain his father from transferring the LLC’s domain name or engaging in other operational, financial and accounting matters outside the ordinary course of business. The appellate court granted Michael’s motion and entered an injunction order on April 14, 2011, on condition that Michael file on an expedited schedule his appeal brief and record on appeal (read the order here).
The appellate court’s decision on the appeal consists of a few, unenlightening paragraphs. After stating the standard for preliminary injunctive relief, the opinion merely offers the conclusion that Michael
demonstrated, inter alia, a likelihood of ultimate success on the merits on the causes of action for an accounting and to impose a constructive trust by submitting evidence tending to show that he is a member of the LLC, including a copy of the LLC operating agreement, which states that he owns a 40% share of the LLC. . . . Further, the plaintiff demonstrated potential irreparable injury to the company absent the preliminary injunction, and the balance of the equities are in the plaintiff’s favor.
The court’s order enjoins Paul, pending the lawsuit’s resolution, from:
- transferring any Yahoo accounts associated with Bedbathstore.com, LLC;
- transferring the domain name associated with Bedbathstore.com, LLC;
- accessing Bedbathstore.com, LLC, computers and servers and the online credit card transaction processing terminals related to the company’s operations except in the ordinary course of business;
- making any expenditure of funds of Bedbathstore.com, LLC, that are not in the ordinary course of business;
- altering the financial records of Bedbathstore.com, LLC, except in consultation with the accountant for the company in accordance with generally accepted accounting practices; and
- drawing any funds from the company, other than a base salary in the ordinary course of business.
Forget as a lawyer, as a parent it’s hard to read the invective-filled appellate briefs in this case and not feel sad for both father and son. I shudder to think what the two said about each other from the witness stand. I imagine the entire Reichman family must be suffering.
Putting emotion aside, what guidance can we draw from the appellate decision? The one lesson I discern is that a documented and signed admission by party A of party B’s ownership will not be overcome by party A’s contradictory, self-serving testimony regardless of party A’s and party B’s relative demeanor and credibility as a witness. Likely the factual specificity of cases like this prevents the court from making any broader pronouncements, which is unfortunate since this is a recurrent scenario in shareholder disputes.
The decision makes no mention of the initial certificates reflecting 80/20 ownership in Michael’s favor. Is it significant that the one and only factual reference in the court’s decision is to the operating agreement and the 60/40 split reflected in its ownership schedule? We don’t know. The decision also doesn’t mention the trial court’s finding, based on the father’s testimony, that Michael subsequently agreed orally to his father’s sole ownership of the company. Should we infer that the appellate court implicitly set aside that finding as unsupported by the record? Probably. And what about the absence of K-1’s issued to Michael? There’s no indication of how the court factored this in, but obviously the court did not deem it to be dispositive.
While the appellate court clearly views Michael as having some ownership interest, it left open what percentage he owns and gives little or no clue how the lower court is supposed to weigh and resolve the conflicting documentary evidence and testimony in reaching a determination whether Michael owns 15%, 40% or 80%. I do not envy the trial court’s job going forward in this case.