I recently wrote about the Kensington Publishing case in which the two children of the deceased business founder’s first marriage took control of a successful publishing house — to the consternation of the founder’s surviving second wife who inherited a majority of the company’s voting shares — by means of a voting agreement signed by the father without his wife’s knowledge several years before he died. In that case, the second wife, who was stymied in her effort to sell her majority stake on a control basis to a major publishing house, failed to convince the court to invalidate the voting agreement which port-mortem left board control in her stepchildren’s hands even upon a sale of the shares to an outside buyer.
The tables are turned in a new decision by Manhattan Commercial Division Justice Charles E. Ramos, in Serota v Scimone, 2014 NY Slip Op 30924(U) [Sup Ct, NY County Apr. 8, 2014], where it’s the second wife who prevails over the sons of her deceased husband’s first marriage by means of a different kind of dead-hand control mechanism involving a blanket delegation of LLC management authority to an outside contractor allied with the second wife and her son from her own prior marriage.
The Management Agreement in question, made by the ailing patriarch and business founder less than a month before his death, left his sons with ownership of a realty empire but with virtually no power to control it even though they automatically became the LLCs’ designated managers after their father died.
Nathan L. Serota was a self-made man and real estate developer who built more than 50 shopping centers on Long Island. When he died in 2010 at the age of 90, he was survived by two sons from a first marriage, Charles and Geoffrey, and by his second wife, Vivian, who had a son, Daniel, from her own prior marriage.
Until his death, Nathan was the sole managing member of numerous limited liability companies comprising his real estate empire with an estimated worth in excess of $100 million. Charles and Geoffrey were non-managing members of some if not all of the LLCs. Joseph Scimone, a long-time business associate of Nathan, served as his Chief Financial Officer and was named executor in Nathan’s will which bequeathed his interests in the realty companies to Charles, Geoffrey and Vivian. Under the LLCs’ operating agreements, Charles and Geoffrey became the LLCs’ co-managing members upon Nathan’s death.
However, about a month before Nathan died, he entered into a Management Agreement with Scimone (read here) that, upon Serota’s death, transferred virtually all operational authority to Scimone, including leasing, rent collection, construction, and repairs and maintenance, for which he was entitled to 6% of gross receipts purportedly amounting to annual compensation in the millions. The Management Agreement, which essentially put Scimone in control until his retirement, disability or death, left Charles and Geoffrey with little or no management role even though, under the terms of the LLCs’ operating agreements, upon Nathan’s death they became co-managing members.
The Management Agreement also permitted Scimone to assign the agreement to a company of which he was majority owner, which he subsequently did to a firm called Lighthouse Realty Partners. Apparently, Lighthouse employed Vivian’s son, Daniel, as a project manager while excluding Charles and Geoffrey from any management role.
The Sons Sue
In 2012, Charles and Geoffrey sued Scimone, Lighthouse and Vivian seeking to invalidate the Management Agreement on the grounds that Nathan lacked physical and mental capacity when he signed it, and due to the defendants’ “undue influence” over Nathan. Here’s how online source The Real Deal reported on the suit:
Two sons of the late real estate mogul Nathan Serota have filed suit against Lighthouse Realty Partners, alleging executives at that firm conspired with his second wife to obtain the right to manage their father’s multi-million dollar real estate empire before he died. In an April 5 lawsuit filed in Manhattan Supreme Court, Charles and Geoffrey Serota allege that Joseph Scimone, the CFO at Valley Stream, N.Y.-based Lighthouse, conspired with their father’s second wife, Vivian Serota, and other Lighthouse officials to obtain the property management rights from the wheelchair-bound founder, just three weeks before his death in 2010.
“Serota could not comprehend and handle interactions with others and could not comprehend events taking place around him,” attorney John Moscow, representing Serota’s sons, wrote in the complaint, adding in another section of the suit that Serota “was unable to understand a one-page telephone bill when it was read to him.”
Charles and Geoffrey subsequently amended their complaint several times. The final version, denominated the Second Amended Complaint (read here), further attacked the Management Agreement on the grounds that, even assuming Nathan had the capacity to enter into it:
- Nathan breached fiduciary duty owed his sons by depriving them of their ownership rights and their ability to derive any significant value from such ownership by a sale of the properties or their operation;
- Nathan lacked authority under the operating agreements to burden the LLCs with the Management Agreement which, by its terms, took effect only after his death; and
- the powers granted to Scimone by the Management Agreement constitute a testamentary disposition, and that because it was not executed with the formalities required by a will, the agreement is voidable.
The Court’s Partial Dismissal of the Sons’ Claims Against Scimone
In September 2013, Scimone moved to dismiss the claims in the Second Amended Complaint seeking to invalidate the Management Agreement on the three grounds bulleted above. Read here Scimone’s main brief in support of his motion and here the opposing brief filed by Charles and Geoffrey.
Breach of Fiduciary Duty. Justice Ramos disagreed that Scimone could be held liable for participating in a breach of trust by Nathan, because “plaintiffs fail to allege a primary breach of duty [by Nathan], which according to the [Second Amended Complaint] is entering into the Agreement” (p. 6). The operating agreement of each LLC (read one of them here) named Nathan as sole managing member and, in Section 4.2, gave him:
full, exclusive and complete discretion, power and authority, on behalf of the Company to . . . enter in any agreement, instrument or other writing, . . . and take any other lawful action that the Managing Member consider[s] necessary, convenient or advisable in connection with any business of the Company.
This contractual language, Justice Ramos found, “refute[s] the contention that [Nathan’s] execution of the Agreement constituted a breach of trust” by providing “broad authority to [Nathan] to exercise his authority as managing member to delegate management of the properties that the LLCs own to Scimone” (pp. 6-7).
Justice Ramos also agreed with Scimone’s alternative contention, that the plaintiffs’ allegations did not overcome the protection of the Business Judgment Rule, by failing to allege that Nathan “acted with divided loyalty when he executed the [Management] Agreement, that he was motivated by bad faith such as to deliberately single out plaintiffs for harmful treatment, or that the transaction was tainted by fraud” (p. 8). The plaintiffs’ characterization of the agreement’s terms as commercially unreasonable, even if true, “does not constitute an actionable breach of trust or fiduciary duty” (p. 8).
Lack of Authority. Justice Ramos also rejected the plaintiffs’ argument that their father lacked authority under the operating agreements to execute the Management Agreement. Justice Ramos found this argument contradicted by the broad authority given to Nathan in Section 4.2 of the operating agreements, to enter into any agreement that he considered necessary in connection with the LLC’s business. This same language also defeated the sons’ contention that the Management Agreement breached the implied covenant of good faith and fair dealing by depriving them of “the very essence of their bargain in establishing the operating agreements . . . which includes their rights as surviving members to take over as managing members after [Nathan’s] death” (p. 9).
Testamentary Disposition. The plaintiffs’ claim that the Management Agreement constituted a voidable testamentary disposition likewise fell short. “The managerial authority that [Nathan] delegated to Scimone in the Agreement,” Justice Ramos wrote, “does not constitute a transfer of property within the meaning of [Estates, Powers & Trusts Law § 1-2.4], and thus, plaintiffs fail to allege a testamentary disposition” (p. 10).
The court’s decision leaves only two remaining claims, for invalidation of the Management Agreement based on Nathan’s alleged lack of physical and mental capacity and undue influence, and against Scimone and Lighthouse for unjust enrichment.
Serota is a fascinating case both because of the family drama and the legal issues raised by the disempowerment of the LLCs’ managing members who, unless they succeed on their remaining claim or pursue a successful appeal, appear to have little room to maneuver. For one thing, the operating agreements in Section 3.6 require the unanimous approval of the members for the sale, lease or exchange or other disposition of all or substantially all of the company assets; presumably the plaintiffs’ stepmother, Vivian, who inherited membership interests from her late husband, will not give such consent.
In addition, were Charles and Geoffrey to petition for judicial dissolution of any of the LLCs, under Section 14.3 of the operating agreements such action would be deemed an offer to sell their membership interests under the provisions in Article IX of the operating agreements, which provides for a purchase price equal to the lesser of the Certificate of Value amount or the fair market value subject to applicable discounts.