Husband and wife start a business. They work hard, sacrifice, grow the business, turn it into a success. When their two children are old enough, they bring them into the business, giving them equal non-voting stock and equal compensation for their different job responsibilities. The parents naturally hope that, as they approach retirement and plan their estate, all will be in place for a smooth transition of full, co-equal ownership and control to the next generation.
But there’s a problem. After years working together, the siblings no longer get along or even talk with each other. The parents realize that their succession plan for joint ownership and management by their two children is destined to fail. What are they to do?
A similar scenario set the stage for a decision of great interest last week by Suffolk County Commercial Division Presiding Justice Elizabeth H. Emerson (pictured above) in a case called Federico v Brancato, 2014 NY Slip Op 50902(U) [Sup Ct, Suffolk County June 9, 2014]. In a nutshell, the parents in this case tried to resolve the dilemma by offering a buyout to one of the two children, who refused the offer, after which the parents terminated her employment, after which she sued her parents and brother asserting various claims including shareholder oppression. In her post-trial decision, Justice Emerson ruled in the daughter’s favor on her claim seeking damages for violation of her “guaranteed” employment under the Shareholders Agreement, but dismissed her remaining claims including a request for reinstatement to her position at the company.
The decision is noteworthy not only for its analysis of the legal issues, but also for its heightened sensitivity to the family setting within which the legal claims were presented. I’m also honored that Justice Emerson saw fit to cite in her decision this blog’s online interview last year with Professor Benjamin Means on conflict in family-owned businesses.
In 1976, Anthony Brancato and his wife Roseann started a small commercial printing business known as Challenge Graphics Services, Inc. Their son worked in the business from the age of 16 and eventually learned all aspects of the business. Their daughter became a certified public accountant and worked at large accounting firms until 1994 when she too joined the family business.
In 2001, the parents gifted to each of their children directly and in trust a 30% non-voting equity stake in the business, with the parents retaining the balance of the equity and all voting shares. At the same time, the four family members entered into a Shareholders Agreement vesting managerial control in the father, who was president and a director, and which also gave him veto power over certain major decisions. The daughter and her mother also were named directors on the three-member board, with the son named to replace any director who resigns or dies. The agreement essentially ensured that, as long as one of their parents is on the board, the two children are not in control.
The Shareholders Agreement appointed the two children as Vice Presidents until their death or resignation, without describing their duties. It also provided, in what became a critical part of the lawsuit, that the company
shall continue the employment of each of the Shareholders in their executive capacity so long as he or she shall continue to duly perform their executive duties, at such salaries and expense allowances as may from time to time be fixed by the Board.
Until her termination in 2012, the daughter functioned as chief financial officer responsible for accounting, finance, and human resources. Starting in 2008, with only a few exceptions she stopped going to the office, worked from home, had limited interaction with other company employees, and had no interaction with her brother, to whom she had not spoken for several years apparently due to events outside the workplace. In that same period, the son took over much of the managerial role of his father, who underwent triple-bypass surgery in 2008 and was spending half the year in Florida.
The two children received identical compensation and benefits despite their different roles, other than certain commission payments. They also each received from their parents 50% interests in two commercial buildings, one of which housed the printing business.
Sibling Estrangement Forces Parents to Choose Successor
In 2010, the parents were elderly, gravely ill, no longer able to continue their roles in the day-to-day operation of the company, and concerned about the future of the company and its 40 or more employees. They were acutely aware of the total estrangement between their two children, who would not be able to run the company together, and concluded that one of them would have to leave. After what the court described as “much soul-searching” by the father, he and his wife decided the company would suffer more if their son were to leave than their daughter.
They then, with counsel’s assistance, sent their daughter a proposed reorganization plan under which she would terminate her employment with the company, sell her shares to her brother for an appraised fair market value, and swap 50% realty interests with him so that he would own 100% of the building housing the printing business and she would own 100% of the other building, with a cash adjustment for any difference in the properties’ appraised values. (The court’s decision doesn’t mention any proposed disposition of the parents’ voting and non-voting shares, which presumably would be conveyed sooner or later to the son either by way of lifetime transfer outright or in trust, or by testamentary bequest, and which may or may not have been an aggravating factor.)
Things went from bad to worse. The daughter rejected the proposal, refused to sell her shares to the son, and refused to negotiate with her parents after her shares were appraised at $615,000 which her parents increased to $900,000. The daughter cut off all direct communication with her parents and refused to allow them to see their grandchildren.
In response, the parents cancelled the daughter’s check-signing authority, reduced her salary from $100,00 to $10,000, stopped making payments for her share of the taxes on the S corp net income, cut off her access to company books and records, and finally terminated her employment.
The Daughter’s Lawsuit
In early 2012, the daughter filed suit against her parents and brother for damages and injunctive relief predicated on direct and derivative claims for breach of the Shareholders Agreement, breach of fiduciary duty, conversion, and unjust enrichment. Her suit sought neither dissolution (it would have had to be of the common law variety since she did not hold voting shares as required for statutory dissolution) nor a compelled buy-out.
At a hearing on the daughter’s preliminary injunction motion, the parties stipulated to proceed directly to trial on the issue of liability only. Justice Emerson conducted a bench trial on various dates between November 2012 and October 2013 at which all four family members testified along with the company’s outside accountant. Post-trial briefs were submitted in March 2014.
Justice Emerson’s Decision
Justice Emerson’s decision quickly disposes of the complaint’s derivative claims, on the ground they failed to establish any cognizable injury to the company; the individual claim for conversion, on the ground it failed to establish that the defendants converted any specifically identified property or funds belonging to the plaintiff; and the unjust enrichment claim, on the ground it is duplicative of the breach of contract claim.
The bulk of Justice Emerson’s analysis is devoted to the claims for depriving plaintiff of guaranteed employment under the Shareholders Agreement, and for shareholder oppression styled as breach of fiduciary duty.
Breach of Shareholders Agreement. The argument boiled down to plaintiff’s contention that by terminating her employment, her parents breached the provision in the Shareholders Agreement quoted above, ensuring continuation of her employment “so long as . . . she shall continue to duly perform [her] executive duties,” versus her parents’ contention that plaintiff was an at-will employee who, in any event, did not perform any executive duties. Justice Emerson found that plaintiff’s employment was not at-will because the provision at issue limited her discharge; that the Shareholders Agreement did not define her executive duties; that she never was expected to participate in the company’s management or to perform any duties unrelated to financial management; that she was performing her regular duties when her parents terminated her; and that the parents terminated her “to induce her to sell her shares and to implement their reorganization plan.” Justice Emerson accordingly found the parents (but not the son) liable for breach of contract and directed the parties to proceed to trial on the issue of damages.
Two other notes of interest regarding this claim: First, Justice Emerson’s analysis gave significant weight to her finding that the Shareholders Agreement was meant to be an “estate-planning tool” for the transfer to the children of the parents’ shares “before their eventual demise.” This helps explain, she observed, the absence of defined executive duties in the Shareholders Agreement and is consistent with the informality typical of family-owned businesses. Second, part of the injunctive relief requested by plaintiff, which Justice Emerson denied, sought to prevent a shareholder meeting to approve, by the necessary 2/3 super-majority vote, the termination of the Shareholders Agreement. Presumably, the parents hope that by terminating the Shareholders Agreement they can bring an end point to the employment guarantee. If they do, they will have to contend with Justice Emerson’s caution that “any wrongful termination of the Shareholders Agreement is compensable by money damages . . ..”
Breach of Fiduciary Duty. The plaintiff contended that her parents and brother breached their fiduciary duties by trying to squeeze her out of the company and force the sale of her shares by means of cancelling her check-signing authority, changing the outside accountants and payroll company, denying her access to books and records, denying her a role in company management, reducing her salary, withholding tax payments and dividends, and eventually firing her. These acts, plaintiff contended, amounted to unlawful “shareholder oppression.” Justice Emerson denied the claim, writing that a majority shareholder’s fiduciary duty “not to engage in oppressive actions toward the minority” is “rooted in Business Corporation Law § 1104-a,” which provides for a judicial dissolution remedy and also authorizes a buy-out of the minority shareholder, neither of which was sought by plaintiff in her lawsuit. Justice Emerson further observed that “the court is unaware of any cases in which a minority shareholder has been allowed to remain a shareholder and recover damages for her oppression, nor has plaintiff brought any such cases to the court’s attention.”
Even assuming the plaintiff could assert such a claim, Justice Emerson continued, she failed to establish that her parents oppressed her. In Justice Emerson’s following summary of the evidence, there’s a striking recognition of what the above-mentioned Professor Means calls “non-market values” in adjudicating disputes among members of family-owned businesses:
The record reflects that the plaintiff expected to remain an officer and employee of Challenge Graphics, working from home, with the same salary and compensation package that she had enjoyed for years. The record does not reflect that she ever sought a greater role in the Company than the one she had, which was limited to financial matters. The plaintiff made no capital investment in the company since her shares were given to her by her parents. Moreover, she received the same compensation as her brother, whose role in the Company was much greater than hers. It was the plaintiff’s longstanding disagreement with her brother, and her refusal to speak to him directly, that caused the Senior Brancatos to try to remove her as a shareholder. Although they offered her what they reasonably believed was a fair price for her shares, she adamantly refused to negotiate with them and retaliated by refusing to allow them to see their grandchildren, among other things. As previously discussed, the Senior Brancatos were not motivated by greed, but by an honest belief that what they were doing was best for Challenge Graphics. There is no evidence in the record that they sought to deprive the plaintiff of a return on her investment of time and service to the Corporation. In fact, the opposite appears to be the case. They were exceedingly generous with her, offering her the fair market value of her shares as determined by an appraiser chosen by her. When she refused that offer, they increased the offer by almost 50%. The plaintiff has not produced any evidence that her shares were worth more than the $900,000 offered or that $900,000 did not represent a fair return on her investment.
Speaking of Professor Means . . .
Knowing he’d be interested in the Federico decision, I forwarded a copy to Professor Means and invited him to comment. Here’s what he wrote back:
Thanks for bringing this case to my attention and for your careful summary of the key points. To underscore the importance of family dynamics, I might highlight an additional fact mentioned in the decision, that the daughter “refused to sell her shares to her brother, although she was willing to sell them to a third party.” Apparently, the central problem was not so much the price offered for the daughter’s stock (50% above the value established by her own appraiser) but the implications of allowing her brother to take control of the family business.
As you point out, Judge Emerson’s decision is also noteworthy for its recognition that the Shareholders Agreement was intended to further the parents’ estate planning goals and should be interpreted in that light. It’s gratifying to see a court give such careful attention to the distinctive characteristics of family businesses–and not just because the decision cites our interview! If your readers are interested in further examples and analysis, I would refer them to a forthcoming article of mine entitled The Contractual Foundation of Family-Business Law available on SSRN here. The final draft will include a discussion of the Federico case.