Are books-and-records proceedings on a roll?
Last September I wrote about an important appellate ruling that month in a books-and-records proceeding against the McGraw-Hill publishing company, in which the court held that the petitioning shareholder’s allegations of mismanagement and breach of fiduciary duty by board members constituted a proper purpose for the inspection demand, regardless whether the inspection ultimately establishes that no wrongdoing occurred. I referred to the ruling as a boost for New York’s under-utilized books-and-records proceeding under Section 624 of the Business Corporation Law, especially for minority shareholders of closely held corporations who, unlike shareholders in public companies with reporting duties, are sometimes shut out completely from any information concerning the company’s business dealings and financial affairs.
Sure enough, less than two months after the McGraw-Hill decision, Brooklyn Commercial Division Presiding Justice Carolyn E. Demarest cited it as precedent for her ruling in Novikov v Oceana Holdings Corp., 2014 NY Slip Op 24332 [Sup Ct, Kings County Nov. 3, 2014], granting a close corporation minority shareholder’s petition to inspect an array of financial and corporate records to investigate possible wrongdoing by the controlling shareholders.
Novikov involves a real estate holding company known as Oceana Holdings Corp. formed in 1994 to own and operate a commercial property in Brighton Beach, Brooklyn. According to his petition (read here), Marat Novikov paid $450,000 and gave loan guarantees in exchange for a 20% stock interest in Oceana. Novikov never had a management role. Aron Bronstein and Diana Bronstein, the adult children of deceased original shareholder Michael Bronstein, run Oceana’s day-to-day operations and serve as directors along with their mother, Rosa Bronstein. Bronstein family trusts own 70% of Oceana’s shares. Oceana has no shareholders’ agreement.
Novikov and the Bronsteins have clashed in court three times over the last 15 years. Both of Novikov’s first two lawsuits, which ended inconclusively, raised allegations of self-dealing and corporate waste by members of the Bronstein family. The second lawsuit culminated in an appellate ruling in August 2013, affirming the non-merits dismissal of Novikov’s claims, in which the court remarked upon his complaint’s failure to plead a proper demand and purpose to inspect the corporation’s books and records.
The Inspection Demand
The latest books-and-records proceeding was precipitated shortly after the appellate court’s ruling, when Novikov made a new, written demand under BCL § 624 (read here), accompanied by the requisite affidavit (read here), to inspect all meeting minutes, financial statements, tax returns, tenant leases, and employment agreements from 2010 onward. The demand listed three purposes for the inspection:
- To ascertain mismanagement in the operations of the corporation;
- To determine the fair market value of the corporation’s shares; and
- To communicate with other shareholders of record.
Soon afterward Novikov received a notice of annual meeting of Oceana’s shareholders, which was held in October 2013, at which the three Bronsteins (Aron, Diana, and Rosa) were elected to the board over Novikov’s dissenting vote. The meeting minutes (read here) also reflect the Bronstein’s approval, again over Novikov’s dissenting vote, of a resolution to convert the corporation to a limited liability company.
About a week later, the corporation’s outside counsel sent Novikov a letter largely rejecting his inspection demand (read here). The letter referred to Novikov’s “belligerent” behavior at the prior shareholders’ meeting, cited the appellate court’s dismissal of his lawsuit as raising “substantial doubts” as to his “good faith and motivation” in seeking to inspect corporate records, and contended that his inspection rights “may have to await a judicial hearing to determine [his] motivation.” The letter agreed to provide Novikov only with Oceana’s 2012 balance sheet and profit and loss statement upon its completion.
Two days after receiving the rejection letter, Novikov filed a petition to enforce his right to inspect Oceana’s books and records identified in his prior demand. The petition and supporting memorandum of law (read here) pointed to Michael Bronstein’s prior criminal conviction for securities fraud, and to Diana Bronstein’s prior suspension from the practice of law for escrow account “irregularities,” as raising “serious concerns . . . as to their activities as to Oceana and their unwillingness to provide [Novikov] with information.”
The petition also alleged “upon information and belief” that the Bronsteins were taking unreasonable compensation, and that they were improperly benefitting themselves at Oceana’s expense in connection with tenancies at the property in which they held a “pecuniary interest.” The petition further justified the need for financial disclosure in connection with the proposed conversion of Oceana to an LLC, which would trigger dissenting shareholder rights.
Oceana opposed the petition, arguing in its memorandum of law (read here) that Novikov’s allegations of management wrongdoing were speculative, vague and conclusory; that certain evidence of anonymous phone calls to Oceana’s tenants, as well as Novikov’s long history of litigation, showed his true motive to “harass” Oceana’s directors and interfere with their authority to manage its business and financial affairs; and that Oceana’s agreement to provide its 2012 financials satisfied its statutory duty under § 624.
In his reply papers, Novikov submitted evidence that Diana Bronstein was managing member of a company that leased space from Oceana and owed more than $135,000 in rental arrears. He also submitted documents evidencing that Oceana incurred a loss of almost $1.5 million in 2012 as to which he was provided with no information.
Justice Demarest’s Ruling
In her decision, Justice Demarest rejected Oceana’s contention that disclosure of its 2012 financials alone satisfied § 624. First, she cited § 624 (f) which provides that “[n]othing herein contained shall impair the power of courts to compel the production for examination of the books and records of a corporation.” Second, she affirmed Novikov’s “common-law right to inspect corporate books and records where the request is made in good faith and for a proper purpose.” Third, quoting from the McGraw-Hill case, she wrote that “investigating alleged misconduct by management and obtaining information that may aid legitimate litigation are, in fact, proper purposes for a BCL § 624 request, even if the inspection ultimately establishes that the board had engaged in no wrongdoing.”
Applying these standards, Justice Demarest concluded that Novikov sufficiently alleged a basis for investigating misconduct by the management of Oceana. As she further explained:
Based upon the documents now produced, there is evidence of an unexplained loan that is approximately equal to the value of the total assets of the corporation, and evidence that significant past rent owed by a business owned by a family member of the Oceana management is not being collected. This is a sufficient basis to investigate management misconduct. The only evidence of harassment proffered by respondent is a telephone call, purportedly on behalf of the petitioner, requesting documents that are in the respondent’s possession, which petitioner denies. Respondent’s argument that petitioner seeks to “inject himself improperly into the Oceana’s corporate decision-making process” is insufficient to demonstrate bad faith or an improper purpose. The petitioner is only a minority shareholder, with no voting authority to affect corporate decisions, and he apparently has no day-to-day involvement in Oceana’s business. As the investigating of alleged management misconduct is a proper purpose for a BCL § 624 request, and respondent has not raised an issue of fact as to petitioner’s improper purpose, the petition is granted to the following extent. [Citations omitted.]
In addition to the tax returns, financial statements, meeting minutes, shareholder list, leases and employment agreements originally demanded by Novikov, Justice Demarest also ordered Oceana to produce documents evidencing the corporation’s long-term debt and losses as reported in its 2012 tax return. On the other hand, Justice Demarest declined to order production of Oceana’s general ledger, and she ordered Novikov not to contact any of Oceana’s tenants pending further order of the court.
The Takeaway. Novikov, decided so soon after McGraw-Hill, may be a harbinger of greater resort to books-and-records proceedings by dissatisfied minority shareholders, before filing suit against management for breach of fiduciary duty, based on the relative ease and speed of securing disclosure. Novikov is noteworthy for three, additional reasons:
- It demonstrates that the minority shareholder has a fairly modest burden under McGraw-Hill to allege reasonable suspicion of management misconduct as a proper purpose for inspection. Once the shareholder does so, the burden shifts to the corporation to show the shareholder’s bad faith or an improper purpose.
- The common-law right of inspection is broader than that provided by § 624. Novikov’s failure to include a claim in his petition for common-law inspection did not deter Justice Demarest from ordering Oceana to produce books and records beyond the narrow categories specified by the statute.
- My post on McGraw-Hill noted that a disgruntled minority shareholder’s demand for inspection of potentially sensitive records may, in some instances, provide leverage to achieve a desired buy-out. Justice Demarest’s decision noted that, not long after Novikov filed his petition, the majority shareholders offered to purchase his shares for over $2.7 million or at a price to be determined by independent appraisers. Novikov declined the offer.