The under-reporting of cash receipts a/k/a skimming by restaurant owners and other cash-intensive businesses costs many billions of dollars in lost tax revenues each year and, when detected by audit, can lead to stiff penalties and even criminal prosecution. When the business has multiple owners, not all of whom are in on the skimming, it also can constitute grounds for judicial dissolution, as illustrated in a fascinating post-trial decision last week by Brooklyn Commercial Division Presiding Justice Carolyn E. Demarest in Cortes v 3A N. Park Ave. Rest Corp., 2014 NY Slip Op 24329 [Sup Ct, Kings County Oct. 28, 2014].
Any publicly aired business divorce involving allegations of looting can be a nasty affair. Throw into the litigation mix the specter of under-reported taxes and it becomes positively toxic, which is the flavor I got from reading Justice Demarest’s detailed findings of fact and conclusions of law in her 24-page ruling which, ultimately, found that the controlling shareholders skimmed about $3.7 million and conditionally ordered dissolution of the corporation, contingent upon the controllers’ buy-out of the plaintiff’s shares for over $1.2 million.
The Cortes case involves a 150-table Mexican restaurant, bar, and nightclub called Cabo, located in Rockville Center on Long Island. In 2003, the plaintiff, Porfirio Cortes, acquired for $50,000 a 16.67% stock interest in the restaurant’s operating company, in which the remaining shares were owned equally by defendants Angelo Ramunni and Domenick DeSimone. The purchase agreement gave the corporation the right to repurchase Cortes’s shares in the event he resigned his designated position as managing partner though, oddly, it did not specify a price or a pricing mechanism.
Cortes worked long hours as the restaurant’s day manager from 2003 until he quit in 2010. He received a salary that peaked at $1,000 weekly and, until 2009, he also received approximately $25,000 annually in cash. Ramunni was in charge of financial matters including handling of cash receipts, banking, day-to-day authorization of payments, and monitoring of sales. DeSimone, who co-owned other restaurants with Ramunni, exercised more limited oversight responsibility.
After he quit, and after he rejected Ramunni’s and DeSimone’s offer to repurchase his shares for no more than the $50,000 he originally paid for them, Cortes filed a lawsuit asserting individual and derivative claims against the other two owners. The suit principally accused them of looting millions of dollars in cash receipts from the restaurant operations, none of which was reported in the corporation’s financial statements or tax returns which consistently showed little or no profit.
The non-jury trial of the case before Justice Demarest earlier this year dealt with Cortes’s individual and derivative claims seeking money damages and imposition of a constructive trust for breach of fiduciary duty and for failure to declare dividends. It also dealt with Cortes’s claim for common-law dissolution of the restaurant corporation or, alternatively, a compulsory buy-out of his shares for “fair value.” (Cortes resorted to common-law dissolution because, as a 16.67% shareholder, he did not meet the minimum 20% threshold for standing to seek involuntary dissolution under Section 1104-a of the Business Corporation Law.)
The defendants denied the looting allegations. Ramunni acknowledged that some cash receipts were not deposited in the corporation’s bank account, but claimed that the cash was used to pay employees and vendors. The defendants also testified that throughout his tenure Cortes had a serious drinking problem and was often “inebriated” on the job; that his mismanagement of the restaurant caused the restaurant to lose money in each of its first ten years of operation; and that it did not become profitable until they instituted new management following Cortes’s departure. They also contended that Cortes was contractually obligated to redeem his shares for $50,000, which claim Justice Demarest dismissed based on the terms of the 2003 purchase agreement.
The Forensic Evidence
The trial of the case was largely an exercise in forensic accounting, in which the best evidence of the restaurant’s cash receipts consisted of the restaurant’s daily “server reports” generated by the restaurant’s point-of-sale system. The server reports record each customer purchase, whether cash or credit card, the tax and tip, and the amount of alcohol and food charges. The problem was, as Justice Demarest found, the defendants had engaged in a “pattern of delay and obfuscation in responding to the [plaintiff’s] numerous requests for records” including the server reports which, by design, are stored and retrievable only for one year. As a result, the defendants produced incomplete server reports only for the period between July 2011 and July 2012.
The defendants’ “deliberate concealment” of the server reports, Justice Demarest wrote, which defendants “knew would reveal their defalcations,” ultimately led her to accept the cash-receipt projections calculated by Cortes’s forensic accounting expert, Michael Garibaldi. (If you read my recent posts about the Zelouf case, you’ll recognize the same phenomenon in both cases of the controlling shareholders’ delayed disclosure of key forensic evidence supporting the minority shareholder’s looting allegations.)
Garibaldi’s estimate of cash receipts over a ten-year period required him to calculate the ratio of the restaurant’s known and verifiable credit card revenues to the amount of cash received as reflected in the limited production of server reports. Garibaldi used a sample of the server reports generated on 11 dates in 11 different months, selected by an expert statistician, to create a statistically significant sample size allowing him to determine the percentage of the restaurant’s revenue received in cash. Garibaldi calculated that between July 2011 and July 2012, 45.6% of the revenue was paid by credit card and 54.4% in cash. He then applied that ratio to the known credit card receipts over the entire ten-year period, together with his analysis of other company records including bank statements, to conclude that the defendants diverted over $3.7 million in cash receipts.
Justice Demarest’s decision gives a lengthy and painstakingly detailed account of the testimony and evidence offered by Garibaldi and the opposing expert — more than I can possibly recount here — which you ought to take the time to read in full if you’re at all interested in forensic accounting issues. For those who can’t devote the time, the following excerpt from the decision provides a good overview:
In light of defendants’ failure to provide any reliable records, other than the server reports, of actual revenue of the corporation, this Court finds the projections of revenue based upon the Credit/Cash Ratio, as described in Plaintiff’s Expert Report and the testimony of Garibaldi, to be the appropriate method by which to assess the extent of defendants’ diversion of cash revenue and determine the true value of the corporation. The Court is satisfied that Madigan randomly selected a statistically significant sample of server report dates for Garibaldi to review in order to determine the cash to credit card ratio and is satisfied that a rational basis exists for Garibaldi’s calculations. Garibaldi is a recognized, and highly experienced forensic accountant, expert in the field of evaluation of closely-held corporations, particularly where, as here, the parties have sought to hide the true value and the extent of their defalcation. Although the defendants repeatedly sought to discredit Garibaldi’s conclusions at trial, the defendants did not provide their own expert, Cannon, with the server reports or bank statements relied upon by Garibaldi, precluded Cannon from reviewing Garibaldi’s report, and did not retain Cannon, or any other independent expert, to analyze plaintiff’s allegations of diverted cash and lost profits. Although Lipke [the restaurant’s accountant] testified that he never saw a restaurant with less than a 60% credit card to 40% cash ratio, he did not contest Garibaldi’s method of calculating the estimated cash payments or contest Madigan’s selection of random dates. While defendants challenged the application of the Credit/Cash Ratio to any time frame outside the period of July 2011 to July 2012, arguing that the ratio was derived from the server reports for only that period, it is defendants’ failure to maintain and/or produce records for any other period (other than, belatedly, for the Sales Summary period of December 2012 to January 2013), that has necessitated the use of the ratio for the entire relevant period. The defendants cannot be permitted to benefit from their purposefully inadequate record-keeping, as a means of concealing their diversion of funds, to defeat plaintiff’s claims. The sole reason that the plaintiff’s expert applied the Credit/Cash Ratio over the course of a number of years is because the defendants maintained such inadequate, and obviously fraudulent, records. It is noted that the defendants’ own expert witness, Cannon, testified at trial that the frequency of credit card use at restaurants has been increasing over the past 10 years, which suggests that the application of the Credit/Cash Ratio, dating back to 2003, may actually be a conservative estimate of the earlier cash payments to the restaurant.
Liability and Remedies
Based on the evidence, Justice Demarest concluded that Ramunni and DeSimone “shared the diverted cash and that each participated in the effort to cheat plaintiff out of his share of the return on his investment”; that they gave “false information” to the accountant for inclusion in the corporation’s tax returns and financial reports; and that “defendants breached their fiduciary duty to plaintiff as a minority shareholder by diverting profits to themselves, without disclosure to plaintiff, depriving him of his right to share therein.”
The court nonetheless held that the harm from the cash diversion fell directly on the corporation, and only indirectly on Cortes as a shareholder, thus supporting only his derivative claim for damages on the corporation’s behalf under BCL Section 626 (and, by the same reasoning, requiring dismissal of his individual claims seeking a money judgment for his share of the diverted cash). Justice Demarest accordingly directed entry of a money judgment against Ramunni and DeSimone, and in favor of the corporation, in the sum of approximately $4.9 million including prejudgment interest through June 2011, plus additional prejudgment interest at 9% from June 2011 to the date of entry.
Justice Demarest also dismissed Cortes’s individual claim for a declaration of dividend based on the diverted cash, finding it undisputed that the corporation never in its history declared a dividend and that “the records of the corporation, while perhaps fraudulent, do not reveal any earnings from which a dividend might have been paid.”
You might be wondering at this point, what good does it do Cortes, the real victim of the looting, for the corporation to get a multi-million dollar judgment against the controller defendants who have no obligation to declare dividends? The answer lies in the buy-out and conditional dissolution remedy also granted by the court.
As noted above, Cortes asserted a claim for the equitable remedy of judicial dissolution at common law which, as formulated by New York’s highest court 50 years ago, in Leibert v Clapp, is available when the majority shareholders “have so palpably breached their fiduciary duty they owe to the minority shareholders that they are disqualified from exercising the exclusive discretion and the dissolution power given to them by statute.” Justice Demarest held that under this standard Cortes established his right to common-law dissolution, but that a buy-out of his interest for fair value is the more appropriate remedy — a remedy that Cortes expressly sought and that the defendants agreed was preferable to dissolution in the event the court upheld the dissolution claim.
Each side’s expert testified at trial on the valuation of Cortes’s shares. Justice Demarest accepted the low end of the valuation presented by Cortes’s expert, Garibaldi, who applied a 3X multiple to his projection of net income for the year ended July 31, 2012. This yielded a base valuation of about $3.2 million for the enterprise value, to which Justice Demarest then added the $4.9 million judgment against Ramunni and DeSimone as an asset of the corporation, resulting in an enterprise value of almost $8.2 million, which in turn yielded a fair value of about $1.2 million for Cortes’s 16.67% interest after applying a 10% marketability discount.
The fair value award, by incorporating the value of the derivative claims, thus compensates Cortes for his pro rata share of the diverted funds. The decision directs the defendants to consummate the buy-out of Cortes within 90 days, and further provides that “upon notice to this Court that no purchase is anticipated, dissolution will be granted and a liquidating trustee will be appointed by the Court.”
Do you see the hammer at the ready in the court’s order? If the defendants complete the buy-out, and thereby become the sole owners of the corporation, tax consequences aside, what happens to the money judgment basically is their own affair. But if they don’t complete the buy-out, the resulting order of dissolution will empower an independent trustee, charged with the duty to marshal the corporation’s assets, to enforce the corporation’s money judgment against Ramunni and DeSimone, the proceeds of which, after discharge of the corporation’s liabilities, eventually will be distributed pro rata to the shareholders including Cortes’s 16.67% share.