No SaleA bitter feud among third-generation owners of a family business has yielded a notable court decision upholding the plaintiff’s standing to seek common-law dissolution and to assert shareholder derivative claims in the face of the defendants’ argument that the plaintiff’s shares automatically were redeemed by operation of the shareholders’ agreement upon the termination by the defendants of the plaintiff’s husband’s employment.

Sounds complicated? Not really.

Queens County Commercial Division Justice Duane A. Hart’s decision in Berger v Friedman, Short Form Order, Index No. 702322/15 [Sup Ct Queens County Oct. 27, 2015], centers on a wholesale distributor of electrical parts and equipment founded in 1945 by the grandparents of the three sibling litigants who each acquired a one-third interest from their parents in 1993. The siblings entered into a shareholders agreement (read here) naming each of them as an officer and director, requiring their unanimous consent for specified “major actions,” and defining a series of trigger events compelling stock redemption at a defined purchase price and on specified terms.

The troubles began in 2012 when the company got caught up in the Manhattan D.A.’s investigation into fraud and corruption in the electrical contracting industry, which resulted in the company entering into a deferred prosecution agreement. At the time, the company’s long-time executives included one of the three siblings (Ira) and the husbands (Todd and Jason) of the two other siblings (Jodi and Meryl, neither of whom was a full-time company employee). Jason — the husband of plaintiff Meryl — cooperated with the D.A.’s investigation and avoided jail time. Ira and Todd did not, and each eventually pled guilty to falsifying business records for which they received jail sentences and large financial penalties.

According to Meryl’s complaint (read here), siblings Ira and Jodi then undertook a punitive scheme against Meryl and her husband Jason, first, by adopting a directors’ resolution without Meryl’s necessary approval as a “major action,” placing Jason on a mandatory leave of absence from his employment, and disabling Meryl from writing single-signature company checks in contravention of the shareholders’ agreement in order to cut off payment of Jason’s (but not Ira’s and Todd’s) legal expenses in the criminal probe.

The complaint alleges that the scheme culminated after Ira and Todd returned from jail when, following unfruitful negotiations for a buyout of Meryl’s shares valued by Ira around $2.3 million, Ira and Jodi sent Jason a notice of termination of his employment and simultaneously sent Meryl a notice stating that, under Section 4 of the shareholders’ agreement, Jason’s termination triggered Meryl’s obligation to sell her shares back to the company at a purchase price of about $66,000.

Section 4(a)(5) of the shareholders’ agreement did indeed mandate a buyback of shares upon “the termination of a Stockholder’s full time employment by Corporation, or his or her retirement as an employee of the Corporation.” Plus, there was no dispute that Meryl had not been a full-time employee for many years. However, Section 4(b) contained an override provision expressly acknowledging that Meryl’s and Jodi’s respective husbands, Jason and Todd, were employed full time by the company, and that:

so long as said husband(s) shall continue to work as full time employees of the Corporation . . . neither Meryl nor Jodi . . . shall be required to offer her . . . shares of stock . . .. However, if . . . either Jason or Todd (as the case may be) shall cease to be a full time employee of the Corporation, [and] if Meryl or Jodi (as the case may be) shall not then resume full time employment by Corporation, the shares of stock in Corporation owned by either or both of them (as the case may be) shall be offered for sale to Corporation as provided in this Agreement. [Emphasis added.]

Meryl responded to the buyback demand with a notice of election to resume her own full-time employment with the company, which Ira and Jodi rejected on the ground the company could not afford to pay her salary. Upon Meryl’s refusal to tender her shares for redemption, Ira and Jodi subsequently purported to cancel Meryl’s shares and reissued new shares in her name to be held in escrow pending the payment in full over ten years of the $66,000 purchase price, supposedly in compliance with the shareholders’ agreement.

At this point Meryl filed suit seeking common-law dissolution of the company; a declaration that the buyback demand was invalid and that she was not obligated to sell her shares; and asserting derivative claims for an accounting and damages.

Ira and Jodi responded with a motion to dismiss the lawsuit based on Meryl’s alleged lack of standing. In a nutshell, they argued that under the shareholders’ agreement Meryl was bound to sell her shares to the company upon the termination of her husband’s employment and, therefore, as a non-shareholder she lacked standing to seek dissolution or any of the other relief sought in her complaint.

Meryl opposed the motion, arguing:

  • Ira and Jodi lacked authority to terminate Jason’s employment without Meryl’s consent because it was a “major action” requiring unanimous approval of the shareholders under the shareholders’ agreement;
  • Ira and Jodi’s refusal to honor Meryl’s election to resume her own full-time employment under Section 4(b) of the shareholders’ agreement negated any obligation to sell her shares; and
  • even assuming the forced buyback was valid, Meryl retained her shareholder status with respect to the shares reissued in her name being held in escrow.

In his decision, Justice Hart called defendants’ dismissal motion “misguided,” initially noting that Meryl’s “second cause of action seeks a declaratory judgment that, inter alia, Meryl has no obligation to sell her shares back to [the company], and since this is a cause of action which she asserts individually, not derivatively, standing is not an issue.”

Justice Hart was equally dismissive of the defendants’ challenge to Meryl’s standing to seek dissolution and assert derivative claims, laying out three reasons “the defendants failed to demonstrate on this motion that Meryl is no longer a shareholder” of the company (citations omitted):

  • “First, the shareholders agreement can reasonably be construed to contain a promise that Meryl could resume full time employment with [the company] if her husband’s full time employment ended, thereby avoiding the sale of her stock back to the company. A party is excused from complying with his or her contractual obligations where the other party has committed a material breach. If the defendants committed a material breach of the shareholders agreement by wrongfully refusing to permit Meryl to resume full time employment, then she had no obligation to sell her shares back to the company and the defendants had no right to cancel her shares. The defendants may also have committed a material breach of the shareholders agreement by firing Jason, arguably a ‘major action’ requiring the unanimous consent of all shareholders.”
  • “Second, ‘a share is the property of the shareholder, not of the corporation *** Hence, the corporation has to reacquire the share to cancel it ***’ The defendants did not properly acquire Meryl’s shares before purporting to cancel them, since she never delivered her shares to them.”
  • “Third, the defendants purportedly issued a new certificate in Meryl’s name which is being held in escrow by an attorney. The shareholders agreement recognizes that an individual who sells his or her stock back to the corporation remains a shareholder while his or her stock is in escrow until the note is fully paid. Paragraph 6(f) provides in relevant part: ‘So long as the Corporation is not in default in the payment of any of the installments *** Corporation shall have the right to vote the stock on deposit with the escrow agent and Seller shall, on demand, execute and deliver an effective proxy or proxies in favor of Corporation.’ Under the shareholders agreement, the seller of stock in [the company] remains the owner until the note is fully paid. Plaintiff Meryl has standing to maintain this action.”

In most respects the decision in Berger is a straightforward application of contract law, construing the shareholders’ agreement within a framework of corporate law principles governing shareholder rights. But the setting of Berger within a family-owned business cannot be overlooked. The shareholders’ agreement’s unusual provisions acknowledging the roles of two of the siblings’ spouses in running the company, and preserving those siblings’ rights to resume employment in order to maintain their stock ownership should their spouses no longer be employed, seem designed to preserve equality among the three, third-generation branches of the family both in terms of management rights and the financial benefits of ownership including employment compensation, dividends, and equity appreciation.

James M. Wicks and Aaron E. Zerykier of Farrell Fritz, P.C. represent the plaintiff in the case described in this post.  

Update June 8, 2017:  Yesterday the Appellate Division, Second Department, unanimously affirmed the lower court’s ruling in this matter, ruling that “the individual defendants failed to establish the plaintiff’s lack of standing as a matter of law. The shareholder agreement, submitted by the individual defendants in support of their motion, did not establish that the plaintiff was no longer a shareholder or that she had been divested of her shares in the manner articulated by and in compliance with the shareholder agreement.” Read the decision here.