Hidden in plain view in Section 1104-a (d) of the New York Business Corporation Law, which authorizes an oppressed minority shareholder to petition for judicial dissolution, is a provision empowering the court to adjust stock valuations and to “surcharge” those in control of the corporation for “willful or reckless dissipation or transfer” of corporate assets “without just or adequate compensation therefor.”
A second, fleeting reference to surcharge appears in Section 1118 (b) of the buy-out statute, empowering the court in its determination of the stock’s fair value to give effect to any surcharge “found to be appropriate” under Section 1104-a.
The ordinary definition of surcharge, at least in the context of settling accounts, is to show an omission for which credit ought to have been given. But what does it mean in its statutory setting, and how has it been applied by the courts?
The fact is there’s been very little case law dealing with the surcharge provision, which I’ve not found in any model statute and which was added in 1990 as an amendment to Sections 1104-a and 1118. Since then, there’s been only a handful of court decisions containing more than passing reference to the provision, and until last month, in none of them did the court award a surcharge:
- In Slade v Endervelt, 174 AD2d 389 [1st Dept 1991], the court rejected the argument that the surcharge provision divested a minority shareholder of the right to pursue derivative shareholder claims concurrently with a dissolution petition.
- In Matter of Markman (Exterior Delite, Inc.), 14 Misc. 3d 910 [Sup Ct Bronx County 2006], following the respondents’ election to purchase the petitioner’s shares under Section 1118, the court in part relied on the surcharge provision in holding that the Special Referee who conducted the valuation hearing erred by failing to consider the petitioner’s allegations of misappropriation of funds by the controlling shareholder, and that such allegations need not be formally asserted as shareholder derivative claims. The court remanded the case to the Special Referee for further hearing on the surcharge claim.
- In McDaniel v 162 Columbia Heights Housing Corp., 25 Misc. 3d 1024 [Sup Ct Kings County 2009], another dissolution-turned-buy-out proceeding under Section 1118, the court rejected on the merits surcharge claims against the respondent shareholders for waste of corporate assets, stating that “fixing blame” is material under Section 1104-a but not under Section 1118 and, in any event, finding that the petitioner herself bore responsibility for management decisions at issue.
- In Pappas v Fotinos, 2010 NY Slip Op 51300(U) [Sup Ct Kings County 2010], a post-trial decision in which the court granted a Section 1104-a dissolution petition, the court rejected a surcharge claim seeking pro rata percentages of the controlling shareholder’s officer compensation, monies used for legal fees, and rental value of the corporation’s property, on the grounds that the petition failed to plead such claims either derivatively or as a surcharge claim; because the surcharge provision in Section 1104-a (d) “by its express terms is limited to ‘stock valuation'” which was not before the court; because there is “at least a question” whether the statute applies in a dissolution proceeding based solely on oppression under Section 1104-a (a) (1) and not on looting, waste, or diversion of corporate assets under Section 1104-a (a) (2); and because the petitioners failed to offer evidence at trial supporting a finding of willful or reckless conduct by the controlling shareholder without just or adequate compensation.
Rennert v S.M.R. Holding Corp.
A decision last month by Manhattan Commercial Division Justice O. Peter Sherwood in Rennert v S.M.R. Holding Corp., 2016 NY Slip Op 31776(U) [Sup Ct NY County Sept 23, 2016], may be the first reported ruling in which a New York court has imposed a statutory surcharge in a dissolution case.
The case involves a family-owned corporation whose sole asset was a modest three-story, mixed use building in Manhattan. In 2011, the court ordered dissolution upon the petition of a one-third shareholder under Section 1104-a (a) (2) and referred the case to the Special Referee to supervise the sale of all assets and thereafter an accounting of the corporation.
The building was sold in 2013 for $3.5 million. The death shortly afterward of the respondent two-thirds shareholder stalled the accounting for over a year pending appointment and substitution of the estate’s executor. In April 2015, after the parties disputed whether surcharges were to be part of the hearing before the Special Referee, Justice Sherwood directed that the hearing go forward including the petitioner’s surcharge claims against the estate totaling over $500,000, of which over $200,000 was for the decedent’s rent-free use and occupancy of the building’s top two floors from 2003 to 2009 and for paying below-market rent in 2009 through 2013.
Other surcharges were sought for use of corporate funds to pay the decedent’s and the estate’s legal fees in the proceeding, and for the difference in value between the building’s alleged fair market value over $4 million and its “depressed” $3.5 million sale price due to a below-market commercial lease granted by the decedent encumbering the building’s first floor.
Special Referee Louis Crespo held a hearing in late 2015 and, in June 2016, issued a detailed, 61-page Report & Recommendation adjusting the corporation’s final accounting with surcharges of about $164,000 for legal fees paid with company funds, $37,000 for the first floor commercial lease, and a couple of minor surcharges for other miscellaneous expenses. The Report rejected any surcharge for the decedent’s use and occupancy of the building’s top two floors based primarily on the long history of the family’s rent-free use going back to the 1940’s. A copy of the Report can be viewed here.
Justice Sherwood’s decision and order last month confirming the Referee’s Report does not contain any discussion of the legal standard for applying a statutory surcharge. The Report, however, offers a few analytical nuggets worth highlighting.
First, the respondent cited passages from the above-mentioned Markman and Pappas decisions to argue that the petitioner was not authorized to seek a surcharge by the language of Section 1104-a (d) because the case did not involve a stock valuation. Special Referee Crespo called the argument “myopic and incorrect,” and he essentially read in the disjunctive the section’s references to stock valuation and surcharge. Here’s what he said in a footnote on page 39 of his Report:
The Referee interprets Section 1104-a [d] to allow for the Court to order an adjustment of stock valuations when the nonpetitioner elects to purchase the movant’s shares at “fair market value” pursuant to BCL “1118” and provide for a surcharge upon the directors or those in control of the corporation upon a finding of wilful or reckless dissipation or transfer of assets or corporate property without just or adequate compensation therefor”. The surcharge contemplated under Section 1104-a [d] can be an “adjustment” to stock in an election to “buy-out” at fair market value – which is NOT the case here – as well as any other surcharge where there is no election to buy-out shares and there is misconduct by those in control of the corporation that has had an adverse impact upon the corporation’s value where the Court has directed dissolution – which is the case here, e.g., claim of tax penalty and interest, payment of legal fees, execution of commercial lease after dissolution is ordered.
Second, the respondent also argued that no surcharge could be awarded because the petitioner failed to prove the respondent’s willful or reckless conduct as required by the statute. This argument likewise failed to impress the Special Referee, who noted in the same footnote quoted above that the Court’s 2011 order of dissolution was expressly based on waste and looting under Section 1104-a (a) (2), and that such “determination is akin to willful and reckless dissipation or transfer of assets upon which a surcharge will rest.”
Third, in each instance in which the Special Referee upheld a surcharge, he recommended its implementation as an adjustment to the final accounting of the gross sums at issue to be “credited back” to the corporation “for purposes of distributing to the petitioner his pro rata 1/3 share of net proceeds.” The Report’s last page also includes a recommendation that, to the extent the final accounting has a deficiency and the petitioner is therefore unable to recover his pro rata 1/3 share, “then he is entitled to first recover the deficiency and satisfy the same from the proceeds held in the Escrow Account before there is any distribution to respondents . . ..”
Closing Thoughts. The paucity of decisions addressing the statutory surcharge provision in the 26 years since it was added to Sections 1104-a and 1118 likely reflects its limited usefulness:
- It is much more common to find shareholder derivative claims included in a hybrid petition/complaint seeking dissolution and damages. Derivative claims based on violation of the controlling shareholder’s or director’s fiduciary duties of loyalty and care arguably permit a lower and broader standard of liability compared to the surcharge statute’s standard of “willful or reckless dissipation or transfer” of corporate assets “without just or adequate compensation therefor.” A derivative claim also carries with it, upon success, the prospect of an award of counsel fees under Section 626 (e) of the Business Corporation Law. Of course, if the petitioner is unable to satisfy one or more of the statutory prerequisites for bringing a derivative claim (e.g., continuous ownership, pre-action demand on the board or demand futility), a surcharge claim may be the next best option for the petitioner.
- Whenever the respondent elects to purchase the petitioner’s shares under Section 1118, effectively mooting questions of blame and converting the proceeding to one to determine the fair value of the petitioner’s shares, the same economic issues forming the bases for a claimed surcharge factor into the share appraisal, typically by way of normalizing the company’s financial statements to adjust for such things as excessive owner compensation, above or below market leases, non-recurring events, and other discretionary expenses. As the Markman decision noted, “case law uniformly holds that even separate proceedings involving misappropriation of corporate assets should be consolidated into the BCL § 1118 proceeding, because the issue of misappropriation proceedings is ‘intertwined with the determination of the fair market value of a petitioner’s shares.'” Where the appraisal captures and converts into a discounted future income stream the value of the alleged improprieties, it becomes less attractive to pursue the same improprieties as a separate surcharge with a higher burden of proof and arguably constituting double-dipping.
Update November 13, 2017: If you found this post of interest you’ll also want to read my article posted this date on a more recent court decision holding that Section 1104-a (d)’s surcharge provision applies only in buy-out proceedings under BCL Section 1118.