shareholderWhat makes a shareholder a shareholder? What makes an LLC member a member?

The simplicity of the questions belies the difficulties and endlessly unique fact patterns encountered in case after case involving close corporations and LLCs in which one faction claims the other has no ownership interest in the entity and therefore lacks standing to seek judicial dissolution or other remedies predicated on violation of owner rights.

That’s not to say there aren’t common characteristics of such ownership contests. Usually they spring from one or more of the following circumstances: lack of shareholder or operating agreement; lack of certificated interests or other formal ownership documents; lack of transparency of tax returns and other business documents requiring owner identification; prior, inconsistent representations in tax returns or court proceedings; and, sometimes, intentional concealment of ownership interests to avoid creditors, tax authorities, ex-spouses, etc.

Last month, in a pair of noteworthy decisions, Nassau County Commercial Division Justice Stephen A. Bucaria rejected challenges to claimed ownership interests in two very different cases, one involving a close corporation and the other an LLC, in both of which one party unsuccessfully claimed to be the sole owner. In the corporation case, Justice Bucaria granted summary judgment upholding the contested 4% stock ownership as evidenced by a stock purchase agreement and stock certificate notwithstanding the shareholder’s sworn testimony in a prior, unrelated case denying that he was a shareholder. In the LLC case, Justice Bucaria granted preliminary injunctive relief in favor of two individuals claiming one-third membership interest each as evidenced by documents provided to a franchisor and municipal agency, notwithstanding an operating agreement naming the adverse party as sole member.

The Re/Max Case

The dispute in Re/Max of New York, Inc. v Weber, Short Form Order, Index No. 600848/16 [Sup Ct Nassau County Nov. 29, 2016], centered on two, diametrically opposed narratives surrounding a 1998 transaction in which a stockholder with 15 shares representing a 4% equity stake sold his interest to the defendant, Weber, who served as president and director of the company in the business of franchising real estate brokers.

The transfer was evidenced by stock purchase agreement, stock power, and a stock certificate made out to Weber which does not appear to bear officer signatures. On its reverse side, the certificate states that the shares are subject to a 1988 shareholders agreement with stock transfer restrictions. Weber maintained that he bought the shares with his own money for his own account.

Fast forward to 2015 when the controlling shareholder, Can-Am Holdings, Ltd., announced a sale of substantially all of its assets, after which Weber demanded his 4% share of the sale proceeds, after which the company filed a lawsuit against Weber seeking a declaratory judgment that Can-Am is sole shareholder.

In its subsequent motion for summary judgment, the company contended that Weber was never a shareholder and had acted as the company’s nominee using company funds to purchase the 15 shares which the company assumed as treasury shares. The company’s argument largely relied on a series of sworn statements by Weber in a prior, unrelated lawsuit in which he denied being a shareholder. The company also relied on Can-Am’s right of first offer under the 1988 shareholders agreement as a bar to any claim by Weber that he validly acquired the 15 shares from the prior owner.

Justice Bucaria’s ruling, granting summary judgment in Weber’s favor on his stock ownership claim, rejected both prongs of the company’s argument.

First, citing Business Corporation Law § 508 and the Second Department’s decision in Essig v 5670 58 St. Holding Corp., Justice Bucaria observed that “[a] stock certificate is written evidence of shareholder status and ownership in the corporation” and that Weber’s sworn denials of his shareholder status in the prior, unrelated litigation did not give rise to an estoppel absent a showing that Weber secured a ruling in his favor in the prior case.

Second, Justice Bucaria found that the company “waived” the first offer provision in the 1988 shareholders agreement by virtue of Weber’s “many years of high level management service” for the company and because, as a company insider, selling the shares to Weber “would not create the disruption in relationships among shareholders that the first offer provision was intended to obviate.”

The court having found that Weber is a shareholder, it further declared that he is “entitled to the fair value of his shares” taking into account the completed sale of the corporation’s assets, as in a dissenting shareholder appraisal.

In many cases of this sort involving disputed share ownership, one side or the other relies heavily if not exclusively on the issuance or non-issuance of tax Form K-1s to the individual whose shareholder status is in question. In Re/Max, no mention is made of the company’s tax returns or K-1s, most likely indicating that the company never made an S-Corp election.

The Harry’s Hot Dogs Case

Sobel v Tulchiner, Short Form Order, Index No. 607651/16 [Sup Ct Nassau County Nov. 16, 2016], involves a Nathan’s Famous Hot Dogs franchise in the Bronx operated by a company called Harry’s Hot Dogs of Bay Plaza, LLC. The question presented was whether the two plaintiffs, who ran the business, were mere employees as claimed by the defendant, who put up all the capital, or were each one-third “sweat equity” members of the LLC as claimed by the plaintiffs.

The plaintiffs filed suit against the defendant after he purported to terminate their employment and barred them from the restaurant, supposedly for diverting company assets, neglecting their management responsibilities, and refusing to provide W-4 tax forms. In so doing the defendant purported to act as the LLC’s sole member. The plaintiffs asserted a number of claims including breach of fiduciary duty, fraud, and a declaratory judgment as to their alleged one-third interests in the company.

The plaintiffs moved for a preliminary injunction restraining defendant from engaging in any transactions outside the ordinary course of business, or taking any distributions, or using the LLC’s funds to pay defendant’s legal fees. As evidence of their claimed membership interests, plaintiffs submitted (1) an information sheet for the franchise closing agreement with Nathan’s identifying them as one-third owners along with the defendant, (2) personal guarantees given to Nathan’s by the plaintiffs; and (3) an application for a food service permit filed with the City’s Department of Health likewise identifying the three members.

The defendant opposed the motion on the ground that plaintiffs were non-members of the LLC, lacked standing to assert derivative claims on the LLC’s behalf, and were lawfully fired from their at-will employment. The defendant relied primarily on an operating agreement signed only by himself and naming himself as sole member, plus the fact that plaintiffs contributed no capital in contrast to defendant’s $600,000 investment.

Justice Bucaria granted the plaintiffs’ injunction motion, finding that they had established a likelihood of success on the merits of their ownership claim based on the documents submitted by the three of them to Nathan’s and to the Health Department identifying all three as members.

Assuming the judge’s preliminary assessment of the merits ultimately prevails, the plaintiffs and defendant will be re-cast as controlling and minority members, respectively, in an LLC with no operating agreement and therefore governed by majority rule under the statute — likely a bitter pill to swallow for the defendant who invested heavily and fancied himself sole member.

Unlike corporations, which by statute (BCL § 508) either must issue stock certificates or give written notice to the owner of uncertificated shares, there’s no statutory requirement for certificated LLC membership interests. In my experience with LLCs all of whose owners are actively involved in the business, only occasionally do I see a certificated LLC membership interest, which leaves the operating agreement as the primary evidence of membership. Indeed, LLC Law Section 102(q) and Section 602(a), which respectively define “member” and govern admission of members, assume the existence of a written operating agreement as required by Section 417(a).

The problem is that many multi-member LLCs are organized and operated without operating agreements, which can turn into a ticking time bomb as illustrated by cases such as Harry’s Hot Dogs and many others I’ve written about on this blog.