I’ve represented clients on both sides of freeze-out mergers of privately owned business entities, so I’m very familiar with their uses, misuses, potential advantages, and potential disadvantages to both freeze-ors and freeze-ees.
Over the years this blog has featured numerous articles about cases involving freeze-out mergers which you can readily access by clicking on the Topics dropdown menu on the right sidebar and selecting Freeze-Out Merger.
If you do, you will find that, when it comes to litigation over the validity of a freeze-out merger, as opposed to valuation contests triggered by a freeze-out merger, most of the reported New York court decisions over the last 10+ years involve limited liability companies. I attribute the phenomenon to the relatively young age of the LLC Law’s merger-related provisions compared to their gray-haired Business Corporation Law counterparts, and the absence thus far of appellate case law construing those provisions.
Which makes all the more interesting a decision last week by Manhattan Commercial Division Justice Jennifer G. Schecter in Van Horne v Ben-Dov, preliminarily enjoining a freeze-out merger of a close corporation for lack of a valid business purpose. In the interest of full disclosure, my firm and I along with my colleague Peter Sluka represent the plaintiffs in the case.
Van Horne concerns a single-asset realty holding corporation formed in 1984 (the “Company”). The Company is ground lessor of a modern apartment building with over 100 rental units in Manhattan’s East Village neighborhood. The Company conveyed a long-term ground lease to the building’s developer in 2012.
The plaintiffs are co-executors of an irrevocable family trust established by the company’s original 5% shareholder and subsequent Trustor who is a long-time business associate of the Defendant 95% shareholder. Trustor and Defendant have been partners in numerous other business and real estate ventures over many years but their personal relationship became strained in recent years over matters unrelated to the Company.
The Board Approves a Freeze-Out Merger
Last month, out of the blue, Defendant, who serves as President and controls two of the three seats on the board, sent Trustor, the third director and Vice President, a notice of special meeting of the board to approve resolutions (1) authorizing a merger of the Company with a special purpose entity formed by Defendant as sole owner to merge with and into the Company, and (2) removing Trustor as an officer.
Under the proposed merger plan, the Trust would have no interest in the post-merger Company and instead would receive payment for its Company shares at a price per share approximately equal to 50% of their pro rata value based on the realty’s appraised value as reported for transfer tax purposes upon the conveyance of the ground lease eight years earlier.
At the board meeting, Defendant asked if anyone would like to discuss the merger resolution but when pressed repeatedly by Trustor to explain the business purpose of the proposed merger and the basis of the proposed cash consideration for the Trust’s shares, Defendant’s only response to each question was, “Duly noted.” The resolutions then carried with the votes of Defendant and his other board designee.
The Trust Sues to Enjoin the Merger
Under New York’s Business Corporation Law, following board approval the proposed merger also requires majority shareholder approval. Shortly after the board meeting, Defendant issued a notice of special meeting of the shareholders for that purpose and also to remove Trustor as a director.
The Trust quickly filed a complaint seeking a permanent injunction against the proposed merger and asserting related claims against Defendant. The Trust simultaneously filed by order to show cause a motion seeking temporary and preliminary injunctive relief barring the shareholder meeting and the merger from proceeding pending the court’s determination of the claims.
The thrust of the Trust’s position was that, not only had Defendant failed to offer any bona fide corporate purpose for the freeze-out merger, but there was no conceivable operational or economic benefit to the Company which, as the post-merger surviving company, would simply continue collecting fixed ground rents. The only difference before and after the merger, the Trust argued, was the expulsion of the Trust which would be forced into an expensive appraisal proceeding to contest the undervalued offer for the Trust’s shares.
In advance of the shareholder meeting date, Justice Schecter conducted a conference call with counsel on the Trust’s application for a temporary restraining order. The result was a stipulation delaying the meeting long enough to permit further briefing and a decision by the court on the Trust’s preliminary injunction motion.
Defendant’s papers opposing the motion, for the first time, alleged as justification for the merger the prospect that the Company might become “entangled” in the divorce proceedings between Trustor and his wife that had been pending for about two years. In support, Defendant pointed to a subpoena he received from the wife’s counsel, seeking records from his past service as co-trustee of the Trust. Defendant also alleged as justification the possibility that the Trust could somehow be forced to convey half its 5% stockholding to the wife.
Defendant also argued against injunctive relief on the ground that the Trust’s statutory right to dissent from the merger and to demand a “fair value” appraisal proceeding provided it with an adequate remedy.
Justice Schecter Enjoins the Merger
Justice Schecter issued her ruling only three business days after submission of all papers, granting the Trust’s motion for a preliminary injunction halting the proposed freeze-out merger.
The decision’s opening paragraph sets forth the legal framework for her analysis along with her characterization of defendants’ proffered justification for the freeze-out merger as “rank pretext”:
Freeze-out mergers of New York corporations are not difficult to effectuate and are preferable to the self-help mechanisms sometimes employed by majority controllers. So long as the corporation can articulate any valid business purpose for the freeze-out, the court will defer to its business judgment and permit it (see Alpert v 28 Williams St. Corp., 63 NY2d 557, 573  [“The benefit need not be great, but it must be for the corporation”]). Freeze-out mergers inherently have a disparate impact on a minority shareholder (see id.) and courts have been liberal in permitting them (see Zelouf v Zelouf, 2013 WL 4734873 [Sup Ct, NY County Aug. 30, 2013] [permitting merger to avoid jury trial]). There must, however, be a valid exercise of business judgment and a corporate purpose. A freeze-out merger that merely seeks “to increase the individual wealth of the remaining shareholders” is not permitted (Alpert, 63 NY2d at 573). In sum, it doesn’t take much for a proper freeze out. But rank pretext will not do.
Justice Schecter found “no showing that the trust that owns the shares is subject to invalidation and even if somehow the soon-to-be-ex-wife becomes a shareholder, that should not materially affect the corporation, since her minority, non-controlling stake could hardly be projected to impact anything about the corporation’s operations–collecting rent.” The judge also noted that the divorce proceedings were pending for years and that “if entanglement in discovery was a true concern the freeze-out would have occurred long ago.”
“On this record,” she continued, “there is no credible evidence at all that the corporation is involved in the divorce proceedings or that the results of those proceedings would have an adverse effect on the corporation if the freeze-out did not occur.” She then added, echoing Defendant’s “duly noted” responses to Trustor’s questions at the directors’ meeting:
It is “duly noted” that the purported risk of corporate entanglement in the divorce proceedings was raised for the first time in opposition to the motion by counsel and appears to be an after-the-fact justification to paper over [Defendant’s] failure to actually consider the corporate benefit requirement at the time he decided to proceed with a freeze-out merger. [¶] No actual corporate benefit has been stated and there is no evidence that proper judgment was exercised either.
Justice Schecter also rejected Defendant’s contention that the Trust had an adequate appraisal remedy, writing that “[i]f these circumstances do not warrant an injunction, it is hard to imagine when one would ever be issued.” If the Trust’s sole remedy was to receive a fair value award, she added, “the business-purpose requirement would be entirely meaningless.”
Section 623 (k) of the Business Corporation Law in general establishes a shareholder’s right to dissent from a merger paired with an exclusive remedy to be paid “fair value” by way of an appraisal proceeding. The statute has a built-in exception, however, authorizing an action for equitable relief when the merger “is unlawful or fraudulent as to that shareholder.”
Over 35 years ago, in the Alpert v 28 Williams case cited in Justice Schecter’s decision, New York’s highest court recognized that corporation controllers have “a fiduciary duty to treat all shareholders equally” and that the expulsion of a minority shareholder in a freeze-out merger “[o]n its face . . . would appear to breach this fiduciary obligation.” Thus, the court, held, the “variant treatment of the minority shareholders” in a freeze-out merger must “relate to the advancement of a general corporate purpose.” In other words, the “removal of minority shareholders [must] further the objective of conferring some general gain upon the corporation.”
A freeze-out merger of minority shareholders, such as the one before Justice Schechter, will not pass muster under § 623 (k) when, as Alpert warned, “the sole purpose . . . is reduction of the number of profit sharers — in contrast to increasing the corporation’s capital or profits, or improving its management structure . . ..”
Finally, it bears noting that the exception to the exclusive appraisal remedy found in § 623 (k) does not appear in the counterpart provisions of LLC Law § 1002 (g) and Revised Limited Partnership Act § 121-1102 (d) governing the rights of dissenting members and limited partners, a distinction I have commented on previously (read here).
Update June 4, 2021: Following the court’s order preliminarily enjoining the merger, the Trust moved for partial summary judgment on its claim for a permanent injunction which the court has now granted (read here) essentially for the same reasons underlying the preliminary injunction order.