The topic of mergers between two business entities designed to involuntarily extinguish the equity interest of a minority owner in exchange for cash is one of our favorites on New York Business Divorce. Almost invariably dubbed a “cash-out” merger by the majority owners effectuating the merger, and a “freeze-out” by the expelled minority owner, we’ve written about the legal rules, statutory procedures, and resulting fair valuation principles for these types of mergers many times. So when new cash-out a/k/a freeze-out merger cases come along, we get excited, hoping to glean new insights and possibly answer some unresolved questions raised by the devilishly arcane merger statutes.
Two weeks ago, Manhattan Supreme Court Justice Laurence Love issued two decisions in a pair of litigations following a corporation cash-out merger of a 19% shareholder, Alan Ades (“Alan”), from a family-owned corporation named Van Dale Industries, Inc. (“Van Dale”). The papers raised either directly or by implication a host of interesting legal issues, but the decisions in some ways represent an opportunity lost, as the Court provided little analysis for its holdings. So I’ll give my take on how the issues might be treated if considered on the merits.
The Company, its Principals, and the Merger Notice
According to its website, Van Dale manages and licenses several well-known women’s apparel brands to retail distributors such as Amazon, Walmart, and Target. Alan was one of the founders of Van Dale, formed in 1982. Last summer, Alan’s co-owners, Gabriel and Jimmie Ades (Alan’s cousins) and Maurice Setton (Alan’s nephew), caused Van Dale’s Board of Directors to circulate a notice of special meeting of shareholders to vote upon and approve the attached Agreement and Plan of Merger between Van Dale and an acquisition company, with Van Dale to be the surviving entity and Alan’s 35 shares of stock to be extinguished and exchanged for a cash payment of $7,780,050.
The notice described the “purpose” for the merger as follows:
In connection with its determination to approve the Merger Agreement, the Board deliberated and concluded that the business of the Company would be best served with management of the Company and ownership being fully aligned, thereby avoiding all potential conflicts of interest based upon the current organizational structure, consisting of three employee-management shareholders and one non-employee non-management shareholder.
Accompanying the notice were two valuation reports (read here and here), one appraising the fair market value of Alan’s 19% interest at a pre-discounted value of $9,674,000, the other at $8,632,000. Each of the reports then applied discounts for both lack of control (prohibited under New York law for corporation interests under the statutory fair value standard) and for lack of marketability (permitted, but not required, under New York law) to arrive at bottom-line valuations for Alan’s interest of $6,578,000 and $6,603,000 respectively.
Alan’s Notice of Election to Dissent
Prior to the shareholder’s meeting, Alan filed with Van Dale, pursuant to Section 623 (a) of the Business Corporation Law (the “BCL”), written notice of his election to dissent from the merger and to seek fair value in an appraisal proceeding, thereby perfecting, he contended, his dissenter’s rights.
The Offer to Purchase and Dispute Over Delivery of Alan’s Shares
Van Dale responded with the BCL § 623 (g) offer to purchase Alan’s interest for the same $7,780,000 figure in the agreement and plan of merger, writing, “An amount equal to eighty percent (80%) of the amount of this offer will be delivered to you . . . promptly upon submission of your certificates representing your shares of the corporation.” Van Dale’s offer to pay 80% up front was a paraphrasing of the rarely-litigated language of BCL § 623 (g) providing that the offer to purchase a dissenting shareholder’s interest “shall . . . be accompanied by (1) advance payment to each such shareholder who has submitted the certificates representing his shares to the corporation” as required by BCL § 623 (f) within one month of filing of the notice of election to dissent from the merger “or (2) as to each shareholder who has not yet submitted his certificates a statement that advance payment to him of an amount equal to eighty percent of the amount of such offer will be made by the corporation promptly upon submission of his certificates.” (The advance payment provision of BCL § 623 (g) has been held inapplicable in cash-out mergers involving LLCs.)
Alan rejected Van Dale’s offer. In his rejection notice, Alan wrote that he was incapable of surrendering his stock certificates to Van Dale as required by BCL § 623 (f) and (g) because he “conducted a diligent search for the Certificate and is unable to locate the Certificate,” demanding that Van Dale either “(i) issue a new certificate for the shares pursuant to BCL § 508 (e) and accept the reissued certificate as timely submission of the Certificate by the undersigned pursuant to BCL § 623 (f); or (ii) deem this notice as timely submission of the Certificate pursuant to BCL § 623 (f).”
Van Dale countered with a demand that Alan provide Van Dale with a bond of $7,780,000 (the amount of its buyout offer) before it would issue replacement share certificates to Alan. Alan declined, and Van Dale then sent Alan a notice that it “hereby exercises it right to deem lost your dissenter’s rights.” Van Dale again demanded a bond of $7 million-plus before it would pay Alan for his shares.
The Two Lawsuits
These events set the stage for two lawsuits filed the same day by Alan.
Alan’s first lawsuit was a summary proceeding by Alan for the Court to fix the fair value of his shares in Van Dale under BCL § 623.
Alan’s second lawsuit was a plenary action to rescind the merger under the so-called “fraud or illegality” exception found in BCL § 623 (k) to the otherwise rigid rule that the commencement of an appraisal proceeding to determine the “fair value” of the dissenting shareholder’s stock constitutes the cashed-out shareholder’s exclusive remedy. Under BCL § 623 (k), the Legislature carved out a very limited right for a cashed-out shareholder to “maintain an appropriate action to obtain relief on the ground that such corporate action will be or is unlawful or fraudulent as to him.” Courts have interpreted this language to mean that a shareholder may bring an action for “equitable relief,” including to rescind or set aside the merger, but not for money damages, unless damages are ancillary to the “primary” equitable relief (see e.g. Sparks v Metrovest Equities, 186 AD3d 177 [1st Dept 2020]). (The BCL § 623 (k) exception has been held inapplicable to LLC mergers, in which the cashed-out member’s sole remedy, without exception other than noncompliance with the operating agreement or LLC Law, is a fair value appraisal proceeding.)
Alan’s sole alleged basis to rescind was that Van Dale’s merger allegedly failed to comply with a line of New York case law holding that corporation mergers must have a “proper,” “legitimate,” or “bona fide” business or corporate “purpose,” a rule emanating from Alpert v 28 Williams St. Corp. (63 NY2d 557 ), holding, “In the context of a freeze-out merger, variant treatment of the minority shareholders — i.e., causing their removal — will be justified when related to the advancement of a general corporate interest. The benefit need not be great, but it must be for the corporation.”
Van Dale and its surviving shareholders moved to dismiss both lawsuits pre-answer under CPLR 3211. You can read the legal briefs in the appraisal case here, here, and here, and in the rescission case here, here, and here.
The Legal Issues and Outcome in the Appraisal Case
The appraisal proceeding papers, in my reading of them, implicitly raised at least four interesting issues, just one addressed by the Court, and only in passing, with several others left for future litigation by the parties.
Issue #1: Is the failure or inability by a cashed-out minority shareholder to tender her stock certificates to the corporation under BCL § 623 (f) sufficient, on its own, to lose all right to dissent from a merger and seek fair value in an appraisal proceeding? On its face, the text of BCL § 623 (f) seems to say the answer is yes (but see below).
Issue #2: Is the cashed-out minority shareholder’s failure or inability to tender her stock certificates to the corporation sufficient, on its own, to refuse to make the 80% advance payment requirement under BCL § 623 (g)? If the dissenter loses all appraisal rights under BCL § 623 (f), then it seems the entity lacks any basis to withhold payment, thus a failure to tender shares should be no impediment to payment.
Issue #3: May a corporation demand a surety bond from a cashed-out minority shareholder who requests issuance of replacement shares under BCL § 508 (e) in an amount equal to the merger consideration as a pre-condition to tendering the 80% advance payment requirement under BCL § 623 (g)? This is an open question, but it seems like an overreach to expect a longtime shareholder (in the case of Alan, an acknowledged shareholder for close to four decades) to provide a multi-million-dollar bond as a pre-condition to payment where the entity itself acknowledged in the merger documents he was, in fact, a shareholder whose equity interest was being cashed-out.
Issue #4: If a cashed-out minority shareholder is unable to locate her stock certificates, what must she show to be excused from the requirement of tendering her shares to the corporation under BCL § 623 (f)?
Unfortunately, in its appraisal proceeding decision, the Court essentially rendered moot the first three questions by ruling on the fourth that BCL § 623 (f) explicitly grants courts discretion to excuse a shareholder from delivering her stock certificates to the corporation for “good cause shown.” In a one-line holding, the Court wrote, “As Petitioner has shown ‘good cause’ for not producing the stock certificates and valid reasons for bringing this petition, it is now ORDERED that Respondent’s cross–motion, CPLR 3211(a) (7), to dismiss the Petition is DENIED.”
What was the “good cause”? According to Alan’s papers, Van Dale never issued the founders, including Alan, stock certificates when they formed the entity in 1982. This explanation was understandable – in closely-held, family-owned businesses, it’s very common that shareholders are never issued, or if they were issued, have lost, stock certificates.
It’s hard to quibble with the Court’s holding, but it would have been helpful for practitioners if the Court provided some modern authority upon which to rely for the good cause standard, briefed in the parties papers and addressed, for example, in cases like Albany-Plattsburgh United Corp v Bell (202 AD2d 800 [3rd Dept 1994]), that the touchstones of “good cause” under BCL § 623 (f) are “due diligence” by the shareholder in attempting to locate the missing certificates, and absence of “demonstrable prejudice” to the corporation.
The Legal Issues and Outcome in the Rescission Case
The rescission action papers, the way I read them, raise at least three key issues:
Issue #1: Is the alleged absence of a “proper purpose” for a corporation merger sufficient, on its own, to rescind the merger under the “fraud or illegality” standard of BCL § 623 (k)? I’m not aware of any court to address this exact question. But Justice Schechter addressed a corollary of it in Van Horne v Ben Dov, where the Court held that the absence of a “proper purpose” was sufficient, on its own, to enjoin a contemplated cash-out merger. In her decision, which she later affirmed on summary judgment, she explicitly held that “an injunction is permitted by BCL § 623 (k).” If an injunction for lack of a proper purpose is permitted under BCL § 623 (k), I don’t see any reason why rescission would not be permitted. Injunction and rescission are functionally equivalent remedies, one issuing pre-merger, the other post-merger.
Issue #2: Is the stated desire to “fully align” “management of the Company and ownership” by divesting a “non-employee non-management shareholder” of ownership and vesting ownership fully among “employee-management shareholders” for the aim of “avoiding all potential conflicts of interest based upon the current organizational structure” sufficient to establish a proper business purpose? In the rescission action decision, the Court did not reach this issue, writing in just one sentence: “As this Court will scrutinize this transaction with care further analysis [is] needed to determine fair market share. ORDERED that the motion to dismiss is denied” (quotations and brackets omitted). I don’t pretend to know how the Court will resolve this particular issue.
Issue #3: Under what circumstances may a minority shareholder sue to rescind a corporation merger while simultaneously suing to recover the fair value of his stock following the merger’s consummation? Merger rescission and an election to seek fair value are inherently incompatible remedies. The former seeks to entirely invalidate the merger; the latter necessarily assumes the merger’s validity. Under the law of rescission of contracts based on fraud, a lawsuit for damages for breach is generally considered an affirmance of the contract, barring an action to also rescind (Big Apple Car, Inc. v City of New York, 204 AD2d 109 [1st Dept 1994] [“a defrauded party to a contract may elect to either disaffirm the contract by a prompt rescission or stand on the contract and thereafter maintain an action at law for damages”]; Brown v Manufacturers Tr. Co., 278 NY 317  [“One cannot rely on a contract as valid and seek to recover because of its breach, which constitutes an affirmance of the contract, and then have a recovery on the ground that the contract is void, which constitutes a disaffirmance of the same contract”]).
One might ask whether there is, or ought to be, any difference for mergers? It seems to me that while a minority shareholder can always plead alternative or inconsistent legal theories, the shareholder must at some point elect to pursue one remedy and relinquish the other. But when? Perhaps at some point in the Ades litigations the Court will address this tantalizing issue.