Nine months ago, we wrote about a 20% shareholder, Alvin Clayton Fernandes, whose bare bones petition Manhattan Supreme Court Justice Frank P. Nervo found stated sufficient grounds to judicially dissolve a seemingly successful modeling agency, Matrix Model Staffing, Inc.
Fernandes’ primary ground for dissolution was that his 80% co-shareholder, Jacquelyn Willard, named Fernandes without his knowledge as the entity’s “responsible person” for withholding and remitting employee income and payroll taxes. Willard allegedly failed to pay employment taxes, saddling Fernandes with personal liability for a $210,000 Trust Fund Recovery Penalty.
“Failing to pay tax liabilities is corporate mismanagement,” ruled the Court in Fernandes v Matrix Model Staffing, Inc. (2022 NY Slip Op 31317(U) [Sup Ct, NY County 2022]), “which defeats a petitioner’s reasonable expectations sufficient to constitute oppression” under Section 1104-a of the Business Corporation Law (the “BCL”).
Because the record was bereft of evidence, though, the Court declined to grant the petition, instead referring the matter to a special referee under BCL § 1109 to conduct an evidentiary hearing on three issues:
- the “underlying facts of the petition for dissolution;”
- the “merits of the petition;” and
- the “appropriate remedy.”
This article picks up 13 days after Justice Nervo issued his decision, when Willard, Matrix’s majority shareholder — hoping to stop dead in its tracks any further litigation over dissolution or an “adequate alternative remedy” to dissolution — filed with the Court a Notice of Election to purchase Fernandes’ stock for “fair value” under BCL § 1118.
The BCL § 1118 Buyout Election and the Timeliness Requirement
Section 1118 permits the respondent corporation or any other shareholders opposing a Section 1104-a dissolution petition to “elect to purchase the shares owned by the petitioner at their fair value.” A successful Section 1118 buyout election terminates the dissolution phase of the case, eliminating the need to prove grounds to dissolve to the potential for an alternative remedy to dissolution, converting the matter to a fair value appraisal proceeding governed by the rules found in BCL § 623 and case law interpreting the statute.
A Section 1118 buyout election has a relatively short timing window: a respondent must make the election “within ninety days after the filing of [the] petition or at such later time as the court in its discretion may allow.” Fernandes sued in November 2021. Willard did not elect to buyout Fernandes’s shares until May 2022. The election was too late unless the Court chose to exercise its discretion to permit an untimely election.
The Motion to Enforce the Untimely Buyout Election
Six months after making her buyout election — and after Fernandes’s counsel apparently deemed the late election a “nullity” — Willard moved to judicially enforce the election and “limit” the issues upon which the previously-appointed special referee could hear and report to just one: “the determination of the fair value of the Petitioner’s shares.”
In his Order to Show Cause, Justice Nervo added an unusual addendum of “additional directives,” instructing the parties to brief two additional legal issues:
- “why the Special Referee . . . should not consider an election under BCL § 1118 as a non-exclusive remedy at the BCL § 1109 hearing;” and
- “why a bond, pursuant to BCL § 1118 (c) (2), should not be required,” including “an appropriate bond value.”
The Parties’ Arguments
In her opening papers, Willard argued that Fernandes would suffer “no prejudice . . . if the election were permitted after the 90-day period had ended.” Conversely, Willard argued, if the Court granted dissolution it would destroy the livelihood of Matrix’s “approximately one hundred and seventy (170) employees.”
In opposition, Fernandes argued that the Court should deny a late buyout election because Willard failed to explain “why [she] did not make her election within the 90-day period prescribed by BCL § 1118 (a).” Fernandes also argued that Willard “failed to demonstrate” that a buyout was an adequate alternative to dissolution, writing that the “Special Referee should address Willard and [Matrix]’s continued failure to address the IRS liabilities as a necessary condition to any proposed buyout.”
On the question of a bond under BCL § 1118 (c) (2) – which states that the Court “may require” a bond “sufficient to secure petitioner for the fair value of his shares” – Fernandes wrote that the Court should require “a bond in the sum of $210,961.22 representing the unaddressed IRS obligation” imposed upon Fernandes personally.
On reply, Willard argued that “the law in New York plainly favors a buy-out as opposed to the liquidation of an on-going company – certainly one like Matrix that employs several dozen or hundreds of people at any given time.”
Willard also argued, quoting O’Connor v Coccadotts (47 Misc 3d 331 [Sup Ct, Albany County 2015]), that a bond would be entirely inappropriate without “‘proof persuasively demonstrating a need for such relief.’” In his article on O’Connor, Peter Mahler wrote that “prevailing appellate authority sets a fairly high but not insuperable bar for entitlement to a bond, in the form of evidence of corporate waste or other circumstances raising doubt as to the respondent’s or the company’s financial capability to carry through on their offer to purchase the petitioner’s shares.” In her papers, Willard argued that Fernandes made absolutely no evidentiary showing in this regard.
Amazingly, neither side presented the Court with any case law addressing the circumstances in which BCL § 1118 (a) permits a court “in its discretion” to “allow” a late buyout election.
The Scarce Appellate Case Law on Untimely Buyout Elections
As far as I can tell there are just three Appellate Division decisions addressing courts’ discretion to allow untimely BCL § 1118 elections, two affirming denial of untimely elections, one affirming the grant of a late election:
- Matter of Weingarten v Thirty-First St. Realty Corp., 68 AD3d 1009 [2d Dept 2009] [“Supreme Court providently exercised its discretion in denying” respondent’s untimely buyout election];
- In re Flushing Off. Ctr., Ltd., 276 AD2d 629 [2d Dept 2000] [“Supreme Court providently exercised its discretion in granting” respondent’s untimely buyout election]; and
- Sobol v Les Pieds Nickels, Inc., 262 AD2d 194 [1st Dept 1999] [“Agostini, owner of half the shares in the subject corporation, failed to exercise her right of election within the 90-day period . . . thus leaving the issue of whether to treat her election as timely within the motion court’s discretion. That discretion was properly exercised in this case [to deny the election] given the lack of factual matter to support Agostini’s conclusory claims”] [citation omitted].
A Missed Opportunity
Unfortunately, in the Decision and Order in Fernandes, the Court declined to reach the untimeliness question, ruling: “While respondent has identified an elective stock buyback . . . as an alternative remedy, respondent has failed to demonstrate, on these papers, that such remedy is adequate to protect petitioner’s fair return on investment.”
“Furthermore,” ruled the Court, “respondent’s characterization of petitioner’s failure to respond to the proposed elective purchase of petitioner’s shares as inappropriate, along with petitioner’s silence in response to the elective purchase, evinces a complete deterioration of relations, a factor supporting an order of dissolution. Under these circumstances, a hearing on the petition and appropriate remedy is required.”
The Imposition of a Bond
On the question of a bond, the outcome was harsh. After remarking that it was potential “reversible error” to deny a bond “in the face of allegations of serious financial impropriety,” the Court imposed a bond of nearly five times the amount Fernandes requested, “requir[ing] respondent post an undertaking in the amount of one million dollars ($1,000,000).
Commentary on Fernandes
Given the relative lack of case law, Fernandes presented a golden opportunity to provide business divorce practitioners and litigants a reasoned opinion addressing the standards for courts’ exercise of discretion to permit late buyout elections. Unfortunately, the Court chose not to address this important question.
Should the Court have permitted a late election without referring the matter to a referee? It seems to me that permitting the late buyout election would have been logical for several reasons.
First, the amount and duration of the Fernandes litigation was relatively modest, the election just three months late and made almost immediately after the Court denied dismissal of the petition.
Second, case law holds that the buyout of a minority interest in a functioning business is generally preferable to the entity’s dissolution. In the words of Suffolk County Commercial Division Justice Elizabeth H. Emerson permitting a late buyout election in Matter of Application of Marro (61 Misc 3d 1214(A) [Sup Ct, Suffolk County 2018]), “[a] buy-out of the petitioners’ shares is clearly preferable to liquidation of the corporation. It would allow the petitioners to obtain a fair return on their investment while protecting the rights and interests of the remaining shareholders.”
Third, referral to the referee of whether a buyout is an “adequate” remedy seems superfluous. In my view, when it enacted BCL § 1118, the Legislature inherently regarded a valuation proceeding in which the petitioning shareholder may establish and receive compensation for the fair value of his or her shares to be an adequate alternative to dissolution, a remedy aimed at providing the “oppressed” shareholder a fair return on investment while also furthering the “statutory purpose of promoting the continuation of corporate enterprises” (Ferolito v Vultaggio, 99 AD3d 19 [1st Dept 2012]). In reality, the “adequate alternative remedy” to dissolution is almost invariably a minority buyout.
Fourth, why force the parties to litigate the substantive grounds for dissolution in an expensive, time consuming evidentiary hearing before a referee after Willard exercised the buyout election? In her papers, Willard also argued – persuasively I think – that a buyout of Fernandes’s interest was essentially a foregone conclusion under the pronouncement of Matter of Kemp & Beatley, Inc. (64 NY2d 63 [1984]), that “[e]very order of dissolution . . . must be conditioned upon permitting any shareholder of the corporation to elect to purchase the complaining shareholder’s stock at fair value.” Why force the parties to spend time and money litigating grounds for dissolution, only to necessarily have to offer Willard a buyout election again should Fernandes prove grounds for dissolution?
Fifth, although the Court seemed concerned about restitution for the unpaid tax liability against Fernandes, I do not view this as a reason to deny an appraisal remedy. Under BCL § 1118, “the alleged wrongdoing or misappropriation of corporate assets may play a role in the valuation determination and is relevant if such misconduct has had an adverse impact upon the corporation’s value” (Cortes v 3A N. Park Ave Rest Corp., 46 Misc 3d 670 [Sup Ct, Kings County 2014] [quotations and brackets omitted]).
For example, BCL § 1104-a (d) provides that a court “may order stock valuations be adjusted and may provide for a surcharge” upon a respondent for “wilful or reckless dissipation or transfer of assets or corporate property.” BCL § 1118 (b) provides that the surcharge remedy survives the buyout election, stating that “giving effect to any adjustment or surcharge found to be appropriate in the proceeding under section 1104-a” shall occur in the resulting appraisal proceeding. In an appraisal proceeding, therefore, the Court has ample flexibility to credit Fernandes and debit Willard for the $210,000 tax liability.
Finally, the bond. To me this is the most surprising aspect of the Court’s decision. BCL § 1118 (c) (2) states that the bond requirement is discretionary (i.e., the court “may” require one). Insofar as the Court did not grant the buyout election, it seems excessive to require a bond. More troubling is the imposition of a bond several magnitudes greater than the one petitioner himself requested. It would be interesting to see how an appellate panel would look upon such a drastic remedy, which truly was the worst of both worlds for Willard: denial of any benefit of the buyout election — cessation of litigation over whether to dissolve the business –– while saddling her with the heavy financial burden of a huge bond.