In business divorce litigation, petitioners / plaintiffs often want to start the case with a bang. A common tactic is to file a petition / complaint simultaneously with an injunction motion. Often there is a real need for an injunction – the respondent / defendant may be engaging in activities that could cause real, irreparable harm.

But often another objective is that if the injunction motion succeeds, it will be an early win in the case, set the stage favorably for the litigation to come, put significant leverage on the respondent / defendant by restricting its freedom to operate the business, and possibly result in a speedier resolution of the case. If the injunction motion or complaint itself has vulnerabilities, however, a case meant to start with a bang may end with an unceremonious whimper. That is just one lesson from a recent decision by Manhattan Commercial Division Justice Saliann Scarpulla in Pappas v 38-40 LLC, 2018 NY Slip Op 30329(U) [Sup Ct NY County Feb. 22, 2018]). Continue Reading Operating Agreement Dooms Derivative Claims by Deceased LLC Member’s Estate

Almost always there are elements of acrimony and intense emotion in litigation between co-owners of closely held business entities. The degree of toxicity can vary widely from case to case, although it tends to show up more conspicuously in litigation involving family-owned ventures.

Claims by non-controlling shareholders accusing controlling shareholders and directors of financial or other managerial abuses frequently are styled as derivative claims seeking recovery on the corporation’s behalf for harm to the corporation. In such suits, under the right circumstances the accused may challenge the accuser’s standing to pursue derivative claims based on conflict of interest.

Conflict of interest usually entails some tangible pecuniary interest held or asserted as a direct claim by the accuser that is adverse to the corporation or otherwise at odds with the claims asserted on behalf of the corporation. But a number of court decisions in New York also have cited as a factor in the analysis the accuser’s “animus” or “retaliatory” motive directed against the accused. The legal theory, akin to that applied in class actions, is that the accuser’s personal hostility and the resulting acrimony undermine the accuser’s ability to fairly and adequately represent the interests of the shareholders and the corporation.

Last year I posted about the decision in Pokoik v Norsel Realties in which a trial judge dismissed for lack of standing derivative claims brought by individuals holding an aggregate 11% interest in a realty-holding limited partnership. Among the reasons cited by the judge was that the plaintiffs “failed to demonstrate on this record that they are free from personal animus” as evidenced by the lead plaintiff’s “litigious nature” including several prior lawsuits against the defendants (including family members) alleging similar mismanagement claims, leading the court to conclude that the lawsuit was being wielded by the plaintiffs as “‘a weapon in the total arsenal’ so as to gain leverage in the other disputes.”

If, based on that decision, anyone thought freedom from personal animus is now part of the required showing by a derivative plaintiff, think again. Last week, the Manhattan-based Appellate Division, First Department, reversed the lower court’s decision and reinstated the derivative claims against some (but not all) of the named defendants. Continue Reading Appeals Court Reinstates Derivative Claims Dismissed for Conflict of Interest Where Parties’ Relationship Not “Especially Acrimonious”

This winter forever will be remembered in the Northeast as the winter of the “bomb cyclone,” which gets credit for the 6º temperature and bone-chilling winds howling outside as I write this. So in its honor, I’m accelerating my annual Winter Case Notes synopses of recent business divorce cases, which normally don’t appear until later in the season.

This year’s selections include a variety of interesting issues, including LLC dissolution based on deadlock; the survival of an LLC membership interest after bankruptcy; application of the entire-fairness test in a challenge to a cash-out merger; an interim request for reinstatement by an expelled LLC member; and a successful appeal from a fee award in a shareholder derivative action.

Deadlock Between LLC’s Co-Managers Requires Hearing in Dissolution Proceeding

Advanced 23, LLC v Chamber House Partners, LLC, 2017 NY Slip Op 32662(U) [Sup Ct NY County Dec. 15, 2017].  Deadlock is not an independent basis for judicial dissolution of New York LLC’s under the governing standard adopted in the 1545 Ocean Avenue case but, as Manhattan Commercial Division Justice Saliann Scarpulla explains in her decision, when two co-equal managers are unable to cooperate, the court “must consider the managers’ disagreement in light of the operating agreement and the continued ability of [the LLC] to function in that context.” In Advanced 23, the co-managers exchanged accusations of bad acts and omissions, e.g., one of them transferring LLC funds to an unauthorized bank account, raising material issues of fact as to the effectiveness of the LLC’s management and therefore requiring an evidentiary hearing, which is just what Justice Scarpulla ordered. Of further note, in a companion decision denying the respondent’s motion to dismiss the petition (read here), Justice Scarpulla rejected without discussion the respondent’s argument that judicial dissolution under LLC Law § 702 was unavailable based on a provision in the operating agreement stating that the LLC “will be dissolved only upon the unanimous determination of the Members to dissolve.” In that regard, the decision aligns with Justice Stephen Bucaria’s holding in Matter of Youngwall, that even an express waiver of the right to seek judicial dissolution of an LLC is void as against public policy. Continue Reading Winter Case Notes: LLC Deadlock and Other Recent Decisions of Interest

When the tsunami of LLC enabling statutes swept the U.S. in the late ’80s and early ’90s, including New York in 1994, many included a default rule authorizing as-of-right member withdrawal and payment for the “fair value” of the membership interest. The default rule was one of many designed to avoid C corporation-style “double taxation” of LLC earnings. After 1997, when the IRS adopted check-the-box regulations cementing pass-through partnership tax treatment for LLCs, New York and other states flipped the default rule, i.e., members are no longer permitted to withdraw unless authorized by the operating agreement.

When New York amended its withdrawal provision, LLC Law § 606, it included a new subsection “b” grandfathering LLCs formed before the amendment’s 1999 effective date, meaning that withdrawal under the “old” § 606 and fair-value buyout under LLC Law § 509’s default rule remain available for members of pre-1999 LLCs — so long as not otherwise provided in the operating agreement. The Chiu case, which I wrote about here, is an example of one such case resulting in a fair-value buyout of a withdrawn member.

After the amendments, some pre-1999 New York LLCs adopted new operating agreements or amended their existing ones to prohibit withdrawal. Some, as in Chiu, did not.

This is a story about one LLC that did not, but with a very different outcome than Chiu. The story’s punch line, which makes it a fascinating one, is that even though the minority member, seeking to force a fair-value buyout, was found to have properly invoked his uncontested right to withdraw under the old § 606, in the end the lower and appellate courts held that his withdrawal did not trigger a statutory buyout under § 509 because the LLC’s operating agreement included mandatory rights of first refusal — with which the minority member never complied — that displaced the buyout statute’s default rule.

The case, Matter of Jacobs v Cartalemi, was decided last week by the Appellate Division, Second Department, along with two decisions in companion appeals in related cases in which the court held that upon withdrawal the minority member also lost his standing to pursue derivative claims against the controlling member. I’ll explain all below, but before doing so I must disclose that, along with co-counsel, my firm and I represent the controlling member of the LLC in each of the cases. Continue Reading Operating Agreement Defeats Statutory Buyout Rights Upon LLC Member’s Withdrawal

I wish I could take credit for it, but I can’t. The phrase “bare naked assignee” was coined by the preeminent scholar and LLC maven Professor Daniel Kleinberger whose massive oeuvre (not to mention his guest posts on this blog here and here) includes a wonderful article published in 2009 called The Plight of the Bare Naked Assignee (available here on SSRN ). As described in the abstract, the article addresses the “new and separate opportunity for oppression” that “exists because LLC law purports to (1) recognize a species of persons holding legal rights vis-á-vis the LLC (assignees) while (2) denying those persons any remedies whatsoever in connection with those rights.”

Under the LLC statutes in New York and most other states, except as otherwise provided in the operating agreement, LLC membership interests are freely assignable in whole or in part. As the Professor’s article explains, the bedrock “pick your partner” principle of partnership law found expression in the default rules of LLC statutes which, contrary to traditional corporation laws, require majority (or unanimous) consent of the other LLC members for an assignee to become a full-fledged member with both economic and voting/management rights. Typical of these statutes, New York’s LLC Law § 603 provides that, absent such consent, the assignee has no right to participate in LLC management “or to exercise any rights or powers of a member” and only has the right “to receive, to the extent assigned, the distributions and allocations of profits and losses to which the assignor would be entitled.”

The vast majority of written operating agreements that I’ve encountered include detailed articles addressing the rights of members to assign (or not) their membership interests and, when permitted, what if any rights non-member assignees possess other than the right to receive distributions and profit/loss allocations. Of course, absent an operating agreement, the rights of an assignee are governed by the statutory default rules.

The Professor’s article broadly discusses theory and case law surrounding the difficulties faced by non-member assignees a/k/a transferees — oftentimes the heir of a deceased member — when it comes to protecting their economic interests against managerial abuse by the LLC’s controllers. My focus here addresses only one, narrow aspect of such protection, namely, the ability of a non-member assignee to inspect LLC records in the absence of dispositive rules in an operating agreement or, as in what I believe is a small minority of states including Texas, a statute giving assignees inspection rights. Continue Reading Can the Bare Naked Assignee Demand Access to LLC Records?

The self-proclaimed entrepreneur and guiding force behind his soon-to-be ex-wife’s highly successful, multi-office pediatric dental practice known as Kiddsmiles is not smiling after the court in Savel v Savel, Short Form Order, Index No. 006375-15 [Sup Ct Nassau County May 19, 2017], dismissed his claim, among others, to impose a constructive trust upon 50% of his wife’s ownership interest in a series of professional limited liability companies.

The facts of the case, as presented in the husband’s complaint in his civil action, which he filed some months after he filed a separate divorce action against his wife, involve tawdry, self-incriminating allegations of illegal kickbacks for patient referrals from which the husband, who is not a dentist, personally benefitted through his separate consulting company that received the alleged kickbacks under the guise of phony “rental” payments.

Between the governing statute’s ironclad requirement that members of a dental practice organized as a professional service LLC be licensed dentists, and the husband’s admitted receipt of kickbacks for patient referrals in violation of the Public Health Law, it’s no wonder the court dismissed the husband’s claims seeking to enforce illegal arrangements. Continue Reading Divorcing Husband Not Smiling Over Court’s Rejection of Ownership Interest in Wife’s Dental Practice

Over the years I’ve litigated and observed countless cases of alleged oppression of minority shareholders by the majority. Oppression can take endlessly different forms, some more crude than others in their execution, some more draconian than others in their effect.

If there was an award for the crudest and most draconian case of shareholder oppression, Matter of Twin Bay Village, Inc., 2017 NY Slip Op 06024 [3d Dept Aug. 3, 2017], decided earlier this month by an upstate appellate panel, would be a serious contender.

The case involves a bitter dispute between two branches of the Chomiak family over a lakefront resort called Twin Bay Village located on beautiful Lake George in upstate New York. In 1957, the husband-and-wife founders, Stephan and Eleonora Chomiak, opened the summer resort on land they owned. They and their two sons, Leo and Vladimir, together ran the business until 1970 when they transferred ownership of the land and business to newly-formed Twin Bay Village, Inc. owned 26% by each parent and 24% by each son. Continue Reading And the Award For Most Oppressive Conduct By a Majority Shareholder Goes to . . .

The third time definitely wasn’t a charm for the plaintiff in Austin v Gould, 2017 NY Slip Op 31494(U) [Sup Ct NY County July 13, 2017], in which the court dismissed ill-pleaded claims for “unfettered and unlimited access to all books and records” of a series of Delaware limited liability companies and their wholly-owned real estate subsidiaries.

The decision by Manhattan Commercial Division Justice O. Peter Sherwood is the latest in a series of trial and appellate court rulings, spread over seven years and three separate lawsuits, rejecting claims by the LLCs’ non-managing one-third owner against the managing two-thirds owner allegedly for failing to distribute millions in management and acquisition fees.

The plaintiff’s two prior lawsuits — the first filed in 2010 and, after its dismissal, the second filed in 2013 — hit dead ends for various reasons including untimeliness and pleading deficiencies. The third lawsuit, filed in 2016, asserted claims for access to the LLCs’ books and records along with damages claims for breach of fiduciary duty and conversion. Continue Reading Books and Records Case Illustrates Crucial Importance of Pre-Suit Demand

A business’s failure to pay state taxes can be a problem if the entity later wants to bring a lawsuit, or its non-controlling owners want to sue on the entity’s behalf.

Under Section 203-a of the New York Tax Law, a New York business entity’s failure to pay franchise taxes for two years can result in automatic dissolution of the entity by proclamation of the New York State Secretary of State. Once a corporation is dissolved by proclamation for failure to pay franchise tax, it “does not enjoy the right to bring suit in the court of this state, except in [very] limited respects specifically permitted by statute.” Moran Enterprises, Inc. v Hurst, 66 AD3d 972 [2d Dept 2009].

What happens when an out-of-state entity, or shareholders on the entity’s behalf, attempt to sue in a New York court, despite the business not having paid taxes for several years in its home state? New York County Commercial Division Justice Anil C. Singh recently considering that question, specifically with respect to a Delaware entity, in Juma Technology Corp. v Servidio, Decision and Order, Index No. 151483/2016 [Sup Ct, NY County May 24, 2017]. Continue Reading Minority Shareholders’ Derivative Suit Foiled by Voiding of Corporation’s Charter for Nonpayment of Taxes

Food-Fight1A little over three years ago I reported on the first round of a fascinating “food fight” among four siblings, each of whom is a 25% shareholder of a Brooklyn-based, second-generation food distributor known as Jersey Lynne Farms, Inc. (the “Corporation”), and each of whom also is a 25% member of Catarina Realty, LLC (the “LLC”) which leases its sole realty asset to the Corporation.

The occasion back then was the court’s decision in Borriello v Loconte denying a dismissal motion in a derivative suit brought by Dorine Borriello on the LLC’s behalf in which she alleged that her three siblings breached fiduciary duty by leasing its realty to the Corporation at a drastically below-market rent and by imposing on the LLC certain expenses that ought to be borne by the Corporation as tenant.

In 2011 — the same year her siblings entered into the challenged lease — they ousted Dorine as a director, officer, and employee of the Corporation. In 2012 Dorine and her siblings negotiated a Separation Agreement and General Release setting forth terms for payment of compensation and benefits along with non-compete and non-disclosure provisions. The agreement left intact Dorine’s 25% stock interest in the Corporation.

Dorine’s derivative suit filed in 2013 claimed that the 2011 below-market lease rendered the LLC unprofitable while increasing the Corporation’s income used to pay salaries and other benefits to her siblings. The first round went to Dorine when the court ruled that her General Release did not encompass her derivative claim and enjoined her siblings from advancing their legal expenses from LLC funds.

In the end, however, and subject to any appeals Dorine may bring, it appears that the siblings have won the food fight’s final rounds. Continue Reading “Food Fight” Sequel Ends Badly for Ousted Sibling