New York Business Divorce

Anesthesiology Practice Undergoes "Legal Equivalent of a Proctology Exam" in Shareholder Dispute

Peter A. Mahler — Mon, 14 May 2012 05:00:00 -0500

The cringe-worthy phrase, "legal equivalent of a proctology exam," gained notoriety about ten years ago when its use by an attorney in a pre-litigation demand letter was cited by a federal judge as partial justification for a $50,000 sanction award which was later reversed on appeal. The phrase involuntarily leapt to mind when I read the recent post-trial decision by Suffolk County Commercial Division Justice Emily Pines in Suffolk Anesthesiology Associates, P.C. v. Verdone, 2012 NY Slip Op 50728(U) (Sup Ct Suffolk County Apr. 25, 2012), a bare-knuckles contest pitting an expelled physician-shareholder of a large Long Island anesthesiology practice against the 11 other physician-shareholders.

The parties' very public charges and counter-charges of improper financial dealings, conflicts of interest and potentially serious healthcare law violations, none of which ultimately swung the case outcome, if nothing else offer a compelling argument for inclusion of a binding arbitration clause in the shareholder and employment agreements, thereby ensuring that the airing of the practice's allegedly "dirty linen" will be confined to a private, confidential setting.

The Verdone case also offers healthcare transactional attorneys a cautionary lesson on drafting mandatory buyback provisions triggered by a shareholder's departure from the practice, to avoid a draining battle as took place in Verdone over whether the expelled shareholder was terminated with or without cause.

The Practices

The Practices (as I'll refer to them collectively) consist of three separate anesthesiology practices --Suffolk Anesthesiology Associates, P.C. (SAA), United Anesthesia, P.C. (United), and Office Based Anesthesia, PLLC (OBA) -- all owned by the same 12 anesthesiologists. The Practices provide anesthesiology services at hospitals, medical offices and ambulatory surgery centers on Long Island and elsewhere in the New York City metropolitan area.

The Agreements

Dr. Verdone and his co-owners signed identical shareholders' agreements (or operating agreement in OBA's case) and employment agreements for each of the Practices.

The employment agreement permits termination of the physician without cause upon vote of 75% of the shareholders and for cause upon vote of two-thirds of the shareholders. "For cause" is defined as acts of "personal dishonesty, gross negligence, or willful misconduct that has a material adverse effect on the Corporation, its business operations, financial condition, assets, prospects or reputation" or that "materially breached any fiduciary duty to the Corporation involving personal profit."

Upon termination "for any cause" and subject to a five-year vesting schedule, the terminated physician is entitled to receive deferred compensation in an amount equal to his pro rata share of the "total accounts receivable," payable over the following year.

The employment agreement includes a post-termination three-year covenant not to compete within a 20-mile radius of any location where the Practices provide services, and a three-year covenant not to solicit employees, clients, contractors, or business of the Practices, or to "disrupt, damage, impair, or interfere with the business" of the Practices.

The shareholders' agreement requires the Practices to purchase the physician's shares at a nominal par value (plus the deferred compensation due under the employment agreement) upon a "Call Event" defined as the physician's death, voluntary termination or retirement, disability or termination "for cause" under the employment agreement. Notably missing from the definition of Call Event is the involuntary termination of the physician without cause.

The Underlying Dispute

Justice Pine's decision includes a lengthy and highly detailed recitation of the facts elicited at the 11-day trial including the testimony of 15 witnesses and over a hundred exhibits. The following, boiled-down summary hopefully will whet your appetite enough to read the entire decision.

According to Dr. Verdone, starting around 2005 he began to have questions about excessive administrative billing and payments to the Practices' president, Dr. Kurlander, and about undocumented arrangements with certain outside surgical practices for which the Practices provided anesthesiology services and paid them fees not based on a fair market evaluation in possible violation of federal and state anti-kickback laws.

A separate and ultimately more explosive controversy surrounding Dr. Kurlander grew out of an effort that began in 2006 to acquire a Bronx-based ambulatory surgery center known as Surgicare for approximately $7.4 million. In April 2007, without getting approval of the other shareholders, Dr. Kurlander entered into a purchase agreement for the acquisition of Surgicare by the 12 shareholders to close by October 2008, but also including agreements by SAA to subsidize Surgicare pending the culmination of the purchase and authorizing a line of credit from SAA to Surgicare. Dr. Kurlander also used SAA funds for the down payment which was not held in escrow. Dr. Verdone through his personal counsel wrote letters to the Practices' counsel objecting to the acquisition and also specifically objecting to the "improper" use of corporate assets for the acquisition, which Dr. Verdone contended constituted an unlawful kickback. The Practices' counsel wrote back in early 2008, assuring Dr. Verdone that the individual shareholders would be the purchasers and that no shareholder of SAA would be financially compromised.

At an April 2008 meeting of the shareholders, according to Dr. Verdone a "verbal deal" was struck allowing any shareholder to pull out of the Surgicare deal at a later time. He also testified that he stayed in the deal for some months afterward at the request of another shareholder pending approval of the acquisition by the Health Department.

At a shareholders meeting in May 2008, a forensic accounting firm engaged by the Practices presented a report focusing on Dr. Kurlander's financial management. The report made findings regarding certain unsubstantiated payments to outside physicians and for personal expenses. Shortly thereafter Dr. Kurlander was suspended as president. He subsequently repaid the Practices $500,000 and ultimately withdrew as a shareholder.

The copies of the forensic accountant's report provided to the shareholders at the May meeting had been collected at the end of the meeting, to maintain their confidentiality. In July 2008, Dr. Verdone brought an Article 78 proceeding against SAA to obtain a copy of the report, which the court granted by order dated August 14, 2008. At least one of the other physicians, who submitted an affidavit opposing the Article 78 proceeding, testified that he believed that Dr. Verdone was interested in causing trouble for the practice for some ulterior motive. Another physician testified that the only complaints he heard from Dr. Verdone over the years related to his view that the method of assigned calls was unfair.

In September 2008, Dr. Verdone saw financing proposals for the Surgicare acquisition identifying SAA as the borrower. He then wrote to the other shareholders demanding that he be permitted to withdraw from the purchase of Surgicare. He also demanded that no action be taken by the Practices to encumber any of their assets in connection with the Surgicare deal, and he warned that if such assets were used he would voice his objections to the prospective lending banks.

Meanwhile, the Practices' regular outside accountant recommended, and all the shareholders except Dr. Verdone agreed, to a finance structure using OBA as the borrower with the shareholders as guarantors. Dr. Verdone also rejected a proposal that he participate in the deal with a proviso that he could sell his Surgicare interest to the other shareholders within 5 days after the closing.

A shareholders' meeting was held on October 2, 2008, at which they approved by a vote of 11-1 the closing of the Surgicare purchase, the terms of a proposed loan from JPMorgan Chase to OBA, and certain by-law amendments permitting the transaction. If the deal did not close, the physicians stood to lose about $2.1 million already invested in the acquisition. Immediately after the meeting, and again the following morning, Dr. Verdone emailed a Chase banker asking her to contact his lawyer and attaching copies of his prior letters stating his objections to any encumbrance of corporate assets, and the Practices' outside counsel's early 2008 letter pledging that the assets of the Practices would not be encumbered.

Chase decided not to proceed with the loan, final approval for which was still pending, after getting the emails from Dr. Verdone. The shareholders scrambled to raise the over $5 million in funds on their own, which they were able to do, in order to close the Surgicare acquisition by the October 6 deadline. Dr. Verdone also contributed his share exceeding $400,000.

On October 14, 2008, notices were sent out for shareholder meetings to terminate Dr. Verdone's employment with each of the Practices, both "with cause" and "without cause". The meetings ultimately were held on December 15, 2008, at which the shareholders voted 11-0 to terminate Dr. Verdone's employment both with and without cause.

The Lawsuits

The Practices and Dr. Verdone each filed suit against the other. The Practices' suit against Dr. Verdone sought a declaratory judgment that he was properly terminated for cause based on his alleged breach of contract, breach of fiduciary duty and tortious interference with business relations. The Practices claimed that such termination required a forfeiture of Dr. Verdone's deferred compensation under his employment agreements. They also counterclaimed in Dr. Verdone's suit for a declaration that his termination for cause constituted a Call Event requiring him to redeem his shares and cutting off any right to further compensation or distributions from the Practices. The Practices also counterclaimed for damages as a result of Dr. Verdone's alleged breach of the non-solicitation provision in the employment agreements.

In his counterclaims in the Practices' suit and in his own suit against the Practices, Dr. Verdone sought a declaration that his termination was not for cause and that it was motivated solely as a result of his role as a whistle blower against improper business practices and a vocal opponent to the Surgicare acquisition. He also claimed that the Practices were liable for his deferred compensation under his employment agreements and for his share of distributions and benefits under the shareholders' agreements. Dr. Verdone also asserted derivative claims for misappropriation of corporate assets, and for dissolution of the entities.

The Pre-Trial Rulings

Between the onset of litigation in October 2008 and the trial in 2012, there were a number of pre-trial rulings that shaped and propelled the litigation.

In late November 2008, the Practices won an order granting partial summary judgment validating their right to terminate Dr. Verdone's employment without cause.

In September 2009, apparently at the same time the court granted a preliminary injunction, the court denied the Practices' motion for partial summary judgment for a permanent injunction against Dr. Verdone under the restrictive covenants in his employment agreements. The court's ruling, that Dr. Verdone raised triable issues based on his defense that the Practices breached the agreements' implied contractual duty of good faith, was affirmed on appeal (read here).

In March 2010, the court required the Practices to post a $7 million bond to secure the preliminary injunction against Dr. Verdone enforcing the restrictive covenants (read here). The Practices' later request to reduce the bond was denied in February 2012 (read here).

In April 2010, the court denied the Practices' motion to dismiss Dr. Verdone's derivative claims on the ground that the termination of his employment also terminated his shareholder status. The court's order (read here) noted that the definition of Call Event in the shareholders' agreements did not include an involuntary termination other than for cause, and that there were triable issues surrounding his termination for cause. This ruling also was affirmed on appeal (read here).

The Post-Trial Decision

Neither side obtained a clear-cut victory in Justice Pines' post-trial decision. Both sides were found to have breached duties owed to the other.

For his part, the court found that Dr. Verdone breached his fiduciary duty of loyalty when he contacted officials at Chase prior to its decision not to approve the loan to OBA for the Surgicare acquisition. As Justice Pines explained:

As closely held corporations (and in the case of OBA, a PLLC) the shareholders/members thereof owed each other and the corporate entities an undivided duty of loyalty and trust. In the case at bar, the events leading to the ultimate purchase by the individual shareholders of the Surgicare ambulatory facility, via prospective loans and guarantees by the corporate entities, was approved by 11 of the 12 shareholders/members after numerous meetings, discussions and negotiations on their behalf with various lending institutions. While Dr. Verdone expressed his disagreement with the method of proposed funding for almost one year before the October 3, 2008 incidents, as was clearly his right, his co-shareholders/ members in the various entities disagreed with him. They voted, in addition, by a vote of a super majority, in accordance with BCL § 908, to change the by-laws of the various entities, to allow the borrowing by one of the corporate entities to occur. When Dr. Verdone telephoned and e-mailed bank officials, without the knowledge or acquiescence of his co-shareholders in the three entities, he clearly breached the required duty of loyalty. Although Dr. Verdone did not wish any of the corporate entities to encumber their assets in connection with the purchase, that is the decision the shareholders/ members made in Dr. Verdone's presence. In this context, the Court found most credible the testimony of both Stolzenberg [the Practices' CPA] and the many other physicians who testified that Dr. Verdone was present during the lengthy presentation by the entities' CFO, Stolzenberg, who informed the physicians that the tax consequences of allowing the PLLC to be the named borrower inured to the benefit of each of the members. In addition, the Court found extremely convincing the testimony of the corporations' former counsel, an expert in the area of health law, that by amending the by-laws and providing for an accounting, the purchase as structured to be based on loans and guarantees by the corporate entities could become legal.

Justice Pines next found that the Practices were justified in terminating Dr. Verdone for cause, likewise based on his conduct surrounding the aborted bank loan. His unauthorized contacts with the bank, Justice Pines concluded, although they were not shown to be a "but for" cause for the bank's decision not to approve the loan, constituted "willful misconduct" that "did cause damage to the reputations of the shareholders/members and the entities involved" and to OBA's members "to the extent of a lost tax benefit." The fact that the Practices and other physicians did not seek damages arising directly from the loss of the loan opportunity made no difference, as Justice Pines further explained:

The Employment Agreements include within their definition of a basis for "termination for cause" a breach of fiduciary duty. In the Court's opinion, reading the documents as a whole in the context of their purpose, which was, at least, in part, to create and sustain a relationship among co-shareholders within a closely held group of entities, who practiced medicine and engaged in various business ventures to act with a degree of loyalty towards each other, the nighttime and early morning telephone calls [to Chase] clearly fall outside the duty of trust contemplated. A finding of breach of fiduciary duty sufficient to satisfy a termination for cause under the Agreements does not require proof of damages such as would be required as an independent element of the cause of action itself.

Justice Pines also found that Dr. Verdone was terminated "solely for his actions in connection with the loans for Surgicare and not, as he insisted at trial, as a result of his role as a whistle blower." She credited the testimony of the other physicians that Dr. Verdone "was not instrumental" in the actions taken by the Practices in regard to Dr. Kurlander's financial management, and that the only issue of concern to Dr. Verdone was "control over the call schedule."

Justice Pines acknowledged the concerns raised at trial by Dr. Verdone with regard to the outside practice requirements under federal and state anti-kickback laws, but found them to be immaterial. While the Practices contended their outside practices "are based on fair market evaluations" and Dr. Verdone contended that the arrangements were non-compliant, Justice Pines observed that

[i]t is for the appropriate authorities to make such determinations; and such has no effect on the parties' Shareholders or Employment Agreements, which are enforceable under the rules . . . [that] sanction actions that are malum prohibitum. Thus, even if certain of the agreements were found to have violated fee splitting and/or anti-kickback injunctions, such violations are not related to the employment and shareholder agreements which are at the center of this case and which are entitled to be enforced.

Then it was the Practices' turn to take some lumps, with Justice Pines finding that they breached Dr. Verdone's employment agreements by refusing to pay him his deferred compensation due in the amount of $2.35 million, plus his unpaid 2008 expenses and income due him as a shareholder through the date of termination. Justice Pines rejected the Practices' contention that Dr. Verdone lost entitlement to his termination benefits by allegedly engaging in wrongful solicitation, which did not cause any harm to the Practices. "[M]ore significant to the Court," she continued:

the corporate entities did themselves engage in less than professional behavior in their takeover of outside practice anesthesiology services for the two east end practices, which they knew had hired Dr. Verdone after his termination from their practice and which were located in geographic locations into which they had not ventured in their many years of operation. In other words, it appears to the Court that each of the parties herein attempted to harm the other financially after the termination and during the pendency of these lawsuits. To the extent that either party seeks damages from the other in either of the pending actions for this post-termination conduct, they are barred from accomplishing the same by the doctrine of in pari delicto. As a court of equity, this court will not sanction nor award such acts by either side of the equation.

Justice Pines next determined that the termination of Verdone for cause constituted a Call Event under the shareholders' agreements, entitling him to payment for his shares at par value. The downside for Dr. Verdone was that, having been found to have lost his shareholder status as of December 2008, the court dismissed his dissolution and derivative claims on the Practices' behalf, and also rejected his claims for post-termination compensation and pro rata distributions.

On the brighter side for Dr. Verdone, Justice Pines dismissed the Practices' claim against him for tortious interference with business relations, and it upheld his claim for repayment of his investment in Surgicare as well as his share of distributions, in amounts to be determined in subsequent proceedings.

A Few Closing Observations

As an outside observer, with no knowledge of the case other than what appears in the court's decisions, my overall impression is that Justice Pines' decision put the parties in the same or similar position they reasonably should have settled for at the outset, that is, Dr. Verdone is out of the Practices with no further equity interest or claim to ongoing distributions; he gets paid the deferred compensation and whatever he was owed through termination; he gets back his investment in Surgicare which was offered to him even before the litigation; and he continues his medical career elsewhere, subject to the three-year restrictive covenants.
Absent a settlement, the only way for the court to get to this result under the constraints of the parties' agreements was to find that Dr. Verdone was terminated for cause, and therein lies what, in my humble opinion, was the fundamental problem: the omission of involuntary termination without cause as a defined Call Event in the shareholders' agreements. Had it been included, Dr. Verdone would have had very limited ability to mount an offensive campaign seeking a multi-million damages award via derivative claims and staking out a share of ongoing and future distributions. By the same token, the Practices would have had much less incentive to mount their own offensive campaign to show that Dr. Verdone had engaged in misconduct justifying termination for cause. The Practices' need to prove termination for cause, and Dr. Verdone's commensurate need to cast himself as a whistle blower, under the pressures of the Surgicare transaction quickly escalated to a DEFCON 1 situation in which each side had little choice but to launch their biggest missiles against the other, necessitating public disclosure of embarrassing and potentially troublesome information about the Practices.
The decisions make no reference to an arbitration clause in the parties' agreements, so I assume there was none. In my view, a provision requiring the parties to privately arbitrate all disputes relating to the agreements and their enforcement would have reduced the level of hostilities, avoided unflattering public disclosures, and produced a much faster resolution than the almost 4 years the parties have spent so far in the court system.

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LLC Dissolution Case Highlights Divergent Interests When One Member is Also the Landlord

Peter A. Mahler — Mon, 07 May 2012 05:00:00 -0500

Kim Kardashian's marriage last summer to Kris Humphries famously lasted only 72 days. Their divorce proceeding even more famously is now in its seventh month. A less celebrated but similar fate may befall the short-lived business marriage of two partners in a Long Island restaurant/deli business, who are now embroiled in three lawsuits with one another including a proceeding to dissolve their limited liability company (LLC). Alas, a pair of rulings last month prefigures a divorce that likely will last longer and cost more than the marriage.

The S's in S&S Eatery, LLC are Elaine Shure and Anthony Spota who in mid-2010 agreed to go into business together as 50/50 co-owners and operators of a new restaurant/deli on Rockaway Avenue in Valley Stream, New York. They decided to situate the restaurant in a vacant unit in a commercial building owned by a trust set up by Ms. Shure's late husband, of which she was the trustee. In retrospect, the decision at the outset to invest in space indirectly owned and controlled by one of the members may have been the beginning of the end of the business relationship.

Spota and Shure agreed that he would manage the restaurant operations and she would oversee bookkeeping, other administrative responsibilities, and food pickup and delivery. In July 2010, Spota commenced renovation of the space after they agreed to invest equally in the construction expenses. In August 2010 they entered into a 10-year lease between the trust and S&S Eatery, and they also signed an operating agreement providing for management of the LLC by its members. In September 2010 they signed an amendment which included a provision requiring them to devote equal time to the business which opened in January 2011.

In the following months relations soured between Spota and Shure. Shure alleged that Spota disparaged her ability to operate the business and used profane language when speaking with her. She also claimed that Spota limited her management rights, denied her access to company records, and failed to collect sales tax or pay additional rent charges under the LLC's lease. Spota charged that Shure became involved with another business, failed to make her agreed-to contributions to the start-up expenses, and failed to devote the required time to running the restaurant business necessitating the hiring of additional staff. He also alleged that Shure deterred customers from entering the restaurant in a deliberate attempt to induce a lease default.

In early January 2012, Shure brought a non-payment summary eviction proceeding in Nassau County District Court on the trust's behalf against the LLC. Shortly afterward Spota filed in Nassau County Supreme Court a lawsuit in his own name against Shure personally for breach of their agreements, in which he applied for and obtained a temporary restraining order staying the eviction proceeding. In late January, Shure filed her own proceeding in Nassau County Supreme Court to dissolve the LLC and appoint a receiver.

The two Supreme Court cases landed before Nassau County Commercial Division Justice Timothy S. Driscoll who handed down two decisions early last month (a) denying Spota's application to stay the eviction proceeding, (b) granting Shure's application to dissolve the LLC, (c) ordering a hearing on Shure's request to appoint a receiver and for injunctive relief, and (d) permitting the business to continue to operate until its "eventual dissolution."

In his decision denying a stay of the eviction proceeding, in Spota v. Shure, 2012 NY Slip Op 31010(U) (Sup Ct Nassau County Apr. 5, 2012), Justice Driscoll noted Spota's contention that, absent the stay, Shure "would then be able to exploit her dual roles as landlord and tenant and the instant action effectively will be rendered moot." But, Justice Driscoll concluded, even assuming Spota can show a likelihood of prevailing on the merits of his contract breach claims, he cannot show the requisite irreparable harm, i.e., injury not compensable with money damages, nor can he show the equities weigh in his favor "as a delay of the District Court Action will potentially prejudice the Landlord [i.e., the Shure Trust] from enforcing its rights under the Lease."

Justice Driscoll's companion ruling in the dissolution case, Matter of Shure (S&S Eatery, LLC), 2012 NY Slip Op 50739(U) (Sup Ct Nassau County Apr. 9, 2012), includes a helpful summary of the standard and grounds for dissolution of an LLC under §702 of the LLC Law, which authorizes dissolution "whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement." Here's Justice Driscoll's summary:

Despite the standard for dissolution enunciated in LLCL § 702, there is no definition of"not reasonably practicable" in the context of the dissolution of an LLC. Matter of 1545 Ocean Avenue, LLC v. Ocean Suffolk Properties, LLC, 72 AD3d 121, 127 (2d Dept. 2010). Most New York decisions involving LLC dissolution issues have avoided discussion of this standard altogether. Id., citing, inter alia, Matter of Extreme Wireless, 299 AD2d 549, 550 (2d Dept. 2002). The standard is not to be confused with the standard for the dissolution of corporations pursuant to Business Corporation Law ("BCL") §§ 1104 and 1104-a, or partnerships pursuant to Partnership Law § 62. Id. Unlike the judicial dissolution standards in the BCL and Partnership Law, the court must first examine the LLC's operating agreement to determine, in light of the circumstances presented, whether it is or is not "reasonably practicable" for the LLC to continue to carry on its business in conformity with the operating agreement. Id. at 128. Thus, the dissolution of an LLC under LLCL § 702 is initially a contract-based analysis.

The Second Department, in Matter of 1545 Ocean Avenue, LLC, outlined relevant case law in New York and other jurisdictions, including Delaware, and concluded that, for dissolution of an LLC pursuant to LLCL § 702, the petitioning member must establish, in the context of the terms of the operating agreement or articles of incorporation, that 1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved; or 2) continuing the entity is financially unfeasible. 72 AD3d at 131. The Court noted that dissolution is a drastic remedy, id., citing Matter of Arrow Inv. Advisors, LLC, 2009 Del Ch LEXIS 66, * 2 (2009), and that the appropriateness of an order for dissolution of the LLC is vested in the sound discretion of the court hearing the petition, id. at 133, quoting Matter of Extreme Wireless, 299 AD2d at 550.

As it turned out, the dispute in S&S Eatery was not whether dissolution should be ordered, but when and how dissolution should be effected. As Justice Driscoll noted, Spota "agrees that the eventual dissolution and winding up of the affairs of S&S is appropriate, but submits that the Court should not grant dissolution until the issues raised in [Spota's related lawsuit against Shure] are addressed." Otherwise, Spota argued, he would lose the time and money he invested in the business, as well as any potential resale value including good will. Spota also contended that immediate dissolution would unjustly enrich Shure (or more precisely, the Shure Trust as landlord) without compensating Spota for the improvements to the restaurant premises for which he paid.

Based on the parties' dueling claims, that the other failed to fulfill his or her obligations under the operating agreement to contribute equally to the management of the LLC, as well as Spota's agreement that "eventual dissolution" is appropriate, Justice Driscoll had little trouble concluding that "it is not reasonably practicable to carry on the business in conformity with the Operating Agreement." Justice Driscoll did not order immediate dissolution, however, finding that a hearing is required to determine whether the grant of injunctive relief and appointment of a receiver is warranted "[i]n light of the issues raised by the parties . . . including [Spota's] concerns . . . that Shure may be unjustly enriched if S&S is dissolved without compensating Spota for the improvements for which he paid . . .." Meanwhile, Justice Driscoll ruled, "it is appropriate to permit the business to continue to operate until its eventual dissolution."

Justice Driscoll's ruling also reserved decision on Spota's request to consolidate the two Supreme Court cases. Although the issues in both cases are similar, consolidation is "somewhat complicated by the fact that the instant dissolution proceeding is a matter to be tried before the Court but the plaintiff [Spota] in the Related Action may have a right to a jury trial." Justice Driscoll suggested the parties may want to stipulate that the two cases will be tried before the court.

In any business partnership attention must be paid to the proper alignment of the partners' interests and to putting in place contractual protections to counter the potentially toxic influences of non-aligned interests. From day one, the interests of Shure as landlord of the S&S Eatery clashed with Spota's interest as an investor in the build-out of the vacant space. If the restaurant goes out of business, the landlord captures the residual value of the improvements. The lease between the Shure Trust and S&S Eatery included a long-term abatement of base rent for the cost of improvements, but perversely that only enhanced Shure's incentive to enforce an early lease termination if she became dissatisfied with the return on her investment in S&S Eatery or with her relationship with Spota.

Can a Member of a Member of an LLC Sue to Dissolve the LLC?

Peter A. Mahler — Mon, 30 Apr 2012 05:00:00 -0500

A lawsuit between the owners of an upper east side Manhattan "gentlemen's club" called Sapphire, involving charges of self-dealing and financial abuse by the managing partner, led to an interesting but not surprising decision earlier this month, holding that a member of LLC #1 which, in turn, is a member of LLC #2, lacks standing to seek judicial dissolution of LLC #2. JG Club Holdings, LLC v. Jacaranda Holdings, LLC, 2012 NY Slip Op 50724(U) (Sup Ct NY County Apr. 20, 2012).

The club, owned and operated by a New York limited liability company called Jacaranda Club, LLC ("Sapphire"), arose from the ashes of the notorious Scores strip club that closed down at the same location in 2008. According to its December 2008 Operating Agreement (read here), Sapphire started operations with two members: Jacaranda Holdings, LLC ("Jacaranda") as the 51.1% managing member and TDK Holdings, LLC ("TDK") as the 48.9% non-managing member. TDK with Jacaranda's consent subsequently assigned its entire membership interest to JG Club Holdings, LLC ("JG") whose membership included Jeffrey Wasserman (the "JG Controlling Member") as the managing majority member, and two non-managing minority members, GRKS II LLC and DZ Ventures LLC (collectively, the "JG Minority Members").

In December 2010, the JG Controlling Member brought suit in JG's name (read complaint here) against Jacaranda, its principal, Michael Talla, and a separate company controlled by Talla called Club at 60th St., Inc. ("60th St.") from which Sapphire leased its club facility, asserting a number of individual and derivative claims on Sapphire's behalf. The suit's gravamen is that Talla/60th St. charged Sapphire grossly excessive rents and also used Sapphire's funds to pay the defendants' separate loan obligations. The complaint did not seek judicial dissolution of Sapphire.

Following a series of inconclusive skirmishes over discovery disputes, in November 2011 the JG Minority Members by their own counsel filed a motion for leave to intervene as plaintiffs. Their proposed intervention complaint (read here) alleged that the relief sought in JG's complaint was inadequate or inappropriate, and requested that the court instead dissolve Sapphire pursuant to §702 of the LLC Law. Their memorandum of law in support of intervention (read here) argued that, as members of JG, they were entitled to seek dissolution of Sapphire derivatively on behalf of JG under the authority of Tzolis v. Wolff, 10 NY3d 100 (2008), in which the New York Court of Appeals recognized a common law right of an LLC member to sue derivatively.

The defendants' opposing brief (read here) argued that LLC Law §702 by its plain wording limits standing to seek dissolution to a "member." Defendants also argued, even assuming there is derivative standing to seek dissolution, that the JG Minority Members did not plead and could not satisfy the demand or demand futility prerequisite for a derivative action, especially since the JG Controlling Member had already brought an action in the name of JG alleging financial misconduct by the defendants. The fact that the JG Controlling Member chose not to seek a dissolution remedy reflects a business judgment that the court should respect, they further argued.

The JG Minority Members replied with their own affidavits (read one of them here) and -- how odd is this? -- the affidavit of the JG Controlling Member (read here) stating that the three of them had discussed and agreed that Sapphire should be dissolved and that, although the JG Controlling Member did not intend to apply for dissolution of Sapphire on behalf of JG, he "invited" the JG Minority Members to seek dissolution of Sapphire if they considered it "appropriate."

The intervention application was heard by New York County Commercial Division Justice Shirley Werner Kornreich who, at a conference on January 31, 2012, requested that counsel submit supplemental authority for their position on derivative standing to seek dissolution. The intervenors' counsel submitted a letter restating their reliance on Tzolis v. Wolff (read here). The defendants' counsel submitted a letter citing a Delaware Chancery Court decision, R&R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318 (Del. Ch. Aug. 19, 2008), in which the court rejected on standing grounds a request for dissolution by a member of a member of the subject Delaware LLC. (Read here the letter and here my post on R&R Capital).

Justice Kornreich's decision denies the intervention application for lack of standing to seek dissolution under the statute, stating:

Section 702 of the LLCL provides that a court may grant dissolution upon "application by or for a member...." The parties have pointed to no precedent, and the court's independent research has discovered none, extending the right to seek dissolution of a limited liability company to non-members. All of the New York precedents confer or deny standing based upon membership. See, e.g., Matter of Cline v Donovan, 72 AD3d 471, 472-472 (1st Dept 2010) (dissolution should not have been granted due to question of fact as to whether petitioner was member of LLC); Caplash v Rochester Oral & Maxillofacial Surgery Assoc., LLC, 63 AD3d 1683 (4th Dept 2009) (plaintiff had standing to dissolve LLC because his resignation as member was not effective before he moved for dissolution).

As the quoted passage notes, neither of the two cited cases dealt with the issue of derivative standing to seek dissolution, so it appears that Justice Kornreich is the first to pronounce on the issue, at least in New York.

Justice Kornreich apparently let the parties know which way the wind was blowing at the late January conference, because shortly thereafter, counsel for JG filed an amended complaint tacking on a claim for judicial dissolution of Sapphire (read here), thereby effectively mooting the issue of the JG Minority Members' standing to dissolve Sapphire.

The membership limitation on standing to seek LLC dissolution is more important than you might think. Unlike subchapter S close corporations that generally cannot have other limited liability entities as shareholders, LLCs often include in their membership ranks multi-shareholder corporations and/or multi-member LLCs which may in turn be composed of other multi-member LLCs. There may be circumstances of overlapping ownership and control, and divergent interests, that leave some stakeholders with no ability to seek judicial dissolution in their own right or through the entity in which they hold a direct interest. Like everything else in the world of LLCs, these are issues to be thought out and addressed in the operating agreement.

Finally, neither in the court's decision nor the parties' submissions in the Sapphire case is any special attention paid to §702's use of the words "or for" in the section's standing formulation, "[o]n application by or for a member . . .." The formulation is lifted verbatim from §121-802 of New York's Revised Limited Partnership Act authorizing judicial dissolution "[o]n application by or for a partner" and is also commonly found in many other states' limited partnership and LLC dissolution statutes. Might "for a member" support derivative standing to seek dissolution? Please leave a comment if you've seen this issue addressed anywhere.

Response from Professor Daniel S. Kleinberger

I'm pleased to be able to share the following response to my query received from Professor Daniel Kleinberger of the William Mitchell College of Law, one of the foremost experts on the law of business organizations. Professor Kleinberger has been immersed in legislative drafting projects for more than two decades, and his scholarship and drafting work have been recognized by the National Conference of Commissioners on Uniform State Laws, the American Law Institute, the American Bar Association Committee on Limited Liability Companies, Partnerships and Unincorporated Entities, and the Section on Agency, Partnership, LLCs and Unincorporated Associations of the American Association of Law Schools.

Peter,

I’ve done some looking into the question of whether “by or for a member” would support derivative standing to seek dissolution. For several reasons, I believe the answer should be no.

First, the origins of the phrase argue against the notion that “for” can encompass derivative claims. The phrase derives from the original Uniform Partnership Act, § 32(1) (“On application by or for a partner the court shall decree a dissolution whenever ….”). Like much of the UPA, § 32 derives from the comparable provision of the English Partnership Act of 1890, which notably does not include the phrase “or for”. Partnership Act of 1890, § 35 (“On application by a partner the Court may decree a dissolution of the partnership in any of the following cases: …..).

The Official Comments to UPA § 32 do not explain the added language, but it is highly unlikely that the drafters had derivative litigation in mind. Then and now, the derivative suit does not exist with regard to general partnerships. See RUPA § 405; Daniel S. Kleinberger, “The Closely Held Business through the Entity-Aggregate Prism,” 40 WAKE FOREST L. REV. 827, 842 (2005) (“RUPA purposefully eschews one of the most logical consequences of entity status--namely, a distinction (with consequences) between direct and derivative claims. ‘RUPA does not authorize derivative actions,’ and each partner has standing to bring claims directly for injuries suffered by the partnership.) (footnotes omitted; quoting RUPA § 405, cmt. 2).

To state that a paucity of case law exists would overstate the number of cases. The longest discussion I have found comprises two paragraphs in an almost 60-year-old New Jersey decision:

The plaintiff applied for dissolution of a partnership formed by the defendant Nicholas Lo Conte and his brother, plaintiff's husband, Michael Lo Conte, now absent, and for the appointment of a receiver of the property and assets of the partnership. The defendants resist on the ground that the plaintiff is not a proper party to make the application, because R.S. 42:1-32, N.J.S.A. [UPA § 32], provides that the court shall under certain circumstances decree a dissolution ‘On application by or for a partner’ and that the plaintiff being neither a partner, the personal representative or agent of a partner cannot make application ‘by or for a partner.’

Had it been the intent of the Legislature to limit the persons, other than partners, who may make application to the court strictly to personal representatives or agents of partners, it would have done so. The statute does not in any wise specify who may make application ‘for a partner.’ In the absence of any limitation, it is to be presumed that any party in interest may make such application-certainly equity dictates that it may properly be made by a person as much in interest as the wife of an absent partner.

Lo Conte for the Use and Benefit of Lo Conte v. Lo Conte, 25 N.J.Super. 42, 43-44, 95 A.2d 443, 443 - 444 (N.J.Super.Ch. 1953). Perhaps to the contrary, at least implicitly, is Jacoby v. Feldman, 81 Cal.App.3d 432, 442, 146 Cal.Rptr. 334, 339 - 340 (Cal.App. 1978) (ignoring the “or for” language, while “hav[ing] no difficulty in holding that [a deceased partner’s estate] was a partner within the meaning of Corporations Code section 15032 [(UPA § 32]”).

In any event, given that derivative suits are inapposite to general partnerships (the source of the “or for” language), I doubt even that a court that found and followed Lo Conte would consider a member X of LLC #1 to be as closely connected to LLC #2 (of which LLC #1 is a member but X is not), as is “the wife of an absent partner” to the absent partner.

As to whether X should be have the right to bring a double derivative suit for dissolution of LLC #2, in JG Club Holdings, LLC v. Jacaranda Holdings, LLC Judge Kornreich held pithily to the contrary. “The parties have pointed to no precedent, and the court's independent research has discovered none, extending the right to seek dissolution of a limited liability company to non-members…. Furthermore, after this motion [for intervention in the nature of a double derivative suit] was submitted, JG [LLC #1] filed a second amended complaint asserting a claim for dissolution of the Club [LLC #2]. If the Proposed Intervenors feel that JG is being managed improperly, they can bring a derivative action against its management.” JG Club Holdings, LLC v. Jacaranda Holdings, LLC, 2012 NY Slip Op 50724(U) (Supr. Ct. NY Co. April 20, 2012) at 3.

Those familiar with the complexity and rationale for double derivative suits will likely agree with Judge Kornreich. For an excellent introduction to the complexity, see Lambrecht v. O'Neal, 3 A.3d 277, 281-287 (Del. 2010). The short version is simply this:

In the pure, conceptual sense, in a double derivative suit:

The plaintiff is a person who is a co-owner (e.g., stockholder, limited partner, member) of Entity #1 but not of Entity #2.
Entity #1 is a co-owner of Entity #2 and, in the judgment of the plaintiff:
- those who manage Entity #2 have wrongfully damaged Entity #2;
- not surprisingly, those who manage Entity #2 are not pursuing the miscreants (i.e., themselves); and
- Entity#1 could bring a derivative action in the name and to the benefit of Entity #2, but the managers of Entity #1 are not properly asserting Entity #1’s rights to bring derivative claims on behalf of Entity #2.
The plaintiff (as a co-owner of Entity #1 but not of Entity #2) seeks to “take control” of Entity #1 for the purpose of invoking Entity #1’s right to sue derivatively on behalf of Entity #2 and against the managerial miscreants who have allegedly harmed Entity #2 (and indirectly Entity #1 and even more indirectly the plaintiff).
The law of derivative actions has both a contemporaneous and continuous ownership requirement. Subject to exceptions not relevant here, the derivative plaintiff must have been a co-owner of the directly damaged entity as of the time of the misconduct and must remain a co-owner of that entity throughout the derivative lawsuit.

Any double derivative lawsuit flunks one or both of those requirements.
Courts (particularly Delaware courts) have made exceptions to those requirements only when a merger or comparable transaction has made a direct derivative suit impossible.

Such impossibility does not exist when LLC #1 exists and is a member of LLC #2. If LLC #1 is “messing up” as it asserts (or fails to assert) its rights viz a viz those who manage LLC #2, the members of LLC #1 have a derivative claim – on behalf of LLC #1 against the managers of LLC #1. To reiterate Judge Kornreich’s words: “If [the members of LLC #1] feel that [LLC #1] is being managed improperly, they can bring a derivative action against its management.” JG Club Holdings, LLC v. Jacaranda Holdings, LLC, 2012 NY Slip Op 50724(U) (Supr. Ct. NY Co. April 20, 2012) at 3.

If the mismanagement concerns LLC #1’s failure to sue derivatively in the name of LLC #2, in theory the court in the initial derivative action could order the managers of LLC #1 to remedy that failure and cause LLC #1 to sue derivatively on behalf of LLC #2.

Attorneys who think such an order is likely resemble the White Queen in Alice in Wonderland – i.e., they are capable of “believ[ing] in ‘as many as six impossible things before breakfast.’” In re Trejos, 352 B.R. 249, 254 (Bkrtcy.D.Nev. 2006) (quoting Lewis Carroll, Alice's Adventures in Wonderland & Through the Looking Glass, ch.5, at 157 (Bantam Classic ed.1981) (1865 & 1871)).

Clash of the Clauses: Divided Appellate Panel Rules that "Binding" Appraisal Per Buy-Sell Agreement Must be Arbitrated

Peter A. Mahler — Mon, 23 Apr 2012 05:00:00 -0500

Buy-sell provisions in shareholder agreements are good. Arbitration provisions in shareholder agreements are good. Inconsistent buy-sell and arbitration provisions in shareholder agreements are bad.

That pretty much sums up the lesson to be learned from an appellate opinion handed down last month in Matter of Grande' Vie, LLC, 2012 NY Slip Op 02190 (4th Dept Mar. 23, 2012), in which a majority of the court, with one judge dissenting, ordered arbitration over an appraisal for the buy-out of a deceased LLC member's interest notwithstanding language in the buy-sell provision stating that the appraisal "shall be binding."

The case involves two real estate holding companies organized as LLCs owned equally by three members, one of whom died in 2008. The operating agreement included buy-sell provisions triggered, inter alia, by the death of a member whose estate was entitled to be paid a purchase price determined by appraisal. The agreement also included a broad arbitration clause. Litigation broke out in 2010 after the estate sought arbitration of the value of the decedent's membership interest, while the surviving members sought to compel a sale at a value set forth in a written appraisal rendered by an appraiser selected by the surviving members after the appraisers specifically named in the agreement declined the assignment.

In April 2011, the Monroe County trial court denied the estate's application to compel arbitration and granted the surviving members' application to enforce the buy-out at the appraised value. The estate appealed.

The appeal naturally focused on the language of the buy-sell and arbitration provisions. The former identified by name the appraiser to determine the "Fair Value" of the membership interest, named a second appraiser in case the first appraiser was not available, and permitted the purchasing members to select any MAI-qualified appraiser if the neither of the two named appraisers was available. In the quoted excerpt of the provision that follows, for reasons that will become clear below, pay special attention to the use of the defined terms "Appraiser" and "Successor Appraiser":

For purposes of this Agreement, within ten (10) days after the expiration of the thirty (30) day period set forth in Section 8.2 (a) (ii) above, the selling Member (either the selling Member or the legal representative of the Deceased Member, as the case may be) and the purchasing Members shall notify Richard Bellows (the 'Appraiser'), to calculate the Fair Value of the Company. In the event the Appraiser or its successor in interest is no longer in business then the purchasing member shall notify Bob Pogel or if he is no longer in business, any MAI appraiser (the 'Successor Appraiser'). The Fair Value of the Membership Interest being purchased shall be determined by the Appraiser, in accordance with such valuation techniques and appropriate methodologies as the Appraiser deems appropriate, all in accordance with Generally Accepted Accounting Principles, and the policies and rules of MAI (Member Appraisal Institute). In all cases, the Appraiser's final determination shall be binding on the selling Member and the purchasing Member(s). The Appraiser shall deliver a written report of its determination of Fair Value to all interested parties, and the cost of such appraisal shall be borne equally Fifty Percent (50%) by said selling Member and Fifty Percent (50%) by the Purchasing Member(s). [Emphasis added.]

The operating agreement also included a broad arbitration clause requiring arbitration of any "controversy or claim arising out of or relating to" the agreement. The appeal focused on the following, additional proviso in the arbitration clause dealing with arbitrator qualifications:

[I]f the matter submitted to arbitration shall involve a dispute as to the value of a Membership Interest, one of the arbitrators shall be a certified public accountant and shall have no prior affiliation with any Member or the Company.

If you've been reading closely, you already see the problem: the buy-sell provision uses the defined term "Appraiser" in the underscored sentence purporting to make the appraisal "binding" on the members. Was it the members' intent that only an appraisal performed by the first-named appraiser (the "Appraiser") be binding, and that an appraisal performed by the second-named appraiser or the back-up MAI-qualified appraiser (the "Successor Appraiser") not be binding? And how does the arbitration clause's explicit reference to a dispute "as to the value of a Membership interest" fit with the stated intent, however broadly or narrowly construed, to make the "Appraiser's final determination" binding on the members?

The appeal was heard by four judges of the Rochester-based Appellate Division, Fourth Department. The three-judge majority opinion reversed the trial court's order and granted the estate's bid to compel arbitration, basically finding that the use of the defined term "Appraiser" in the sentence making the "Appraiser's" determination binding clearly did not apply to the appraisal rendered by the "Successor Appraiser" selected by the surviving members. Here's what the majority wrote:

By the plain wording of the appraisal clause, the MAI appraiser was the "Successor Appraiser," but only the "Appraiser's" determination would be final and binding on the parties. We therefore conclude that the parties intended that, where the "Appraiser" was not available to value the companies and the member's interest, the matter should be submitted to arbitration.

The dissenting justice, who would have upheld the lower court's order enforcing the buy-out at the appraised value, disagreed that the term "Appraiser" as used in the sentence making the "Appraiser's" determination binding applied only to the first-named appraiser. He drew support for this conclusion from two other sentences in the buy-sell provision -- one giving instructions as to how the Fair Value of the membership interest is to be valued, the other directing that a written report of the appraisal be delivered to all parties -- that use the term "Appraiser." As the dissent further explains:

Thus, if the appraisal clause is interpreted as respondent suggests (so as to distinguish between the Appraiser and the Successor Appraiser), the Successor Appraiser would play no role in the appraisal process upon being "notif[ied]" by the purchasing member. In other words, to construe the appraisal clause as giving binding effect to an appraisal submitted by only Bellows [the first-named appraiser] would render meaningless the provisions for selecting another appraiser in the event that Bellows declines to perform an appraisal. That construction of the appraisal clause is contrary to the well-established rule that courts should "avoid an interpretation that would leave contractual clauses meaningless." (Two Guys from Harrison-N.Y. v S.F.R. Realty Assoc., 63 NY2d 396, 403). As the Court of Appeals has advised, "[i]t is a cardinal rule of construction that a court should not adopt an interpretation which will operate to leave a provision of a contract . . . without force and effect" (Corhill Corp. v S.D. Plants, Inc., 9 NY2d 595, 599 [internal quotation marks omitted]; see Muzak Corp. v Hotel Taft Corp., 1 NY2d 42, 46-47).

The dissenting justice also found that the arbitration clause's reference to a valuation dispute "does not compel a finding that the parties' dispute over the value of the decedent's membership interest must be arbitrated." He gives three reasons:

The reference to a valuation dispute in the arbitration clause does not differentiate between appraisals submitted by an Appraiser -- which the parties agree would be binding and therefore non-arbitrable -- or a Successor Appraiser.
The provision of the appraisal clause "directing the Appraiser or Successor Appraiser definitively to determine the value of a membership interest removed that subject from the purview of the arbitrator."
Under the rule of contract construction that specific provisions control over general provisions, "the appraisal clause is far more specific than the arbitration clause, which is contained in a section of the agreements entitled 'General Provisions.'"

I've seen many shareholder and operating agreements that provide for a binding valuation process when a buy-out event is triggered by death, disability or other specified disposition of an ownership interest. The whole idea is to avoid the burden, expense and delay associated with litigation in favor of a reasonably prompt and orderly determination by one or more qualified appraisers of the value of the interest being purchased. The appraisal provision in Grande' Vie failed its purpose because the drafter did not state with sufficient precision the intent of the parties to be bound by the appraisal under the different scenarios for selection of the appraiser. I would go one step further by pointing out that, in my view, it's always a bad idea to give either the buyer or the seller the power unilaterally to select the appraiser because, regardless of the selected appraiser's qualifications, it almost always gives rise to mistrust and accusations of manipulation by the non-selecting party.

Judicial Dissolution of the Not-For-Profit Corporation

Peter A. Mahler — Mon, 16 Apr 2012 05:00:00 -0500

We don't normally associate non-profit organizations with factional fights leading to judicial dissolution proceedings, much less with a bloody riot among members wielding swords, cricket bats and microphone stands. But that's exactly what happened at a religious center in Queens, New York, eventually leading to the courthouse on a petition for judicial dissolution of the non-profit corporate entity that operates the center.

The unusual case, Matter of Singh (Baba Makhan Shah Lobana Sikh Center, Inc.), Short Form Order, Index No. 18204/11 (Sup Ct Queens County Mar. 7, 2012), invites a look at the judicial dissolution provisions of New York's Not-for-Profit Corporation Law (NPCL), which in many ways parallel the judicial dissolution provisions in New York's Business Corporation Law (BCL) but also contain some differences.

Trouble at the Gurdwara

Baba Makhan Shah Lobana Sikh Center, Inc. is a New York not-for-profit corporation formed in 1998. The Sikh Center maintains an office and temple, known as a "gurdwara," in the Richmond Hill section of Queens County, which has a significant Sikh population.

During its first decade the Sikh Center's governance featured a two-year rotating presidency shared by the gurdwara's founders. Starting in 2008, the term was shortened to one year. At the end of 2010, the sitting president, Jarnail Singh, and his supporters filed a lawsuit against other members seeking to change the Sikh Center's governance and to allow more worshipers a role in electing officers.

As reported in the New York Times, Queens County Supreme Court Justice Augustus C. Agate granted a temporary restraining order that kept Jarnail Singh and other top officers in power into 2011 while the case proceeded. In the ensuing weeks arguments and scuffles broke out at Sunday prayer services between competing factions of worshipers.

In April 2011, the court issued a decision denying Jarnail Singh's motion for preliminary injunction but also denying the defending faction's motion to dismiss the lawsuit. Matter of Baba Makhan Shah Lobana Sikh Center, Inc., 2011 NY Slip Op 31271(U) (Sup Ct Queens County Apr. 18, 2011).

The unresolved lawsuit stoked tensions to the boiling point at the next Sunday service. While Jarnail Singh and his allies prayed inside the gurdwara, 100 members of the opposing faction gathered outside, and then surged into the Center. A bloody melee erupted (captured on videotape here) in which some combatants used short swords, cricket bats and other makeshift weapons. The police arrested eight of the brawlers and a number of others landed in the hospital.

The Dissolution Proceeding

In an unreported decision in June 2011, Justice Agate decreed that Gurmej Singh, who was associated with the out-of-power respondent faction, was the Sikh Center's President.

In August 2011, Jarnail Singh and several of his allies commenced a proceeding for judicial dissolution of the Sikh Center under NPCL §1102(a)(2). The statute authorizes a director or ten percent of the total number of members to present a dissolution petition on any one of five different grounds:

The directors are so divided respecting the management of the corporation's affairs that the votes required for action by the board cannot be obtained.
The members are so divided that the votes required for the election of directors cannot be obtained.
There is internal dissension and two or more factions of members are so divided that dissolution would be beneficial to the members.
The directors or members in control of the corporation have looted or wasted the corporate assets, have perpetuated the corporation solely for their personal benefit, or have otherwise acted in an illegal, oppressive or fraudulent manner.
The corporation is no longer able to carry out its purposes.

Practitioners who handle dissolution of for-profit closely held business entities will quickly recognize that the first three grounds resemble those found in BCL §1104 for deadlock dissolution proceedings brought by a 50% shareholder; the fourth ground resembles BCL §1104-a's provisions for dissolution by an oppressed minority shareholder; and the fifth ground echoes LLC Law §702's provision for judicial dissolution of a limited liability company.

Jarnail Singh and the other Sikh Center petitioners argued that dissolution was warranted based on the internal dissension within the gurdwara for many years culminating with physical attacks between members of competing factions including the April 2011 melee.

The respondent faction opposed dissolution. First, they argued that some of the statements of members supporting the petition for dissolution are "forgeries and were not prepared or signed by the individuals who are named on the statements." Justice Agate was not swayed, stating that this "bare, conclusory assertion is insufficient to raise any factual issue as to whether the member statements annexed to the petition are forgeries."

The respondents also argued that the manifestations and existence of dissension had significantly subsided since Gurmej Singh's installation as President.

Justice Agate's analysis initially notes that "[t]here is no absolute right to judicial dissolution of a corporation since that determination lies within the discretion of the trial court." He also notes Gurmej Singh's concession that "disputes and disagreements have arisen between the competing factions of the Gurdwara within the last two years."

Ultimately, however, Justice Agate agrees with the respondents that the past tensions have subsided sufficiently since June 2011 so as not to warrant dissolution, writing as follows:

Even accepting petitioners' allegations as true, they have failed to show that the drastic remedy of dissolution would be beneficial to the members of the Gurdwara as required by NPCL §1109. The incidents of violence set forth in the petition occurred before Gurmej Singh became President pursuant to this court's June 2011 order, and there is no evidence in the petition that such incidents continued after June 2011. Based upon the evidence before it, this court cannot conclude that there is dissension to such a degree that dissolution would be beneficial to the members of the Gurdwara. [Citations omitted.]

There are only a handful or two of reported decisions involving application of NPCL §1102 and its predecessor statute under the General Corporation Law. Justice Agate cites two of them. The more recent one, Matter of Cusato (Glen at Great Kills Homeowners Association, Inc.), 23 AD3d 464 (2d Dept 2005), involved a dispute among members of a non-profit homeowners association in which the appellate court affirmed without analysis a lower court's order dismissing a dissolution petition predicated on allegations of oppressive conduct and internal dissension.

The older and more interesting case, Matter of John Luther & Sons Co. (Geneva Builders and Trade Association, Inc.), 52 AD2d 737 (4th Dept 1976), involved a dispute among members of a non-profit trade association. The appellate court observed that the "nub of the case" was a fight between competing factions for control of the non-profit entity. In essence, the court refused to use the judicial power to interfere in the democratic governance process associated with non-profit member organizations. The same can be said for the outcome in the Sikh Center case.

Dueling Dissolution Petitions Lead to Forced Buy-Out of 50% Shareholder

Peter A. Mahler — Mon, 09 Apr 2012 05:00:00 -0500

Last December I wrote about a business divorce case from Saratoga County involving dueling dissolution petitions that went up on appeal to the Appellate Division, Third Department, called Matter of Carson (Carrabasset Mgmt. Corp.). The appellate court affirmed the lower court's order of dissolution and held that the minority shareholder, who filed for dissolution under the oppressed shareholder statute, §1104-a of the Business Corporation Law (BCL), had no right to compel a buy-out of the majority shareholder who had cross-petitioned under the deadlock statute, BCL §1104.

Less than four months later, along comes another case from Saratoga County also on appeal to the Third Department, once again involving dueling dissolution petitions. This time around, in Matter of Clever Innovations, Inc., 2012 NY Slip Op 02536 (3d Dept Apr. 5, 2012), the appellate court upheld the lower court's order compelling a 50% shareholder, who had petitioned to dissolve under the deadlock statute, to purchase for fair value the stock of the other 50% shareholder who had cross-petitioned to dissolve under the oppressed shareholder statute.

Confused? Don't be. The unifying principle in both cases is that a petitioner seeking dissolution under the oppressed-shareholder statute, BCL §1104-a, can seek a forced buy-out of his or her own interest, but cannot compel a buy-out of the other shareholder, even when the other shareholder files a competing deadlock petition under BCL §1104.

Background

In 2001, Paul Neilson as sole shareholder and director formed what became an e-tail business called Clever Innovations, Inc., naming his wife Gwen as vice-president and treasurer. A year later, Christopher Dooley became a 50% shareholder. Dooley and Paul Neilson shared responsibility for day-to-day operations, although Dooley was never formally elected as an officer or director. The decision does not mention the existence of a written shareholders' agreement.

In 2009, by which time the company was highly profitable, Paul Neilson died unexpectedly and without a will. His widow was appointed administrator of her late husband's estate including his shares in Clever Innovations. Relations between Dooley and Gwen Neilson quickly deteriorated, due in part to the latter's refusal to accept Dooley's assertion that he was an officer of the company, which in turn led to the company's bank freezing its account. In May 2009, the parties agreed to work toward negotiating a buy-out of the estate's shares by Dooley who, in the interim, would operate the business and keep Ms. Neilson apprised of all financial transactions.

The court's decision does not indicate if any buy-out negotiations took place, but a month afterward, in June 2009, Dooley filed a deadlock dissolution petition under BCL §1104. Simultaneously he opened a new bank account for the company funded with $280,000 from customers, and he redirected the company's mail to his home address. In August 2009, Ms. Neilson commenced her own dissolution proceeding on the estate's behalf under BCL §1104-a, alleging oppressive conduct by Dooley and seeking a mandatory buy-out of the estate's shares for fair value upon the authority of BCL §1118 and Matter of Wiedy's Furniture Clearance Center Co., 108 AD2d 81 (3d Dept 1985).

In an unreported September 2010 decision, the Saratoga County trial court denied Dooley's motion for summary judgment in his favor, and instead granted Ms. Neilson's petition and ordered Dooley to purchase the estate's shares for fair value. Dooley appealed to the Albany-based Appellate Division, Third Department.

The Appellate Court's Decision

The Third Department's analysis emphasizes that the dueling dissolution petitions, while both seek to terminate the parties' business relationship, "invoke different grounds and seek very different relief." Dooley's petition under BCL §1104 requires a showing that the "shareholders are so divided that the votes required for the election of directors cannot be obtained" or that "there is internal dissension" such that "dissolution would be beneficial to the shareholders," in which case the company would be dissolved and its assets distributed among the shareholders. In contrast, Ms. Neilson's petition under BCL §1104-a requires a showing of oppressive conduct by the controlling shareholder in which case the court has discretion to determine whether the appropriate remedy is dissolution or an alternative such as a forced buy-out.

Addressing Dooley's deadlock petition, the appellate court agrees with the lower court that Dooley

failed to set forth a prima facie case that the shareholders were deadlocked. Although the parties were experiencing disagreement and, while [Ms. Neilson] is acting on behalf of the estate, each controls 50% of the company's shares, [Dooley] does not assert that an election was held or demonstrate that a deadlock was harming the shareholders. Rather, the record demonstrates instead that the parties had met and agreed upon an interim arrangement for operating the company, but that the arrangement was never fully implemented due to [Dooley's] unilateral decision to act in contravention of it by filing a petition for dissolution.

The appellate court next agrees with the lower court's determination that Dooley engaged in oppressive conduct warranting the grant of Ms. Neilson's §1104-a petition, based on Dooley's "unwillingness to either negotiate a sale of the estate's shares or to include [Ms. Neilson] in the operation of the company." The court also rejects Dooley's argument that the lower court should have conducted a hearing on this issue, stating as follows:

[A] hearing is required only when allegations contained in the pleadings present issues of fact (see Business Corporation Law § 1109; Matter Carrabasset Sq. Mgt. Corp., 90 AD3d 1279, 1279-1280 [2011]). Here, the only factual issue in dispute is whether, despite the absence of an official appointment, [Dooley] had become an officer of the company. As this fact is not material to the issue of whether [Dooley] – a 50% shareholder – engaged in oppressive conduct, and given that he apparently never requested a hearing, we find that Supreme Court was not required to hold one (see Matter Carrabasset Sq. Mgt. Corp., 90 AD3d at 1279-1280; Matter of Quail Aero Serv., 300 AD2d 800, 803 [2002]; Matter of Wiedy's Furniture Clearance Ctr. Co., 108 AD2d at 84).

The court last addresses the mandatory buy-out remedy, again stressing the lower court's "broad latitude in fashioning alternative relief." Here's how the court explains its affirmance of the buy-out remedy:

It is undisputed that the parties no longer desired to continue in business together, but it is also clear from the record that, had they reached agreement on a price, [Dooley] would have purchased the estate's shares. With [Paul Neilson's] passing, [Dooley] maintained the primary relationship with the company's customers and, considering his actions designed to move the operation of the company beyond [Ms. Neilson's] reach, Supreme Court was justified in finding that, through dissolution, [Dooley] seeks to avoid paying the estate the fair value of its shares while personally continuing to profit by operating the company's business either individually or through a new corporation. Under these circumstances, we cannot say that Supreme Court abused its discretion in ordering the extraordinary remedy of a forced buyout.

I've commented before that dissolution involving 50/50 shareholders raises some of the trickiest tactical decisions for litigation counsel. Clever Innovations highlights two very important lessons that counsel must keep in mind when planning to file or respond to a dissolution petition involving 50/50 shareholders:

Don't labor under the false notion that only minority shareholders can seek dissolution under the oppression statute, BCL §1104-a. The statute gives standing to a shareholder holding at least 20% of the voting shares, which includes a 50% shareholder or, in theory, even a 99% shareholder.
Don't labor under the false notion that buy-out in a §1104-a case can only occur when the respondent affirmatively elects to purchase the petitioner's shares under BCL §1118. The Third Department's 1985 Wiedy's decision, authorizing a court to compel a buy-out of the petitioner's shares notwithstanding the absence of any explicit statutory authorization, has garnered a wide enough following to become an accepted part of the court's remedial toolbelt.

Minority Shareholder Wins Appeal Challenging Grant of "Bonus" Treasury Shares to Controlling Shareholders

Peter A. Mahler — Mon, 02 Apr 2012 06:00:00 -0500

Disclosure: The author represents the plaintiff and argued the appeal in the case discussed in this post.

Minority shareholder oppression takes many forms, the most common ones being termination of the minority shareholder's employment, expulsion from the board of directors and payment of excessive compensation to the controlling shareholders.

Oppression also can take the form of stock dilution, as occurs in the absence of preemptive rights when the controlling shareholders authorize and issue new shares to themselves without providing minority shareholders the opportunity to maintain their percentage interest. The Xtenit case, in which the controlling shareholder authorized and granted himself new shares sufficient to dilute the minority shareholder from 15% to 1%, is one of the more notable examples of a court placing the burden on the controlling shareholder as fiduciary to demonstrate a bona fide business purpose for such unequal shareholder treatment.

This principle was reaffirmed in a recent decision by the Appellate Division, Second Department, in Armentano v. Paraco Gas Corp., 90 AD3d 683, 2011 NY Slip Op 09075 (2d Dept. Dec. 13, 2011), involving a dispute between the second generation shareholders of a family-owned propane distribution business. The decision in Paraco primarily turned on whether the bonusing of treasury shares to the controlling shareholders had a dilutive effect on the minority shareholder's stock interest. The lower court held that it did not and dismissed the complaint. The appellate court unanimously reversed the lower court's order, holding that the plaintiff's complaint sufficiently alleged that the controlling shareholders breached fiduciary duty by granting themselves treasury shares without legitimate business purpose and for the sole purpose of diluting the minority shareholders.

Paraco Gas, based in Westchester, New York, is among the largest propane distributors in the United States with sales over $100 million. At one time the company's founder, Pat Armentano, and his four sons all worked in the business. At the time of Pat's death in early 2010, his sons Joseph and John managed the business and held a majority of the shares. His two other sons, Robert and Michael, who had left Paraco's employment to pursue other ventures, held minority stakes consisting of non-voting Class B shares.

Paraco's capital stock included a number of Class A voting and Class B non-voting shares held in treasury. Joseph and John, holding two of the board's three seats, approved annual stock bonus compensation plans for themselves under which they received (and will continue to receive) shares of Paraco stock from treasury.

Robert filed suit in mid-2010, alleging that the stock bonus plans had no substantial business purpose and were adopted solely to dilute the shares of the minority shareholders. Robert's complaint alleged self-dealing, breach of fiduciary duty and unjust enrichment, and sought rescission of the bonus shares given to Joseph and John out of treasury.

Joseph and John moved to dismiss the action, arguing that the complaint failed to plead valid causes of action and that all of the claims were precluded by the business judgment rule. They contended that the bonus treasury shares were issued pursuant to proper employment agreements and that in any event the utilization of treasury shares did not dilute the number or value of Robert's shares.

By Decision and Order dated August 11, 2010, the lower court granted defendants' motion, finding that the challenged stock bonus plans "did not dilute the number of shares held by plaintiff, which remain the same both in number and percentage of stock ownership." The lower court also found that, absent a showing of "bad faith" the compensation of corporate officers is "a matter within the purview of the board of directors" immune from judicial scrutiny under the business judgment rule.

Robert's subsequent appeal focused on the nature of treasury shares which are defined in Section 102(14) of New York's Business Corporation Law ("BCL") as:

shares which have been issued, have been subsequently acquired, and are retained uncanceled by the corporation. Treasury shares are issued shares, but not outstanding shares, and are not assets.

Under other express provisions of the BCL, Robert argued, treasury shares carry no entitlement to dividends or voting rights, and do not participate in the surplus of the corporation. Thus, when treasury shares are re-issued to select shareholders and once again carry voting and dividend rights, and the right to participate in the corporate surplus, as a matter of simple math the proportionate interest of the other shareholders becomes diluted. Robert also argued that the business judgment rule does not apply to the self-dealing conduct of the defendant directors in approving stock bonuses for themselves.

In opposition, the defendants argued that the treasury shares did not increase the capitalization or the number of Paraco's outstanding shares, and that the complaint did not offer factual support for its allegations that the stock bonus agreements diluted plaintiff's shares, or that the stock bonus plans lacked a substantial business purpose.

The Appellate Division agreed with Robert and reversed the lower court's order. Its decision notes that the directors of a corporation have a fiduciary duty to treat all shareholders fairly and evenly, including when it comes to issuing stock. The court also referred to the directors as "trustees" for all the shareholders in regard to the issuance of shares, and that as such they are prohibited from increasing their own proportionate interest in breach of their duty, although "'[d]eparture from precisely uniform treatment . . . may be justified . . . where a bona fide business purpose indicates that the best interests of the corporation would be served by such departure'" (quoting Schwartz v. Marien, 37 NY2d 487, 492 [1975]). The court then ruled:

Here, affording the complaint liberal construction, accepting the facts alleged therein as true, and according the plaintiff the benefit of every possible favorable inference, the complaint sufficiently alleged that the Armentano defendants, as directors of the corporation, breached a fiduciary duty owed to the plaintiff, and the other shareholders similarly situated, by issuing to themselves treasury shares without a legitimate business purpose and for the sole reason of diluting the equity interest held by the plaintiff and the other shareholders. Moreover, the complaint sufficiently stated a cause of action to recover damages for unjust enrichment, as it alleged that the Armentano defendants were unjustly enriched by receipt of the treasury shares, at the expense of the corporation and its shareholders, and that it is against equity and good conscience for them to retain the treasury shares. [Citations omitted.]

The Appellate Division also held improper the lower court's reliance on the business judgment rule, which "'does not foreclose inquiry by the courts into the disinterested independence of members of the board of directors of a corporation and cannot shelter individuals from responsibility for breaches of duty of care they owe as directors'" (quoting Ench v Breslin, 241 AD2d 475, 476 [2d Dept. 1997]).

In the realm of corporate finance -- especially for public companies -- the acquisition and re-issuance of treasury shares can serve a valid purpose. Public companies will often repurchase their own shares on the open market to protect against a takeover threat, or to enhance shareholder value when the stock's market price is under-valued, or to create a pool of treasury shares available for use as incentive compensation for employees.

These reasons have little or no application to closely held corporations. In any event, the appellate decision in Paraco puts to rest the notion that no dilution occurs when directors of closely held corporations grant themselves treasury shares. It also reinforces that the business judgment rule does not obviate the directors' heavy burden to demonstrate a legitimate business purpose for departing from their general duty to treat all shareholders equally in relation to the issuance of shares.

Inconsistent Documents and Conflicting Testimony Cloud Stock Ownership Issue in Corporate Dissolution Case

Peter A. Mahler — Mon, 26 Mar 2012 06:00:00 -0500

New York's statutes authorizing judicial dissolution of close corporations require the petitioner to own 50% of the voting shares in deadlock cases and at least 20% in shareholder oppression cases.

I've featured on this blog many cases involving battles over the petitioner's stock ownership and standing to seek dissolution. One judge captured the essence of the problem when he wrote, in Matter of Pappas (Corfian Enterprises, Inc.), that in "the real world, particularly that in which close corporations operate, clear evidence of share ownership is often not found in the corporate books and records, for any number of reasons."

You can say that again. Last week, a panel of the Albany-based Appellate Division, Third Department, in Matter of Sunburst Associates, Inc., 2010 NY Slip Op 02135 (3d Dept Mar. 22, 2012), reversed a trial court's decision that had thrown out a dissolution petition on the ground the petitioner owned no shares in a corporation that operated a small chain of tanning salons. What makes the case particularly interesting is the fact that, on the one hand, the respondent relied on a document signed by the petitioner confirming that the respondent was the sole shareholder and, on the other hand, the petitioner relied on the corporation's subsequent tax returns, some of which were signed by the respondent, identifying the two parties as 50/50 shareholders. These two ingredients were just part of an evidentiary bouillabaisse of contradictory documents and conflicting testimony offered at trial.

Background

The case stems from a petition brought under §1104 of the Business Corporation Law for judicial dissolution of Sunburst Associates, Inc. based on 50/50 shareholder deadlock. The petitioner, Michael Vilardi, and the respondent, Fred Babbino, each as a 50% shareholder, formed Sunburst in 1995 to operate a pair of tanning salons in the greater Albany, New York area. The operations later expanded to five locations. Babbino had principal responsibility for finance and personnel, Vilardi for operations. The two owners received equal compensation.

The trial centered on two key events in 2007. First, in July 2007, the owners signed an agreement whereby Vilardi endorsed his stock certificate over to Babbino in escrow purportedly to secure an unquantified and unidentified indebtedness by Vilardi to Babbino "in relation to corporate activities." A recital in the agreement left a blank space for the dollar amount of the indebtedness; it was never filled in. The agreement provided that delivery of the stock to Babbino "shall not change . . . [Vilardi's] voting rights or status as an officer, director or shareholder of the corporation" and that the corporation shall carry on "as if [the] shares of stock had not been transferred to [Babbino] by [Vilardi]." The agreement contained no terms addressing the duration of the escrow or the conditions for release of the stock from escrow. Vilardi claimed that he had previously endorsed in blank his stock certificate and had left it in the company safe; that he received no consideration from Babbino for transfer of shares; and that not until shortly before trial did he learn that someone had filled in the words, for "value received," on the back of the certificate.

Second, in August 2007, Vilardi and Babbino signed an oddly named "statement of corporate action" stating that Babbino was the sole shareholder, officer and director of Sunburst as of July 30, 2007. The document further stated that it was intended to "confirm to those with whom Sunburst Associates, Inc. does business as to who the corporate officers are, and who has authority to act for and on behalf of [Sunburst]." Babbino signed the document as the sole shareholder, director and officer of Sunburst, and Vilardi signed it to affirm that the statements set forth therein were "true and accurate for Sunburst." Vilardi contended that the statement did not effect a transfer of stock ownership and was only intended for use with Sunburst's lenders to show that Babbino, whose credit history was stronger than Vilardi's, was in control of Sunburst.

At the trial Vilardi placed in evidence unsigned copies of the corporation's tax returns for the years 2007, 2008 and 2009, all of which identified Vilardi and Babbino as 50/50 shareholders. Babbino testified that he "believes" he signed the 2007 returns, that he was unsure if he signed the 2008 returns, and that he did not sign the 2009 returns, although he did admit signing and filing his personal returns for those years inclusive of Sunburst's K-1s reporting his 50% ownership. Babbino contended that the tax returns were not probative of ownership because the tax preparer was "very good friends" with Vilardi and admitted in her testimony that the returns may have been "inaccurate." Babbino also contended that upon discovering the "mistake" he attempted to correct the tax returns but was stymied by the tax preparer.

The parties offered sharply conflicting accounts of their relationship and roles in the company in the period 2007 through 2010 when Vilardi sued for dissolution. Babbino contended that Vilardi was a mere executive employee throughout the period. Vilardi contended there was no change in their respective management duties or shareholder status following the 2007 documents; that he invested $50,000 in the business in each subsequent year; and that he continued to receive the same compensation. Babbino claimed that the $50,000 "investments" were intended to "offset" Vilardi's compensation.

Trial Court's Decision

In September 2010, the trial court held an evidentiary hearing on the issue of whether Vilardi was a 50% shareholder as required for standing under BCL §1104. On November 23, 2010, the trial court issued a one-page Decision and Order dismissing the petition based on a bare recital of "the Court having decided and found that petitioner, Michael Vilardi, owns no stock in Sunburst Associates, Inc., and that respondent, Fred Babbino owns one hundred percent of the stock in said corporation."

The Appellate Decision

Vilardi appealed to the Appellate Division, Third Department. His appeal brief (read here) argued that the July 2007 escrow agreement lacked consideration and was unenforceable; that even if enforceable the escrow agreement did not effectuate an outright transfer of his shares to Babbino; that the endorsement on the back of the stock certificate and the August 2007 "statement of corporate action" could not be considered apart from the escrow agreement and likewise did not effectuate a transfer of his shares to Babbino; and that the parties' subsequent conduct including the 2007-09 tax returns eviscerated Babbino's claim of sole ownership of all of Sunburst's shares.

Babbino's opposing brief (read here) primarily argued that the parol evidence rule precluded any consideration by the court of extrinsic evidence to disprove Vilardi's unrestricted endorsement for "value received" of his stock certificate over to Babbino and Vilardi's unequivocal representation in the August 2007 statement of Babbino's 100% ownership. As to the blank dollar amount in the escrow agreement and the issue of consideration, Babbino pointed to the accountant's testimony that Vilardi at the time was indebted to Babbino for $187,000, and he argued that the omission did not render the documents so ambiguous as to justify circumventing the parol evidence rule. Babbino also argued that the weight of the evidence as a whole justified the trial court's determination that Vilardi held no shares in Sunburst.

And the winner is: neither side! Although it rejected Babbino's reliance on the parol evidence rule, the appellate court found that it could not exercise "intelligent" appellate review due to the trial court's omission of any findings of fact in its bare-bones decision. Here's what the court said:

[U]pon our review of the record, in view of the conflicting testimony and documentation presented by the parties — reflecting two completely divergent explanations of the facts — resolution of the issue of standing depends, in large part, upon credibility determinations. However, in its decision and order, Supreme Court simply indicated that it had "decided and found the essential facts which the [c]ourt deems established by the evidence," without any elaboration whatsoever as to what those facts were, what evidence it found determinative and what, if any, credibility determinations it made (compare Matter of Pickwick Realty, 246 AD2d 863, 865-866 [1998]; Matter of Pappas v Corfian Enters., Ltd., 22 Misc 3d 1113[A] [2009], affd 76 AD3d 679 [2010]). While we recognize that "this Court's authority 'is as broad as that of the trial court' and includes the power to 'render the judgment it finds warranted by the facts, taking into account in a close case the fact that the trial judge had the advantage of seeing the witnesses'" (Matter of Pappas v Corfian Enters., Ltd., 76 AD3d 679, 679 [2010], quoting Northern Westchester Professional Park Assoc. v Town of Bedford, 60 NY2d 492, 499 [1983]), where, as here, we are unable to discern the basis of Supreme Court's determination, intelligent appellate review is foreclosed. We, therefore, reverse the order and remit the matter to Supreme Court to make additional findings, after such further proceedings as it deems appropriate, and to render a new decision and order, accordingly.

Disappointing? Yes. Surprising? No. Unlike a jury verdict, a decision upon a "bench" trial before a judge entitles the losing side to "de novo" review of the trial record by the appellate court. In other words, the appellate court can make its own findings and reach its own conclusions based on its independent review of the trial testimony and exhibits, the one exception being witness credibility determinations "in a close case" where the trial court has the advantage of seeing and hearing the witnesses first hand. But the appellate function remains one of review, and without any findings of fact or credibility assessment by the trial judge, the appellate court is incapable of fulfilling its role.

So now we wait to see what happens next before the trial court. Note that the appellate decision in Sunburst leaves it up to the trial judge whether to conduct any further proceedings before rendering a new decision with the requisite findings. It will be interesting to see if the appellate court's rejection of Babbino's parol evidence argument, which presumably he also raised before the trial court, will have any effect. Whatever the outcome, I'll wager the case makes a return trip to the Appellate Division.

Elimination of LLC Manager's Fiduciary Duties Divides Appellate Panel

Peter A. Mahler — Mon, 19 Mar 2012 06:00:00 -0500

The Delaware limited liability company (LLC) is the preferred entity of choice for many New York-based business ventures for a number of reasons, including greater latitude in restricting or even eliminating the fiduciary duties of the LLC's managers. Delaware case law remains relatively sparse on issues of scope and adequacy of fiduciary disclaimers in LLC agreements. As a result, New York courts have limited guidance when called upon, as they often are, to adjudicate fiduciary breach claims against managers of Delaware LLCs doing business in New York.

Last month, in Kagan v. HMC-New York, Inc., 2012 NY Slip Op 01514 (1st Dept Feb. 28, 2012), a divided Manhattan appellate panel by 3-2 vote affirmed the summary dismissal of fiduciary breach claims brought by the non-managing member of two Delaware LLCs against the managing members. The majority ruled that the fiduciary claims were precluded under Delaware law because (1) they were based on the same facts underlying the plaintiff's contract claims and (2) a provision in the LLC agreement limiting the liability of the managers eliminated default duties even though it did not say so in haec verba.

The two dissenting judges (who joined the majority opinion in other respects) would have sustained the fiduciary claims on the grounds (1) the allegations of financial manipulation by the managers were sufficiently outside the contract claim to make out a viable claim for breach of fiduciary duty and (2) the disclaimer language used in the LLC agreement did not explicitly eliminate the traditional fiduciary duties otherwise applicable by default.

Let's take a closer look at Kagan, particularly its discussion of the fiduciary disclaimer.

Background

The plaintiff, Howard Kagan, is an investment professional in the money management industry. The defendants, which include two investment funds (the Onshore Fund and the Offshore Fund), are part of a group of entities and individuals associated with a New York-based private investment firm known as Harbinger Capital. The subject Funds are managed by two management companies organized as Delaware LLCs (the Onshore Manager and the Offshore Manager).

Kagan provided consulting services starting in early 2003 and, in 2006, became a member of the Onshore and Offshore Managers. Under the LLC agreements, his membership interest entitled him to receive a portion of the manager entities' performance compensation which rose and fell on the performance of the Onshore Fund.

In August 2008, the managing members involuntarily terminated Kagan's relationship with the Harbinger entities. Kagan sued in 2009, claiming that he was owed over $62 million for performance-based compensation in 2007 and 2008. His complaint asserted claims, among others, for breach of contract and the implied covenant of good faith and fair dealing, and for breach of fiduciary duty against the managing members of the manager entities and their controlling persons. The fiduciary claims alleged that the managers purposely failed to pay Kagan amounts they acknowledged to be owed; conditioned payment on Kagan's signing a release and waiver of certain rights; asserted the right to pay Kagan in part with worthless securities; failed to properly calculate amounts owed; and failed to ensure that sufficient assets would be available to pay Kagan. (Click here to read a copy of the complaint.)

The defendants moved to dismiss the breach of contract claims as against the member managers, and to dismiss the remainder of the complaint in its entirety. In part they relied on the following two provisions in the LLC agreements concerning manager duties and exculpation:

§ 7.9 Duties of Managers. The Managers shall act in good faith and in the best interest of the Company and with such care as an ordinarily prudent person in a like position would use under similar circumstances.

§ 7.10 Limitation of Liability. No Manager or Officer shall have any liability to the Company or any Member or Holder for any loss suffered by the Company or any Member or Holder that arises out of any act or omission by the Manager or Officer, if such Manager or Officer performs its duty in compliance with the standard set forth in the immediately preceding sentence, except loss or damage resulting from intentional misconduct, knowing violation of law, gross negligence or a transaction from which the Manager or Officer received a personal benefit in violation or breach of the provisions of this Agreement. . . .

(Click here to read a copy of the complete LLC agreement.)

The lower court, in a decision dated May 28, 2010, dismissed all of Kagan's claims except those for breach of the LLC agreements. As to the fiduciary breach claims, the lower court based dismissal not on the exculpatory language in § 7.10, but solely on the ground that the allegations of fiduciary breach mirrored the contract breach claims.

Both sides appealed to the Appellate Division, First Department, which handed down its decision late last month. The five judges on the panel unanimously agreed that the lower court erred by not dismissing the contract claims against the member managers, including the claim for breach of implied duty of good faith and fair dealing, under the exculpatory provision in § 7.10. The panel also unanimously affirmed the dismissal of the remaining claims with the exception of those for fiduciary breach as to which three judges voted for dismissal and two voted against.

Justice Catterson's Majority Opinion

The majority opinion, authored by Associate Justice James M. Catterson and joined by Associate Justices David B. Saxe and Sallie Manzanet-Daniels, concludes that the lower court properly dismissed the fiduciary breach claims under Delaware case law holding that when "the same facts that underlie [a plaintiff's] contract claim also form the basis of plaintiff's fiduciary claim, the fiduciary claim is precluded" (citing Gale v. Bershad, 1998 WL 118022, 1998 Del Ch LEXIS 37 (Del. Ch. 1998), and other cases). Since the defendant managers' obligation "to properly calculate and distribute monies owed to the plaintiff arises out of the LLC agreements," Justice Catterson writes, the plaintiff's fiduciary claims "are substantially identical to the breach of contract claims [and] were properly dismissed."

The majority opinion next addresses the dissent's view that Delaware law requires "explicit elimination or restriction of fiduciary duties otherwise such duties apply by default . . ." (italics in original). Justice Catterson offers that the dissent's view is based on the mistaken "belief that 'explicit' requires such elimination or restriction to be written into an agreement in haec verba." The provision for manager's duties set forth in § 7.9 ("The Managers shall act in good faith and in the best interest of the Company"), Justice Catterson reasons,

imposes only specific limited contractual obligations on the managers, thus eliminating the traditional fiduciary duties imposed under Delaware law; expressio unius est exclusio alterius [the expression of one thing is the exclusion of another].

Justice Catterson also finds misplaced the dissent's reliance on Kelly v. Blum, 2010 WL 629850, 2010 Del Ch LEXIS 37 (Del. Ch. 2010), in which then Vice Chancellor (now Chancellor) Leo Strine ruled that similar provisions in an LLC agreement did not explicitly disclaim the applicability of default principles of fiduciary duty. The distinction, according to the majority opinion, is that the LLC agreement's provision in Kelly analogous to § 7.10 in Kagan referred to liability arising out of a "willful breach of [the Manager's] contractual or fiduciary duties" (emphasis added), thereby warranting the court's finding in Kelly that the parties intended traditional fiduciary duties to apply. In Kagan, writes Justice Catterson, "[n]o such reference to the fiduciary duties of managers appears in the applicable section 7.10 in this case. On the contrary, it is explicitly omitted."

Justice Moskowitz's Dissenting Opinion

The dissenting opinion, authored by Associate Justice Karla Moskowitz and joined by Associate Justice Peter Tom, begins its analysis by noting that § 18-1101(e) of the Delaware LLC Act expressly authorizes provision in the LLC agreement "for the limitation or elimination of any and all liabilities for breach of contract and breach of duties (including fiduciary duties)." It next notes defendants' argument that § 7.9 of the LLC agreement in Kagan "replaces the managers' fiduciary duty that would exist under common law with a contractual one" and that, accordingly, "plaintiff cannot assert a cause of action for breach of fiduciary duty whatsoever."

Citing Kelly v. Blum, Justice Moskowitz concludes that "Delaware law does not support defendants' interpretation" because, as in Kelly, "no clause in the LLC agreements explicitly restricts or eliminates the fiduciary duties that exist at common law." Justice Moskowitz explains further:

The parties do not dispute that member managers would traditionally owe fiduciary duties to non-managing members. Thus, as the LLC agreements do not explicitly eliminate these traditional fiduciary duties, they remain to the extent they do not duplicate a claim for breach of contract or fall within the terms of an exculpatory clause.

Justice Moskowitz then goes on to find that, although there is "some overlap" between Kagan's contract claims and fiduciary claims, his allegations

that the member managers breached their fiduciary duty by failing to ensure sufficient assets were available to pay plaintiff and by transferring assets to other members of the manager entities that they should have used to pay plaintiff are sufficiently outside the contract to sustain a claim for breach of fiduciary duty. . . . At this early pleading stage, considering the nature of the allegations, it would be inappropriate to dismiss this claim as duplicative of claims for breach of contract.

Justice Moskowitz concludes her analysis of the point by finding that Kagan's allegations of deliberate self-dealing by the member managers fall within the "intentional misconduct" exception to the exculpatory provision in § 7.10 of the LLC agreement.

What's a Drafter to Do?

It's too early to say whether Kagan will at some point be presented or accepted for review by New York's highest appellate tribunal, the Court of Appeals. Such review certainly would provide welcome guidance for transactional and litigation attorneys tasked with advising clients, who already have formed or seek to form Delaware LLCs based in New York, on important issues surrounding the fiduciary obligations of the LLC managers. (Even better would be a procedure for certification of questions of Delaware law to the Delaware Chancery or Supreme Court, akin to the process that allows the federal circuit courts to certify questions of law to the state supreme courts, but that's just wishful thinking on my part.)

So what's a drafter to do in the meantime? The cautious approach for the drafter who seeks to eliminate the traditional fiduciary duties is to use a strong form of broad, unequivocal disclaimer such as the one enforced by former Chancellor Chandler in Fisk Ventures, LLC v. Segal, 2008 WL 1961156 (Del. Ch. 2008), where the LLC agreement stated that "no member shall have any duty to any Member of the Company except as expressly set forth herein or in other written agreement." In his recent opinion in Auriga Capital Corp. v. Gatz Properties, LLC, C.A. 4390-CS (Del. Ch. Jan. 27, 2012) (read here my article on Auriga), Chancellor Strine commented consistent with Fisk that a "general provision stating that the only duties owed by the manager to the LLC and its investors are set forth in the Agreement itself" will "displace the traditional fiduciary duties of loyalty and care owed to the Company and its members . . .." Such general language also ought to satisfy the principle espoused by Chancellor Strine in footnote 70 of his Kelly opinion, that

drafters of and parties to an LLC agreement should be expected to provide parties and anyone interpreting the agreement with clear and unambiguous provisions when they desire to expand, restrict, or eliminate the operation of traditional fiduciary duties.

How about what not to do? Look no further than Chancellor Strine's 2009 decision in Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. 2009), where the LLC agreement contained "two separate and seemingly contradictory provisions," one of which stated that "members shall have the same duties and obligations to each other that members of a limited liability company formed under the Delaware Act have to each other" while the other stated that "[e]xcept for any duties imposed by this Agreement . . . each Member shall owe no duty of any kind towards the Company or the other Members in performing its duties and exercising its rights hereunder or otherwise." Chancellor Strine proceeded to construe the latter provision narrowly, as eliminating only those duties "that are not traditional fiduciary duties or are otherwise not expressly contemplated in the LLC Agreement."

The Judicial Perspective on Business Divorce Litigation: Interview with Hon. Ira B. Warshawsky

Peter A. Mahler — Mon, 12 Mar 2012 06:00:00 -0500

Few attorneys can boast a career spanning over four decades dedicated to public service like that of the Honorable Ira B. Warshawsky. Legal Aid attorney. Assistant District Attorney. Law secretary. Judge of the Nassau County District Court. Justice of the Nassau County Supreme Court. His list of extracurricular accomplishments is no less impressive, including former Director of the Nassau County Bar Association; former Dean of the Nassau Academy of Law; frequent lecturer for the National Institute of Trial Advocacy; contributing editor of the Benchbook for New York Trial Judges; past-President and charter member of the American College of Business Court Judges; and member of the Advisory Board of the Sedona Conference.

Justice Warshawsky, who retired from the bench last December, presided over countless cases during his 25 years as a judge, including the last ten years as one of three judges of the Nassau County Commercial Division where he adjudicated important commercial law disputes. The New York Official Reports website includes almost 350 of his written decisions since 2003.

Regular readers of this blog recognize Justice Warshawsky's name as author of many interesting, lively decisions concerning business partnership breakups. By my count, over the last four years I've posted 27 articles about business divorce cases decided by Justice Warshawsky. That's over 10% of the cases I've covered!

Last month, Justice Warshawsky became Of Counsel to Meyer, Suozzi, English & Klein, P.C. as a member of its Litigation & Dispute Resolution law practice located in Garden City. I asked Justice Warshawsky if he would share with my readers some of his experience handling business divorce litigation, and after he graciously agreed we spent some time talking about various dissolution and valuation issues. I hope you enjoy as much as I did the transcribed interview that follows.

Mahler: Over the years I’ve noticed a disproportionately large number of judicial decisions in business divorce cases by the Commercial Division judges in Nassau County. Is there something in Nassau County’s water that makes business partners dislike each other?

Warshawsky: I’d say two factors are at work, and neither one is the water which happens to be quite good. The first is, Long Island is a heavily populated bedroom community with loads of small businesses started by families, close friends and neighbors. They open up a shop or service business of some sort, maybe one partner contributes cash, another contributes sweat equity, and over time for one reason or another their interests diverge. Or maybe one feels he or she does more work and should get more of the profits. So they find themselves at odds, with no written agreement that deals with the situation or provides an exit, so they end up in court. The second factor is, unlike the judges in Manhattan and other urban courthouses, the Nassau County judges don’t issue so-called “gray sheet” orders, which are often one-page handwritten, unpublished decisions on motions -- which I have nothing against and perhaps I should have used myself -- and they rarely or infrequently dictate decisions on the record. In the great majority of cases the Nassau judges issue written, reasoned decisions which I gather tend to get picked up for publication or are otherwise available on the court’s website.

Mahler: Did you find that shareholder disputes demand more of the court’s time and attention than other categories of cases?

Warshawsky: Absolutely. It’s called “business divorce” for a reason. I had a matrimonial caseload for two years, the parties and attorneys were constantly battling over highly emotional issues requiring frequent judicial intervention. You see the same phenomenon in shareholder disputes, and even more so with family-owned businesses where you have father versus son or brother versus sister. Generally I was willing to take conference calls to resolve urgent situations—not all judges do that—and I enjoyed being able to calm the waters, but it can’t be done in every case because you’d be on the phone all day every day.

Mahler: Many lawyers believe that most litigation over corporate dissolution is tactical, in the sense that if it’s a viable business, in the end there won’t be a dissolution because someone is going to buy out someone else. Do you share that view and how if at all did it influence your handling of these cases as a judge?

Warshawsky:There’s some truth to that. As a judge it’s frustrating to see tactical litigation designed only to bring about a buy-out. Sometimes I would urge a buy-out even when the respondent shareholder didn’t exercise the statutory buy-out election. I would tell both sides, “Everyone loses if I dissolve the business.” Romper Nursery is a good example of a dissolution case brought solely to force a buy-out between two owners who, despite the fact that they literally had not spoken to one another for 13 years, had a very profitable business, a proverbial goose laying golden eggs. When the petitioner, who had brought one dissolution petition, withdrew it, then started a second dissolution proceeding, asked me to let her discontinue the second case without prejudice to her bringing yet a third one, I drew the line and told her, either go to trial in this case or withdraw it with prejudice, meaning she couldn’t come back a third time.

Mahler: What happened?

Warshawsky: Not surprisingly, they settled fairly soon after the decision.

Mahler: Do you believe that judges ought to talk about a buy-out at the earliest stages of the case, even if the parties aren’t?

Warshawsky:It depends. If I had a case where the business owners were not getting along and clearly could not remain in business together, I would say, one of you should think about buying out the other and I would ask, have you had an appraisal done? To the petitioner, I might say, from what I see in your petition, you contend you’re not being treated fairly, but you may have to go through a lengthy period of discovery, motion practice and a hearing, at the end of which I may deny dissolution and you and your partner will be stuck with one another. To the respondent who hasn’t elected to purchase the petitioner’s shares, I might say, you’re also taking a big risk if in the end I decide that the petitioner’s allegations of unfair treatment are substantiated. To both of them, I’d say, be careful what you wish for, because everyone loses whether I order the dissolution of a viable, going concern or I deny dissolution and leave two, miserable partners in business together. A fair buy-out, or a division of the business assets if that’s possible, is the logical solution in the vast majority of these cases.

Mahler: The Commercial Division rules permit judges to order the parties to participate in mediation. Did you find that useful in dissolution cases?

Warshawsky: Often the attorneys, who know better the value of mediation, are hamstrung from asking for mediation by their clients who for emotional reasons are more interested in swinging a litigation club. So the rule worked quite well, because I could tell the attorneys to blame me for ordering mediation.

Mahler: How in general do you see the role of alternative dispute resolution in business divorce cases?

Warshawsky: It’s becoming more and more essential, for very practical reasons having to do with the growing strain on judicial resources. Case volume continues to increase in the courts and in the Commercial Division in particular, all the while court budgets and support staff are decreasing. Mediation or arbitration must be given serious consideration as an alternative to slipping under the rising tide of cases in the courts, which tide is not going out.

Mahler: LLCs started in New York in 1994. In the last 10 years or so I’ve seen a big shift in my own case work away from close corporations to LLCs. I assume from the bench you saw the same phenomenon. In general did you find LLC cases any more or less difficult to resolve than corporate dissolutions?

Warshawsky: Generally I did not treat LLC cases any differently, unless someone made a motion that forced me to focus on the differences in the LLC Law and the Business Corporation Law as concerns dissolution. I never saw it mattered to the business owners, in the way they conducted themselves with one another, whether they had a corporation or an LLC, and I can’t say that I viewed the two as different in any meaningful way, or that the LLC cases were any more or less difficult to resolve.

Mahler: The Second Department’s 2010 decision in the 1545 Ocean Avenue case was a watershed in terms of differentiating the standards for dissolution under the LLC Law and the Business Corporation Law. Do you feel that the contract-focused approach for LLC dissolution taken in 1545 Ocean has had an impact?

Warshawsky: I think so, though I can’t think of a case I had after 1545 Ocean in which the result would have been different had it preceded 1545 Ocean. One case that comes to mind is Mehraban v. McIntosh, in which I wrote a decision granting dissolution of an LLC based on the standard defined in 1545 Ocean. I did rely on the parties’ agreement, which I would have looked at anyway, in deciding that the business was no longer financially feasible given its stated purpose. But I do think that the more refined standard for LLC dissolution set out in 1545 Ocean was long overdue given the lack of any real guidance in the dissolution statute itself.

Mahler: You certainly made a mark in valuation contests involving close corporations and LLCs. Here I’m thinking of cases like Murphy, Jamaica Acquisition and Sassower. Many judges stay away from the topic and routinely refer valuation matters to court referees. What is it about valuation of interests in close business entities that interested you?

Warshawsky: I was a math major in college for two years, which probably is why I enjoyed learning the nuances of valuation. Judges can’t be expected to come to the job knowing the ins and outs of business valuation, but we’re very willing to learn and, the better the attorneys in teaching us about valuation issues, the better the judges will become in understanding what by any measure is a difficult and complex subject. I also found it challenging to cut through the masses of figures and studies being thrown at me by the experts, some of which defied logic in terms of the company being valued. If the data and other support offered by the expert could not logically be connected to the company-specific facts, it had little weight in my determination of value.

Mahler: What kinds of problems have you encountered with valuation experts?

Warshawsky: The court relies heavily on valuation experts. None of us has the personal expertise to put ourselves in their place. But it’s highly questionable when you see during discovery or at trial the appraiser changing his or her opinion based on what the attorney wants rather than based on logic and the actual knowledge of the expert. Also, an expert should not intentionally or unintentionally confuse the court with obscure appraisal terminology. At times I’ve had to ask the expert what they’re talking about, not only to clarify the record for appellate purposes, but because I simply did not understand what they’re talking about. If the appraiser uses technical terms, they have to be defined or, better yet, provide the court with a list of defined terms used in the testimony.

Mahler: Was it your practice to permit pre-trial depositions of valuation experts?

Warshawsky: When parties agreed to expert depositions, I did not stand in the way. In fact, last year the Nassau County Bar Association spearheaded a pilot program, which was approved by the statewide Office of Court Administration, authorizing expert depositions when both sides consent. But when there’s no agreement, unlike in federal practice the CPLR [Civil Practice Law and Rules] does not authorize expert depositions, although when a party submitted an untimely expert report on the eve of trial, I could order a deposition as a condition of allowing it in. The general unavailability of expert depositions in valuation contests is, I think, unfortunate both in terms of trial preparation and also for settlement purposes because depositions of the appraisal experts are very effective tools for gauging the strengths and weaknesses of the parties’ positions.

Mahler: In the Jamaica Acquisition and Murphy cases you ruled that the discount for lack of marketability is not limited to the corporation’s good will. At least on the surface, your rulings appeared to buck Second Department precedent starting with the Whalen and Cinque cases which seemed to take a categorical position that the discount applies to good will only. The Second Department then affirmed your ruling on appeal in Murphy, without really acknowledging that it was taking a new position. At the time of your decisions did you feel you were bucking the Second Department?

Warshawsky: Not at all. I carefully read the Second Department decisions, none of which affirmatively said that the marketability discount can only be applied to good will, and none of which offered any reasons for applying or not applying the discount only to good will. I believe in logic in the law. I didn’t think it logical to apply the discount only to good will. It didn’t make sense to me, the Second Department never said it made sense, and the Second Department I’m pleased to say agreed with me in Murphy.

Mahler: In those two cases you also tackled the discount for built-in capital gains or "BIG" which had almost no precedent in New York fair value case law. The Second Department’s Murphy decision also upheld your decision to apply a BIG discount based on the present value of future gains assuming a certain holding period, as opposed to the 100%, dollar-for-dollar discount allowed in fair market value appraisals in the federal gift and estate tax cases. What influenced your approach?

Warshawsky: That’s simple: the relevant facts. I took into account the facts in the record indicating what the company’s post-valuation date plans were, that were known as of the valuation date, for disposing or not disposing of the company’s appreciated assets. I think that’s what the governing statutes required me to do. Besides, the federal case law such as Jelke, mandating a 100% BIG discount, made no sense in the context of a fair value proceeding when the evidence told me that the assets were not going to be sold any time soon. By the way, I understand there's a pending motion in Murphy before the Court of Appeals, presumably for leave to appeal, so the case may not be over.

Mahler: How’s the transition been from the bench to private practice?

Warshawsky: It’s very different but I’m liking it very much. I have not had a chance to be bored. There’s a world out there for a retired judge to be useful to the court system and the business community.

Mahler: What kind of work do you look forward to doing at your new firm?

Warshawsky: I’m involved in commercial litigation and alternative dispute resolution as an advocate on behalf of clients. I also plan to serve in a neutral capacity as arbitrator, mediator, private judge or referee. I also foresee taking on assignments as special master in complex discovery disputes, especially those involving e-discovery where I had a great deal of experience on the bench.

Mahler: Judge, it's been a pleasure speaking with you. Thanks so much for taking the time to share your views on business divorce litigation, a subject that will bear your imprint for a long time to come.

Update April 3, 2012: By order dated March 29, 2012, the NY Court of Appeals denied further review of the Murphy v. U.S. Dredging decision.

The Importance of Defining Capital Contributions in the LLC Agreement

Peter A. Mahler — Mon, 05 Mar 2012 06:00:00 -0500

I don't know Mr. Duff or Mr. Curto. I do know they went into business together to develop real estate and formed a limited liability company for that purpose. I imagine Mr. Duff and Mr. Curto were friends, neighbors or business associates when they decided to start their relatively modest venture. I imagine their prior social or business relationship fostered a sense of mutual trust, confidence and enthusiasm for the project, along with a casual attitude toward documenting the economic and management rights and obligations owed one another. I imagine they found online or otherwise obtained and signed a one-size-fits-all form of LLC operating agreement without consulting an attorney, before they made provision for financing their business plan.

I do know that Mr. Duff sued Mr. Curto after the business venture failed, alleging that Mr. Curto did not put in his pro rata share of capital contributions. I do know that Mr. Duff lost his suit because he and Mr. Curto left blank the space in the operating agreement where they were supposed to fill in their required capital contributions, and because the agreement did not otherwise address disparate member financing. I do know that this kind of costly oversight happens all too frequently with new business partners who fail to appreciate the insurance value of seeking out competent legal advice to assist them in crafting a partnership agreement that adequately addresses the partners' financial responsibilities.

Duff v.Curto, 2012 NY Slip Op 30264(U) (Sup Ct Suffolk County Jan. 25, 2012), decided earlier this year by Suffolk County Commercial Division Justice Emily Pines, results from a perfect-storm confluence of poor legal planning and the real estate market downturn. At the top of the market in 2006, Duff and Curto as 50/50 owners formed Fairlea Court Holdings, LLC to acquire land in North Haven, New York for construction of a single-family home. When the improved property was sold in the down market in 2009, the sale proceeds were insufficient to cover the mortgage, construction loan and expenses.

In his lawsuit, Duff contended that he made a $300,000 capital contribution when the LLC was formed, another $173,000 during the project, and another $50,000 to cover the shortfall upon the property's sale. Duff claimed that the LLC's operating agreement required each member to provide 50% of the capital contributions to fund the land acquisition and construction. Duff alleged that Curto made no capital contributions, and that Curto therefore was liable for breach of contract, unjust enrichment and other claims.

Section 3.1 of the operating agreement, captioned "Initial Contributions," provided that "[u]pon the execution of this Agreement, each Member shall contribute cash and/or property to the Company as set forth opposite their names in Exhibit A". Based on the description in the court's decision, here's a reasonable facsimile of what Exhibit A looked like:

**Exhibit A**
Member	Initial Cash Contribution	Description of Property Contributed and Adjusted Basis (AB), Liability Subject to (LS) and Agreed Value (AG) of Property	Percentage
Gary Duff			50%
Peter Curto			50%

Notwithstanding that the columns for cash and property contributions were left blank, Duff argued the Section 3.1 required matching capital contributions by Curto who, Duff further alleged, gave Duff "assurance" upon which he relied that Curto would equalize the contributions. Duff alternatively argued that the operating agreement's provision for capital contributions was ambiguous and that a question of fact existed regarding its construction.

Curto contended that he was entitled to summary judgment dismissing the complaint. Curto argued that he had no obligation to make any capital contribution because Exhibit A did not list any capital to be contributed by either member. Curto alleged that the funding provided by Duff was in the form of loans, not capital contributions, as demonstrated by the LLC's 2007 and 2008 tax returns listing a loan payable to Duff of approximately $309,000.

Justice Pines agreed with Duff that the operating agreement is ambiguous as to whether initial capital contributions were required by both Duff and Curto. "The first sentence of section 3.1 of the Operating Agreement," Justice Pines wrote, "appears, on its face, to mandate initial capital contributions by each Member" but "Exhibit A does not set forth the amount of any such initial contribution." The court therefore "may consider extrinsic evidence of the parties' intent." The tax returns showing loans and Duff's deposition testimony, in which he admitted that he reported a recourse loan to the LLC on its tax return, "demonstrate as a matter of law that Duff loaned the funds to [the LLC]."

Based on this finding, Justice Pines granted Curto's summary judgment motion and dismissed all of Duff's claims with the exception of a claim for conversion which was not part of Curto's dismissal motion.

As I've previously written (here and here), §502 of the LLC Law authorizes provision in the operating agreement for compulsory capital contributions. Business partners forming an LLC must carefully consider the immediate and future capital needs of the venture, and they must include in the operating agreement a provision that meets those needs. The provision also should spell out the consequences when a member fails to contribute his or her share, such as dilution or even forfeiture of membership interest. Provision also can be made for member loans to the LLC in lieu of capital contributions. Under no circumstances, however, should the parties sign an operating agreement such as the one in Duff with missing entries for the capital contributions.

A Question of Procedure: Are Merits-Based Pre-Answer Dismissal Motions Allowed in Dissolution Proceedings?

Peter A. Mahler — Mon, 27 Feb 2012 06:00:00 -0500

The New York Supreme Court's Commercial Division, which hears the bulk of corporate dissolution cases, operates in 11 counties across the state including Suffolk County on eastern Long Island. The pictured courthouse in Riverhead, New York, is home to the newest member of the Suffolk County Commercial Division, Justice Thomas F. Whelan, who last month handed down a thoughtful decision on an arcane but important procedural question: Can the respondent in a corporate dissolution proceeding move for dismissal in lieu of answering based on factual assertions contesting the merits of the petition?

In other words, can the respondent essentially move for a summary judgment of dismissal based on undisputed facts, prior to answering the petition? Or is the respondent limited at the pre-answer stage to a dismissal motion based on the facial inadequacy of the petition's allegations assuming them to be true, or on other non-merits grounds such as statute of limitations, lack of standing, lack of personal jurisdiction, etc.?

Justice Whelan's decision in Matter of Langella (Front Door Associates, Inc.), 34 Misc. 3d 1212(A), 2012 NY Slip Op 50058(U) (Sup Ct Suffolk County Jan. 13, 2012), involves a petition brought under §1104-a of the Business Corporation Law (BCL) for judicial dissolution of two closely-held corporations based on the controlling shareholder's allegedly oppressive conduct. The petitioner claimed to own 22% of Corporation #1 and 50% of Corporation #2. In lieu of answering the petition, the respondent corporations moved to dismiss the petition on the grounds that petitioner lacked standing to seek dissolution of Corporation #1 because he owned less than the requisite 20% voting interest, and based on the purported lack of merit of petitioner's claims of oppressive conduct with respect to Corporation #2.

Corporation #2: Dismissal Based on Lack of Merit

Justice Whelan's decision tackles the latter ground first. He notes that the procedural aspects of a special proceeding for judicial dissolution under BCL Article 11 are governed by the provisions of Article 4 of the Civil Practice Law and Rules (CPLR) "except to the extent that BCL Article 11 or some other applicable statute provides otherwise." CPLR §404, he goes on, requires that a legal defense to claims in a special proceeding must be raised in an answer as an "objection in point of law" -- a term the statute does not define -- or in a pre-answer motion to dismiss. Justice Whelan then cites a number of decisions in special proceedings of various sorts for the proposition that objections in point of law

should not involve a contest on the merits of the targeted claims, but instead, should be limited to the assertion of one or more of defenses in bar of the type contemplated by CPLR 3211(a). Accordingly, motions to dismiss special proceedings interposed pursuant to CPLR 404 . . . should be predicated upon defenses in bar, such as failure to state a claim, lack of standing or capacity to sue, statute of limitations, accord and satisfaction, res judicata and the others contemplated by CPLR 3211(a). [Citations omitted.]

Applying this rule, Justice Whelan concludes that the arguments made by the respondents in support of the dismissal motion regarding Corporation #2 must be denied because they

are not predicated upon objections in points of law within the contemplation of CPLR 404 and 3211(a). Instead, the respondents challenge the merits of the [petitioner's] claims for such relief by disputing the factual assertions set forth in the petition regarding the allegedly wrongful conduct which form the basis for the petitioner's demands for dissolution of [Corporation #2] under BCL 1104-a. Since such challenges are beyond the scope of this pre-answer application, the respondents' cross motion for dismissal of the petitioner's demands for dissolution of [Corporation #2] is denied. To the extent that the respondents' challenges may be read as being predicated upon legal insufficiency, they are rejected as unmeritorious.

Justice Whelan's discussion highlights the interplay between CPLR Article 4's rules generally applicable to all special proceedings, and the specific requirements in BCL Article 11 governing dissolution proceedings. BCL §1109 provides that, "[a]t the time and place specified in the order to show cause, or at any other time and place to which the hearing is adjourned, the court or the referee shall hear the allegations and proofs of the parties and determine the facts." The "hearing" specified in the order to show cause that initiates the dissolution proceeding (see BCL §1106) does not necessarily contemplate an evidentiary hearing.

A number of appellate court decisions, such as Matter of Williamson, 259 AD2d 362 (1st Dept 1999), Matter of HGK Asset Management, Inc., 228 AD2d 246 (1st Dept 1996), and Matter of Goodman, 200 AD2d 670 (2d Dept 1994), authorize the trial court to grant dissolution without an evidentiary hearing in cases where, whether by motion to dismiss or by answer, the respondent fails to raise material issues of fact in response to the petition's allegations of oppressive conduct or deadlock. These decisions effectively confer upon the trial court the same authority to make summary determinations upon the return date of the initial show cause order as exists under CPLR §3212 governing post-answer summary judgment motions generally. Such authority also is granted explicitly by CPLR §409(b) stating that the court "shall make a summary determination upon the pleadings, papers and admissions to the extent that no triable issues of fact are raised" and "may make any orders permitted on a motion for summary judgment."

Corporation #1: Dismissal Based on Lack of Standing

Justice Whelan finds no similar procedural bar to the respondents' motion to dismiss the petition as to Corporation #1, finding that the argument based on petitioner's alleged ownership of less than 20% of the corporation's shares, is a "quintessential defense in bar, namely, that the petitioner lacks 'standing' to prosecute his claims in this dissolution proceeding." In the discussion that follows, Justice Whelan helpfully cites numerous case authorities concerning the burden of proof to establish standing -- it rests on the petitioner; the necessity for a hearing to "aid the court's determination of the threshold ownership issue in those cases where the record is replete with factual issues"; and cases in "other special proceeding contexts, such as Article 78 proceedings," in which courts have denied pre-answer dismissal motions where issues of fact exist "without prejudice to the assertion of appropriate affirmative defenses in an answer, thereby leaving threshold issues presented on the pre-answer motion to the court's ultimate determination of the proceeding."

Based on the unresolved issues of fact surrounding the Langella petitioner's stock ownership, largely concerning his compliance or non-compliance with a shareholders' agreement that contemplated the issuance to him of additional shares upon satisfaction of certain conditions, Justice Whelan ultimately denies without prejudice the respondents' motion to dismiss the petition as to Corporation #1. "[I]n light of the procedural posture of this proceeding," he adds, "determination of the threshold issue of the petitioner's ownership should be made as part of the court's ultimate determination of the petition, as the same includes the petitioner's separate dissolution claims with respect to [Corporation #2]."

The Takeaway. As I've said before, if you're a petitioner in a dissolution proceeding you need to load up your petition (or supplemental affidavits) with as many facts as are available in support of your claims; bare "notice" pleading will not suffice. My advice to respondents wishing to oppose dissolution essentially is the same: whether you file an answer or a motion to dismiss, don't hold back, put in everything you've got by way of factual affidavits with as much documentary support as possible.

Family Feud Highlights Hurdles to Derivative Actions Against Close Corporation Directors

Peter A. Mahler — Tue, 21 Feb 2012 06:00:00 -0500

From time to time I read about or am involved in a business divorce case that shows all the signs of an irreparable breach between opposing 50/50 shareholder factions but, for any number of reasons including buy-out leverage, is brought as a plenary action asserting claims for diversion of assets or other financial abuse rather than as a corporate dissolution proceeding.

The claims in such a plenary action usually allege injury to the corporation and thus, under New York's Business Corporation Law (BCL), must be brought as derivative claims seeking recovery on the corporation's behalf. There are several BCL provisions with special requirements that come into play when suing derivatively.

A decision earlier this month by Suffolk County Commercial Division Justice Elizabeth H. Emerson (pictured) in Gillette v. Sembler, 2012 NY Slip Op 50188(U) (Sup Ct Suffolk County Feb. 3, 2012), highlights some of the hurdles to be overcome at the pleading stage in such a case. Gillette also features a particularly interesting discussion of the demand requirement for derivative claims arising from an unusual alignment of parties and board control.

Gillette involves a family-owned business called South Shore Dredging Co. ("Dredging") that owns a five-acre parcel of waterfront property on Long Island used as a boatyard and marina. Dredging is owned in equal 25% shares by four siblings whom I'll refer to as S1 through S4. The suit was brought by S1 and S2 against S3, S3's wife, and a company separately owned by S3 called South Shore Boat Yard, Inc. ("Boat Yard"). S4 was not made a party to the suit.

S1 and S2 alleged that S3 misappropriated Dredging's assets and corporate opportunities for the benefit of Boat Yard; that Boat Yard was using Dredging's real property without paying fair rental value; that S3 had collected for himself rents from tenants of Dredging's property; that S3 was paying himself and his wife compensation from Dredging that was not authorized by the board of directors; and that S3 had denied S1 and S2 access to Dredging's books and records.

As became significant to the court's decision, the parties disagreed over the composition of Dredging's board of directors. S1 and S2 alleged that all four siblings, including non-party S4, were officers and directors. S1 and S2 also alleged that S3 was "in the process" of buying S4's shares. S3 alleged that the board had only three members consisting of himself, S1 and S2. S3 denied that he purchased S4's shares and asserted that the corporate records continue to show S4 as a 25% shareholder.

The complaint asserted shareholder derivative claims under BCL §§626, 719 and 720. Section 626 does not establish liability for officer or director misconduct. Rather, it sets forth stock ownership and pre-suit demand requirements for derivative lawsuits, and it also contains provisions governing settlement of derivative lawsuits and recovery of attorney's fees. Section 719 imposes joint and several liability on directors who vote for or concur in certain enumerated actions such as making shareholder distributions when the corporation is insolvent or post-dissolution without adequately providing for creditor liabilities. Section 720 authorizes an action against corporate directors and officers for a broader array of misconduct, including:

to compel an accounting for "neglect of, or failure to perform, or other violation of his duties in the management and disposition of corporate assets committed to his charge" and for the "acquisition by himself, transfer to others, loss or waste of corporate assets due to any neglect of, or failure to perform, or other violation of his duties";
to set aside "an unlawful conveyance, assignment or transfer of corporate assets, where the transferee knew of its unlawfulness"; and
to enjoin a "proposed unlawful conveyance, assignment or transfer of corporate assets, where there is sufficient evidence that it will be made."

S3 and the other defendants moved to dismiss the complaint based on the plaintiffs' failure to make pre-suit demand upon Dredging's board of directors as required by BCL §626(c). The pre-suit demand requirement stems from the principle acknowledged by New York's highest court in Auerbach v. Bennett, 47 NY2d 619, 631 (1979), that "[d]erivative claims against corporate directors belong to the corporation itself."

Justice Emerson's decision contains a useful summary of New York law concerning the demand requirement including the three circumstances under which demand will be excused as futile, as outlined by the New York Court of Appeals in Marx v. Akers, 88 NY2d 189 (1996). S1 and S2 contended that S3 was an "interested director" thereby rendering demand futile but, as Justice Emerson points out, S3 "is only one director and does not constitute a majority of the board of directors." Justice Emerson also notes that, assuming a three-member board, and further assuming S3 boycotted the directors meeting, attendance at the meeting by S1 and S2 would constitute a quorum enabling them to approve commencement of a lawsuit by the corporation against S3.

S1 and S2 argued (apparently accepting for argument's sake S3's assertion of a three-member board) that a demand is not required since they represent a majority of the board, citing the trial court's decision in Bouhayer v. Georgalis, 169 Misc.2d 779 (Sup Ct Queens County 1996). The court in Bouhayer excused demand in a derivative suit for fraud, conversion and waste brought by a majority of the board's directors against the minority, as "serv[ing] no useful purpose, since [if the court dismissed the suit] all that the plaintiffs need do is meet, vote and recommence the action" as a direct action in the corporation's name. Justice Emerson declined to follow Bouhayer, stating that it has not been followed by other courts and that it is contrary to the demand-futility test established in Marx v. Akers.

The outcome is no different, Justice Emerson finds, even assuming a four-member board inclusive of S4. As the court explains:

On the other hand, if [S4] is a director of South Shore Dredging, as [S3] contends, the plaintiffs would have to show that [S4] is dominated or controlled by [S3] and that the board is deadlocked. The plaintiffs have made no such showing. Allegations of wrongdoing and control must be made with particularity and conclusory allegations are insufficient to circumvent the requirement of a demand. The plaintiffs simply allege that [S3] is in the process of buying [S4's] shares. Such conclusory allegations, without more, are insufficient to establish domination or control of [S4] by [S3]. Accordingly, the complaint is dismissed insofar as it asserts claims derivatively under Business Corporation Law §626. [Citation omitted.]

The defendants also moved to dismiss the plaintiffs' causes of action under BCL §§719 and 720 for failure to plead a valid claim. Justice Emerson's decision agrees with defendants that the allegations of financial misconduct do not fall within the narrow categories of claims specified in BCL §719, and she accordingly dismisses the plaintiffs' claims to the extent brought under that statute.

The plaintiffs fare better under §720. Justice Emerson finds that the complaint's allegations of defendants' trespass, conversion, waste and misappropriation of Dredging's assets adequately plead claims for an accounting and other relief available for director and officer misconduct under §720, and that these claims sounding in breach of fiduciary duty are alleged with sufficient particularity to satisfy §3016 of the Civil Practice Law and Rules.

Why, you may ask, are the plaintiffs in Gillette permitted to pursue claims under §720 for recovery on behalf of Dredging even though they did not satisfy the pre-suit demand requirement? It's because §720(b) expressly authorizes suit by an officer or director, as well as by a receiver, trustee in bankruptcy, creditor or shareholder. It's typical in suits between owners of close corporations, where the parties also serve as officers and directors, for the plaintiffs to sue in dual capacities, i.e., as shareholders and as officers/directors, to avoid any dispute over their standing and to take advantage of the express remedies in §720, and also to take advantage of the potential award for counsel fees available in shareholder derivative suits brought under BCL §626.

What Does Chancellor Strine's Auriga Capital Decision Teach Us About Fiduciary Duties of New York LLC Managers? (Part Two)

Peter A. Mahler — Mon, 13 Feb 2012 06:00:00 -0500

[This is the second of a two-part series on the basis for imposition of fiduciary duties on LLC managers. Part One (read here) reviewed a recent Delaware Chancery Court decision in which Chancellor Leo Strine, Jr. formulated that court's most comprehensive statement to date on the subject. Part Two compares New York's framework for holding LLC managers responsible as fiduciaries.]

While not without its critics (read here Widener Law Professor Ann Conaway's commentary), the core of Chancellor Strine's opinion last month in Auriga Capital v. Gatz presents an elegantly straightforward analysis of fiduciary duties of Delaware LLC managers. Simply stated, the Delaware LLC Act expressly in §18-1104 and impliedly in §18-1101 incorporates traditional default duties of loyalty and care to which LLC managers must adhere except to the extent such duties are modified or eliminated in the members' LLC agreement.

Chancellor Strine's use of a statutory launching pad to explore fiduciary duties of Delaware LLC managers invites a similar approach to the question of New York LLC manager fiduciary duties. Starting with the statute also makes sense given the LLC's relatively recent birth as an entirely new, hybrid species of business entity whose DNA comes entirely from its legislative parentage, without any common-law ancestry.

Before looking at the New York statutory scheme, which I'll follow with a brief look at New York case law, permit me to offer the following caveat. I've yet to come across judicial opinion or other legal scholarship that offers, à la Auriga, a comprehensive analysis of New York statutory and case law analyzing and defining the fiduciary duties of LLC managers. Such examination of this complex question is far beyond the scope of this post which merely attempts to identify the pieces of the puzzle, not to solve it.

Comparison and Analysis of New York's LLC Law

In Auriga, Chancellor Strine begins his statutory analysis by observing that the Delaware LLC Act has no affirmative provision expressly imposing fiduciary duties on LLC managers. Rather, he looks primarily to §18-1104 of the Act, providing that "[i]n any case not provided for in this chapter, the rules of law and equity . . . shall govern," to conclude that the Act incorporates default duties of loyalty and care upon managers whose exercise of discretionary powers to direct the LLC's affairs qualify them as fiduciaries under "traditional principles of equity." The court's resulting construction creates a coherent interplay between traditional equity principles, statute, and the LLC agreement.

New York's LLC Law has a radically different footing that, at first glance anyway, raises interesting questions about the source and scope of manager duties. Not only does the LLC Law have no analog to §18-1104 of the Delaware LLC Act, it contains in subsection (a) of LLC Law §409, entitled "Duties of Managers," an affirmative, mandatory statement of the LLC manager's duties:

A manager shall perform his or her duties as a manager, including his or her duties as a member of any class of managers, in good faith and with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances.

Taking our cue from Auriga, the threshold questions presented by §409(a) are twofold.

First, under generally applicable canons of statutory construction, what impact does the mandatory provision have on the application of traditional equity principles of fiduciary duty in resolving claims brought against LLC managers? I see three possible answers:

The legislature's positive articulation of mandatory manager duties displaces entirely the imposition of traditional common-law fiduciary duties.
The provision by its terms incorporates (channels) the traditional common-law fiduciary duties.
The provision sets forth non-exclusive duties that courts are free to supplement with the traditional common-law fiduciary duties.

Second, what duties does §409(a) impose? If we parse the language of the statute, it requires a manager (1) to "perform his or her duties" (2) "in good faith" and (3) "with that degree of care that an ordinarily prudent person in a like position would use under similar circumstances."

The first clause mentions "duties" without defining them. Did the legislature intend that "duties" means the traditional duties of loyalty and care? That seems unlikely given the third clause which clearly references and defines the traditional duty of care. None of the clauses specifically refers to the other traditional fiduciary duty, i.e., the duty of loyalty. This omission potentially is significant given that the vast majority of fiduciary breach claims against persons who control closely held business entities, including LLCs, is based on allegations of self-interested conduct at odds with the duty of loyalty.

Does the second clause's reference to "good faith" implicate the duty of loyalty? It's a question that, in the context of corporate directors' duties, has generated much controversy in the case law (particularly in Delaware) and much debate in academic circles. The late Professor Ribstein described good faith as "a distinct set of non-fiduciary duties that are applied to people who may, or may not, also be fiduciaries," such as a director's duty to assure that "transactions are based on adequate information." A February 2009 Harvard Law School paper co-authored by Chancellor Strine, called "Loyalty's Core Demand: The Defining Role of Good Faith in Corporation Law," characterized the duty of good faith as "a subsidiary component of the duty of loyalty" and "as the key element in defining the state of mind that must motivate a loyal fiduciary." Neither description seems to suggest that the words "good faith" standing alone equate with the duty of loyalty.

Are there other provisions of the LLC Law that shed light on the scope of manager duties mandated by §409(a)? Recall that in Auriga, Chancellor Strine looked at the Delaware LLC Act's fiduciary-out and exculpation provisions in subsections (c) and (e) of §18-1101, respectively, and found by implication that they supported the imposition of default fiduciary duties of loyalty and care. The only comparable provision in the New York LLC Law is §417(a), which authorizes the operating agreement to eliminate or limit the personal liability of managers to the LLC or its members "for damages for any breach of duty in such capacity" except when the manager's action or omission involved bad faith, intentional misconduct, knowing violation of law, or the manager gained an unlawful profit or financial advantage. Since this provision merely refers to "breach of duty in such capacity," however, it's hard to see how it adds anything to our understanding of the scope of manager duties mandated by §409(a).

If, however, we step away from a purely textual analysis of the statute, the answer to this riddle may lie in §409(a)'s derivation. Its operative language was lifted verbatim from New York Business Corporation Law §717(a) entitled "Duty of Directors." In Foley v. D'Agostino, 21 AD2d 60 (1st Dept 1964), the court construed the directors' duties under §717(a) as inclusive of the duty of loyalty, stating:

[Directors] may not assume and engage in the promotion of personal interests which are incompatible with the superior interests of their corporation. (See 19 C. J. S., Corporations, § 761, and cases cited.) "Officers and directors of a corporation owe it to their undivided and unqualified loyalty. * * * They should never be permitted to profit personally at the expense of the corporation. Nor must they allow their private interests to conflict with the corporate interests. These are elementary rules of equity and business morality. Courts of equity must ever enforce strict compliance with these rules."

Sixteen years after Foley, in Limmer v. Medallion Group, Inc., 75 AD2d 299 (1st Dept 1980), the same court cited BCL §717(a) for the proposition that "directors and officers are bound by their duty of undivided and unqualified loyalty to their corporations, a duty which encompasses good faith efforts to insure that their personal profit is not at the expense of their corporations."

Based on these and similar precedents decided before 1994, when the New York legislature enacted the LLC Law, it may be reasonable to assume that the legislature's verbatim incorporation of BCL §717(a)'s operative language in LLC Law §409(a) carried with it the duty of loyalty, consistent with the former statute's authoritative judicial interpretation. However, the analysis may have at least one glitch, namely, BCL §720, which authorizes an action against directors and officers for misconduct, states in subsection (c) that "[t]his section shall not affect any liability otherwise imposed by law upon any director or officer" (italics added). The LLC Law has no similar provision.

Cases Applying LLC Law §409(a)

As noted above, I haven't found any New York cases that offer a critical analysis of LLC manager fiduciary duties, such as the one undertaken by Chancellor Strine in Auriga. Instead, the cases I've found seem to share a common, uncritical assumption that traditional fiduciary duties of loyalty and care apply to managers of New York LLCs, based on explicit analogy to the fiduciary obligations traditionally imposed on partners and corporate officers and directors.

The analogies have a surface appeal, but perhaps not if we keep in mind, as Justice Leonard Austin wrote in the 1545 Ocean Avenue case involving judicial dissolution of LLCs, that "[l]imited liability companies thus fall within the ambit of neither the Business Corporation Law nor the Partnership Law."

One of the first, and most frequently cited, New York appellate decisions addressing LLC manager fiduciary duties is Blue Chip Emerald LLC v. Allied Partners, Inc., 299 AD2d 278 (1st Dept 2002), in which the court reinstated a complaint against the manager of a real estate holding LLC that bought out the minority member's interest without disclosing that it had received a third-party offer to purchase the property at a substantially higher valuation. The decision does not even cite §409(a), and instead relies on classic statements of fiduciary duties under New York corporate and partnership law, including quotations from Meinhard v. Salmon. What's also odd about Blue Chip is that the subject LLC was formed in Delaware, although it's nowhere mentioned in the opinion.

There are a number of subsequent appellate decisions addressing LLC manager duties that explicitly mention or quote §409(a), but with little or no further analysis. Examples include Nathanson v. Nathanson, 20 AD3d 403 (2d Dept 2005) (self-dealing); Salm v. Feldstein, 20 AD3d 469 (1st Dept 2005) (non-disclosure of third-party offer for LLC assets); Out of the Box Promotions, LLC v. Koschitzki, 55 AD3d 575 (2d Dept 2008) (diversion of company assets); and Cottone v. Selective Surfaces, Inc., 68 AD3d 1038 (2d Dept 2009) (waste, mismanagement and self-dealing).

As a reward for readers who've made it this far, by clicking here you can access a chronological list I prepared with citations to about 20 cases, including some federal court cases, involving fiduciary breach claims against managers of New York LLCs. The citations are followed by the pertinent excerpts from the decisions. If any readers know of any other such cases, please post a comment or email me with the citation, and I'll be glad to update the list.

What Does Chancellor Strine's Auriga Capital Decision Teach Us About Fiduciary Duties of New York LLC Managers? (Part One)

Peter A. Mahler — Mon, 06 Feb 2012 06:00:00 -0500

[This is the first of a two-part series on the basis for imposition of fiduciary duties on LLC managers. This first post examines a recent Delaware Chancery Court decision that is required reading on the subject. Part Two (read here) compares New York's framework for holding LLC managers responsible as fiduciaries.]

Delaware's Chancery Court, generally regarded as the country's premier business court, undeniably has had great influence over the development of New York's corporate law jurisprudence. As I see it, the influence drivers are twofold. First, New York judges decide many cases involving the internal affairs of New York-based Delaware corporations, to which they must apply Delaware statutory and case law. Second, the steady output and, more importantly, the consistent, unsurpassed depth and quality of the Chancery Court's opinions on corporate law issues create a gravitational tendency for attorneys and judges in New York to look to Delaware case law for guidance in deciding difficult cases under New York's corporate laws.

This tendency already is seen at work in the relatively undeveloped jurisprudence for limited liability companies (LLCs) which have existed in Delaware and New York only since 1992 and 1994, respectively. For instance, in a 2010 decision by the Manhattan-based Appellate Division, First Department, the court relied on Chancery Court precedent in construing manager indemnification rights under New York's LLC Law (read here). More significantly, the Brooklyn-based Appellate Division, Second Department's 2010 decision in the 1545 Ocean Avenue case, in which the court redefined the standard for judicial dissolution of LLCs, drew heavily on the contract-based approach formulated by the Chancery Court (read here).

One very important area of LLC jurisprudence that, so far, has garnered scant analysis by New York courts is fiduciary duty of LLC managers. Identifying the source, contours and beneficiaries of an LLC manager's fiduciary duty is no simple affair, given the LLC Law's sparse legislative history, it's amalgam of provisions drawn from corporate and partnership statutes, and its novel structure largely as a set of default rules subject to contractual modification.

A decision last month by Chancery Court's top judge, Chancellor Leo E. Strine, Jr. (pictured), in Auriga Capital Corp. v. Gatz Properties, Inc., Slip Op., C.A. 4390-CS (Del. Ch. Jan. 27, 2012), may spur the kind of analysis of LLC manager fiduciary duty that so far has eluded New York decisional law. The case involves a dispute between the minority and controlling members of a Delaware LLC structured as a holding company for a long-term ground lease for a golf course in Riverhead, New York, known as the Long Island National Golf Club. In his 74-page post-trial decision awarding damages against the LLC's manager, who engineered a sale of the LLC's assets to himself on highly unfair terms, Chancellor Strine holds that the manager of a Delaware LLC by default owes traditional duties of loyalty and care to minority members unless such duties are explicitly modified or eliminated by the operating agreement.

The decision exhibits the usual thoroughness, scholarship, wit and linguistic dexterity that has come to characterize Chancellor Strine's writings. What interests me most about the decision is not its holding, which is consistent with a number of prior Chancery Court rulings on LLC manager fiduciary duty, but the analytic framework Chancellor Strine uses to identify the source of the duty (i.e., common law, the LLC Act, or the operating agreement) and to determine the means and extent to which the members may alter or eliminate the manager's default duty. These issues are no less important in analyzing fiduciary duty of the New York LLC manager recognizing, however, that Delaware's LLC Act and New York's LLC Law diverge in certain aspects that may or may not be important.

The Auriga Decision

I won't lay out in detail the facts in Auriga, and I won't cover all the issues addressed in the decision. For readers who want a broader treatment, I recommend Francis Pileggi's post on Auriga here. Also, Doug Batey comments on Auriga here.

In a nutshell, a number of investors took a minority position in Peconic Bay, LLC which was formed to hold the ground lease and develop a Robert Trent Jones-designed golf course on land owned directly or indirectly by Williams Gatz, who also held the majority interest and was sole manager of Peconic Bay. Gatz brought in a golf course operator under a sublease with a minimum 10-year term. After only a few years it became obvious that the operator was not interested in making the course a success and would not renew the sublease. Instead of finding a new strategic option for Peconic Bay that would protect its investors, Gatz, realizing that the land could be developed more profitably as a residential community, discouraged third-party offers to take over the golf club operations, made a (rejected) low-ball bid to buy out the minority investors, and eventually conducted a sham auction for the LLC at which he was the only bidder, with a "winning" bid of $50,000 in excess of the LLC's debt on which Gatz was a guarantor.

The minority investors sued for damages, contending that Gatz breached his contractual and fiduciary duties. Gatz's defenses boiled down to his contentions, first, that Peconic Bay's operating agreement displaced any fiduciary obligations that otherwise might exist under equitable principles and, second, that as majority member he was free to pursue his own, selfish interests even to the detriment of the minority members.

The heart of Chancellor Strine's fiduciary duty analysis appears on pages 15 to 27 of his slip opinion. Here's a summary of the salient points:

The Delaware LLC Act (the "Act"), similar to the Delaware General Corporation Law ("DGCL"), contains no statement that the traditional fiduciary duties of loyalty and care apply by default to managers or members. (Page 16)
However, the Delaware Supreme Court, in its 1971 ruling in Schnell v. Chris-Craft, rejected an argument that such absence in the DGCL displaced "equitable fiduciary duties" owed by corporation directors, "stating famously that 'inequitable action does not become legally permissible simply because it is legally possible.'" (Page 16)
Application of "fiduciary duties grounded in equity" to LLC managers has an even stronger, statutory justification as reflected in §18-1104 of the Act providing that "[i]n any case not provided for in this chapter, the rules of law and equity . . . shall govern." (Pages 16-17)
Under traditional principles of equity, "a manager of an LLC would qualify as a fiduciary of that LLC and its members" because "the manager is vested with discretionary power to manage the business of the LLC." (Pages 17-18)
Because the Act provides for principles of equity to apply, and because fiduciaries owe traditional duties of loyalty and care, "the LLC Act starts with the default that managers of LLCs owe enforceable fiduciary duties." (Page 19)
The Act, when adopted in 1992, provided that fiduciary duties could be "expanded or restricted" by the operating agreement. Following a Delaware Supreme Court ruling construing the state's limited partnership statute concerning default fiduciary duties, the legislature in 1994 amended the Act (1) by amending §18-1101(c) to permit the "elimination" of fiduciary duties in an LLC agreement, and (2) by providing in §18-1101(e) for full contractual exculpation for breaches of fiduciary duty, except for the implied contractual covenant of good faith and fair dealing. If equitable fiduciary duties did not apply in the first instance by default, there would have been no need for the legislature to provide for the elimination of, and exculpation for, something that did not exist. (Pages 19-20)
While the statute "incorporates equitable principles" that "view the manager of an LLC as a fiduciary" and subject the manager by default "to the core fiduciary duties of loyalty and care," the statute in §18-1101(c) "allows the parties to an LLC agreement to entirely supplant those default principles or to modify them in part." The courts will give effect to the parties' contract choice, but when "the core default fiduciary duties have not been supplanted by contract, they exist as the LLC statute itself contemplates." (Page 21)
The non-waivable, statutory duty of good faith and fair dealing serves a limited purpose as an "equitable gap-filler" for express contractual terms. It does not address a "potential for managerial abuse" and does not delimit a manager's fiduciary obligations. (Pages 22-23)
The "eradication of the explicit equity overlay in the LLC Act could tend to erode [Delaware's] credibility with investors in Delaware entities" who, as a result of the legislative amendments to the Act, reasonably expect that managers of Delaware LLCs owe fiduciary duties of loyalty and care except to the extent the LLC agreement says otherwise. (Pages 24-27)

Chancellor Strine goes on to find that the express terms of Peconic Bay's operating agreement neither eliminate Gatz's traditional fiduciary duties nor exculpate him from the breach of those duties. He notes that the agreement contains no general statement that the manager's duties are limited to those set forth in the agreement, i.e., the agreement does not displace the traditional fiduciary duties of loyalty and care owed to the LLC and its members. Chancellor Strine also relies on a section of the agreement which prohibits the manager from engaging in self-dealing transactions without the minority members' consent except on terms and conditions "of similar agreements which could be entered into with arms-length third parties." This provision, Chancellor Strine writes, "reaffirm[s] that a form akin to entire fairness will apply to" Gatz's purchase at auction of the LLC.

After finding that Gatz's entire course of conduct, beginning with his failure to pursue strategic alternatives for the benefit of all the LLC members when he realized that the golf club operator would not renew its sublease, and ending with the "sham" auction at which Gatz acquired the LLC essentially for the amount of its debt, constituted a breach of Gatz's fiduciary duties of loyalty and care, Chancellor Strine awarded the plaintiffs damages of about $776,000 representing the return of their capital investment plus a 10% return. He also awarded 50% of plaintiffs' attorneys' fees and costs under the bad-faith exception to the American Rule. In my favorite line from the decision, in footnote 184, Chancellor Strine admonishes Gatz and his counsel that, should they contest the amount of fees incurred by plaintiffs' counsel, they "should remember that it is more time-consuming to clean up the pizza thrown at a wall than it is to throw it."

A Toxic Mix of Family and Business

Peter A. Mahler — Mon, 30 Jan 2012 06:00:00 -0500

It's not surprising that the ancient adage, "Never mix family and business," is more honored in the breach than the observance. After all, as the late Professor Larry Ribstein observed in his terrific 2010 research paper entitled "Close Corporation Remedies and the Evolution of the Closely Held Firm" (reviewed here):

The earliest small firms were partnerships, which began as intimate, usually family, relationships. They were referred to as 'compagnia,' which means those sharing bread, reflecting their origins in households. Kinship ties were an important mechanism for controlling agency costs. As Kerim told James Bond in From Russia with Love, "all of my key employees are my sons. Blood is the best security in this business."

Blood may be the best security in some family-owned businesses, but in many others the same bonds of kinship and trust that induce family members to enter into a business association in the first place, when abused or perceived to be abused, can and often do instigate conflict, entropy, and ultimately the dissolution of the firm and destruction of family ties. In other words, the emotional ties that encourage family members to dispense with diligence and formalities when starting and operating a business can also drive them apart with even greater force when things go wrong, in no small part due to those very dispensations.

For this column I've chosen three recent, illustrative cases presenting dissolution and related claims involving family-owned businesses. The substantive issues in each case are interesting and informative, if not novel. I wasn't involved in any of the cases, so I can't really say to what extent the blood relations of the parties contributed to the outbreak of hostilities or the underlying problems. But I think it's fair to say that each case in its own way shows tell-tale signs of the dysfunctional circumstances and dissension peculiar to business divorce, family style.

The case summaries follow after the jump.

Billanti v. Billanti, Short Form Order, Index No. 4536-11 (Sup Ct Nassau County Dec. 15, 2011)

Billanti Casting Co., located in New Hyde Park, Long Island, is a family-owned business since 1955 servicing the jewelry industry. One of the founders, Joseph Billanti, eventually brought his children Frank and Rosemarie into the business. In 1992, Joseph, Frank, Rosemarie and Joseph's brother John (a co-founder of Billanti Casting) and John's wife as co-equal partners formed a general partnership called the Billanti Family Investment Partnership. The Partnership's purpose was to invest profits from Billanti Casting as venture capital in connection with potential expansion of the casting business, which never took place. The Partnership's assets consist of fixed income assets held with an investment firm and a loan made to Billanti Casting to cover a tax obligation. Starting around 2000, Rosemarie became head of the casting business while Joseph and John became less involved. Frank stopped working at Billanti Casting in 2008 apparently after losing a fight for control with his sister Rosemarie. Their father, Joseph, died in 2010.

In 2011, Frank brought suit for judicial dissolution of the Partnership under §63 of the Partnership Law based on his sister Rosemarie's alleged conduct including her exclusive control over its books and records, for an accounting, and for other relief concerning the Partnership and Billanti Casting. Rosemarie and the other defendants denied Frank's allegations of misconduct and opposed the request for dissolution of the Partnership.

In his decision earlier this month, Nassau County Commercial Division Justice Timothy S. Driscoll granted Frank's motion for summary judgment dissolving the Partnership, but not under Partnership Law §63 as requested. Because the Partnership has no agreement establishing its duration, Justice Driscoll explained, it "is a partnership at will, that may be dissolved at any time by any partner" under Partnership Law §62(1)(b). Frank's expression of his desire to dissolve the Partnership suffices without need for proof of other partner misconduct. Justice Driscoll also ordered the defendants to provide Frank with an accounting of the Partnership's assets and its affairs since commencement, and he appointed a receiver to direct the dissolution of the Partnership, the sale of its assets, the collection of all monies and the division of the proceeds.

Zekry v. Zekry, 2012 NY Slip Op 30104(U) (Sup Ct NY County Jan. 18, 2012)

In 2004, plaintiff Nicole Zekry and her husband, defendant Pinhas Zekry, formed David Ben Barouck Corp. to operate a hair salon, spa and cosmetology business on Columbus Avenue in Manhattan. They entered into a shareholders agreement which recited that Pinhas held a 60% stock interest in consideration of his payment of $283,680 and for his "know-how and managerial experiences, and infrastructure and availability of selling and work force and personnel, which he has invested in the corporation and in facilitating the construction of the premises." The agreement also recited that Nicole held a 40% stock interest for her payment of $189,120.

In 2008, after Nicole sued to dissolve their marriage, Nicole filed a complaint against Pinhas (read here) for fraud, breach of fiduciary duty and to reform the shareholders agreement to enlarge her stock ownership to 71.1% based on evidence that Pinhas only contributed about $77,000 at the inception rather than $283,680 as recited in the agreement.

In her decision issued earlier this month, New York County Justice Deborah A. Kaplan denied Nicole's motion for a summary judgment of equitable reformation of the stock percentages on the ground that the agreement by its terms did not condition Pinhas's share allocation based only on his payment of $283,680 "but also his personal investment in the business, including, inter alia, his knowledge and managerial experiences, his work force and personnel, and his facilitation of the construction of the premises." In other words, since the agreement did not provide for the division of share ownership based solely on the parties' respective initial capital contribution, Nicole failed to establish as a matter of law that Pinhas "fraudulently induced unilateral mistake regarding his capital contribution" such that their agreement "does not express the intended agreement" as a basis for reformation.

Kimelstein v. Kimelstein, 2011 NY Slip Op 32949(U) (Sup Ct Suffolk County Oct. 26, 2011)

The Van Depot, Inc. was formed in 1999 by brothers Jeffrey and Larry Kimelstein to operate a used car sales business in Lindenhurst, Long Island, on a lot owned by a second corporation also co-owned by the brothers.

Larry sued Jeffrey in 2008, claiming breach of an oral agreement by Jeffrey to pay Larry $350,000 in exchange for Larry's alleged 50% ownership interests in the two companies. Jeffrey denied Larry's ownership of shares in either company. In a February 2010 decision, Suffolk County Commercial Division Justice Emily Pines dismissed Larry's claims for breach of oral agreement and specific performance, denied Jeffrey's motion to dismiss the claim to impose a constructive trust, and granted Larry leave to amend his complaint to add a claim, among others, for corporate dissolution as an oppressed shareholder under §1104-a of the Business Corporation Law.

In her latest decision, Justice Pines summarized the contest as one "between brothers concerning the extent of their business relationship and what, if anything the Defendant's brother and the two corporate Defendants, in which Plaintiff claims ownership, owe the Plaintiff for his investment in time and sweat equity, following Plaintiff's departure from what may or may not constitute a closely held family business." In opposition to Jeffrey's motion to dismiss the amended complaint, Larry offered a number of checks from his brother allegedly representing partial payment for his shares, along with affidavits from non-party witnesses attesting that Jeffrey held Larry out to them as his equal partner in the family business.

Justice Pines agreed with Jeffrey to the extent of dismissing Larry's claims for breach of fiduciary duty and a formal accounting which were asserted individually instead of derivatively as required. Justice Pines nonetheless refused to dismiss Larry's claim for dissolution based on lack of standing because "there exists documentary evidence presented on both sides of this issue," and she allowed Larry to proceed with his equitable claims in the alternative. Finally, she also ruled that, should the court find that Larry has standing and proves oppression, the court is empowered "to order a less drastic remedy than dissolution, such as an accounting."

Forensic Accounting Helps Wins the Day in Oppressed Shareholder Stock Valuation Proceeding

Peter A. Mahler — Mon, 23 Jan 2012 06:00:00 -0500

A company's financial statements constitute the core data used by business appraisers to value shareholder equity in statutory appraisal proceedings triggered by dissolution petitions brought by oppressed minority shareholders.

In my experience, most small and medium sized closely held businesses do not have audited financial statements but instead rely on their outside accountant to prepare either a compilation or review report which merely compiles management's financial reports without any probing whatsoever (compilation) or employs a limited analysis of the company's accounting practices and other factors but without any data testing as would be done in an audit (review).

When using the income and market approaches to value a business, appraisers engaged as expert trial witnesses routinely make "normalizing" adjustments to the income statement (a/k/a Profit & Loss statement or "P&L") before applying a capitalization rate or market value ratios. For instance, the appraiser will eliminate extraordinary gains or losses, or may adjust officer/owner compensation to reflect reasonable compensation rates based on generally accepted industry surveys.

But beyond standard normalization, an expert appraiser using non-audited statements must determine whether the underlying income, expense, asset and liability data provided by management are reliable to a reasonable degree. Otherwise it's GIGO -- garbage in, garbage out.

That's where forensic accounting comes in, as nicely illustrated in a recent case decided by Queens County Commercial Division Justice Orin R. Kitzes in Matter of Adelstein (Finest Food Distributing Co. N.Y., Inc., 2011 NY Slip Op 33256(U) (Sup Ct Queens County Nov. 3, 2011).

Adelstein involves a family-owned distributor of specialty foods called Finest Food. It was started by the Adelstein brothers Sidney, Jack and Joel over 50 years ago as a pickle distributor and later became the largest distributor of Caribbean foods in the New York metropolitan area. By 2006, Sidney and Jack passed their interests on to their respective sons who, in 2009, terminated their uncle Joel's employment after he spurned their buy-out offer.

Joel initially sued his nephews for breach of contract and other claims which were dismissed in 2010. Shortly afterward he filed a petition for judicial dissolution of Finest under the oppressed minority shareholder statute, §1104-a of the Business Corporation Law (BCL). In August 2010, after Justice Kitzes denied the nephews' motion to dismiss the petition on various grounds (read here my post on the decision), Finest elected to purchase Joel's shares for fair value under BCL §1118. The court then held a valuation hearing featuring appraisal reports and testimony by the Company's appraiser, Brian Serotta, a CPA with no appraisal certifications, and Joel's appraiser, Paul Marquez, a CPA with an array of appraisal and financial forensic credentials.

The Company's Appraisal

Serotta submitted a 3-page report based upon his review of the company tax returns, the "sparse records" he found and conversations with the company's accountant and principals. He valued Finest using the capitalized income method only, with income adjustments to salaries, depreciation and loans to arrive at average normalized earnings of $206,000. Serotta computed a 20% capitalization rate (i.e., 5x earnings) that included specific company risk factors for limited management and its significant amount of business with the A&P supermarket chain which might end due to A&P's bankruptcy. Serotta also purported to apply a 20% marketability discount to arrive at a $230,000 value for Joel's one-third interest. I say purported because, as quoted in the decision, Serotta described what sounds suspiciously like a prohibited minority discount. Here's what he said:

[The 20% marketability discount was used because of the] difficulty finding somebody to buy a one-third interest. There's really no market. It's a privately-held company. Anybody who bought that one-third interest would conceivably have nothing to say about the company.

Joel's Appraisal

Justice Kitzes's decision describes in great detail the comparatively rigorous methodology used by appraiser Marquez whose $1,287,000 conclusion of value of Joel's one-third interest is 560% higher than the Serotta valuation. In a nutshell, the disparity derived mainly from (1) Marquez's determination of a weighted average net income of approximately $486,000 -- more than double Serotta's earnings base; (2) his application of a 12% capitalization rate (8.3x earnings) as compared to Serotta's 20%; and (3) his application of a 5% marketability discount based on estimated transaction costs.

Marquez's calculation of the company's dramatically higher earnings base illustrates forensic accounting at work. Marquez discovered that while the company's sales doubled in the years 2004 to 2010, from $5.1 million to $10.2 million, and its cost of goods sold grew commensurately, the gross profit margin oddly decreased in the last two years from 27.5% to 24%, at the same time the salaries of the two owner/officers went from zero to $500,000 annually. Critically, Marquez could find no reason for the gross profit margin to decrease when sales were significantly increasing, other than the existence of unreported sales.

Marquez tested his unreported-sales hypothesis by using a "stress test" to the sales invoices and other data. Here's how Justice Kitzes describes the process:

He compared what was being received and invoiced for sales versus what was being reported as paid for those goods. According to this test, the company had a gross margin of profitability of almost 35%, rather than the 25% reported by the Company in its tax returns. Based upon this differential in profitability, given a company like Finest with gross sales of approximately $10,000,000, the amount of unrecorded sales was likely to be approximately $1,000,000 in 2010. He also based this conclusion on his analysis of the sales invoices, truck manifests and tax returns which showed that the gross profit experienced by the company was higher than that being reported. Consequently, he made a correction in the gross profitability of the company based upon the imputed existence of unreported sales. He then imputed gross profit for the company at the industry-wide level of 35% rather than the lower level of 25% reported by Finest.

Marquez's forensic testing for unreported sales was bolstered by Joel's testimony that some of Finest's smaller chain store customers, as well as the many small bodegas it serviced, pay cash on delivery which is collected by the Finest truck drivers. According to Justice Kitzes's summary of Joel's testimony,

These cash sales are not computerized, but are contained in the salesmens' reports. According to [Joel] Adelstein, about twenty percent of the entire business consists of smaller stores which pay cash in this manner.

Marquez next capitalized the $486,000 earnings base at a 12% rate, which he arrived at as follows:

Risk Free Rate	4.43%
Equity Risk Premium	5.2%
Industry Risk Premium	(1.74%)
Small Stock Risk Premium	6.28%
Company Specific Risk Premium	0.5%
Long-Term Growth Rate	(2.7%)
Cap Rate	12%

Applying the 12% cap rate to the $486,000 earnings base produced an enterprise value of $4,051,862, to which Marquez assigned a 70% weight. As a "cross-check" on his valuation he utilized the merged and acquired method weighted at 30%, looking at private market sales transactions that have occurred within the industry of companies falling within the same or similar Standard Industrial Classification (SIC) code. Marquez used Pratts Stats to determine valuation multiples of revenues, gross profit and EBITDA (earnings before interest, taxes, depreciation and amortization), which ultimately indicated enterprise values fairly close to his capitalized value, ranging from $3,990,000 to $4,094,000.

The weighted values produced a control, marketable value for Finest of $4,063,800 which Marquez then discounted 5% for lack of marketability reflecting the low end of his estimate for transaction costs in the sale of a small business like Finest. This generated a "fair value on a non-marketable value basis" of $3,860,610 which in turn generated a value of $1,287,000 for Joel's one-third interest in Finest.

The Court's Decision

Justice Kitzes' decision highlights the crucial role of expert appraisals in a fair value proceeding, stating that "[i]n the case at bar, the valuation of Joel Adelstein's interest in Finest rests primarily on the credibility of the appraisers and the reliability of their valuation methods." Justice Kitzes further notes that "the extent of the witness's qualifications has a bearing on the weight to be given to his testimony."

Justice Kitzes concludes that appraiser Marquez's testimony and report "are credible and reliable" based on his valuation and financial credentials; his "thorough process of evaluation of Finest" which included a site visit, understanding the business and industry, interviewing management, and carefully selecting valuation approaches; carefully selecting evaluation factors such as the capitalization rate; having a knowledge of New York law relevant to valuations; and taking into consideration Joel's testimony concerning the "considerable cash business that would not be noted in the financial statements." Justice Kitzes sums up on the last point:

He [Marquez] also explained the indications in the financial statements that such unreported sales existed. Significantly, [Joel's] testimony regarding cash sales was not refuted by Respondents. In sum, the court finds that Marquez' valuation report is clear, thorough, professional and reliable.

Justice Kitzes then contrasts the report and testimony of Finest's appraiser who does not possess valuation credentials; prepared his 3-page report primarily relying on Finest's accountant; did not take into consideration the existence of cash sales; devised a discount rate that relied on Joel's minority interest in Finest; used a single method of valuation that was not checked against any other method; and in "an apparent contradiction," stated that the gross sales of Finest had more than doubled between 2004 and 2010 but claimed that the profitability of the company had been "basically flat." For these reasons, the decision goes on, "the court places diminished weight on the testimony and report of the Respondent's expert concerning the valuation of Finest" and finds that the value of Joel's interest in Finest is $1,287,000 -- the exact value indicated by Joel's expert.

Joel did not get everything he wanted, however. Justice Kitzes denies his request for an adjustment or surcharge against the other two owners in the sum of $863,000 for "salary, distributions and benefits" not shared with Joel. The requested adjustment, Justice Kitzes states, "functioned as a component of [Joel's] calculation of the fair value of his shares," presumably referring to normalization adjustments to the financial statements. In addition, Joel did not offer evidence that the salaries amounted to "willful or reckless dissipation" of company assets as required by the surcharge provision in BCL §1104-a(b)(2)(d).

Justice Kitzes also denied Joel's requests for an award of attorney's fees and for interest at 9% (the statutory rate) from the date of the filing of the dissolution petition. On the other hand, he denied the company's request for a 5-year pay-out of the valuation award and ordered entry of judgment for the full amount, stating that "an extended payout period is not warranted in view of the time that this valuation proceeding has been pending and the time that the Respondents have had to allocate funds for payment."

Adelstein is hardly the first valuation case in which the accounting for a company's cash receipts became an issue. Business appraiser Mark Warshavsky, who also frequently lectures on forensic accounting, tells me that "whenever you have a company with cash sales, employing analytical procedures to benchmark account balances for the years included in your valuation as compared to other company years or industry data, is an excellent forensic technique."

The forensic accounting done by Joel's expert, tying in the company's significant cash business to what was otherwise an anomaly in the financial statements, clearly resonated with the judge and, I can only speculate, cast a shadow on the company's entire appraisal from which it never emerged. It is a lesson every appraiser and lawyer in a valuation case should not forget.

Court Orders Dissolution of Unprofitable Real Estate LLC

Peter A. Mahler — Mon, 16 Jan 2012 06:00:00 -0500

Back in 2008, I wrote a couple of posts about the Youngwall case in which the court ordered involuntary dissolution of a commercial real estate limited liability company (LLC) owned 50/50 by two brothers who also were involved in a bitter dispute over their father's will, based on the personal animosity between the brothers and because the vacant building was losing money (read here and here).

Youngwall foreshadowed the landmark decision in 2010 by the Appellate Division, Second Department, in the 1545 Ocean Avenue case, which redefined the standard for judicial dissolution of LLCs under §702 of the LLC Law as requiring the petitioner to show "in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible."

I emphasize the disjunctive "or" in the quoted passage because the cases involving judicial dissolution petitions based solely on financially failing LLCs are few and far between, as opposed to the more common scenarios involving management and/or money disputes between members of otherwise profitable ventures. The explanation may well be that most business people don't like to pay lawyer's fees fighting over a corpse.

LLCs being the entity of choice for real estate holding companies, and the real estate market having remained in a slump the last four years, it was only a matter of time before another Youngwall case appeared. And so it has, in the form of Mizrahi v. Cohen, 2012 NY Slip Op 50030(U) (Sup Ct Kings County Jan. 12, 2012), decided last week by Brooklyn Commercial Division Justice Carolyn E. Demarest.

Mizrahi, like Youngwall, is a family feud between brothers-in-law -- one a dentist, the other an optometrist -- who in 1999 purchased a property in Brooklyn's Gravesend section and subsequently built a mixed-use building to house their own businesses and to rent to other tenants. They formed an LLC named 372-376 Avenue U Realty, LLC to own the property and entered into a written Operating Agreement as 50/50 managing members.

The LLC obtained mortgage financing, personally guaranteed by both members, for the purchase of the realty and construction of the four-story building which wasn't completed and occupied until 2006 when the original mortgage was refinanced in the sum of $4.7 million. The plaintiff dentist, Mizrahi, occupied a second floor office and the defendant optometrist, Cohen, occupied a smaller ground floor unit.

At the outset the two members contributed $100,000 each. The Operating Agreement required no additional capital contribution absent the members' unanimous consent. The Operating Agreement also generally provided for unanimous approval of "any matter coming before the Members."

Until 2003, the two members made additional capital contributions in equal shares to cover expenses. After 2003, Mizrahi made substantial, unmatched contributions and loans to the LLC. By the time of trial in 2011, Mizrahi's capital contributions totaled almost $1.2 million compared to about $300,000 for Cohen.

In 2010, Mizrahi filed a complaint seeking judicial dissolution of the LLC and asserting claims against Cohen for an accounting and damages for alleged embezzlement of LLC funds and failure to make his share of capital contributions.

Justice Demarest's analysis of the dissolution claim begins by citing 1545 Ocean Avenue and other cases for the proposition that "the court must look to the Operating Agreement to determine the rules applicable to the operation of a particular LLC" and that "[o]nly where the Operating Agreement is ambiguous, contrary to law or does not contain any provision for the particular matter at issue, do the statutory provisions of the [LLC Law] control."

Mizrahi centered his dissolution claim on Cohen's alleged failure to carry his "fair share" of the financial responsibility for the real estate business under the terms of the Operating Agreement. He also claimed, and Justice Demarest agreed, that Cohen breached fiduciary duty by withdrawing $230,000 that the LLC could ill afford as a loan to himself, after Mizrahi withheld his consent.

Cohen argued that the dissolution claim should be dismissed because the Operating Agreement limits the conditions under which the LLC can be dissolved to the members' unanimous consent or certain defined events of "involuntary withdrawal" by a member which were not present. Justice Demarest labeled the argument "specious," stating:

Such interpretation of the law would void the statutory provision for judicial dissolution pursuant to Section 702 of the LLCL in any situation in which an operating agreement provided for dissolution only on consent or at the end of a definite term of duration for the LLC, and would thus thwart the obvious legislative intent of LLCL §702, to provide a mechanism to equitably terminate a business relationship that is dysfunctional or abusive, without the consent of all of the members.

Justice Demarest instead posed the central question in the case as

whether plaintiff has borne his burden to demonstrate that it is impracticable to continue the operation of the LLC in light of Cohen's failure to provide needed financial support and his undermining of the LLC's financial integrity so as to warrant dissolution of the LLC.

The answer came largely from the LLC's accountant, who testified that the LLC consistently operated at annual losses totaling over $1.1 million in the years 2006 (when the building was first occupied) through the trial in 2011, which loss was covered by application of mortgage proceeds to the day-to-day operations of the LLC and by Mizrahi's capital contributions which prevented foreclosure on the property. Justice Demarest also credited the accountant's testimony that the monthly carrying charges for mortgage, taxes and building expenses totaling over $51,000 exceeded the rent roll by about $12,000 per month. Cohen's contention that the LLC "going forward" will show a profit, Justice Demarest commented, "appears to be based on speculation and wishful thinking."

Justice Demarest concluded that "given the significant losses sustained over the years, which were covered by plaintiff, it is not plausible that continuing the LLC, as presently constituted, is feasible." Under the Operating Agreement's terms, the plaintiff Mizrahi is under no obligation to continue making capital contributions to keep the LLC afloat. Justice Demarest's fuller explanation is worth reading:

In 1545 Ocean, the Appellate Court cautioned that "[d]issolution is a drastic remedy", not to be lightly ordered merely based upon disagreement, or even deadlock, among the members of the LLC, but that "where the economic purpose of the limited liability company is not met, dissolution is appropriate"(72 AD3d at 129-131). In the case here, the agreed purpose of the LLC is the development and management of a mixed-use building, presumably for the economic benefit of its members. That purpose was achieved by the construction and occupancy of the building, but the expected profit has not been realized and the building does not support the costs of its maintenance, including payment of the mortgage taken to finance the project. The deficit has consistently been financed unilaterally by plaintiff, who, under the terms of the Operating Agreement, cannot be liable for the debts of the LLC (Section 3.2). Defendant not only has failed to contribute equally in meeting the losses, but has affirmatively undermined the financial integrity of the LLC by withdrawing a substantial portion of his capital contributions, thus evidencing his inability or unwillingness to permit or promote the purpose of the LLC. Under these circumstances, it is only a matter of time, should plaintiff choose to exercise his right to refrain from making additional capital contributions or loans to the LLC, before the LLC will default upon its mortgage and the mortgage will be foreclosed, thus eliminating the sole purpose of the LLC. Accordingly, plaintiff has established that continuing the LLC is financially unfeasible and that the LLC should be dissolved. (See Mehraban v McIntosh, 2011 WL 486101, p.3 [Sup St, Nassau Co., 2011]).

The plaintiff also contended that, upon dissolution, he should be allocated a greater than 50% interest in the LLC proportional to his capital contributions and should be permitted to purchase Cohen's diminished interest. The plaintiff relied on Matter of Superior Vending, about which I wrote here, where the court ordered an equitable "liquidation" by means of requiring one member of the LLC to pay the other an amount equal to his investment in the LLC plus interest. Justice Demarest didn't buy it, distinguishing the two cases as follows:

Superior Vending involved a limited liability company formed to acquire and operate a vending machine company. The business had been originated by one of the members through his own corporation and was expanded to a second company through investments made by the other member three years later. No operating agreement was ever executed and the relationship of the LLC members terminated after two years, but the LLC continued to operate under the management of the original member. An initial effort to dissolve Superior Vending was abandoned by the departing member, but a new petition was brought three years later to recover his share of the assets and interim distributions. Unlike the case here, the members consented to dissolution and had severed their mutual operation of the business years prior to the litigation. Because one member had continued to operate, and had expanded, the business in the intervening years, the court found it appropriate, after determining the departing member's right to recovery on his investment, to permit the remaining member to purchase, or buy-out, the other member's interest for that sum, notwithstanding the absence of a provision for such relief in the LLCL. As is apparent from the stated facts of that case, the equities of the Superior Vending case differ from the circumstances at bar in which both members have remained active in the operation of the LLC and there has been no hiatus in their joint participation, other than that created by plaintiff's removal of the bank account from access by defendant.

The Mizrahi opinion, besides ordering dissolution and appointing the company accountant to perform an accounting, addresses a number of other interesting factual and legal issues, so do yourself a favor and read it in its entirety.

An Ill-Fated Solution to an Ill-Fated Buy-Sell Agreement

Peter A. Mahler — Mon, 09 Jan 2012 06:00:00 -0500

Let's face it: If you have a close corporation shareholders' agreement or LLC operating agreement including a buy-sell provision with a fixed share price that's supposed to be updated periodically, there's a good chance you (or your estate) are in for a nasty fight when the buy-out is triggered by the death, disability or retirement of one of the owners. Why so? Because more often than not the owners never update the agreed share price, so that when a buy-out is triggered many years later, the last agreed value no longer reflects a fair value for the ownership interest due to the growth (or decline) of the business in the interim, e.g., the Nimkoff case about which I wrote here.

Many such buy-sell agreements include an alternative valuation method when the agreed price -- often memorialized in a so-called Certificate of Value appended to the shareholders' agreement -- is not updated within a stated number of years before the trigger event, such as using an appraiser to perform a current evaluation. Such alternatives are no panacea, however, especially when the agreement fails to specify valuation parameters including the standard of value (e.g., fair market value, fair value, book value) and level of value (e.g., controlling, marketable minority, nonmarketable minority). The Sassower case, about which I wrote here and here, is a textbook illustration of the litigation woes that can follow when the buy-sell fails to articulate relevant valuation parameters.

If there's anything worse than failing to specify standards for the alternative valuation, it's providing no alternative, as when the buy-sell mandates use of the stale fixed price, which brings us to this week's featured case, DeMatteo v. DeMatteo Salvage Co., 2011 NY Slip Op 09586 (2d Dept Dec. 27, 2011).

DeMatteo is a poster child for all that can go wrong with a poorly designed buy-sell agreement. DeMatteo Salvage Co. is a Long Island based, family-owned business since the 1920's, designing and installing machinery and equipment for scrap paper and solid waste customers. In 1966, siblings Domenick, Edward, Carmine and Joseph DeMatteo entered into mirror image buy-sell agreements for DeMatteo Salvage and a second company they owned called E&J Holding Corp. The agreement requires the estate of a deceased shareholder to sell, and the companies to buy, the decedent's shares at a fixed price. The agreement does not require that the agreed value be updated periodically. Rather, it merely provides that the agreed price "may be redetermined at any time by mutual agreement of the Corporation and the Stockholders" and then goes on to specify that the failure to redetermine value for however long does not disable the last, agreed value:

The last value established preceding the death of a Stockholder shall be the value of his stock for purposes of this agreement. This provision shall not be altered by the fact that the Corporation and the Stockholders for any reason have failed to redetermine such value at any time or from time to time. All redeterminations of value shall be endorsed upon Schedule A hereof, dated and signed by the Corporation and the Stockholders.

Fifteen years later, in 1981, Schedule A was formally endorsed with new values of $7,500 per DeMatteo Salvage share and $10,000 per E&J share. Although Schedule A thereafter never was amended, on several occasions in 1984-86 there were shareholder meetings whose minutes reflected redetermined values, the last of which set per-share prices of $20,000 for DeMatteo Salvage and $37,500 for E&J.

Further muddying the issue, minutes of a shareholder meeting in March 1992 reflect a resolution to "table" the re-evaluation of the shares until October 1992, and to keep the previously set values of $66,197 per DeMatteo Salvage share and $66,666 per E&J share. (The court decisions don't reveal when those share values were set or how they were recorded.)

It appears that all of these share re-evaluations were done by the shareholders themselves without the assistance of an appraisal professional.

The eldest brother, Joseph, died sometime before 2000, which sparked the first buy-out litigation culminating with a settlement that forced the surviving three siblings to borrow funds to pay the estate. In April 2000, apparently hoping to avoid a repeat, the three surviving shareholders adopted a formal resolution stating "that the values for the shares of stock in both corporations [are] voluntarily canceled at their present value" and that "Paul Iadanza at the office of Delle Fave & Tarasco, has been retained to value both corporations."

Edward DeMatteo died two years later, in June 2002. In the interim, for reasons never made clear to the court, the designated company accountant, Mr. Iadanza, did not perform the evaluations authorized by the April 2000 resolution.

Thus began an 8-year litigation saga, commencing in 2003 when Edward's widow, Gloria, as executrix, sued DeMatteo Salvage and E&J to enforce a buy-out of the Estate's shares based on what she claimed was the last validly determined value of approximately $66,000 per share for each company based on the March 1992 resolution.

In 2004, Gloria moved for summary judgment on her buy-out claim at $66,000 per share. The companies, now owned by the two surviving siblings, cross moved for summary judgment based on what they claimed were the last valid determinations of value, namely, the 1981 endorsements on Schedule A at $7,500 per DeMatteo Salvage share and $10,000 per E&J share.

In a decision and order dated February 8, 2005, Suffolk County Commercial Division Justice Elizabeth Hazlitt Emerson concluded there were factual issues precluding a summary determination of the buy-out price. In so ruling, she found that the 1992 resolution was not binding because Dominick DeMatteo was not present at the meeting and because the values were not endorsed on Schedule A. She also found that the 1984-86 re-evaluations evidenced the siblings' intent to redetermine the value of their stock after the 1981 valuation, but that they were not conclusive as to "whether [the shareholders] took all steps necessary to redetermine the value in accordance with the buy/sell agreements."

At some point during the litigation, Mr. Iadanza prepared current appraisals of both companies, reporting values not disclosed in the court's decisions other than mentioning that they were less than the values adopted in the 1981 endorsements to Schedule A. The surviving siblings thereupon sought to enforce a buy-out based on Mr. Iadanza's valuation. In June 2009, Suffolk County Commercial Division Justice Emily Pines held a framed-issue hearing at which the surviving siblings testified that their deceased brother, Edward, drafted the April 2000 resolution and specifically chose Mr. Iadanza to perform new valuations, and that all the siblings agreed to accept Mr. Iadanza's valuations in lieu of the prior valuations over which there had been years of litigation following Joseph's death.

In her decision dated July 2, 2009, Justice Pines credited the surviving siblings' testimony and granted them summary judgment to the extent of finding that they and Edward agreed in April 2000 to scrap the prior valuations and to be bound by new valuations as of that date to be performed by Mr. Iadanza. As Justice Pines further explained:

While [Gloria's] counsel has suggested that the Iadanza evaluation that was in fact performed should not be accepted as it was lower than the one set forth by the shareholders themselves in 1981, clearly that was part of their purpose in enacting the 2000 resolution; i.e., for the valuation to reflect a number which would not place the corporations in extremis when the estate of the next shareholder was entitled to payment. They made the decision consciously with the imprimatur of [Edward] who chose the evaluator.

However, since the valuations prepared by Mr. Iadanza valued the companies as of a date some years after April 2000, Justice Pines also ordered him to prepare new valuations as of April 2000.

Approximately one year later, in August 2010, Justice Pines entered judgment based on Mr. Iadanza's new valuation reports, awarding Edward's estate the sum of approximately $500,000 for his combined interests in both companies based on an aggregate valuation of both companies of approximately $1.3 million.

Both sides thereafter appealed to the Appellate Division, Second Department which in its December 27, 2011 order, reduced the award to Edward's estate by approximately $100,000. The appellate court found that Justice Pines should not have disregarded minority and marketability discounts applied by Mr. Iadanza to the value of one of the company's shares (the decision does not specify which company), thereby reducing the per-share value for that company by a combined 30% discount, from $12,379 to $8,665. By the way, the fact that the parties litigated the applicability of discounts tends to confirm the fact that the April 2000 resolution authorizing an appraisal by Mr. Iadanza was silent concerning standards and levels of value.

Gloria's appeal argued that, pursuant to the April 2000 resolution, the shareholders did not intend to be bound by Mr. Iadanza's new report, but the appellate court declined to reach the issue on procedural grounds based on that court's dismissal of Gloria's previous appeal from Justice Pines' July 2009 decision for failure to prosecute.

[Note: The buy-sell agreements provided for the companies to procure insurance policies on the lives of the shareholders for the purchase of their shares. In September 2006, Gloria won a prior appeal to the Second Department which ordered the companies to pay Edward's estate approximately $440,000 in life insurance proceeds (read here). It's not clear if that amount is in addition to, or is applicable in satisfaction of, the lesser sum awarded in the recently decided appeal.]

Between the first buy-out litigation following the eldest brother Joseph's death, and the second lawsuit started by Gloria after Edward's death, the DeMatteo family has been warring in the courts over the value of the companies' shares for more than a decade. Whatever one thinks of the outcome, what's absolutely clear is that the buy-sell agreement failed miserably, both in its design and its implementation, in its intended purpose to ensure family control of the businesses while providing the shareholders' heirs with a measure of financial security based on a consensual, non-litigated, fair valuation of the companies' equity.

It was a mistake to design the buy-sell agreement without requiring periodic updates.
It was a mistake to design the buy-sell agreement without providing an alternative valuation method when a buy-out event occurs more than a year or two after the last agreed valuation.
It was a mistake for the shareholders to come up with their own valuations over the years without seeking the guidance of a professional appraiser.
It was a mistake for the shareholders to agree to rescind the prior valuations in favor of obtaining a professional appraisal, and then not following through by having the professional perform the appraisal until long after the death of a shareholder, when the financial interests of the surviving shareholders and the deceased shareholder's estate became antagonistic.

Business appraiser and author Z. Christopher Mercer, a leading authority on buy-sell agreements, has described fixed pricing in a buy-sell agreement as a "ticking time bomb". The DeMatteo case is a powerful demonstration of the accuracy of Chris's warning.

Update January 14, 2012: Chris Mercer has written a post on the DeMatteo case on his highly informative blog, ValuationSpeak.

Top 10 Business Divorce Cases of 2011

Peter A. Mahler — Mon, 02 Jan 2012 06:00:00 -0500

I'm pleased to present my fourth annual list of picks for the past year's ten most significant business divorce cases. This year's crop includes rulings on substantive and procedural issues involving dissolution, buy-out, appraisal and fiduciary breach involving closely held corporations, limited liability companies, and professional corporations. All ten were featured in this blog previously; click on the case name to read the full treatment. And the winners are:

Matter of Supplier Distribution Concepts, Inc., 80 AD3d 869, 2011 NY Slip Op 00084 (3d Dept Jan. 6, 2011), presenting a fight over the proper venue for a corporate dissolution proceeding, in which the appellate court reversed an order departing from the statutory mandate requiring commencement of the proceeding in the judicial district correlating to the county in which the business is located as stated in its certificate of incorporation.
Matter of Darvish (Haslacha, Inc.), 2011 NY Slip Op 30134(U) (Sup Ct NY County Jan. 19, 2011), involving the liquidation and winding up of a real estate holding company by a receiver, in which the court rejected a shareholder's contention that the property must be sold at public auction rather than by private sale.
Matter of Giaimo (EGA Associates, Inc.), 31 Misc 3d 1217(A), 2011 NY Slip Op 50714(U) (Sup Ct NY County Apr. 25, 2011), a valuation proceeding involving a large portfolio of Manhattan apartment buildings, where the court applied a discount for built-in capital gains but refused to apply a marketability discount.
Centro Empresarial Cempresa S.A. v. America Movil, S.A.B. de C.V., 17 NY3d 269, 2011 NY Slip Op 04720 (Ct App June 7, 2011) and Arfa v. Zamir, 17 NY3d 737, 2011 NY Slip Op 04719 (Ct App June 7, 2011), a pair of highly important decisions by the Court of Appeals dismissing fiduciary breach claims between shareholders based on written releases given as part of the challenged transactions.

Matter of Bernfeld (Michael Bernfeld, D.D.S. and Yakov Kurilenko, D.D.S., P.C.), 86 AD3d 244, 2011 NY Slip Op 05071 (2d Dept June 7, 2011), a case involving a professional corporation dental practice in which the widow of a deceased majority shareholder was denied standing to seek judicial dissolution.
Gitlin v. Chirinkin, 32 Misc 3d 1226(A), 2011 NY Slip Op 51433(U) (Sup Ct Nassau County June 29, 2011), in which the court ruled that, in the absence of a formal withdrawal from membership, an inactive minority member of a limited liability company was entitled to his pro rata share of profits from the liquidation of realty assets.
Matter of Harlem River Yard Ventures, Inc., Decision and Order, Index No. 602341/07 (Sup Ct NY County July 11, 2011), a dissenting shareholder case in which the court endorsed a discounted cash flow method and rejected post-merger tax benefits in valuing the company's real estate holdings.
Barasch v. Williams Real Estate Co., 33 Misc 3d 1219(A), 2011 NY Slip Op 51979(U) (Sup Ct NY County Nov. 3, 2011), in which the court ruled in favor of a dissenting shareholder over the objection of the controlling shareholders who denied that a complex corporate reorganization triggered the right to dissent and seek appraisal.
Matter of Carson (Carrabasset Management Corp.), 2011 NY Slip Op 09063 (3d Dept Dec. 15, 2011), a case involving dueling dissolution petitions in which the appellate court held that the petitioner had no statutory buy-out right.
Roni LLC v. Arfa, 2011 NY Slip Op 09163 (Ct App Dec. 20, 2011), in which the New York Court of Appeals allowed plaintiffs to proceed on a complaint alleging breach of a fiduciary duty of pre-formation disclosure by the "promoter" of a limited liability company.